Why you should ignore the coronavirus effect on this medical stock

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Warren Buffett once said: "The worst mistake you can make in stocks is to buy or sell based on current headlines." That's exactly why we're ignoring Integral's 5% share price decline this morning, thanks to coronavirus fears, and looking 10 years out instead.

Demand for diagnostic imaging services has grown 7% a year since 2005 due to Australia's growing and ageing population, but it could be even higher this decade as baby-boomers reach their 70s.

Australia's diagnostic imaging (which includes x-rays and MRIs) sector is underutilised compared to almost all other OECD countries.

integral diagnostics

Far fewer scans are being performed each year relative to what you would expect, thanks to a 20-year freeze on Medicare rebates, which has led to growing out-of-pocket costs for patients.

That's why July's re-introduction of indexed Medicare fees is so significant, at which point out-of-pocket costs should start to decline as Medicare rebates increase. We expect this to unlock some of that pent-up demand and push revenue growth to the high-single digits.

Profit growth may be higher still, due to Integral's high fixed costs and operating leverage.

Doctor risk

That potential doesn't come risk-free, however. Medicare could decide to cut fees again, though we think this is unlikely due to imaging's role in early diagnosis and the benefit that has on the government's healthcare budget.

More importantly, Integral is reliant on highly trained radiologists. As scan volumes increase with the re-introduction of indexation, the current shortage of doctors could worsen, giving them more power when negotiating pay.integral diagnostics

We saw a little of that in Integral's interim result, which showed rising staff costs chipping away at profit growth - though a 10% increase is still nothing to sneeze at.

While rising doctor costs is our main concern, we're comforted that margins industry-wide have been stable for at least a decade, suggesting that any pressure from doctors can often be balanced by price increases. It would be imprudent to expect anything other than a little margin contraction, but we don't think it will be as severe as it was for Vision Eye Institute a few years back.

This may be the main difference between Integral and Vision. Integral's services are medical necessities, while many of Vision's procedures were discretionary or able to be substituted.

Patients can debate whether to get the $100 glasses or the $1000 LASIK surgery - but when your doc says you need an MRI to rule out cancer, you get the MRI no matter the cost.

In analyst-speak, we think Integral has slightly more pricing power with patients - which is probably why demand for imaging services doubled over the past decade despite a 60% increase in out-of-pocket expenses.

Good company, fair price

All up, though, the risks are bearable - so long as we can buy the stock at a reasonable price. So what's a fair price to pay for a business with prospects for decent organic growth and the possibility of supplementing it with favourable acquisitions?

Including the acquisition of Imaging Queensland in September, consensus estimates are for the company to earn around $290m of revenue in 2020 and a net profit of $31m.

That puts the stock on a price-earnings ratio of around 22 and a fully franked dividend yield of 3%.

Assuming annual organic growth of 5-7% over the long term, with room for savvy acquisitions to add to that, total annual returns could comfortably reach 8-10% a year, possibly more. So while Integral isn't going to be the next CSL, if you're after reasonable growth and a steady yield, there's a lot to like.

We're upgrading Integral to Buy up to $4.00 a share, with a recommended maximum portfolio weighting of 4%. It may be worth starting below this limit, though, to allow room to increase your holding if the price falls. BUY.

Note: The Intelligent Investor Model Income and Model Ethical portfolios own shares in Integral Diagnostics, as does the Intelligent Investor Ethical Fund and the Intelligent Investor Equity Income Fund.

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Graham Witcomb is a senior analyst at Intelligent Investor owned by InvestSMART Group. Graham has a degree in psychology from the University of Sydney and is a Chartered Financial Analyst charterholder. He previously worked for one of the world's most successful professional gamblers, and joined InvestSMART in 2013 where he focuses on healthcare, insurance and transport infrastructure. This article contains general investment advice only (under AFSL 226435). To unlock Intelligent Investor stock research and buy recommendations, take out a 15-day free membership.
Comments
Mitch Biddylph
March 29, 2020 3.01am

Great Recommendation Graham if we had followed your advice we would have lost 50% of our money, maybe leave stock picking to someone who knows what they are doing

Daniel Saddik
April 1, 2020 7.39pm

Hi graham,

As someone who works in this industry, the amount of cases we are now scanning (in all areas including MRI) have dramatically fallen.

I know of imaging sites which are reducing hours, closing scanners, and imaging specialists forced to take leave.

The entire sector is taking a hit. In fact, the title of your article should be "how Coronavirus is adversely impacting Medical Imaging Companies."

Regards

Daniel