Pro Medicus Limited (Pro Medicus, ASX: PME, or the Group) is a healthcare IT business founded in 1983 and listed on the ASX in 2000 at $1.15 a share. The Group provides medical imaging and software services to hospitals, imaging centres and health care groups globally. Its main product, the Visage 7 imaging platform, is a clinical desktop application used by radiologists to view images from any device to make a clinical diagnosis. Pro Medicus’ healthcare imaging software is available in Australia, North America and throughout Europe.

High growth, recurring fees and pricing power drive premium earnings multiple

There are many factors at work that support the extremely high earnings multiple applied to Pro Medicus’ earnings. Chief executive and co-founder, Sam Hupert, believes it is because most of the Group’s Research & Development expenditure ensures that the core product stack keeps moving forward and remains ahead of the competition. He is confident the company’s software, which enables hospitals and radiology clinics to stream medical images to mobile devices, would remain ahead of its competitors.

A key justification of the stellar valuation of Pro Medicus is that although 80 percent of revenue comes from North American customers, the Group’s market penetration is just 7 percent of the US radiology market, representing about 650 million scans a year. This leaves a large addressable runway for the transaction-based model of the Group’s core imaging product.

Moreover, the transaction-based revenue model means that revenue is based on the number of medical imaging procedures performed using the Pro Medicus software, by charging a separate fee for each individual image processed on their platform. Rather than charging a periodic subscription fee, this model involves a per-transaction fee under long dated contracts with high switching costs. This provides for recurring revenue streams and operational leverage based on the simple premise of ‘make it once but sell it many times. ‘

The cloud-based, rather than computer network-based software saves the time and cost of scanning and compressing images and files avoiding sending them down a network, which is slow and cumbersome. Cloud-based software imaging technology is quick and enables near real time diagnosis to be done remotely, including to mobile devices. This saves clinicians time and money.

Another factor that supports the extraordinarily high earnings multiple of Pro Medicus is the application of Artificial Intelligence (AI) to the Pro Medicus imaging software. AI has the potential to boost clinician productivity and diagnosis accuracy to an unprecedented level. AI can use sophisticated algorithms to systematically analyse vast volumes of medical imaging data, by identifying patterns and abnormalities that might be missed by the human eye. This significantly boosts the effectiveness and efficiency of the Pro Medicus imaging software, enabling it to command high prices from clinicians and hospitals. This pricing power is another factor supporting the high price-earnings multiple of the Group’s shares.

Importantly, this technology is proprietary to Pro Medicus and so is protected from being commercialised by a competitor. Furthermore, the over-arching demand for Pro Medicus’ advanced imaging technology is driven by an ageing population and rising global living standards.

This irreversible demand growth is another all-important factor that supports the premium price-earnings multiple applied to Pro Medicus’ earnings.

Index fund buying lending support to the share price

Pro Medicus is a component of 15 different indices and 141 exchange traded funds (ETFs). Some of these indices include the S&P ASX 200, S&P ASX 200 Health Care, S&P ASX All Ordinaries, and the S&P ASX 200 Health Care Equipment & Services index. The ETF with the largest weighting of Pro Medicus is the Telemedicine & Digital Health ETF.

Index fund buying supports the Pro Medicus share price when it is newly added to an index, because of the buying support from index funds that must maintain their proportionate portfolio composition. This buying support increases the market capitalisation (market value) of Pro Medicus, which in turn increases the market weighting within the market index. The higher market weighting requires index funds to purchase more Pro Medicus shares to maintain their exposure to the index. A higher Pro Medicus share price means a larger portion of the index is represented by Pro Medicus, driving additional buying pressure from index funds that must replicate the index composition.

This phenomenon is often called the “index effect” and is another factor that supports the seemingly inordinately high price earnings multiple of Pro Medicus.

Looking ahead

In FY24 Pro Medicus earned an Underlying Profit Before Tax margin of 72 percent on 29 percent higher Revenue from ordinary activities. The Group is debt-free and pays fully franked dividends.

These are impressive numbers produced by a defensive business with disruptive innovation in medical technology that delivers stable recurring revenue streams and has high barriers to entry within an expanding sector. The Group’s market-leading software, ongoing R & D advancement, expanding market penetration, and exponential growth prospects explain the current price earnings multiple.