The three listed diagnostic labs have seen a sharp rally of around 15 per cent since May-2023 when their 4QFY23 results were announced. The stocks were facing headwinds in the last year as Covid volumes dissipated and regular business from non-Covid was yet to drive volume growth. The stiff competition from predominantly online players (Tata 1mg, PharmEasy) also played their part in these stocks’ diminishing attractiveness. After the recent rally, Dr Lal PathLabs and Metropolis shares are up by around 2 to 3 per cent in the last year while Thyrocare is still down 17 per cent, compared to Nifty 50’s 20 per cent rally in the last year.
Milder competitive threat from online players whose spending power has been slashed was a supporting factor in the price rally. But the primary reason was the price hikes announced by the three established players. This allayed fears of price-based competition in the industry eating into growth prospects and the strength of the diagnostics players to pass on price hikes. While this development is a positive, we contextualise price hikes against overall growth, ongoing competition and industry valuations amidst much-anticipated consolidation in favour of organised players.
Price-based growth was largely absent in the highly competitive industry even prior to Covid. For instance, Dr Lal Path’s price per sample declined at 4 per cent CAGR from FY17 to FY20. With Covid testing taking over volumes in the next two years, sample pricing (given high price for Covid tests) grew at 7 per cent CAGR for FY20-22 before returning to pre-Covid levels in FY23 at 12 per cent y-o-y decline.
In such a scenario, leading operators Dr Lal PathLabs and Metropolis announced 2-4 per cent price hikes in specialised tests and flat prices in other routine tests in Q4FY23. Specialised test menus account for around 40-50 per cent of the volumes and should add incremental 1.5-2.5 per cent price growth to overall FY24 revenue for the companies. The price hikes were long overdue, despite competitive pressures, as the cost of operations including reagents, lab consumables and employee costs had increased, especially post-Covid.
But price-based growth may not be a sustainable growth driver, given the competitive intensity. The industry is in a long-drawn competition for market share, from unorganised to organised (15 per cent of total market), and between established organised players, online aggregators, and new entrants. With EBITDA margins at 25-28 per cent for the industry and a long tail of competitive intensity yet to unfold, we expect further hikes to be low-impact events. With the recent hikes factored into Q4FY23 operations, Dr Lal Path labs does not expect significant price-based growth in FY24.
Volume and acquisitions
Volume growth by way of adding new clinical labs or pick up points and redirecting samples to a central reference/clinical lab has been the growth driver for the industry. Metropolis expects to add 15-20 per cent more labs in FY24 followed by Dr Lal Path which expects to add 4-5 per cent to labs and focus more on pick-up-points expansion alongside.
Preventive health tests or bundles are also adding to volume growth. Compared to one/two tests per patient in a prescription model, these bundles can add 4-5 tests per patient thereby increasing the volumes per patient. Dr Lal PathLabs generates close to 22 per cent of Q4FY23 revenues from such bundles. Overall volume growth will be the main growth driver for these companies driven by physical expansion, expansion of test menu and bundled tests.
Acquisition of smaller regional labs has been the other prominent growth driver for these companies which also aided in geographic expansion of these companies. But current valuations, listed or not, will be an impediment to additions. After Covid disruption and return to normal business and with prospects of higher prices, higher valuations will hinder acquisition sprees.
The companies themselves are trading at a higher valuation of 57 times FY24 earnings for Dr Lal PathLabs, 47 times, and 29 times for Metropolis and Thyrocare respectively. While volume growth will sustain and pricing may not be as high a drag on growth as expected, the high valuations may not be fully justified by overall growth prospects. We recommended investors sell Dr. Lal Path Labs last year and we continue to maintain the same view.