Will The Stellar Run Of Diagnostic Stocks Continue?

Dr Lal Pathlabs Ltd. and Metropolis Healthcare Ltd. are trading at record levels despite their costliest valuations in the sector, surging 43 percent and 49 percent in 2019. That compares with a 9 percent decline in the Nifty Pharma Index.

A rising trend for evidence-based treatments, higher incomes and awareness, and a shift to an organised market will continue to drive secular volume growth for pathology companies, Shyam Srinivasan, an analyst at Goldman Sachs, wrote in a report. Investors prefer the stocks because of an asset-light franchise expansion model that doesn’t not involve capital expenditure, he said.

The optimism about diagnostic businesses contrasts with the rest of the healthcare market. While India’s generic drugmakers have seen growth slow down as competition took away pricing power in the U.S., one of their biggest markets, shrinking margins. Hospital chains too have been weighed down by high capex and the government’s pricing caps.

$9-Billion Fragmented Market

The pathology business in India is fragmented with unorganised laboratories contributing 85-90 percent, according to reports from brokerages including Kotak Securities and Ambit Capital. The rest is shared by Dr Lal Pathlabs, followed by SRL Diagnostics, unlisted unit of Fortis Healthcare Ltd.; Metropolis Healthcare; and Thyrocare Technologies Ltd.

Kotak Securities pegs the market at $9 billion, expecting it to expand at an annualised rate 13-14 percent in the next five years. Credit Suisse forecasts a growth of 10-11 percent.

The diagnostic chains have a network of laboratories that either directly service patients or provide backend services to hospitals or smaller laboratories. But standalone laboratories corner 47 percent market share, according to Kotak Securities, as entry barriers have been low.

Fragmentation and competition slowed growth for the four large laboratory operators for the third straight year in 2018-19. And they are looking to expand into tier 2 and 3 cities.

Smaller cities are seeing growth due to emergence of tertiary-care hospitals, Ameera Shah, managing director of Metropolis Health, told BloombergQuint. The market continues to be large as less than 6 percent of Indians have been diagnosed, and insurance penetration will drive growth, he said.

A Velumani, founder and CEO of Thyrocare Technologies Ltd., said the pace of growth is faster in tier 2 cities. Om Manchanda, chief executive officer at Dr Lal Pathlabs, said in an analyst call after the first-quarter earnings that the chain will expand into tier 2 and 3 cities to reduce dependence on the National Capital Region market.

While shares of Dr Lal Pathlabs and Metropolitan Healthcare surged this year, Thyrocare Technologies tumbled more than 14 percent.

Peers are growing faster and have better valuations because a larger share of their revenue comes from business-to-consumer market by providing services directly to patients. But Thyrocare, he said, will continue to focus on business-to-business segment by testing samples for hospitals and smaller laboratories. That continues to drive better margins for it.

Metropolis expects direct services to patients and specialised tests to drive growth, while Dr Lal Pathlabs is banking on both consumer and business-focused segments.

Online Challenge

While a fragmented market will remain a challenge, all diagnostic chains expect growing insurance penetration and minimum standards to drive the shift towards the organised players. And Velumani said the worst of the disruption caused by aggressive pricing by private equity-backed players is over.

Anubhav Aggarwal, analyst at Credit Suisse, however, cautioned that entry barriers remain low and a ramp-up by online pharmacies, which also offer diagnostic laboratories, could impact growth. Goldman Sachs quoted Avinash Phadke, head of SRL Avinash Phadke Labs as saying that the likes of Practo, 1MG or Pharmeasy are a serious threat to pathology chains as they operate in a part of the market where customers decide the service provider based on competitive pricing.

Still, Chirag Talati, pharma analyst at Kotak Securities, expects organised chains to continue taking away market share from standalone labs, driven by increasing awareness for brands and a rise in specialised tests. And he expects larger players to continue trading at a premium to domestic pharma companies and hospital chains, aided by a steady volume growth, asset-light expansion and limited regulatory risks.

Analysts Expect Thyrocare To Bounce Bank

Given the stellar run of Dr Lal Pathlabs and Metropolis Healthcare, analysts don’t see them offering much upside. They are most bullish on Thyrocare though.