Sonic Healthcare Outlook Remains Clouded

This story features SONIC HEALTHCARE LIMITED. For more info SHARE ANALYSIS: SHL

-Rising collection centre costs
-Regulatory uncertainty prevails
-Is the downgrade now factored in?
 

By Eva Brocklehurst

On the heels of its rival, Primary Health Care ((PRY)), Sonic Healthcare ((SHL)) has also downgraded its FY15 estimates. The company now expects the FY15 result to fall 3-4% short of prior guidance, as Australian pathology operations have underperformed.

With capacity to fund further acquisitions now diminished – the company recently acquired Medisupport in Switzerland – Deutsche Bank expects earnings growth will track back to mid single digits in the medium term. The broker observes domestic pressures are largely stemming from the impact of reimbursement funding cuts and rising collection centre costs, which will have a flow-on effect on FY16. The company has guided to FY16 earnings to be up 20% on FY15 but still well below consensus estimates. Guidance excludes the Alberta Health Services contract because of uncertainty surrounding the commencement date. Deutsche Bank now assumes this contract starts July 2016.

The lift in collection centre numbers this year partly explains weaker margins, in Deutsche Bank's view. Industry feedback suggests rents paid to medical practices have continued to climb, reflecting competition between providers. The broker highlights market hopes that new regulations will be implemented to limit rental payments but, at this stage, the health minister's intentions are unknown and, if current regulations are maintained, downward pressure on domestic pathology margins is expected to continue.

Credit Suisse, which downgraded the stock to Underperform just prior to this guidance update, believes the Australian government could decide to change regulations and, as a result, instigate a reduction in collection centre rents. Separately, there is also a review taking place in the Medicare Benefits Schedule with actionable points being delivered to the minister later this year. All up, the broker suspects there is downside risk to growth in pathology outlays over the medium term. In its favour, Sonic Healthcare has exposure to more favourable and/or stable pricing geographies, and further acquisitions in these regions could be well received.

Morgans suggests, with the stock falling 10% over the week since Primary Health Care's announcement, the latest downgrade is factored in. The broker considers the company's forecast of 20% growth in FY16 is fair, albeit mainly driven by acquisitions. This is the second downgrade from Sonic Healthcare for FY15. Last November the company signalled it was plagued by weaker volume growth, higher collection costs and Medicare funding restrictions for vitamin D/B12 and folate testing and brokers maintain this latest downgrade reflects the same issues.

Morgans believes the crux of the problem appears to be management's difficulty in determining the fall-out from changes to Medicare funding because, given the cycling of changes come this November, the impact should not be ongoing. The upcoming review of Medicare item numbers remains a major uncertainty but Morgans suspects this review may have more bark than bite.

Overall, weakness could persist as governments around the world are facing budgetary pressures so reimbursement cuts could exceed the market's expectations. On this basis UBS also trims US earnings estimates for FY15 and FY16. Citi, however, forecasts a gradual improvement in revenue growth for Australian pathology and the US, generally, with its restructured CBLPath unit. The broker no longer includes acquisitions in base forecasts so the potential award of the Alberta contract and further bolt-on acquisitions represent upside risks.

The extent of the second downgrade surprised Morgan Stanley as the company indicated previously that Australia was on track, albeit the broker suspected previous guidance requiring 4-8% growth in the second half was a challenge. Nevertheless, no structural issues seem to be behind the downgrade and pathology volumes are expected to recover. While surprised by the escalation of collection centre costs, Morgan Stanley envisages potential for regulation to reduce this burden. The broker believes the downgrade has been priced in and retains an Overweight rating.

The company has four Buy ratings, three Hold and one Sell (Credit Suisse) on the FNArena database. The consensus target is $22.01, suggesting 2.7% upside to the last share price and compares with $22.52 ahead of the update. Targets range from $20.80 (Deutsche Bank) to $23.90 (UBS).

See also, Sonic Booms In Europe on June 16 2015.
 

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