Why we think Sonic Healthcare is a buy

Sonic Healthcare (ASX Code: SHL) is one of the leading medical diagnostics operators in the world. If you've been scanned for injury, tested for illness or have been PCR tested for COVID-19 in the past year, there is a high chance that Sonic has facilitated this in some way.

The company provides a range of radiology and pathology services to hospitals, medical practitioners and community medical services providers. It operates in Australia and globally, servicing some 130 million patients and employing 38,000 people.

Sonic's business can be viewed in three segments: laboratory, radiology and medical centres (revenue share by business segment and geography is shown in the charts below).

Most of Sonic's revenue comes from its laboratory services business which provides the study and diagnosis of disease through examination of organs, tissues, cells and bodily fluids. Sonic is the largest private pathology operator in Australia, Germany, Switzerland and the United Kingdom, the second-largest in Belgium and New Zealand and the third-largest in the United States of America.

In addition, Sonic's diagnostic imaging business provides x-rays, ultrasounds, CT and MRI scans and other imaging technologies to clients in Australia, and is the number two player in this market.

Finally, its medical centres and occupational health services provide primary care clinics and administrative services to general practitioners. Sonic is the leading provider of such services in Australia.

Revenues have grown significantly in recent times due to the increased need for COVID-19 PCR testing. While this revenue is expected to moderate, the potential for ongoing testing requirements as the pandemic evolves remains.

Beyond COVID related effects the longer-term prospects for the business are underpinned by demographic changes such as ageing populations and the increasing prevalence of chronic diseases.

This is expected to result in an increasing underlying demand for healthcare services. Sonic is well placed to take advantage of this long-term, structural thematic. The company's strong market position today has been achieved via the combination of organic growth and a series of global acquisitions.

This is the strategy going forward and there are multiple opportunities in existing markets such as the US or for the company to look at acquisitions in other countries.

Returns          

Over the past 10 years, Sonic has achieved an impressive annual return of 17.6%, when reinvesting the dividends, which compares to the ASX200 return of 11.5%. This return is approximately made up from capital returns (share price increase) and from dividends to shareholders in equal measures.

The company's current dividend yield is just under 3% and this has been growing at over 4% per annum. The dividend is 65% franked, which represents the fact that Sonic earns a large amount of its profits overseas. Sonic only pays 33% of its profit out as a dividend, the rest has been earmarked for future acquisitions to support its long-term growth ambitions.

ESG considerations

Sonic scores well on our Environmental, Social and Governance Ratings and especially in categories such as corporate governance, shareholder rights and social responsibility. The board is well diversified from a gender perspective, with 33% female representation.

From an environmental perspective, Sonic is committed to actively reducing its carbon footprint and planning a pathway towards net zero emissions, a key objective given the reliance on its courier network for pathology.

Recommendation - BUY

Sonic Healthcare rates as a BUY according to our analysis. From a valuation perspective the stock looks cheap, however, earnings boosted from the COVID-19 pandemic are expected to normalise over 2022.  The company is a high-quality business and enjoys leading market positions in all sectors it competes in.

This allows the company to generate high margins by taking advantage of the synergies obtained from large scale operations. These characteristics are affirmed by the fact that the company's profit in 2023 is expected to be 65% higher on revenue growth of just 20% versus its 2019 (pre-COVID) results.

Its geographic diversity is another key advantage, especially important given the risk imposed by potentially reduced government funding for healthcare. Sonic's low level of capital intensity allows it to generate strong cashflow and maintain a sensibly leveraged balance sheet.

These positive characteristics are reflected in our rating for the stock which scores well on both quality and growth metrics. On this basis, Sonic is currently our preferred healthcare stock.

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