Description

SOURCECORP, Incorporated (SRCPE) is a provider of business process outsourcing solutions. Due to a confluence of recent negative news flow, I believe that you can purchase SRCPE today for <10x normalized EPS with a nice near-term catalyst to boost the shares.

SRCPE provides a fairly broad range of outsourced business services to both corporate and government customers. The company categorizes these services into two broad categories: 1) Information Management and Distribution – company captures, digitizes, and archives large volumes of documents for customers, and 2) Healthcare, Regulatory and Legal Compliance – services include medical records release administration, records management, healthcare document digitization conversion, class action claims administration, and specialized consulting services. Note that the company’s categorization is somewhat arbitrary and there is overlap between the two categories. I would refer those interested in a more detailed description of the company’s businesses to both the 10K and corporate management. Over the last 18 months, the company has either shut down or divested several units that tended to be lower return, more commodity-oriented businesses. This should improve consolidated returns on capital going forward. Roughly 70% of the company’s revenue stream relates to multi-year contracts (averaging 3-4 yrs in duration), with the remaining 30% tied to shorter-term projects (averaging one year in duration). In sum, this is a company with a reasonable mix of businesses and good contractual visibility.

In late October 2004, SRCPE announced that accounting irregularities in one of its divisions would necessitate a restatement of its historical financials from 2003 forward. Concurrently it announced that the SEC was undertaking an informal investigation of the restatement and related circumstances. Moreover, as a result of no longer having reliable audited financial statements filed, SRCPE was put on notice by NASDAQ for possible delisting. The initial restatement estimate was for a downward revision to revenues of $8.2mm (1.3% of the revenue amount originally reported for 2003 and the first half of 2004). In January 2005, the company extended the restatement period back to 2001 and raised the aggregate revenue restatement amount to $12-$20mm (roughly 1% of the revenue amount originally reported). Concurrent with the upward revision in the restatement, the company announced that the SEC investigation had become formal.

The financial restatement and associated SEC investigation has overshadowed what has otherwise been a solid organizational turnaround in the company’s sales effort. It is my contention that current guidance is overly conservative, and that the issues identified in restatement are isolated and limited in scope. As the company’s sales turnaround takes hold, operating leverage will drive earnings growth ahead of expectations, the earnings power of the business will become apparent, and significant upside in SRCPE’s shares may result.

Some background on the restatement. Thru 2001, SRCPE was built in large part thru an aggressive acquisition program. Deal structuring typically included a mix of cash consideration and an earn-out component. By 2004 only two material earn-outs remained, one of which related to a data capture subsidiary that was still being overseen by the individual whom had sold the business to SRCPE. The earn-out for this subsidiary was based on a multiple of trailing cash flow, and in order to maximize the value of his earn-out this individual employed both aggressive revenue recognition and, in addition, blew through contractual revenue limits on several large contracts. The revenue recognition issue is simply one of timing, i.e. revenue previously recognized in 2001-2004 will now be recognized in 2005 and beyond. The resolution of the contractual limitation issue is less certain. Work was done for several clients in excess of contractual limitations. Generally speaking, the customers are happy with the work but didn’t have authorization for incremental amounts billed to them. As such, SRCPE is currently negotiating with these clients to determine how much (if any) of the work will be paid for. There is a total of roughly $18mm of potential revenue (on a base of roughly $400mm) that may accrue in 2005 and beyond depending on the resolution of these contractual matters. The restatement issues are completely isolated to this one subsidiary. The upward revision to the restatement amounts in January 2005 resulted from the completion of the forensic audit at this subsidiary, and the associated uncovering of several incremental problem contracts. It is highly unlikely that there will be further adjustments to the restatement amounts.

Meanwhile, SRCPE’s revenue backlog has been growing strongly. The company undertook a major restructuring of its sales force in late 2003 (primarily by hiring more aggressive, seasoned salespeople) and the results have been impressive. Quarterly revenue bookings over the last four fiscal quarters have ranged from $50-$70mm, compared to a run-rate of roughly $30mm/qtr over the preceding 12 mos. Applying the 70%/30% recurring/non-recurring breakdown mentioned earlier, and using a 4-yr average contract length on recurring revs and 1-yr average on projects, the $120mm incremental year-over-year increase in bookings implies $57mm in incremental revenue in 2005 (= (0.7 x 120 / 4) + (0.3 x 120)). This would imply over $440mm in revenues for 2005, well above the current $400-$425mm guidance range. Personally, I believe that management is being extremely conservative in its guidance after having been stung by the restatement. As a final aside on the sales effort, booking rates have actually been trending up over the last few quarters so it appears that there is still low-hanging fruit to be picked.

A number of SRCPE’s subsidiaries have relatively high fixed cost components, so revenue can translate into strong positive operating leverage and earnings gains. This operating leverage negatively impacted the company between 2001 and 2004 as a tepid overall business environment and sluggish sales effort negatively impacted revenue and management had to eat the cost of excess capacity. However, these circumstances (in combination with the aforementioned disposition of several operating units) are now operating in reverse and I expect beneficial margin expansion to result. On a base of $440mm in revenues for 2005, and with a 12% operating margin (well below peak of >17%), SRCPE should be capable of generating $1.70/shr in EPS. Modest improvement into 2006 could take this number north of $2.00/shr.

I expect restated financials to be filed within the next couple of weeks. This milestone will take the company out of NASDAQ’s penalty box, and investors will once again begin to focus on the very positive improvements that management has made in both the top line, the business’ positioning, and the underlying earnings power.

Risks:
Inability to meet NASDAQ filing requirements – associated delisting; upward revision in restatement amounts; material SEC fine

Catalyst

Filing of 2001-2004 financial statements; full NASDAQ listing regained; conservative 2005 guidance revised upwards; resolution of SEC issues; favorable resolution of negotiations with clients regarding the $18mm of previously billed work whose recoverability is in question