Top broker tipping this small cap to bounce back into favour after period of purgatory

This small cap has been struggling recently and is underperforming its peers like Sonic Healthcare Limited (ASX:SHL) and Healthscope Ltd (ASX:HSO). But that might be about to change.

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The share price of Capitol Health Ltd (ASX: CAJ) might be stuck in a pretty tight trading band for the best part of the past year but the stock could soon break out of purgatory as Credit Suisse is expecting a re-rating for the unloved medical imaging company.

The stock is trading at an “unnecessary discount” according to the broker after the deal to merge with Integral Diagnostics Ltd (ASX: IDX) fell through and has left Capital Health in no-man’s land.

But the broker thinks Capital Health’s decision to walk away from the deal is a sensible one and will allow management to take a more conservative growth strategy.

“The proposed IDX transaction had some merit – financial synergies, geographic diversity, a more broadened sub-specialty offering and a larger group better positioned to consolidate,” said Credit Suisse.

“However, mixed engagement from radiologists, pushback from the IDX Board and several profit upgrades (from IDX) rendered the process all too hard. Hostile acquisitions in people-based businesses rarely end well, and in this respect the lapse of the proposed transaction is a positive for CAJ.”

The market isn’t looking at Capital Health from a glass-half-full perspective and this could present an opportunity as Credit Suisse believes the stock is currently trading at a 7.2 times earnings before interest, tax, depreciation and amortisation (EBITDA) multiple based on the broker’s FY19 estimates.

That equates to around a 30% discount to the market!

Management has given earnings guidance and is expecting FY18 revenue of between $129 million and $132 million, which equates to an organic growth rate of 3.5% to 6% for its core Victorian business. This estimate compares to Medicare data that suggests the market is growing at around 7%.

But there could be upside from bolt-on acquisitions. There are opportunities for Capital Health to consolidate the market even as it spurs the IDX tie-up.

Credit Suisse certainly thinks the chance of mergers and acquisitions (M&A) is high as it is forecasting EBITDA of circa $27 million for FY19 that is largely underpinned by acquisitions. The broker even hinted that its forecast might be conservative as it has not factored in any operating leverage where economies of scale lifts profits by more than revenue.

If it’s bullish assessment of Capital Health is on the money, there is a decent amount of room for the stock to climb given that it has been underperforming its peers over the past six months with an 8.6% drop in its share price.

In contrast, Sonic Healthcare Limited (ASX: SHL) and Healthscope Ltd (ASX: HSO) have jumped around 7% each over the period, while Primary Health Care Limited (ASX: PRY) has rallied over 18% when the All Ordinaries (Index:^AORD) (ASX:XAO) is largely flat.

Credit Suisse has a 35 cents a share price target on Capital Health.

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Motley Fool contributor Brendon Lau has no position in any of the stocks mentioned. 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 Scott Phillips.

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