The UK is out of favour when it comes to asset allocation and has been for some time. Small companies are proving particularly unpopular as investors’ appetite for risk retrenches, and it’s not clear when the situation will improve.
So says Ken Wotton, managing director for public equity at Gresham House and co-manager of its UK Micro Cap Fund. It’s a hard stance to refute: while the FTSE 100 has fallen by 8 per cent since January, the FTSE Small Cap Index has tumbled by over 20 per cent after a series of lockdown highs.
For all the doom and gloom, however, Wotton is optimistic. “This is the time when you can make great investments – where you look back in five years and think ‘they've been fantastic’. That was the case in 2009 and 2010, in the aftermath of the financial crisis. Some of the best investments I've ever made were in that period when it felt quite uncomfortable.”
For investors willing to endure some discomfort, therefore, there are “great opportunities” out there – even if the stock exchange hasn’t realised it yet.
Hot take on healthcare
Medica (MGP) is the UK market leader in ‘teleradiology’. This sounds complicated, but the concept – if not the work itself – is straightforward. The group receives patient images such as X-rays, CT scans and ultrasounds, and interprets them. The analysis is carried out by an extensive team of “reporters”, consisting of consultant radiologists, radiographers and rheumatologists, and is used by over 100 NHS hospitals, as well as private clinics.
Following a couple of recent acquisitions, Medica also interprets images used in US clinical trials, and has a smaller operation in Ireland. The lion’s share of work is UK-based, however, and it’s no secret that the NHS needs all the help it can get. A recent staffing census by the Royal College of Radiologists predicted that the UK’s radiologist shortfall would hit 44 per cent by 2025 if things don’t improve, and demand for complex imaging is high in the wake of the pandemic.
A company that promises to ease the burden on radiology departments looks primed for success, therefore.
“One of the areas we're really keen on – because we think there are some good, multi-year, structural growth opportunities and tailwinds – is healthcare services and outsourcing,” said Wotton. “There's a major structural shortage of qualified radiologists in the UK, but also globally. There's also increasing demand for the interpretation of imaging in various medical situations, like routine procedures and research and development.”
Wotton’s thought process echoes that of our own small-cap expert Simon Thompson, who stressed the potential of Totally (TLY), an Aim-traded provider of frontline healthcare services, this summer.
Can’t get the staff
Medica’s growth trajectory has been impressive thus far, and its chief executive says demand for its services is at an “all-time high”. Sales have more than doubled over the past five years and Ebitda growth has been steady if you ignore 2020, when Covid-19 fire-bombed normal operations. (That said, the group managed to stay profitable throughout, aided by its capital-light business model.)
There seems to be an abundance of further opportunities, as well: the group eventually wants to establish a remote reporting service for pathology cases, allowing it to provide broader diagnoses. The best example is the diagnosis of cancer, which often requires doctors to analyse tissue or individual cells, as well as radiological images of a tumour.
There is one obvious problem with the business, however. If the NHS can’t find enough radiologists, why will Medica have better luck? A sceptic would argue that it won’t. Management has been a little coy about workforce numbers since 2020, when it stopped reporting how many radiologists it had on its books, and instead focused on “rostered reporting hours”. Since then, finding specific headcount figures has been a challenge.
This came to a head in Medica’s results for the six months to 30 June 2022. While Medica’s urgent reporting arm is performing very well, a “shortage of radiologist capacity” meant the group failed to make the most of a bounce-back in higher-margin elective work. The shortage – which management blamed on accrued annual leave, recruitment problems and doctors doing more overtime at hospitals – “limited [its] ability to generate the revenue growth [it] had expected in elective over the period and into the summer”.
Compared with the second half of 2021, elective revenues fell by 7 per cent, and management expects elective growth to be “relatively flat” for the rest of 2022.
Wotton remains undeterred, however, arguing that pressures should be transitory. For starters, Medica is able to bring a broad range of doctors into one place. Some are directly employed by the company, while others fit the work around NHS shifts. Flexibility is a big selling point, and 75 per cent of reporters work from home. The group is also ramping up its recruitment of doctors in Australia and New Zealand so there are experts available around the clock. Since the start of September, management assured shareholders, the group has started to see the return of radiologist availability to expected levels.
“As with any outsourcing service, it’s about the aggregation of supply, which enables you to get economies of scale and enables you to better optimise the scheduling and delivery of the service,” said Wotton.
Margin for error
That said, Medica’s margins have taken a hit over the past six months. Competition from private companies such as Everlight Radiology has driven down prices and management now expects the net operating margin for the year to be “moderately below” expectations.
Wotton is convinced of Medica’s strong position, however. “There's a bit of competition on price. There are other people doing it – but there are barriers to entry, too. It's not easy to get yourself through the procurement process to be accredited to do this kind of thing for the NHS… So I think the prospects for a new entrant are quite limited.”
Wotton’s original concern about Medica did not not relate to margin pressures or staff shortages, but to robots. “There has been some analyst coverage suggesting that artificial intelligence is effectively going to get rid of the need for this market,” he said.
These predictions are not entirely unfounded: the Royal College of Radiologists predicts that AI “represents one of the most potentially fundamental changes in medical care since the inception of the NHS”.
Medica has teamed up with a technology provider, but the risk of consultant radiologists being replaced by robots any time soon looks slim. “My view is AI and machine learning and technology in general is likely to be an enabler for this business to improve the productivity of what it's doing and the quality of service and ultimately drive operating margins,” Wotton said.
“I don't believe it's going to be a material threat to their business. The reason I say that is because, although the technology is there to interpret scans, the regulatory framework is miles away from being in a position to effectively sign off on this kind of algorithm.”
Private equity discount
Shares in Medica tumbled by 10 per cent after it published its half-year results last month. Even before this, however, Wotton argued that the group was good value compared with prices elsewhere.
“We know that Medica trades on an EV/Ebitda forward multiple of about nine times. And we know that there were directly comparable private equity transactions done at 15 times. That gives me a lot of confidence that there's a margin of safety on the valuation. If the stock market doesn't recognise Medica’s qualities and re-rate it, I think there's a decent chance that somebody else will come along and try to exploit that difference.”
As US private equity firms start to flex their muscles, this might not take long. Regardless, Medica’s valuable services and overworked client base suggest Wotton’s on to a winner.
