Monday 30th May 2016
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An election sweetener
While certainly not a new issue, the government’s decision last week to tackle excessive rental costs for pathology collection centres appears to be compensation for their decision late last year to cut bulk billing incentive payments for certain diagnostic tests. In our view, this essentially restores the balance, with the government able to retain the budget savings from its cut to bulk billing, while the likes of Sonic Healthcare can look forward to lower rental costs.
Although the timing and mechanism for controlling rents remains unclear at this stage, it could provide material relief to earnings over the medium-term. As per Sonic Healthcare’s 1H16 results, it appears as though rent (i.e. operating leases) accounted for around 6.2 percent of the company’s FY15 revenue, compared to 4.8 percent in FY06. Even if this ratio can be reversed, or at least capped, it remains unknown what the net effect of this and the cut to bulk billing will have on earnings.
Nevertheless, the fact that Sonic Healthcare’s share price did respond favourably to last week’s announcement by the government is encouraging. Sonic Healthcare has not commented on the release, with this probably due at least in part to the fact that the specific details relating to the government’s initiative remain unknown. What is clear, in our view, is that the government latest decision provides some hope that regulatory pressures in the Australian market may now be easing.
Of course, the proof could be in the pudding. In our view, the pathology industry (i.e. or at least the industry’s national peak body, Pathology Australia) will no doubt be keen to get clarity on the government’s rental initiative before the election – the fact that the industry body has withdrawn its ‘Don’t Kill Bulk-Bill’ petition suggests that it is confident that a satisfactory outcome can be gained from its discussions with the government.
Management reiterated the earnings guidance that it initially provided to the market in August 2015 at its FY16 results in February 2016. That is, for a full-year EBITDA of $815-840 million on a constant currency basis. While this implies a 1H/2H split of circa 45/55, this does not appear to be too much of a stretch given the potential for incremental gains from existing and new acquisitions and upside from management’s recent initiatives to counter the pending changes to Medicare.
Sonic Healthcare is currently trading at an FY16 earnings ratio of 20.6 times and offering a partially franked yield of 3.5 percent. We believe that Sonic Healthcare should trade at a premium to the broader market, with the company’s technical set-up currently adding some weight to this view - the next focal point of resistance is located at the 78.6% Fibonacci retracement of $22.26. A drive above this level would likely result in a re-test of the all-time high of $23.73 over the longer-term.
While the devil could be in the detail, the government’s latest move provides the clearest sign yet that the regulatory pressures that have been heaped on Sonic Healthcare’s (SHL.ASX) Australian pathology business are now receding. Although this recent positive news has arguably already been factored into Sonic Healthcare’s share price, this does in our view remove a key earnings risk from the business, and in doing so make the company’s shares more attractive to investors.
James Lennon is a senior analyst at investment research and funds management house Fat Prophets. To receive a recent Fat Prophets Report, CLICK HERE
Disclosure: Sonic Healthcare is held within the Fat Prophets Share, Income Model.
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