No-moat Integral Diagnostics (ASX: IDX) and Capitol Health are seeking to merge. The firms have agreed to complete due diligence and finalize a binding agreement during four weeks of mutual exclusivity. The current proposal would see Capitol shareholders receive 0.12849 Integral shares per Capitol share, implying 63% ownership of the combined group for Integral shareholders and 37% for Capitol shareholders. This would add a significant 138 million shares, a 59% expansion of Integral’s current share count.

We decreased our fair value estimate by 6% to $3.40 as we view the merger as value-dilutive. We do not think the scrip being offered is worth Capitol’s earnings and potential synergies, with our forecast earnings per share for fiscal years 2026 to 2033 decreasing by 5% on average. Shares remain significantly undervalued as we remain positive on Integral’s margin recovery as it focuses on digitization and higher-value imaging modalities.

We think the merger is strategically sound. It provides instant scale, adding Capitol’s 65 clinics to create a combined network of 155 diagnostic imaging sites. The merger is subject to regulatory approvals and customary closing conditions, including Capitol shareholder approval, but we expect it to proceed. Capitol’s board intends to unanimously recommend the proposed merger, barring a superior proposal and an independent expert’s opinion. We expect the merger to be completed by the end of the September 2024 quarter and credit nine-months earnings contribution in fiscal 2025.

We forecast $10 million in annualized pretax net cost synergies to be realized evenly between fiscal 2025 and fiscal 2026. We expect this to largely be from reducing duplication in headcount, IT, insurance, and listing costs. The combined group is also expected to have greater buying power to save on procurement and leverage technology such as teleradiology across a larger network to help attract and retain radiologists.

Integral Diagnostics business strategy and outlook

Integral’s strategy centers on capitalizing on the growing demand for diagnostic imaging. Volume growth is driven by population growth, ageing demographics, higher incidence of diseases, and wider adoption of preventative diagnostics. These drivers are often greater in regional areas which Integral focuses on.

While the Australian government placed a freeze on Medicare fee rates for diagnostic imaging in 2013, it resumed indexation in fiscal 2022. The majority of group revenue is earned from the public health Medicare system via bulk billing, but Integral still pushes price increases selectively which raises a patient’s out-of-pocket fee for certain services.

The industry is also seeing a shift toward higher value modalities such as MRI and PET scans which support average fee increases. This has been a key investment area for Integral, and we estimate more than a quarter of group revenue stems from these two modalities.

To attract patients and build relationships with referrers, Integral seeks to differentiate itself on service levels and accessibility to modalities. Service levels rely on Integral’s ability to attract and retain high quality radiologists. Accessibility is based on sufficient capacity in convenient locations. To expand capacity, Integral either upgrades or adds machines at existing sites, or establishes new sites. Higher utilization at clinics results in a lower cost per scan as labor, equipment, leases and overhead costs are all leveraged.

Expansion of its hospital operations is another key strategy. These contracts, which often last longer than five years, generate complex hospital referral work, which is typically higher-margin and attract quality radiologists. A competing practice often can’t setup within the same hospital. We estimate these sites represent just under half of group revenue. To tender or renew contracts, Integral must demonstrate an ability to manage caseload at required service levels.

Integral’s success is evidenced by achieving an additional 2% on average in organic growth over the last five years versus the market. Growth is also aided by acquisitions, with synergies from procurement and IT being relatively easy to capture.

Moat rating

Learn more about how to find a company with a sustainable competitive advantage. 

Integral’s relatively small market share in a fragmented radiology industry, as well as its largely undifferentiated service offering, prevents us from awarding the company a moat. We forecast Integral to post an average return on invested capital, or ROIC, including goodwill of roughly 9% over our 10-year explicit forecast period, slightly exceeding its weighted cost of capital of 8%. However, this is largely a function of industry recovery rather than a moat. We include goodwill in the invested capital base which arose from acquiring independent practices.

Integral has no discernible intangible assets that are unique, exclusive, or irreplicable. While competitors typically require a certain level of scale to fund and profitability operate equipment such as MRI machines, access is equitable. The Australian government also regulates and limits the number of MRI licenses that it awards to providers, including Integral, which allow patients to receive partial or full reimbursement.

MRI is the only modality of diagnostic imaging in Australia which operates under a licensing system. However, an MRI license is just for reimbursement purposes, with roughly a third of MRI machines in Australia being unlicensed which incur out-of-pocket expenses for patients. The limit on licenses is largely to balance providing suitable access to MRI services with saving Medicare money, and not based on durable competitive advantages of radiology providers. Integral also relies on skilled and experienced staff members, but we don’t see this as grounds for a moat as turnover is inevitable.

We also see no switching costs. Patients are free to choose which imaging center to visit and can switch any time. Patients can be influenced by their referrer, usually their general practitioner or a specialist, but radiology providers are prohibited by law from making commercial arrangements with referrers. With no significant differences in quality or price, referrers typically suggest an imaging center that is closest in proximity, provided it has the relevant imaging modality. We also see no obvious network effect, with higher volumes potentially increasing waiting times.

Finally, Integral lacks scale to have any material cost advantages to undercut more dominant rivals on price or take higher profits. In Australian radiology in fiscal 2022, Sonic Healthcare had 16% market share, Healius had 9%, Integral had 7%, and Capitol Health had 4%. In the same year we estimate the market leader, I-MED had over 20%. Regardless, with roughly 85% of operating expenses being labor and consumables, scale benefits, which are mostly in IT and procurement of machines, is limited.

Despite varying market shares, we think this can be seen in comparable fiscal 2022 imaging EBITDA margins of 22%, 21%, and 20% for Sonic, Integral, and Healius, respectively. Here, Integral’s imaging margin is buoyed by its higher-margin operations in Auckland, New Zealand. Integral’s operations in Australia are mostly in less-populous regional areas, likely making efficiencies from higher utilization more challenging. We think Integral benefits from traces of efficient scale in these local areas where a rational new entrant may be deterred from investing because the additional capacity would create an oversupply on a micro level. However, given the fragmented market and a lack of competitive advantages or significant barriers to entry, we think the durability of this is tenuous. In Australian radiology, the investment to add additional capacity is fairly incremental and unlikely to destroy returns for all players, particularly on a macro level.

Terms used in this article 

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.