Hope rally in diagnostic stocks may fizzle on disruption in OPD services

Topics Diagnostic | stocks | Coronavirus

The near-term prospects are still bumpy. Stock valuations, too, are rich, given PE multiples of 40-70 times trailing 12 months’ earnings.
Investor sentiment towards diagnostics firms has improved in July, adding to gains seen in the April-June period. While recovery in business volumes after the 25-30 per cent hit during the lockdown has helped, the rise in Covid-19 testing by private players will support volumes and revenues.

Hence, shares of Dr Lal PathLabs (hit a new high this week), Thyrocare Technologies (12 per cent from its 52-week high) and Metropolis Healthcare have risen 14-20 per cent in July. However, investors need to be cautious.

For one, outpatient department (OPD) services and elective surgeries are yet to return to normal. And, the timeline for normalisation is uncertain as Covid-19 cases continue to rise. Besides, the increase in testing might not add much to profitability, and at best, it will cover fixed costs, say analysts. Surjit Pal of Prabhudas Lilladher feels that the near-term outlook remains weak.

Dr Lal PathLabs, Thyrocare and Metropolis had seen their profit before tax (PBT) decline 7.5 per cent to 40 per cent year-on-year (YoY) during the March quarter, with 7-14 per cent decline in operating profits. With a steeper decline in expected in June quarter (55.4 per cent and 59.2 per cent for Dr Lal and Thyrocare, according to Edelweiss estimates, and 87.5 per cent fall for Metropolis, according to Kotak Institutional Equities), the pressure on earnings will intensify.

While the Covid-19 testing in the Delhi NCR region could arrest the volume decline for Dr Lal, the additional costs will likely limit cost control levers, pressuring margins, say analysts.

For Thyrocare, analysts expect top line to decline 40 per cent because of its dependence on the wellness business, and Covid-19 testing having been ramped up only in June. The additional cost associated of testing is expected to impact Thyrocare to a lesser extent because of a favourable cost structure, say analysts. For Metropolis, Kotak Institutional Equities expects revenues to decline 35 per cent YoY with non-Covid revenues declining 46 per cent YoY.

Cost pressures remain a bigger challenge for diagnostics players even as recovery continues. While the businesses have been built on the concept of providing a complete “lab experience”, transitioning to a pick-up based model will not be easy, say analysts at Emkay Research. Covid-19 will lead to higher home collection and larger companies will have to employ a minimum of 40-80 persons to match earlier footfalls at collection centres, and this will eat into margins, estimate analysts.

Analysts at Morgan Stanley, too, say that near-term operating dynamics will change because of social distancing norms and Dr Lal PathLabs expects higher volumes from home collections and less crowded franchisee/collection centres. Higher investments to augment digital connect will be essential to cater to the online channel. Companies are, thereby, resorting to cost controls including re-negotiation of rental agreements, and network rationalisation.

The near-term prospects are still bumpy. Stock valuations, too, are rich, given PE multiples of 40-70 times trailing 12 months’ earnings.

In the long run, organised players are structurally better placed. Also, as Morgan Stanley says, higher operating costs might hurt margins of smaller players, leading to consolidation. Looking at the fragmented industry, this will be positive for large firms such as Dr Lal, Thyrocare, Metropolis, SRL and a few others. They now account only for a fifth of the market.

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