Worries that medical facilities operator Sonic Healthcare Limited (ASX: SHL) would be next in line to face a profit downgrade have proven to be on the mark.
Shares in Sonic tumbled 3.8% to $21.04 this morning but that's better than the 8% loss it suffered at the start of trade when management warned that 2014-15 full year earnings before interest, tax, depreciation and amortisation (EBITDA) would fall short of guidance by 3%-4%.
That may not sound like a big deal but it has left investors wondering if Sonic can generate any organic growth in the current financial year.
The disappointing result is being blamed on issues weighing on the Australian pathology market with lower-than-expected patient volumes in recent months.
The drop in patient numbers also forced fellow medical facilities operator Primary Health Care Limited (ASX: PRY) to issue a profit warning last week. This news sparked rumours that Sonic would be next to lower the market's earnings expectations and caused the stock to plunge around 10% since.
Primary Health Care's downgrade was also fairly modest but the stock suffered a big sell off because defensive stocks that trade at a premium to the market are not supposed to spring negative earnings surprises.
Sadly, Sonic fits into this category and I think there is further downside to the stock as it's still trading close to 18x consensus price-earnings for the current financial year. Analysts will be downgrading their earnings forecasts and this means the stock is probably trading closer to 20x – and that's too high for a stock that's facing earnings headwinds.
But lower volumes aren't the only drag on Sonic's earnings. Management has underestimated the impact of fee cuts and other changes for some tests under the Medicare Benefits Schedule that were implemented in November last year.
Further, higher-than-expected costs in specimen collection and exit costs incurred from contracts that expired in New Zealand are also impinging on group earnings.
Sonic tried to appease investors by pointing out that 2015-16 EBITDA would be around 20% higher at $850-$875 million compared with its 2014-15 EBITDA estimate of around $730 million.
However, I can't help but feel that the big boost to EBITDA comes mainly from recent acquisitions and not organic growth.
Sonic purchased Swiss medical laboratory group, Medisupport S.A. last month and that acquisition alone should add close to $50 million to its full year EBITDA before synergies.
Sonic has made a number of other acquisitions in the last financial year too, which includes four bolt-on acquisitions in Germany, the inhouse lab of Sydney Adventist Hospital and a joint venture with the University College London Hospital.
It would be interesting to see if EBITDA is actually sliding backwards this year if all these deals were excluded.
In the face of these earnings uncertainties and Sonic's relatively high P/E even after today's price correction, I think investors would be better off switching to other stocks in this sector like blood products maker CSL Limited (ASX: CSL).
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