A healthy outlook for Sonic Healthcare shares

Sonic Healthcare (ASX:SHL) is the 28th largest stock on the ASX by market capitalisation.

They are a healthcare business focused primarily on pathology, but also have a radiology business and some other small related businesses including medical centres and occupational health services. They are the largest operator of pathology labs in Australia with 37% of the market share.

But they provide services to more than just Australia.

This dominant position in Australian pathology only accounts for 25% of their revenue. They derive 35% from European laboratories and 26% from US laboratories. 10% of revenue comes from the Australian radiology business.

The structure of the pathology industry in Australia is currently in a state of flux as the third largest operator Australian Clinical Labs (ASX:ACL) has lodged a hostile takeover bid to acquire the second largest player, Healius (ASX:HLS).

Were the acquisition to be successful, the combined Healius/ACL would have 42% of the Australian pathology services market. The directors of Healius are strongly opposed to the transaction. The Chairman of Healius explicitly stated in the company's takeover statement that "the offer is plainly inadequate".

However, even if it were to proceed in some amended form, the ACCC would also be likely to review it on the grounds that it may lessen competition, but they may deem that having two strong players still provides a sufficient level of competition. The offer has been structured as a nil premium merger.

A new merged entity means Sonic would face a stronger competitor which may put some pressure on both its growth strategy and margins. However, at this stage the probability of the deal going through is not high.

Pathology and diagnostic businesses should receive a boost from some of the measures announced during the recent Federal government budget. Nearly 12 million people will be eligible for new bulk billing subsidies when they visit a GP. More affordable GP visits should lead to an increase in visits and a flow-on increase in the volume of diagnostic tests ordered.

At present about 16% of the population of Australia are over 65. By 2066 this is expected to increase to 21%. The over 65s population is expected to grow at about double the rate of the broader population. Similar effects are playing out in Europe and the US.

Older people tend to have greater health care requirements including requiring more tests. According to government statistics, the number of pathology tests has increased from 119.5 million in 2016 to 150.9 million today.

This is a compound growth rate of 5% per annum, which is a faster growth rate than the broader economy. Growth in diagnostic imaging has also been increasing at a similar pace to that observed with pathology.

These broad macro trends are favourable for Sonic Healthcare. In addition, they have been picking up market share. In the half year report the CEO commented that, "Comparing our own Australian based business Medicare billings to the national Medicare data over the last decade shows that Sonic has been consistently growing market share organically."

In addition to this organic growth, they are looking at two other channels for growth: acquisitions and outsourcing contracts. They have had a long history of acquiring other companies and this continues to be a core part of their strategy. They have recently acquired laboratories in Europe, including 19 laboratories in Switzerland just yesterday.

Outsourcing contracts refers to the trend for hospitals and other healthcare providers to outsource or joint venture their laboratory services. Sonic is working with governments and hospital groups that are pursuing this strategy including being in late-stage negotiations for a large UK outsource contract.

A major source of risk for these types of companies is regulatory risk. Whilst the recent budget should provide a boost for diagnostic companies, other changes in government policies could equally work against them.

A large portion of their revenue comes from government funding. When governments seek to reduce costs their business models could come under pressure.

When looking at the revenue profile of Sonic, and also its competitors, there was a big revenue bump in 2021 and 2022 which then start falling away in 2023. This is the COVID bump where laboratory PCR testing was far more common than it is now.

Revenue received a big boost during the pandemic as Sonic provided COVID testing services. Demand for these services has fallen sharply in the last 12 months, however it has not fallen to zero and is not likely to anytime soon. Australia is currently recording around 20,000 new COVID cases each week.

That said, this was a temporary boost to the business and forecasts are now based on the assumption that this will be a relatively small component of revenue moving forward.

Management are taking the trouble to emphasise the strength of their base business and strip out the impact from the COVID bump. And to be fair, they often did so during peak COVID times quoting figures including and excluding COVID testing. In the latest half-year result the company was able to grow its base revenue as well as profit.

The balance sheet is strong and the level of debt cover has improved substantially in recent years. Debt cover refers to Net debt / EBITDA. This strong position gives them flexibility. In addition to looking at growth opportunities, including acquisitions, they have been able to increase their dividends and also undertake a buyback.

Of course, this business strength has not gone unnoticed. There was a 10% dip in the share price in early February following the release of competitor Healius' half year report which missed expectations with a big fall in earnings.

However, it rebounded quickly the following week when Sonic's own report showed strong growth in the business compared with pre-pandemic levels. Since then the share price has been rising steadily which has led to relatively high valuation metrics like a PE ratio of 23 and fully franked dividend yield of 2.9%.

However these levels are certainly not excessive, and the Warren Buffett adage of paying a fair price for a good business may be relevant here.

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