RadNet, Inc. (RDNT) Earnings Call Transcript & Summary

All right. Thanks, everybody, for joining. I'm Chris Brustuen, Managing Director in the investment banking team here in the New York office for the health care group. Before we get started, I want to read the public disclaimer. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. I'm joined today with Mark Stolper, CFO of RadNet. Thank you again for joining us today. Before we jump into the questions, maybe I'll just pass it to you for any opening remarks that you have.

Well, first of all, thank you, Chris. It's a pleasure to be here. It's our first time presenting at this conference, and it's a wonderful conference. So we appreciate the opportunity and the exposure.

Thank you. I want to start off thinking about the competitive landscape. Given your scale, can you discuss a little bit on your perspective on opportunities there for further industry consolidation?

Yes. I mean, one of the great things about our industry, at least from our perspective, is that it is highly fragmented. If you read the research out there, it's believed to be that there's over 6,000 outpatient diagnostic imaging centers in the United States. And if you took ourselves who own roughly 400 of those 6,000 imaging centers and the next 4 largest players in the industry, which are private equity backed, we would only own between 10% and 15% of all the imaging centers in the United States. So it's an industry that has a lot of opportunity for growth and consolidation and we believe that, that consolidation will take place. Going forward, there are significant efficiencies that you get from scale. And it also -- having scale also allows you to invest in technology that further patient care and improve patient care, which is great for the whole health care delivery system. These are investments in not only the equipment but in -- more recently, we're investing in AI and I'm sure we'll have to talk about that a little bit later. Software solutions that improve the patient's experience post processing, software on the machines, radioactive isotopes, contrast materials, all these things are driving more clinical indications for ordering diagnostic tests, which will continue to grow the industry going forward. And the shift that's occurring between hospital-based imaging and freestanding diagnostic imaging continues to drive revenue into the lower-cost sites of care like the ones that we operate.

That's very helpful. And following up on that point, I want to spend a minute thinking about kind of white space in the broader radiology market. What is the reimbursement environment like across this market? And how can this help drive incremental growth for the business?

Well, when you talk about reimbursement, you really have to bifurcate the discussion between government payers, meaning Medicare, and commercial payers. And I think the experience of the industry might be very different depending upon which provider you're talking to. With respect to government, you'd have agreement that Medicare rates have been fairly stable since 2015. There was a period going back over a decade where Medicare was reducing reimbursement for advanced imaging in the early 2000s and really from 2007 as part of The Deficit Reduction Act up through 2014. Since that point, we've had very stable reimbursement. There hasn't been a target on the industry's back. We have had some smaller reimbursement cuts in the last several years, but it wasn't targeted at diagnostic imaging. It was really a payback for -- under budget neutrality when Medicare about 4 years ago substantially increased the reimbursement for primary care doctors and internists under these E&M codes and they're taking that reimbursement back from all the other specialties. So we've had small declines in reimbursement from Medicare. But essentially, it's been fairly stable and it's believed to be stable going forward. Where we've seen benefit has been on the commercial side of our book of business. We've built ourselves into the largest provider of outpatient services in virtually all the markets in which we operate. And what that means is we are the principal alternative to the much more expensive hospitals in our markets. And so when we go back to the insurance companies and we're setting what we hope to be fair and equitable long-term rates with them, they recognize that they can save a lot more money by trying to move this business into the freestanding centers and they obviously need to have us be a healthy company in order to be able to service that book of business. So we have been -- we've not been shy about potentially sending cancellation notices to payers who don't appreciate the value that we're providing. And so far, we've been able to negotiate fair and equitable rates once we've done that because the hospitals in our markets are charging anywhere between 200% and 500% for the same services that we're providing. So we've actually been getting price increases on average in our commercial book of business, which represents about 58% of our payer mix, where the government portion which I spoke about earlier is about 22% of our payer mix. In addition, we have a very special book of business that we do that we're not aware of any other major imaging center chain does, which is called capitation business. These are full risk contracts, primarily in the state of California, where we take the utilization risk on about 2 million patients for a per-member, per-month fee and then it's our burden and responsibility in managing those contracts profitably and managing the utilization. There also we have built in price increases in those contracts as we project continued heavy demand for utilization going forward.

Thank you. Shifting to a hot topic, the labor and inflationary environment that we're in today, can you spend a minute talking about what the current labor and inflationary environment is for your business? And then have you been able to automate any processes or positions to help alleviate some of these pressures?

Yes. So I think what we're experiencing is not dissimilar to what any health care business is experiencing today. And even if you were to go outside the health care delivery system, it's just a fact of life in the labor market today that it's a very difficult labor market in terms of attracting and retaining talent. So we've had to be much more aggressive or much more generous with our employee base in recent years to be able to attract the talent that we need and retain that talent, particularly in the areas of technologists, which make up the majority of our 10,000 employees. As diagnostic imaging has grown steadily over the last decade and will continue to do so into the next decade, there is heavy demand for these technologists. We're simply not graduating enough of these folks from these vocational programs to meet the heavy demand in diagnostic imaging and they're in high demand from other imaging centers, from hospitals and the like. So although we've demonstrated margin enhancement over the last several years, that margin enhancement would have even been better had we not had this difficult labor market. But we're doing all the things that I think -- we think are necessary to manage this labor situation effectively. One is that we're establishing much better relationships with the vocational schools where we're offering internship programs, tuition reimbursement programs. We're offering bounties to our own employees to bring in technologists from the outside. And in one case in California, we're actually setting up our own schools in California in partnership with a large vocational not-for-profit firm called JVS Southern California. So that's been effective and will continue to be effective. But to your -- directly to your question, we're also making the necessary investments on the technology side of our business. We own our own IT backbone. Today, it's called eRAD. It's an end-to-end solution. And we are in the process of redeveloping that product into a new product -- that product is called eRAD. We're developing it into a product called DeepHealth OS, which we're launching as a fully commercialized product in November at the big radiology show in Chicago called the RSNA. And that solution is taking the current product, eRAD, to the cloud. And in that solution, we've built in a number of generative AI-powered automation tools that will further automate areas of patient scheduling, preauthorization, insurance verification and certain revenue cycle functions that will all allow us to rely less on human capital, i.e., labor, which should help the labor situation going forward. And that's a tool not only do we use -- or a software package not only do we use internally, but we sell that software currently, the eRAD version of that software, to about 200 customers outside of RadNet.

Discussing a little bit on organic growth, I want to shift to that and just talk a little bit about what are some key initiatives you have that drive organic growth and same-store volume trends for your business?

Yes. Well, I'd say a couple of things. First of all, part of the organic growth is just being driven by some nice tailwinds and trends that we're seeing within health care and within diagnostic imaging, specifically. The first thing to note is that our industry grows every year. As technology advances on the equipment side, the post-processing software side, contrast materials, radioactive pharmaceuticals, these advances simply drive more medical indications -- or clinical indications for ordering these tests going forward. And so more and more of these tests are going to continue to be ordered as technology advances. Second, as that pie grows, we're also seeing that market share shift that's not unique to diagnostic imaging. You're seeing it in all areas of health care where the payers are getting more and more aggressive in trying to move this business out of the hospitals into free -- into lower-cost sites of care. And you're seeing that in diagnostic imaging, you're seeing that with outpatient surgeries -- with outpatient surgery centers. You're seeing that with urgent care visits, home health, physical therapy and the like. And so more of that business is coming into our centers, which is creating tremendous demand. The other thing trend that we're seeing in our business is that the -- a lot of these technology advances are focused on the higher or the more advanced imaging modalities of MRI, CT, and PET/CT. For instance, in the PET/CT world, you've got a newer test called the PSMA test, which is a prostate test, but now that really has been exploding over the last couple of years and represents over 10% of our PET/CT business today. You've got the promise of Alzheimer's bringing in a lot of imaging, both on the PET/CT side and the MRI side. So if you look at all the projections that we -- that are out there about the industry, you're going to see that the industry is going to continue to grow and that's going to drive organic growth. Specifically to RadNet, in addition to those trends, we're building a number of de novo facilities. We've got a big de novo initiative as to try to build capacity to meet the heavy demand in our local markets. So we've got 6 centers that should open between now and the end of the year. We've got 15 additional de novo projects that are slated for 2025. And all of those will continue to drive growth. And then I'd say, finally, the hospital partnership initiative is creating great organic growth for us. This is a business that we've been growing very substantially over the last 5 or 10 years where many of these same hospitals that are losing business to us and to other ambulatory players are looking for a long-term strategy around outpatient diagnostic imaging. They have very little expertise or business acumen in being able to operate ambulatory sites of care with low pricing and high volume with any level of success. So they look to partners to potentially do that for them. And we essentially allow a hospital to participate in this trend as opposed to continuing to fight this trend. And so today, as we sit here, we have 149 of our 398 locations held within partnership with some of the larger health systems in our marketplaces, partners like Cedars-Sinai, MemorialCare, Dignity Health, Adventist Health on the West Coast. Folks like the RWJBarnabas system here in New Jersey and the University of Maryland health system in the Mid-Atlantic. And so this is becoming a bigger portion of our business. 37.4% of our centers are now held in joint ventures and we think that it's not -- it wouldn't be unlikely that within the next 3 or 4 years that number could grow to over 50% of the imaging centers that we own.

Interesting. Shifting back to AI. How important is AI and technology to your business? And how should we think about that as driving same-store volume growth and growth overall for revenue?

Yes. Well, we have conviction that AI is going to have a transformative impact on the business of radiology or owning diagnostic imaging centers. Today, every scan that we take is read by a human being, a licensed physician, a radiologist. That is a cost of delivering our service. We bill globally for both the technical component and the professional component and we pass on most, if not all, of that professional component to our radiologists for the services that they provide. These tools that have been cleared by the FDA or CE marked in Europe have been cleared as productivity and accuracy tools to be used by the radiologist. Some of these tools we've developed ourselves and gotten cleared through the FDA, others are third-party tools. We're using them in the areas of breast cancer, prostate cancer, lung cancer, and ultimately, we're interested in colorectal cancer and cardiac screening. And the idea is that we believe that these tools can be used to drive screening opportunities into the RadNet facilities and into the industry. Today, of those chronic diseases and those cancers that I mentioned, only one of them relies heavily on diagnostic imaging as a screening tool, meaning breast cancer with mammography. But we believe using AI to increase the accuracy and lower the cost of MRI for prostate screening, CT for lung cancer screening, CT ultimately for colorectal screening and CT for cardiac screening that we can deliver these screening services on a mass level to keep the population more healthy. So that's where our interest lies with respect to our own internal investments in that. But I would say broader -- when you speak broadly about how it will change radiology, there could be a time sometime 10 years from now, 20 years from now, 7 years from now, we don't know, where some of these tools are actually cleared for autonomous use meaning you can actually eliminate the requirement for a radiologist for certain scans and that will have a massive impact on health care and the cost of delivering diagnostic imaging services. So we're all in, in AI. We were an early investor in AI in the year 2020 when -- before AI became ubiquitous in the news. And this area of health care is really ripe for AI, both on the clinical side, where computers can clearly recognize patterns in digital images better than human beings can. But also on the generative AI side in the areas of automation tools that can help our business processes that we perform on behalf of our centers that we're building into that DeepHealth OS product.

Thank you. Spending a minute on your multi-modality strategy, how is this diversified strategy and also tied with some of these exclusive managed care capitation arrangements that you have in place driven your growth?

Well, we've always had a strategy around what we call centers of excellence, our large centers that have the full breadth of capabilities from the routine studies to the more advanced studies for a number of reasons. First is from a marketing perspective, this is a way that we can distinguish the RadNet facilities from some of our competitors, meaning that we can put 1 prescription pad on their desk and say no matter what imaging needs you have for your patients, you can send it to the RadNet facility down the street. And though people have said, well, wouldn't it be more profitable for you to only do MRI, CT and PET/CT, meaning the advanced imaging that have higher prices and better margins? The answer is yes, however, we capture a lot of the advanced imaging because we are a one-stop shop to the referring physician community. Often someone will be referred into one of our centers for some routine study like an x-ray and an ultrasound. And based upon the results of that study, they'll be sent back for the more advanced imaging. The other thing is that when you look at a normal patient population and the distribution of imaging that occurs within that population, 75% of what a normal patient population needs is advanced imaging -- excuse me, is routine imaging. And so that's the test that the primary care docs and the internists and the specialists are sending on a daily basis, and we want to be able to capture all of their business, including that 25% of the high-end exams. And because we have the relationship with them on the routine studies that they're constantly communicating and sending us business around, we capture all of their business. And then back to your question with regards to capitation, when we're contracting exclusively for what's now about 2 million lives on a per-member per-month basis for capitation, we have to be able to perform all of the breadth of services because we're not just capitating on one modality, we're capitating on all the diagnostic imaging. So it's really a way for us to capture a tremendous amount of revenue and referral sources.

Very interesting. I'd not appreciated all of that. Shifting back on the de novo and the JVs with hospitals and home systems for a minute. Can you talk a little bit about how the de novo development strategy and these joint ventures with health systems is accelerating your growth as well?

Yes. So de novos is something that we've always done as part of our growth algorithm. What I would say is that, that part of our business is accelerating because the opportunity is there. What we're finding is that we're experiencing extremely heavy demand in virtually all of our markets. We're running into capacity constraints. Sometimes, there are small mom-and-pops that we could buy that might have excess capacity that we can fill, but other times they're not. And so we've embarked on a program where we're more aggressively building the capacity in many of our local markets. As I mentioned, we've got 6 that should open up by year-end, 15 slated for next year. Interestingly enough, almost half of these de novo facilities that we have in development are going to be within hospital joint ventures. So some of them are wholly owned centers, some of them are health system joint ventures. All of them have opportunities where we believe either we're losing business today because we can't schedule patients fast enough into our centers to satisfy them; or b, we don't have access points for certain patient populations that we're currently not servicing -- we're currently unable to service effectively today. And so a typical de novo facility will cost us anywhere between $5 million and $7 million to build. It may take upwards of a year between conceptual idea to signing a lease, building out the center, provisioning the equipment, getting accreditation for the machines, any nuclear licenses and seeing our first patient. So it's a long process. But that center that costs $5 million to $7 million to build should produce, once mature, anywhere, give or take, about $6 million of revenue and bring about 20% EBITDA margins to the contribution line before the allocation of corporate overhead. So when we look at the return on invested capital of a de novo center, we're looking at targeting anywhere between 4 and 6 years in terms of our return.

Shifting back to M&A, thinking about a typical tuck-in acquisition. Can you walk through what a typical tuck-in acquisition looks like from LOI to integration phase? What are some of the key drivers that you have for incremental volume cost reductions, margin expansion at your fingertips?

Sure. Well, the first thing I'd say is I'm not sure there's a typical M&A trend. Everyone is a little bit different. And I would also characterize M&A differently in separating kind of the small mom-and-pop tuck-in transactions from kind of a midsized group versus something at a larger scale because there are different characteristics of those deals, both from a pricing perspective as well as the synergies that might exist once we get them into our network. But typically, we'll spend anywhere between 4 and 6, 4 and 7x EBITDA for a small tuck-in transaction in our market. There are typically economies of scale that we bring to the table. Many of these mom-and-pops -- or all these mom-and-pops don't have the benefits of scale that we have. So when we get in there, we can lower their cost of equipment service, we can eliminate their corporate overhead. We take on their billing and collecting operations. There's a variety of things that we can do to get more EBITDA. And then also, if they have capacity, we're generally pretty good at filling that capacity over time. So on the larger transactions, kind of the midsized transactions, we might stretch beyond that multiple level for something that's very strategic, that there's scarcity value, that's important to the network in that regional marketplace. And then we haven't done anything of real scale in recent years. There are those transactions available out there. They're very binary in nature and many of them are owned by sophisticated sellers, private equity firms, and we just haven't had a lot of success in buying from financial sponsors. We've been much better suited at buying from physician owners who care about who they're ultimately going to work for. They care about our clinical protocols. They care about our -- the quality, what equipment we're buying, the software solutions we have and they're not -- it's not all about price. But we would do something of scale. We certainly have the firepower of doing something of scale. We ended last quarter with $741 million of cash on our balance sheet. Our net leverage is about 1.1x. So we have a lot of capacity to do this, not only using cash and leverage, but our own equity as well. So we have the appetite to do that, do something we would like to expand geographically. And we demonstrated that this year with our acquisition in Houston, where we bought 2 imaging center chains and we put them together, we're going to continue to do more in Houston, but we'll see.

I know we only have a few minutes left. I'll ask another question, and then we'll open it up for a question from the audience. Following up on that last point on M&A, can you discuss a little bit more on -- you mentioned on the core radiology side M&A opportunities in digital health and AI as well potentially. And then on that same note, how does your scale expand your reach here and your ability to integrate these across your platform?

Yes. So I'm glad you brought that up because I was talking about M&A for our core business, but there will be M&A opportunities in digital health. There's been a lot of money poured into AI solutions within radiology, and there aren't a lot of business models that are being successful right now in terms of revenue. We've managed to create a business model by going directly to our patients and charging $40 out of pocket for this mammo product that we have that's been incredibly successful at detecting cancer up to 2 years sooner than the human eye. And so we'll have an AI division that this year will do somewhere likely between $20 million and $25 million of revenue by itself in '24. But others haven't had this success because they don't -- we're a living laboratory of 400 imaging centers that we can monetize our AI through. Others have to sell it to folks like us. And the radiologists have been hesitant or resistant to adopt these solutions, not because they're not great solutions, but because they can't then bill and collect for it on the back end. So there are a lot of companies that were funded by private capital that today are struggling to find a business model and looking for a home. So I think that there's going to be a consolidation in the radiology AI space. I think we're obviously well positioned to do that. And look in the near future for us to do some things. We're not going to be spending the kind of capital we did initially when we got into AI because the market's changed and we don't have to, but there will be a consolidation there. And there may be some other interesting software solutions that we could also integrate with our DeepHealth OS product that we'll look to acquire in the future. So I think we'll see acquisitions in both segments of our business.

Any questions from the audience? Another for me. Can we -- going back to cost and operating leverage, it'd just be interesting to hear about the variability at the clinic level that you have from a cost and operating leverage perspective, and I guess at the corporate level as well if there's additional levers there.

Yes. Well, I mean, like most investors in the audience, we have a portfolio of imaging centers, right, and they're all a little bit different. And some are performing better than others at times and so on and so forth. But the real benefits of scale in this industry come down to a number of areas. One is owning our own IT solution has been key to our success. It allows us to drive efficiencies, everything from patient scheduling to all back-end billing and collecting. And that's been important for our growth. And when we acquire businesses or build centers, they immediately go on to our IT platform and that's a necessity for us. So we've got billing platform, one end-to-end radiology software solution. We're also -- we use our scale in provisioning equipment, meaning procuring equipment, buying equipment. We're often the largest purchaser of imaging equipment to all of the major vendors in the United States. So we're able to use our scale to drive bulk pricing. Same thing on equipment service, which is not an inexpensive part of our operating costs. These advanced imaging equipment are very costly to keep up and running. Because we have scale and because we have a regional scale, it allows us to contract for those services less expensive than those folks that were buying. Our revenue cycle management program is extremely robust and much more sophisticated, both on the system side but on a workflow side than a lot of the folks that we're competing against and buying. That's been a big benefit of our scale. And I would also say the ability to subspecialize. So our radiology groups who are large -- some of the largest groups in the country on a regional basis are able to subspecialize so that if your son or daughter is going in for a test, we'll have a pediatric radiologist read that scan or if you're going in for a brain scan we'll have a neuroradiologist. Our breast imagers are the only ones reading our mammo scans, specialists. And that's a major selling point to referring physicians when they're thinking about who to send their diagnostic imaging to. So all of these aspects and many others is what really creates the benefits of scale in our industry.

Well, I know we're up on time. So thank you again for the time today. This has been very interesting on our end, and we appreciate the conversation.

Appreciate it, Chris. Thanks for the opportunity.

All right.