The stock picker’s guide to Sonic Healthcare Limited in 2014

Buy, sell or hold? What you need to know about Sonic Healthcare Limited in 2014.

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Sonic Healthcare Limited (ASX: SHL) is the dominant provider of pathology services in Australia. However, almost half of its business comes from overseas; the company owns pathology practices in New Zealand, the United Kingdom, the USA, Germany, Switzerland, Belgium and Ireland.

Pathology is the branch of medicine that deals with the laboratory examination of samples of body tissue for diagnostic or forensic purposes. In other words, when the doctor doesn’t know exactly what disease (if any) the patient has, one way to find out might be pathology. In Australia, most pathology tests are performed by Sonic Healthcare, or its main competitor, Primary Healthcare Limited (ASX: PRY). Critically ill patients often require a multitude of tests, as doctors must carefully monitor their condition, and the body’s response to medication. Almost everyone has had a pathology test from the GP, at some stage.

Pathology practice requires the safe handling of potentially infectious bodily fluids, and is itself a sophisticated science, so the barriers to entry are reasonably high. Furthermore, the collection of samples requires a large network. Such networks tend to become more efficient with size, so there is a certain advantage to being a large organisation in this industry.

Sonic Healthcare relies on physicians and hospitals to use their services. Sonic is ultimately paid out of the patient’s pocket, or by a government (via the public health system), or by a private health insurer. There is therefore some risk of fee reductions as governments or insurers seek to reduce the cost of healthcare. In 2013, 10% of Sonic’s revenue was derived from medical centres and occupational health businesses and 12% of revenue came from diagnostic imaging (think MRI scans). In that respect, Sonic Healthcare is a competitor of Capitol Health Limited (ASX: CAJ). Pathology remains the main business of Sonic Healthcare, accounting for 78% of revenue in 2013.

Why buy

Director Philip Dubois bought shares on market at $16. With the price around $16.60, is Sonic worth buying? Sonic has given guidance that it expects EBITDA to grow around 5% in FY 2014, on a constant currency basis. The company has strong free cashflow and plenty of room to increase its dividend over time. Shares currently yield about 3.7%, partially franked. Another reason to buy this company is as a hedge against the falling Australian dollar, although I believe that a lower Australian dollar is somewhat priced in already.

Why not buy

Sonic has debt approaching $2 billion and its interest expense was almost $60 million in FY 2013. Rising interest rates would definitely hurt free cashflow and the current low rates have certainly helped the company. Furthermore, the average Return On Invested Capital (ROIC) over the last 10 years sits at 9.1%, according to CommSec. I generally try to find companies with ROIC of at least 15%.

Foolish takeaway

Sonic is a solid company, with strong long-term prospects. While I’m not enticed to buy at current prices, I keep the company on my watchlist because it has plenty of room to grow, industry tailwinds, strong management and a clear corporate conscience. I believe the company will be around for many years to come. It should also grow its dividend substantially over the next decade. The key expense to keep an eye on is the cost of operating leases (which has been increasing). The key metrics to watch are margins and return on invested capital. For my money, Sonic is a hold (although I do not own shares).

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Motley Fool contributor Claude Walker (@claudedwalker) does not own shares in any of the companies mentioned in this article.

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