We explore the business of India’s leading healthcare diagnostic company and assess the opportunities and challenges it faces.
Statutory Warning: This is NOT an investment advice to buy or sell shares. Please make your own decision, as blindly acting on anyone else’s research and opinions can be injurious to your wealth. I do not own the stock, but my analysis can be biased, and wrong. I have been wrong many times in the past. I, Vishal Khandelwal, am a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014 (Registration No. INH000000578).
About Dr Lal Pathlabs (DLP)
DLP is a leading player in the fragmented and unorganized (85%) Indian diagnostics market. The company was established in 1949 by Dr. Major SK Lal, and now has a pan-India network on the back of a good brand and scalable hub and spoke model. This network boasts of a National Reference Laboratory in Delhi, over 189 clinical laboratories, 1,759 patient service centers and 5,021 pick-up points. DLP possesses capabilities to carry out a comprehensive range of ~ 1,110 test panels, organized into around 1,930 pathological tests and 1,560 radiology and cardiology tests and services. The company derives around 72% and 12% of its revenues from the North and East Indian regions. Its customers include individual patients, corporates and institutions, healthcare providers as well as hospital and clinical labs.
Let’s understand a bit about the diagnostic industry in India. In the spectrum of healthcare delivery services, diagnostic services play the role of an information intermediary, providing useful information for correct diagnosis and treatment of patients’ diseases. Diagnostic services would have a lower share in overall healthcare spends, yet play a vital role in identifying problem areas and major illnesses. Major diagnostic healthcare service providers in India offer a wide range of healthcare tests and services.
The industry can be classified into imaging diagnostics and pathology testing services. Pathology testing or in vitro diagnosis involves reporting diagnostic information on the basis of collected samples (in the form of blood, urine and stool, among others) and then analyzing the samples in a lab to arrive at useful clinical information. On the other hand, imaging diagnostics, or radiology, involves procedures such as taking X-rays and ultrasounds, which help mark anatomical and physiological changes inside a patient’s body to help doctors diagnose the disease.
CRISIL Research estimated the size of the Indian diagnostics industry stood at around Rs 37,000 crore in 2014-2015, and expected the same to grow at a CAGR of 16%-17% over the next three years to reach around Rs 60,000 crore by 2017-2018.
Let’s now analyze DLP using a set of questions to test the underlying business and management quality.
1. Has the company done well in terms of sales and profit growth over the past few years?
DLP has grown its revenues and profit before tax at average annual rates of 22% and 29% over the past five years. Despite the unorganized nature of the diagnostic industry, the company has created a well-known brand through steady investments in the same over the years.
The company follows a hub and spoke model where its patient service centers and pick-up points facilitating penetration within a given region and expansion of reach, and its centralized diagnostic testing provides greater economies of scale.
As per the management, as has been outlined in the annual reports, growth going forward will continue to come from its focus market of North India, and also through deeper penetration in the East. DLP intends to expand presence here through construction of regional reference laboratories in Lucknow and Kolkata at a capex of around Rs 40-45 crore over and above the land cost. As per reports, while the NCR market around Delhi is growing at 13-15%, the Eastern market (Bengal, Bihar and North East) is growing at a faster pace of 17-18% with potential to grow at >25%.
Apart from this, DLP is also focusing on increasing the breadth of its business by providing newer diagnostic testing services, and also expanding its lab management venture (undertaking management of laboratories which are functioning within hospitals). While margin in this business is expected to be lower than what DLP earns in its existing business, this move should help it secure large captive high volumes.
Now, as I mentioned above, the diagnostic industry is highly fragmented and unorganized in India. Organized chains account for only 15% of the industry’s revenues. Even DLP, which is the largest player (followed by SRL and Thyrocare), has only 2% market share. Now, while this (fragmented and unorganized) is the nature of the industry even globally, leaders generally have around 10-20% market share. This should be encouraging news for DLP, and the company is already seeing some consolidation in its leadership led by shifting of business from unorganized to organized (especially in cities), expansion beyond North and East, and acquisition of smaller/regional labs.
2. How profitably have retained earnings been reinvested?
DLP earns the best return on capital in the organized part of the diagnostic industry. Its average ROCE over the past five years has been around 48%. While the same dropped to 36% in FY17, it remains better than Thyrocare’s 28% (average of 29% over past five years).
Returns have come down over years given the expansion the company has been undergoing to widen its reach and range of offerings (as discussed above). While these steps will drive growth going forward, return numbers may remain under some pressure, though at higher numbers and better than close competitors like Thyrocare.
3. Does the business have a durable competitive advantage?
DLP’s advantage over competition, especially from the large unorganized segment, is its brand that it has built over years. However, it isn’t such a big advantage as seen from its market share that stands at just around 2% (still the largest in the organized segment). The company is investing aggressively (geographic reach and wider breadth of offerings) to widen this advantage further, but it’s still not going to be an easy pitch to bat on for the company.
The company also scores over competitors through hits hub and spoke model, especially in its core North & East markets by strategically positioning its clinical laboratories, patient service centers and pick-up points to ensure maximum coverage. This business model is scalable as well as asset light, with around 95% of its patient service centers under franchisee revenue sharing contracts and most of its diagnostic equipment being sourced through rental agreements. This has enabled DLP to clock 22% CAGR in revenues over the past five years, despite its fixed asset base expanding at just around 11% CAGR during the same period.
4. How has the management fared?
DLP started operations in 1949, which was sort of a pioneering effort by its founders. Its current management team has experience in the healthcare industry, and the company has done well in terms of growth and capital allocation over the last several years. Management compensation is also within reasonable limits.
5. What are the risks to the business?
DLP follows a franchisee model – franchisees control around 95% of the company’s centers. This opens the company to a reputational risk, as controlling practices across so many franchisees isn’t easy. In fact, a case in point here is the unconfirmed allegations that one of DLP’s franchisees in Jalandhar has contravened certain provisions of the Human Organs Transplantation (Amendment) Act, 2011, by swapping blood samples to match the DNA sample reports of donors and recipients for kidney transplants. Such allegations can be severely damaging to the brand equity of DLP which functions in a competitive market where quality and trust play a major role.
Intensive competition, both from unorganized players (85% of market) as well as from regional and pan-India chains, can lead to undercutting of prices. This may suppress DLP’s profitability.
Another key risk is technological advances, which may lead to the development of more cost-effective technologies or non-invasive diagnostic healthcare tests which are more convenient and/or less expensive than solutions offered by players like DLP. If the company is not able to reinvent itself with changing times, it may face severe pressures on growth and profitability going forward.
DLP’s stock is currently trading at around Rs 895 (as on 14th March 2018), which implies a P/E multiple of around 46 times its trailing twelve months EPS of Rs 19.5 per share.
DLP looks to be in a sweet spot to take advantage of the structural long-term growth story of Indian diagnostics. This is considering its market leadership in the organized space, pan-India presence, quality testing capabilities and asset light model that helps it generate strong free cash flows. However, apart from these positives, you must also consider the risks to the business (competition, fragmented market, low entry barriers) plus ensure sufficient margin of safety in the stock’s price, before making any investment decision.
Statutory Warning: This is NOT an investment advice to buy or sell shares. Please make your own decision, as blindly acting on anyone else’s research and opinions can be injurious to your wealth. I do not own the stock, but my analysis can be biased, and wrong. I have been wrong many times in the past. I, Vishal Khandelwal, am a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014 (Registration No. INH000000578).[/show_to] [hide_from accesslevel=’almanack’]
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