Capitol Health leaps into NSW

As predicted, the diagnostic imaging company has made an accretive acquisition interstate. More are likely.

Capitol Health jumped 17.2% to 75.5 cents over two days last week after it announced the acquisition of Sydney-based Southern Radiology Group for $64.6 million. It has now surged 86% since we began coverage of the stock in early July.

The purchase was partly funded by a $37.5 million capital raising at 58 cents, with the remainder from increased debt. The transaction is due to settle in April 2015, but we have forecast it to start contributing to earnings from the start of 2015-16.

It represents the company's first entry into NSW, and allows the company the opportunity to benefit from efficiency gains and synergies in much the same way it has done with Victorian acquisitions (see Capitol Health on the prowl, Oct 27).

Source: Company presentation

On a pro-forma basis Southern Radiology is 10-15% earnings accretive for 2014-15, with the purchase on a nine times enterprise value to earnings before interest, tax, depreciation and amortisation (EV/EBITDA) multiple. However, this doesn’t include the efficiency gains and cost savings of being part of the Capitol group.

The smaller operators such as Southern don't have the luxury of benefiting from a management structure such as Capitol's. They may have a chief operating officer, but not a chief executive officer. Their systems in IT, general administration and marketing are also less developed. This all leads to sub-optimal utilisation and some easy gains once they become part of Capitol.

There are eight radiologists who will join Capitol, with all of them signing long-term employment agreements with performance incentives aligning them to the overall group. From their perspective Capitol provides greater long term certainty than a private equity firm who would more than likely be looking to sell again in three to four years. This is significant as private equity presents the largest risk to Capitol's consolidation ambitions.

New South Wales is the largest diagnostic imaging market in Australia with 36% of industry revenue, and a number of smaller operators. The first acquisition was always going to be the hardest, and given Southern is very well regarded, it could lead to other smaller operators approaching Capitol to become part of the combined group.

The larger operators in NSW are I-Med, Sonic and Primary Healthcare. In Victoria the largest operators are I-MED, Primary Healthcare, and Capitol Health. Victoria comprises about 25% of domestic revenue with the market now largely consolidated.

Capitol Health is now the largest community based diagnostic imaging (DI) network in Victoria with 52 locations across metropolitan and regional Victoria.

The company's strength in 2013-14 was driven by the full-year impact of the MDI Group (acquired in May 2013), regulation encouraging increased use of MRI, and market share gains with organic growth at 12.8%.

Director boost

In unrelated positive news, Andrew Demetriou joined the company as non-executive chairman effective from November 17. Managing director John Conidi has done an excellent job thus far, but the assistance from Demetriou is likely to be a positive influence on the group.

Conidi is the largest shareholder with approximately 7.5%. Hence his decision to complete a capital raising with no facility for existing retail shareholders actually hurt himself more than anyone else.

Without getting into the argument of whether existing retail shareholders should have been looked after via a share purchase plan or equivalent, one thing is for certain: Capitol Health's future growth will rely heavily on its ability to continue raising funds at short notice for further accretive acquisitions. Therefore, from a business viewpoint, it is a significant positive to welcome new institutional shareholders to the register, and see such strong interest for the capital raising.

MRI licenses

Capitol Health previously had seven Medicare licensed MRI machines. They will now add another five from the Southern purchase. From between 2011 and 2012 to between 2016 and 2017 there are only 10 new Medicare licenses to be issued Australia wide. Further, from now on, there will be no licenses granted in the proximity of existing Capitol Health licenses – creating a strong barrier to entry.

The federal government announced a diagnostic imaging review reform package of over $100 million in 2011 and 2012 to improve accessibility and affordability of MRI services across Australia.

In 2013-14, while revenue from specialist referred MRIs only increased 1.7% to $124.6 million, GP referred MRIs increased from $3.4 million to $49.9 million as a direct result of the regulatory changes.

Growth by acquisition

In 2010 Capitol Health acquired two clinics from each of MDI radiology and Reflective Imaging. In 2012 it acquired IM Medical's radiology business and five other DI clinics in Melbourne. Then in 2013 it acquired the complete MDI group and gained an additional 11 clinics and two MRI licenses.

The combination of the acquisitions and the government changes towards Medicare funded MRI scans has produced huge earnings growth for Capitol Health. From 2009-10 to 2013-14 compound annual growth revenue growth has been 26% and EBITDA growth has been an amazing 53%. Clearly these are exceptional numbers, and the good news is that the NSW Diagnostic Imaging (DI) market is larger and more fragmented than Victoria.

Southern Radiology

Southern provides diagnostic imaging services in metropolitan Sydney and consists of private community and hospital based practices, as well as two imaging research facilities. It operates 14 clinics and employs imaging specialists across a range of fields including prostate, urology, musculoskeletal and neuroogy. In 2013-14 Southern achieved normalised revenue and EBITDA of $37 million and $7.2 million respectively.

The 19% EBITDA margin compares to Capitol Health's margin of 16%, and is a reflection of the mix of scans.

In addition to Southern, Capitol is in negotiations to acquire another business which provides diagnostic imaging services. This business is located in Melbourne and the purchase price of $25 million represents 7.5 times EV to normalised EBITDA of $3.3 million in 2013-14.

3D printing

The company is already using the new technology of 3D Printing. The file of an MRI or CT scan can be converted and sent to a 3D printer. This allows an actual 3D print of the relevant body part that is being scanned to improve diagnosis and preparation for any surgery.

Whilst it is hard to quantify what this actually means for Capitol Health just yet, it is certainly encouraging to see that they are pursuing opportunities to benefit from technology shifts.

The company also recently announced that they have taken a 10% stake in a small start-up 3D printing company called 3D Medical (SFP). Due to cost savings and improved diagnosis, the UK is considering mandating 3D printing for radiology purposes.

Risks

The number one risk for Capitol Health is regulatory; in particular, any changes to the current support policy towards greater access and affordability for MRI scans.

With the business model being reliant on growth by acquisition there is also integration risk, but comfort can be taken in the success thus far.

In terms of risk from competitors, the major issue would be if another player gains traction in growth by acquisition by potentially providing a better structure. Thus far we think Capitol has a natural advantage over private equity groups due to the greater long term stability.

Technical analysis

For those that use technicals, it is worth noting the break above key resistance from around 70 to 73 cents. This prior resistance should now provide strong support and enable a longer term move towards $1.00. With the new shares from the capital raising available to be traded on Wednesday this week, there is the possibility that this new support zone will be tested.

Valuation

We view 2015-16 as the most relevant year to assess in regards to earnings multiples given the acquisition doesn’t contribute until then. We have increased our prior 2015-16 earnings per share forecast by approximately 30% to 3.3 cents per share. This is also approximately 90% growth from 2014-15.

Our increased valuation of 86 cents is assuming future potential accretive acquisitions as well as a smooth integration process. Although 86 cents comprises an 2015-16 price-earnings (P/E) multiple of 26, we believe this is supported by the strong growth rates, and future likely acquisitions in a fragmented sector.

With an entry into a fragmented market presenting very high growth potential, we believe Capitol Health should now be valued on a price-earnings to growth (PEG) basis, rather than a P/E. Given a PEG of below 1 is considered cheap, there is valuation support at these levels.

We maintain our “buy” recommendation with our prior valuation of 75 cents increased to 86 cents.

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