The revenue and earnings of Sonic Healthcare (ASX:SHL) have benefited from COVID-19 due to increased laboratory testing. With testing numbers recently receding, so has the share price. We recently researched the Company to assess, firstly, the veracity of this view, and secondly, whether there were other factors that could support a restoration in SHL’s premium rating.
About Sonic Healthcare
Sonic Healthcare (SHL) provides highly specialised pathology/clinical laboratory and diagnostic imaging services. Its clients are 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
Base Business Continues to Generate Strong Growth Rates
Perhaps the most important aspect of the FY21 result was the strong revenue growth reported for the base business (i.e. excluding COVID-19 testing) across the key pathology markets, which was contemporaneous with a rapid uplift in the overall earnings base for the Pathology division as a result of the acceleration in COVID-19 testing.
Overall, base business revenue (ex-COVID-19 testing) grew by 6% on FY20 and 4% on FY19 (excluding the impact of currency, acquisitions, disposals, one-off gains). The Australian Pathology business reported organic growth of +28% (base business revenue growth +9%). The US reported +34% organic growth (base business revenue growth +5%), while Germany reported revenue growth of +50% (base business revenue growth +5%).
In terms of the Australian Pathology business, the 9% growth for the base business was above historical levels. However, the prior corresponding period (FY20) was negatively impacted by lower testing. While the base could be disrupted in 1H22 as lockdowns returned across much of the east coast of Australia, COVID-19 testing is expected to more than compensate for any base revenue postponed/lost.
Expected Earnings Impact from Lower COVID-19 Testing Volumes may be Overstated
Consensus EBITDA forecasts in FY23/24 are lower relative to FY21/22, as a result of the impact of lower EBITDA margins from 2H22/1H23 onwards. The lower margin expectations reflect the impacts of reduced reimbursement and lower COVID-19 testing volumes. In context, COVID-19 testing margins are around 3.5x those of the base business.
However, we highlight several factors that could lead to the decline in the overall earnings base being less severe than currently forecast.
- COVID-19 testing rates – based on testing data from several countries with high vaccination rates that are open and living with COVID-19 – are likely to maintain or rise from currently high levels. While restrictions have eased in several countries with high levels of vaccination, COVID-19 case numbers continue and is likely to be further exacerbated by the recommencement of significant international travel on a global scale. However, COVID-19 case numbers have varied based on the level of vaccination coverage.
- Testing for COVID-19 is likely to become a part of the laboratory testing menu going forward just like other respiratory viruses.
- There is still a degree of uncertainty in relation to the ongoing efficacy of COVID-19 vaccines, the need for boosters and continued transmissibility of the virus. As international travel commences and mobility increases (particularly in areas where there is lower vaccination coverage), the likelihood of new variants is high. This will likely require continued monitoring and testing to sequence emerging variants and monitor the efficacy of vaccinations against these mutations.
- Operating leverage is improving across SHL’s overall business. Excluding the contribution from COVID-19 testing, the Company delivered another strong result on the organic cost base, with total expenses in FY21 growing substantially slower than revenue (+14% vs +34%). Although consumables costs increased significantly (+45%), labour cost growth came in significantly below sales growth (+6% vs. +34%). Whilst both are functions of the high volume of COVID-19 tests performed, SHL is also continuing to generate labour savings from changes that were made at the start of the COVID-19 pandemic.
A Relatively Stable Regulatory Environment
The current regulatory environment across all major markets appears relatively benign (likely more so than most of the recent past given the increased contribution from COVID-19 testing). As an illustration, the Company disclosed at the FY21 results release that the next round of fee cuts in US (January 2022) will have a largely immaterial impact on group revenues (-US$8m).
Aside from the PAMA fee cuts, there is unlikely to be reimbursement pressure in the base business, especially following several reimbursement cuts in recent periods (in particular Germany, which is a significant market for SHL).
Beyond reimbursement pricing pressure in the base business, the more relevant pricing debate currently is the likely pressure on COVID-19 reimbursement. This current reimbursement rates paid by Medicare are due to expire at 31 Dec 2021. However, given that COVID-19 testing has been the main response to Australia’s COVID-19 outbreaks, it is becoming increasingly likely that the current COVID-19 reimbursement will be maintained at least until the federal election in 2022. This would ensure the pathology players will be able to accommodate further surges in demand, particularly with the current resurgence from the Delta variant.
Acquisitions on the Agenda as Gearing Level Is at Record Lows
The significant uplift in earnings from COVID-19 testing as well as a 50% increase operating cashflow for FY21 has driven SHL’s gearing (on a net debt to EBITDA basis) down to 0.4x as at 30 June 2021. This level of gearing is well below the 5-year average of 2.4x and the debt covenant limit of 3.5x.
As a result of the significant reduction in gearing, there is now substantial headroom (~$1.5b), which SHL has indicated will be focused on growth initiatives (organic/inorganic) as opposed to capital management, with a range of acquisition opportunities under consideration.
The Company has typically targeted acquisition opportunities in the US and German pathology markets. Previous acquisitions in these regions (i.e. Staber and Bremen in Germany and West Pacific Medical & Aurora in the US) have been well received by the market, as these have broadly delivered the expected earnings accretion, have generally performed in line with expectations and have been integrated well.
Sonic Healthcare is currently trading on a 1-year forward P/E multiple of ~19x, which is well below the multiple in recent periods and likely reflecting the difficulty in forecasting earnings in light of COVID-19-related factors. Also, the market has been taking a conservative approach in regard to encapsulating the expected earnings tailwind from higher COVID-19 testing volumes.
We consider that the significant decline in consensus estimates for group EBIT in FY23/34 may be too punitive, in light of: i) The existence of several factors that could lead to the decline in the overall earnings base being less severe than currently forecast and ii) The base business likely to continue growing at trend (~4-6%) over the medium term.
Aside from the potential for earnings upgrades for FY23/24, a key catalyst for the shares is likely Merger & Acquisition opportunities. While acquisition multiples are elevated at present, it is worth noting that an acquisition up to ~$1.3b (i.e. the majority of the current balance sheet headroom of ~$1.5b), at EBITDA multiples of 10-15x (i.e. above the historical 8-10x paid by SHL) would still be low single-digit EPS accretive.
When we looked at the SHL chart on 22 June in The Dynamic Investor report, we noted that the upside break was a buying opportunity. After peaking over a month ago, the share price has started to slide back. There is a bit of support around $39, but obviously there will be much stronger support between $37 – $38. For now, we can be patient and wait to see if we can get SHL a couple of dollars cheaper. A break back under $37 would be viewed as a negative.
Michael Gable is managing director of Fairmont Equities.
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