Historically, the path labs business has been dominated by mom and pop shops carrying out routine testing services such as blood tests, urine tests, and X-rays. These are typically one-room clinics rented in a local shopping complex by a pathologist who, usually, tends to be a sole practitioner. Such clinics tend to have tie-ups with local doctors who will refer patients in return for a share of the revenue, although it is illegal to do so. As the economy formalises, and as it becomes harder to operate such businesses on a cash-basis with patients themselves asking for better facilities, the path industry will continue to evolve. Over the past two decades, Dr Lal PathLabs has been at the vanguard of this change, especially in north India.
What’s The Difference?
Our channel checks suggest that there is no major difference in the quality and accuracy of diagnostic tests between one diagnostic firm and the other since all labs (both mom and pop labs as well as national chains) use diagnostic equipment provided by similar large vendors. There are only two areas of differentiation that a diagnostic lab brings forth: one, customer acquisition — which could be driven by a combination of doctor-network-connect, location of the lab / sample collection centre and brand and, two, logistics of testing — which in turn leads to difference in turnaround times, customer interface to check reports such as mobile app or digital access.
Dr Lal PathLabs has evolved its business model from being a mom and pop diagnostic lab till 15 years ago into a pan-India retailer today, with its key strength being the execution of its retail expansion rather than product differentiation. Formalisation of the economy, rising awareness among consumers, and expansion of organised medical set-ups such as hospitals have led to a dilution in the doctor-connect related moat of unorganised diagnostic set-ups, especially in larger cities with some doctors leaving the choice of laboratory in the hands of the patient. Moreover, as diagnostics related to preventive care (such as annual check-ups organised by corporates and insurance companies) and lifestyle-related diseases (such as lipid profile used to assess cardiac risk) increases in prevalence, the doctor-connect moat of small path lab players will get diluted further. Through such evolution in larger cities, Dr Lal PathLabs has built its moats around optimising the network of national reference labs (two opened thus far), nodal labs, and sample collection centres in terms of their location, size and diagnostic features — thereby offering an end-to-end service to patients for their diagnostic needs while also building a strong brand recall around it. Though the diagnostics industry in smaller cities is still under the tight control of mom and pop labs, over the next couple of decades, they are likely to undergo evolution similar to the one seen in larger cities.
At the heart of Dr Lal’s ability of building its competitive advantages around the retail network of labs and collection centres, lies the firm’s deep focus on only pathology in its offering unlike most competitors who do a combination of pathology and radiology. Besides, the company follows a high degree of capital allocation discipline, despite a highly cash-generative business model, that has led to the accumulation of over Rs.6 billion of surplus cash on its balance sheet.
Proof of Dr Lal’s competitive advantages lies in the fact that the firm’s operating margin has been stable at 25-27% for three years despite no price hikes. Post-tax return on capital employed has also been stable over this period at around 35%.
Dr Lal is a mass market play, primarily in northern and eastern India. In these parts of the country, formal jobs are hard to come by. The risk is that as the firm gets bigger, it might have to compromise on prices in order to increase market share. In fact, over the past few quarters, Dr Lal’s pricing has been under pressure even as volumes continue to grow at double digits. In Q3FY19, average realisation per test fell by 5.1%. However, profit margin rose to 15.8% during the quarter from 13.8% in the year-ago period. Margins have been maintained despite the fact that the diagnostics sector, being exempt from the Goods & Services Tax (GST), has to bear additional expenses towards higher input costs that cannot be offset against output GST.
What Happens Next?
As on March 31, 2018, the diagnostics chain had 193 clinical labs including a national reference lab at Delhi), 2,153 patient service centers (PSCs) and 5,624 pick-up points (PUPs). PSCs are for the purpose of collecting specimens for shipment to the national reference lab. PUPs are points where large and small-scale hospitals, nursing homes, physician practices, laboratories and other healthcare service providers can deliver specimens for testing.
Over the past year, Dr Lal has increased its focus on its wellness offering — the firm is allocating more resources and promoting its “SwasthaFit” wellness packages and bundled tests as these provide more value for money for customers. This strategy has yielded early results — tests/patient are up 10% year on year, as of the third quarter of the current fiscal, with wellness packages accounting for 11% of revenue, up from 7%.
The other strategic thrust for the firm is its growth initiative in the east where it is replicating the successful hub-and-spoke retail expansion already executed in north India over the past decade. The company has incurred a capex of Rs.622 million primarily on the opening of a reference laboratory in east India. The laboratory in Kolkata brings the entire spectrum of tests to the region, thereby, helping improve its turnaround time and customer acquisition capabilities both directly as well as through tie-ups with other hospitals.
The company’s geographical revenue mix has been witnessing a shift over the past few years. South, which contributed a meagre 0.1% in FY13, contributed 13% in FY18. East and west witnessed a decline in contribution, from 18.4% in FY13 to 13.5% in FY18. With the new lab in Kolkata, one can expect incremental contribution from the east and north-east markets.
Valuation
Assuming that the company can maintain its post-tax return on capital employed at 35% and can grow earnings over the next five years at 20% CAGR, given that it has compounded earnings at 25% over the past five years, I see no reason why the stock won’t be able to command a multiple north of 40x. This compares to the current FY19 multiple of 30x, implying a 30% upside.
The author owns the stock both in his personal and his professional capacity. All views expressed here are personal.
