No-moat Healius (ASX: HLS) downgraded fiscal 2024 underlying earnings before interest, taxes, depreciation and amortisation (“EBITDA”) guidance by 5% at the midpoint to $345 million to $350 million. Improving pathology volumes over second-half fiscal 2024 have been offset by lower-than-expected average fees due to softness in general practitioner attendances and general inflationary pressures. However, Lumus Imaging and Agilex Biolabs have continued to perform well. The firm expects to better its $15 million net savings target for fiscal-year 2024.

We reduce our fiscal 2024 underlying earnings before interest and taxes (“EBIT”) forecast by 15% to $63 million, within management’s revised guidance range of $60 million to $65 million. However, our long-term estimates are broadly unchanged, including our midcycle EBIT margin forecast of 14%. Driven by Healius’ cost and revenue initiatives, our full-year fiscal 2024 EBIT forecast implies a significant improvement on first-half EBIT of $16 million.

Shares are materially undervalued against our unchanged $3.00 fair value estimate. Healius is well placed to service known underdiagnosis for routine healthcare services. Longer term, we anticipate increased operating leverage from higher volumes in the base businesses—and a continued focus on labor productivity and higher-value pathology tests—will more than offset current rent and wage inflation. We also anticipate margin expansion from network optimization, digital initiatives, and increases to out-of-pocket fees for non-Medicare items.

In addition, we expect average fees to increase on additional government funding. Roughly 50% of the pathology schedule by revenue is resuming indexation from July 1, 2025, and will help to offset inflationary pressures and is generally allocated for lower-margin labor-intensive diagnostics. Healius maintained its significant pathology market share at 24% in first-half fiscal 2024. We forecast Healius’ base pathology revenue to grow at a 5% compounded annual growth rate (“CAGR”) over our 10-year forecast period.

Business strategy and outlook

n 2018, the former Primary Healthcare rebranded itself as Healius to signify the strategic turnaround underway. Healius is looking to new sources of strategic growth as well as dealing with prior underinvestment in infrastructure.

There is much to fix in the business and we anticipate it to take a few years before significant margin improvements are made in the base pathology and imaging businesses. Healius selling its medical centers and Montserrat day hospitals to focus on redirecting capital toward infrastructure upgrades and its diagnostic businesses is viewed as a positive strategic step.

Improvement in systems is key to improving efficiency. Pathology is an increasingly technologically driven service and the company intends to invest in a new laboratory information system, automation, and digitization through to fiscal 2024. However, while we view the system upgrades as necessary to restore earnings growth, we don't see the company building an advantage over rival Sonic Healthcare, which is also continuously improving its systems.

Virtually all revenue is earned directly from Medicare via bulk-billing in the pathology and imaging segments. Healius’ organic volume growth in its core pathology segment has typically ranged between 3% and 5% and we forecast a similar rate over our 10-year forecast period. The volume growth is underpinned by population growth, aging demographics, higher incidence of diseases, and wider adoption of preventive diagnostics to manage healthcare costs.

In addition, the number of tests available is expanding. Increasing complexity of tests, such as veterinary and gene-based testing, is also resulting in average fee price increases. Pathology has a high fixed cost of operation and thus benefits from volume growth to drive lower cost-per-test outcomes. Higher testing volumes result in a lower cost-per-test as labor, equipment, leases, transportation, and overhead costs are all leveraged. In 2013, the Australian government placed a freeze on Medicare fee rates but resumed indexation in fiscal 2021 for diagnostic imaging.