Is the stock price surge of Pro Medicus justified

Imaging business Pro Medicus (ASX: PME) has certainly benefited from market momentum with a stellar rise in its stock price. In fact, its share price surged just over 12 per cent last week after it scored a $140 million 10-year contract with the US healthcare business Baylor Scott & White Health.

There is plenty to like about the business

“Due to low capital requirements and high profit margins, Pro Medicus enjoys high returns on invested capital,” Morningstar analyst Shane Ponraj says.

“It also stands to benefit from industry tailwinds including larger datasets, cloud adoption and remote access that will likely accelerate the need for hospitals to switch to a faster and more scalable solution.”

Despite these positives, Ponraj highlights that Pro Medicus is currently overvalued, that is, the business is trading above its fair value. Our fair value estimates are based on what we think a company’s shares are worth. This means looking “beyond fleeting metrics, such as a company’s recent earnings or any stock price momentum”. In essence, the fair value estimates are based on how much cash Morningstar thinks a company will generate in the future.

Market momentum can sometimes drive investors to look at stocks as a great buy. With this optimism, investors can often overpay for stock. Indeed, there could even be a certain FOMO or “fear of missing out” that comes from this irrational exuberance, such an example played out during the buy now, pay later phenomena. Growth does have a downside. 

So, let’s look at beyond this hype using the Morningstar investment lens.

Going beyond fleeting metrics

Ponraj acknowledges that the $140 million contract win was positive for the business, raising Morningstar’s fair value estimate. However, this lift was not reflective of market sentiment—with the stock now trading around the $80 mark—higher than Morningstar’s fair value estimate.

Looking deeper into the business, he believes that the market is likely underestimating the competitive pressures for the business.

The Morningstar analyst expects any further margin upside to be limited given the research and development spending required to stay competitive long-term.

In addition, its main product Visage 7, resonates with US academic hospitals that typically have large endowments and greater interest in advanced visualisations.

“While Pro Medicus is staring to demonstrate that smaller radiology groups are willing to pay a premium for its technology, we still anticipate a wider uptake to be slow.”

Ponraj also expects downward pressure on the size of the future contracts as the more lucrative academic hospitals market inches closer to saturation.

In other words, he believes that it is unlikely any future contract wins will be within the scope of the Baylor Scott & White Health win.