CATS…Naked Shorts and the Public/Private Disconnect

I often refer to investing in public micro-cap companies as “public venture capital”. This is because when you get it right, you can have venture-type returns; winning positions have the potential to return multiples on your investment. Venture upside with the benefit of liquidity which, hopefully, enables one to reduce the downside risks, is what has always attracted me to micro-caps.

Besides the obvious benefit of liquidity, the last few years has brought another benefit to micro-cap investors over their venture brethren. This has come in the form of a valuation discrepancy. Instead of trading in line with their private counterparts, public micro-caps have been trading at discounted valuations. Sometimes these discounts are small, but, occasionally, they can be quite large. Which means that, as the companies grow, the upside for the pubcos is possibly much larger.

This is the case lately with one of our favorite names, Catasys. CATS is trading at a market cap of $65 million, which is around 3X the billings expected for 2018. This is a multiple that would normally be associated with a larger, more mature company, with lower growth prospects. But, due to its status as a public, micro-cap, this is the valuation that the market has assigned to CATS.

Contrast this with the valuation of their nearest private competitor, Quartet Health. Quartet is a smaller company (about 50% smaller), in terms of revenue. Their product is somewhat similar to Catasys’, in that it pairs patients with physicians, however they do not have a proven record of saving money for the HC system. As such, it appears they have only one real client (Sutter Health) and are only active in NJ for them; their eligible patient population is a fraction of that of CATS, which has signed contracts with 5 of the 8 largest insurers in the US and is active in multiple geographies.

In the last few weeks, Quartet raised $40M in financing. This was rumored to be done at a valuation of $400M. I’m not going to cast judgement on this valuation; but, I will say that Quartet’s valuation is a statement by VCs about the attractiveness of the space in which these companies are operating. When companies command valuations like Quartet, you know you’re in a hot area.

Now, let’s contrast Quartet’s valuation with Catasys’. CATS has about double the run rate in revenue, many more clients (bigger companies, with broader mandates), a product that is proven to provide benefits, and a market cap about 1/7th of Quartet. CATS would need to go up 7X just to achieve the same valuation as their nearest private competitor.

Will this happen? Only time will tell. But, if you wanted to invest in this space, wouldn’t you prefer the strong company, especially at a tiny fraction of the valuation???

Why the Disconnect?
There are several possible reasons that public companies trade at lower valuations. It could be that the investors are more short term focused. They are looking for performance (i.e. earnings and revenue) today, not willing to bet on a future that could be several years from now. We do know that VCs are forced, by illiquidity, to look much further down the road.

Also, by nature, private companies get bid up over time. The pool of investors is smaller and, generally, the early stage investors return and work to build up the valuation in later rounds. This generates very positive returns in their portfolios, but leads to eventual problems like SNAP’s crappy IPO or UBER’s valuation dropping while still private (it would likely be lower still if public).

However, the most likely reason I can find for the disconnect in valuation is naked shorting. It appears that microcaps are very vulnerable to this phenomenon and CATS is no stranger to this; by my calculations as many as 2 million shares of Catasys could be naked short.

Shorts are smart and tend to do well with early stage companies; drive their stock down and cover on the next round of financing. It’s a self-fulfilling game plan.

But, it is not infallible. Sometimes a company comes along that is funded and has a business plan that is ramping. Catasys is this kind of company; the kind that can really take it to the shorts.

Bottom Line; Valuation is low, Shorts will bid it up…
When last I wrote about Catasys, I said that the tax loss selling was ending and the stock should start reflecting what is really happening; which is new contracts being signed and increasing enrollment in their programs.

Since then, CATS has rallied from $3.50 to $4.07. Based on the potential, as evidenced by private valuations, the stock has a long ways to go. The first quarter is forecasted to have several new clients and expanded programs from existing ones. Additionally, the fourth quarter looks like it was a very strong quarter; Catasys is at a hockey stick inflection point in their revenue cycle.

More contracts along with a solid quarter of growth should go a long ways towards helping Catasys close the public/private valuation disconnect. And, if there truly are, as I surmise, a lot of naked shorts in CATS, it could be a very exciting quarter for the stock. Because, as the Company executes, the shorts will be forced to cover.

I added to my CATS holdings this week and it is one of my favorite names, not only for all of 2018, but especially for their catalyst-filled first quarter.

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