Profit-making: It's In The Blood

Sydney Morning Herald

Monday August 16, 1999

Margot Saville

Tests are big money and one of the few profitable areas in medicine open to lay investors. Margot Saville examines the pathology industry.

Australia's first group of baby boomers are now in their fifties. New medical technology has made possible widespread DNA testing. And more doctors are being sued by aggrieved patients.

This all adds up to the best of times for the pathology sector. Continuing industry rationalisation and consolidation is driving cost efficiencies and boosting profits.

Third-ranked player Swiss industrial group SGS plans to sell off its pathology businesses in the next three months, either by float or trade sale. The two listed players in the sector, Mayne Nickless and Sonic Healthcare, are rumoured as possible buyers.

Ten days ago a new player entered the market when WA investor Revesco bought half of Victorian pathology company Gribbles.

All these operators are fighting for a share of the over 18 million sets of pathology requests made by medical practitioners a year a number showing strong annual growth.

That growth is being boosted by aging baby boomers, who are demanding more diagnostic tests and are suing doctors who fail to detect their diseases lawsuits against doctors have risen four-fold in the past decade alone. Also, to this group, DNA testing is a godsend. If you can establish a genetic disposition to bowel cancer, then bad eating habits are not the cause.

Faced with spiralling medical costs, the Federal Government imposed a cap on the level of Medicare pathology rebates a few years ago. Those rebates, which will amount to $1.1 billion a year over the next three years, have just been renegotiated, with a 4 per cent growth cap.

Chief executive officer of the Australian Association of Pathology Practices, Mr David Kindon, says that certainty of spending and revenue is good for the government and for the industry. ``They know how much money is involved, so the only issue is market share."

And the fight for market share is fierce, with the top five companies controlling more than 70 per cent of the national market, up from 60 per cent just two years ago. Mayne Nickless is the leader, with a 23 per cent national share, followed by Sonic with 19 per cent. The next three operators are SGS (15 per cent) and Queensland Medical Labs and Gribbles, both with 11 per cent.

The ACCC is monitoring the industry on a continuing basis, signalling prospective regulatory issues for either Mayne Nickless or Sonic buying the SGS businesses.

But Salomon Smith Barney healthcare analyst Mr Stephen Goldberg says the ACCC should include the $1 billion public pathology sector when determining market dominance.

At the same time, each company has strengths in different states, so that the ACCC could impose conditions requiring some selldowns as further industry consolidation continues.

Gribbles, for example, is strong in Victoria and SA, with Mayne Nickless' pathology interests strong in Victoria, WA, NSW and the NT.

Sonic is estimated to hold 40 per cent of the NSW market, 55 per cent of the ACT and about 45 per cent of the SA market, while SGS has 20 per cent of the Victorian market and 40 per cent of each of the Queensland and NZ markets.

Overlapping regional interests will complicate bidding by either Sonic or Mayne Nickless for SGS, which is yet to decide whether to float the pathology business or conduct a trade sale. Valuations of its pathology operations range up to $400 million. One complication is that SGS does not own all of its businesses, with 40 per cent in the hands of its pathologists, who are thought not to support a trade sale.

In pathology, size matters, which is why the SGS sale will be crucial to the future status of the other four main players. If revenue mostly in the form of the Medicare rebate is largely fixed, then the sole way to raise earnings is to cut costs. And the key here is to get bigger and achieve economies of scale.

The stand-out performer has been Sonic, headed by Dr Colin Goldschmidt. It has increased dividends, revenue and net profit each year since going public in 1995 and is now capitalised at $500 million.

According to ABN AMRO, Sonic could report this week a 36 per cent lift in profit for 1998-99 to $15.7 million, on an estimated 17 per cent rise in revenue to $170 million.

Sonic's shares, which closed at $4.05 on Friday, have outperformed the All-Industrials by more than 300 per cent over the past three years.

According to Salomon's Mr Goldberg, Sonic's margins are about 20 per cent, 5-8 per cent higher than Mayne Nickless and the other players. This has been achieved by buying five pathology businesses in the past four years and consolidating operations, reducing duplication of collection centres, staff, equipment and couriers. The company has also built a ``superlab" in North Ryde, where samples for automated tests are transported from all over Australia. As a result, unit costs have plummeted.

``When they get additional volumes that will improve, because a lot of it is mechanised. The incremental cost is really small. But you get a full Medicare rebate so at the gross level you get good margins," Mr Goldberg said.

And the future of the industry is more consolidation.

``There will be more rationalisation, and fewer and fewer big players ... so that unit prices will be driven down. Pathology is becoming a kind of commodity, so that size and the efficiency that size can bring will be absolutely critical if you want to maintain and grow margins."

Sonic's Dr Goldschmidt said his company was looking for ``double digit EPS growth over the next two or three years", ignoring the impact of any acquisitions.

Rothschilds Australia holds 8 per cent of Sonic. Its director of smaller companies, Mr Campbell Boag, says that recent changes in the sector have been driven ``by the Government's stated wish for a lower cost of delivery" following a period of over-servicing due to referral kickbacks to general practitioners.

``But as the degree of regulation and supervision increased, this squeezed out the less professional and also higher-cost players."

Mr Boag also points to demographics, highlighting statistics that 85 per cent of one's lifetime medical costs are incurred after the age of 60. Then you enter an ``intensive medical treatment zone", he says.

Mayne Nickless is seeking to emulate Sonic's success. Its health care division contributes 30 per cent of revenues of $2.6 billion. Of that, one quarter came from the pathology and radiology sector (last year $180 million), with growth here outstripping hospital revenue growth. Diagnostic revenues will increase sharply this financial year following the purchase of Macquarie Pathology and Laverty's Pathology, which have combined revenues of $49 million.

Mayne Nickless has spent about $1 billion in the past seven years building its healthcare business.

The newest player, Revesco, recently bought 49.9 per cent of Melbourne based pathology company, Gribbles, and 13 per cent of Gribbles Malaysia for $71.2 million, as it targets the medical services sector for growth. Revesco has also taken up $4 million of convertible notes in Perth-based medical services provider Spectrum.

Revesco general manager Mr James McAuliffe said his company saw ``huge growth potential in the pathology sector".

``We have been looking to make an investment in the overall health sector for the past 12 to 18 months and pathology is a key sector in the health care industry."