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Morningstar | Transfer of Analyst Coverage on Sonic Healthcare; AUD 25.50 FVE Unchanged

We have transferred analyst coverage of narrow-moat-rated Sonic Healthcare. We maintain our AUD 25.50 fair value estimate, although we make some minor adjustments to our forecasts. These include slight downward adjustments to our gross margin assumptions and a slight paring-back of our revenue growth assumptions for the Australian pathology business. In combination, the changes do not alter our fair value estimate, highlighting their minor nature.

As one of the two market leaders, Sonic generates reliable earnings from the consolidated Australian pathology market. Operations in the European and U.S. markets supplement earnings growth as Sonic realises operating efficiencies from the integration of multiple acquisitions. Competitive advantages include Sonic's strong Australian pathology business, which gives it a cost advantage, driving our narrow moat rating. The firm also generates earnings growth from smaller radiology and medical centre businesses, both of which are beginning to realise scale benefits and greater operating efficiency.

Sonic has established a strong competitive position in the Australian pathology market, with a reputation for quality in an industry where accuracy and reliability are of paramount importance. The market is consolidated into two core providers, Sonic and Primary Health Care, which between them process more than 80% of market test volume, resulting in scale-related cost advantages that constitute a meaningful barrier to entry. Several dynamics underpin pathology test volume globally, including ageing populations, the economic benefits of preventative medicine, and ongoing innovation in pathology testing technology.

Sonic Healthcare's narrow moat comes from cost advantage stemming from the scale of its Australian pathology business, coupled with strong positions in the laboratory markets of seven other countries. It is the largest private operator in Australia, Germany, Switzerland, and the U.K.; the second-largest in Belgium and New Zealand; and within the top five in the U.S. This adds to Sonic's aggregated global buying power that underpins the lower cost of lab consumables relative to regional peers, strengthening cost-competitiveness.

Regulatory risk remains a key risk to Sonic’s profitability, especially a change to relevant government policy. The Australian government is on record as saying it does not review operators' profit margins, and that it is more focused on total diagnostic expenditure, particularly relative to that of international peers. However, should operators achieve excessive profit margins via, for example, new information technology, then political pressure could build to pass on cost savings to the customer, which is ultimately the government.