Sonic and Australia's newest duopoly

Monopolies are great for investors and awful for customers. Anyone who has caught a cab to Sydney Airport, been slugged a 10% fee for paying by card and had to face the various horrors of T1, T2 or T3 – or, God forbid, the nightmare transfer between them – would know what we’re talking about.

The irony is appropriate and intended. Cabcharge and Sydney Airport deliver such fantastic returns because of their firm grasp on the customers’ wallets, be they airlines, passengers or cab drivers.

Our model portfolios, featuring the likes of Computershare, ASX and Woolworths, plus Sonic Healthcare for that matter, only reinforce the point. Monopolies are great businesses because you can squeeze the customer where it hurts and they generally won’t walk away.

What has this got to do with Sonic? Well, Australians are now facing the emergence of a new monopoly, or duopoly to be precise, in pathology services. Oddly, and in direct conflict to its stated aim, government policy is reinforcing the strength of Sonic’s position.

Gone are the days when a grandfatherly family doctor would make a house-call, tap on the patient’s back a few times and issue a diagnosis. Pathology is now a corporatised network of collection centres and mega-labs conducting more than 120m tests a year. Sonic conducts more than 130,000 tests a day – and that number will almost certainly increase.

Unlike most areas of medicine, pathology is capital rather than people intensive. Tests typically rely on very expensive equipment and this means there’s a strong incentive to make sure these machines are rarely idle. The consolidation of pathology labs has made their services increasingly efficient and pathology rebates have actually fallen by about 60% in real terms since Medicare began in 1984 – unmatched by any other health sector.

It also means small, less well-funded pathologists that can’t afford to keep up with the latest technology have plenty of reasons to sell out to larger players, which is exactly what’s been happening. Sonic, now with a 42% market share, is the largest player followed by Primary Health Care, with 32%.

That scale has a compounding effect. Sonic enjoys a significant cost advantage, generating operating margins of 17% compared to 15% for Primary’s pathology division. There’s a very good reason why we believe Sonic will not only maintain that margin advantage but actually increase its market share over time.

Know your customer

On average, Australians are subject to five pathology tests each year, each of which is referred by a doctor. So doctors are the people that Sonic has to please.

More than half of all GPs now work in medical practices with five or more practitioners. Most have a space dedicated to the collection of specimens and blood, perhaps just a couple of square metres, which is leased and run by an affiliated pathology service. Given the stream of referrals, these collection centres are hot property.

In the past, however, pathology groups have only been permitted to operate a limited number of collection centres. That changed in 2010 when the market was deregulated and the restriction removed. The belief was that it would boost competition, which it has, but with almost the opposite effect to that intended.

Pathology collection centres are now some of the most expensive real estate in the country. The Australian Association of Pathology Practices found one medical centre in Victoria had secured a deal where it was paid $14,000 per square metre per week. Had the same area been rented as an ordinary medical suite it would have generated just $415 per square metre per week.

You can probably see where this is heading. Sonic and Primary, with their existing efficiency and cost advantages, can afford much higher rents than smaller operators and have been more than willing to out-bid them.

The result is that for three years small operators have been progressively priced out of the market. Healthscope, the third largest player, wrote off $120m from the value of its pathology assets earlier this year following the sale of its WA operations to Sonic in October 2012. Why? It just couldn’t maintain a decent margin after the increase in rents.

The overall effect is stupendous. Sonic and Primary have increased their combined market share by 9% since deregulation and now control 74% of the market. And that figure is likely to increase. Australian pathology is now approaching a supermarket-style duopoly. If the two heavyweights can learn to play nice, they should soon be able to put pressure back on the medical practices and prevent further rent escalation.

While Sonic is the strongest player, it's no Woolworths or Coles, at least not yet anyway. Primary Healthcare, as well as owning a pathology business also operates medical centres and is busy consolidating them. In effect, it’s doing in medical centres what Sonic is doing with pathology. That’s a threat to Sonic’s referral base. As practices and pathology providers integrate under one owner, there’s no need to rent out collection centres.

Whilst Sonic's strategy has long centred on improving efficiency by acquiring other pathology operators, growing its collection of wholly-owned medical practices, the Independent Practitioner Network (IPN), may be of increasing strategic importance. It’s a division we’ll be watching closely.

As the government recently capped Medicare outlays for pathology to a 5% annual growth rate, funding is a more immediate risk. With 80% of Sonic’s Australian income coming from Medicare, the company’s substantial foreign earnings – currently 49% of the total – are valuable insurance against this fee pressure, and another reason why we prefer it to Primary.

Sonic's future value will depend more on how well it implements its efficiency and acquisition strategy overseas than either of the above two threats. So far management has done a commendable job.

Demand for diagnostics is growing relentlessly due to a steadily aging population and Sonic's position as the low-cost operator gives it a moderate competitive advantage. Despite its privileged position, Sonic looks expensive at 22 times free cash flow before acquisitions, but we would happily consider upgrading at prices below $11.50.

The stock is flat since 3 Oct 13 (Hold – $16.06) and, while we’re not rushing for the exits, we note our maximum portfolio weighting of 5% and suggest that those with larger holdings might consider taking some money off the table if the price approaches our sell recommendation of $17. HOLD

Note: The model Growth Portfolio owns shares in Sonic Healthcare.