Capitol Health on the prowl

Since initially calling Capitol Health (CAJ) as a “buy” July 2, the stock has run up from 42 cents to a high of 72 cents and closed at 64 cents today. Although the share price movement has been in our favour it is currently a tough one to call in the 60-70 cents range.

When I initially recommended CAJ the valuation was 54 cents. This valuation didn't assume further acquisitions or an entry into the NSW and/or Queensland diagnostic imaging market.

The strong share price movement has been a reflection of the expectation of an interstate market entry and that it would be earnings accretive. Now, four months later, there has been no further news flow around an interstate expansion.

Make no mistake, if for whatever reason CAJ can't expand interstate then the stock is a “sell” trading on a 2014-15 price-earnings (P/E) multiple of 29.

However, John Conidi (MD) deserves some credit for the way he consolidated the company's position in the Victorian market. Further, even without assuming acquisitions, we are forecasting 38% earnings per share (EPS) growth for 2014-15, and 21% growth for 2015-16. This gives a 2014-15 P/E to growth (PEG) ratio of 0.76 – which would be cheaper again if an accretive acquisition is executed.

The company has been telling anyone who will listen that acquisitions are around the corner – hence why the stock trades on such an inflated short term P/E multiple.

From an analytical viewpoint the prospect of an interstate market entry is one thing to consider. But further questions need to be answered as to whether there are willing sellers at the right price, and how good a fit they will be with CAJ.

Today I am upgrading my CAJ valuation from 54 cents to 75 cents on the basis that the company will successfully achieve an interstate entry. I am also placing more weight on the PEG valuation, with 2014-15 at 0.76 and 2015-16 at 1.1. If CAJ don't achieve an interstate entry within the next six months then my recommendation is likely to be incorrect and the CAJ share price will fall.

There is no doubting the number of smaller players in NSW and Queensland. Rather, the risk to CAJ is more if someone else beats them to it. For example, Advent Private Equity partnered with Lake Imaging and South Coast Radiology to form the fourth largest diagnostic imagining company in Australia. Lake Imaging is Victoria's largest independent radiology group, and South Coast is Queensland largest independent radiology group with its core services on the Gold Coast.

Background

As a reminder, Capitol Health Limited (CAJ) is the largest community based (non-hospital) diagnostic imaging (DI) services provider in Victoria, with a market capitalisation of about $200 million.

The company is benefiting from government funding initiatives aimed at expanding the use of Medicare funded magnetic resonance imaging (MRI) scans.

They have seven MRI licenses, and have ordered another seven unlicensed MRI machines to more effectively balance the demand between rebated and non-rebated referrals.

The expanded access to low-cost MRI scans is beneficial for CAJ on two levels. Firstly, the increased amount of scans, with a large percentage going to community based clinics rather than hospitals.  Secondly, some of the smaller clinics without MRI machines are now under pressure and looking to exit the industry. This enhances the consolidation opportunities for CAJ, and may enable an easier market entry into NSW and Queensland.

Whilst this shift towards MRI is ongoing, the regulatory landscape has become more uncertain since the federal budget. This is due to the proposed changes to co-payments for general practitioners, pathology and radiology. The proposal still has to pass through the Senate, but even if successful the impact for CAJ is not likely to be as negative as the market currently fears.

The company's network in Victoria includes 52 clinics, with seven Medicare-funded magnetic resonance imaging (MRI) licenses, 25 CT scan, 50 X-ray and 60 ultrasound machines. In April 2013, CAJ acquired MDI Group, which included 11 clinics. The acquisition has been successfully integrated and has provided an instant higher margin earnings boost for the group.

Conclusion

My increased 75 cents valuation assumes a 0.9  times 2014-15 PEG ratio. As a reminder a PEG under 1 is seen as cheap, especially when there are positive longer-term growth drivers. The risk to my call is that if an interstate market entry is not achieved in the next six months then the high short-term PE is unlikely to be sustained.