Sonic Healthcare: Interim result 2015

Just as clothing has its seasonal fashions, so too does pathology. And today the in thing is 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.

As part of a widespread effort to rein in the healthcare budget, the Federal Government slashed Vitamin D test rebates by 9% in November 2014, which is expected to cut around $5m from Sonic Healthcare's top line in 2015.

While that's not the end of the world for a company that earned $2.0bn in revenue for the six months to 31 December, fee pressure is likely to be a growing issue for Sonic as Medicare shifts its attention to other potentially over-used tests, such as those for liver and thyroid function.

Sonic is Australia's largest provider of pathology services, with a 42% market share, followed by Primary Health Care, with 32%.

Revenue from the Australian operations – Sonic's largest division accounting for 29% of group revenue – increased 2.8% for the half. That's a decent result given the overall Australian pathology market only grew 1.7% but is a clear sign average test prices are coming down, as overall test volumes increased roughly 4%.

Worse still, as prices come down, so too do margins – Sonic has high fixed costs due to the machinery and staff required to run the labs. While overall group revenue increased 5%, net profit actually fell 2% after removing the effect of currency fluctuations.

Sonic now earns just over half its revenue offshore. Its US pathology division – the company's second largest at 21% of total revenue – had organic revenue growth of just 1% in constant currency terms. This was also due to Medicare fee cuts, which we expect to continue for some time yet given the US healthcare budget is under even greater pressure than the Australian one. 

Thankfully, Sonic's European operations picked up some of the slack, with 6% revenue growth in Switzerland, 21% in Germany, helped by four small acquisitions, and 9% growth in the UK.

Sonic is building a new laboratory in central London to gear up for a 10-year contract to provide pathology services and analytics to the National Health Service in a joint venture with University College London. The contract is expected to commence in April and generate £50m a year in revenue (roughly $100m at today's exchange rate).

Alberta appeal

Across the Atlantic, Sonic was selected as the exclusive pathology provider to Canada's Alberta Health Services in October. Alberta is roughly the size of NSW with a population of around 4 million. The 15-year contract, which is to be finalised over the next few months, is expected to generate more than CA$200m a year in revenue.

The best part of the deal is that Sonic essentially inherits the existing infrastructure from the incumbent, DynaLife, and a new lab facility will be built to Sonic's specifications but funded by the government. The contract requires little capital expenditure from Sonic, which means incremental returns on capital will be high.

Using Sonic's historic profit margin of around 9–10%, the contract could add up to $20m a year to the bottom line, or around 5.0 cents per share. It will also provide a platform for other provincial contract wins. As pathology has significant economies of scale, you can bet that once Sonic has settled in to Alberta, management will be on the lookout for Canadian acquisitions.

The contract isn't in the bag yet, though – DynaLife is appealing the decision. However, an independent fairness review of the bidding process found no misconduct, and it can't hurt that the appeals process is being adjudicated by Alberta Health Services itself. We're not losing any sleep.

Sonic's share price is barely changed since Sonic downgraded to Sell from 6 Nov 14 (Sell – $18.94) and trades on a partially franked yield of 3.5% and price-earnings ratio of 20. That's a high price given fee pressure in the Australian and US divisions will likely anchor growth to the mid-low single digits. Sonic is a high quality company but there are better opportunities on our Buy list. We're sticking with SELL.