Microcap With Upside Potential

Pacific Healthcare Organization Inc (PFHO, Financial) is a specialty workers’ compensation managed care company providing a range of services for self-administered employers, insurers, third-party administrators, municipalities and others. The company operates under five segments:

• Medex – Administers health care organizations and medical provider networks. Helps clients save money by giving them more control over the Insurance claims process, reducing the cost of fraudulent claims and disability awards.
• Industrial Resolutions Coalition Inc. – Creates legal agreements for the implementation and administration of Workers’ Compensation carve-outs for California employers with collective bargaining units.
• Medex Medical Management Inc. – Manages nurse case management services.
• Medex Managed Care – Offers automated medical bill and utilization review services that can cut the overhead costs of the clients and increase payer savings.
• Medex Legal Support – Offers lien representation services.

What happened?

The company lost its second-largest client, Companion Property & Casualty Insurance Co., in the second quarter of 2015 after it was acquired by Enstar Group in August 2014.

In November 2015, the company reported that its largest client, AmTrust North America (34% of FY 2015 first nine months revenue), provided a 60-day notice to cease all services. This means that revenues and profitability will be affected as early as Q4 of 2015 (they report next month). This will also be reflected in its 2016 financials, hence the 0.96 EV/EBITDA ratio.

Why buy now?

Less exposure to large clients

Having lost its two largest clients, the company is now less exposed to concentrated clientele risks. As of Dec. 31, 2015, according to the 10-K:

During 2014, AmTrust North America, Companion Property & Casualty Insurance Co. (“Companion”) and Prime Health Services Inc. accounted for approximately 19%, 13% and 13% of our total sales. During 2013, AmTrust North America and Companion accounted for approximately 14% and 13% of our total sales.

The only one of those three companies left is Prime Health Services, which by my estimates should account for approximately 20% of 2016's revenues. It's also likely, though, that one of the existing clients will become a "large" client as a result of the smaller base.

Variable costs

For its utilization review and medical bill review subsegments, the company outsources employment and is able to feasibly cut those cuts. To put this into perspective, after Companion Property & Casualty Insurance was acquired, Pacific Health Care lost it as a client in Q2 and subsequently shed $393,000 of outsource service fees in Q3. AmTrust North America is concentrated in those two subsegments. The company should be able to shed the costs associated with that client. Capex is also minimal as the company provides services and does not manufacture anything.

No-growth liquidation valuation

The company carries a solid balance sheet with a high cash balance and no debt. The company also generated $1.8 million in FCF in 2014. FY 2016 cash flows will be lower as a result of the loss of AmTrust and Companion (both of these were included in FY 2014 and partially 2015 financials). I'm going to tackle the valuation from a liquidation perspective. We'll start with the balance sheet:

The actual case represents the numbers on the balance sheet as of Q3. The base case assumes that accounts receivable take a 4% (in line with historical bad debts) haircut, all other current assets, -25%, PP&E, -66%. The bear case assumes that accounts receivable takes a 50% haircut, all other current assets + PP&E, -75%. We arrive at Liquidation Value (LV) of -$1.71 million (base) and -$2.62 million (bear).

From a profitability perspective, the company generated $6.7 million in revenues with net income of $2.4 million in the first nine months of FY 2015. Companion and AmTrust were responsible for $2.61 million or 39% of revenues. Now if we take the FY 2014 revenues of $9.46 million and shed 50%, rather than 39% (for conservative purposes), we arrive at $4.73 million. Profit margin for FY 2016 was 21%, but we are going to use a conservative 15% to arrive at net income of $709,500.

If we also assume that net income approximates cash flows, then the company would trade at an LV/FCF ratio of 2.42 for the base case and 3.7 for the bear case. I'll have a better idea of what these numbers will be when the dust settles after Q1 2016 in May. My assumptions above are reasonable. The company could also be taken private as the CEO owns just under 60% of the shares outstanding. He also purchased more shares after the November drop. One of the directors also bought some shares earlier last month and now owns 7% of the company.

Buying strategy

This one's very illiquid, so I'm going to be buying it in small sizes over the course of this week to avoid a price spike. This will make up 5% of the portfolio.

Note: I published this article on my website on Feb. 16, 2015. Any dates in this article refer to that period. My final average purchase price was $8.02/sh.