Read the previous week’s Investment matters.
Following completing a four-week week series reviewing our portfolio construction approach and individual stocks held to meet these objectives, this week we examine recent portfolio additions in the health sector.
Background
While the portfolio is constantly being reviewed for:
- pricing mismatches in individual stocks;
- the impact of changes in Government policy or economic fundamentals; or
- changes in tilts/positioning to recognise long-run fundamental thematic;
…the New Financial Year always seems a logical time to consider a reset or reposition.
Some recent portfolio changes we have made include the inclusion of a ‘pairing’ of pathology stocks in the Healthcare. These stocks (and sector) were amongst were underperformers of the overall ASX market in FY24, getting the value-minded investor within us to get more curious.
We discuss each of these in turn below.
The market
Pathology stocks – Healius (HLS) and Australian Clinical Labs (ACL)
Industry backdrop
Pathology is a medical specialty that focuses on determining the cause and nature of diseases. By examining and testing body tissues (e.g. biopsies, pap smears) and fluids (e.g. blood, urine) pathology helps doctors diagnose and treat patients correctly.
In Australia, there are four primary players in the market, with the three largest providers being ASX-listed companies.
Sonic has the largest market share:
Source: Company Data, Medicare
Favourable growth history but a more challenging revenue outlook
There has been a number of favourable tailwinds to pathology revenues:
- a rising population
- an ageing demographic
- a broad-based increase in complexity of services (e.g. chronic disease testing)
Composition of Pathology volume changes
Source: Medicare, ABS, Macquarie Equities
This has led to a solid underlying growth rate in Government payments for pathology services of 5-6% p.a. on average over the past 20 years.
Pathology MBS outlays over time – CAGR > 5% p.a. ($m)
Source: Medicare, Ord Minnett
Revenue headwinds
However, there are some recent headwinds to revenues which have plagued pathology industry providers.
Covid cyclical high
As shown above, the industry has recently come off a relative cyclical high associated with testing in the covid-19 period.
Lower GP utilisation
Since then, given widespread adoption of telehealth appointments and lower inclination to attend a GP clinic for minor medical conditions amongst other factors, there has been a shift in visits to GPs.
With lower attendance in clinics, a commensurate increase in lapses in pathology attendance has occurred. In-clinic pathology participation is quite high at 70%, whereas telehealth appointments generate a much lower pathology follow-up by patients of around half this level. This flows through to a 10% decline in pathology volumes.
Face to Face GP visits – ~25% below trend
Source: Medicare, Macquarie Equities
Base pathology volume – ~10% below trend
Source: Medicare, Macquarie Equities
A lack of indexation
Understanding the scale that providers have and the decreasing average cost of providing pathology services once a provider is at scale, the Federal Government has reflected this in its allocation within its health budget.
A problem for providers has therefore been that the Government has not indexed to inflation the revenue it pays for these services, as it has in other services like Imaging. This has meant that the pathology providers are vulnerable to pressure upon margins should they encounter cost inflation from wages, rents, and interest costs or there is a decline in pathology volumes.
Operating cost inflation – somewhat self-enforced
For the pathology providers, the industry is recognised as a scale game, with the cost of labour, technology, consumables (think syringes and plastic vials), logistics (cars collecting samples) and occupancy costs (incl renting access to become the select in-house provider within medical centres) all spread across a revenue base largely funded by the Government via Medicare.
Mounting rent pressures
The acknowledgement of the benefits of scale by industry participants and gaps in pathology centre coverage for some players has led to an unfortunate land-grab for access to pathology sites within medical centres, where the ‘audience’ is considered captive. Often, rents paid to medical centre operators are multiples higher on a per square metre basis than for ordinary commercial space.
Australian Pathology Centre Penetration by player per State
Source: Services Australia
Financial pressure upon GP’s, given modest increase in prescribed Medical Benefits Schedule fees for services and declining face-to-face visitation by patients since Covid, has exacerbated the need to seek alternative revenue sources. Pathology providers have been willing to meet this increased demand for rent by medical centre owners given a land grab for share in preferred sites.
This has proven to be an own goal for the pathology industry in many ways though given softening in growth in pathology volumes.
Wages and interest rates higher too
Rising interest costs have been a feature for most corporates. Additionally, higher-than-historic prescribed award wage increases for healthcare industry staff (the author would say well deserved) have been required to be met by pathology industry providers.
In combination, this confluence of factors has led to declining returns for pathology providers. Most notably, Healius has demonstrably underperformed its peers.
Recent stock price performance – disappointing
And this decline in profitability has been notably reflected in falling share prices.
While healthcare stocks, in general, delivered positive absolute returns for shareholders in FY24, pathology stocks, more specifically, have delivered much less favourable performance.
The share price of the pathology sector’s largest provider, Sonic Health, fell 23% in FY24, 2nd player Healius’ share price fell 49% and Australian Clinical Labs fell 24%. A relative tale of woe for all.
Why have we now elected to buy?
After a poor past 2-3 years for shareholders and a difficult period for industry returns since Covid-19, we believe the major industry participants are keen to rectify returns and are prepared to take measures to enable this.
Mergers and Acquisitions
While consolidation amongst the biggest players has been prevented by the ACCC (see the ACL bid for Healius was knocked back in December 2023), we think that there remains an opportunity for takeovers and consolidation in the sector.
As we’ve seen with other ASX companies, there is a reasonable prospect of interest in the sector from private equity buyers. Healius (previously known as Primary Healthcare) was bid by Private Equity in 2020 (and 2019). A relative weak A$ (albeit this has shifted a little in the past 3 months) will be an enabler.
We also see the potential for the pharmacy industry to explore an opportunity to provide pathology services. Companies with large balance sheets like Wesfarmers, which is the owner of Priceline pharmacies, seems to be a potential acquirer. It has sufficient balance sheet capacity, aligned business interests and political connection to drive this change of approach.
Reduce costs
There is an increased necessity for providers to push back on rental increases (albeit 4Cyte Pathology, owned by the family of the former founder of Primary Healthcare/Healius appears keen to continue to increase penetration/scale).
Still, with necessity comes innovation for the industry. In that respect, pharmacies may play a part in providing lower-cost, but convenient services
Push for regulatory support
While the government needs to continue to support preventative medicine and early detection of health problems, it has thus far rejected moves by the pathology industry to index scheduled fees to inflation, which will assist Pathology providers efforts to generate and maintain sustainable returns.
It’s been 24 years since the government provided for indexation of inflation for Medicare fees associated with the provision of pathology services. While the recent 2024/5 federal budget saw a reintroduction of indexation on haematology, immunology, tissue pathology, cytology and infertility/pregnancy services, so there is some progress occurring. Other services such as chemical, microbiology and genetics testing is not being indexed because of an assumption that automation, economies of scale or newer service technologies exist.
Executive change
After several years of disappointing financial performance, Healius’ board of directors replaced its CEO in March, installing CFO Paul Anderson as Managing Director.
Summary
Declining returns for pathology providers over the past couple of years have led to poor share price performance. It is apparent that the action of pathology providers (mergers, political lobbying, and executive changes) recognises that something must be done to improve participant returns.
We think that the share market participant response has, on balance, been too negative. This provides an opportunity for us to buy at depressed share price levels.
The information in this article is of a general nature and does not take into consideration your personal objectives, financial situation or needs. Before acting on any of this information, you should consider whether it is appropriate for your personal circumstances and seek personal financial advice.