5 Top Picks for 2023 – 350% Upside Scenario to Fair Value...What a year… I, like many other have been unequivocally and entirely destroyed in 2022 but if you look at the underlying fundamentals, I think many of them are in a better spot today then they were 12 months ago yet their stock prices are off 50, 60 even 80% in some instances.
Firstly, we must address what I got wrong in 2022. Two words, multiple fade. That is the driver for such a large share of your outperformance/underperformance when you look down market cap and it is a two-way street, for as much as it can work for you it can work against you.
So, what drives multiple expansion/contraction, biggest thing here is the growth rate of the business and direction of margin structure whether it is strengthening/weakening. More importantly it is the second derivative of those numbers so looking at the growth rate of the growth rate.
In 2022, there was unquestionably a growth slowdown across many of these names as we return to a more normalized operating environment post COVID, coming out of a tech bubble and as the inflationary bullwhip goes through some of these cost structures.
That’s what gets us to today; and the opportunity to find the names that have weathered the storm and are coming out the other side. So, what are we looking for;
1) Accelerating Revenue Growth
2) Expanding Gross Margins
3) Expanding EBITDA Margins
4) Manageable Net Debt/EBITDA
5) Trough Valuation on Recovering 1) 2) 3)
Lets Get into it;
First Name – Premier Health of America Inc. ($PHA.V)
I am starting with this name as it reported very strong numbers yesterday and between myself and the company buyback the stock barely traded.
Lets go through the Criteria;
1) Accelerating Revenue Growth - You can grow organically or by acquisition, and when you have an asset light business that generates a lot of cash you are able to do so without adding further dilution to the shareholder base. On the acquisition side the geographical expansion into Ontario with the April deal is looking better every Q. the strategic importance of its footprint expansion is critical.
But being balanced we have to recognize that there have been regulatory headwinds in their core Quebec based business around normalization back to a post covid World. More importantly we are looking at a trough level that the business is going to recover from here into FY23 with a return to more longer-term contracts and bidding terms.
So we got an M&A strategy that is adding close to 25% of revenue on a YoY basis and a recovering home market into FY23 at the same time last 3 Q Revenue Growth has been Q2 3.41%, Q3 20.30%, Q4 25.39%
So, check that off, we have an accelerating growth rate into a recovering end market without economic sensitivity into FY2023 with upside optionality of further consolidation.
2) Expanding Gross Margins – not as important for a cost-plus business on longer term contracts as always going to be more stable.
The FY20 in a COVID environment margin structure might be seen as a peak margin environment but over the past 4-6 Qs the margin decay was getting worrying. That is why the Q4 report out last night was so important as it bucked that trend getting the gross margin profile back over 25%.
So check that off, a little early seeing just one Q of strengthening gross margin profile but the factors driving it I think are persistent and we can see the recovery already further down the income statement.
3) Expanding EBITDA Margins – this is where the rubber meets the road on the name which gets me so excited. There were several factors that hit EBITDA margins in 2022 that I think are reversing and you are already seeing the recovery in EBITDA margins Q2 2.65% Q3 7.06% Q4 10.06%.
I think there are three factors that led to the collapse of EBITDA margins that are all in the rearview mirror. Firstly, footprint expansion they took a Quebec based business and added a completely new operating segment in Ontario which took some time to buildout. Costs will always come before the revenues.
Secondly, tech infrastructure buildout this is critical to the story and you can even see it in their MD&A as they talk about bidding on more tech enabled contracts in the coming years and help diversify them against smaller players in the space and helps make each incremental deal more accretive.
Thirdly, those darn Transport contracts, was great in 2021 when we heard about these multimillion-dollar transport contract wins but the demise of them were supply chain delays with the inability to procure the required vehicles. Management moved quickly and from a capital allocation perspective already moved away from them and you can already see it in the recovery in EBITDA margin.
So check that off with a big check mark, I have been so impressed with this management team from a cost discipline and a capital allocation perspective. I think that recovery in Q4 shows that these 2022 headwinds were dare I say… “transitory” and should be in the rear view mirror.
4) Manageable Net Debt to EBITDA ratio - $22M in Debt against $5M in Cash for a Net debt of $17M against 9.0-9.5M in FY23 EBITDA for a Net Debt/EBITDA <2x
Balance sheet does not seem stretched to me. Especially seeing that this is such an asset light business with minimal CapEx requirements. Add the fact that they said the majority of the IT infrastructure spend associated with their Ontario expansion is largely in the rear-view mirror.
So check that one off, balance sheet is in a good spot with room for further M&A/buybacks to accelerated growth. Only thing to keep an eye on is that the debt is variable rate but given I think rates are peaking we don’t have to worry about that as much.
5) On Valuation -The is where it gets too cheap to ignore.
Lets say for FY23 I get to an estimate of $90-95M in revenue (excluding any incremental M&A) with the recovery in the margin structure even just to Q4 FY22 levels of 10% results in a $9.0-9.5M EBITDA estimate.
So current Valuation is 2.0-2.5x EBITDA which is trading like this is going out of business. In a more normalized environment with recovering margin profile and top line growth I think you could see anywhere from a 8-12x EBITDA multiple put on the business given how scalable, with predictability, lack of economic sensitivity and the asset light nature of the business.
As a result, on that 8-12x EBITDA multiple on my $9.0-9.5M EBITDA estimate I get a share price target range of 1.28/share – 2.03/share for a midpoint target of 1.67/share or 350% upside just on a recovery of sentiment without stretching on multiple or growth rate with further upside from M&A/Buyback.
So, there it is my first case out of five, the lack of economic sensitivity paired with the predictability of the business makes it’s one of my favourite names into FY23. The set-up here is exactly what I am looking for, a bombed-out stock price trading at a trough valuation where the stock price is still at the lows even though the business has already bottomed and recovered.
LONG
Keep an eye out for second pick 2 out of 5