Wednesday, May 24, 2006
Mr. Market causing you pain? (1 of 2)
Still stinging from EXPE's impressive-(ly bad) Q1, I've been investigating various pain treatment options. Sure, your OTC analgesic might relieve the afternoon headache or Jack & Coke hangover, but stock market pains sometimes need a little extra... like an implantable morphine pump.
Fortunately, the good people at PainCare Holdings (AMEX: PRZ) offer just that. PRZ is a healthcare services company specializing in the treatment of pain. They offer pain management care (to treat chronic or acute pain), minimally invasive outpatient spine surgery, and orthopedic rehabilitation. The Pain Management field is increasingly becoming an important component of patient care and PRZ is a fast-growing provider of these services.
PRZ is attempting to roll-up the Pain Management industry by acquiring high-performing practices, expanding their service offerings, and increasing practice revenues and operating profits by 25-50%. To be clear, the consolidation strategy aims at capturing revenue synergies, not leveraging the cost base to achieve a scale advantage. Given that physician salaries comprise most of the cost bar, I believe PRZ sees limited opportunity on the cost front.
Preliminary results have proved successful. Since 2003, PRZ has increased revenues and operating profits by more than 400% to 69M and 15M, respectively.
BUT, of course there's a 'but':
Just a few weeks ago, the SEC took issue with PRZ's treatment of some non-cash, accounting charges and the stock plummeted by more than 50%. The revisions are an absolute mess and incredibly difficult to weed through. However, I honestly believe they are the nature of the beast and not Management's attempt at disguising the truth. They are all non-cash, non-operating and deal with the accounting treatment for cash-less stock options, debentures, PIPEs, & warrant financing instruments, and intangible asset amortization. The Company has been working hard to revise the financials and is expected to submit their 2005 10K by June 2nd. Most of these issues will persist through Q2 2006.
So, here's the investment thesis.
Industry has favorable long-run prospects
Addressable market is sizeable and growing
Google tells me that each year 75M (or 1/4 of) Americans complain of chronic or acute pain and spend $100B on treatment annually. Common sense tells me that most of these complaints are from baby-boomers and the elderly.
The US Census says that the 45 - 84 age segment is likely to grow by 30% by 2010. As aging baby-boomers are generally perceived as more active than previous generations (interviews with my parents confirmed this, n=2), I would expect many of them to suffer from arthritis, back pain, and chronic joint symptoms.
Let's assume:
- Treatment volume will increase: 75M * (1 + 30%) * 'X' Higher incident rate
- Healthcare costs will increase (a given, I think)
Driven by volume and price increases, the overall market for pain management has very strong growth prospects.
As this relates to PRZ, Pain Management is just one piece of the puzzle. The market opportunity becomes even more attractive when you consider the trends in spinal surgeries. Deutsche Bank estimates that the market for spinal replacement parts will grow at a 23% annual CAGR through 2007. Spinal replacement parts require professional installation; and, PRZ provides these services.
Margins are stable
PRZ margins are mostly driven by pricing and doctors' salaries. Currently, PRZ practices achieve an ~80% gross margin and ~20-30% cash operating margin. All acquired practices have fit this profile and PRZ as a whole reports similar results.
Even as competition increases, I would expect pricing to hold constant over the near to medium term. I don't know of any "2 for 1" deals on percutaneous disectomies. Remember, we're talking about multi-syllabic medical devices and spinal surgeries, not car insurance.
As for doctors' salaries, they are controlled by PRZ Corporate and are locked in through employment agreements signed at the time of acquisition.
Management is competent
Management has successfully executed... and ....Management has unique experience in...
Reviewing the 10K, management biographies indicate a wealth of experience in Healthcare, Industry roll-ups, Pain management, and Mergers & acquisitions.
In addition, PRZ has brought on board a six-person deal team to integrate each practice as it comes online. The acquisition process is methodical and well-tested with more than 20 acquisitions completed to date.
Growth increases firm value
Acquisition strategy is viable
So far, PRZ has kept a sharp focus on their acquisition profile. I believe the acquisition strategy is viable for the following reasons:
- Clear business definition: PRZ has acquired and continues to acquire high performing Pain Management, Spinal Surgery, or Orthopedic rehabilitation practices. These businesses rank highly on both customer and cost sharing.
- Attractive targets are abundant: American Academy of Pain Management has 6.600 members. Assuming 3 members per practice and that only the top 25% are high-performing (e.g. 80% gross margins, 25% cash operating margins), there are at least 550 potential targets.
- Merger terms are replicable: Almost every PRZ acquisition has been identical. PRZ pays 5x operating earnings with 50/50 cash/equity consideration with earnout agreements spaced from one to three years.
- Consolidation captures synergies: Organic revenue and operating earnings growth for acquired practices trends between 20 and 50% in the first two years after acquisition.
Execution has delivered value
Management has publicly-stated that PRZ will only engage in transactions that are accretive to fully diluted EPS. Since the SEC ruling, this metric has been difficult to track, but my educated estimate is that fully-diluted EPS increased from $0,05 to $0,20 from 2003 to 2005.
Another way of answering the value question, is reviewing ROIC - WACC evolution. Once again, this is difficult without the revised 10K, but my best guess (note: this is not an educated estimate) is that ROIC minus WACC has fallen from -4,5% to 0,0%.
As for the rest...to be continued
As indicated in the title, this is "1 of 2". Without reviewing the most recent financials, I can't truthfully prove that "Financing benefits equity holders" or that "PainCare is attractively priced". These are two very important points given that PRZ has a very aggressive acquisition strategy that relies heavily on convertible debt financings and stock issuance. My biggest fear is that PRZ could dilute away all shareholder value or might not have enough fuel in the tank to cover debt repayment.
Nonetheless, my 30 second answer is postive. Management has forecasted pro forma, fully-diluted earnings for 2006 at $0,20 - $0,22 with no further acquisitions. Assuming $1,50 as the current share price, PRZ trades at a PE of ~7,5x. I cannot reliably estimate intrinsic value, but I would speculate that it sits above $2,00 per share.
Finally, I think PRZ is interesting to speculate on not only because of the proof points outlined above but also:
- I think the stock has shown a lot of weakness as persons familiar with PIPE transactions may have anticipated the SEC announcement and shorted the stock ahead of time.
- Investors often shudder after missteps by small-cap companies causing share prices to overreact.
- The non-cash accounting losses are ironically exacerbated by the appreciation of PRZ shares during those time periods (e.g. share price goes up, derivative instrument losses increase as well). As the share price has dropped precipitously in Q1 2006, PRZ is going to announce a monster (great) Q1 that might attract a lot of momentum investors providing the catalyst for the share price to gap upwards.
I look forward to taking a closer look at the revised 2005 10K and 2006 Q1 10Q.
Good luck,
RMA
# posted by RMA @ 06:25 
Comments:
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Yet another interesting analysis. I have known Paincare for a long time. Lately I have not looked at it. I fully agree with your thoughts. I think I will jump into it soon. This is a no brainer.
Thanks.
Thanks.
Oh, by the way, we just bought EXPE warrants at $1.50 and still buying. We are going to accumulate about 10K shares of EXPEW. Another no brainer...
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