Providence service corp (PRSC) is the wonderful story of a good company that has been growing at a great pace but has been mismanaged over the years by a distracted CEO but now has the team in place to unlock shareholder value.

The company operates in 2 segments; Outsourced social services and outsourced non emergency transportation (NET). The first business is their legacy business and is now only 30% of sales and dropping every year. The NET business is won on a state by state or county by county basis to service people of Medicaid/care and provide them free transportation to the hospital for regularly scheduled appointments. This saves the state money since PRSC can do it for less, so whole state budgetary pressure is a concern, they are usually the last item to come under attack. The NET business was acquired in 2007 and has been winning tons of new contracts. PRSC took on a lot of debt to buy their NET business and it almost bankrupted them in 2008/9. They managed to pull through that and have now delevered so net debt stands at 90 million, down from 150 million at the end of 2009.

The basic story here is that the social services business has been holding its own, the NET business has been winning tons of new contracts and growing quickly, but margins have suffered. Revenues have grown from 691mm in 2008 to an expected 1.1 billion in 2012, almost entirely from NET. NET keeps winning new contracts, but rolling out these contracts entails on time startup costs. As well, 3 contracts this year were poorly bid. PRSC bids on a contract and gets paid based on the number of people in the geographic area. Thus if more people use the service in that area than they expected, they don’ get extra compensation. Snow storms are actually good for them because people cancel their appointments and stay home (big reason why Q1 this year was so weak vs 2011). So in those 3 contracts, utilization rates came in much higher than management had modeled, ruining the profitability of the entire company.

On many a conference call, management has said they aim for a company wide ebitda margin of 6.5%. From 2008-2010 they managed to surpass this, delivering margins of 6.5%, 8.3%, and 8.3%. However, in 2011 the problems started and they only achieved a 6.2% ebitda margin. This year looks to come in below 5%. That’s a terrible margin obviously, and has been more than offsetting the huge revenue growth.

The former CEO of the company, Fletcher McCuster is the founder of PRSC. He did a decent job growing the company but never worried greatly about profitability and often seemed more concerned with saving downtown Tuscan, AZ than maximizing shareholder value. Here’s a link to a news story on Fletcher after he announced his retirement 2 weeks ago http://www.insidetucsonbusiness.com/...9bb2963f4.html. As you can see he lacks focus, and owns no shares.

Things got interesting this summer when an activist hedge fund, Coliseum Capital, bought a larger stake in the company (7% at the time). I did some digging on their backround and they take outsized bets on a few companies (150mm AUM and will take stakes up to 35mm) and push for change or ultimately a sale. It worked for them in Benihana and last year as well when they sold Rural/Metro (former symbol rurl) to a private equity firm. RURL is in the EXACT SAME BUSINESS AS THE NET DIVISION. So clearly this hedge fund understands the business and hot to get value from it.

Let me walk you through the timeline on RURL. Coliseum bought a small stake in 2009. In 2010 the increased their stake dramatically over the year by buying shares directly from treasury. In the back half of the year, they fired the CEO, renegotiated the expensive debt from 12.75% to 6% and managed to improve margins on the underlying business. They then sold the business for $17 or 9x ebitda, to PE shop Warburg Pincus. This was in the spring of 2011. Coliseum bought their initial shares around $4 and their big stake at $7.50.

Now stop me when this sounds familiar. Coliseum bought their initial stake in PRSC in spring 2012 around $14. The managing partner of Coliseum, Christopher Shackelton became a director of PRSC in June. In the summer when the shares came under pressure due to bad margins they increased their stake dramatically, buying on the open market to hold 16% of the company. 2 weeks ago Shackelton “retired” the CEO and CFO of PRSC and becomes chairman of the board. A lead director has taken over as interim CEO and a former director from rural/metro has become the new CFO. Coliseum also bought an extra 100k shares the week after announcing the management changed around $12.50.

It is so clear what happens next that I shouldn’t even have to explain it. The turnaround is already occurring, and on the last conference call the COO of the company who runs the NET service said steps have been taken to deal with the 3 contracts that are dragging down the performance of the entire company. One contract has been renegotiated for a higher rate, another will be terminated at no cost to PRSC and the third is being reworked. Shackelton will continue to stress margins when bidding on new contracts. The ebitda margin should improve to at least 6.5% since the company has beat that many times in the past and RURL had higher margins closer to 10%. Then he will sell the company.

If we assume revenues of 1.1 billion and margins of 6.5% we get ebitda of 71.5 million. Like I said RURL sold for 9x in 2011, and a bigger comparable, EMS, sold to a PE firm for 10x in 2010. If we give PRSC 8x, that equates to a 570mm EV. Take off the debt which should be down to 60mm by the end of 2013 and the market cap of equity is $510mm. 13mm shares outstanding and you have $39 a share. The stock is currently trading at $14 and was as low as $10 in august. Even at 5% margins and 7x ebitda you get a takeout price of $25.

There are no big insiders who can block it, old management is already gone, and you have a guy driving the bus who has done the exact same thing only 1 year before. This seems like a pretty obvious buy to me, and is one of my largest holdings.

Enjoyed reading your writeup, thanks for posting it.

Good reading. As a reality check, what would your bearish pitch be for this stock?

hard to come up with one. at a minimum they free cash flow 20mm a year after capex and with the hedge fund in control of the board even if they couldnt find a seller they can just pay that out as a dividend.

Have you bought any of this yet? If not, why?

yea its my second biggest holding. ive owned it for awhile but doubled down this summer when I saw the hedge fund buying actively in August

Buyout funds do not like to buy companies with sub 10% EBITDA margins especially if there is any Capex.

Here are the potential negatives I see:
What happens in a bad winter flu season? This one is shaping up on multiple indicators to be worse than normal according to the CDC. I have no idea how this impacts their business, I know nothing about the industry, but I imagine this means many more transports. A quick google of "ambulance flu season" shows multiple news article of ambulance services struggling to cope with flu seasons, so it could be a significant hit on an already thin margin. 2011/12 was unusually mild, which makes me nervous about the significant declining results in this period. And overall their higher volume/lower percentage profit increases their vulnerability to these kinds of things going forward compared to previous years.

To me this would seem a good point for a bearish pitch. Precisely why are the margins decreasing so much? Is it just the bad contracts? Anything that increases revenue while decreasing margin in a government tender business where they get paid by area and not work done worries me. You're basically increasing the risk while not increasing the return.

OK, so the guy founded the company, grew the business well, earned better ebitda than today consistently. What caused the ebitda to dive? Was it a change in how he managed, or a change in the nature of business, or the nature of growing into less profitable markets? One off bad contracts?
This is great analysis and is actually the entire pitch, to me.

Do you know the breakdown of how much these contracts are hurting the business?

Competent new management + their due diligence + done it before = a winner for me too.

What do you think Q4 2012 results are going to look like? They come out early January. I can see a good case for why they'd be under performing.

all good questions. let me try to answer them all.

Bad flu season: I don't think the flu or normal colds affect their business too much. Normally when people get the flu they may go see an MD once to get checked out. This is a 1 time event and wouldnt drive people to use the service much higher than PRSC models. If they have a bad case of the flu they may call an ambulance for the ER which is not PRSCs business. To back this theory up, in the last bad flu season, 2009 swing flu, they actually had high margins of 8.3%. A bigger driver of high utilisation and source of risk is actually high gas prices because it encourages some people to use their service rather than drive themselves and pay for their own gas. PRSC gets compensated for higher fuel costs but not necessarily for the higher utilization rates high fuel costs lead to.

Why have margins dropped so much: The low margins have been an area of focus on every conference call this year. They also dont post the contract profitability for obvious reasons so all we can go on is what mgmt says on the calls. They have been claiming for some time that it is 3 bad contracts causing them to miss their targets, and that is you take out these 3 contracts, the rest of the company is achieving 6.5% ebitda. Like I said in the main post, they claim to have already taken action on each contract, so 2013 should be a clean year free of the negative effects on margins from these deals. These can be considered in between one off bad contracts combined with the goal of growing aggressively. They should never have bid for them at the prices they did, which they recognize and take the blame for. As well, they have passed on some recent bids since prices were coming in too low and it wasnt worth it. Anyways, the CEO has already taken the fall for this.

Hedge fund as biggest plus: I agree completely and its the main part of my pitch.

I think the Q4 results are actually going to look decent. Of the 3 bad contracts 2 have been worked out and should not be affecting the quarter. As well, Sandy acts in the same way as a big winter storm. People stay home to clean up or because the roads are bad and cancel their medical appointments. PRSC serves NJ so their footprint was directly impacted. Management also confirmed this on the last call. So Q4 might be a good quarter.

capex is pretty minimal because these guys dont have many fixed assets.

2 different buyout funds bought their direct comparables, EMS and RURL in 2010 and 2011 respectively, and both companies have margins in the same ballpark and both buyouts were for decent multiples.

Thanks for the answers. It's really hard not to see a buy here. I like their results. I like that debt is going down and reaching a threshold where the company starts looking attractive to a lot of cautious third party investors. They have a credible reason for the drop in ebitda and I have no reason to doubt them given recent purchases by major due diligence. They're in an industry that does contracts with dumb municipals that can be gamed by smart management. And they just got very smart management experienced in this industry.

And thanks for the post. It's pretty rare to get these tips from someone you can trust.

Coliseum bought another 110k shares over the past few days:

http://www.sec.gov/Archives/edgar/da...c30688_4x0.xml

nice, them buying even in the $14 range gives me even more conviction for a mid 20's or greater intrinsic value

What are your thoughts on the min/max time frame for a buyout? I see they sold RURL in 6-9 months from restructuring management, is that likely here?

Up a decent amount since you recommended but on a pullback now so thinking of adding some options as well. Longest is July this year.

Nice thread

Enjoyed the write up as well. Its my understanding that most private insurance companies don't cover NET and most payments come from Medicare/Medicaid. Any reason the new Obama care law would cut spending to NET services or any federal, state laws that would hurt their NET business?

its my understanding that Obamacare increases the amount of people who are offered medicaid, so more business for PRSC since they get paid based on a formula where one of the inputs is number of people under coverage in the region. Check out the new presentation on edgar. PRSC has a slide about it.

no idea. I wouldnt buy options on this, just the shares.

picked some up, ty/gl

thank you for the write-up / tip, stock up over $19/share.

It looks like Coliseum has an even larger bet on LHC Group (LHCG), another health care company. Any thoughts here?

What happened with your Lone Pine pick? You were extremely bullish at $3, they have since fallen to $1.25 ish (fun blog to read btw).

I should start jumping along for the ride whenever ahnuld posts about a stock. 28% rise since 12/8/12.

ya I got out in late nov for a big loss. Crappy management and crappy nat gas environment leads to bankruptcy.

took a quick look awhile ago, but looking again I see Van Berkhom is a major shareholder as well. They are another montreal buy side shop and my firm often holds the same position as them (but our returns are better hehe), so thats another positive. Ill have to take a closer look.

if you post about a stock idea you should definitely try to follow up when you do get out. (just speaking generally, i didn't see the idea referenced above)