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Morningstar | Sonic Meets Expectations and Continues to Expand International Pathology by Stealth; Raising FVE

Narrow-moat Sonic reported full-year results broadly in line with our expectations with steady growth achieved on multiple fronts. Adjusting for nonrecurring items, EBITDA came in at AUD 962 million, up 6.4% (constant currency) compared with the previous guidance range of 6%-8% and our forecasts of AUD 953 million. Net profit after tax came in at AUD 476 million on group revenue of AUD 5,541 million, up 11% and 8%, respectively, compared with our forecasts of AUD 470 million and AUD 5,405 million.  This compares with our five-year group revenue CAGR of 6%, in the context of incremental expansion of consolidated group operating margin from 12.5% in fiscal 2018 to around 14% by fiscal 2023. We believe this is achievable, given Sonic’s strong track record of efficiency gains and its well-established consolidation strategy executed to date.

We raise our fair value estimate by 6% to AUD 25.50 per share from AUD 24 to reflect the time value of money and a 1% increase in our growth assumption for Australian pathology to incorporate the national bowel cancer screening contract won in second-half 2018. This incorporates management’s EBITDA guidance of 3%-5% EBITDA growth for fiscal 2019. However, given comments by management, we think acquisitions are imminent in Germany and regard guidance as overly conservative. As such, our 8% forecast increase on underlying fiscal 2018 EBITDA assumes uplift from acquisitions in the short term. Nonetheless, we consider shares in Sonic Healthcare to be trading in line with fair value.

International pathology in aggregate grew 10% year on year and now represents about 58% of group revenue, with Germany again the standout performer, which was not surprising given the spate of acquisition made over recent years, with good traction in both the U.K. and Ireland and Switzerland. Domestically, Australian pathology, although a diminishing piece of the pathology mix, delivered solid organic growth of around 6%, while diagnostic imaging achieved 7% organic growth.

We think Sonic’s growing footprint in Germany, given its central location in Europe, raises prospects for potential synergies for neighbouring operations in Switzerland and Belgium. Our five-year revenue CAGR forecast for Germany and Switzerland is unchanged at 7% for both. Germany, representing 21% of group revenue in fiscal 2018, has been a focus of the company for several years and grew by a solid 12% in constant-currency terms. Sonic has grown primarily via acquisition in Germany and now has around 15% market share, with the market remaining highly fragmented. Management has flagged further acquisitions in the pipeline, which we expect could be folded into existing operations, with efficiencies adding to margin. The other standout in Europe was Switzerland, which grew at 5% in constant-currency terms. As such, the recent major Zug Cantonal Hospital contract win for outsourced pathology services commencing Jan. 1, 2019, bodes well for growth in that country.

We see budgetary pressures in the U.K. as positive for outsourcing opportunities for private service providers and see Sonic as well positioned to compete and add to its growing private service offering to medical specialists at its new state-of-the-art Halo lab in Central London. Our five-year revenue CAGR for the U.K. stands at 10%. In the fiscal year, the U.K. and Ireland performed well with 8% constant-currency growth, including the Barnet/Chase Farm hospital contract, which commenced in October 2017.

In the U.S. division, despite the U.S. reimbursement cuts to the Medicare clinical lab fee schedule, related to PAMA, introduced in January 2018, Sonic delivered reasonable 2% organic growth. Medicare-derived U.S. pathology revenue constitutes around 20% of U.S.-generated pathology revenue, equal to less than 5% of group revenue. With further PAMA-related cuts to Medicare reimbursements still to be finalised for commencement in 2019, we are not changing our growth outlook, which remains a modest 3% in five-year CAGR terms. However, we do think any fallout from PAMA-related cuts could add upside to Sonic’s growth via acquisition opportunities.

Australian pathology, representing 25% of group revenue, delivered better-than-expected 6% growth, buoyed by the commencement of the national bowel cancer screening contract in the second half. The contract should add around AUD 30 million to revenue per year. As such we have revisited our growth outlook and raise our five-year CAGR for Australian pathology to 6% from 5% previously.

Sonic Imaging, representing 9% of group revenue, was another high point for the year, delivering 7% organic growth. We think the area of diagnostic imaging is benefiting from technological advances, and as such, we see introduction of new modalities as positive for demand. In addition, we think the relatively stable regulatory environment around diagnostic services in Australia, with implementation of fee indexation from 2020, bodes well for continued growth of the division. We maintain our five-year revenue CAGR at 5%.
From a balance sheet perspective, Sonic is in good shape. The company ended the year with net debt/EBITDA a manageable 2.6 times, well below covenant limits of 3.5 times. According to management, the firm has available headroom for up to AUD 650 million in acquisitions; when modelled, this would still result in net debt/EBITDA of 2.94 times. As such, we remain comfortable with Sonic's ability to execute on acquisitions flagged in the German markets. Based on similar metrics to the Staber acquisition in 2016, we expect these to be made on an EBITDA multiple of around 8 times. Sonic declared a full-year dividend of AUD 0.81 per share, equating to a payout ratio of 72%, franked to 30%. Our forward payout ratio assumption is unchanged at 70%.