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PFHO Writeup
Pacific Health Care’s operating business, Medex (http://www.medexhco.com/), helps corporations, not-for-profits, and municipalities reduce their workers’ compensation claims costs by providing a network of healthcare providers, reviewing medical bills to reduce costs, and having a professional oversee the life of a claim. The business has similar financial traits to a law or accounting firm because highly skilled professionals are providing services, so there is no inventory, low working capital, high returns on invested capital, and net income closely matches free cash flow.

Thesis:
Strong Business. Strong FCF, low working capital and fixed results in a 109% ROIC, consistent revenue and earnings due to long-term relationships with customers.
Aligned Management Team. CEO Tom Kuboda owns over 60% and has been buying more (seven open market purchases in the last 2 years). Management takes low salaries and has maintained strong margins at different revenue levels. The board has returned cash to shareholders with a buyback and special dividend in the last two years.
Record of Growth. PFHO grew sales at a 55% CAGR from 2010-2014 as the company added new customers and grew relationships with existing customers. Sales in 1Q10 were $0.35mm, and grew to a peak of $2.75mm in 3Q14, but then declined to a low of $1.25mm in 2Q16 as PFHO lost its three largest customers (detailed below). However, since then, PFHO has grown sales back to $1.60mm as of 3Q17 (+21% y/y YTD sales growth). PFHO is back on track for 15-30% sales growth more consistent with performance from 2010-2014.
Strong Balance Sheet. PFHO has $7.02/share in net cash. The company’s cash balance covers its liabilities by over 10x. Management has hired investment bankers to review mergers & acquisitions. PFHO is not getting credit for the cash on its balance sheet, so deploying via an acquisition would unlock ~$7/share of value.
Acquisition Candidate. The business generates high ROIC, strong FCF, and has a good record of growth, so would make an attractive acquisition candidate. Management already owns over 60%, so could finance a go-private transaction with its existing cash balances plus borrowings. In addition, the sector has high private equity interest (as outlined below), so shares could be acquired by private equity at 10x 2018 EV/EBITDA of $2.5mm which would be $40/share.

Business Description

Services:
The company are workers’ compensation cost containment specialists. They provide the following services that help corporations, not-for-profits, municipalities, and insurance companies reduce workers’ comp costs.
• HCO (Health Care Organization) is network of healthcare professionals and service providers that work with Medex to help injured employees quickly recover while also controlling the cost for the employer. Medex charges the employer per enrollee and sometimes also generates revenue from the dollars saved by using the network
• MPN (Medical Provider Network) is similar to an HCO but do not require the same level of medical expertise in treating workplace injuries
• UR (Utilization Review) involves an experienced professional reviewing the injured workers’ recovery plan to ensure there is not excessive treatment. Medex will typically charge the client a percentage of the money saved
• MBR (Medical Bill Review) involves an experienced professional reviewing health services provided and ensuring proper reimbursement (coding review, rebundling, etc)
• NCM (Nurse Case Management) services has a nurse oversee the recovery process to ensure it is moving along at an appropriate pace in order and following-up with the injured worker to ensure he/she is attending treatment sessions which reduces time out of the office and saves money
Customers:
• Corporate: Best Buy (BBY), Walmart (WMT), Republic Services Group (RSG), Hilton Worldwide (HLT), KPC Healthcare
• Municipalities: City of Long Beach, City of Carson, City of Oceanside, San Jose Unified School District
• Not-For-Profit: Goodwill, AAA
• Other: Athens, SHARP, Preferred Operator Group, DART

Competitors:
• Corvel (CRVL) is the only publicly traded peer and sells for 13.7x TTM EV/EBITDA and 31x TTM P/E
• Sedgwick – largest company in the sector was acquired by KKR in 2014 for 12x EV/EBITDA
• Concentra – Humana (HUM) sold to private equity in 2015
• First Health – owned by Coventry
• Genex – Apax Partners private equity acquired in 2014

Why shares fell from their highs:
As noted above, PFHO had a strong track record from 2010 to 2014, growing sales at a +55% CAGR. Starting in 2014, PFHO lost its three largest customers Prime Insurance, Companion, and AmTrust for different reasons. This caused PFHO’s revenue to fall from $2.75mm in 3Q14 to $1.25mm in 2Q16
• Prime Insurance – PFHO had been providing overflow processing services for Prime in 2013-2014 and Prime caught up on overflow work, so was able to take the work back in-house.
• Companion Property & Casualty Insurance was acquired by Enstar Group and Enstar brought the services in-house.
• AmTrust cited changing business needs as the reason for no longer using PFHO’s UR, NCM, and MPN services.
PFHO’s remaining customer base is focused on corporates, not-for-profits, and municipalities which have proven to be more stable than insurance customers because they are less likely to perform the services in-house. Evidence of this stability is that revenues have consistently grown since 2Q16 when the large insurance clients were fully off of PFHO’s platform. Since 2Q16, revenue has grown at a ~20% rate which I expect is sustainable going forward.

Financial Analysis
I estimate PFHO is back to ~20% revenue growth based on results from 2Q16 through 3Q17. EBITDA margins have continued to recover each quarter from their low of 12% to 27% in the last quarter. I estimate EBITDA margins will continue to recover to ~35% where they were in 2014 and 2015 as revenue continues to grow. This results in EPS growth at a 33% CAGR for the next 3 years.


PFHO Financial Model
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Revenue 1,616 2,832 4,827 6,573 9,463 8,225 5,688 6,500 7,800 9,360 11,232
Growth 75% 70% 36% 44% -13% -31% 14% 20% 20% 20%

EBITDA (76) 336 1,262 2,099 3,347 2,892 1,054 1,750 2,496 3,276 3,931
Margin -5% 12% 26% 32% 35% 35% 19% 27% 32% 35% 35%

EPS $ (0.08) $ 0.25 $ 0.89 $ 1.54 $ 2.45 $ 2.10 $ 0.71 $ 1.22 $ 1.80 $ 2.38 $ 2.87
Growth 256% 73% 59% -14% -66% 72% 47% 33% 21%

Cash / Share $ 0.44 $ 0.46 $ 0.60 $ 1.58 $ 3.68 $ 4.79 $ 6.26 $ 7.32 $ 9.12 $ 11.50 $ 14.37
Growth 30% 164% 133% 30% 31% 17% 25% 26% 25%

Valuation
CRVL is the only publicly traded comparable at 13.7x EV/EBITDA and 31x P/E. However, Corvel has more scale so will likely trade for a premium to PFHO (though PFHO does have better margins and growth). I estimate PFHO’s fair value is 10x EV/EBITDA and 20x P/E ex-cash. At $2.5mm EBITDA in 2018, I estimate PFHO’s EV is $25mm plus $7mm of cash = $32mm / 0.8mm shares = $40.00 fair value today. By 2020, I estimate PFHO will generate $3.9mm of EBITDA and be worth $39mm EV + $11mm net cash = $60mm / 0.8mm share = $75/share

Catalysts
• Continuing to deliver revenue growth and margin expansion which grows EPS
• Generating FCF and continuing to build FCF
• Deploying large cash balance for an acquisition which will accelerate the growth profile
• Takeover acquisition – either management buyout (using large cash balance) or selling to one of the many private equity companies involved in the sector
Risks
• More customer losses
• Poor acquisition or overpay
• Regulatory changes that negatively impact the workers’ comp cost containment industry