Australia | Mar 17 2010
By Chris Shaw
The share prices of both Sonic Healthcare ((SHY)) and Primary Health Care ((PRY)) have struggled since the imterim reporting season in February with both shares weakening by double digits over the past month. Analysts at Citi last week poined out the two stocks had underperformed the ASX/S&P200 Index since Mid-February respectively by 12% and 30%.
In Citi's view there have been a few contributing factors to this underperformance, including market factoring in generally lower Federal Government spending on health care plus competition intensifying in the diagnostic imaging market, in which both are significant players.
What the increased competition in diagnostic imaging means, in Citi's view, is there is now potential for earnings across the industry to be re-based at a lower level. This is especially the case if Government funding cuts in pathology cannot be recovered.
Citi estimated if diagnostic imaging earnings were to re-base lower and if the government funding cuts in pathology were not recovered, this would imply a 7% cut to its earnings forecast for Sonic in FY11. This would put the stock on a 12-month forward earnings multiple of a little over 15 times, which the analysts suggested was around 10% expensive.
Given such an outlook for Sonic's Australian operations, there appears a need to find earnings growth in other markets, so a recent site tour of the group's Hamburg operations is of some relevance given RBS Australia expects the German assets will contribute 18% to earnings in FY11.
The tour was of the GLP lab and RBS notes management of the lab has confirmed an increase in test volumes of around 40%, with a minimal associated increase in staff levels. Natural attrition in staffing levels is being used to lower costs, which Bank of America Merrill Lynch sees as important given Germany's tough labour laws.
RBS Australia also notes there are plans to further integrate smaller satellite lab volumes into larger labs, which means potential for cost savings. Bank of America Merrill Lynch agrees, pointing out Hamburg represents the first major lab consolidation among Sonic's 26 lab footprint in Germany. This implies similar opportunities across the company's portfolio.
These synergies should generate some margin expansion in its view, so BA Merrill Lynch suggests in the absence of any further funding cuts in the German market, the earnings story in later years remains quite positive.
The numbers appear to support this, RBS Australia seeing potential for Sonic's German labs to contribute about $15 million in EBITDA (earnings before interest, tax, depreciation and amortisation) synergies in FY10.
This is before any additional acquisitions are factored in, as BA Merrill Lynch expects some more deals will emerge in markets such as Berlin and Frankfurt in coming months. These would allow the company to further consolidate its existing presence in these markets, so offering scope for further synergy benefits.
Given the potential upside offered by further acquisitions, BA Merrill Lynch sees enough value to maintain a Buy rating on Sonic given upside to its valuation based price target of $15.25. RBS Australia is less bullish and rates Sonic as a Hold, its target of $14.05 suggesting the stock is fully valued at current levels.
Overall, the FNArena database rates Sonic as Buy three times, Accumulate once and Hold six times, with an average price target of $15.44. The range in price targets is significant as RBS Australia is the low marker while JP Morgan has a target of $16.75 and Macquarie of $16.83. Investors should take into account though that these price targets may have to come down as analysts are revising their views on the outlook for local pathology operations in Australia.
Shares in Sonic today are stronger and as at 1.45pm the stock was up 11c at $14.00, which compares to a range over the past year of $10.55 to $15.64. At current levels Sonic offers around 10% upside to the average price target in the FNArena database (however: see above).