All Part of the Plan
Diagnostics specialist, Sonic Healthcare (ASX:SHL) continues to expand in two of its major offshore markets (Germany and the US) which, combined, account for over 40% of revenues. Today, we provide an update on the developments on this front and provide some commentary on how it is likely to impact the company going forward. We maintain our BUY rating on the shares.
What’s New?
In our last coverage of the global pathology provider in June (FAT-AUS-877) we provided commentary on the recent “false negative” scandal that took place in Ireland and affected over 200 women.
Understandably, and much like all medical procedures, no screening test is “perfect” though management reiterates that they have long since established quality assurance steps to minimise the possibility of such errors and maintains results well above the accepted accurate rate, though there will always be a small percentage that slips through.
The company (as at 1H18) maintains a strong balance sheet with gearing well below 40% and this has remained stable year-on-year despite a flurry of acquisitions. Interest coverage is also quite healthy with a multiple of 10x which means that its earnings can easily service debt payments.
That said, we believe that one of the underlying growth factors for the company is its offshore expansion plans and this is outlined in the 1H18 presentation. According to management, they continue to build up a pipeline of acquisition and joint venture opportunities to further fuel growth and that is reflected in the graphic below:
Source: 15 February 2018 Company Interim Presentation
Today, the focus of this report is to provide an update on the developments on this front and provide some commentary on how it will impact the company going forward.
Pathologie Trier Acquisition
As at 3 July, the company announced that it has acquired Pathologie Trier (Acquiree), one of Germany’s leading anatomical pathology practices in Germany. The Acquiree runs a variety of pathology services from molecular pathology to tumour genetics services with annual revenues of circa €20 million.
The Acquiree has operations in three West German Cities (Trier, Düsseldorf and Düren) with clients covering 30 large hospitals and many general practitioners and specialist histopathology practices. The management team, which includes the 4 founders, will continue to run the operation. Total staff are around 160 which includes 24 pathologists.
The initial acquisition price was funded in Euros from the company’s existing debt facilities though the actual figure was not disclosed. Some 25% of the total purchase price is subject to a 3-year revenue-based earnout provision. We do expect to see more details in the company’s Annual Report filings for precise figures later.
That said, according to the company, most the purchase price will be tax deductible in Germany over 15 years as goodwill amortisation while management expects the initial return on invested capital to exceed the company’s cost of capital, and that the transaction should be EPS accretive by 1-1.5%.
Source: 15 February 2018 Company Interim Presentation
In light of that fact, the continue development in German operations is a welcome development in our view considering that it is the 2nd most important revenue source for the company, accounting for circa 21% of the total revenue. This acquisition is also expected to support topline growth and boost market share for the group.
Joint Venture with ProMedica Health System
Across the pond, in the US, the company has also been continuing its growth via a recent laboratory joint venture (JV) with ProMedica Health System (Partner). The Partner is a Toledo, Ohio-based health care network that covers over 30 states and includes over 2,300 physicians, 13 acute care hospitals and 500 post-acute and outpatient facilities.
Image Credit: rawpixel on Unsplash
According to management, the deal is not a material transaction since it only includes the company contributing its Ohio laboratory business (known as Pathology Laboratories or PathLabs) and some undisclosed amount of cash from existing debt facilities or cash on hand for a 49% ownership stake in the JV. PathLabs currently generates annual revenue of circa US$30 million. ProMedica, on the other hand, will contribute its existing outreach/community laboratory business and hospital inpatient testing operations for a 51% stake in the JV.
According to Sonic (ASX:SHL), the JV is expected to increase the scale of operations and subsequently deliver cost efficiencies. Its operations will be at ProMedica’s Toledo Hospital with the older laboratory to be closed after the transition period.
Furthermore, although the company will be managing the day-to-day operations of the JV it will not consolidate the JV in its financial reports. The performance will be reflected in its EPS and should be accretive from the 1st year of operations. The JV is expected to begin operations by 1 September 2018.
Turning to the charts, resistance around the August 2017 all-time high of $23.76 was surpassed earlier in the year, which was suggestive of higher levels ahead over the broader horizon. The February high of $24.97 has also been usurped as prices have gapped above current support at $25.82. 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). The next summit in focus is the all-time high of $26.90 seen this year.
Regarding the monthly chart, dynamic support is indicated at the green uptrend 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
Sonic Healthcare (ASX:SHL) continues to seek growth via its offshore expansion activities in Germany and the US via a combination of acquisitions and joint ventures. Recent growth initiatives are expected to be earnings accretive from the first year of operations and have mainly been funded from internal resources.
Sonic (ASX:SHL) shares are trading on circa 23.4 times estimated FY18 earnings, falling to 21.6 times the following year. The prospective yield over the same time frame is 3.1% expanding to 3.3%.
Overall, we are comfortable with the risk/reward trade-off and recommend remaining invested in Sonic, despite a premium rating. The company has built a strong reputation on the back of a robust quality assurance programme.
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 Australian Share Income Managed Account Portfolios.
