We remain positive on diagnostic sector in India considering a growth potential of ~15% CAGR over medium term and possibility of multiple tailwinds that are likely to emerge in near to medium term. These tailwinds include faster shift of unorganised business to organised players in current environment, potential consolidation in industry through inorganic or partnership model, upside from COVID-19 related RT-PCR as well as anti-body (or anti-gen) tests and sizeable scale which would help in mitigating any realisation-related potential risks. The business for the companies have recovered at very fast pace after reaching a trough in Q1FY21 and we expect normalization Q3FY21 onwards. We believe large organised players are best positioned to benefit from their scale and strong balance sheets. Our recent interaction with company managements reinforces our view.
Multiple levers to add growth: The businesses of diagnostic companies got temporarily impacted by COVID-19 related lockdown as observed in Q1FY21. However, we expect normalisation of business Q3FY21 onwards, as we believe the business has reverted to ~80-90% of the pre-COVID levels. In our view, COVID-19 led disruption has also created multiple growth opportunities for large scale players.
- The shift of unorganised market to organised players is likely to hasten as patients would prefer visiting branded and recognised lab considering safety and hygiene, ability of large players to adapt to and invest in new standards/protocols and increasing probability of acquisition or partnership with small standalone labs.
- Large players are well positioned to garner incremental market share either through acquisition of smaller players or through partnership as smaller players may find operational difficulties due to additional costs of maintaining for implementing higher safety protocols such as social distancing and reduced volumes.
- Incremental business opportunity from COVID-19 related tests like RT-PCR and anti-body (anti-gen) tests in medium-term as these tests would become part of regular test offerings. Further, increasing awareness would lead to higher growth in preventive and wellness tests.
- Strong balance sheets of large established players would help in absorbing near term revenue/margin pressure and would also provide opportunity to capture any available strategic inorganic asset for enhancing scale.
Scale is an added advantage: Scale is an important factor for long term success in diagnostic business. Large scale helps in effective negotiation with vendors, driving operating leverage, attracting franchisees to grow business and free cash flow generation. This is also visible from the potential growth (~15% revenue CAGR) and return profile (>40% RoIC) of large players like Dr Lal Pathlabs and Metropolis.
Our view: We remain positive on the Indian diagnostic sector and believe multiple growth drivers would support the growth momentum over medium to long term. We place Dr Lal Pathlabs as our top pick within the sector. We retain ADD rating on Metropolis and HOLD on Thyrocare.