Top pathology providers are significantly undervalued. Shares in narrow-moat Sonic Healthcare (ASX:SHL), no-moat Healius (ASX:HLS), and no-moat Australian Clinical Labs (ASX:ACL) have fallen by roughly 60% on average since the beginning of 2022 and now trade at an average 35% discount to our fair value estimates of $32.00, $3.00, and $3.50, respectively.

Within the healthcare sector, pathology stocks look attractive when compared to the average ASX healthcare sector share under our coverage which is trading at a 11% premium to our fair value.

Elevated higher-margin coronavirus testing was never going to last forever, but it appears pathology providers have fallen out of favour with the market, with margins now below prepandemic levels. While the market doubts a return to prepandemic profitability, we see several reasons to expect a stronger recovery than market consensus.

What next for industry margins?

The market appears skeptical about any meaningful profitability improvement, with the past year particularly challenging. Margins have deteriorated with elevated cost inflation, operating deleverage as higher-margin coronavirus testing stops, limited pricing power to offset rising costs for Medicare items, and a slow recovery in general practitioner referrals.

We see industry margins recovering through increased pricing, stabilizing costs, and scale benefits. Most revenue in pathology is bulk-billed and earned via direct reimbursement from the public health Medicare system at fixed fee-per-service rates. At almost 90%, pathology has the highest rate of bulk-billing in any health sector, and as such, pricing power to offset inflationary pressures is constrained.

Increased pricing

Nonetheless, pathology providers are increasing fees for services not bulk-billed, which we estimate at over 10% of revenue. Also, an industry mix-shift to higher-priced testing, such as more complex gene-based and veterinary testing, is driving average fee increases. This trend is largely from a growing specialist referral base and the improved mix supports margin expansion.

In addition, the industry is lobbying for indexation to resume for all pathology items funded by Medicare, which we ascribe a 50% likelihood in our valuations. If indexation is applied at the inflation rate over our 10-year forecast period, on average, we estimate roughly 1% upside to operating margins and 10% upside to our fair value estimates.

If fees stay frozen, we estimate a commensurate downside to both metrics. The sector is grappling with an immense cost burden. Despite rapid cost inflation for pathology testing, Medicare rebate indexation has been frozen for 24 years. Between July 2008 and November 2014, the level of Medicare funding for pathology services was also cut four times by 12.5% in total.

The industry has historically relied on volume growth, efficiency gains, and low-cost inflation to remain profitable, but this is currently challenging, particularly at a collection center level, given depressed GP referrals, fewer remaining options for productivity improvements, and recent high-cost inflation.

Stabilising costs

We expect stabilising direct costs to enable margin expansion. Sonic, Healius, and Australian Clinical Labs all recorded significantly weaker first-half fiscal 2024 margins than prepandemic levels. This is largely from inflationary pressures, with pathology providers susceptible to inflation as staffing and rental expenses make up most costs.

However, the rate of inflation declined to 3.6% in the March 2024 quarter from 7.8% in the December 2022 quarter. In addition, all three companies are still resizing labor and infrastructure costs with coronavirus testing ceasing. We estimate all three are bearing additional costs for site closures and severance payments. But margins stand to benefit as networks are optimized and as less profitable centers close.

Scale benefits

We see scale benefits from improved operating leverage and digital initiatives supporting margin expansion. Pathology has a high fixed cost of operation, and margins are thus sensitive to volume growth which drive lower cost-per-test outcomes. By maximizing throughput across a network of laboratories and collection centers, scale efficiencies are realized. As underlying testing volumes increase, we anticipate operating leverage to boost margins in the long term.

With volumes the main earnings driver, productivity improvements are key to throughput and operational performance. Pathology is a technologically driven service, and all players are balancing the competing aims of managing costs and investing in digitisation. We expect digital initiatives to drive further productivity, efficiency improvements, and cost reductions by optimizing staff, increasing automation, and reducing administrative paperwork and manual, repetitive processes.

Opportunities for revenue growth

Underlying Australian pathology volume growth drivers are solid and underpin our long-term revenue growth forecasts. Growing demand for diagnostic testing is largely defensive and underpinned by population growth, aging demographics, higher incidence of diseases, wider adoption, and a higher number of tests available.

We forecast a five-year Australian pathology industry revenue compounded annual growth rate (“CAGR”) of roughly 5% to fiscal 2028. This is made up of roughly 3.5% volume growth due to population factors and volume growth per capita and 1.5% average fee increases, partly due to a mix shift to more complex tests such as veterinary and gene testing, but mostly assuming a 50% likelihood of indexation resuming at an average rate of 3% over our explicit 10-year forecast period.

Industry volume and price CAGRs were 3.7% and 0.8%, respectively, in the seven years to fiscal 2019, resulting in an Australian pathology industry revenue CAGR of roughly 4.5% for this period. The Australian population is aging with increasing life expectancies and declining fertility rates. Those aged 65 and over have grown at a 3.3% CAGR for the past 10 years versus 1.0% for people aged under 65. Meanwhile, in the past 30 years, life expectancy has grown by at least five years, and the age-standardized incidence rate for cancer has steadily grown to 0.5% from 0.4%.

Industry leaders in a strong position

We think the three major publicly listed providers will continue to dominate the Australian pathology market. Together, they have a combined market share of over 80% in both Australian Approved Collection Centres and revenue. As of April 2024, Sonic, Healius, and Australian Clinical held 31%, 30%, and 20%, respectively.

Sonic trades at the smallest discount to fair value at approximately 16% however we believe the firm benefits from a narrow economic moat due to cost advantages derived from scale. Scale matters in pathology as they operate a hub and spoke model whereby collection centers, mostly either in hospitals or near doctors’ rooms, feed samples through to large, centralized labs for processing. Sonic’s higher testing volumes result in a lower cost per test as labor, equipment, rent, and overhead costs are all leveraged.

Sonic’s pathology earnings before interest and taxes (“EBIT”) margins have been higher than its closest two competitors by an average of 5 percentage points over the last four years, and we expect Sonic to continue to lead the industry in profitability and maintain its scale advantage.

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