Sonic/SHL

Sonic is the big pathology operator.

The results were a miss to market, and guidance was “toward the lower end” for FY24. The market definitely did not like any of that, and the stock was sold off hard.

We’ve written a somewhat similar note for ANN, in that much of the story is about over and undershooting relative to trend, from the COVID related impacts (COVID, revenues up, end of COVID, revenues down).

In ANN’s case, that mattered a lot due to inventory, and whilst it matters for SHL it’s nowhere near as important.

The graph up top on sales shows the slow grinding upwards pressure on the top line.

And splitting out the segments shows the good outcomes in radiology, where SHL is growing very nicely.

Sonic are expanding, usually by acquisition, in addition to organic growth, pretty much everywhere.

The market got far too excited during COVID, with the market cap of the company being far above any plausible estimate of what future cashflows the underlying assets could possibly generate.

We knew that, and thought we were clever buying in at the low $30’s mark. That didn’t quite play out as well as we’d hoped, timing wise. But, as the below helps indicate, perhaps the current market cap relative to assets is at much more reasonable levels moving forward, particularly as the business grows over time.

Here is what we mean by overshoot. The upside is clear, and the return to “trend earnings” has involved some degree of undershooting (i.e. below the historical pre-COVID trend that your eyeballs can likely discern). Some of that comes from unwinding the people and infrastructure associated with COVID, which weights on margin and produces no benefits.

Deep in our hearts, we know we’d expected slightly better operating income outcomes, and thus the result is indeed a disappointment. We’d thought “return to trend” rather than “undershoot” was the most likely. It almost certainly will be, but timing wise, not right now, at least not this result.

Cashflows are strong…

…and gearing is low.

Earnings are expected to grow quite strongly over time, and you can see the degree to which the market was surprised by the result (red line is where consensus was, and the now updated column bars of where consensus sits across the next three years – in other words, to grow, a lot, but by less than was previously expected).

Part of the issue for SHL is that they’ve spent a lot of money on AI-related initiatives that are not generating any income. This is an investment for the future, but it is definitely weighing on returns at a time in which revenue trends and inflationary cost pressures are hard to get a handle on.

The idea that this is getting closer to fruition is promising, but it is clearly a longer-dated phenomenon, however exciting it may be.

Given how low this half’s earnings/NPAT outcome was, the step up required to hit the low end of the full year guided range is quite high. The market is doubting SHL’s ability to meet guidance, given it would imply an unusually large skew, and, that this downgrade to “the low end of guidance” isn’t going to be the last.

Sonic have set out what will drive earnings in the next half; there’s plenty of individual items (contributions from acquisitions, organic growth in the base business, and so on)…

…and mgmt have flagged what they think will drive earnings in and beyond FY25. This is all stuff very in keeping with SHL’s track record, even as it is a bit difficult to weight.

The Q&A call highlighted management’s opinion that this is a) the bottom b) margins should step up quite a bit in the 2H and c) longer run, they’ll get most of their “pre-COVID” margin back.

Although it is fair to say the analysts are skeptical. But, funds management is like that. Sonic have the track record, they’ve got the weight of history on their side. They are best placed to know how they are positioned, and we have to decide if the odds of them being right are in our favour, or, at the least, compensated appropriately by a margin of safety with either regard to the balance sheet or to the valuation.

On that, Sonic is perhaps not particularly cheap, at 22x forward earnings. It isn’t super expensive, either, and for a stock with good structural tailwinds (demographics, aging populations, the AI-optionality explored above) we think it a good stock to own in the current, uncertain macroeconomic environment.

In sum, it’s not without its risks, at the moment, but we also think the decades-long track record (which is owned by current management, Colin Goldschmidt has been around as CEO forever) confers the benefit of the doubt.

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