We maintain our $3 fair value estimate for no-moat Healius following (ASX:HLS) CEO Maxine Jaquet’s decision to resign after serving as CEO for one year. The past year has proven challenging to navigate, with higher-margin coronavirus testing revenue largely disappearing while inflationary pressures mounted. This resulted in the company raising equity at a dilutive price in November 2023 and the share price has dropped more than 22% year to date.

Healius’ CFO, Paul Anderson, will take over as CEO and managing director effective immediately and will lead a strategic review to ensure Healius’ operations are structured efficiently. We think Anderson is well placed to consider asset sales and resize Healius’ labor and infrastructure costs following pandemic testing largely ceasing.

Before being appointed CFO of Healius in March 2023, Anderson had a 17-year tenure at Network Ten, which included the roles of CFO, COO, and CEO. We see many parallels to his media experience, including balancing the competing aims of managing costs and investing in digitization in an industry facing change.

Shares are materially undervalued. Healius’ base businesses remain well-placed to service known underdiagnosis for routine healthcare services. In the longer term, we anticipate increased operating leverage from higher volumes in the base businesses and a continued focus on labor productivity and higher-value pathology tests and imaging modalities, which will more than offset current rent and wage inflation. Operating leverage refers to the degree to which a firm or project can increase operating income by increasing revenue

We also anticipate margin expansion from network optimization, digital initiatives, and increases to out-of-pocket fees for non-Medicare items.

We don’t yet explicitly forecast the resumption of indexation for pathology Medicare items. Still, we know the industry is lobbying for this to resume after 24 years and could see an outcome in the May 2024 federal budget.

Business strategy and outlook

In 2018, the former Primary Healthcare rebranded itself as Healius to signify the strategic turnaround underway. 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 centers and Montserrat day hospitals to focus on redirecting capital toward infrastructure upgrades and its diagnostic businesses is viewed as a positive strategic step.

Improvement in systems is key to improving efficiency. Pathology is an increasingly technologically driven service and the company intends to invest in a new laboratory information system, automation, and digitization 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. Increasing complexity of tests, such as veterinary and gene-based testing, is also resulting in average fee price increases.

Pathology has a high fixed cost of operation and thus benefits from volume growth to drive lower cost-per-test outcomes. Higher testing volumes result in a lower cost-per-test as labor, equipment, leases, transportation, and overhead costs are all leveraged. In 2013, the Australian government placed a freeze on Medicare fee rates but resumed indexation in fiscal 2021 for diagnostic imaging.

Economic moat rating

Read more about how identifying a company with a moat impacts investment results.

Despite Healius having 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 the second-largest pathology operator in Australia. Sonic is roughly one third larger, earning Australian pathology revenue of $1.5 billion in prepandemic fiscal 2019 versus Healius’ $1.1 billion. In the same year, Sonic’s global pathology earnings before interest, taxes, depreciation and amortisation (“EBITDA”) margin was 18% versus Healius’ Australian pathology EBITDA margin of 12%, with Sonic’s margin also likely diluted by its less-dominant regions overseas.

We think this substantial margin differential is largely driven by Healius’ weaker scale efficiencies and aging infrastructure and IT systems. Despite Healius operating roughly one third of Australia’s collection centers, 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. 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 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%.

Healius is looking to reinvest in its business to upgrade its aging lab information systems, IT infrastructure, and automation. 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, hence our no-moat rating.

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