Description

Here’s an asset-value/turnaround opportunity for those of you who can invest in micro-caps. There is a surprising amount of liquidity for such a small market cap, and we’ve had no trouble establishing a meaningful position. PCIS was written up by Met99 in this forum in December of '03 at $3.75. We believe that it is a timely idea now due to the lower price and the incremental information regarding the company's business progress and prospects for 2005. One catalyst we don't mention is the potential value for PCIS in an acquisition, which is always a possibility for a company of this size. I refer you to Met99's piece for his thoughts on the potential attractiveness of PCIS to an acquirer.

Precis is a nationwide provider of healthcare savings programs and affordable health insurance designed for persons who are un-insured or under-insured. As you can imagine, this is a large and growing market – there were an estimated 43.6 million uninsured Americans in 2003, or 15.2% of the total population, up from 14.6% of the population in 2001.

It’s a large opportunity, but also a tough one. Precis faces the challenge of providing adequate solutions within an industry that’s in a state of flux and turmoil. In particular, 2004 marks a transition year as Precis lays the groundwork for moving beyond its traditional audience of individual consumers to also address the needs of cost-conscious employer groups. This investment in new opportunities is causing a drag on current profitability, which has weighed heavily on the stock. The stock recently dipped as low as $2.10, down from prices above $6 less than two years ago.

At the current price around $3.00, the stock is hovering just above its fully-diluted book value of $2.78. Notably, book value is growing as Precis has remained both profitable and free cash flow positive in the first two quarters this year. Furthermore, management is confident the company will remain free cash flow positive through year-end, after which Precis should begin to show the fruits of this year’s investment in pursuing business from employer groups.

As an investment opportunity, we think of Precis as an “intelligent speculation” with low downside and undefined but substantial upside. Asset value, including $9 million in net cash ($0.72/share), should help limit any permanent risk of capital loss. Downside risk is also minimized thanks to a recent share buyback authorization for 500,000 shares; from its announcement on July 8 until the 10-Q filing on August 16, the company had already repurchased 50,000 shares at an average price of $2.57. Finally, CEO Judith Henkels strikes us as a rational manager with a sensible vision for the company; and, as a 30% equity owner, she has serious skin in the game.

Background: Our Dysfunctional Healthcare System
Rising healthcare costs are central to the problem of inadequate coverage for practically anyone who is not employed by a large corporation. Between 2002 and 2003, monthly premiums for employer-sponsored health insurance rose 13.9%, marking the third consecutive year of double-digit premium increases. The increases are hitting small employers (< 200 workers) especially hard. With rising costs, workers are being asked to share the employers’ burden through higher contributions. Small businesses are searching for alternatives. In 2003, 62% of employers reported having shopped for a different healthcare arrangement, according to the Kaiser Family Foundation’s report, “Employer Health Benefits 2003.”

The rising healthcare costs are partially due to over-utilization of the healthcare system. Behind this phenomenon is the fact that insurance plans and healthcare management organizations are structured to encourage usage. Small co-payments, generally $10 or $15 per office visit, encourage insured consumers to use the healthcare system more frequently because they do not perceive themselves ultimately as having to pay the full costs of the medical services received.

With costs on the rise, more Americans are being forced to self-insure and pay a growing portion of the cost of their healthcare. Some are entirely uninsured. Others can only afford or choose only a high deductible or limited benefit health insurance policy. In either case, this patient population increasingly forgoes medical procedures or relies on emergency care for its healthcare needs and often incurs prohibitive expenses. Sadly, the costs of healthcare (in doctors' offices and hospitals) for this patient population are often far higher than the amount an insurance company would pay for the same healthcare services for its insureds. The problem is evident: The uninsured and underinsured patients have had no one to negotiate healthcare service costs on their behalf.

Precis’ Consumer Healthcare Solution: Care Entrée
Precis’ healthcare savings programs are based upon and emphasize the following factors:

• Responsibility for the use of healthcare must be put back in the hands of the patient. Insurance policies with low co-pays and deductibles have become very popular; however, these arrangements actually encourage the over-utilization that increases the costs of healthcare;

• The healthcare decision must be put back in the hands of the doctor and the patient; without undue oversight by parties with only economic interests in the decision; and

• Healthcare must be affordable for the patient, while providing the medical providers with adequate payment on a timely basis for services provided.

Precis’ leading program, Care Entrée, is designed to significantly reduce out-of-pocket medical expenses at affordable rates to consumers while helping medical providers receive accelerated payment for their services. Precis is able to deliver savings of 15% to 50% on members’ medical bills, and frequently more, by steering them to the most cost-effective healthcare providers in their area.

The Care Entrée program encompasses all aspects of healthcare, including physicians, hospitals, ancillary services, dentists, prescription drugs, vision care, hearing aids, chiropractic and alternative care, air ambulance, 24-hour nurse hotline assistance, and long- term care. Memberships in Care Entrée range from $9.95 to $69.95 per month per family depending on the selected options and include a one- time enrollment fee of $20.00 to $30.00.

Unlike insurers, Precis allows the patient and the healthcare provider to decide treatment protocols with no interference from any third party. Precis facilitates the financial transaction between the healthcare provider and patient-member to allow the provider to receive prompt payment. Finally, because the patient-member is directly responsible for a significant portion of his or her medical expenses, the patient has an incentive to minimize utilization to achieve cost savings, regardless of whether the patient has a high deductible insurance policy or is self-insured.

Impact of Instituting Escrow Requirements
Unlike most “discount card” programs, which are rapidly losing acceptance amongst medical providers, Precis requires that its members maintain escrow accounts ($25 minimum, $100 encouraged). The escrow system is significant because it assures providers they’ll receive rapid payment with Care Entrée members, and therefore Care Entrée is widely accepted by providers. The escrow accounts were introduced in Q4 ’02 and became required for all members effective October 1, 2003 in order to access hospital services, physicians, and ancillary providers using the membership program. As of March 31, 2004, after six quarters under the policy, total escrow account balances had grown to $4.0 million.

However, the flip side of this escrow requirement is the reduction in customer count as customers who do not want to provide the escrow funds discontinue their use of the service. The membership base has declined from 89,000 in June 2003 to 75,000 as of June 2004 as a result of the escrow requirement, and membership may not yet have bottomed. At June 30, 2004, some 14,900 members, or 31.3% of the individual healthcare membership roster, had escrowed funds. (This percentage excludes Precis’ private-label programs, where the escrow requirements have not been mandated.)

In addition to customer loss, the escrow policy has made the membership a tougher initial sell for the company’s independent marketing representatives. Precis has an undisclosed number of these reps who are paid commissions equal to 20% of the membership fees for the life of members’ enrollment. Precis’ reps can also recruit other reps and earn override commissions on their sales. Precis pays a total of 35% in override commissions down through seven levels. Until this past year, independent marketing representatives were the company’s primary means of distribution.

But since instituting the escrow requirement, Precis has experienced a significant reduction in the number of reps. Of course, in direct marketing the 80/20 rule applies, so in all likelihood the rep losses are centered on the more marginal reps. Also, as the company expands its focus from individual consumers to employer groups, Precis will become less reliant upon its independent reps because it will be utilizing an in-house sales force to reach employer groups.

New Initiative: Targeting Employer Groups
Precis is rapidly positioning itself to address the needs of employer groups, with expected traction beginning in 2005. The target audience here includes companies and government agencies that have chosen to move towards the self-funded and/or high-deductible insurance route. With health insurance premiums rising at double-digit rates, Precis anticipates a receptive marketplace for more affordable solutions.

Precis’ preparation for this opportunity dates back to Q4 2001, when Precis established Care Financial which operates, in many ways, like an insurance agency. Care Financial features a suite of products, including high-deductible and scheduled-benefit insurance policies, as well as life insurance from Lion's Share (Allianz). The use of these policies in conjunction with the Care Entrée program can provide a very affordable solution to groups who previously could not afford fully-inclusive medical plans. Care Financial also helps to assure payment to the healthcare providers.

Then in Q4 2003 Precis established Care125, a benefit plan administration service. Care125 provides the administration behind a variety of employee benefit programs that allow employers and employees to save money by paying for certain IRS-approved expenses on a pre-tax basis. Care125 can assist employers in the offering of Health Reimbursement Arrangements (HRAs), Flexible Spending Accounts (FSAs), and arrangements to help their employees pay for dependant care and transportation expenses. In the case of the Flexible Spending Accounts for dependant care (i.e., day care), employers can offer these plans as an additional benefit to their employees at no additional cost to the employer because these fees are based on a percentage of the tax savings realized by the employer in redirecting salary costs for distribution on a pre-tax basis. The remaining fees for services provided by Care125 are monthly fees based on the number of members enrolled.

Also in Q4 2003, Precis began reorganizing and rebuilding its corporate sales team to be better positioned to enter into the large self-insured employer group and medical benefits market. In January 2004, the company hired Terry Brewster as Vice President of Sales and Marketing. Brewster came from Aetna where he directed sales and marketing for the company's $1 billion southwest region, which includes 500,000 members.

Acquisition of Access HealthSource
Precis made a further step towards preparing to service employer groups with its June 21 acquisition of Access HealthSource, a third party administration services company. The El-Paso-based company is well established after 25 years of operation. Precis will pay $2 million in cash, $1.4 million in stock, and will also pay some performance-based compensation (up to $6 million) if certain targets are hit post-acquisition. Access provides TPA services covering some 40,000 El Paso “employee lives”, and generated $6.1 million in revenues and had EBITDA of $0.7 million and net income of $0.4 million in fiscal 2003.

Access brings a number of benefits. First, it has a lot of public sector business, which is where Precis is now targeting its new Care125 and other growth initiatives. Also, Access has access to a large PPO network in El Paso through which Precis can add membership benefits. Finally, there should be numerous opportunities for cross-selling and expansion of the business.

In amplification of these points, the Q2 ’04 10-Q said the following about the Access acquisition: “Through the acquisition of Access, we now provide a wide range of healthcare claims administration services and other cost containment procedures that are frequently required by governments and other employers who have chosen to self fund their healthcare benefits requirements. Access helps us offer a more complete suite of healthcare services. We are now able to provide individuals and employee groups access to preferred provider networks, medical escrow accounts and full third party administration capabilities to adjudicate and pay medical claims. From a sales distribution standpoint, we have the ability to grow Access’ regional business through our numerous independent marketing representatives who sell both to individuals and employer groups throughout the United States. Our acquisition of Access serves to complement our most recent entry into the public sector market through our agreement with the State of Louisiana. Access’ primary area of expertise is in the public sector market.”

Historical Financials (2000 – 2003)
From Precis’ start in 2000, it enjoyed significant initial success and strong growth in revenues, jumping from virtually nothing to $21.6 million in 2001 to $43.1 million in 2002. The stock jumped accordingly, from just over $1 in January 2001 to a high of $15 in the spring of 2002 as growth stock aficionados took the stock higher. The flattening of growth through 2003 (the company finished with $42.1 million in revenues, $1 million less than in 2002) caused the stock to drop back below $5, and it has since done the standard “$5 to $3” swoon that so often happens when a stock drops below the $5 mark and institutions begin to sell it.

Despite the stock price decline, this has been a profitable and cash flow positive business right from the beginning and continues to do so. Cash flow provided by operations had actually shown substantial improvement right through the end of fiscal 2003. OCF was $3.1 million in 2001, $4.0 million in 2002, and $7.8 million in 2003. Due to very modest cap-ex requirements of this business, that OCF has translated nicely into FCF, with the relevant figures being $2.5 million in ‘01, $3.1 million in ’02, and $6.9 million in ’03.

Recent Results
The transition-nature of 2004 was already apparent in the Q1 results. Revenue dropped 7.5% YOY to $9.9 million, while operating income declined by more than a third to $1.1 million from last year’s $1.8 million. As poor as these comparisons were, the company did manage to remain both profitable and free cash flow positive. Net income declined by nearly half to $605K from $1.2 million. Cash from operations came in at about $1.4 million, less $151K in cap-ex, yielded FCF of about $1.3 million. Also, the escrow account balance grew nicely to $4.2 million, up from $2.8 million at year-end 2003.

Revenue continued to decline in Q2, down 14.2% YOY and down 5.5% sequentially. Q2 revenue of $9.4 million included $209,000 of revenue contributed by the recent acquisition of Access. Operating income remained positive, albeit by a lesser margin at $0.6 million. Net income came in at $0.3 million, with FCF of $0.4 million. In addition to enduring the costs of ramping up the employer group business, Q2 profitability was also hurt by $275,000 in litigation expenses during Q2, which were one-time in nature. In Q2, Precis’ number of escrow-providing customers declined slightly on a sequential basis from 15,000 at March 31 to 14,900 at June 30. But these remaining customers did manage to put more money in their escrow accounts, as the overall escrow balance grew from $4.2 million at March 31 to $4.4 million at June 30.

The best news in the Q2 earnings release was the outlook from CEO Henkels:

“Our investments in our product enhancements and new product lines will continue to impact earnings for the remainder of 2004. However, I am highly optimistic about 2005 given the recent customer activity. We already have received tentative commitments from a number of large customers to roll out our Care125 FSA's and HRA's for their January 1, 2005 enrollments. These customers include a major U.S. city, a number of municipal entities as well as large corporate accounts. In addition, a large insurance company is allowing us to roll out the Care125 product to their agents, and a number of large insurance agencies are also sponsoring this product line. We have also seen a significant increase in business and activity and a new level of excitement in our Care Financial division over the past few months that bodes well for the future. We are also in the process of quoting some employee groups for administration of their self-funded plans through our Access subsidiary and look forward to increased activity after our representatives receive extensive training on selling this line at our leadership conference to be held at the end of August.”

On the conference call, Henkels also mentioned that by early 2005 the company is expecting growth in members and marketing reps. In a clear expression of her confidence, Henkels closed the call by saying, “Watch Q1 ’05, we’re expecting good things.”

Valuation
Precis’ Q2 ending sharecount, after including 488,486 shares issued as part of the Access acquisition, was roughly 12.414 million. At $3, that puts Precis’ market cap at $37.2 million. That’s only 1.08x book value of $34.5 million. Backing out net cash of $9.0 million, the EV is $27.2 million. Even on current depressed revenue of $9 million per quarter, the run-rate EV-to-Sales is a very reasonable 0.76x.

Free cash flow in 2004 is likely to be minimal, and it’s too early to tell what level of profitability to expect for 2005. But just to take a guess, let’s say the new employer group business lifts revenue by 25% and restores Precis to quarterly revenue of $11 million. Further, let’s assume this added revenue allows Precis to return to the low-end of its historical structural FCF margin range of 10% - 13% (achieved from 2001 to 2003). That would allow for SFCF of $4.4 million in 2005. If we grant a 10x multiple, Precis’ business would be worth $44 million. Add in the current $9 million in net cash, and Precis could be valued in excess of $50 by this time next year. That’d be good enough for a 40% increase in the stock.

Catalyst

Catalysts:

• Ongoing share repurchase program
• Accretive acquisition and related synergies of Access Healthcare.
• Continued modest growth in escrowed healthcare memberships and eventual bottoming out of non-escrowed account losses.
• The kicking in of new growth initiatives targeted at government and corporate customers, which should begin gaining traction in January of ’05 when such buyers typically review their healthcare costs and options.