PFMT- Performant Financial: Boring Business but a diamond in the rough

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#1
PFMT: Boring Business but a Diamond in the Rough
PFMT- Peformant Financial
Overview:

PFMT is a technology-based provider of audit, recovery, payment accuracy, coordination of benefits (COB), and outsource services in the United States.  PFMT solutions analyze claims and identify, prevent and correct inaccurate payments. Using their proprietary analytics platform and industry expertise, PFMT helps to reduce losses on billions of dollars worth of improper healthcare payments, state/federal/and treasury tax delinquencies, defaulted student loans and other receivables.  Primary customers include government commercial health plans, CMS, Blues plans, regional Insurers, private/commercial programs, etc that operate in complex and highly regulated environments that rely on PFMT's innovative and disruptive approach. Revenue is generated based on a percentage of validated recoveries for clients. Contracts are negotiated on case by case basis, fees may range from 10-30% of recoveries and the duration of contracts may last 3-5 years+.  These are high margin, recurring revenue contracts, expected to provide multiple years of prolonged double digit growth.

This is not a sexy business, quite boring in fact. However, a good investment should be boring. Hopefully you will appreciate the new path management has coursed, and see the potential upside in this turnaround story.

Historically, PFMT was known for it's legacy business as a collection agency for student loans, federal/state tax delinquencies and other receivables. Since the taking over of student loan originations by the Federal government a decade ago, PFMTs student loan collections have seen a diminishing contribution to revenues over time. Currently, the student loans collection business accounts for about 22% of revenues. While Other legacy collections still account for about 26% of revenues. Growth in Other legacy collections has remained relatively flat over the years. A smaller business segment derives marginal revenues from first party call centers and licensing of hosted technology solutions to clients.  The diamond in the rough refers to PFMT's up-and-coming healthcare business segment, composed of claims auditing and eligibility reviews. After seeing losses in 2018/19 due to high ramp up costs and standard implementation time lags, this segment  appears to finally be set up for robust growth going forward.  Mgmt has been clear that from 2017-2019, adjusted EBITDA has witnessed a slowdown to reflect a period of transformation in the company to establish itself in the Healthcare space. Management has confidently reiterated their belief in successfully reaching  a 2021 goal of achieving $200M revenue with 20% EBITDA margins, with double digit growth continuing for years to come.

Covid-19 Impact:

This year was shaping up to be a strong year for PFMT, as Q1 showed promising results that validated the new trajectory of the company. Unfortunately, Q2 and Q3 were impacted by the public health emergency related to Covid-19. The CARES act brought changes that affected the student loans collection segment. Student loan payments, interest accrual and involuntary collection of payments (wage garnishments) were originally suspended till September 30, 2020 but were extended till December 31, 2020. However, PFMT continued to generate student loan revenue for a number of months from existing in-process borrow rehabilitation agreements. Another impact of Covid came from existing healthcare audit customers, that requested a short-term pause on PFMT activities. Mgmt has indicated these pauses have largely ended during the third quarter. To mitigate the impact of this temporary slowdown, mgmt had furloughed more than 500 employees which could result in savings of about $18 million. The company is now aggressively ramping up efforts (including hiring/recruiting). Mgmt anticipates the ramp up efforts to be properly reflected in revenue by Q1 of 2021.
 

Healthcare Business:
The healthcare platform has finally reached scale, accounting for the largest (and continually growing) contribution to PFMTs revenue. In Q3, the healthcare business generated $17.6M in revenue  (48.5% of total revenues). That is a 20.5% increase on sequential basis and a 63% increase from the same period last year.
Healthcare revenues over last 11 quarters:
Q3 2020= $17.6M
Q2 2020= $14.6M
Q1 2020= $17.5M
Q4 2019=$14.3M
Q3 2019= $10.8M
Q2 2019= $9.3M
Q1 2019= $9M
Q4 2018= $9.9M
Q3 2018= $6.6M
Q2 2018= $6.1M
Q1 2018= $3.5M
This segment will continue to grow as Mgmt has made it clear this will be a main focus for the company. Soon healthcare will be the primary source of revenue (50%++), leading to a market multiple re-rate.

Macro:
The macro environment indicates there should be tailwinds for the audit, recovery, payment accuracy and coordination of benefits outsourcing business solutions PFMT provides. According to the CMS, national healthcare expenditures are forecast to grow at 5.4% CAGR for the next 8 years. Reaching  $6.8T by 2028. Despite efforts to reduce the amount of improper payments, error rates in the industry range from 6% in commercial to 14.9% in government plans. Healthcare spending growth is driven primarily by a combination of increasing enrollment and cost inflation. Given the current unemployment environment, we are witnessing a spike in Medicaid enrollment, which should continue to benefit the business via rising utilization and claims volumes. It is useful to note that there can be a lag of several months between Medicaid eligibility and resulting claims volumes. This indicates that a majority of the benefits from the current environment are still to come. Also, as private organizations and state governments are struggling with lower revenues and budget deficits, this could create an increased focus on cost containment strategies where PFMT could play a supporting function. PFMT mgmt sees a $200B+ healthcare TAM growing annually.

Healthcare insurance payments explained

Claim Submissions (Steps 1 + 2): After treating a patient, the healthcare provider submits a claim for reimbursement to the health insurer. The claim will include information on the diagnosis and treatment/procedure

Claim Adjudication (Step 3): The health plan conducts administrative checks (eg. validates provider information and patient eligibility/ coverage) and prices the claim using the providers contract/ fee schedule.

Pre-payment Review (Step 4): The payor will leverage internal tools, followed by third party/outsourced solutions (ie. PFMT offerings) to conduct payment accuracy analysis prior to payment. Errors (discrepancies between the submitted claim and the payors payment policies) are identified and corrected.

Claim Payment (Step 5 + 6): The health plan will reimburse the provider for the patient care and services rendered

Post-payment review (Step 7): The payor will again use internal tools, followed by third party solutions (PFMT) to evaluate prior payments with additional information that has become available (eg. clinical reviews). Payors will correct

Competitors:
PFMT differentiates itself with its proprietary technology and customizable approach to each of their customers' needs. The space is mostly dominated by large, slow moving players, that lack flexibility and uniqueness in their approach.  Major competitors include HMS Holdings Corp (HMSY-US, ~~$3B mkt cap) and Cotiviti (acquired in mid-2018 for $4.9B). Contracts in this industry are limited, take time to implement and can last years. PFMT continues to build a moat around it's business by consistently winning, maintaining and being awarded new contracts. An example includes being re-awarded CMS recovery Audit Region 1 and being awarded the newly created Region 5. Thus successfully showcasing PFMTs superior product and path to success in this space. PFMTs will continue to encroach on incumbents' healthcare market share as the market begins to realize the superiority of their technology and approach. 


Debt:
On Aug 2017, PFMT entered a credit agreement with an existing shareholder and customer, ECMC. As of September 30, 2020 PFMT has about $62M loan outstanding under this credit agreement.  ECMC has been able to accumulate about 5.8M warrants in PFMT as part of the agreement (about 10% of outstanding shares) all at an average exercise price of $1.95.  The effective interest rate was about 13.9% in the 1H 2020. The loan is classified as a current liability, with maturity in August 2021. However, PFMT has two one-year options to extend maturity.

PFMT currently (as of Sept 30,2020) has about $17.3M cash and equivalents on hand and is entering a period of FCF generation.

The current low interest rate environment offers low hanging fruit for companies looking to refinance their loans at a lower rate. Reducing their loan rate to 5-8% could save up to $5.5M in annual interest expense.


Timing/Technicals:
As the calendar approached their earnings announcement date (Nov 11), PFMT stock was trading around recent highs of $2. The stock started selling off aggressively into the earnings and significantly further following earnings (despite a very positive release). The selling pressure appears to have been caused by portfolio management layoffs at Invesco, a top holder. Public disclosure of these layoffs coincides with timing of initial selloff, and a recent 13G filing confirms the exited position. This should quell any fears holders and followers of this stock may have had, as the selling was not based on fundamental flaws in the company or a new short thesis. Invesco owned about 18% of PFMT. Following the recent pressure, it appears the stock is in extremely oversold territory. Since their exit, the average volume profile of the stock has improved significantly, making accumulating a position easier for both retail and institutional demand.


Valuation:
The timing of Covid partially contributes to why the market overlooked this stock, as Q2 and Q3 earnings were impacted. To establish a fair EBITDA estimation for 2020, we will use Q1 results with a conservative bias. Q1 is most appropriate because it will give us the clearest picture of how the company was performing prior to the temporary impacts of Covid. Using Q1, EBITDA was $6.4M (after deducting stock compensation).  Annualizing that amount will give us an EBITDA run rate of $25.6M. This is a conservative measure becuase we do not account for the impact of any potential interest rate savings or growth in the healthcare segment. Next we need to establish the enterprise value (EV= debt + mkt cap - cash). Which we use to calculate EV/EBITDA.  Calculation below.

EBITDA= $25.6M
Enterprise Value (EV)= $62M (debt) + $41 (mkt cap) -$17.3M (Cash) =  $85.7 M

EV/EBITDA= 3.3X
Fully diluted share count of 59.7M o/s
Now lets take a look at some Healthcare IT comps. The first 7 are general comps, the bottom 3 are the most similar comps to PFMT. To clarify, HMSY is currently publicly trading and is a direct competitor to PFMT. In December 2019, HMSY acquired Accent (a coordination of benefits/payments accuracy unit of Intrado focused on commercial and Medicare Advantage payers) for $155M. Accent had generated about $50M of revenue during the 12 months ending October 2019 (vs PFMTs $150M revenues in 2019). Based on the transaction price, HMSY paid an estimated 11-12X EV/Ebitda on a TTM basis.  COTV was acquired and taken private in 2018, it continues to be a direct competitor with PFMT. COTV operated in payment integrity and was acquired for $4.9B in mid 2018, an estimated EV/EBITDA multiple of 14-15X based on consensus 2019 estimates.  Also, keep in mind that the average EV/EBITDA for S&P companies in 2020 is about 14.5X.

Healthcare IT Peer Trading Comp Table
                        Mkt Cap     SHARES O/S          EV        EV/EBITDA
HMSY             2,793          88.6M                   3,021      16.8X
CHNG             5,581        304.5M                 10,237      11.2X
ACN         173,423           661.1M             171,554           19X
ADS             3,466            49.6M                 24,047       30.3X
HQY             5,013              77M                   5,803       27.2X
IQV               34,135       191.7M                 45,733       19.5X
CERN           23,727        306.6M                 24,167          14X

                                                                        Average: 19.7X

PFMT            40.5            59.7M                         86       3.3X
                                     (fully diluted)

Most Similar Comps:
COTV           4,900 (2019 est)                                        14.5X
Access           155 (Acquired by HMSY in 2019)              11-12X
HMSY             2,793       88.6M                     3,021         16.8X

                                                                              Average: 14.3X


Best Case: Applying 14X multiple
EV= 25.6 EBITDA * 14 EV/EBITDA= $358.4M
358.4/59.7(fully diluted)=  $6 per share

Base Case: Applying 12X multiple
EV= 25.6 * 12 EV/EBITDA= $307.2 M
307.2/59.7= $5.15 per share

Worst Case: Applying 10X multiple
EV= 25.6 * 10 EV/EBITDA= $256M
256/59.7= $4.29 per share



The market still largely views PFMT as a declining student loans collections firm. Yet growing beneath the surface is an attractive healthcare business. As this segment continues to grow the market will recognize the high quality recurring revenue, ability to scale, and increasingly healthcare-focused pure-play as a catalyst for a multiple rerate.  Now using the comps above, I will provide 3 scenarios (best, base, worst case scenario) applying a discount to conservatively account for the micro-cap nature and higher leverage of PFMT. 

In the best case scenario, we apply a 14X EV/EBTDA ratio (rounded down from the most similar comparable peer average of 14.3X) which, on a fully diluted share basis, lead to a current price per share of $6.

In the base case scenario, we take a couple of notches off the closest peer average and apply a 12X EV/EBITDA ratio. Resulting in a current target price of $5.15/share

In the worst case scenario, we further take off two more notches from the most similar peer average to apply a 10X EV/EBITDA ratio. Resulting in a price of $4.29/share.

Also, considering the existing ownership of the company. Parthenon investors, Prescott Group, Mill Road Capital are all large shareholders. It is not unreasonable to think that they pursue a more aggressive activist role in the company and set it up for sale at a premium. It is also possible that competitors recognize the massive discount of this up-and-coming threat, and decide to acquire PFMT before other market participants drive up the price making such a strategic acquisition far more expensive. All of which offer upside to existing shareholders.

As we approach future quarters and results continue to support this positive narrative we should start to see investor appetite pick up for this name. Average daily volumes have quadrupled since Invesco's recent exiting has added to the freely trading shares, improving the liquidity profile of PFMT.  These signals will start appearing on investor screens as they (professional small cap investors, value investors, quant investors, generalists, hedge funds, etc) look for new ideas. There is virtually zero sell-side coverage of this stock at the moment, this will likely change in the future. Accumulating a position now, presents an opportunity for entry at basement level prices in a stock that has the potential to provide 500-700% upside.


Thank you for taking the time to read my idea. Full disclosure, I am long PFMT, i do no hold an employment position with the issuer.

Feedback and criticism of this idea are encouraged. Always do your own due diligence. Ive included the sources used for this analysis in the links below.


Sources:
https://www.performantcorp.com/investors...fault.aspx

https://www.sec.gov/cgi-bin/browse-edgar...er=exclude

https://www.cms.gov/Research-Statistics-...it-Program

https://www.cms.gov/Research-Statistics-...Historical
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#2
More industry developments supporting $PFMT thesis:

Yesterday (January 6) United Health ($UNH) announced the acquisition of Change Healthcare ($CHNG). The transaction value of $13.8B, values CHNG at a 13X forward EV/EBITDA multiple, a 41% premium to the previous days close and a 98% premium relative to their recent IPO price of $13 in 2019. CHNG mgmt noted that the company was not up for sale, they only IPOd in 2019 and were in near the end of an 18 month process of  restructuring their business, exiting underperforming assets/segments and repositioning their focus on long term growing segments (similar to PFMT's strategic turnaround story). However, the UNH offer was too compelling to turn down.  UNH recognizes the value of CHNG complicated businesses such as Payment Integrity, Cost Containment, Payment Networks, Data assets, among others.  So here we have another Healthcare IT firm being acquired in less than a month. We can compare the 13X multiple paid for CHNG to the recent HMSY acquisition (on Dec 21,2020) where Veritas paid a 16-17X multiple. The difference may be due to the complexity and diverse nature of CHNG's product offerings as well as $5 billion of debt on their balance sheet that weighed on the valuation relative to the HMSY transaction (no debt).  Given the list of recent HealthCare IT transactions, the market is telling us that a low-mid double digit EV/EBITDA multiple is the standard for companies in this space.  The frequency of transactions in this space over the last 18 months indicates that market participants see undervalued companies and are capitalizing on the opportunity through business combinations and takeouts.

Performant continues to grow it's healthcare business, quarterly releases in recent past have evidenced this trajectory. Future releases will prove to be catalysts confirming PFMT is a healthcare IT firm operating in the same industry and competing in similar segments as the firms mentioned above. Some critics point to PFMTs $62 M debt as a weakness. But as we read the terms of the credit agreement and look at the macro environment, it is easy to see that the terms are flexible and the opportunity to refinance more favorable terms is low hanging fruit. If CHNG with a massive $5B debt can be acquired at 13X multiple, then it is not unreasonable to apply a conservative base-case scenario of 12X EV/EBITDA to PFMT. Such a multiple equates to a $5.15/share price target (565% upside from current prices).

In a market where TSLA and bitcoin continue to make ludicrous all time highs, lacking any rational fundamental reason, PFMT continues to offer a compelling deep discount opportunity to participate in a budding Healthcare IT turnaround story that is backed by fundamentally sound operations poised to succeed within a growing industry.
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#3
With Performant about to release earnings mid-March, I think now is a good opportunity to discuss the company again. This update is to emphasize the importance of PFMTs growing medical reimbursement business by clarifying the reimbursement process. Keep in mind as you read this that US healthcare spending was about $4 trillion in 2020 and is expected to be $6 trillion by 2027. Also, consider how quickly medical technologies are advancing. Imagine how digital multi-sensor contact lenses, 3D medical prosthetic/drug/organ printing, robotic surgery, new imaging tech, faster clinical trials, robot assistance, brain-computer interface and DNA customization will redefine our lives. The mass adoption of such technologies will no doubt shock the bureaucratic coding, claiming and reimbursement processes of the world thus requiring companies like PFMT to provide dedicated expertise that in-house tools cannot handle alone. With ever rising healthcare costs in the US, reimbursement is only likely to increase in importance with the potential for a faster pace of change as well. Understanding reimbursement is a critical part of medical tech/IT investing. There are and always will be changing pressures on healthcare so it is safe to assume there will be ongoing change and nuance to this process. The US process is complex and the triggers that cause commercial/government payors to implement change are not well understood by in-house teams. Successful navigation of the reimbursement process in the US requires interactions with multiple large organizations including government regulators (CMS), large physician run societies and commercial insurers. All of which PFMT has existing contracts and relationships with. And like any other process that demands interaction with multiple large organizations: focus, persistence and having proper strategy is what matters significantly.
The first step in attaining reimbursement for medical service is to ensure appropriate coding. Coding is the standard cost identification system used by MCS, healthcare providers and third party payors and is the link between coverage an payment. The existence of an official code facilitated the entire process as it is a formal recognition system. A code does not guarantee reimbursement from a payor but it is a critical step in the standardized process. Coverage and payment for non-coded services is possible but that process is far more difficult, manual and time-consuming. Given the broad range of health-related events that might happen to a given patient, there are a vast array of codes and types of codes that exist to describe everything from where a procedure was performed (inpatient/outpatient setting or at home), who performs it (physician, nurse, tech) and the type of equipment/procedure involved (equipment, consumables or medical technologies). By analyzing these codes, payors are able to make informed reimbursement decisions based on symptoms of patient and procedures performed.
These codes can be broken down further into multiple categories, each with more complexity. For the sake of this piece, it is only important to understand that with such a complicated coding system doctors may be hesitant to use certain codes or simply may not be familiar with all the nuance, this raises concerns over whether or not they will be paid for the services provided. These concerns and natural ambiguity provides opportunity for PFMT to reclaim improperly coded services and collect a fee in the process.
In theory, you would expect experienced teams of large payors to understand all codes and handle them accordingly. In practice, payors can often be so inundated with new applications that they cannot fully and appropriately give fair and full reviews of claims so there is tremendous amount of leakage in the system.
Side note: This stock always starts to run higher into earnings releases. The last quarter had the unfortunate timing coinciding with layoffs and fund closures at top shareholder (filings confirm this). Hence there was selling pressure but not due to any fundamental reason related to PFMT operations. The stock is still trading at extremely depressed prices. In this market it should be trading at the best case scenario $5.15 per share. Investors will start to see the potential in this name and accumulate positions. Not only that, but from a broad market perspective, many sectors and particular names are getting to be at very overvalued frothy levels. It is not unreasonable to see a rotation out of growthy large cap tech names into deep value. Anyone shorting PFMT will get squeezed hard. It is still a relatively unknown name, this is a great entry point.

Please comment with questions and thoughts!
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