Psychiatric Solutions. Inc. – ‘Crazy’ Pricing for Big Potential Returns

Psychiatric Solutions, Inc. [PSYS: $23.94] is a pure-play provider of inpatient behavioral health care services. They offer its services for children, adolescents, and adults through acute inpatient behavioral health care facilities and residential treatment centers. Services include 24-hour nursing observation and care, daily interventions and oversight by psychiatrists.  These services are all coordinated by physician-led teams of mental health professionals. PSYS also provides contract management and managed care plans involving the development, organization, and management of behavioral health care and rehabilitation programs within medical/surgical hospitals. As of year-end 2009, it owned and leased inpatient behavioral health care facilities with approximately 11,000 beds in 32 states, Puerto Rico, and the U.S. Virgin Islands.

PSYS came public during the stock market’s boom years and was priced accordingly at $21.25 /share even though they were yet to show earnings. Losses ensued through the year 2000 before the company turned consistently profitable in 2001.  Since then, six of the past eight years have shown year-over-year improvement and EPS surged from $0.10 in 2001 to $2.10 last year.  Revenues grew from $113.9 million to $1.81 billion over that same eight years.

Here are PSYS’s per share numbers as reported by Value Line:

At this morning’s quote of $23.94 these shares are offered at just 11.4x trailing 12-month earnings and about 10.4x forward estimates of $2.30 for 2010. That seems extremely cheap for a company that has shown historical growth that often merited much higher multiples in the recent past.

Even 14x forward projections would bring PSYS back to $32.20 or up 34% from the current quote. Value Line is using an 18 multiple in calculating their 3 – 5 year target zone. Standard and Poors and Morningstar both agree that PYSY seems undervalued. Their ‘fair value’ estimates [reflecting their views of today’s true worth] are now at $27.30 and $30 respectively.

Is my goal of $32.20 realistic? PSYS shares hit a peak price of $29.90 in 2005 when EPS were only $0.59 and these shares changed hands at highs of $38.80 – $42.90 during parts of each calendar year from 2006 through 2008 (also times when revenues and earnings were significantly lower than today’s).

Any expansion of health care benefits to a wider group of patients would seem to add to the potential pool of users of psychiatric treatments in this crazy world we live in.

Despite the good fundamentals and the big market rally from last March’s low, PSYS shares still trade at a very reasonable valuation. In fact, the current price is lower than the lows from the entire period running from late in 2005 right through most of 2008. 

If you’re option savvy and want a relatively low risk play for just over six months you might want to consider this trade:

If PSYS shares rise modestly to at least $25 [+ 4.5%] by Sep. 17, 2010:

·         The $25 calls will be exercised.

·         You will sell your shares for $25,000.

·         The $25 puts will expire worthless (a good thing for you as a seller).

·         You will have no further option obligations.

·         You will end up with no shares and $25,000 in cash.

That’s a best-case scenario profit of $25,000 – $18,390 = $6,610

$6,610 / $18,390 =  + 36.9% net cash-on-cash return

achieved in 6.25 months on shares that only needed to rise by 4.5% over the same period.

What’s the downside?

If PSYS shares remain < $25 on Sep. 17, 2010:

·         The $25 calls will expire worthless.

·         The $25 puts will be exercised.

·         You will be forced to buy another 1000 PSYS shares.

·         You will need to lay out an additional $25,000 in cash.

·         You will have no further option obligations.

·         You will end up with 2000 PSYS shares.

What’s the break-even point on the whole trade?

On the original 1000 shares it’s the $23.94 purchase price less the $2.35 /share call premium = $21.59 /share.

On the ‘put’ shares  it’s the $25 strike price less the $3.20 /share put premium = $21.80 /share.

Your overall break-even point will be $21.70 /share or 9.37% below the trade inception price.

Summary:

Psychiatric Solutions looks to be trading at a significant discount to both its present day ‘fair value’ as well as its year-end projected price. Outright buyers could see 30 – 35% gains over the next 12 months.

Investors willing to buy shares and write (sell) both call and put options for this September’s expiration at the $25 strike price could reap cash-on-cash returns of > 36% over that 6.25 month period on any increase of 4.5% or better by the trade expiration date.

Dr. Paul Price

www.BeatingBuffett.com

Disclosure: Author is long PSYS shares and short PSYS options.