A game of two halves
Radiology expert Integral Diagnostics has recovered from the negative reaction to first half fiscal 2023 numbers when a slow recovery in trading combined with a tough costs environment to crimp profits. The headwinds are set to persist for a while, but we do expect moderating pressure going forward and with the bar set relatively low, for solid earnings growth to be delivered over the next few years.
Integral Diagnostics Limited (IDX) is the fourth-largest radiology imaging firm in Australia and has built a substantial presence in the New Zealand market.
While we acknowledge the recent and near-term headwinds, we see the operational headwinds as abating over the next year and a bright picture for the business over the medium-term given the segment can grow quicker than the broader (defensive) healthcare market.
Effectively we view Integral Diagnostics (ASX:IDX) as a high-quality, established business run by capable management that is trading at a reasonable price. We see the company as possible prey for a corporate buyer or private equity though this aspect is not core to our investment thesis and we view it as attractive as a standalone investment proposition.
There are appealing competitive strengths to businesses of Integral Diagnostic’s ilk and the market segment in which it operates has been a steady, solid grower, with the underpinning for that likely to continue for many years. This provides fertile ground for Integral to grow in what is still a fragmented market.
Integral Diagnostics (ASX:IDX) operates in regions where they are a market leader and benefit from a network effect through a hub and spoke model, with nearby hospitals the hub and Integral’s clinics (sites) serving as spokes. Accordingly, Integral Diagnostics tends to benefit from good stickiness, with patients often referred to the same nearby clinics and the proximity helps with patient flow and utilising radiologists (who are paid very highly) time effectively, along with the expensive imaging equipment.
Over the medium-term, there are good prospects for the company to improve productivity by leveraging advancing technology. There have already been significant strides down this path but the potential for AI to improve diagnostic capability and efficiency in this complex area is quite dramatic. We expect this to support margin expansion going forward once the worst of the cost headwinds abate.
The company stated that 2H23 is expected to be “materially stronger” than 1H23 unless there are unforeseen circumstances.
Now, turning to the Daily Chart, IDX has been range-bound since mid-2022 trading between ~2.40 to ~3.30 levels. Currently, IDX has re-entered a much tighter ~3.10 and ~$3.30 consolidation range having trended higher since hitting the February 2023 lows. The 50-day Moving Average (Red line) and 200-day Moving Average (Green line) have also crossed further supporting the fact that the shares are range-bound. Multiple tests of a resistance level can portend to a breakout in the near-term and should be monitored closely.
Operating revenue for 1H23 increased 19.2% to $215.1 million, reflecting modest organic growth and contributions from acquisitions. There was only a slow recovery for patient volumes, with only limited price increases and favourable mix benefits. On the other hand, there were significant cost pressures, especially higher labour costs due to inflation and labour supply constraints. Interest funding costs were another headwind. Management remains focused on cost containment and reduction where possible but faces tough challenges here currently.
There was only limited support from Medicare indexation of 1.6% which is running well below inflation. We expect there to be some better relief here going forward to bridge the gap somewhat. Average fees per exam did increase by 5.2%, reflecting the continued move to higher-end scan modalities.
The company noted no inflation adjustment from the Accident Compensation Corporation (ACC) and District Health Boards (DHBs) and limited inflation indexation from private health insurers in New Zealand. “Selective price increases” were pushed through “where possible” while remaining competitive.
The operating EBITDA margin compressed by 300 basis points compared to the prior corresponding period to 18.5%. Accordingly, EBITDA increased just 2.4% to $39.8 million.
Operating NPAT fell a sharp 36.4% to $7.8 million, with this headline number hitting the stock price. Diluted EPS almost halved (-48%) to 3.3 cents per share and the dividend was reduced to 2.5 cents per share, fully franked (4.0 cents in 1H22). Free cash flow improved to $38.5 million from $24.7 million.
Source: Integral Diagnostics (ASX:IDX)
The company reported a 4.1% organic revenue increase in Australia, adjusted for working days, outperforming the broader industry that experienced a 1.2% decrease in Medicare weighted average benefits for the states in which IDX operates. The company anticipates that the gradual recovery of patient volumes will lead to improved profitability over time due to positive operating leverage. The market was lacklustre against a backdrop of consistent industry growth of almost 6% per annum for a decade. Australian revenue dominates, accounting for about 87% of group revenue in the half.
In New Zealand, the company achieved a 4.1% organic revenue growth on a constant currency basis, adjusted for working days.
Summary
The first half of FY23 was another tough patch for Integral Diagnostics (ASX:IDX), although the shares have edged higher year-to-date, suggesting the market is beginning to anticipate moderating cost pressures, and the interest rate cycle nearing a peak. We are optimistic patient volumes and historical growth patterns will slowly return to pre-Covid levels although have been a little surprised at the slow pace to date and unpleasantly surprised by the extent of the cost pressures. We should see some decent relative improvement flow through over the next year and as the market is forward-looking, we can hope this will help be a re-rating catalyst.
Once through the peak of cost inflation and as technology advances further in this fast-moving field, we see the scope for margin expansion to bolster solid top line growth prospects, with the latter a combination of organic growth opportunities and the ability to continue bulking up via selective acquisition in this fragmented and essential market. As a wildcard, we believe the company could be attractive as prey for a corporate or private equity predator, although we are content with the investment prospects on a standalone basis.
We continue to rate Integral Diagnostics Limited (ASX:IDX) as a hold.
