Sonic Healthcare (ASX:SHL) shares have endured a challenging 24 months. The main reason is that the contribution from high-margin COVID PCR testing has been all but eroded.

We recently researched SHL in The Dynamic Investor after the Company released results for the six months to 31 December 2023 (1H24). Are the shares nearing a bottom? Or are there still red flags to keep investors on the sidelines?

About Sonic Healthcare

Sonic Healthcare (SHL) 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 and 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

Are Expectations for Margin Recovery Realistic?

At the interim results release in February, management maintained EBITDA guidance for the full year (FY24). But this relies heavily on a significant uplift in margin for the 2nd half. This is because SHL’s EBITDA margin are no longer supported by high-margin COVID PCR testing. To achieve a meaningful improvement in EBITDA margin, SHL must first overcome two operational headwinds in 2H24:

i. A 15% cut to the national fee schedule in Belgium, partially offset by fee indexation of 6%. Both of these came in effect on 1 January 2024. SHL can mitigate this impact via price increases for tests not on fee schedule and increased focus on automation and efficiency gains. In context, Belgium accounts for 2% of group revenue.

ii. The Pathology Watch business is currently lossmaking and is expected to slightly impact 2H24 EBITDA. The acquisition of Pathology Watch (in January 2024) is expected to become breakeven very quickly. However, the upside is long dated and reliant to some extent on the speed of validation of the artificial intelligence pathology tools.

The Company continues to expect material upside in FY25 from its enhanced revenue collection system in the US. The pilot was yielding mid-to-high single digit revenue uplift by reducing the number of claims rejected due to incomplete information. However, it is too early to quantify the ultimate revenue uplift. Implementation will occur in FY24, with benefits expected in FY25.

Diagnostic Imaging Segment Remains a Steady Performer

The Diagnostic Imaging division accounts for ~10% of group revenue. It continues to benefit from the accelerating trend towards higher-value modalities (CT, MRI, PET) as well as the addition of Medicare-funded MRI licences. In 1H24, the segment reported organic revenue growth of 11%, as well as EBITDA margin expansion of 160 basis points. Margin expansion was augmented by the Company’s continued focus on cost control.

In terms of the outlook, earnings and margin for the Diagnostic Imaging segment appears to be well positioned to benefit from two factors. The first is increased hospital/specialist referrals and the second factor is a stronger-than-expected rate of annual fee indexation of 3.6%. The latter was applied to diagnostic imaging services (excluding nuclear medicine services) from 1 July 2023. When combined with favourable macro trends (increasing and ageing population, utilisation and continued improvement in mix), double-digit % industry benefits growth is expected over the medium term.

Balance Sheet Capacity for Acquisitions

Gearing (on a net debt to EBITDA basis) as at 31 December 2023 increased to 1.6x, reflecting recent acquisitions. Prior to this, SHL had progressively reduced its level of gearing in the post-COVID period. Notwithstanding, the current gearing level is below the 5-year average of 2.4x pre-COVID, as well as the debt covenant limit of 3.5x.

The Company has significant balance sheet headroom (~$1.5b prior to the interim dividend payment) 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 twofold. Firstly, they are expected to be EPS-accretive and, over the short term. Secondly, the acquisitions are expected to help to offset the drop in high-margin COVID PCR-related revenues.

Fundamental View

At current levels, the shares are trading on a 1-year forward P/E multiple of ~22x. This multiple remains in line with the average multiple over the last five years. As such, there is downside risk to the multiple. This is due to the market not fully factoring in challenges in achieving meaningful EBITDA margin expansion over the medium term.

The current multiple is also unappealing in the context of an EPS growth profile of +3.6% over FY23-26 on a CAGR basis, which has been revised downwards from +6% at the time of our last report. The current multiple is also unappealing when referencing the EBITDA growth profile of +6% over FY23-26 on a CAGR basis.

The achievement of EPS growth over the medium term is becoming increasingly reliant generating synergies from recent acquisitions, as well as completing EPS-accretive acquisitions. To this end, SHL has generated modest EPS growth over an extended period despite substantial merger & acquisition activity.

Charting View

SHL bounced off support late last year but a few weeks ago it was sold down sharply on high volume. It is now back near this $28 support zone, and that is a bearish sign. It is at risk of breaking support and falling lower. Investors looking to buy SHL can therefore be patient with SHL and wait to see if it breaks support. If so, then they are likely to get it at cheaper levels over the next few months.

 

Michael Gable is managing director of Fairmont Equities.

 

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