Multiple headwinds could act as margin tourniquet for diagnostics

Competitive pressures, valuations cap gains from current levels

After a mixed performance in the July-september quarter (second quarter, or Q2) of 2022-23 (FY23), listed players in the diagnostic health care space could witness near-term headwinds due to competitive pressures, a seasonally weak December quarter, and higher valuations. Except for Vijaya Diagnostic Centre, which has been flat since the start of the month, other listed players have seen a decline.

Dr Lal Pathlabs and Thyrocare Technologies are down 4-6 per cent, while Metropolis Healthcare has shed 18 per cent during this period.

The Q2 results of the largest player — Dr Lal Pathlabs — while delivering on the margin front, lagged behind estimates as far as non-covid business was concerned. On a higher base, non-covid organic growth came in at 6.5 per cent, compared with the year-ago quarter. This is lower than the three-year annual revenue growth of 9.2 per cent.

Analysts Rahul Jeewani and Punit Pujara of IIFL Research point out that Dr Lal Pathlabs’ execution remains strong, but its non-covid organic revenue is yet to revert to the pre-covid growth trajectory of mid-teens. Growth in the highly-penetrated metro markets remains lower, in view of the pent-up demand witnessed after Covid subsiding, they add.

Operating profit margins at just under 27 per cent was down 150 basis points (bps), compared with the year-ago quarter due to lower Covid proportion to revenue. On a sequential basis, however, margins were up 360 bps on lower employee costs and operating leverage, given the rise in volumes. Q2 is considered the strongest quarter in the diagnostic space.

Bhavesh Gandhi of YES Securities believes that 27 per cent margins appear to be peak for FY23 as the second half pis typically weaker in operating profit generation, compared with the first half.

The company is looking at improving the growth trajectory and offsetting the higher base by enhancing the presence/meeting demand from tier II/III towns and momentum in the Swasthfit (bundled offering) portfolio. Analysts expect these measures to bear fruit in the medium term, while the near term could get impacted from higher competition.

Metropolis Healthcare outperformed Dr Lal Pathlabs and met Street expectations with a non-covid revenue growth of 16 per cent. At ~288 crore, the company recorded its highest quarterly revenue in the quarter. While the wellness segment accounted for 12 per cent of revenue, the company is seeking to increase this share to a fifth of sales by catering to the affordable and premium segments.

The company’s operating profit margins at 26.3 per cent was down 350 bps year-on-year (YOY), but increased sequentially by 180 bps, beating Street estimates.

JM Financial Research expects recovery in the government business, better share from the wellness segment, and focused network expansion to aid growth, along with sustained operating profit margin trajectory. Government business (5-6 per cent of revenues), which is lumpy in nature, was down 40 per cent YOY in Q2 on a high base.

South India-based Vijaya Diagnostic Centre, too, beat Street estimates with an overall revenue growth of 10 per cent and 15 per cent sequentially. Its noncovid sales were up 15 per cent, aided by healthy pricing growth. Non-covid volumes rose 18 per cent quarter-onquarter (QOQ). Operating profit margins were up 216 bps on a sequential basis to 40.4 per cent and this, according to YES

Securities, was due to healthy volumes, coupled with operating leverage.

Nuvama Research says the company is among the few players to offer high growth visibility over the next two to three years due to expansion plans with radiology providing a competitive edge as it is insulated from competition.

Declining Covid-related revenues impacted the top line of Fortis Healthcare’s diagnostic business, which was down 15 per cent YOY. Excluding the Covid impact, revenues were up 3.8 per cent — lower than peers.

Margins improved 181 bps to 21.4 per cent QOQ. Nomura Research expects the company to improve its volumes, in light of the aggressive addition of collection centres.

Some brokerages believe there could be pressure on realisations and margins, taking into consideration the intense competition. While competitive pressures from smaller online players are expected to decline, taking into account a flailing funding activity, analysts Alankar Garude and Samitinjoy Basak of Kotak Institutional Equities remain cautious on any meaningful earnings boost to the listed incumbents.

“The real threat remains from the top-tier health technology (tech) platforms and large offline entrants. The pricing of incumbents, such as Metropolis, is 2-3x higher than the cheapest organised alternative across cities, even for specialised and semi-specialised tests. Apart from pricing, there can be additional pressure on margins due to higher tech and marketing spends,” observe analysts.

Anticipating multiple headwinds and a 16-33 per cent rally in the stock from September/october to their highs in November, investors should await volume/margin trends before considering the stocks.