Diagnosing Pathology Problems

By Ben Macnevin | More Articles by Ben Macnevin

Sonic Health Care (ASX: SHL) and Primary Health Care (ASX: PRY), the two largest pathology service providers in Australia, announced earnings downgrades in the past fortnight. While Primary cited “extreme” weather for the weakness, we think the underlying reason is far more structural in nature.

A pathology operator identifies diseases from patient samples, which is typically done in centralised laboratories. Prior to 2010, the number of Approved Collection Centres in Australia was capped, which meant that providers could service a local area with a certain level of control.

But when the Government deregulated the industry, it spurred a race among pathology providers to get as close to patients as possible, which in this case was setting up shop in Medical Centres. By 2014, the three main players at the time (being Sonic, Primary and Healthscope) comprised 80 per cent of the pathology market, but only held 8 per cent of Medical Centre revenue in Australia. Because the pathology providers did not control this channel, the Medical Centre owners have been able to increase rents in response to the substantial increase in demand.

Against this backdrop, the Government, which provides 85 per cent of funding to the market, will only support an industry growth rate of around 5 per cent. The Government has no qualms to reduce fees to ensure the ceiling is not exceeded.

With a rising cost base and capped market revenue, it’s unsurprising to see Sonic and Primary reduce earnings expectations. Indeed, the tightening economics caused Healthscope to withdraw from the market earlier this year, though its exit is unlikely to temper the growth ambitions of the larger competitors.

For what it’s worth, we prefer Sonic over Primary in this space, though we desire a lower price point before investing.