Sonic Healthcare (ASX:SHL) shares have been under pressure over the last 18 months and they are trading well below the highs reach in mid-2023. Sentiment has been impacted by slower delivery of margin improvement initiatives, profit downgrades, and low organic growth rates in the US pathology business.

After the Company recently reported interim results (1H25), we researched SHL in The Dynamic Investor. Does the current weakness in the shares present an entry opportunity?

About Sonic Healthcare

Sonic Healthcare provides highly specialised pathology/clinical laboratory and diagnostic imaging services. These services are provided 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. SHL is the largest private operator in Australia, Germany, Switzerland and the UK.

Key Fundamental Drivers

Weak Organic Growth in US Pathology a Concern

The Pathology division reported strong overall organic revenue growth (+6.1%) in 1H25. This was supported by above-average organic growth rates in across Australia (9%), Germany (7%), UK (8%) and Switzerland (6%). However, organic growth was partially offset by softness in the US, which reported organic growth of 2%.

In context, the US business is currently the largest contributor to group revenue (22%). Organic growth in the US was impacted several factors: i) Lower-than-expected organic growth in other anatomical pathology operations (~30% of US revenue), ii) A lack of hospital related deals, (i.e., no hospital management contract fees) and iii) Potential cost of living pressure increasing caution around physician interactions that could result in co-payments.

Organic revenue growth of ~+2% (in constant currency terms) is probably below the pace of cost growth. Further, margin for the US business (SHL only disclose margin for the group) is likely regressing. This may have longer term implications for the targeted Return on Invested Capital and future acquisitions, given that SHL already has top market share position in many other markets (#1 in Germany, #1 in Australia, strong position in Switzerland and UK).

Another setback for the US business is that the benefit of SHL’s enhanced US revenue collection system is delayed, following management pushing out this cost saving initiative by 6-9 months into FY26.

Several Key Drivers of Earnings Growth Beyond FY25

• Operational leverage is set to continue on the back of tight cost control. Labour cost as a percentage of revenue decreased by 50 basis points in 1H25 with management noting a plan to continue to dial back labour costs. In addition, the Company has closed ~60 collection centres in the past year, with further rationalisation expected.

• Realisation of majority of synergies from acquisitions made in FY24 and FY25 (in Germany, Switzerland, US)

• Expected uplift of US$20-25m in FY26 from enhanced revenue collection system in US, with further benefits expected in FY27;

• Benefit of annual fee indexation in various markets and contracts, including Radiology, UK, Belgium, SCS and Australian Pathology.

Balance Sheet Capacity to Support Acquisitions

Gearing (on a net debt to EBITDA basis) as at 31 December 2024 increased to 2.0x, from 1.9x as at 30 June 2024, reflecting recent acquisitions. SHL estimates current headroom of ~$1.7b (before interim dividend and the recent LADR acquisition) available for future acquisitions and growth opportunities. SHL expect their debt cover ratio to stay below long-term pre-pandemic levels (~2.4x) following the LADR acquisition.

While the Company noted that further acquisitions and contract opportunities are under consideration, we contend that further acquisitions are unlikely to be as well received by the market as they once were. Despite substantial merger & acquisition activity over FY09-FY19, the Company was only able to generate ~3% EPS growth over this period (on a CAGR basis). This is likely due to the synergies or benefits from acquisitions being eroded away by other factors including price cuts and higher operating costs.

Fundamental View

The potential for operating leverage over the medium term still exists. However, the extent of EBITDA margin growth over this period is now lower as a result of lower organic growth rate assumptions in the US. Importantly, expectations for margin improvement have historically been a key catalyst for the shares.

At current levels, the shares are trading on a 1-year forward P/E multiple of ~20.5x, which is broadly in line with the average multiple over the last five years (~21x). The current multiple is also unappealing in the context of an EBITDA growth profile of ~10% over FY24-27 on a CAGR basis.

Charting View

We last looked at the SHL chart at the end of December in The Dynamic Investor and noted that it had broken above the downtrend line and was retesting that line. It started to head higher after that but the last few weeks has seen it ease back again and has now broken below that line. The past few days has seen it also break under support near $26. At best, SHL may need to trade sideways for a while longer before it is ready for a recovery. A break above the mid $29’s would be the sign that the share price is ready to recover.

 

Michael Gable is managing director of Fairmont Equities.

 

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