Sonic Healthcare (ASX:SHL) shares have been under pressure over the last 12 months. Sentiment has been impacted by inflationary pressures, currency headwinds and slower delivery of margin improvement initiatives.

In mid-May, SHL downgraded its EBITDA guidance for FY24. The revised guidance was not a surprise to us and we had held concerns as to whether the previous guidance could be met. The shares subsequently weakened, although did stage somewhat of a recovery. This prompted us to research SHL in The Dynamic Investor to assess the prospects for a further recovery in the shares.

About Sonic Healthcare

Sonic Healthcare provides highly specialised pathology/clinical laboratory and diagnostic imaging services to clinicians (GPs and specialists), hospitals, community health services, and their patients. The Company is one of the largest providers of pathology/clinical laboratory services. It has strong positions in the laboratory markets of eight countries, being the largest private operator in Australia, Germany, Switzerland and the UK.

Key Fundamental Drivers

Is There Scope for Margin Improvement?

SHL’s updated guidance implies an EBITDA margin of 17.9%. This represents a ~300 basis points decline in FY23 and also appeared below consensus estimates at the time of the May update.

The challenge for the Company in achieving a sustainable expansion in EBITDA margin is that the latter is vulnerable to wage inflation. In particular, employee costs represented ~50% of SHL’s revenue according to the latest financial statements. Wage growth and overall inflation are expected to have peaked in 2023, but the decline doesn’t seem to be as quick as previously anticipated by SHL management.

The Company also has limited pricing power, as evident by the price cuts in Switzerland and Belgium over the past two years. More recently, a 15% cut to the national fee schedule in Belgium was partially offset by fee indexation of 6%, both effective 1 January 2024. SHL can mitigate this impact via price increases for tests, as well as increased focus on automation and efficiency gains. However, there is potential for a better pricing environment in Australia with the re-introduction of indexation for some tests from FY26.

Diagnostic Imaging Division Remains a Solid Performer

The Diagnostic Imaging division continues to benefit from the accelerating trend towards higher-value modalities (CT, MRI, PET). Further, the addition of Medicare-funded MRI licences has supported revenue growth. In 1H24, the segment reported organic revenue growth of 11%, as well as significant EBITDA margin expansion. The latter has been augmented by the Company’s continued focus on cost control.

The Diagnostic Imaging division appears to be well positioned to benefit from two factors. Firstly, increased hospital/specialist referrals and ii) A stronger-than-expected rate of annual fee indexation of 3.6% that was applied to diagnostic imaging services (excluding nuclear medicine services) from 1 July 2023.

Medicare Indexation for FY25 has been legislated at 3.5%, reflecting current inflation trends. Notably, the FY25 indexation is expected to apply to a high portion of industry benefits (~90%). Double-digit % industry benefits growth is expected over the medium term. This is underpinned by Medicare Indexation as well as favourable macro trends. In contrast, the average growth rate between FY10-19 was ~7%.

Recent Medicare date for May 2024 highlight that benefits growth has maintained double digits for the 2nd consecutive month. Further, the growth in higher-value modalities outpacing that for lower-value modalities.

Balance Sheet Capacity for Acquisitions

Sonic Healthcare had progressively reduced its level of gearing in the post-COVID period. There is significant balance sheet headroom for further acquisitions and capital management. In context, bolt-on acquisitions have been a historical growth strategy. Over the last three years alone, SHL has spent $1.9b on acquisitions.

SHL has flagged that further acquisitions and contract opportunities are under consideration. Having said that, we contend that further acquisitions are unlikely to be as well received by the market as they once were. The merit in the acquisitions undertaken over the last three years is that they are expected to be EPS-accretive and, over the short term, should help to offset the drop in high-margin COVID PCR-related revenues.

However, over the longer term, EPS growth will be contingent on commercial and public payers of pathology services (insurers/governments) willing to fund margin expansion for SHL. Despite substantial merger & acquisition activity over FY09-FY19, the Company was only able to generate ~3% EPS growth over this period. This is likely due to the synergies or benefits from acquisitions being eroded away by two factors. Firstly, price cuts and secondly, higher operating costs (i.e. collection centre rents and labour costs).

Fundamental View

The achievement of EPS growth over the medium term is becoming increasingly reliant on the completion of EPS-accretive acquisitions. There is potential for margin expansion from factors such as synergy benefits from recent acquisitions, as well as initiatives around digital pathology and AI. However, the expected earnings/margin uplift from these has been pushed out; which in turn limit the potential for a re-rating in the shares.

Charting View

Ever since topping out at the end of 2021, Sonic Healthcare has been trending lower. Despite the recent jump higher in early June, the stock remains in a longer-term downtrend, so caution is warranted from a charting perspective. Ideally, we need to see the stock make some higher highs and higher lows and it needs to be pushing beyond $28 before the chart can begin to look a bit more positive. We could also interpret price action from the past few months as an inverse head and shoulders, which also would indicate that a push above $28 would be a positive. If that were to occur, then we would be potentially targeting a short-term move towards $32.

 

Michael Gable is managing director of Fairmont Equities.

 

Current share prices available here.

You can learn more about technical analysis in this article.

 An 8-week FREE TRIAL to The Dynamic Investor can be found HERE.

Would you like us to call you when we have a great idea? Check out our services.

Disclaimer: The information in this article is general advice only. Read our full disclaimer HERE.

Like this article? Share it now on Facebook and Twitter!