Not Good News For Primary And Sonic

This story features SONIC HEALTHCARE LIMITED, and other companies. For more info SHARE ANALYSIS: SHL

-Medicare review ongoing, adds uncertainty
-Bulk billing changes still have to be approved
-Less problematic for diagnostic imaging
-Planned aged care changes modest
 

By Eva Brocklehurst

At its mid-year economic and fiscal outlook (MYEFO) Australia's government has unveiled its – somewhat anticipated — intentions to reduce bulk billing funding for pathology and diagnostic imaging.

The impact is clearly negative for major providers of pathology, Sonic Healthcare ((SHL)) and Primary Health Care ((PRY)), brokers contend, but the devil remains in the detail. These announcements also appear to be changes that are separate to the ongoing Medicare review, which is looking at over-utilisation of services. This all adds uncertainty into the mix for 2016, brokers maintain.

Morgan Stanley, while unclear about the allocation of the expense measures between industries or the bulk billing mix within each company, estimates the revenue mix exposed to these changes in FY17 for Sonic Healthcare is 34%, while for Primary Health Care it is more like 79%.

Brokers covering the stocks and monitored daily on FNArena's database have not changed their ratings per se for Primary Health Care. Citi notes that as the share price have fallen substantially in recent weeks, the stock is now more like fair value. Otherwise, the broker observes, the risk remains to the downside.

Two brokers decided to downgrade Sonic Healthcare on the announcement, Citi and Credit Suisse. Citi moves to Sell from Buy, suspecting that not only will the MYEFO plans be a hit to earnings but the US Medicare changes, effective in 2017, and a potential fee cut in Germany are looming negatives as well.

Credit Suisse also adjusts for changes to foreign exchange forecasts and downgrades earnings estimates for Sonic Healthcare by 6.0%, with the rating moving to Underperform from Neutral.

JP Morgan calls whoa! Reminding investors that these proposed changes to funding have to yet go through the arduous process of being approved by parliament. Moreover, the broker observes the market does not appear to be factoring in any potential for the companies to recover some of the funding via co-payments.

Nevertheless, JP Morgan suspects the government is attempting to shift the burden of charging a co-payment onto the industry and, irrespective of the MYEFO announcement, reimbursement risk prevails in terms of the Medicare review.

On the subject of parliament's approval, Credit Suisse is not so sure that the changes will meet the same level of opposition the previous co-pay legislation received, because of the exclusion of GPs from any funding changes.

So, what are the changes that are planned? Bulk billing incentives will be removed from pathology and bulk billing incentives for diagnostic imaging services will be aligned with those that apply to GP services. The bulk billing incentive for MRI (magnetic resonance imaging) services will be reduced to 10% from 15% of the schedule fee. Bulk billing incentives for diagnostic imaging will continue to apply to concession card holders and children under 16. The changes are expected to begin in FY17.

The impact weighs more on Primary Health Care, given its model is more heavily skewed to bulk billing. Sonic Healthcare has existing co-payments on certain tests. Deutsche Bank suspects the changes, in time, will lead to higher rates of private billing but highlights that past efforts to introduce out-of-pocket changes have proven difficult because of the adverse impact on demand and the competitive nature of the industry.

UBS is surprised by the extent of the government's proposed cuts. The broker believes this development is signalling an industry nadir, capable of re-setting provider pricing or the industry structure.

The broker expects the cuts will be confronting for the industry, not only in efforts to recoup the immediate impact via co-payments, but also as it ushers in the potential for smaller operators to be unable to absorb the cuts and bring around a final bout of industry consolidation.  UBS currently estimates industry consolidation at around 90% for pathology and 40% for diagnostic imaging.

The impact of the government's changes for diagnostic imaging is likely to be materially less than for pathology, Macquarie observes, as there are more offsets from diversified revenue sources, lower reliance on bulk billing and a greater ability to offset cuts through patient co-payments.

FNArena's database has two Buy, four Hold and two Sell ratings for Primary Health Care. The consensus target is $3.59, signalling 48.7% upside to the last share price. The dividend yield on FY16 and FY17 estimates is 6.7% and 7.2% respectively.

Sonic Healthcare has four Buy, two Hold and two Sell ratings. The consensus target is $20.59, signalling 16.7% upside to the last share price. The dividend yield on FY16 and FY17 estimates is 4.5% and 4.8% respectively.

Mooted aged care changes in the MYEFO are only modest. The cuts from FY17 equate to around a 1.0% reduction in total federal funding of the sector, which is comparable to the indexation freeze Deutsche Bank had assumed.

The exact changes will be finalised after industry consultation and the implementation date is July 1 2016. Morgan Stanley will also re-assess the impact when more detail emerges but considers Estia Health ((EHE)) the more leveraged to any funding changes.
 

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