Sonic Healthcare: Result 2014

Much of pathology is about finding abnormality, but if anything can be said of Sonic Healthcare’s full-year result it’s that it was pleasantly ordinary. Besides the proposed GP co-payment and the odd bit of fee pressure to spice things up, it was business as usual.

Favourable foreign exchange movements and underlying growth of 5% combined to deliver a 12% increase in revenue to $3.9bn from a year earlier. Net profit came in at $385m, up 15%, while earnings per share rose 13% to 95.5 cents (up 5% in constant currency terms). The board declared a final dividend of 40 cents (55% franked, ex date 3 Sep) bringing the annual total to 67 cents, for a current yield of 3.8%.

The company’s largest division, Australian pathology, had a relatively strong year with 6% revenue growth despite the government cutting Medicare fees. The division’s operating margin was flat, however, with cost cutting being offset by escalating rents for collection centres (see Sonic and Australia’s newest duopoly from 11 Dec 13 (Hold – $15.85)).

The deregulation of collection centres is a double-edged sword. On the one hand, higher rents have strengthened Sonic’s position as the largest Australian pathology provider, with a 42% market share, by making it too expensive for small operators to compete. On the other hand, it’s a bit like standing on tiptoe at a parade – once Sonic pays a little more to secure its place in a medical centre, Primary Health Care, the second largest operator with 32% market share, must quickly follow suit, leaving both companies with higher rent expenses.

Although in the short term the bidding war will go on, it’s likely Sonic and Primary will keep taking market share from weaker players. Eventually, and assuming they can play nice, the companies should be left in the favourable position of being the only two left at the parade. Then, with far stronger negotiating power against their suppliers, they can take their seats and break open the esky of profitability.

Mein test

Sonic now earns just over half its revenue offshore, though its US pathology division – the company’s second largest at 21% of total revenue – had a relatively poor year. In 2010, the Affordable Care Act, or ‘Obamacare’, was introduced to improve health insurance affordability.

The increased insurance coverage boosted the number of tests Sonic provides by 2.2% in 2014, in line with competitors. However, this was offset by a 5% cut to the US Medicare budget (Medicare reimbursements account for 22% of Sonic’s US revenue). This forced Sonic to lower its fees, which led to revenue falling 1%. The US is a competitive market and, given the pressure on the government to balance its budget, we expect at least a few more difficult years.

Sonic’s European operations did far better, with 12% revenue growth in the UK, 11% in Switzerland, and 12% in Germany, which was helped by the acquisition of Labco (see Sonic acquires in Germany from 3 Oct 13 (Hold – $16.06)).

The German government reduced the insurance reimbursement funding pools by 10% in 2012 to curb runaway healthcare costs (see Sonic Healthcare: Result 2013 on 20 Aug 13 (Hold – $15.41)). The funding pools, however, grew slightly this year and the company has flagged that the country's ‘fee quota headwind [is] over’.

Not so fast

Less can be said for headwinds in Australia. The Federal Government funds over 85% of Sonic’s Australian revenue via Medicare rebates. In 2011, the five-year Pathology Funding Agreement came into effect, which restricts growth in pathology spending to 5% per year.

Strong volume growth in 2012, however, caused spending to exceed the 5% threshold and so the Government introduced a 0.67% reduction to all pathology item rebates and a $3.50 reduction in the fee for Vitamin D tests in 2013. With the Australian division earning revenue of $1,131m, that 0.67% took about $6.5m straight off the top line.

What’s more, in its latest budget the Federal Government proposed a patient co-payment of $7 for bulk-billed GP visits, as well as a $5 reduction in Medicare Benefits Schedule rebates (see Budget changes hit pathology stocks from 14 May 14 (Hold – $17.48)).

If the budget is approved, the cost of seeing a doctor will increase, which will likely cause a small reduction in GP visits and, consequently, pathology test volumes.

Sonic’s Independent Practitioner Network of GP’s (IPN), which contributes 9% of total revenue, will also be affected. However, IPN largely abandoned the bulk-billing business model, which is still used by Primary Health Care, when it was acquired by Sonic in 2005. That change caused a drop in the number of consultations at the time, but may ultimately prove to be the better strategy as we expect its mostly private-billing patients to be less price sensitive if the GP fee hike gets through.

Management anticipates EBITDA growth of about 5% in 2015. The share price is flat since 14 May 14 (Hold – $17.48) and up 54% since we initially upgraded the stock on 5 Aug 11 (Long Term Buy – $11.47). With the stock trading on a multiple of 18 times 2014 earnings per share, Sonic is on the expensive side so it’s important to note our recommended portfolio limit of 5%. Having said that, it's is a high-quality company and we’re happy to HOLD.

Note: Our model Growth Portfolio owns shares in Sonic Healthcare.