We first recommended that members Avoid Primary Health Care back in 2013 when it was trading at $4.90, then reiterated that view this past September at $3.81. With the stock down 41% in three months, the GP network and pathology provider is starting to look cheap. Is now the time to buy?
Before diving in, some of the negative publicity is certainly justified. The Government recently announced its Mid-Year Economic and Fiscal Outlook, which included various Medicare fee cuts to lab and imaging services. That’s bad news for Primary, which has a 32% share of the Australian pathology services market, as well as larger competitor Sonic Healthcare (ASX: SHL), which has a 42% share.
To see why the Government seems hell-bent on cutting the pathology budget, look no further than Vitamin D testing. In 2000, the number of Vitamin D tests billed to Medicare came in at 22,670. Last year the number had blown out to a staggering 4.3 million. No one is questioning the validity of this blood test for specific circumstances, but even the Australian Medical Association says the frequency of testing is now beyond anything clinically justifiable.
With this in mind, it isn't too surprising that the Federal Government slashed Vitamin D test rebates by 9% in November 2014 as part of a widespread effort to rein in the healthcare budget. The price changes cut around $5m from Sonic’s top line in 2015 and slightly less for Primary.
The recently proposed cuts go much further – Sonic estimates the changes might cause a $50m a year drop in revenue. That's not the end of the world for a company with $4.2bn a year in sales, but fee pressure is likely to be a growing issue as the Government shifts its attention to other potentially over-used tests, such as those for liver and thyroid function.
Unfortunately, as prices come down, so too do margins – Sonic and Primary have high fixed costs due to the machinery and staff required to run their labs. That 1.2% reduction in Sonic’s revenue would translate to a 5–6% hit to operating earnings in 2017.
Primary has said operating earnings would fall 5% in 2016 due to ‘a subdued revenue environment and margin compression’. With the next wave of fee cuts coming into force on 1 July, we don’t expect the 2017 financial year to be much better.
Debt the real issue
A 5% decline in operating earnings isn’t anything to lose sleep over, but, when combined with rising debt, it does add risk to an already shaky situation.
Primary’s net debt rose 8% in 2015 and now sits at $1.2bn, most of which is a legacy of the company’s acquisition of Symbion Health in 2007. Interest payments now consume an unhealthy 29% of operating earnings. The same figure for Sonic is 11%, leaving much more wiggle room.
Earlier this year Primary extended its bank debt facility to 2018, but, while that relieved some pressure in the short term, rising interest rates and refinancing still pose a significant risk. Encouragingly, management outlined plans at the annual result to reduce debt but so far they're just that - plans.
Primary has an underlying price-earnings ratio of 11 so the stock is far from expensive. A lot of bad news has already been baked into the share price, yet the company still has many things going for it, not least of which is that demand for its services is growing relentlessly due to a steadily aging population. Primary and Sonic’s dominant market positions also give them a moderate competitive advantage due to economies of scale.
However, we expect it to be a slow grind before Primary’s balance sheet is genuinely under control and the latest proposed fee cuts won't make that grind any smoother. A dilutive capital raising is a very real possibility. For now, the risks still outweigh the potential rewards and we recommend you steer clear.
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