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PRICE CRASH: Is there any value in Capitol Health Ltd shares?

Things just seem to keep going from bad to worse for diagnostic imaging provider Capitol Health Ltd (ASX: CAJ). After releasing a profit downgrade in late October, the share price has taken another hit as the government looks to cut spending in the diagnostic imaging and pathology sectors by around $639 million.

The share price is now trading around 24 cents – down by more than 78% since reaching an all-time high of $1.10 in April. A disappointing result for a company that the market had high expectations for – including myself.

I have owned shares in Capitol since September as I thought the company looked like good value with reasonably sound fundamentals and a positive growth outlook. What has since unfolded has left me with a loss of around 50%!

The question for me now is:- Is Capitol good value at current prices or is this a classic value trap with more falls to come?

To answer this question it is important to look at both the positives and negatives of the company. Here is what I think are the main points to consider:

Negatives:

  • Reliance on government funding – Capitol is highly reliant on the government for reimbursement for its services. Although Capitol has the potential to begin charging a co-patient payment to recoup some of the funding cuts from the government it is unlikely the company will be able to recover the entire potential loss of revenue.
  • Ongoing Medicare Benefits Review – Regulatory uncertainty is never welcome for any businesses and this is especially the case in the healthcare sector where businesses are reliant on the government for the bulk of the revenue. The latest review isn’t expected to be completed until mid 2016 and it is unknown whether there will be more cuts for the diagnostic sector than already announced earlier this week.
  • Recent profit downgrade – In October, Capitol announced that the regulatory uncertainty caused by the ongoing Medicare review had negatively impacted revenue in the four months to October by between 4% and 6%. Changes in referral patterns have been the major cause of this and this is expected to continue in the short term while the review is ongoing.
  • Increasing debt to equity – Capitol’s business model is reliant on acquisitions to quickly drive up revenue and earnings growth but this is being increasingly funded through debt. To fund its acquisitions in 2015, Capitol increased it borrowings to more than $74 million – up from just over $8 million in 2014. This means the company now has a debt to equity ratio of around 80% in 2015 compared to just 22% in 2014. At an interest rate of 5% for example, Capitol will have interest repayments of around $3.7 million.
  • Intangible assets are the company’s biggest asset – According to Capitol’s 2015 annual report, the company carries around $105 million in intangible assets such as goodwill. Considering the total assets are just over $191 million this makes up more than half of the company’s total assets. With the potential for regulatory change, the carrying value of its intangible assets may need to be reviewed.

Positives

  • Capitol is building scale – Capitol’s strategy of consolidating the sector means it should be able to extract cost savings as it gains scale. The company is diversifying geographically, and while this in itself brings challenges, also provides new opportunities.
  • Ageing population tailwind – Although the government is on an ongoing mission to cut spending, the demand for healthcare services will continue to grow as the population gets older. The demand for diagnostic imaging will certainly continue as healthcare professionals aim to diagnose patients as early as possible before complications develop.
  • Higher than average market growth – Capitol had an organic growth rate of 7.9% in 2015 which was higher than the overall growth rate of the market of 6.6%. Other diagnostic image providers have also been hit hard by the recent review particularly Primary Health Care Limited (ASX: PRY) which also reported a fall in its diagnostic imaging revenues as a result of the change in referral patterns.
  • Government measures are yet to be passed – The recent measures announced by the government have a reasonable chance of being rejected in the Senate and therefore of limited consequence. Affordability and accessibility have been key features of Australia’s healthcare system and any perceived change to this will not win community support.
  • Substantial expansion potential – With the ongoing disruption in the sector, Capitol will have opportunities to further consolidate the sector as poorly operated businesses fail to cope with changes.

Foolish takeway

Based on the points above, I think most of the bad news has already been priced into the current share price but I believe Capitol Health is only a hold right now. While the long-term outlook for the company is still positive, the regulatory uncertainty in the short term is likely to place a dampener on any share price recovery.

In addition, investing in Capitol Health is now a higher risk proposition suitable for investors with a reasonably high risk tolerance and long-term investment horizon.

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Motley Fool contributor Christopher Georges owns shares in Capitol Health. Unless otherwise noted, the author does not have a position in any stocks mentioned by the author in the comments below. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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