Dr Lal PathLabs: Diagnostics at a premium valuations

While brand name, network and strong cash flows are positives, pricing leaves little room for near-term gains

The oldest diagnostic chain in the country, Dr Lal PathLabs, is seeking to raise about Rs 450 crore from its initial public offering (IPO). The issue is an offer for sale, which will see a part exit of existing private equity investors, besides stake sale by promoters, and will constitute about 14 per cent of the post-issue capital of the company.

In other words, all the funds raised through the IPO will flow to the promoters. While that should not dishearten investors, given the strong position and fundamentals of the company, the IPO valuations the company is seeking leaves little room for gains in the near-term.

The company offers routine and specialised testing services and is looking to scale up its operations by setting up its second reference laboratory in Kolkata (currently its only reference laboratory is in Delhi) and improve its presence in North India.

While the diagnostic chain has a pan-India presence with 172 clinical labs and over 1,500 patient service centres, a large chunk of it is skewed to North India, which gets the company about 72 per cent of its revenues.

The company whose overall revenues over the FY13-15 period have grown at 20 per cent annually and its operating profit by 25 per cent is looking at volumes to improve its top line as well as margins. This is because of the limited effectiveness of the remaining two levers of revenue growth— improving case mix and pricing.

While business mix and improving realisations are constrained due to similar business models of its rivals, the diagnostic business lacks pricing power as the competition is severe both from organised and standalone centres, which have mushroomed all over the country.

The company's focus will thus be operating leverage namely, achieving economies of scale with large laboratories which service requests from retail (walk-ins), hospitals and smaller clinical labs.

What the management of Dr Lal PathLabs is hoping to gain from is the under-penetrated healthcare market and the potential for growth of diagnostic services. CRISIL expects the diagnostics space to grow at annual rate of 16-17 per cent between FY15 and FY18 to reach Rs 60,000 crore.

Given the tilt towards organised or branded players (half of the current market is run by standalone centres) who have the scale, the expertise and the reach, the company seeks to capture a bigger pie through both organic route as well as acquisitions. Large pan-India chains like Dr Lal, SRL and Metropolis form only six per cent of the overall diagnostics space.

Dr Lal has been able to maintain steady margins and given profitable growth generates operational cash flow Rs 100 crore annually with capex of about Rs 30 crore which is funded from internal accruals. The company follows an asset-light model given its network of franchisees and the pay-per-use deals for equipment helps in keeping costs/capital requirement under check. Going ahead, its depth of network, brand name and increasing share of branded players should help the company grow faster than the industry.

While there is no denying that the company’s financials are ahead of bigger peers such as SRL (valued at Rs 3,400 crore vs Dr Lal’s Rs 4,500 crore), at Rs 540, the company is asking for valuations of 40 times its FY16 estimated earnings and 34 times its FY17 estimates.

While analysts at Motilal Oswal say the valuations of Dr Lal on an enterprise value/Ebidta basis for FY15 numbers at 27 times are in line with the recent transaction of another major diagnostic chain Metropolis, the company (Dr Lal) should have left something on the table for investors.

Even after considering the Rs 15 per share discount for retail investors, there might not be much gains in the short term. So, only those investors with a period of at least two-three years can look at subscribing to the issue.