Near-term outlook prescription for diagnostic firms looks fragile

Competitive pressures, high valuations limit upsides for listed lab chains

The January-March quarter (fourth quarter, or Q4) results of largest listed players in the diagnostic space do not portray a healthy picture. Competitive pressures, weak organic growth, integration challenges, and higher costs injured the operational performance of companies in the sector.

In light of the above, brokerages have slashed their earnings estimates for the three large listed players – Dr Lal PathLabs, Metropolis Healthcare, and Thyrocare Technologies – by 15-20 per cent. 

If Q4 results of 2021-22 are any indication, growth is going to be a near-term challenge for the sector.

The country’s largest listed player - Dr Lal PathLabs - reported a sequential decline in revenue, excluding Covid-driven business. The base business (like-for-like) was up 4.4 per cent over the year-ago quarter, compared to the two-year average annual growth under 14 per cent. 

Rahul Jeevani and Punit Pujara of IIFL Securities have downgraded the company’s 2022-23 (FY23)/2023-24 (FY24) earnings per share (EPS) by 15 per cent since non-Covid organic revenue growth of 9 per cent (three-year average growth) has remained below pre-Covid growth rates of 14-15 per cent.

The other key reasons for the downgrade are near-term margin pressures owing to normalisation of the Covid-led business, heightened competitive intensity in the market, and integration of lower-margin Suburban portfolio.

Revenue and earnings downgrades are also driven by accounting of Suburban’s revenue on a net basis, higher depreciation, and amortisation impact from the deal. 

Dr Lal PathLabs had acquired Sequoia-backed Suburban Diagnostics in October last year for an enterprise value in the range of Rs 925-1,150 crore. At the current price, Dr Lal PathLabs is trading at about 60x its FY23 earnings estimates. 

The quarter wasn’t good for Metropolis either. The company reported weak performance due to higher costs and adverse product mix. Overall revenue (up 5 per cent) was restrained due to lower Covid-propelled earnings, while core business (non-Covid) was impacted by the Omicron disruption in January.

Non-Covid revenue was passive, growing at 6.9 per cent, compared to Dr Lal PathLabs’12.3 per cent growth. The company’s operating profit margins at 24.5 per cent were 300 basis points short of brokerage assumptions and pegged back by higher employee expenses and other expenditure, given the investments in marketing, digitisation, and expansion. Net profit was down a sharp 35 per cent year-on-year. 

Analysts at Kotak Securities cut their EPS estimates (E) for FY23/24E by 18-20 per cent on account of sluggish pick-up in non-Covid sales and meaningful increase in employee, technology, and marketing costs. 

Alankar Garude and Samitinjoy Basak of the brokerage highlight an interesting trend that could influence leading players. They believe that pricing of incumbents is 2-4x higher than the cheapest organised alternative across cities, even for specialised and semi-specialised tests. “There can still be a further downside risk to our flattish long-term pricing assumptions for Metropolis and Dr Lal PathLabs if the new entrants stay aggressive beyond the next few quarters, thereby forcing the incumbents to offer higher discounts.”

Although the Metropolis stock has witnessed sharp correction from its 52-week high, at 36x its FY24 earnings estimates, “valuations are still not cheap”, say Garude and Basak of Kotak Securities.

In addition to private equity-funded players, pharmaceutical companies, such as Lupin and Mankind, have made an entry into this space, while hospital majors like Apollo Hospitals, Max Healthcare, and Aster DM Healthcare are expanding their presence across the country. Metropolis, however, believes that its focus on specialised tests/premium wellness will help it resist competition better. 

Another listed player Thyrocare Technologies could also feel the impact of languid revenue growth and margin pressures in the short term. The company’s non-Covid revenue grew 12 per cent sequentially on a weak base, translating into a four-year average growth of a low-key 3 per cent.

Margins, which fell below 30 per cent, compared with 35-40 per cent pre-Covid, came down on aggressive pricing, high fixed employee expenses, and other operational costs.

Analysts at Edelweiss Securities believe that execution after the acquisition of PharmEasy will be decisive. The stock (27x its FY23 earnings estimates) is under review by the brokerage.

ICICI Securities, however, has a ‘buy’ rating on the stock.