Pro Medicus’ (ASX: PME) fiscal 2025 earnings before interest and taxs (“EBIT”) grew 40%, with revenue up 32% on contract wins and EBIT margin expanding 450 basis points to 74%. Revenue from new contracts is outstripping cost growth, with new staff for research and development making up most of the year’s increase in costs.

Why it matters: Reported EBIT was 3% above our forecast, largely due to a greater proportion of contracted revenue being recognized upfront after completing data migration for clients. Second-half data migration revenue more than doubled to $12 million.

  • Our EBIT forecasts over the next 10 years increase by 2% on average, with slightly lower staffing expenses. Our forecast midcycle EBIT margin increases to 78% from 77% prior. We expect positive operating leverage, but the additional staff required to stay competitive limits margin expansion.

The bottom line: We raise our fair value estimate for narrow-moat Pro Medicus by 4% to $52 on earnings upgrades and the time value of money. Shares are expensive with unrealistic growth baked in based on the size of the market. Shares currently trade at 175 times our forecast fiscal 2027 EPS.

  • While some smaller hospitals pay a premium for Pro Medicus’ software, we expect wider uptake to be slow. Visage 7 resonates most with US academic hospitals that have an interest in advanced visualizations. We think most hospitals don’t require the best technology in the market.
  • We would have to assume a midcycle EBIT margin of 90% and a 10-year revenue compound annual growth rate of 34% to justify the share price, versus our current 78% and 11% forecasts, respectively, and we think this is unlikely.

Long view: We expect downward pressure on the average size of future contracts as the more lucrative academic hospitals market inches closer to saturation. We think it is unlikely that the majority of future contract wins will be comparable in size to Trinity Health, for example.

Pro Medicus’ business model is sound but shares screen as expensive

Pro Medicus’ strategy revolves around renewing existing contracts and winning new clients for its main product, Visage 7, while increasing its price point. The company won six out of six major public tenders it competed for in fiscal 2021, which often involved on-site pilot tests. While this likely highlights Visage 7’s current superior speed, scalability, and resilience, continued investment in research and development is imperative for the firm to remain at the forefront of innovation and consistently win contracts. Most of the firm’s expenses are allocated to over 40 software engineers with the main R&D center located in Berlin. The company also recently extended its R&D capability in New York in collaboration with NYU Langone Health in 2021. Its R&D efforts mostly revolve around software enhancements, program extensions, and research in artificial intelligence to assist in diagnoses.

Many of Pro Medicus’ competitors already utilize server-side rendering and cloud-native architecture. Legacy systems are also mostly owned by larger competitors such as GE Healthcare, Fujifilm, and Philips, which will be incentivized by the high returns in the industry. In Australia, Sectra won an AUD 85 million 13-year deal over Pro Medicus with NSW Health for both its Radiology Information System and Picture Archiving Communications System in 2020.

Visage 7 has found most success with US academic hospitals and in fiscal 2022 was in nine out of the top 20 ranked US hospitals, more than double its nearest competitor. While Pro Medicus has secured a few contracts with midmarket US hospitals such as Allegheny and Wellspan, wider uptake has been slow, with Visage 7’s features likely superfluous for their normal operations. However, Pro Medicus is still targeting smaller radiology groups that seek to consolidate IT infrastructure and become more efficient.

Currently, Visage 7 is limited to radiology departments, but Pro Medicus is aiming to extend the product set to other specialty departments, including cardiology and ophthalmology. In addition, when winning contracts, the firm has other product offerings, such as Open Archive or Visage RIS, that it can cross-sell to clients.

Bulls say

  • Pro Medicus is well positioned to benefit from industry tailwinds such as cloud adoption, larger datasets, and remote access.
  • Earnings are extremely defensive due to contracted revenue being largely guaranteed over five to eight years from customers.
  • The long-term growth opportunity is significant as most of the US market still uses legacy systems, and other geographies are largely untapped.

Bears say

  • Product differentiation is unlikely to be durable, with low barriers to entry and larger competitors already utilizing server-side rendering and cloud-native architecture.
  • Wide adoption outside of academic hospitals is unproved, and superior speed and visualizations are likely superfluous features for the average hospital.
  • Future contract wins are likely to be smaller as Pro Medicus already dominates the larger US academic hospital market.

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Terms used in this article

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.

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.