THE SMART INVESTOR: Regulatory worries for diagnostic players
While the organised sector is gaining market share, there are near-term challenges for Dr Lal Pathlabs and Thyrocare
While the organised sector is gaining market share, there are near-term challenges for Dr Lal PathLabs and Thyrocare. RAM PRASAD SAHU writes
Amuted June quarter performance on the back of pricing pressures coupled with worries on regulatory action could hamper the near-term outlook for diagnostic companies. The largest listed diagnostic players, Dr Lal Pathlabs and Thyrocare Technologies have indicated that competitive intensity in the sector is high. Given the focus on higher volumes, some of the pressures on pricing could continue to hamper the profitability of the companies.
Disappointing June quarter
This was reflected in the June quarter performance both on volumes and margins. Thyrocare, for example, reported 11 per cent sales growth which was significantly below analyst estimates. In fact, sales growth from diagnostic testing services, which accounts for over 90 per cent of revenue, grew a measly 9.5 per cent, its lowest in at least nine quarters. Analysts at Edelweiss Research say heightened competition from smaller regional players who gained market share and a voluntary cut of 7 per cent by the company were responsible for the muted show.
Similarly for Dr Lal, though the sales growth was better at 17 per cent, it was lower than analyst estimates. Dr Lal is focussing on driving operating leverage and a large part of the June quarter performance was led by volumes with the company going slow on price increases. There was also pressure at the operating level given higher reagent costs and increased payout to collection centres. The increase in reagent costs was due to higher rates of goods and services tax.
The biggest worry, however, is any government intervention or regulatory framework at the Centre or states, which calls for pricing caps on various diagnostic tests. Just like the list of essential medicines whose prices are capped, analysts believe that the government over the next couple of months is expected to announce a set of basic diagnostic tests at an affordable cost so that it can be within reach of consumers. Any adverse pricing mechanism will eat into the profits of diagnostics players. On this front, managements of the companies indicated that while testing is a volume game with a minimal number of labs, servicing (collection centres) is a big part of the overall costs and it will difficult to contain or get leverage on that regard.
The road ahead
In the near term, the Street will look at company-specific triggers. Given the slowdown, the Thyrocare management is looking at shifting focus back to business-to-business segment (B2B, 80 per cent of revenues), higher ad spends and promoting franchise model in imaging. A Velumani, CMD & CEO, Thyrocare says the company will adjust pricing downwards as long as the margins are north of 40 per cent. Growth matters more than profits, he added. The company ended Q1FY19 with operating profit margins of 42.4 per cent, up 90 basis points over the year-ago quarter. However, analysts at Spark Capital expect B2B growth to taper given the less sticky nature of the business, competition from regional chains and pricing pressures.
For Dr Lal, growth is expected to come from higher volumes with expansion across the country through franchisees/own centres and market share gains from unorganised players. Om Manchanda, CEO of Dr Lal, says: “Our primary focus is topline growth led by strong volumes.”
Higher volumes, according to analysts at Nomura, would allow the company to have bargaining power with reagent suppliers and thus keep costs down.
However, in the long term, most analysts are bullish about the sector’s prospects given that 80 per cent of the sector is still unorganised. With the organised sector estimated to grow at 400 basis points higher than the overall sector at about 19 per cent, expect the listed players in this space to gain market share. The trade-off would be in the volumes and market share versus margins.
As of now, most analysts prefer Dr Lal’s to do better than Thyrocare, given the focus on branding, expansion and direct reach (business-to-customer) to doctors and customers. The valuations for the company at 33 times its FY19 earnings estimates are, however, stiff and a correction will be an opportune time to add the stock.