Ask the analyst is your chance to ask questions about the ASX companies and industries that our analysts cover.

If you have a question, please email it to [email protected] and I will submit it to the analyst responsible. It may appear in a future edition of this series.

Today’s question

Today’s question came from Bruce, who wanted to know if the slump in Healius (ASX: HLS) shares last week was justified and where it stemmed from. Was it, Bruce asked, mostly a reaction to the CEO’s comments on how less government funding might impact the business’s profits? Or was it something else?

I put this question – and a couple of my own – to our healthcare analyst Shane Ponraj. What follows is a summary of our conversation. But first, a quick reminder of how Healius makes money and how things have been going recently.

How does Healius make money?

Healius is Australia's second largest pathology lab operator behind Sonic Healthcare. This segment will be responsible for essentially all of Healius’ earnings going forward because it recently sold its imaging business Lumus for just shy of $1 billion.

Healius and other pathology businesses benefitted from a spike in testing revenue during the pandemic. As life slowly returned to normal, the fall in profits from this kind of testing was compounded by a slower than expected recovery in more routine medical testing.

These dynamics, as well as the cost inflation many businesses have seen from 2022 onwards, are reflected in the company’s recent revenue and operating profit history.

healius-profits

Figure 1: Healius operating profits 2019-2024. Source: Morningstar

They have also been reflected by the performance of the company’s shares:

healius-shares

Figure 2: Healius share price since 2019. Source: Morningstar

In typical fashion, investors seemed to become overly confident in 2021 that Healius’ inflated pandemic-era revenue and profits would persist. By contrast, investors now seem to think that the company’s weaker profit margins will hang around.

The number one issue for Healius and its shares

It is the latter issue – struggling profitability in the pathology business – that Ponraj thinks is behind the latest share price stumble. Government funding is soon to be more supportive of the industry, with Indexation resuming for a portion of the pathology schedule from July 1, 2025.

In recent months, investors had grown hopeful that some of Healius’ cost pressures may have abated. However, management’s latest update suggests that they will continue to depress profits in the short term.

If we look a bit further ahead, though, is there room for optimism in this regard? Ponraj seems to think there is. Even though management’s latest update led him to cut his forecast for mid-cycle EBIT margins from 12% to 10%, that still leaves a lot of upside from recent levels of around 5%.

Three potential levers for margin improvement

Ponraj sees three major tailwinds for Healius’ profit margins in the coming years.

1. Volume growth leads to operating leverage

A lot of the costs of running a network of pathology labs (like labour, equipment, leases and transport overheads) are fixed. This means that a higher volume of tests generally results in lower costs on a per-test basis and therefore higher profits. This is one reason why profits were so high during Covid.

Ponraj thinks that continued population growth, aging demographics, higher incidence of diseases, and wider adoption of preventive diagnostics to manage healthcare costs should see the number of pathology tests taken in Australia rise. And, thanks to the operating leverage described above, help Healius achieve higher profit margins in time.

2. More complex tests (and more of them)

Increasing demand for more complex tests, such as those used by veterinary practices and gene-based testing, should also result in higher average prices per test. Similarly to increases in volume, this can result in higher profits as several costs remain the same regardless of which test is being carried out.

3. Investing in systems leads to greater efficiency

Healius is investing in new information systems, automation and digitisation to increase profits. Among other things, this includes the use of AI to speed up diagnosis times and save on labour costs. Ponraj thinks these system upgrades are necessary to restore earnings growth, but he doesn’t see them giving Healius an advantage over its rival Sonic Healthcare, which is making similar investments.

Margin improvement potential, but no moat

Even though Ponraj is confident that investors underestimate Healius’s profit margin recovery potential, he does not think it has what it takes to generate excess returns on capital it employs in the business for a sustained period of time.

Healius relies on Medicare bulk billing for 90%+ of its revenue. It is a price taker, not a price maker. It also does not, in Ponraj’s opinion, come close to having the scale needed to turn its revenue into outsized profits in the way that Sonic Healthcare (ASX: SHL) can.

As much as anything, this comes down to Healius owning collection centres in lower population areas that have far smaller test volumes per centre and therefore less operating leverage. This, in Ponraj’s view, is a key structural impediment to Healius reaching similar levels of profitability as its larger peer.

Will a more focused approach help?

Ponraj wasn’t exactly pleased with Healius’ sale of Lumus – he cut his Fair Value estimate by 17% after the deal was announced because he thought it could eventually deliver more earnings than the sale price. He also thought it had stronger profit margin potential than the core pathology business.

With net proceeds from the deal expected to be just over $800m, though, it raises the question of what Healius might do with the cash.

We’ve already touched on the fact that scale (more specifically, the volume of tests at each collection centre) makes a big difference to profits in the pathology business. This is an area where Healius has struggled versus Sonic, which has fewer centres but processes far more tests than Healius.

If Healius wants to improve its margins for the long run, then, might it use some of the Lumus proceeds for M&A? For now, Ponraj doesn't see this as a priority.

Management, he says, have stressed that they are focused on debt reduction, shareholder returns and improving the efficiency of their existing network. If anything, Healius seems more likely to close down less profitable collection centres than buy new ones.

Ponraj expects that most of the net proceeds will go towards debt repayment and a special dividend, in line with management’s comments on the deal. He thinks the remainder, perhaps $100m or so, will be kept to fund some of the investments outlined earlier.

All things considered, the shares continue to look cheap at around $1.40 versus Ponraj’s Fair Value estimate of $2.30. But, as with any stock or investment, they should only be considered as part of a broader investing strategy. Go here to read a four-step guide to forming yours.

If you have a question about an ASX stock or industry under our coverage, please email it to joseph.taylor@morningstar and it may feature in a future article.

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