Strength in diversity
Shares in Sonic Healthcare (ASX:SHL) have ticked higher since our last review, with little in the way of official stock exchange announcements. Investors though no doubt remain encouraged by the growth story at the pathology provider, and as evidenced by its interim results earlier in the year. We remain positive on the company’s long-term prospects, with a strong underlying thematic, and the scope for further earnings gains from offshore expansion.
Indeed, we see a key strength of Sonic being that the company has demonstrated clinical excellence and has been able to expand successfully to other territories and diversify its earning base by geography.
This of course boosts the avenues for growth, but also arguably reduces the company’s overall risk profile – in a sector where regulatory risks are ever-present, and can be subject to political whims and regime change.
Also, given our view that upside in the Australian dollar is likely to be contained in the medium-term, we also see the prospect of a currency kick coming through. Sonic does not hedge its currency exposures.
Source: Sonic Healthcare (ASX:SHL) Company Presentation
The specific nature of Sonic’s business does however mean that certain risks cannot be diversified away, and at the core is the company’s ability to consistently deliver robust test results, with an ‘acceptable’ error rate.
On this note, the company has become embroiled in a “false negative” scandal in relation to cervical cancer testing in Ireland. A false negative is when a negative report is issued when a disease is in fact present. The company’s US based subsidiary, Clinical Pathology Laboratories (CPL), is said to have missed the early signs of cervical cancer in some Irish women, and last month made a £2.5 million payment to one of these misdiagnosed.
Sonic Healthcare (ASX:SHL) is involved in the CervicalCheck screening programme in Ireland through CPL and local related company MedLab Pathology. The latter receives just under 50% of smear tests in Ireland, with the remainder going to other providers.
In one action, a woman has claimed that she was diagnosed with state two cancer by a doctor in Northern Ireland, just nine months after being given the ‘all clear’ by the programme across the border.
MedLab is now a defendant or a co-defendant in five of the 10 legal cases being brought in Ireland arising out of incorrect smear test reports. This has also not surprisingly been a significant political issue in Ireland which has seen new legislation coming in with the appointment of a new Health Service Board to improve accountability and governance. The government has also opened an official inquiry, after the programme mistakenly cleared over 200 women between 2010 and 2014 who later received diagnoses of cervical cancer.
The situation will clearly be monitored closely, and while clearly highly unfortunate and very sad, as the company notes, no screening test is ‘perfect.’ Management noted that while various quality assurance steps are taken to minimise false negative cases, they will always be a small part of population screening.
Given the involvement of Austin based CPL, there is clearly a possibility that the Irish cases are not isolated.
This could open up to a wider scope for much greater damages in the more litigious US. In total, CPL has more than 50 labs across 28 states.
However, this is very much a case of ‘ifs’ and ‘maybes’ in our view, with Sonic and its subsidiaries being widely known for clinical excellence. Indeed CPL management have stated that the results of its cervical cancer screens were well above the accepted accuracy rate for the type of screening conducted.
Overall, we are comfortable with the risk/reward trade off of remaining invested in Sonic. The company has built a strong reputation on the back of a robust quality assurance programme, and has also in our view expanded astutely into a number of geographies.
From a financial perspective the outlook is strong in our view, and we are encouraged by the update of a few months ago that the company was on track to meet full year guidance. This followed a robust first half with revenues up a healthy 8%, while net profit surged 16%.
Balance sheet wise Sonic (ASX:SHL) is also in good shape, with gearing under 40% despite a flurry of acquisitions. Interest cover is healthy at more than 10 times at last count (31 December 2017).
Turning to the charts, resistance around the August 2017 all-time high of $23.76 was surpassed this month, which is suggestive of higher levels ahead over the broader horizon. Next target is the February high of $24.97. Medium-term momentum remains in favour of the bulls, as backed by the bullish moving average crossover present (where the 50-day moving average red line crosses above the 200-day moving average green line).
Regarding the monthly chart, dynamic support is indicated at the uptrend line at the $22.00 region (upward sloping solid-green line). Positively, and from a longer-term standpoint, prices have closed (on a monthly-basis) above the 78.6% Fibonacci retracement of $23.28. Long-term momentum remains favoured to the upside, as evident from the series of higher lows and higher highs, which are characteristics of a dominant broader term uptrend in place.
Summary
Shares in Sonic Healthcare (ASX:SHL) have ticked higher since our last review, with little in the way of official stock exchange announcements. Investors though no doubt remain encouraged by the growth story at the pathology provider and as evidenced by its interim results earlier in the year. We remain positive on the company’s long-term prospects, with a strong underlying thematic, and the scope for further earnings gains from offshore expansion.
Recent revelations regarding issues with the company’s subsidiaries involved in cervical screening in Ireland are highly unfortunate and not to be dismissed lightly. That said, we accept the company’s representations that no screening test is ‘perfect’ and that screens were above acceptable accuracy rates.
Overall, we are comfortable with the risk/reward trade off of remaining invested in Sonic, and despite a premium rating. The company has built a strong reputation on the back of a robust quality assurance programme.
Sonic shares (ASX:SHL) are trading on circa 23 times estimated 2018 earnings, falling to 22 times the following year. The prospective yield over the same time frame is 3.2% expanding to 3.3%.
Accordingly, Sonic Healthcare (ASX:SHL) will remain firmly held in the Fat Prophets portfolio. For Members without a current holding, we recommend Sonic Healthcare’s shares as a long-term Buy.
Disclosure: Sonic Healthcare (ASX:SHL) is held within the Fat Prophets Share, Income Model.
