Diagnostic imaging company RadNet Inc. (RDNT, Financial) delivered solid results for the fourth quarter of 2018, beating expectations.
The company's stock has not appreciated much and its low valuation makes it very appealing to growth investors. The big question, however, is whether the market is actually undervaluing the stock or whether the company has an inherent fundamental issue that is causing it to be traded at a discount.
A good quarter for RadNet backed by two solid revenue streams
RadNet is a diagnostic imaging company known for multimodality imaging, mammography, X-rays and ultrasonography. It also produces and commercializes imaging software under the eRAD brand name. The company has spread its presence to over 250 commercial health care entities, which use the eRAD imaging and software technology.
For the fourth quarter, the company reported revenue of $248.21 million, which was a 9.19% increase from the prior-year quarter and $9 million higher than analysts' expectations. The company posted earnings of 37 cents per share, topping FactSet's estimates by 19 cents.
RadNet's first main revenue stream is its fixed onsite freestanding outpatient diagnostic facilities. These facilities contribute substantially to the total revenue and are termed as fee-for-service, where the patient is charged depending on the type and number of scans done.
The other source of revenue is capitation, which is a form of fixed monthly revenue. In this case, insurance providers pay fixed monthly fees against their health insurance-enrolled clients irrespective of the number of scans done. Capitation currently makes up 15% to 20% of revenue. While this form of payment mitigates risk, as the payment is assured, it may be a loss-making proposition in some cases, especially when the same patient has to undergo an imaging procedure multiple times in a month at the same fixed cost. It also tends to block capacity for fee-for-service patients, from whom the revenue return efficiency is greater.
Competitive advantage and key strategic partnerships
RadNet’s business model has clear barriers to entry. The company’s large-scale radiology imaging processing capabilities, infrastructure, machinery and skilled labor it has acquired over the years make it one of the few solid incumbents within the space.
Management has also forged partnerships with other image enablers in areas where RadNet did not have a sizeable presence. For example, it has fortified operations in Bakersfield, California with the acquisition of five imaging centers from a single operator. This deal was sealed at the end of 2018. RadNet also has a joint venture with RWJBarnabas, which is going to be operational starting next October.
In terms of expansion, management is working to forge radiology imaging contracts with diverse insurance clients over a long-term horizon. The company is also stepping into new areas like oncology, which may yield good revenues in the future.
Rising debt and operational issues
RadNet has been actively closing many of its underperforming imaging centers over the past several months. This is affecting the top line, but is the main driver behind the improved profitability. The problem, however, is management is unable to get good value from these sales and its free cash flow is also limited, which is why the company was forced to raise debt. The debt burden has risen so much that the debt-equity ratio is above 6, significantly increasing the risk around the stock.
It is evident from the chart above the stock has appreciated by about 6% over the past 12 months. It is currently trading at an enterprise value-to-revenue ratio of 1.47 and a price-earnings ratio of 21.58. While this may be a reasonable valuation, the high level of debt does raise some concerns. This high leverage has resulted in an Altman Z-Score of 1.42, which puts the company in the distressed zone.
Key takeaways
RadNet has its fair share of positives in terms of a solid setup, a skilled team, growing revenue and profitability. Its biggest problem is the high level of leverage, which is causing the stock to trade at a discount. There is a slim chance for multiple expansion and fundamental capital appreciation unless management reduces its level of debt significantly. However, the stock could benefit from a future acquisition as the company looks like an excellent takeover target, where the potential acquirer can repay the debt and fuel growth through investments. Overall, RadNet is a stock that should be observed but not purchased at its current levels.
Disclosure: No positions.
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