Better Times Ahead For Sonic Healthcare?

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New research coverage on Sonic Healthcare suggests better times are ahead, supplemented by new technologies including artificial intelligence and genetic engineering.

-After five years of disappointment, new research suggests Sonic’s future looks brighter
-Growth and margin improvement further boosted by AI & genetic testing
-Increasing efficiency via Franklin.ai and PathologyWatch
-Bell Potter sees 110bps of margin upside across FY25-27

By Mark Woodruff 

Loyal shareholders in global healthcare services provider Sonic Healthcare ((SHL)) have had little to be excited about in the post-covid years. The share price surged to an all-time record high above $47 in 2021 (when societal lockdowns coloured the overall environment) but it has subsequently embarked on an elongated slide south that has pulled the price back to the mid-$20s.

Underlying, relentless margin pressure has pulled back the company’s earnings per share to a pre-covid level, hence it seems but appropriate to see the share price equally at a pre-2020 number.

Cold comfort, no doubt, for those shareholders, but Sonic Healthcare’s challenges have been mimicked by most of its peers across the healthcare sector globally. In Australia, previous can-do-no-wrong stalwarts such as CSL ((CSL)) and Cochlear ((COH)) have presented their shareholders with similar underwhelming performances, and let’s not even mention Ramsay Health Care ((RHC)) or Healius ((HLS)).

But that was then, and the past does not necessarily provide investors with a blue print for the future. New research by Bell Potter suggests those suffering loyal shareholders in Sonic Healthcare might soon have something to smile about.

In initiating coverage yesterday, the broker points to macro-economic drivers such as population ageing, rising healthcare expenditure, advancing medical technologies, and growing demand for personalised and precision medicine as key tailwinds for the industry.

In Sonic’s case, the research notes demand is also being driven by the normalisation of core operations post-covid, the integration of FY24 acquisitions, and business restructuring aligned with shifting volume patterns.

A cornerstone of Sonic’s growth strategy remains its consistent acquisitive expansion, having taken over around 100 businesses globally to become the largest pathology provider in Australia, Germany, Switzerland, and the UK, and the third largest in the US.

Recent investments in automation, artificial intelligence, and operational scale are expected to deliver incremental efficiencies and underpin margin improvement.

While AI’s transformative impact is still emerging, Bell Potter considers Sonic the most advanced AI-integrator in its coverage and believes current earnings expectations may underestimate the company’s future potential.

Business split

Pathology operations in Australia, Germany, and the US accounted for approximately 65% of group revenue when Morgan Stanley initiated its own research coverage in March. In total, Pathology accounts for 85% of group revenue.

Since entering the US pathology market in 2005, Sonic has completed around 19 acquisitions, yet its expansion has remained regional rather than nationwide.

The US pathology landscape remains highly fragmented and offers ongoing acquisition opportunities, though competition from dominant national players, namely Quest Diagnostics and Laboratory Corporation of America, remains intense. The difficult operating environment prompted the analyst at Ord Minnett to suggest management should consider divesting its US assets.

Domestically, Sonic is also Australia’s second-largest radiology provider by revenue (10% of group revenue). It also operates a clinical services arm, Sonic Clinical Services, which generates around 5% of group revenue.

Clinical Services partners with over 2,000 general practitioners across 200 medical centres and delivers services spanning general practice, occupational and remote health, aged care, and clinical trials.

Margins and AI

A suite of technologies is now being invoked by management to improve both operational performance and efficiency, which Bell Potter anticipates will flow through to margins over time. Two recent examples include Franklin.ai and PathologyWatch (more on these later).

Morgan Stanley sees three core drivers for healthcare AI adoption: revenue enhancement through improved diagnostic yield; cost reduction via more efficient development processes; and better workforce utilisation.

Management at Sigma notes prior margin compression was due to post-covid normalisation and inflation, but Sonic is now considered well-positioned for expansion through labour optimisation, operating leverage, and digital efficiencies.

Bell Potter agrees, anticipating 110bps of margin improvement between FY25-FY27.

Overcoming staff shortages

One of the most pressing operational challenges for Sonic, and the industry at large, is the shortage of skilled pathologists and laboratory staff.

Retirement trends and preference for higher-paying roles outside the lab are driving attrition, notes Bell Potter, while rising case volumes exacerbate burnout.

Management is actively tackling this issue through digital transformation and strategic investment in AI.

Sonic’s 49% joint venture with Harrison.ai, called Franklin.ai, is developing AI decision-support tools in pathology. At Morgans Stanley’s recent 7th Australia Investment Summit, a speaker from Harrison.ai highlighted how AI is transforming healthcare across multiple dimensions.

The first product is a decision support tool for the clinical evaluation of prostate cancer, with initial deployment occurring in the second quarter of FY25 in Australia. In time, the aim is to market ‘Prostate Digital’ on the global stage.

Early user feedback reports a 30% efficiency gain and enhanced diagnostic confidence, observes Bell Potter. The tool is expected to launch in Australia in Q2 FY26, with plans for broader global deployment pending regulatory approvals.

Bell Potter notes Sonic holds a 12% stake in Harrison.ai, also giving the company exposure to a radiology decision support AI solution, Annalise.ai.

In November 2023, Sonic deepened its digital pathology presence by acquiring PathologyWatch in the US for -US$130m.

This company specialises in dermatopathology. Importantly, Bell Potter explains the acquisition offers an integrated digital pathology platform, which management believes will accelerate digital transformation across its entire anatomical pathology business, an internal revenue stream of around $1bn.

Management sees potential for digital workflows to expand across all sub-specialties globally, boosting margins and diagnostic accuracy.

Beyond AI, Sonic’s genetic testing operations, currently less than 10% of revenue, are poised for significant growth.

Following the sequencing of the human genome, the genetic testing market is forecast to grow at a 22.6% CAGR, expanding from a current US$12bn industry to US$92bn by 2034, highlights Bell Potter.

Sonic is expected to benefit as this segment scales and contributes meaningfully to its revenue base.

Interim Results

In February, Sonic Healthcare’s first-half FY25 revenue, earnings, and net profit proved broadly in line with consensus, supported by stronger pathology and imaging revenue.

Pathology revenue rose 8% year-on-year, with standout contributions from Australia, the UK, and Europe, though margins yet again proved slightly below expectations.

Imaging revenue lifted 12%, benefiting from Medicare indexation and greenfield site contributions, while margins were flat year-on-year.

Group earnings (EBITDA) margins improved by 60bps to 17.8% but missed Jarden’s forecast by -50bps as cost savings from closing collection centres and the US revenue collection system disappointed.

The Pathology and Imaging margins expanded by 50bps and 20bps, respectively, highlighted the analyst at Citi, with “Others” contributing the balance.

Management has been aggressively rolling out an enhanced revenue collection system across its US operations, aiming to improve billing efficiency, reduce bad debts, and increase cash collection rates.

Jarden is anticipating organic operating leverage in FY26 partly from realisation of the US enhanced collection system savings target of US$20m-25m, along with synergies from acquisitions in the US, Germany, and Switzerland.

Management’s FY25 earnings guidance of $1.70-1.75bn (constant currency) was re-affirmed.

Valuation and outlook

Bell Potter points out Sonic Healtcare trades around -13% below its long-term average EV/EBITDA multiple. Its premium relative to the ASX200 has narrowed to 13% compared to a historical 27%.

Near-term catalysts, according to the broker, include the completion of the LADR acquisition in Germany (one of the country’s top five lab networks, with an extensive footprint across the country) and the release of FY25 results.

Promisingly, after years of trying to right-size the cost base to better reflect the post-covid world, labour costs are “just about there”, with operating leverage returning and profitability improving.

Now Bell Potter has joined research coverage with a Buy rating, all seven daily monitored brokers in the FNArena database actively cover the company. Morgans is also a Buy (or equivalent), four others are on Hold (once bitten, twice shy?), while Ord Minnett has a Lighten rating.

The average target of the seven is now $29.34, up from $27.8, due to Bell Potter’s leading $33.70 target. This average implies around 11.7% upside to the $26.27 closing share price on June 19.

Outside of daily coverage, Jarden is Neutral-rated with a $29.84 target.

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