Blue sky still ahead for Capitol Health

FY15 earnings guidance

Capitol Health (CAJ) last week announced detailed guidance for its financial year 2015 results, with the final result to be announced after final audit later this month.

The underlying revenue and profit guidance was higher than our prior forecasts, with management continuing to successfully execute its strategy and benefit from consolidation in the diagnostic imaging (radiology) sector.

Underlying net profit before tax (NPBT) was up 58 per cent to $16.1 million, and revenue up 23 per cent to $111.2m. The NPBT margin continued to increase from 11.3 per cent in 2014 to 14.6 per cent. Although management previously flagged one-off acquisition costs, they were higher than we anticipated with $8.4m stamp duty, transaction costs and re-structuring costs.

With the company in a high growth phase and further acquisitions likely, dividends are not a priority. But the final dividend is up 30 per cent to 0.65 cents (taking the full year dividend to 1.25 cents).

The acquisitions completed during FY15 underpin our high growth forecasts for FY16. As a reminder Southern Radiology, Imaging at Olympic Park, Sydney and Eastern Radiology Services were all acquired during the year with only partial earnings contribution for FY15.

Is the premium PE justified?

The company is trading on a price-earnings multiple of 21 times FY16. With FY15 earnings de-risked we believe this multiple is justified, and expect further share price appreciation as the market looks forward to continued high growth rates.

The majority of our forecast 40 per cent earnings growth for FY16 is just the full-year benefits from the recent acquisitions. There is upside risk to this forecast from higher organic growth, utilisation and synergy benefits.

The continued opportunity for strong revenue growth rates and the scalability benefits of increasing utilisation is likely to underpin at least five years of high earnings growth. With the multiple structural tailwinds we believe the market will become comfortable with a high short-term PE premium to both the market and the healthcare sector.

Our FY16 forecast doesn't factor in any further acquisitions, despite their likelihood and the company's ability to at least partially debt fund further purchases. This provides further valuation support, with industry estimates of $300m of revenue up for grabs in the fragmented NSW market.  

Diagnostic imaging growth rates

The industry has been growing at a very respectable 7.8 per cent compound annual growth rate for the five years to June 2014.

This has been driven by Australia's ageing population, an increased focus on early detection, and improving accuracy of scans. Finally the government initiatives driving increased Medicare funded non-hospital MRI usage have not reduced lower value scans such as general X-ray, CT scans and ultrasound.

Capitol Health with its non-hospital radiology exposure has achieved above industry organic growth rates over recent years, due to its focus on increased exposure to Medicare licensed MRI volumes, and selecting acquisition targets with utilisation upside.

The Victorian clinics are now likely to be approaching maturity but still able to achieve annual revenue growth rates of 5 per cent. But the NSW business is likely to be targeting around 8 per cent revenue growth rates.

Competitors

Capitol Health (CAJ) is the only sole exposure to diagnostic imaging on the ASX, with its nearest comparables being Primary Healthcare (PRY) and Sonic Healthcare (SHL). We view the PE premium to PRY and SHL (17-19 x FY16) as justified given their far more mature market position, and less appealing growth opportunities. It is also worth highlighting the recent share price declines for PRY and SHL are most likely due to weakness in other non-radiology parts of their businesses.

The unlisted I-MED is the largest industry player with 17 per cent, followed by Sonic at 13 per cent and Primary at 11 per cent. Capital Health is approximately 5 per cent, with the opportunity to increase to 10 per cent in the next five years.

Comparable consolidators

There are three other main ASX “consolidators” that Capitol (CAJ) gets compared against, despite the fact they operate in different industries  – Greencross (GXL), G8 Education (GEM) and Affinity Education (AFJ). GXL and AFJ have had some earnings issues, but a common theme among all four in recent months has been a significant PE de-rating.

For CAJ, although it had run too hard back in March, the stock now looks to have over-corrected to the downside.

Medicare Benefits Schedule (MBS)

The company and industry is highly reliant on continued government support through Medicare funding, with it providing 80-90 per cent of industry revenue.

The Federal Government has announced a Medicare Benefits Schedule Review Task Force to review each of the 5500 separate items. The review is testing for relevance and an effective use of government funds.

When considering the risk of this review there are a number of key factors that need to be taken into account. Firstly there has been no real increase to Medicare funding per unit of diagnostic imaging since 1999. This naturally favours industry players who can cut costs and increase scale.

Therefore it is promoting industry consolidation as the smaller radiologists are encouraged to sell their equity and earn a secure income in the larger group. This dynamic is a positive for the government as a less fragmented industry reduces regulatory costs.

An increase in scans is seen as a productive solution that saves costs in the healthcare system. This is because funding for early detection minimises expenditure in more expensive later follow-on costs such as hospital charges.

Despite the logical answer being for no major changes in radiology funding, the facts are that any government review provides uncertainty, and therefore the market may continue to discount the stock until this uncertainty is removed.

Track record

It is not by chance that the company has benefited to such a large extent from consolidation. MD and significant shareholder (6.8 per cent) John Conidi has a well thought out strategy for appropriate targets and how to maximise the benefits from them.

The first consideration is location with 45 facilities in Melbourne, 7 rural facilities, and more recently 15 clinics in NSW.

CAJ holds 23 MRI licences, with 17 Medicare funded so that GPs can refer patients to these machines for tests that can be bulk-billed. These changes were only introduced in 2013 and it is no surprise to see the instant up-tick in popularity, given the higher quality image that would normally be far more expensive than other scans.

These MRI machines provide strong earnings security for CAJ, given the limited amount of licensed MRIs, and the government objective to diversify the locations.

Conidi specifically targets smaller clinics with unutilised capacity that can be optimised as part of the broader group. He also has flexibility around the payment arrangements to ensure the radiologists are adequately incentivised and motivated to stay within the business.

With the consolidation in Melbourne largely complete, we believe there is an even greater growth opportunity for CAJ through the consolidation of the NSW market. 

Risks

As previously discussed changes to government regulation are the largest risk for the company, with the potential for changes to state and/or federal policies.

Although the growth by acquisition model has worked well in the past, there is obviously still risk going forward of management over-paying for acquisitions, or having integration issues.

There is also risk of increased competition from current and/or new industry participants.

There is key man risk among the relatively small management team, and also the radiologists and other key employees.

The company's reputation among GPs is also critical, especially since the change from 2013 allowing GPs to refer to non-hospital clinics for Medicare funded MRIs.

We mentioned the positive of CAJ having direct exposure to a high growth sector of healthcare, rather than PRY and SHL which are more diversified and have largely mature earnings. The offset to this is that the lack of diversification means the risk is higher in regards to any potential negative structural change in the industry.

On balance a share price in the 70s presents a compelling risk/reward opportunity with a large margin of safety to our longer term valuation of $1.10.

Valuation

We maintain our BUY recommendation with a long-term DCF valuation of $1.10. Although we don't specifically forecast acquisitions for our FY16 earnings, we do assume higher medium-term growth rates in our assumptions for the DCF valuation.

In the shorter term, the CAJ share price may stay at a discount to our valuation until the market gains more confidence in the medium-term high growth opportunity.

To see Capitol Health's forecasts and financial summary, click here.