Capitol Health hits an air pocket

Capitol Health (CAJ) shares have endured dramatic price action since their addition to the Growth First model portfolio. Since the portfolio's inception, the CAJ share price has sunk by more than 50 per cent — from 76.5c to as little as 35.5c mid last week.

Capitol suffered the biggest drop last week in the wake of two announcements. One was a short-term disappointment on revenue. The other was a technology partnership that could add genuine value to the firm in the medium- to long-term.

The market chose to focus on the bad news and punished Capitol for “burying” its downgrade in a late-afternoon ASX announcement. Traders slashed more than 37 per cent from the CAJ share price on Wednesday (October 28).

Is now time to sell, or is this as bad as it gets?

Capitol's valuation has fallen as the market has pared back lofty expectations. CAJ now looks remarkably cheap at just 11.8 times our revised FY16 forecast earnings. My analysis suggests that this high-risk stock could well reward growth-seeking investors over the next two to three years.

A disappointing downgrade

On the afternoon of October 27, Capitol revealed that revenue growth in the current financial year to date has been weaker than expected. Gross revenue is tracking 4 to 6 per cent below Capitol's expectations.

I understand management had planned to grow revenue faster than the mid-single digit rate at which the broader diagnostic imaging (DI) market had been expanding. Capitol still believes it can outgrow its competitors and expand revenue in FY16, but growth in the pool of DI work has slowed to a snail's pace.  

Over the past five or six months, doctors' behaviour has changed. General practitioners have become more cautious about referring patients to DI providers for the relatively high-value tests that Capitol runs — magnetic resonance imaging (MRI) scans.

Part of this caution has been reflected in last month's ABC Four Corners report on waste in scanning, and last week's Catalyst report suggesting that some diagnostic tests can do more harm than good. Ultimately, regulatory uncertainty has driven this change in referrer behaviour.

More specifically, the Australian government — in the middle of a comprehensive review of healthcare funding — is indicating that GPs should think twice before referring patients for MRIs. It is also suggesting patients should ask their doctor for evidence that such a scan could improve their outcome.

The government is on a cost-saving drive and GPs are heeding the message. The result is a slowdown in volumes for DI providers.

You can understand doctors' reluctance to ignore the government on this front, since GPs have been heavily penalised in the past for referring patients for scans without clinical evidence. But I don't expect this trend to become a permanent feature, as MRI referrals do remove unnecessary hospital visits and improve initial diagnosis. I expect doctors to shift back toward their normal patterns of DI referral in the second half of FY16. This should ease the pressure on the DI industry.

It's worth noting that the revenue softness seems unrelated to Capitol's competitive position. However, part of CAJ's share price weakness could be driven by a rotation into the newly-listed DI provider Integral Diagnostics (IDX).

Some investors may have been enticed by Integral's significant valuation discount to Capitol. IDX listed at less than nine times earnings before interest, tax, depreciation and amortisation on enterprise value (market capitalisation plus debt minus cash). Capitol competes in different markets to Integral and I sense little competitive tension between the firms on organic or acquisition growth.

I view Capitol Health as a relative winner thanks to its ability to boost referrals by demonstrating the quality of its work to GPs. On this basis I expect FY16 revenue growth to expand modestly, albeit at a rate lower than previously expected.

An intriguing stake

The market has overlooked Capitol's subsequent announcement of an investment of up to $US10 million in US-based medical startup Enlitic. This little firm has built software based on “deep learning”, a type of programming which mimics how the brain sorts information. Capitol believes Enlitic's tools can help radiologists make faster, more accurate and less expensive diagnoses.

Capitol will receive a minority interest in Enlitic, a board seat, exclusive marketing rights to its technology in Australia and rights to market it into New Zealand and Asia. Capitol is making up to half of its investment available to medical specialists in its network. I assume Capitol will end up with less than 10 per cent of Enlitic's equity for an outlay of approximately $7.5m. The firm has balance sheet capacity to make an investment of this size, with more than $36m of cash at the start of FY16 and plenty of borrowing capacity.

If Capitol is right about the impact Enlitic could have on the DI market, this will prove to have been a shrewd investment. Across the industry, around 25 per cent of all diagnoses are incorrect, so there is certainly scope for improvement in diagnosis. Capitol's managing director John Conidi thinks Enlitic could help radiologists significantly improve their confidence in spotting cancer and bone fractures.

The blue sky scenario for Capitol is that Enlitic helps to boost its growth in both revenue and profit. Once Capitol integrates the Enlitic software into its systems by the start of FY17, it could let radiologists spend less time on each patient, run more scans per day and potentially decrease Capitol's cost per scan. Enlitic should enhance Capitol's ability to capture new work and could smooth the path for continued acquisitions, as radiologists come to appreciate how the software can improve their productivity. It's worth noting that Capitol has already attracted two well-regarded radiologists to its network on the strength of the Enlitic partnership.

The worst case scenario would assign no value to Capitol's stake in Enlitic and see the investment as a wasteful distraction. Last week's share price action suggests that the market is pricing in the worst case. For what it's worth, insiders are putting more skin in the game down here — last week, two directors bought around $100,000 worth of CAJ stock on-market between 38c and 42c per share. 

It seems a gross overreaction to erase nearly $110m of Capitol's value on the basis of an industry headwind that could abate in the second half. At less than 40c per share, CAJ is trading at just over 12 times brokers' consensus FY16 earnings estimate. Capitol retains several drivers of earnings growth which should see the shares climb off the canvas. On balance, risk/reward looks skewed to the upside.

Earnings impact

I reduce my estimates of scans per day, forecast no specific acquisitions, and assume Capitol is unable to trim its costs. With a more conservative assumption around profit margins, I reduce my net profit estimate to $17.2m in FY16.

I also strip out a premium the market might have paid for meeting its expectations, and assume no value for the high-potential Enlitic investment. I believe Enlitic will enhance shareholder value over time but it is unlikely to have a material impact on revenue and profit in the near term.

The market is pricing Capitol cheaply at less than 12 times our forecast of this financial year's earnings. I expect the stock to re-rate gradually as the market regains confidence in Capitol's ability to sustain its high historic rate of earnings growth.

This is a high risk stock due to the layers of uncertainty between the schedule review and the federal election before its completion. The firm also faces the risk of overpaying for acquisitions which become difficult to integrate into its system. Maintaining Capitol's reputation among GPs will also be critical.

My long-term discounted cash flow valuation reduces to 88c per share. It will take time for the market to remove CAJ from the “sin bin”, but the stock's potential to enhance shareholder value from here keeps it a buy in the Growth First model portfolio.

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