UK’s Smartest Small Caps: Medica



The UK is out of favor when it comes to asset allocation and has been for some time. Small businesses are proving particularly unpopular as investors’ appetite for risk wanes, and it’s unclear when the situation will improve.

So says Ken Wotton, managing director of public equities at Gresham House and co-manager of its UK Micro Cap Fund. It’s a hard position to refute: while the FTSE 100 has fallen 8% since January, the FTSE Small Cap Index has fallen more than 20% after a string of lockdown highs.

Despite all the misfortune and sadness, however, Wotton is optimistic. “This is the time when you can make great investments – when you look back 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 at that time when I felt quite uncomfortable.”

For investors willing to endure some discomfort, there are therefore “great opportunities” – even if the stock market has not yet realized it.

Hot take on healthWarning

Medication (PGM) is the UK market leader in “teleradiology”. It sounds complicated, but the concept – if not the work itself – is simple. 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’, made up of consultant radiologists, radiographers and rheumatologists, and is used by more than 100 NHS hospitals, as well as private clinics.

Following some recent acquisitions, Medica also interprets images used in clinical trials in the United States and has a smaller operation in Ireland. However, the lion’s share of the work is based in the UK, and it’s no secret that the NHS needs all the help it can get. A recent staff census by the Royal College of Radiologists predicted that the shortage of radiologists in the UK will reach 44% by 2025 if things do not improve, and demand for complex imaging is high as a result of the pandemic.

A company that promises to ease the burden on radiology departments therefore seems poised for success.

“One of the areas that is really close to our hearts – because we believe there are good multi-year structural growth opportunities and tailwinds – is in healthcare services and outsourcing,” Wotton said. “There is a major structural shortage of qualified radiologists in the UK, but also globally. There is also a growing demand for the interpretation of imagery in various medical situations, such as routine procedures and research and development.

Wotton’s thought process echoes that of our own small cap expert, Simon Thompson, who highlighted the potential for Totally (TLY)a publicly listed frontline healthcare provider by Aim this summer.

I can’t get itthe staff

Medica’s growth trajectory has been impressive so 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 flat if you ignore 2020 when Covid-19 set normal operations on fire. (That said, the group has managed to remain profitable throughout, helped by its small-cap business model.)

There also seems to be an abundance of additional opportunities: the group eventually wants to set up a remote reporting service for pathology cases, allowing it to provide broader diagnoses. The best example is cancer diagnosis, which often requires doctors to analyze tissues or individual cells, as well as X-ray images of a tumor.

There is, however, one obvious problem with the company. If the NHS can’t find enough radiologists, why will Medica have any better luck? A skeptic will say no. Management has been a little coy about headcount since 2020, when it stopped reporting the number of radiologists it had on its books, and instead focused on “listed reporting hours.” Since then, finding accurate numbers on numbers has been a challenge.

This peaked in Medica’s results for the six months to June 30, 2022. While Medica’s urgent reporting arm is working very well, a “shortage of radiologist capacity” has prevented the group from pulling the best advantage of a rebound in the upper sectors. elective marginal work. The shortage – which management blamed on accumulated annual leave, recruitment problems and doctors working more overtime in hospitals – “limited [its] ability to generate revenue growth [it] had planned as an elective during the period and until the summer”.

Compared to the second half of 2021, elective revenue fell 7% and management expects elective growth to be “relatively stable” for the remainder of 2022.

Wotton is undeterred, however, arguing that the pressures should be transitory. For starters, Medica is able to bring together a wide range of doctors in one place. Some are directly employed by the company, while others adapt to working around NHS shifts. Flexibility is a big selling point and 75% of journalists work from home. The group is also accelerating its recruitment of doctors in Australia and New Zealand in order to have experts available 24 hours a day. Since early September, the management assured shareholders, the group has begun to see radiologist availability returning to expected levels.

“As with any outsourcing service, it’s about aggregating the offering, which allows you to achieve economies of scale and allows you to better optimize the planning and delivery of the service,” said said Wotton.

Margin of errorr

That said, Medica’s margins have taken a hit over the past six months. Competition from private companies such as Everlight Radiology has driven prices down and management now expects net operating margin for the year to be “moderately below” expectations.

Wotton, however, is convinced of Medica’s strong position. “There is a bit of price competition. There are other people who do, but there are also barriers to entry. It’s not easy to go 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 initial concern about Medica was not about margin pressures or staffing shortages, but robots. “There have been analyst reports suggesting that artificial intelligence will effectively eliminate 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 creation of the NHS”.

Medica has partnered with a technology provider, but the risk of consulting radiologists being replaced by robots in the short term seems slim. “I think AI, machine learning and technology in general is likely to be a catalyst for this company to improve the productivity of what they do and the quality of service and ultimately , to generate operating margins,” said Wotton.

“I don’t believe it will be a material threat to their business. The reason I say this is that while the technology is there to interpret the analytics, the regulatory framework is miles away from being able to effectively approve this type of algorithm.

Private equity dicount

Medica shares fell 10% after reporting its half-year results last month. Even before that, however, Wotton argued that the band was good value for money compared to prices elsewhere.

“We know that Medica trades on an EV/Ebitda forward multiple of about nine times. And we know there have been directly comparable private equity deals done 15 times. It gives me a lot of confidence that there is a margin of safety on the assessment. If the stock market doesn’t recognize Medica’s qualities and re-evaluate it, I think there’s a good chance someone else will come along and try to exploit that difference.

As US private equity firms begin to flex their muscles, it might not take long. Either way, Medica’s valuable services and overstretched clientele suggest Wotton is a winner.

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