Sonic Healthcare is the largest private pathology player in the Australian private pathology testing market with 40% share. Scale has been achieved via multiple acquisitions, integrated using a well-established hub-and-spoke operating model, has driven synergy benefits domestically and we believe will support the offshore growth strategy in the U.S. and European markets.
Sonic has historically grown via acquisition, both domestic and offshore. With approximately 40% of the domestic market now captured, it is our view that future growth will be increasingly driven by greater penetration of the U.S. and European markets, given their high degree of fragmentation. Furthermore, we expect margins in the existing U.S. and European pathology businesses to expand as Sonic improves efficiencies through implementation of its hub-and-spoke operating model.
Sonic's financial health is good. Net debt/equity was 62% as of June 30, 2016, with about 71% of total assets composed of goodwill and other intangibles. Total debt/EBITDA was 2.9 times, while EBITA comfortably covered net interest more than 7 times, reflecting about 3% average pretax cost of debt, the majority of which is sourced from U.S. and European capital markets. Cash flow generation is good; Sonic consistently converts 100% of profit to cash. Given the reliability of Sonic's cash flow, we regard the debt and interest cover ratios as comfortable.
Sonic Healthcare posted an interim result that generally met market expectations, despite slight weakness within the Australian pathology division. We maintain our AUD 24 per share fair value estimate, implying the shares are undervalued at current levels. Management reaffirmed guidance for fiscal 2017 revenue growth of 5% and underlying EBITDA growth of 6% in constant-currency terms.
Highlights included accelerating 3.3% organic growth in the U.S. business, now 22% of group revenue, after a relatively sluggish average of 2% over the past three years. We anticipate continued momentum, given the recent acquisition of the West Pacific Medical Laboratory in Los Angeles, and expect the added scale will lead to significant synergies by fiscal 2018, given its close proximity to existing operations on the West Coast.
We were particularly impressed by strong growth in Germany and Switzerland of 6% and 8%, respectively, and expect this momentum to continue, given the recent acquisitions of Staber Laboratory Group and Medical Laboratory Bremen. We also see the newly commissioned addition to the Bioscientia central lab in Ingelheim as adding meaningfully to Sonic’s esoteric test offering. With Germany so centrally located, we expect acquisitions in adjacent countries to increase over the medium term, thereby adding to Sonic’s scale-related cost advantages, a key source of our narrow moat rating. We also expect the rollout of Sonic’s now 80%-owned GLP automation technology system to further improve operating efficiencies globally and margin expansion over the medium term.
Regulatory risk concerns have increased recently because of an ongoing government review of funding arrangements under Medicare. However, in our opinion, Sonic's foreign exposure diversifies revenue streams and lowers the company's vulnerability to Australian funding risk. International revenue as at the interim result stood at 59% of group revenue on a statutory basis.
Current Price: $21.31 AUD
Target Price: $22.36 AUD
Upside Potential: 5% +