Friday, June 16, 2006
Mr. Market causing you pain? (2 of 2)
In part 1 of 2, I laid out an investment thesis with five points to prove, leaving the last two for further research: Financing benefits equity holders and PainCare is priced attractively.
Proving the last two points has been difficult, to the say the least. The aggressive acquisition model inherently brings with it a lot of moving parts; however, adding in financial re-statements and recent equity restructurings makes this exercise even more daunting. In that context, I’ve elected a more back-of-the-envelope approach. Any output is, as a result, more speculative.
Financing benefits equity holders
Debt levels are manageable… and… Cash flow covers earnouts
In 2006, a number of convertible and straight debt as well as performance earnouts will come due for PRZ. One of my biggest doubts has been whether PRZ will have enough cash in the tank to fund these liabilities while adhering to debt covenants. In fact, even PRZ has raised this concern. In their discussion of risk factors, Management says:
“We may need to negotiate a waiver letter with respect to our credit facility…
If we are forced to repay our debentures and notes in cash, we may not have
enough cash to fund our operations.”
To ease this fear, I conducted a quick cash analysis comparing the expected sources and uses of cash for 2006. Most inputs were available from the recent 10K; however, I had to estimate the 2006 Earnout payment.
I’ve estimated the 2006 earnout payment value using a quick & dirty approach. Instead of researching every contingent payment, from every acquisition, from every 8K, I’ve made my own estimate. I believe that CY’s earnout payment is correlated with the PY’s growth in the Goodwill account. Since earnout payments are deferred cash distributions of the Goodwill recorded at the time of acquisition, this seems rational. Thus, I’ve estimated the 2006 earnout payment as the 2005 growth in the Goodwill account times an adjustment factor.
In addition to the 2006 earnout payment, I’ve made some broad assumptions on a few variables (e.g. assumed same interest rate on all debt, 10% organic growth, same-sized credit facility waiver fees, cash operating income), however I think they are reasonable.
Assuming that PRZ will continue to be in violation of its debt covenant (e.g. minimum EBITDA levels) and that the share price doesn’t rise above $1,90 (the price at which the convertible debt converts, the net cash position is $4,4M – enough to run the business. However, if the share price recovers, the convertibles would most likely convert, freeing up an additional $8,5M in cash.
A large caveat to this analysis would be that this ignores the timing of all cash flows.
Nonetheless, I’m comfortable enough to say that Debt levels are manageable and Cash flow covers earnouts.
Dilution is acceptable
I’ll start off by saying: “I have no idea how many shares are outstanding.” PRZ has been so busy swapping out warrants for restricted shares, vesting stock options, and issuing contingent performance share awards that I can’t reliably determine how many fully-diluted shares are outstanding. But, I’ll try nonetheless.
In the 2005 10K, Management reported ~50M shares outstanding. Yet, a few weeks ago, the CFO told analysts in a conference call that he estimated the 2006 year-end, fully-diluted, outstanding share count between 65-70M. I’ll take the most conservative estimate and assume 70M.
With 70M shares outstanding, 2006 fully-diluted EPS falls within Management forecast of $0,20 – 0,22.
PainCare is priced attractively
As a starting point, I always like to look at a company’s earnings power value (EPV) assuming a no growth scenario. Effectively, the EPV is a perpetuity function, assuming current earnings forever. I calculate the no growth EPV by looking at last year’s distributable cash earnings less net debt divided by fully-diluted shares outstanding. I also make an adjustment for maintenance CapEx.
Here is the no growth EPV for PRZ.
Taking last year’s earnings, PRZ trades at a little more than half of the no growth EPV of $1,96. Yet, we know that Management expects to grow the business 20-30% annually over the next few years. I believe they can accomplish this, earning returns above their cost of capital, and thus creating value.
So what?
I am cautious about making a significant investment. However, I will dabble.
Frankly, the investment decision depends on a number of factors outside my circle of competence: the potential for numerous debt covenant violations (e.g. market cap, EBITDA, FCF), the delay in financial statements submissions, the complex financing instruments. Although, I think a flexible and patient investor could be well rewarded.
For better or for worse, it's been an interesting exercise.
Good luck,
RMA
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