Thread by @DownunderValue

Sonic Health $SHL $SHL.AX is Australia’s largest listed imaging and diagnostics healthcare company that’s taken on the world. Will this stalwart continue its Covid-sponsored run?

Let’s take a deep dive! 👇

1. Investment Thesis: A stalwart; with Covid and long-term tailwinds; good management; runway for organic and acquisitive growth in a still fragmented market; and historically a decent safe dividend yield.

2. Full disclosure, I first owned Sonic in 2010, and sold in 2015. It kept running, but not very fast. I considered in mid 2020 buying at $26, but anchor bias made me think $22 from March 2020 was better and I sat on the sidelines!

3. Sonic Health is the 3rd largest clinic lab / pathology and diagnostic imaging company in the world.

Their main role is in the lab work where it's a game of scale using expensive equipment, but they do also get involved in collection through some sites they own directly.

4. The categories of tests and services they provide is wide ranging, and continues to grow with new technologies and market demands.

Their labs are sophisticated with over 3,000 different tests.

5. The overall diagnostics and imaging market is expected to continue to grow +5% CAGR in to the medium term. But, it’s just a commodity, albeit a high tech commodity.

There is $0 spent on R&D by Sonic on their cash flow / income statements. 🤯

6. Artificial intelligence is expected to substantially disrupt imaging, and in particular replace a lot of the laborious work – this may increase volumes, drive down prices, and likely in the longer term to drive down margins.

7. Personal diagnostics (e.g. point of care, POC) are also expected to grow rapidly. This could reduce demand for lab work as people increase self monitoring, though may also drive more demand – a lot of uncertainty for a segment of the market Sonic is not well positioned for.

8. Sonic’s strength has been their roll-up strategy in a fragmented market. Since listing on the #ASX in 1987, they expanded nationally and then ramped up their global expansion from 2002. Revenue is 🇦🇺=22%, 🇺🇸=27%, 🇩🇪=23%, 🇬🇧=7%, 🇨🇭=7%, 🇧🇪=2%.

9. Top-line revenue growth has been impressive, mostly through acquisitions but also through some organic growth.

However, prior to Covid this had been tapering off.

10. Dividends have been increasing at 14.9% CAGR since 1994, increasing from 2c to 85c in 2020.

This has slowed over past 10yrs to 3.7% CAGR, while franking has reduced from 100% to 30%. Partly this was driven by increasing dividend payout ratios to ~75%.

11. ROIC is low but stable. For past 10+yrs it has hovered around ~8%. Gross margins remain high, but operating and net margins remain low.

TTM returns have been bolstered by Covid, but I expect mean reversion.

12. Growth metrics across the board are consistent: mid single digits for revenue, earnings, dividends and book value. Cash flow has been artificially boosted by Covid over past 2 yrs, otherwise similar result.

13. Balance sheet has shown signs of weakness, with increasing debt and significant goodwill. While shareholder equity and book values have been growing, it’s not an ideal situation.

Covid’s increased earnings are likely to go to debt repayment, not special dividends.

14. Management has performed well over a long period of time. I like the fact that they are stacked with technical folks (Professors, Doctors etc) supported by the bean counters.

It’s a good mix I reckon: boring, stable and safe.

15. Big question is about Covid / normalised earnigns. FY20 were flat vs FY19, though this masked Covid driving up income and lockdown driving down imaging referrals. Earnings growth of ~6% was largely due to Aurora Diagnostics acquisition in the US.

16. FY21f EPS are super high at ~270c.

Covid testing will add $1.1bn or 43% EBITDA according to Credit Suisee. This was seen in 1H21 results with revenue +44%, EBITDA +89% and NPAT +166%.

2H21 should only be slightly off from 1H21 despite vaccinations increasing.

17. Sonic has warned against forecasting ongoing growth at these rates. While their “base business is increasingly resilient to the pandemic”, Covid testing will fall off to some degree.

Question is, how much?

18. Broker’s reckon a lot.

For FY22, Credit Suisse reckon ~180c EPS, while Morningstar is ~150c EPS, well above FY20 119c EPS.

No-one is game enough to forecast Covid testing rates in FY23 for obvious reasons, but brokers en masse are not bullish.

19. Today’s price is ~$37. To get that as ‘fair value’ I need to assume 150c EPS is the new base case (+25% on FY20); growth of 8% in next 5yrs and 6% thereafter; 6% discount rate; terminal multiple of 13.

That seems pretty bullish to me. 🤔

20. My DCF is closer to $31.

This still assumes some Covid testing tailwinds into the future (I don’t think this simply goes away with a vaccine), some organic growth from non-Covid, and returning to ~5% growth thereafter. Though even this makes me feel a bit uncomfortable.

21. For dividend growth investing I expect absolute returns of +10%.

If I assume ~6% growth and no share buy backs, then I need 4% dividend yield. Based on ~90c DPS (i.e. most Covid cash is directed to debt repayments), then entry price is $22. Even with 7% growth it’s $29.

22. Historical PE has been around 20, though good entry points have been around 15. Current PE=19 but will likely drop to 15 on Covid-inflated 250EPS.

If I normalise earnings to my estimate of 135c EPS, then entry point is around $27 and a good entry point is around $20.

23. The bear case is a commodity product; disruption to the industry by AI/tech; depressed demand after Covid, overly optimistic valuation.

Overall I will continue to watch Sonic as I am bullish on the sector, but won't consider nibbling until it's in the mid $20s.

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Questions and feedback always welcome. DYOR.

Disclaimer, I have no position in SHL.