The coronavirus pandemic and other trends in the healthcare segment seem to have put the diagnostics sector in a sweet spot, with brokerage firms expecting double-digit gains for these companies in the long term.
"The Indian diagnostics industry offers consistent, long-term growth potential of 11-12 percent and national diagnostic chains would continue to outperform the industry growth," brokerage firm IIFL Securities said in a note.
Increasing health awareness post-COVID-19, specialised and home collection segment would continue to aid realisations, it said.
Larger players from the sector are positioned to gain more than the smaller ones and fragmented market share is an opportunity for larger players to expand market share.
"While pathology business requires limited capex and offers high free-cash-flow (FCF) with a median return on invested capital (RoIC) of 45-50 percent, the fragmented market structure (top 20 players have only about 17 percent market share) provides an opportunity to larger players to act as consolidators and gain share from unorganised standalone labs," IIFL said.
"With an increasing patient preference for larger diagnostic players, COVID-19 testing has enhanced brand awareness for national chains and has allowed them to make further in-roads into non-core markets through network expansion."
IIFL said healthcare would remain a key focus area post-COVID-19 and likely drive higher specialised, preventing and wellness testing, and home collections, which have better per patient realisations and will aid in driving growth in the number of tests processed per patient and overall margins.
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Buy call on Metropolis, Thyrocare
IIFL Securities has "buy" calls on Metropolis Healthcare (target price: Rs 3,050) and Thyrocare Tech (target price: Rs 1,250) and upgraded Dr Lal PathLabs to an "add" (target price: Rs 3,100).
Metropolis’ asset-light model of network expansion has enabled it to create a strong business-to-consumer (B2C) franchise within its focus cities, with the company’s overall B2C revenue growing 20 percent CAGR over FY16-20, IIFL said.
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Metropolis is well-positioned to sustain its B2C growth momentum as its young service network provides sufficient headroom for growth, which will be complemented by the company’s aggressive intent on larger acquisitions and efforts to expand in noncore markets, IIFL said.
Metropolis would also likely lead the consolidation wave in the industry, as the recent Hitech deal demonstrated its aggressive appetite for inorganic growth, it said. Metropolis can significantly outperform Dr Lal PathLabs on the overall revenue growth trajectory.
"We expect 20 percent EPS CAGR for Metropolis over FY21-23 and believe the stock provides an attractive entry point to play the long-term growth narrative of the diagnostics industry," IIFL said.
Thyrocare’s strong business-to-business (B2B) model and industry leadership in wellness testing allows it to process high volumes of routine tests which, along with lower sample acquisition costs, drive significant operational efficiencies and 40 percent margins for Thyrocare, IIFL said.
The brokerage firm expects a 12 percent revenue and 23 percent EPS CAGR for Thyrocare over FY21-23.
"While Thyrocare trades at 30-50 percent discount to its B2C peers owing to higher pricing pressures in B2B/wellness segment, Thyrocare’s unparalleled focus on operating efficiencies enables it to offset such pricing impact," IIFL said.
For Dr Lal PathLabs, IIFL said that most of its acquisitions have been meaningfully smaller as compared to those of Metropolis.
"We believe scaleup in non-core markets and aggressive intent on M&A is critical for the company to maintain long-term growth. We forecast 15 percent EPS CAGR for Dr Lal over FY21-23 and upgrade our rating to add given strong near-term momentum expected in the COVID business," IIFL said.
"With non-COVID volumes normalising and sustained momentum in COVID business, we expect the three national chains to report strong organic revenue growth of 17-25 percent in FY22," it said.
Valuation not a concern
As per IIFL, the listed Indian diagnostic companies —Dr Lal, Metropolis and Thyrocare—trade at median valuations of about 49 times FY23 PER (price-earnings ratio).
The brokerage firm expects valuations for these chains to sustain on the back of their long-term volume-led growth potential, continued gains in market share from unorganised standalone labs, limited capex and working capital investments, strong FCF generation and high RoIC post-tax.
The financial and operating metrics for the national chains are comparable to that of FMCG and consumer discretionary stocks and the B2C segment also provides long-term durability to diagnostics business through consumer brand building akin to FMCG. Consequently, the diagnostic companies trade at similar valuations to many of the FMCG and consumer discretionary stocks, IIFL said.
"Given their small revenue base and current low market shares, diagnostic companies have enough headroom for growth and their earnings growth profile will be substantially higher than some of these FMCG and consumer discretionary stocks (such as Asian Paints, Pidilite, HUL, Dabur, Britannia, Marico)," IIFL said.
Potential price caps imposed by the government on essential tests are a key risk for the sector.
"Given the Indian government’s focus on reducing out-of-pocket health expenditure, there are industry concerns that some of the routine diagnostic tests (haematology, biochemistry, vector-borne diseases) included under the NEDL (National Essential Diagnostics List) could be brought under the purview of price controls," IIFL said.
The regulatory authorities over the past few years have implemented price caps on cardiac stents, knee implants, various cardiac and diabetes medicines, which were not part of NLEM (National List of Essential Medicines), and trade margin caps on select oncology medicines.
"If price caps are implemented, then players such as DR Lal and SRL will be impacted more as they derive 35-38 percent of their overall revenues from routine tests as compared to Metropolis, which derives 27 percent of its total revenue from routine tests."
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