Pathology stocks derate back to pre-Covid levels: A buy or value trap?

Pathology was one of those industries that was supercharged by Covid. But gone are the days of lining up for a PCR test. And with that, goes the valuations of ASX-listed pathology names like Sonic Healthcare (ASX: SHL), Healius (ASX: HLS) and Australian Clinical Labs (ASX: ACL).

In fact, all three companies are trading back to, if not below, pre-Covid levels.

Sonic Healthcare (black), Healius (red) and Australian Clinical Labs (green)

For many months now, the market's main focus for pathology companies has been how well their regular business can make up for the drop in covid tests.

In this article, I'll take a look at recent trading updates from the companies, Goldman's coverage on pathology stocks, and a fundie's view from a recent episode of Livewire's Buy Hold Sell.

Trading updates: Sonic and Healius

Sonic's trading update on 17 November 2022 reiterated deflating demand for Covid and a slump in margins for the 4 months to October 2022.

• Covid-19 revenue of $280m, down 65% compared to a year ago

• Base business revenue of $2.45bn, up 6.7%

• EBITDA of $621m, down 37.3%

• EBITDA margins fell 930 bps to 22.8% (up 200 bps compared to pre-Covid)

Note that Sonic Healthcare currently trades at a price-to-earnings of just 9.65x FY22 earnings. But what happens when FY23 rolls around?

The narrative was similar for Healius, which reported its interim half-year results on 7 February.

• BAU revenue of $825m, up 3.2% compared to the prior period

• Covid revenue of $64.4m, down 88.1%

• Total revenue of $889m, down 33.6%

• EBITDA of $182m, down 64.4%

Goldman Sachs: Headwinds continue

"For an industry characterised by high fixed cost leverage, the underwhelming recovery in base business is driving a challenging margin dynamic," Goldman said in a note on Thursday.

"Whilst there have been signs of modest [market] share gains for both SHL and ACL in their respective markets, they appear well below the level required to offset the headwinds in market volumes."

For Sonic, Goldman expects a "more challenging operating backdrop given expected decline in Covid testing volumes/elongated recovery in base business," which will in turn weigh on margins. The note retained a SELL rating with a $29.00 target price. Sonic shares opened at $29.26 on Thursday.

Healius was NEUTRAL rated with a $2.90 target price, which represents a small upside to its current price of $2.80.

While Australia Clinical Labs was downgraded to NEUTRAL from Outperform with a $3.40 target price. Surprisingly, this represents a 13% upside from Thursday's open of $2.98.

A fundie's short: Healius

Speaking to Livewire's Ally Selby, Totus Capital's Ben McGarry warned there could be pain on the horizon for Australian Clinical Labs (ACL).

ACL was formerly owned by Australian private equity firm Crescent Capital, which bought the company for $105m back in 2015. Instead of selling the business for an outright profit, they decided to list it in the heat of Covid - on 14 May 2021.

McGarry's short thesis was based around the fact that Covid testing volumes have collapsed and the business has yet to reveal the impact that's had on margins.

"We think there's reasonable downside for margins as we've seen with Healius," he said.

Crescent Capital also remains an ongoing risk as they "still need to exit." According to Market Index data, the PE firm still has a 17.1% stake in the business.

ACL's top 5 shareholders (Source: Market Index)