I specialize in turnaround situations though they are hard to find. My last such article was about Tuesday Morning (NASDAQ:TUES) a company in bankruptcy which has already risen 8x since published. Some of the best returns come from companies, deservedly left for dead, after years of poor performance. The stock pops once it becomes clear the company is turning it around can be explosive. I believe Performant Financial Corporation (PFMT) is such a case. It has struggled in recent years with a declining business. In fact, revenues declined every year starting in 2013 from $255 million to $127 million in 2018.
Hidden inside it however is a high-growth business and a recovering business that have reached the tipping point to put the company as a whole on a relatively rapid revenue growth trajectory and quickly be solidly profitable.
Performant’s legacy business is as a collection agency for student loans, federal and state taxes, small bank loans and hospitals receivables. The original and still largest component is student loans. In 2010, the Federal government changed the student loan market in effect taking over student loan originations. As a result, this business has been on a steady decline but still makes up about 22% of revenues. The other portions of the collections business are essentially flat for revenues and make up about 26% of revenues. Performant management provided me the following to describe lower revenues in this business.
“We lost two contracts within our legacy Recovery business, however in both cases it was not due to any issues on our side
The Dept. of Education cancelled the procurement after awarding the contract to us and one other company—cancelled due to lawsuits from companies who did not get the contract. Great Lakes was a guaranty agency client of our, but they wanted a single vendor to service their internal technology and servicing needs, since we are not a servicer, could not compete for this aspect of the business.”
Performant has another business they call healthcare which is growing rapidly. It is made up of two components, claims auditing and eligibility-based reviews. The company believes its technology is better than the incumbents. They believe growth has mostly come from taking business away from the incumbents due to superior technology.
Eligibility-based reviews is determining who should pay for the medical claim, Medicare, Medicaid, insurance company A or insurance company B. This business had $27.7 million in revenues in 2019, up 61% from one year earlier.
Claims auditing is performed for Medicare, Medicaid and insurance companies. It looks at paid healthcare claims and screens those that are most likely to be in error, not following the protocols or fraudulent. Proprietary algorithms are used to screen with medical experts used in many cases on top of that. This business was a large portion of revenues at one time. Revenues totaled $67 million in 2014, but it lost most of its contracts. Performant management has provided the following statement on the prior decline in revenues.
“As it pertains to the decline in our Healthcare revenue, this was not a function of a lost client, but rather a considerable change in the RAC program by CMS following a series of lawsuits brought on by the AHA and other lobby groups. To provide one example of how the changes hurt us and the other auditors, CMS reduced the Additional Documentation Request (ADR) limit by 75%, on the initial contract and further limited them under the new risk-based ADR limit policy (minimum of .5%, maximum of 5% – based on provider’s historic billing accuracy)”
Things are starting to turn around. Claims auditing had $15.6 million of revenues in 2019, up 77% from one year earlier. Management expects a 5X growth in audits performed over two years starting in 2019. This does not necessarily translate to the same increase in revenues but it shows how fast things are growing.
Through the two healthcare businesses, the company expects to have saved clients $2 billion in 2020, making it a very compelling value. The company now serves 3 of the 5 largest healthcare plans in the country. With some the largest potential customers already onboard, the growth rate should slow but still be rapid. The company is successfully widening its business within many of its newer customers.
There is a third smaller segment that handles call centers and licensing which had revenues of $17.5 million in 2019.
The chart below summarizes operating results over the past 3.5 years.
Source: Performant forms 10-K and 10-Q
Management has stated that the losses in 2018 and 2019 were due to ramping up new programs in their rapidly growing healthcare segment. There were significant costs to build out their platform, upfront work, and hirings before the bulk of the revenues from these programs kicked in. It was essentially a three- year process. In 2019, revenues increased for the first time in six years as the new healthcare programs started flowing. Also, that year the company stabilized its legacy businesses.
In 2020, the company became profitable (before goodwill impairments) due to reaching scale in this segment. Net income in the first quarter of 2020 was reduced by a $19 million intangible asset impairment. It was reduced again by $8 million in the second quarter of 2020 for the same reason. Otherwise both quarters were profitable.
The first quarter of 2020 is before Covid-19 kicked in and represents a good indication of the profitability of the business. Adjusted EBITDA was $7.1 million that quarter after two years of losses. The second quarter was significantly impacted by Covid-19, more so in the legacy segments but also in the healthcare audit segment. Management successfully lowered expenses in the second quarter almost as much as revenues declined through furloughs and other methods. Some of these lower costs are expected to be permanent from the legacy side. Despite the large revenue decline, EBITDA was still $3.7 million in the second quarter. Management expects the Covid-19 impact to be significantly reduced in the current quarter.
The most important line item is the healthcare percentage of revenues. It has increased rapidly and is closing in on half of the total. There remains a significant runway for this growing business. Revenue in this segment is highly recurring. The chart below breaks out claims auditing and eligibility reviews growth by quarter. Audit levels dropped considerably in the last quarter due to Covid-19 but management expects that segment to get back on track over the remainder of this year. A breakout of the healthcare segment growth is below.
Source: Company presentation LD Micro Conference 9/2/20.
As noted above, the audit segment was impacted by Covid-19 last quarter but should pick back up as Covid-19 hospitalizations, lockdowns and restrictions fade.
The balance sheet is weak. Performant had a tangible net worth of -$13.1 million on June 30, 2020. It had debt totaling $62.6 million on that date. The debt is from a related party, ECMC, a customer and shareholder. Over the past 3 years, that lender has extracted warrants totaling 5,794,990 all at an exercise price of $1.95. This represents about 10% of the outstanding share base. The interest rate was an effective 13.9% in the first half of 2020. The loan matures in late 2021 but the company has two one-year options to extend. The company does not have a line of credit but did have cash totaling $15.2 million on June 30, 2020. Things are starting to improve as the company generated $15.7 million from operations in the first half of 2020.
Refinancing the loan is a major opportunity. The loan had an effective interest rate of 13.9% in the first half of 2020 when dividing interest expense into the average loan amount. The company has now had two quarters in a row of solid interest expense coverage and strong EBITDA. Another one or two strong quarters and they should be eligible for a more market interest rate. A 5% interest rate would save them $5.5 million a year in interest expense.
The growth of the healthcare business appears sustainable due to a limited amount of direct competitors and a mostly proprietary platform of algorithms and models used and refined. There is a barrier to entry in replicating their platform.
The healthcare industry is growing steadily. CMS (Medicare) estimates it grew 4.6% in 2018.
Performant has built out its healthcare platform. New customers can now be obtained with just tweaks to it. That means a much higher percentage of new revenues will drop to the bottom line going forward.
Management compensation is low versus peers. The top four officers received $1.5 million in 2019.
The stock is currently relatively illiquid. It currently averages 49,248 shares a day, which is only about $30,000 per day at the current price. Part of the problem is a low float as shown in the section below.
The balance sheet is highly leveraged and the company has a slight negative tangible net worth.
The student loan segment is likely to continue to decline. This segment is currently about 22% of the total so it is becoming less of an impact.
The top three customers represent 45% of revenues. The company has lost large contracts in the past. Those contracts were primarily government clients. The company has diversified away from the government though it is still a large portion of revenues.
Performant has a very concentrated ownership structure as shown below. Due to the low float, any significant buying or selling by these institutions or others could significantly move the stock.
Source: Performant Proxy Statement 5/22/20
Parthenon previously majority owned Performant and kept the current shares after the IPO in 2012. ECMC is a customer and Performant’s lender.
The first quarter of 2020 is a good indication of the run rate of the business. Revenues were $45.9 million, up 22.0% if annualized from calendar 2019. EBITDA without adding back stock compensation was $6.4 million. Management has a goal of getting to a 20% EBITDA margin. They hope to recover from Covid-19 program delays by the end of this year, and this quarter should be better than the second quarter.
Annualizing the first quarter indicates a $25.6 million EBITDA run rate, assuming no growth. While it is difficult to go on one quarter, that number is probably conservative based on likely interest rate savings and healthcare segment growth. The enterprise value is currently $81.5 million (debt $62.6 million + stock cap $34.1 million – cash $15.2 million). Enterprise value is 3.2x annualized EBITDA. That is extremely low. According to Investopedia a normal EV/EBITDA ratio the last few years is 11 to 14. Discounting for Performant’s high leverage and microcap size an EV/EBITDA ratio of 8 is estimated as market value. Based on an EBITDA of $25.6 million that puts the stock price at $2.64 based on the following formula.
Enterprise Value = $25.6 million EBITDA x 8 = $204.8 million
Stock value = Enterprise Value $204.8 million – debt $62.6 million + cash $15.2 million = $157.4 million
Price per share = Stock value $157.4 / Shares diluted 59.7 million = $2.64/share
This calculation assumes the company can at least meet or exceed its first quarter 2020 results, which were the last before Covid-19, by the first half of 2021. But even the second quarter 2020 Covid-19 impacted results were relatively good.
I also looked at Performant’s peer healthcare IT companies.
Source: Value Line and Yahoo Finance
HMS provides healthcare cost containment solutions. PRGX provides recovery audit services. HealthEquity provides healthcare information to employers and consumers. The first two are the most similar to Performant.
Performant has underperformed in earnings and revenue growth in the past. However, revenue growth was 18.2% in 2019 and 22.0% in the first quarter of 2020. Keep in mind, Performant is still under 50% healthcare at this point, so not the pure-play their competitors are. Once the healthcare exceeds 50% of total revenues, it will be compared more closely with the peers shown above. Based on the peers, I believe the 8x EV/EBITDA ratio is supported if not conservative.
I recommend a long position in Performant with a one-year price target of $2.64. That is 4x the current stock price.
Disclosure: I am/we are long PFMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.