The chart below clearly shows medical diagnostics company Sonic Healthcare Limited (ASX: SHL) outperforming the S&P/ASX200 (ASX:XJO) (Index:^AXJO) over the last year. While the broader market has struggled to push higher, Sonic Healthcare's share price is reaching all time highs. Investors seem to be enthusiastic about the company but there are several issues which may limit further share price gains.
Background
Sonic Healthcare has built a dominant position in the Australian medical diagnostics market and is now Australia's largest pathology laboratory operator. It also has operations in the USA, UK, Germany, New Zealand, Ireland, Belgium and Switzerland. Sonic Healthcare most recently announced a large acquisition to expand its operations in Switzerland that combined with its existing business moves it to a market-leading position in Switzerland with 13% of the broader pathology market.
Pathology testing is the largest contributor to Sonic Healthcare's revenues but the company also has business units in diagnostic imaging and operates IPN which is the largest medical centre operator in Australia. The medical diagnostics sector provides investors exposure to defensive earnings which should remain steady throughout the economic cycle.
Financial Results
Sonic Healthcare's most recent financial results were somewhat disappointing. The company was only able to achieve modest revenue growth of 6% and net profit actually declined by 2% against the prior corresponding period. The only bright spot for investors was a 7.4% increase in the dividend.
Management has maintained earnings guidance for the full year of growth between 2-4% based on constant currency assumptions. With a large proportion of revenues earned offshore, a currency tailwind is expected in the second half of FY15 and investors will hope the Australian dollar can fall further.
Sonic Healthcare has a sizeable amount of debt and the weaker Australian dollar had the effect of increasing the company's net debt. Low interest rates have allowed the interest expense to be reduced but the high level of debt remains a negative for investors.
Operational Risk
Much of Sonic Healthcare's pathology revenues come from government or private health insurance reimbursement. In Australia, the fee paid to Sonic Healthcare by Medicare has been reduced and this has already resulted in negative earnings growth even as test volumes increase. With healthcare costs constantly increasing due to an aging population, governments will find it hard to increase the reimbursements it pays to companies like Sonic Healthcare.
Deregulation has also increased competition in the sector and this has resulted in a large number of new pathology collection centres which could pose a threat to Sonic Healthcare's market share.
Valuation
Sonic Healthcare shares are trading at a significant premium to the rest of the market on a price-to-earnings ratio of more than 22 at the current share price of $21.62. It offers a partially franked dividend yield of around 3.3% and the share price has reached a record all time high following the announcement of the Switzerland acquisition.
Outlook
The ageing population, new tests and an increased focus on preventative medicine means the medical diagnostic sector is expected to grow around 5% annually. Sonic Healthcare should be able to increase its market share as its scale gives it a cost advantage over its competitors. The company also has a pipeline of acquisitions that management hope will boost earnings in the medium term.
Should you buy?
Although the long-term outlook for Sonic Healthcare is positive, I think the shares are over priced. Short-term earnings growth is going to be difficult to achieve and with the shares trading at 22 times earnings, there may be better investment opportunities elsewhere. The company faces several short -term headwinds and I believe the current uptrend in the share price might be reversed if management delivers disappointing full-year results.
