Capitol Health’s Higher Margin Outlook

Small Caps | Mar 13 2024

Capitol Health’s first half results exceeded brokers’ expectations with higher margins thanks largely to good cost control.

-Brokers raise targets following Capitol Health’s first half results
-The earnings margin increased by 200bps due to stringent cost control
-An increasing focus on higher fee modalities
-External review to identify further cost savings

By Mark Woodruff

Capitol Health’s ((CAJ)) first half results, released a fortnight ago, showed good cost control in a period when the industry at large continued battling ongoing cost pressures.

Capitol provides diagnostic imaging and related services and is the fifth-largest radiology provider in Australia, with a strong presence in Victoria, Tasmania and South Australia.

Underlying earnings and margins came in ahead of consensus expectations, prompting analysts to raise 12-month target prices.

The momentum from 9.5% revenue growth in the first half continued into the second half, with management noting February year-to-date growth of 10.2%, even with persistent challenges in the GP referral market

Capitol's earnings (EBITDA) margin of 20.3% in the first half received a 200bps lift on the previous corresponding period. Wages as a percentage of sales improved by 160bps accounting for the bulk of the earnings margin increase, explains Jarden.

This broker believes the higher margin largely reflects better pricing from indexation and lower onboarding of radiologists (which weighed heavily in the second half of FY23), in addition to the better discipline on wages.

Medical imaging staff shortages, which have increased wage pressures, are showing early signs of easing, note the analysts, with vacancies declining in recent months from their peak in October 2023.

Assuming limited incremental inflationary pressure, Canaccord Genuity believes its 21.5% peak operating margin forecast looks conservative. Beyond FY26, Wilsons also forecasts margins will return to 21.5%.

While Capitol management noted the days of a 23-24% margin are gone, these old levels remain an aspirational goal.

Bulk billing rates and GP vacancies are two key metrics Jarden monitors. Both appear to have turned a corner (though the analysts are not confirming a trend yet), with government initiatives on international recruitment and the tripling of the bulk billing incentive fee having a positive impact.

Macquarie continues to anticipate a recovery in face-to-face GP consultations as a catalyst for improving diagnostic imaging volumes, with indexation of 4.1% expected to support revenue growth.

Management’s strategic plan is progressing well, offers Canaccord Genuity, with a standard operating model across all practices, and now, unified clinical software across the board with the aim of restoring margins. Unprofitable sites are also being closed and an external review is being undertaken to identify further cost savings in procurement processes.

Going forward, the company intends to focus on the higher fee modalities of computed tomography (CT) and magnetic resonance imaging (MRI). The resulting mix-shift should produce ongoing benefits, notes Canaccord.

Macquarie agrees and expects the addition of new MRI machines will support fee growth. Capitol currently has 28 MRI machines (14 unfunded).

The company’s bulk-bill mix has reduced to 74% from 78% in FY22, notes Ord Minnett, reflecting increasing ongoing investment in higher end modalities, with MRI and CT now accounting for 48% of revenue.

Valuation and outlook

Wilsons suggests there is an element of ‘corporate take-over premium’ in the current Capitol Health share price, with the broker’s FY24 multiple suggesting a 10% premium compared to the average multiple for the company’s peer group.

By contrast, Canaccord Genuity looks out to FY25 and notes an unwarranted discount to peer multiples, given Capitol’s balance sheet health and the potential pathway for growth, which include brownfield expansion and M&A.