Ord Minnett Research Recommendation: Sonic Healthcare (ASX: SHL)
After a period of sharp underperformance, with the share price retreating nearly 30% at time of writing since the start of 2022 versus the S&P/ASX 200 Index’s 4% decline, Sonic Healthcare has become too cheap, in our view. We have upgraded our recommendation to Buy from Hold, while our target price has reduced to $37.30 from $38.70 due to changes to our earnings forecasts.
We continue to foresee a sharp earnings contraction as COVID-19 testing revenues shrink. We assume testing in FY23 will deliver $600m of revenues and more than $100m of after-tax profits, down dramatically from $2.3bn of revenues and at least $0.5bn of profits in FY22.
We are confident, however, that the core diagnostic business will return to its historical utility-like performance, supporting mid-single-digit growth once the COVID-19 boost is cycled.
Given Sonic’s now-underutilised balance sheet, we expect M&A activity to provide a further boost to earnings growth. Net debt has reduced by $1.3bn over the past two years, despite spending nearly $600m on acquisitions, due to large cash inflows from COVID-19 testing. Management is keen to deploy this cash to expand the Sonic empire, and has flagged an active pipeline of opportunities. We expect EPS-accretive deals to further boost earnings growth and the upcoming $500m share buyback should also help support the shares.
The recent floods in NSW and Queensland will undoubtedly cause business in affected regions to slow, although as no major facilities were affected the impact should be modest. The recent appreciation of the Australian dollar, especially against the euro, will also be a potential headwind, especially if current levels hold. We note more than half of group revenues come from offshore – 25% US dollar, and 35% euro, UK sterling and Swiss franc.
After a further review of our COVID-19 testing forecasts, base business growth and margin assumptions, we have reduced our FY22 and FY23 forecasts by 2% and 5%, respectively. Our sensitivity analysis suggests that even if COVID-19 testing were to stop completely from the start of FY23, the impact on Sonic’s earnings would be manageable and our valuation would fall by only 10% − which, at $34, is still above the current share price.
Walter is the Editor of Ord Minnett's retail investor publications, such as the Opening Bell, Ords Weekly and the Ords Monthly, along with various investment guides and investor information published by Ord Minnett.
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