The biomedical treatment of disease and injury is what we call Pathology.

Needles. Blood. Tissue. Other gross things. Etc.

From the commonplace lab services which take and test our blood – to the cutting edge biological research of medical innovation – jabbing everyone with syringes is merely the tip of the haemagloberg.

And while all pathologists undoubtedly look back at 2020-22 with a wistful sigh of COVID-longing, for these major ASX-listed bloodsuckers, the pandemic was a Cambrian-like explosion of activity which has left a void that’s been hard to fill.

Shares in Sonic Healthcare (ASX:SHL), Healius (ASX:HLS), and Australian Clinical Labs (ASX:ACL) have fallen by roughly 60% on average since the start of 2022.

And, according to the fastidiously nocturnal studies of ageless Morningstar equity analyst Shane Ponraj, each stock now trades at an average 35% discount to Morningstar’s fair value estimates which look thusly:

  • SHL – $32.00
  • HLS – $3.00
  • ACL – $3.50

Ergo sum: Australia’s top pathology providers are significantly undervalued.

In this, Part 2 of our bloody-minded three-part Stockhead special, Ponraj extracts, dissects and analyses each of the majors across the full spectrum of each business.

And finds opportunity in rude health.


Here’s the bloody history

Within the broader ASX healthcare sector, Shane says pathology stocks screen attractively.

The rather niche subsector trades at an average price/fair value estimate of 0.65 versus the healthcare sector average of 1.11.

That means there’s a lot of room to grow.

The joys of higher-for-longer elevated margins during coronavirus testing might’ve seemed like it at the time, but was never going to last forever, Shane says.

And in the intervening few years it appears traders have new and more timely narratives so pathology providers have fallen out of favour with the market, and margins are now below pre-pandemic levels.

While the market doubts a return to pre-pandemic profitability, Shane says he sees several reasons to expect a stronger recovery than market consensus – increased pricing, stabilising costs, and scale benefits.

“Our fiscal 2028 operating margin forecasts for Sonic, Healius, and Australian Clinical Labs are 14%, 12%, and 11%, respectively, versus operating margins of 12%, 8%, and 4% in fiscal 2020 before material coronavirus earnings.


Bloody dominant

The three main pathology providers, with over 80% combined market share, are well-positioned to benefit from industry trends, Shane says.

And long-term volume growth drivers are intact.

“In the near term, we expect elevated volume growth as patients return to routine diagnostic testing and general practitioner attendances recover on new bulk billing incentives.

“We forecast a five-year revenue compound annual growth rate of 5% for the pathology industry, with roughly two-thirds from expected volume growth and the rest from pricing.

“Demand is driven by population growth, aging demographics, higher incidence of diseases, wider adoption, and a higher number of tests available.”


Part bloody 2.

Healius (ASX:HLS)


  Dracula – Bram Stoker, 1897


Healius is the second-largest pathology operator in Australia and third-largest diagnostic imaging provider.

HLS told the ASX this week, it’d successfully refinanced Tranche A of its syndicated debt facility with the support of lenders until March 2027.

At December, Healius had $327m of net debt, which was 3.17 times its earnings, below its covenant of less than four times.

But it had reduced the level through a capital raising, after it was $447m in the 2023 financial year.

Its banking facilities had been reduced by $250m to $750m and it is reviewing asset sales as part of its Capital Management focus.

Pathology and imaging revenue is almost entirely earned via the public health Medicare system. Healius typically earns approximately 75% of revenue from pathology and 25% from diagnostic imaging.

As part of the refinancing, Healius has scaled back both demand and the size of the tranche from $250m to $180m, while ensuring sufficient headroom and liquidity for its operations. Gearing covenants for both facilities are 4.5 times earnings for the 12 months to June 30 and December 31 before reverting to 3.5 times for subsequent annual and half-year reporting periods.

Despite Healius operating roughly one-third of Australia’s collection centres, slightly ahead of Sonic’s share, its pathology business is significantly smaller.

“This suggests Healius’ network is less efficient, with collection centers likely being smaller on average and in less populous locations.”

For example, while Sonic operates the majority of centers in the most populous state, New South Wales, Healius claims the majority in the least dense, Northern Territory.

Location Shane says is key as patients tend to submit test samples at a convenient pathology lab and doctors are unable to specify the lab unless there is a medical reason for it.

“This poses a significant structural challenge for Healius to gain throughput efficiently and generate economic profits. Its weaker competitive position in the Australian pathology market is also highlighted by Healius’ trailing three-year organic revenue CAGR of 3.8% to fiscal 2020 versus Sonic’s 5.3% and market growth of 4.7%.”


Strategic growth

Back in 2018, the former Primary Healthcare rebranded itself as Healius. It was the kind of strategic turnaround which called for a new name.

Today, Shane says Healius is looking to new sources of strategic growth as well as dealing with prior underinvestment in infrastructure.

“There is much to fix in the business and we anticipate it to take a few years before significant margin improvements are made in the base pathology and imaging businesses. Healius selling its medical centeres and Montserrat day hospitals to focus on redirecting capital toward infrastructure upgrades and its diagnostic businesses is viewed as a positive strategic step.”

Key for Shane is improvement in systems to lift efficiency.

“Pathology is an increasingly technologically driven service and the company intends to invest in a new laboratory information system, automation, and digitisation through to fiscal 2024.

“However, while we view the system upgrades as necessary to restore earnings growth, we don’t see the company building an advantage over rival Sonic Healthcare, which is also continuously improving its systems.”

Virtually all revenue is earned directly from Medicare via bulk-billing in the pathology and imaging segments.

“Healius’ organic volume growth in its core pathology segment has typically ranged between 3% and 5% and we forecast a similar rate over our 10-year forecast period.”

The volume growth is underpinned by population growth, aging demographics, higher incidence of diseases, and wider adoption of preventive diagnostics to manage healthcare costs. In addition, the number of tests available is expanding.

Shane also reckons that although Healius enjoys sizable market shares in Australian pathology and diagnostic imaging, its inability to set prices and weaker market position relative to Sonic Healthcare prevent it from digging an “economic moat” sourced from cost advantages.

“Revenue in pathology and imaging is earned via direct reimbursement from Medicare at fixed fee per service rates. Healius neither currently earns a return on invested capital above its cost of capital, nor do we expect it to in a typical year over our forecast period. We include goodwill and intangibles in the invested capital base, which arose from acquiring independent practices and the up-front sign-on payments to attract healthcare professionals.”

Healius is looking to reinvest in its business to upgrade its aging lab information systems, IT infrastructure, and automation, Shane says.

“While we expect this to narrow its relative technological disadvantages, and the returns on this reinvestment could be very high, we forecast Sonic to maintain a significant cost advantage derived from its superior and growing scale. Healius may also remain the laggard as Sonic simultaneously continues to upgrade its systems.”


Fair value

Morningstar’s $3.00 fair value estimate for Healius factors in 5% group revenue growth in a typical year and a mid-cycle operating margin of 14%.



“Our estimates deliver EPS growth of roughly 10% in a typical year. The pathology segment is the primary earnings driver. We forecast a 10-year pathology revenue CAGR of 4% and expect segment EBIT margins to expand to 14% by fiscal 2033 from 1% in first-half fiscal 2024 on operating leverage, improved mix, and productivity improvements.

“Our 4% revenue CAGR is made up of 3% volume growth due to population factors and volume growth per capita and 1% average fee increases due to a mix shift to more complex tests such as veterinary and gene-testing. We do not factor in reimbursement pricing pressure in our base case.”

Morningstar’s forecast for diagnostic imaging revenue is to increase at a 7% CAGR over the 10 years to fiscal 2033 from a combination of organic volume growth and indexation of fees.

“We forecast EBIT margins to expand to 14% by fiscal 2033 from 8% in first-half fiscal 2024 through network optimisation, customer digitisation and exposure to higher-margin imaging modalities increasing.”



Risk and Uncertainty

“Despite the relatively predictable nature of its revenue growth drivers in the base business and the industry being defensive, there remains some uncertainty surrounding the success of Healius’ turnaround efforts and how much coronavirus testing will persist at a base level – notwithstanding the ongoing threat of new contagious strains.”

“Given Healius’ high operating leverage, margins are sensitive to test volumes, and system upgrades may fall short of productivity improvement targets. Due to volume rather than price being the main revenue driver across Healius’ divisions, productivity improvements are critical.

“Historical margin declines in the core pathology segment illustrates that the company has been challenged and needed to invest with productivity and cost savings in mind. Reimbursement pressure is less of a concern.

“We expect little change in the regulatory environment with inflationary fee increases also recommencing in diagnostic imaging in fiscal 2021.

“The primary ESG risk is related to product governance, where a major failure in lab technology or improper tests lead to a large increase in misdiagnoses. Lab results are critical in making decisions about appropriate treatment and surgery, and a serious systematic failure may expose Healius to patient liability claims and contract losses.

“However, given Healius’ proven track record in overseeing its operations with well-established processes, we do not think this is likely or would lead to material value destruction. Healius’ processing, collection, and storage of large amounts of sensitive patient data introduces another ESG risk.

“Failure to secure and protect private data from theft or misuse could lead to patient liability claims and reputational damage. However, we think one-off fines or extra compliance costs would be immaterial, and reputational damage is limited given that Healius operates under numerous brands.”


Capital Allocation 

Healius’ balance sheet is in sound condition after the sale of its medical centres, Shane says and financial risk is slight given low revenue cyclicality and solid cash conversion.

“Assuming no significant acquisitions, we forecast the company to be in a net cash position for most of our ten-year explicit forecast period, while also funding its organic growth and maintaining a 60% dividend payout ratio.

“Healius has suffered from underinvestment in the past but we think simplifying the business by selling its medical centres and Montserrat day hospitals and redirecting capital toward much needed infrastructure upgrades is strategically sound.

“We expect returns on invested capital to improve but typically remain below the company’s 8.5% weighted average cost of capital over our ten-year forecast period. As Healius has a history of making acquisitions, we include goodwill in our invested capital base.

However, shareholder distributions are mixed.

“While we think the current target 50%–70% dividend payout ratio of earnings is appropriate to fund its planned reinvestment, its 2021 share buyback program was dilutive with shares repurchased at an average execution price of AUD 4.47, roughly a 6% premium to our fair value estimate.”

The views, information, or opinions expressed in the interviews in this article are solely those of the interviewees and do not represent the views of Stockhead. Stockhead does not provide, endorse or otherwise assume responsibility for any financial product advice contained in this article.