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Morningstar | Sonic’s in Line Result Met with Bullish Outlook and Earnings Upgrade, FVE Increases 6% to AUD 25.50

Sonic Healthcare’s positive outlook on the potentially “company transformative” Aurora Diagnostics acquisition was hard to ignore when management released first half fiscal 2019 results. We have made minor upward adjustments to earnings assumptions due to upgraded guidance provided on the back of this acquisition, which increases our fair value estimate 6% to AUD 25.50. The interim dividend of AUD 33 cents per share, or cps, is marginally higher on AUD 32 cps a year ago. At current prices, Sonic screens as fairly valued.

Top line group revenue growth for the half was healthy, albeit in line with previous guidance, but lower margin contract wins resulted in slightly lower growth rates across operating earnings. On a constant currency basis, group revenue was up 4.8% on the previous corresponding period, or pcp, to AUD 2.8 billion. This flowed through to underlying EBITDA growth of 3.4% to AUD 467 million and NPAT growth of 2.6% to AUD 214 million for first-half fiscal 2019. This largely reflected the pickup of lower margin revenue contracts, such as National Health Service, or NHS, in the U.K., as well as consumable cost increases and some slightly weaker underlying pricing. Among other factors, Sonic’s targeting of both high-margin private and low-margin nonprivate contracts globally makes group margin estimation difficult, so we assume a relatively steady state through our forecast period.

Management went to great lengths to highlight the potential company transformative nature of the Aurora Diagnostics acquisition, giving us a potential taster with earnings guidance hiked as a result--albeit not markedly different from previous guidance. Specifically, fiscal 2019 underlying EBITDA growth was upgraded to 6%-8%, on a constant currency basis, which compares with pre-Aurora Diagnostics acquisition guidance of 3%-5%. The revised EBITDA guidance moves forecast fiscal 2019 EBITDA to a midpoint of just over AUD 1.02 billion on a constant currency basis. The Aurora acquisition will also be transformative in that over time, management expects the U.S. to be the major source of group revenue. Keep in mind, first-half revenue, which are reflective of recent trends, were largely derived from Australia (25%), the U.S. (21%), and Germany (21%). Further acquisitions might alter this mix; however, we expect any near-term corporate activity to be focused on smaller bolt-on buys.

Strong organic growth within Australia and the U.S. in particular laid the foundations for this result. Australian Pathology revenue displayed an encouraging 6% organic growth, supported by a National Bowel Cancer Screening contract. We accordingly upgrade our earnings growth assumptions in this segment, anticipating growth to come from additional procurement wins, a new expanded lab opening in Adelaide in the second half, and continued IT-driven efficiency gains. The U.S. also displayed healthy top line revenue growth of 6%, on a constant currency basis, although it was slightly offset by PAMA Medicare fee cuts, which represented about 1.3% of total U.S. revenue. Similarly, we adjust our earnings growth assumptions slightly upwards in the U.S. business to reflect the more optimistic U.S. outlook, which includes the Aurora Diagnostics-driven earnings upgrade. Germany, on the other hand, experienced flat organic revenue growth, which management attributed to the European heat wave and regulatory changes. Our less optimistic growth outlook in Germany leaves our growth assumptions unchanged, tracking at 3.0% per year through our forecast period. Keep in mind, Germany has grown enormously in recent years to become Sonic’s third-largest division.

Otherwise, the U.K. and Ireland experienced organic revenue growth of 9% on the pcp, Switzerland 5% on the pcp, whereas Belgium was flat. Within the U.K. and Ireland division, the Barnet/Chase Farm hospital laboratory contract commenced, albeit margin eroding in the process. This region was further supported by strong growth in the non-NHS market, however, by bidding on several long-term NHS contracts, further margin erosion is likely should Sonic succeed in winning them given the lower margin nature of NHS contracts. Switzerland, where Sonic remains the number one market player, continues to perform strongly and should continue to do so in the near term as the ZUG Cantonal Hospital contract was recently transitioned with operations commencing. The Belgium outlook appears more challenging, although seasonal elements worked against Sonic this half in the form of a heatwave. Slightly offsetting this, there is some regulatory relief with an indexation fee increase in January 2018 and January 2019 equivalent to a 1% increase in Sonic revenue per year.

Between Sonic Imaging and Sonic Clinical Services, or SCS, which combined to represent about 15% of group revenue in the half, earnings growth was mixed. Sonic Imaging, generally a strong growing division, displayed moderate earnings growth despite 6% revenue growth, once again highlighting margin pressure within parts of the business. SCS on the other hand displayed weaker earnings on the pcp, on the back of flat revenue. We expect these businesses to continue to generate mid- to high-single-digit growth rates through our forecast period but as important as they are, they’re not the main drivers of near-term earnings growth.

Sonic continues to display a strong financial profile, which backed by healthy free cash flow generation, should support management’s reiterated intention for further acquisitions as the firm continues to seek growth. Aided by the recent AUD 928 million equity raising used to fund the Aurora Diagnostics acquisition, company gearing has fallen to 29% at Dec. 31, 2018, compared with 37% at June 30, 2018--well under the required covenant limit of 55%. Similarly, interest cover of approximately 10 times, which remains unchanged from June 2018, remains comfortably in excess of the required covenant limit of greater than 3.5 times. Net debt/EBITDA of 2.0 times at December 2018, fell from 2.5 times at June 2018, however, management did guide to this returning to levels closer to 2.5 times again by the end of the 2019 fiscal year. Given Sonic’s reliance on operating leases, these numbers understate the true amount of total debt, with lease-adjusted debt closer to 3.0 times at December 2018 and likely to move back towards 3.6 times at the end of fiscal year 2019.