By any measure, the growth in productivity of Australian pathology has been spectacular. Rebates for pathology have, in real terms, fallen by roughly 60% since Medicare began in 1984.
Pathology differs significantly from most medical disciplines because it's capital intensive, rather than people intensive. Tests rely on costly automated equipment so there’s an incentive to centralise its use and ensure the machines never run idle. In other words, the industry has significant economies of scale.
Small, less well-funded pathologists often can’t afford to keep up with the latest technology, and so face a dire choice – slowly go out of business, or sell out to larger players. Of course, most pick the latter. Just two companies now dominate the industry: Sonic Healthcare (ASX: SHL), with a market share of 43%, and Primary Health Care (ASX: PRY), with 34%.
On average, Australians receive around five pathology tests a year, but it’s not the patients who are Sonic and Primary’s customers. Ultimately, the referring doctor acts as a gatekeeper.
Strict technical standards, however, mean there’s a forced consistency between services so the companies have only limited ability to compete on speed or more accurate results. Instead, they motivate a practice the old fashioned way – financial incentives.
Fortunately, pathology labs can’t legally throw money and kickbacks to doctors for referrals as this could compromise their duty to the patient.
However, most medium to large medical centres have a space, sometimes just a couple of square metres, dedicated to the collection of specimens which is leased by a pathology group. The rent a provider is willing to pay for these collection centres is an indirect financial incentive for a practice to be affiliated with a particular pathology network.
In 2010, the Government removed restrictions on the number of collection centres a pathology network could operate with the expectation that such a move would boost competition.
And it did ... sort of. Given the ongoing stream of referrals to be gained from the associated practice, competition for the collection centres became intense.
However, the two dominant players, Sonic and Primary, with their existing efficiency and cost advantages could afford much higher rents than smaller operators. Rents rose dramatically.
Those collection centre closets are now some of the most expensive real estate in the country, with many commanding thousands of dollars a week in rent per square metre.
The unintended consequence of deregulation and the land grab that followed was an even less competitive environment. The little guys have been progressively priced out of the market.
Even hospital operator Healthscope (ASX: HSO), once the third largest player, wrote off $120m from the value of its pathology assets in 2013 following the sale of its WA operations to Sonic in 2012. It hived off the rest of its Australian pathology business to a private equity group in July 2015.
Sonic and Primary have increased their combined market share by 12% since the collection centre restrictions were lifted. These two companies now control 77% of the pathology market, and that number is still rising.
Sonic’s Australian pathology division increased revenue 5.2% in the six months to December, whereas Primary increased pathology revenue 5.7%. The overall market grew just 1.9% according to Medicare data, implying both companies increased market share.
While the Australian pathology industry seems to be cascading towards a supermarket style duopoly, the future may not be as rosy as the past.
If Sonic and Primary play nice, they should be able to prevent further rent escalation now that the land grab is cooling down. Better still, they may be able to push for lower rents with their increased negotiating power.
However, medical practices are consolidating into large networks too – Primary is already a major player – so it’s a bit of an arms race.
Australian funding is an equally important risk. The Government's recently announced Mid-Year Economic and Fiscal Outlook included various Medicare fee cuts to lab and imaging services, which could strip $100m in revenue from the industry. With 80% of Sonic’s Australian income sourced from Medicare, its foreign earnings are an increasingly valuable buffer.
Sonic is our preferred company, with good management, moderate competitive advantages, and a well executed international expansion. Primary has many things going for it too, but with net debt of $1.1bn, rising interest rates and refinancing pose a significant risk, which outweighs the potential rewards.
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