PRG-Schultz International (PRGX) is an audit recovery service firm, providing services to customers in over 25 countries. The company's primary business is the auditing of accounts payable to find over-payments to vendors or providers, usually due to the increasingly complex nature of promotional activities in the retail and wholesale industries which comprise the vast majority of PRG's customers. Finding and obtaining reimbursements for these over-payments provide its clients with meaningful cash flow. Generally, PRG enters into contracts with clients for a defined period of time, and earns revenues as a percentage of amounts recovered. 43% of revenues are earned from business outside the United States.PRG-Schultz is a very cheap stock, with a near-19% trailing earnings yield and over 16% against 2010 estimates. New management has done a good job improving earnings from a historically unprofitable position, and Magic Formula-adjusted return on capital is currently an excellent 148%. Therefore, I believe the company is a good choice for MFI investors. However, I'm holding back from adding it to the MagicDiligence Top Buys portfolio due to concerns over growth prospects. Let us have a look at that, in addition to the other discussion points on competitive position, financial health, and risks.
First, let's get financial health out of the way - PRG-Schultz is in no meaningful distress. The company has $27 million in cash on the balance sheet with only slightly over $15 million in debt, only $5 million of which is due in the next 12 months. Operating income covers required interest payments 7 times over, a safe multiple. Free cash flow generation is excellent, with a 7% free cash flow margin and about 90% of operating income being converted into free cash on average (most firms are in the 70-80% range). Capital expenditure requirements are low, as auditors and software are the company's primary working assets.
Competitive position is a little more difficult. Direct competition is not really a concern. PRG-Schultz is the world's largest audit recovery firm, and one of only two capable of performing international accounts payable audits for large clients. Large accounting firms provide audit services for tax payments but not accounts payable. More of a concern is the increasing sophistication of software and internal auditing functions inside PRG's large retail customers as they improve their information technology. This factor has drastically reduced the demand for outside audit services. Also, as PRG-Schultz's services mature to individual firms, less errors are usually detected, meaning that the value of a contract declines as it matures.
Those two factors have led to what looks like a secular decline in demand for PRG's legacy retail and wholesale audit business. Management believes this business will continue to decline long-term, and indeed revenues have declined at a double digit annual rate over the past 5 years. The first step for the company was to return to a focus on large clients and eliminate unprofitable smaller contracts, which has returned PRG to profitability. However, it has also intensified major customer concentration risk, as the top 5 clients account for over 30% of sales, and one client, Wal-Mart (WMT), accounts for 11% alone.
With this bleak growth backdrop, the company has little choice but to try and find new sources of revenue, and they may have located a major one - providing audit recovery for the Center for Medicare Services (CMS). From 2006-2008, PRG operated as an auditor for CMS's trial recovery audit contractor (RAC) program in California. The trial was terminated in 2008, but the RAC will be rolled out nationwide in 2010, and PRG has won a subcontracting position in 3 of the 4 areas. This could be a major opportunity, but little is known about the potential magnitude or timing of revenue. Additionally, ramping up for this program will require capital and operating expenditures, so the margin potential is unknown as well. Management has provided little detail on their expectations for this business, but we do know that it should begin contributing in the back half of 2010. With an intense government focus on controlling health care costs, I believe it is likely that the RAC program will endure for some time, even against intense criticism from care providers who are the "victims" of charge-backs.
So, in conclusion, PRG-Schultz is a very cheap and financially sound company that faces a declining legacy customer base and an uncertain replacement strategy with Medicare auditing. Overall, the chances for nice gains in this stock outweigh the risks. MagicDiligence has a positive "buy" opinion on it at this time.
Date: Dec 21, 2009
Competitive Moat: C
Financial Health: C+
Opinion: OK to buy. Cloudy future, but cheap and financially sound.
Disclosure: Steve owns no position in any stocks discussed in this article.