Australia | Nov 22 2012
–Agreement on pathology overspend
-Sonic sees 1.1% reduction in revenue
-Brokers generally positive on the news
-Investigation into collection centres
By Eva Brocklehurst
An agreement has been reached between the federal government and the pathology industry regarding the 'overspend' on Medicare benefits in 2012, and the outcome was generally better than expected. Sonic Healthcare ((SHL)) has stated it will affect around a 1.1% reduction in pathology revenues and Primary Health Care ((PRY)), which has not commented, is presumed by brokers to be similarly affected. Brokers had generally been penciling in around a 2% reduction so considered the news quite positive.
The funding adjustment involves price cuts to the Medicare Benefits Schedule (MBS) to bring spending under control and will be implemented from January 1, 2013. The provisions are designed to claw back the overspend, seen at around $43m, over 18 months. The price reduction will be achieved through two separate measures, firstly a 0.67% reduction in the price of pathology items on the MBS (ex Vitamin D tests) and, secondly, a reduction in the price paid for Vitamin D tests from $42.55 to $39.05. A practice that was bulk billing would see a reduction of $3.50 per test and non bulk billing practice in receipt of only 85% of the MBS price would see a reduction of $2.90 to $33.30.
Citi finds there is no impact on forecasts as its outlook for both Sonic and Primary incorporated a 2% funding cut and assumed around half to be offset by cost savings. There is modest upside risk to for earnings in the order of 1-2% if either elects to offset the cuts this way. Citi notes risks still remain for Sonic offshore, however, as this company is facing earnings pressure in its businesses in Germany and the US. The broker forecasts earnings growth of 8% in FY13, 10% in FY14 and 9% in FY15 and rates the stock a Hold. However, for Citi, Primary shares have now rallied more than 40% in the past 6 months and thereby earn a downgraded rating to Hold from Buy. The target price is $4.07.
Deutsche finds the outlook for local pathology operations has been boosted by the outcome of the negotiations but takes a different tack on its stock preferences. This broker sees valuation upside for both but Primary is preferred, given the funding uncertainty Sonic faces in Germany and the US. So, a Buy rating on Primary and a Hold for Sonic. The revisions to Deutsche's earnings estimates resulted in small upward adjustments to its price targets to $4.35 (from $4.20) for Primary and $13.55 (from $13.35) for Sonic. Goldman Sachs also took the opportunity to revisit its Australian FY13 revenue growth assumption for Sonic and has made an earnings upgrade of 1% for FY13-FY15. The $12.75 target price is unchanged and the broker notes, without material acquisitions, Sonic is likely in FY13 to deliver no more than its historical range of 6%-8% organic earnings growth.
BA-Merrill Lynch notes Primary's Australian pathology represents a higher proportion of revenue (at around 56%) than for Sonic. However, as Primary's earnings are dominated by the Medical Centre division, the impact to earnings is not as severe as the high proportion of revenue implies. BA-ML considers Primary's earnings growth has been mixed recently but the stock's outlook has now stablised. The downside risks for Sonic, where the broker has a $13.90 price objective, are further regulatory reform in pathology (in overseas markets) and increased competition from domestic competitors.
On the FNArena database the consensus target price is $13.76 for Sonic with five Holds and three Buys. For Primary the consensus target is $3.86 with one Sell, four Holds and three Buys.
The other aspect to the industry the government is looking at is the collection centres. An investigation will be undertaken into rental levels and competition associated with deregulated pathology collection. The brokers are not optimistic for anything revolutionary to come out of this review, particularly in terms of earnings for pathology operators. Deutsche said it was a positive development as it opens the door to potential reforms which could reduce the upward pressure on rental costs. BA-ML said speculation has been rife that deregulation has resulted in GPs being paid high rents to direct pathology referrals. If the review can crack down on this practice and curtail the rental impost on the pathology companies, then the broker sees out-year margin relief/upside. Again, not much is expected in the way of action as it would involve the government eating humble pie on deregulation, but it could put the brakes on any further rent rises that are still incrementally eroding margin.
UBS also notes examples of extreme rents to GP practices to secure co-located collection centres as the pathology industry continues to aggressively expand its footprint. Its recent channel checks suggest that rents for collection centres are now at levels where the work being secured through each new centre is unlikely to be profitable. UBS also identified situations where the rent being paid for the collection centre is greater than that paid for the entire premises of the GP practice. Nevertheless, most brokers expect the government will be reluctant to re-regulate the sector and hence the potential for material changes which reduce costs is modest.
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