Has Capitol Health Ltd made a fatal mistake?

Growing your business by acquisition has its benefits, but has already proven fatal for a number of companies – ABC Learning being the highest profile lesson.

Has Capitol Health Ltd (ASX: CAJ) made the same fatal mistake?

When debt is cheap, it’s fairly easy for companies listed on the ASX to borrow millions from their bankers and go on an acquisition spree. More businesses in your stable generally means higher revenues, profits and higher earnings per share. It also means nice bonuses and in many cases, the issue of cheap options to senior executives.

But debt cuts both ways.

Taking on that debt also carries with it a number of implications, in particular, adhering to debt covenants. Now, rather than having the freedom to operate in the best interests of the business, the company finds that its priority has suddenly changed to meet the needs of its bankers first and foremost. Debt repayments will now curb cash flow, while interest payments will impact on net profit, earnings per share and dividends.

And Capitol Health is cutting it fine with its debt covenants based on its last six months results.

At the end of December 2015, Capitol Health had $97.6 million of debt – and a facility to borrow up to $140 million. Most of that debt has been used to acquire additional diagnostic imaging centres – with the company now having around 70 facilities. However, the company says it is looking at taking out a $50 million bond, which could be used to pay down debt.*

The company also expects to pay out US$10 million this year, US$5 million this week plus two payments of US$2.5 million in April and August respectively for US$10 million of shares in Enlitic Inc – and exclusive rights to Enlitic technologies in Australia for at least five years.

For a small company with $92 million in equity, $138 million in intangible assets (mostly goodwill) and a market cap of $81 million, total debt approaching and likely to exceed $100 million shortly, is a scary prospect.

debt vs intangibles chart

Source: company reports

That is exacerbated when operating cash flow sinks from $7.8 million in December 2014 to just $94,585 for the six months to December 2015.

cash flow vs net profit

Source: company reports

Debt becomes even more of an issue when a company like Capitol Health sees its net profit sink thanks to issues outside its control (government funding decrease and review into Medicare funding for diagnostic imaging benefits – among others), and one-off expenses. As a result, Earnings before Interest, tax, depreciation and amortisation (EBITDA) margins have been crushed – falling from 31% in 2014 to 14% in the latest half.

Foolish takeaway

Capitol Health may have suffered a rush of blood to the head, making too many acquisitions at too fast a pace – with shareholders paying the price. Instead of being able to focus its businesses on operating at lower margins and getting through a tough period, more bad news including writedowns of goodwill is highly likely.

I’m still holding my shares, but may not for much longer – particularly after the board’s shocking decision to award 15 million options to managing director John Conidi yesterday.

* In the original version of this article, we assumed that Capitol Health was looking at issuing $50 million in additional debt. That was incorrect.

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Motley Fool writer/analyst Mike King owns shares in Capitol Health. You can follow Mike on Twitter @TMFKinga

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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