As a Company that enjoyed elevated earnings from COVID testing during the pandemic, Sonic Healthcare (ASX:SHL) has emerged from COVID well. The base business margins are resilient and the balance sheet is stronger. This provides ample liquidity for capital management and further acquisitions. Likewise, its share price has recovered from its lows earlier this year after an impressive interim result for the six months to 31 December 2022 (1H23),
With this in mind, we recently researched Sonic Healthcare in The Dynamic Investor to assess whether the recovery in the shares can continue, or whether there are still downside risks.
Overview of 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
Favourable Trends in Australian Pathology
In 1H23, SHL reported organic growth of at least 5% across each market (with the exception of Switzerland, which was flat following a fee cut in August 2022), and post-COVID catch-up testing, which is expected to continue for at least 12-18 months.
The base pathology business in Australia saw strong growth as the increased level of specialist referrals and backlogs are worked through. Australian pathology was the highlight of the 1H23 result, with base business growth of 8% vs Medicare of +3.5% and its nearest competitor (Healius (ASX: HLS) +2.2%).
SHL’s dominance in the Hospital and Specialist referral channel is generating more complex, higher-margin test referrals which helps account for this disparity in growth. SHL’s expertise in genetic and anatomical pathology globally further solidifies its positioning and does appear to give SHL access to exclusive arrangements with highly specialised tests. However, specialist/hospital referrals and specific exclusive arrangements are seeing the benefit of the patient backlog that accumulated during COVID. As such, this strength to moderate as the backlog is addressed. Having said that, SHL retains a dominant market position in Australia without any real competitive threats.
Costs Are Being Well Managed – But Margin Pressure in Pathology Still Expected
In contrast to other health service providers in SHL’s peer group, who have shown material cost pressures within their business, SHL’s pathology base business margins continue to show resilience. Costs are well contained and upside is driven by a favourable price mix. SHL notes that labour costs grew +7.5% in 1H23, with labour costs as a % of revenue (47% in 1H23) in line with pre-COVID levels. This is due to the Company being able to generate automation and procurement savings.
In terms of the outlook for FY24/25, EBITDA margin for Pathology is expected to be impacted by a normalisation of test mix away from the high-margin specialist referral channel back to the GP channel.
Diagnostic Imaging Segment Supported by Strong Macro Factors
The Diagnostic Imaging segment performed well in 1H23. Organic revenue increased by 10%, with EBITDA up by 12%. The segment benefited from the ongoing growth in higher-value modalities (CT, MRI, PET). This includes two new commissioned sites for PET CT and the successful rollout of Annalise.ai chest X-ray in all centres. An additional six MRI sites received full Medicare funding.
In terms of the outlook, earnings and margin for the Diagnostic Imaging segment appears to be well positioned to benefit from increased hospital/specialist referrals and a stronger-than-expected rate of annual fee indexation of 3.6% that will be applied to diagnostic imaging services (excluding nuclear medicine services) from 1 July 2023. Notably, the indexation is expected to apply to a high portion of industry benefits (~90%). 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. In contrast, the average growth rate between FY10-19 was ~7%.
Further Acquisitions Remain on the Agenda
The significant uplift in earnings from COVID-19 testing as well as increases operating cashflow in recent period has seen SHL’s level of gearing (on a net debt to EBITDA basis) decline to down to 0.5x as at 31 December 2022, which is which is well below the 5-year average of 2.4x pre COVID as well as the debt covenant limit of 3.5x.
Prior to two recent acquisitions in Germany, it was estimated that SHL had a ~$1.5b available capacity for Merger 7 Acquisition (M&A) opportunities. Following the €370m spent across the recent acquisitions in Germany, the remaining capacity is estimated to be ~$900m taking into account that SHL will be funding both acquisitions in Euro from existing cash and debt facilities.
Significant headroom remains for further acquisitions, most likely in the Germany and US pathology markets, given that the Company has previously indicated that it considers a long-term gearing target of ~2.5x is manageable. It is worth noting that pre-COVID gearing was at, or above this level and was not considered a burden given the typically strong free cashflow historically generated.
Fundamental View
At current levels, the shares are trading on a 1-year forward P/E multiple that is at the upper end of the average trading range over the last five years, which we contend is factoring in the potential for further EPS-accretive acquisitions, rather than earning growth potential for the base business, which points to EPS growth of -19% over FY22-25 on a CAGR basis.
Notwithstanding that margins are benefitting from improved pricing mix, volume recovery and strong cost control, we consider that further material upside in the shares is unlikely until the Company can improve margin for the Pathology segment, especially considering recent acquisitions in Germany that need to be integrated.
Charting View
SHL spent 2022 in a downtrend. We then received a clear reversal signal in February when it formed a bullish engulfing candle on the weekly chart (circled). Since then it has traded higher. However, it is now hitting a major resistance level (blue line). SHL is likely to ease back here and those looking to invest can be patient and wait for levels closer to $34. If SHL can eventually break above the blue line, then that would be a bullish sign.
Michael Gable is managing director of Fairmont Equities.
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