Shares in pathology and diagnostic imaging provider Sonic Healthcare Limited (ASX: SHL) rose 5% this morning after the release of the company's full year results – which were impressive.
- Revenues rose 20% to $5,052 million (up 14% to $4,789 million on a constant currency basis)
- Net Profit After Tax jumped 30% to $451 million (up 24% to $429 million on a constant currency basis)
- Earnings per share up 27% to 109 cents (up 21% to 86 cents on a constant currency basis)
- Total dividends of 74 cents per share, up from 70 cents in 2015
- Gearing* of 38%, debt cover** of 2.6 times, good maturities (more on this below)
- Outlook for 5% profit growth in 2017 excluding impacts from acquisitions and potential regulatory reform
*Net debt divided by net debt + equity (banking covenant limit of 55%)
**Net debt divided by Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) (covenant limit of 3.5 times)
So What?
A good year for Sonic, which continued to post organic growth of 3% or more across most of its markets despite mixed performance in Australia (due to regulatory issues) and the US (due to a partial restructure). More acquisitions appear to be on the cards generally as Sonic's organic growth, while respectable, isn't huge. I saw that costs increased roughly in line with (very slightly below) revenue, which suggests that 'operating leverage' (earning progressively wider profit margins as the business grows) is not in effect or at least has very small impacts on Sonic.
This means that Sonic needs to maintain its profit margins as it expands, and events which might impact margins (such as regulated fee changes) should be treated with respect. Fortunately, regulatory change in Australia seems to have been taken off the front burner recently.
As a side note, it was interesting to see that many businesses in the medical sector as diverse as Medibank Private Ltd (ASX: MPL) and Primary Health Care Limited (ASX: PRY) are reporting 'procurement efficiencies' which makes me uncomfortable about what companies like my medical device supplier Lifehealthcare Group Ltd (ASX: LHC) might reveal in its upcoming report.
Great as it is to hear about companies paying lower prices for goods, someone else has to foot the bill for those 'efficiencies'
A hidden fee bullet?
The Australian (25%), US (22%), and German (18%) markets are the three biggest contributors to revenue now, with 59% of revenues coming from overseas compared to 41% from Australia. Investors will be relieved to see the postponement of proposed fee changes in these markets.
German, Australian, and US fee reforms have been postponed for the time being, and one suspects that politicians are husbanding their political capital for the elections. Yet the scope of the impacts of the proposed changes, up to 20% of Sonic's US revenues and 5-6% of Australian EBITDA (announcement in Dec 2015), shows the real risk of regulatory impacts if they go ahead.
The need for reform also raises questions for me about the diagnostic industry, which has been growing well ahead of GDP in recent years – especially in countries which subsidise these services. Last year, Australia's Productivity Commission identified unnecessary repeat imaging as a potential area of waste. As previously mentioned, margins are important for Sonic and with the regulatory fee pressures I'd be wary of overpaying for the business.
Well, should I buy it?
Regulatory risks may never come to pass or may be watered down so significantly as to have no impact. Yet it would be a foolish (lower case F) investor who ignored the risks of government intervention in the sector. Further, Sonic's businesses are geographically diversified and the hit from any one change is likely to be small. In a boon for investors everywhere, Sonic earned just over $1 per share in 2016 and its Price to Earnings (P/E) ratio is equal to the value of its shares, currently $23.
Considering its pedigree of value creation via acquisitions over the past 20 years, its growth opportunities, and the above risks, I believe that Sonic shares are trading around fair value today.
