Is it time to buy Sonic Healthcare?

Shares of pathology giant Sonic Healthcare (ASX: SHL) have risen 15.4% over the last year, compared to a 12% rise in the ASX 200 Index (Index: ^AXJO) (ASX: XJO) over the same period. Is this out-performance likely to continue and should investors get on board?

Here are three compelling reasons why Sonics’ shares could power your portfolio in the years to come.

Pathology, radiology and imaging

Sonic is an international diagnostic services company, offering laboratory medicine/pathology and radiology services to the medical community. It is the largest pathology services provider in Australia and second only to privately owned I-Med Network in radiology.

Sonic operates in eight countries, across three continents, and employs around 26,000 people, despite starting with operations in just one state (New South Wales) of Australia.

Prospects for future growth

The company has grown mainly through acquisition, making more than 50 acquisitions since listing on the Australian Stock Exchange in 1987. In a widely fragmented market – such as pathology was in Australia, and as Sonic is now finding in other countries – growth by acquisition can be a sensible move to make. As usual, the main issues with this type of strategy are integrating those new companies into Sonic and the level of debt that is required to make that many acquisitions.

Sonic is likely to maintain its strategy of growing through acquisitions – after all, its main industries of pathology and radiology are heavily fragmented in most markets. Continuing acquisitions are the most likely driver of Sonic’s business going forward, although management have suggested that a period of consolidation may lie ahead, as the company integrates and refines its most recent buys.

In 2012, Sonic grew its revenues by over 8%, which is low compared to its all-time median of around 19%. Earnings per share grew by 4.5%, but could accelerate if the US and European economies show further signs of recovery.

Balance sheet and management

With $1.7 billion of debt, compared to $2.6 billion in equity (60% ratio), and just $170 million of cash, Sonic has more debt than we usually like. However, because of its defensive business, it should be able to cope with higher debt levels than in other industries. Another issue is that those 50 plus acquisitions have had a major effect on Sonic’s balance sheet, now sporting a whopping $3.6 billion of intangibles as the company’s major asset, with the lion’s share being goodwill. With both debt and equity increasing substantially, that has had a major impact on its return on incremental equity (ROIE), which stands at around 12%.

That could improve substantially, if the company hits the ‘acquisition’ pause button, and focuses on extracting further synergies from its existing businesses.

Healthcare companies don’t come cheap

Trading on a forecast P/E of around 15.6 and paying a partly franked 4.4% dividend yield, Sonic doesn’t look expensive compared to its peers, nor its five-year average P/E, of around 20. Sonic also appears cheap on an enterprise value to EBITDA basis, trading at 11 times, compared to Primary Healthcare (ASX: PRY) on 12.3 times and Ramsay Healthcare (ASX: RHC) on 17 times.

Given its potential balance sheet issues, investors will need to do their homework on Sonic before making the leap.

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Motley Fool writer/analyst Mike King doesn’t own shares in any companies mentioned. The Motley Fool’s purpose is to help the world invest, better. Take Stock is The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it’s still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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