Sonic past the worst of overseas funding cuts

Thursday, May 2nd, 2019

One way to take the stress out of investing is to keep a watchlist of quality companies built using a robust methodology, then wait for a temporary disappointment or market correction to price. Preferring companies that have proven their competitive advantages by growing earnings and dividends over the very long term is a surer path to wealth than hoping speculative stocks with a story, but no earnings and dividends, will come home on odds of 100 to 1. For every spec that goes up 10 times there will be another 20 that drifted lower or failed entirely, and by the time you clean up those messes from your portfolio you realise the quality companies quietly kept growing their dividends in the background.

One such quality large-cap stock we would like to buy for the Clime Direct Model Portfolio in the next market pullback is Sonic Healthcare, which delivered a total shareholder return of 12.2% over the last 10 years including dividend per share growth in eight of these years. This compares with the 10.1% return on the All Ordinaries Accumulation Index over the same period. These achievements are superior to many other stocks.

The growth formula is mergers and acquisitions in existing and new countries and markets, structural annual growth in the number of pathology and diagnostic imaging tests done in every country as populations grow and age, and margin expansion from efficiency gains and the adoption of new technologies like automation. Since establishment in 1987, SHL has grown to become the world’s third largest pathology/laboratory medicine company with operations in eight countries. Total revenue in 2018 was $5.5bn -and the stock is entrenched in the ASX 50.

Government funding is a source of both downside and upside risk, which is why the stock caught our eye late last year. The stock peaked at $27 in August then fell as low as $21 on cuts to reimbursement rates under the US Protecting Access to Medicare Act (PAMA) and adverse regulatory demand management strategies in Germany. The US is SHL’s largest market and Germany its third.

Then in the February interim result SHL reported 8% constant currency organic revenue growth in the US after all, boosted by joint ventures with hospital laboratories. This was a positive surprise to a disillusioned sharemarket and should be an ongoing theme. And while German organic revenues were flat, the problematic referrer bonus system will be lapped this month, after which a return to more normal growth is likely.

After seven months of trading SHL reaffirmed underlying 2019 earnings growth of 3-5%. Including the new acquisition of US anatomical pathology firm Aurora Diagnostics, guidance was raised to 6-8%. The absence of any guidance downgrade convinces us the worst of the PAMA cuts and German revenue headwinds are over and already captured in consensus earnings forecasts, and the acquisition of Aurora diversifies SHL away from the clinical pathology fields where funding was cut. Today just 13% of US revenues are exposed to Medicare cuts.

In Australia it’s normally a nervous Budget night for shareholders in healthcare companies as they wait to hear about government funding for the year ahead. But in its Budget reply federal Labor pledged an extra $2.3bn of Medicare funding for cancer care including $600m over four years for diagnostic imaging to reduce radiology out of pocket costs for cancer patients. This is an extra $150m of annual funding and SHL, as the market share leader in Australia, should benefit incrementally. The Coalition had itself earlier proposed an increase in funding but it looks like Labor’s funding commitment is $100m per annum higher. Commentators are already predicting increases in episode rates as providers cash in on the largesse. Meanwhile pleasing organic revenue growth continues in the existing business. In the first half Australian pathology revenue grew 6% including two per cent from the National Bowel Screening contract.

SHL retains sufficient balance sheet strength to fund further acquisitions, which could present in the fragmented markets of the US and Germany facing reimbursement pressures. The firm is bidding for UK National Health Service contracts worth £100m. We are confident the business can continue to use acquisitions to diversify its risks of government funding cuts.

Over time the market should be prepared to pay a premium for SHL’s structural, long duration volume growth, resilience to funding cuts, strong cash generation and balance sheet flexibility. The stock is a low-volatility way to play the theme of increased demand for healthcare from ageing populations. We have warmed to this business and upgraded our valuation to $26.50 per share.

 


Figure 1. SHL guidance
Source: SHL

Clime Group owns shares in SHL.

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