Diagnostic Chains: The Pandemic's Big Bet Is Proving To Be A Dud

Most pathology and radiology service providers have missed estimates so far. And analysts are flagging concerns about the limited growth visibility and high valuations.

Most of these stocks are trading at high multiples despite a sharp correction in their stock prices post-Covid, Rahul Jeewani, a pharma analyst at IIFL Securities, told BQ Prime. "While Dr Lal Pathlabs is trading at around 50x FY25 P/E, the others—Metropolis Healthcare, Thyrocare, and Vijaya Diagnostics—are in the range of 35-40x."

These are still relatively expensive compared to the rest of the pharmaceutical and healthcare companies, which trade at around 20–25 times their earnings.

Investors had bet that the pandemic-induced boost for diagnostic chains would sustain as Covid-19 increased awareness about healthcare. That expected growth has eluded the sector.

The base business (ex-Covid) growth for diagnostic players is currently 6-10% on a two- or three-year CAGR basis, Jeewani. That's below the pre-Covid trajectory of 13–14%.

According to Jeewani, the two- or three-year CAGR is:

• 9–10% for Dr Lal Pathlabs

• 5–6% for Metropolis Healthcare

• 4–5% for Thyrocare (non-Covid portfolio)

"There is limited visibility of when growth will pick up and return to the original 13–14% pre-covid CAGR levels."

By comparison, he said, India's domestically produced drugs business and hospitals continue to grow at 14–15% and are trading at reasonable valuations. Diagnostics chains were his last preference within the pharma sector..

Vishal Manchanda, a pharma analyst with Systematix, said growth and consolidation haven't met expectations. This, coupled with fears of competition from digital and unorganised players, has weakened investor sentiment, he said.

"The PE multiples at which the stocks are trading indicate overvaluation, and the players seem to be struggling to scale up in the current competitive landscape," he said. With most pathology tests being highly commoditised, it is difficult to see how operating leverage and profitability will remain under pressure even if revenue expands, he said.

A large part of business for diagnostic chains comes from occupational health safety check-ups, which is dominated by the unorganised sector, according to Manchanda. Organised players are still not able to deliver competitive pricing and the last-mile execution required for tying up with businesses providing these services, he said. Doctor penetration, too, seems to be slow, with most tie-ups still lying with the unorganised sector.

In the diagnostic space, Manchanda sees potential in specialised diagnostic providers that would provide oncology and genetic testing services requiring large investments versus the regular tests currently provided by the diagnostic players. Although there are no listed players in this space so far, he believes that the area holds merit due to the niche nature of services and high entry barriers resulting from the need for high investment, reducing competition.

Other analysts are still betting on the segment. The third quarter is known to be historically weak for diagnostic players. Sriraam Rathi, an India analyst for pharma and healthcare at BNP Paribas, told BQ Prime.

The research firm has a 'buy' recommendation on Dr Lal Pathlabs and Metropolis Healthcare.

The companies, he said, continue to operate at low costs, and the competition-led price sensitivity is only limited to preventive wellness packages. Metropolis and Dr Lal Pathlabs have only 12% and 18% exposure to this price-sensitive category, respectively.

He expects the overall diagnostic sector to grow at 12–13% in FY24, in line with hospitals. "The current valuation is lower than pre-Covid levels and presents a good opportunity to buy," he said.

Aditya Khemka, fund manager at InCred PMS Healthcare, too, sees growth prospects, ranking the segment as his second-best pick. He, however, prefers companies that see "revenue growth through volumes over price."

InCred has exposure to Thyrocare and Krsnaa Diagnostics.

Because of discounted diagnostic platforms, companies may find it difficult to grow through price hikes, Khemka said.

Manchanda sees potential for specialised diagnostic providers that provide oncology and genetic testing services. Although there are no listed players in this market, he said, the niche service areas hold merit because the high investment requirement reduces competition.

Rathi said Dr Lal Pathlabs' ex-Covid margin was impacted due to the Subarban acquisition and one-time costs related to the new reference lab. He expects the company to return to its 12–14% growth trajectory in FY24. Also, the management has hinted at a price increase that may further aid growth and margin, he said.

While Thyrocare's profitability in the third quarter missed estimates by 44%, that's not comparable year-on-year as salary and ESOP costs due to professional management have risen this year. Also, the nine-month non-Covid growth is strong at 23% year-on-year. Rathi sees no hurdle for the company to continue growing in the high teens to low 20s.

Metropolis Healthcare and Vijaya Diagnostic are yet to announce their quarterly numbers.