Imagine a conspiracy brewing in corporate Australia: the Government secretly wants to create an all-powerful and obscenely profitable duopoly in the pathology industry. How might the plot unfold?
We first noticed reducing competition in pathology a few years ago, but since then things have become even more extreme – and a recent Government proposal could mean a significant jump in profitability for the two industry heavyweights, Sonic Healthcare and Primary Health Care.
Before we gather our tin foil hats, though, let’s set the scene with a few facts and figures. These days, most medium to large medical practices have a space dedicated to the collection of blood or specimens that need to be sent to a lab for testing. These ‘collection centres’ – often no larger than a walk-in wardrobe – aren’t run by the practice; they’re leased by a pathology provider.
Pathology competition decreasing
Rent controls will save operators money
Partially offset by lower Medicare incentives
When a GP refers you to get a blood test, you’re technically able to get it done anywhere you like. But let’s face it, if you walk out of the doctor’s office and there’s a collection centre eight feet to your left, you’re unlikely to shop around; you’ll just hand the script to whichever pathology service happens to be affiliated with that clinic.
In any case, why would anyone bother shopping around: 85% of pathology services are bulk-billed with no out-of-pocket expense for the patient – the highest rebate rate of any medical specialty. There’s no financial incentive to choose one provider over another, nor much difference in service quality, so the deciding factor is down to convenience.
David and Goliath
Until 2010, however, there was a limit on the number of collection centres a pathology group was allowed to operate. The idea was that if Australia had too many collection centres it would make the system inefficient and so add expense for Medicare, which essentially funds the whole industry. But here’s where the plot begins to thicken.
In 2006, auditor KPMG released a report that said the existing regulatory framework hindered the growth of small operators and recommended that there be no cap on collection centres. Four years later, the Government deregulated collection centre licencing with the expectation that it would increase competition. And it did – but only in the sense that both David and Goliath were unchained at the same time.
Pathology, you see, is an extremely technology intensive business. Tests typically rely on expensive automated equipment and this large fixed cost means that the average cost per test goes down as the volume of tests running through the machine increases. In other words, the operators with the highest turnover earn the highest profits, and this was the main incentive behind all the mergers of the past 20 years.
Collection centre explosion
Deregulating collection centres did two things. The first, as you might expect, is that they started popping up everywhere, especially in the smaller medical practices previously ignored due to the cap on centre numbers. Since 2010, the total number of collection centres has risen from 2,200 to 5,500 today.
But what the Government wasn’t expecting, it seems, was how the industry’s powerful economies of scale would affect prices.
The two dominant players, Sonic and Primary, with their existing efficiency and cost advantages could afford much higher rents for the collection centres than smaller operators. Without a cap on the number of centres they could operate, they were now in a position to outbid their competitors.
Rents rose dramatically and those little wardrobe sized collection centres now command rents to rival top real estate in Point Piper or Toorak, with many costing thousands of dollars a week … per square meter.
We don’t really think the Government was conspiring with Sonic and Primary, but it might as well have been. Far from helping the little guys, deregulation and the land grab that followed made pathology an even less competitive environment.
As you can see in Chart 1, Sonic and Primary have been increasing their market share at the expense of smaller operators, which have been progressively priced out of the market.
To put it in perspective, the Australian Competition and Consumer Commission (ACCC) says that competitive issues typically arise in an industry when the top four firms account for 75% or more of industry revenue, or where one company has more than a 15% share. This threshold is what triggers an investigation into a proposed merger that may be anti-competitive.
Sonic and Primary – two companies, not four – now account for 79% of the pathology industry's total revenue and Sonic, the largest player, accounts for almost half.
Whether by will or accident, there's no doubt that the Labor Government’s actions in 2010 concentrated power in the two largest pathology operators.
But here’s where the conspiracy theorists really have something going for them. The current Liberal Government intends to introduce new provisions to collection centre regulation that would mean medical practices can only charge 'fair market value' rents. That is, rent will now be based on local commercial rates.
It isn’t unusual for a collection centre located inside a practice to pay five times the rent that would be charged were it located separately but nearby.
Morgan Stanley estimates that rent expense has risen from 5% of Sonic’s revenue in 2010 to 15% today. Rising rent costs have been a significant drag on profit growth, so the proposed regulatory changes would be a huge saving for Sonic and Primary and a significant loss of income for medical practices.
|Year to June||2016||2015|| /(–)
|Net Profit ($m)||451||348||30|
|Final dividend||44 cents, up 7%, 30% franked
ex date 8 Sept
However, as we’ve explained previously, the Government is also cutting the $6.00 bulk billing incentive for pathology, which is currently paid to providers who bulk bill certain patients, such as children, concession cardholders or those in rural areas (the latter of which garners a $9.10 payment). Sonic expects this will shave around $50m from revenue, though that loss will still be more than offset by the new rent controls.
Macquarie Securities estimates that the rent caps will save Sonic around $116m at its 2,000 collection centres, leaving the company a good $66m better off if and when all the regulatory and Medicare changes go through. After tax, that would boost net profit by around 10%.
The real benefit, though, will only be seen over many years. A large proportion of Sonic’s operating costs are fixed due to the testing equipment mentioned earlier, and, with rents anchored by commercial rates, the company’s operating leverage will be even greater.
As Sonic continues to grow its market share – and the overall number of tests increases thanks to an ageing population – more of each incremental dollar of revenue will fall to the bottom line. All things being equal, we expect Sonic and Primary’s profit margins to be materially higher a few years from now under the Government’s proposed changes.
So, we’ll ask again, if the Government secretly wanted to create an all-powerful and obscenely profitable duopoly in the pathology industry, how might the plot unfold? First, the Government would deregulate the industry so that the two leading companies could outbid smaller rivals at rent negotiations, thus driving them out of business. Second, when the industry is more concentrated than ever, it would introduce rent controls so that the two biggest players no longer have to pay sky-high rents to medical practices. Economies of scale should take care of the rest.
Better to wait
The question now is what's Sonic worth? Management expects EBITDA to rise 5% in 2017, with the potential for new acquisitions to add to that. The stock currently trades on a forward price-earnings ratio of around 18, which isn’t particularly expensive for a business of this quality.
We’re notching up our Buy price to $18, which would put the stock on a forward price-earnings ratio of 16. Conservative, no doubt, but we’re mindful of two things and don’t want to be caught overpaying. The first is that given the need to constantly upgrade expensive equipment, free cash flow – which can be distributed to shareholders – typically trails net profit. Despite the seemingly low price-earnings ratio, the current free cash flow yield is only 4.4%.
The other thing to note is that Sonic suffers from ‘customer risk’ as the company essentially has just one customer, and a powerful one at that. The Government, mind you, is a whimsical creature. In December, when it proposed various Medicare fee cuts to lab services, Sonic’s share price promptly dropped 15%. If Sonic did become super profitable, the Government would have plenty of incentive to whack down Medicare rebates even more to cut costs from the healthcare budget.
Nonetheless, with good management, various competitive advantages and economies of scale, there’s plenty to like about Sonic and we hope we get the chance to upgrade sometime soon. HOLD.