This week, we’ve been deep diving into the blood-soaked corner of the ASX taken up by the local pathology companies.

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:

Shane says the top ASX pathology providers “remain significantly undervalued following the supportive pathology policy changes announced in the federal budget.”

Overall, the budget affirms our outlook for the industry, Shane says.

“About 50% of the pathology schedule by revenue is resuming indexation from July 1, 2025. While we had assumed a 50% likelihood of indexation resuming for the entire pathology schedule, the net outcome is very similar and we maintain our earnings estimates.”

The increased government funding will help to offset inflationary pressures, he adds.

“The only pathology items that will remain frozen are in chemical, microbiology, and genetics, which are generally higher margin and benefit more from automation and economies of scale, or largely consist of newer services and technologies, whose costs are decreasing over time.”

In diagnostic imaging, planned reforms were more neutral, Shane says.

“The positive of annual indexation, soon to be applied to nuclear medicine imaging, was offset by an expected 2% one-off fee reduction for most computed tomography imaging items, which accounted for roughly a third of Medicare diagnostic imaging benefits paid in fiscal 2023.

“The government is also phasing out its magnetic resonance imaging licensing requirements. Currently, there is roughly an even split between MRI machines with full, partial, and no reimbursement. The planned changes would almost triple the number of fully Medicare-eligible MRI machines by fiscal 2028, and is a negative for providers as increased competition will likely reduce pricing.”

“We maintain our fair value estimates for narrow-moat Sonic Healthcare, no-moat Healius, and no-moat Australian Clinical Labs at $32.00, $3.00, and $3.50, respectively.


Australian Clinical Labs (ASX:ACL)

ACL is the third-largest pathology operator in Australia.

Sonic is roughly three times larger, earning Australian pathology revenue of $1.5 billion in fiscal 2020 versus Healius’ $1.2 billion and ACL’s $0.5 billion.

In the same year, Sonic’s global pathology EBIT margin was 15%, with Sonic’s margin also likely diluted by its less-dominant regions overseas, versus Healius’ Australian pathology EBIT margin of 11%, and ACL’s pro forma EBIT margin of 6%.

“We think this substantial margin differential is driven by ACL’s weaker scale efficiencies and we forecast this relative disadvantage to persist.”

Shane says that Australian Clinical Labs’ strategy centres on capitalising on the growing demand for diagnostic testing.

“Volume growth is underpinned by population growth, aging demographics, higher incidence of diseases and wider adoption of preventative diagnostics to manage healthcare costs.

“These drivers are often greater in lower-density Australian states in which ACL is largely based. In addition, the number of tests available is expanding. Increasing complexity of tests, such as veterinary and gene-based testing, is also resulting in average fee price increases.

“The majority of group revenue is earned from the public health Medicare system via bulk billing.”

Pathology has a high fixed cost of operation and thus benefits from volume growth to drive a lower cost per test.

“ACL aims to benefit from cost efficiencies by maximising throughput across its network of labs and collection centres. Higher testing volumes result in a lower cost per test as labour, equipment, leases, transportation and overhead costs are all leveraged. Improvement in systems is also key to improving operational performance. Pathology is an increasingly technologically driven service, and the company intends to invest in its laboratory information system, automation and digitisation.”

“Growth is also aided by acquisitions, with synergies from procurement and integrating IT being relatively easy to capture.”

Size matters in pathology

Shane says that despite ACL’s sizable high-teens market share in Australian pathology, its limited ability to set prices, smaller scale relative to its larger competitors Sonic Healthcare and Healius, and largely undifferentiated service offering leave it more vulnerable.

Over 90% of revenue in pathology is bulk-billed and earned via direct reimbursement from Medicare at fixed fee per service rates.

“We forecast ACL to post an average return on invested capital, or ROIC, including goodwill of roughly 10% over our 10-year explicit forecast period, slightly exceeding its weighted average cost of capital, or WACC, of 9%. However, this is largely a function of the underlying industry recovering from pandemic lows rather than a moat, as doctor visits recover and subsequently, volumes for diagnostic testing. We include goodwill in the invested capital base that arose from acquiring independent practices.”

As intimated above, Shane says scale matters in pathology labs as they operate a hub and spoke model whereby collection centres, either in hospitals or near doctors’ rooms, feed samples through to large, centralised labs for processing.

“Despite ACL operating over a fifth of Australia’s collection centres, versus Sonic and Healius with roughly a third each, its pathology business is disproportionately smaller. We estimate ACL’s network is less efficient, with collection centres likely being smaller on average and in less populous locations.

“While Sonic operates the majority of centres in the most populous state, New South Wales, ACL claims the majority in the lower-density states of Northern Territory and South Australia, and we estimate is still the trailing third player in Victoria based on pathology revenue.

“Location 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 ACL to gain throughput efficiency in more populous states and generate significant economic profits.


Fair value

“Our fair value estimate for ACL is $3.50 per share. This implies a forward fiscal year P/E ratio of 22 and an EV/EBITDA ratio of 4.

“We forecast a five-year group revenue CAGR of 4% to fiscal 2028, driven by our typical forecast revenue CAGR for the base Australian pathology business of 4%. This 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.

“On the profitability front, we assume modest margin expansion from operating leverage, with our midcycle operating margin forecast at 12% versus 9% in fiscal 2023. Our estimates deliver EPS growth of roughly 6% in a typical year. We forecast average annual capital expenditure of roughly AUD 12 million over the next 10 years, or 1% of group sales.”

On the risk front, the primary environmental, social, and governance, or ESG, risk to ACL 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 ACL to heaps of litigation.


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