SHL has been on a volatile journey throughout the pandemic, being a key beneficiary of Covid testing seeing record levels of earnings, which are now evaporating. The base business recovery is underway, however recent quarterly reports from global peers indicate potential softening of volume growth. Whilst SHL may have better operational efficiency, we struggle to justify the excessive premium valuation to the market in a falling and low growth earnings environment.
Key US peer operating income was down in the March 2023 quarter, with Quest Diagnostics and LabCorp reporting group EBIT falls of ~37% and ~38% respectively. Whilst the market is forecasting SHL’s 2H23 EBIT down ~43%, we believe there is potentially some downside risk given a significant tapering of Covid related earnings and margin impacts. This may be partly offset by the continued recovery of the base business, where peers are seeing high single-digit growth, in-line with SHL’s 1H23 base business growth of ~9%.
Costs are likely to remain high, with peers reporting still elevated wage costs. Whilst the SHL 1H23 result noted that labour costs as a % of revenue were back in-line with pre-Covid, we still see upside risk to wage growth given low unemployment levels. Further, we see continued inflationary headwinds for consumables as well as smaller costs such as transport and utilities, likely to impact margins.
SHL’s share price trades well in excess of its earnings, with the PER ratio reaching ~23x, almost 1 standard deviation above its 10-year average. Whilst SHL does have defensive qualities and a solid dividend policy, we believe the recent share price run warrants some profit-taking.
INVESTMENT VIEW
The recent run in SHL’s share price in our view has moved well ahead of any potential earnings upgrades. The elevated PER ratio, especially when compared to the market warrants some profit-taking. We struggle to justify the current valuation premium to the market, especially where forward EPS growth is likely to be in the mid-single digits over the next 3 years.
SHL does have some quality defensive characteristics, and the base business is seeing recovery momentum. We however believe the market has gotten ahead of itself, where we would look for a valuation de-rate in order to be more positive in the stock. We downgrade our rating from Hold to Sell based on valuation concerns and potential earnings risk.
Is FY23 Revenue at Risk?
At the 1H23 result, SHL noted that its January base business revenue was ~14% on the prior year, indicating a solid recovery. March quarterly reports from key US peers noted base business volumes growing by 8-11% and revenue growth of 11-12%, indicating some potential slowdown for SHL from its January trading highs over the remainder of the quarter.
2H22 base business revenue was ~$3.4bn and for our calculations we assume the continued growth rate of ~14%, driving 2H23 revenue of ~$3.9bn. We note however that given key peers reporting top-line growth for the entire quarter lower than SHL’s January update, there is downside risk to these numbers, especially where many governments are looking at spending less to curb inflation.
For Covid related revenues, in 1H23, SHL’s Covid revenue was just $0.4bn, down 72% from the peak of $1.3bn in 1H22. We expect 2H23 Covid revenue to be even smaller. Where 2H22 Covid revenue was $1.1bn, we conservatively expect an ~80% reduction, or just a ~$0.2bn contribution for 2H23.
Putting the numbers together, we can reach 2H23 revenue expectations of ~$4.1bn, which is in-line with consensus numbers. As mentioned above however, there is potential downside risk to the numbers if the base business does not perform as expected. There is also risk around the Covid related revenues, where many governments have begun cutting back rebates for PCR tests (including in Australia, where the Aged Care testing contract ended in April 2023).
Figure 1: 2H23e revenue may potentially be at risk
Do Costs Remain Elevated?
Recent comments from competitors admit that labour costs remain high and that there is still competition for talent. This can be explained by still low unemployment levels, as well as a general skilled staff shortage in pathology and radiology.
Whilst SHL at the 1H23 result revealed that its labour cost as a % of revenue is in-line with pre-Covid levels, this may be at risk given a still elevated wage inflation environment. Further, whilst consumable costs are falling in-line with falling inflation as supply chains normalise, the costs are likely to remain above pre-Covid levels. Other smaller incidental costs such as transport and utilities are still elevated, although are less material.
SHL has made 2 acquisitions recently in Germany, and whilst they are relatively immaterial to the overall group (<2% of group revenue), there are always costs associated with integration of new businesses. SHL also does not split out earnings and margins per geography, however we assume costs to be in-line with the rest of the business. Germany now represents ~20% of group revenue in 1H23.
Group EBIT margins clearly benefitted from government rebates from PCR testing, however these are again normalising. On a calendar year basis, SHL’s CY25 EBIT margins are forecast to sit ~0.7% higher than CY19 levels, which are significantly above key peers which are seeing ~0.2% movements. We believe these elevated figures might be at risk.
Figure 2: EBIT margins reverting lower post-Covid earnings
Figure 3: SHL EBIT margins forecast to sit ~1% above CY19 levels in CY25e
Valuation Considerations
Whilst we have looked at potential revenue and margin risk, the key thesis for our downgrade to Sell recommendation is largely on a valuation basis. SHL’s PER has risen materially in recent months, well ahead of earnings. We don’t believe there to be material upside risks to earnings given the cost inflationary environment and the evaporation of easy Covid earnings. SHL is now also trading well in excess of peers and the ASX200. We therefore view the current share price as a tactical opportunity to take profits and be patient for better opportunities to be more positive on SHL.
Figure 4: PER +1SD above history
Figure 5: SHL trading well above the market
Figure 6: SHL PER trading well above key US peers
There is a strong correlation between the forward EPS for SHL and the share price. Recently, the share price has run well in excess of the EPS trajectory, indicating that either the stock is too expensive, or earnings need to be upgraded. We believe there is limited upside risk for earnings and therefore see the recent stock rally as an opportunity to take profits.
Figure 7: SHL share price moving ahead of earnings
Investment View
SHL has performed strongly so far this calendar year to date, however this has predominantly been driven by an expansion of its multiple rather than backed by earnings upgrades. Covid revenues are likely to evaporate over the next year, with SHL needing to rely on base business growth again. We believe that volume growth is likely to be softer over the coming quarters as the business moves back to normal growth rates.
Costs are likely to remain elevated with unemployment remaining low and wage inflation remaining high. Consumables costs are coming down, however are likely to rebase above pre-pandemic levels. Other smaller costs such as transport and utilities are also remaining high.
With the valuation of SHL being far in excess of its long-term average and well above market multiples, we believe it is an opportunity to take profits in SHL, with a PER of 25x difficult to justify for low single digit EPS growth over the next 3-5 years. Whilst SHL does have quality characteristics and a solid dividend, as well as having potential upside catalyst risk with M&A from a strong balance sheet, we prefer to be patient and wait for a fairer multiple before becoming more positive on the stock.
Risks to Investment View
Increased government support for pathology/other testing programs sees additional revenue sources for SHL. Other favourable pricing outcomes from regulatory changes would improve sales and margins. M&A activity provides potential catalysts to drive market share and synergy gains. If the base business recovers above expectations, earnings may be upgraded leading to further share price outperformance. SHL may conduct additional capital return activities such as buybacks which may support the current share price.
Recommendations
We have downgraded our recommendation from Hold to Sell.
