Industry CMP Recommendation Add on Dips to band Sequential Targets Time Horizon Healthcare Rs. 960 BUY Rs Rs Quarters

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1 INVESTMENT IDEA 31 MAR 2017 Dr. Lal PathLabs Industry CMP Recommendation Add on Dips to band Sequential Targets Time Horizon Healthcare Rs. 960 BUY Rs Rs Quarters HDFC Scrip Code DRLALPEQNR BSE Code NSE Code Bloomberg LALPATHLAB DLPL CMP 31 Mar 17 Rs 960 Equity Capital (Rs cr) 82.7 Face Value (Rs) 10 Equity O/S (cr) 8.27 Market Cap (Rs cr) 8080 Book Value (Rs) 82 Avg. 52 Week Volumes Week High Week Low 792 Shareholding Pattern (%) Promoters 58.6 Institutions 36.0 Non Institutions 5.4 Company Background Dr. Lal Pathlabs (DLP) is a leading player in the fragmented & competitive Indian diagnostics market. Established in 1949, DLP based company has been able to widen its reach to a pan-india network on the back of strong brand equity and a scalable hub & spoke model, whereby specimens are collected from multiple locations within a catchment area or region for shipment to a clinical laboratory for centralized diagnostic testing. This network boasts of a National Reference Laboratory in Delhi (2010), over 172 clinical laboratories, 1,559 patient service centers and 4,967 pick-up points. The company has 172 labs, most of which are in Northern Region and It is the highest revenue contributor with 72% contribution. DLP possesses capabilities to carry out a comprehensive range of ~ 1,110 test panels, organized into ~ 1,934 pathological tests and ~ 1,561 radiology & cardiology tests & services in its quality laboratories which have been accredited by the College of American Pathologists (CAP) and National Accreditation Board for Testing & Calibration Laboratories (NABL). Its customer mix of individual patients, hospital tie-ups and other healthcare providers & corporates enabled DLP to test over ~ 22.2 mn & ~ 26.3 mn samples and ~ 10.1 mn & ~ 12.0 mn patients in 9M FY17 & FY16 respectively. Its centralized information technology platform is the backbone of its efficient operations as it integrates its network through a common logistics & payments system, thereby allowing efficient collection of samples & payments and offers convenience to healthcare providers & patients in locating patient service centers, booking tests and accessing test results online through their website & mobile app. DLP has established an international presence as well through its partners in the Middle East, Africa & South East Asia. Investment Rationale Diagnostic market size to touch ~US$ 9.8bn by FY18E Strong brand Dr. Lal PathLabs supported by self-sustaining business model PCG Risk Rating* * Refer Rating explanation Yellow Kushal Rughani kushal.rughani@hdfcsec.com Has a network of 172 labs, PSCs and Pick Up Points Well defined Strategy in place Hub and Spoke Model Patient Service Centres (PSC) quickest way forward for expansion Private Client Group - PCG RESEARCH P a g e 1

2 Risk & Concerns: To set up two more reference Labs at Kolkata and Lucknow aa Set to post 20% revenue and 33% PAT cagr over FY16-19E View & Strong Valuation: Free Cash Flows and robust balance sheet Talwalkars Better Value Diagnostic market size to touch ~US$ 9.8bn by FY18E The size of the diagnostic services market in India is estimated at US$ 6.5bn infy15 and the industry is likely to post 17% cagr to touch US$ 9.8bn by FY18E. Moreover almost 82-85% of market remains unorganized which leaves significant opportunity for the organized players like SRL diagnostics, Dr. Lal PathLabs, Metropolis etc. DLP has posted 20% revenue and 33% PAT cagr over FY12 16 with operating margin range of ~23 27% and robust RoE/RoCE of 30 35%. We expect ~19% revenue cagr and 21% PAT cagr over FY15 18E with 230bps margin expansion. Management is keen on to expand its presence in existing markets such as North and East. DLP is setting up two more Reference labs in Kolkata and Lucknow. In other geographies, Company is likely to do network expansion through strategic acquisitions and partnerships. As part of growth strategy, company also plans to foray into international markets by opening laboratories in neighboring countries such as Nepal, Bangladesh and Sri Lanka, as well as selective entry into African and Middle East countries. Currently, International revenues are negligible or to the tune of ~Rs 10cr. Beneficiary of industry shift Increasing incomes, medical awareness, emergence of preventive healthcare and only a modest pricing differential has led to a gradual shift towards regional/national chains that offer a wide range of tests at attractive rates. Thus, while the industry will grow in the low-teens, we expect the chains to grow in mid-tohigh teens. Company has dominant market share in North market. We believe Dr. Lal s strong consumerbrand in its legacy northern market has helped it garner not only market share, but also a premium with compared to other players. Unlike pharma companies, which face several headwinds such as regulatory interference and pipeline pressures, the organised diagnostic industry has limited competition, which should ensure sustainable volume-driven growth. We expect the Return Ratios to be in the range of 25 30%. We believe these factors should help Dr. Lal Path sustain its premium valuations. The company has Rs 370cr as cash and current investments in the balance sheet as on Dec These are adequate to fund future growth as company is setting up two additional Reference Labs (Rs cr) and satellite labs (each lab cost: Rs 3 4cr). Private Client Group - PCG RESEARCH P a g e 2

3 Strong brand supported by self-sustaining business model DLP has established itself as a strong brand in the pathology diagnostics market, especially in North India, which contributes ~70% of the company s revenues. The hub-and-spoke model has provided the company a strong competitive advantage versus standalone chains and has helped the company in establishing a strong foothold in North India around its National Reference Lab. We like DLP s strategy (1) expansion in a fastgrowing market through well-established hub-and-spoke model, (2) strong franchise network, (3) tapping new market opportunities such as South and East, all of which are underpinned by a wide array of test menu and backed by a strong management team and logistics system. Massive untapped market The Indian diagnostic market, which is growing at 15 16% per annum, is the result of increasing healthcare penetration in India as well as a surge in non-communicable disease. This combined with increasing spend on healthcare has led to a double-digit growth across the healthcare space pharma, diagnostics and healthcare services such as hospitals. The national chains such as Dr. Lal Path, SRL and Metropolis form miniscule 6 8% of the Rs 380bn diagnostic market. Well-defined strategy in place; Hub-and-spoke model Dr. Lal has a well-defined strategy, which can fuel sustainable growth, going forward. The hub-and-spoke model ensures that high-capex incurring reference labs are fewer in number and expansion is mainly through clinical labs, patient service centres (PSC) and pick up points (PUPs). This includes the National Reference Laboratory in New Delhi, 172 other clinical laboratories (of which 166 are owned), 1,559 PSCs and almost 5,000 PUPs. The specimens are collected across multiple locations within a region for delivery to a clinical laboratory for centralised diagnostic testing; this not only provides for greater economies of scale, but also offers a scalable platform for the continued growth of the business. A regional reference lab is located in or around a metropolitan city. It accumulates samples from satellite labs and PSCs across the region. Usually these are equipped to do a variety of tests ranging from the most basic to the specialised ones including radiology. The newly opened labs generally get break-even within 4-5 quarters from commencement of operation. They perform basic testing functions through the samples it generates as well as those acquired from PSCs. The more complex tests are referred to the regional reference/national reference labs. Collection centres are an effective way to enhance the sample collection. They are located in nursing homes, hospitals, pathology labs, doctors clinics and also on rented premises. They are either company-owned or franchised, in which case company pays as franchisee fee to get the license to operate a collection centre for a satellite lab. Private Client Group - PCG RESEARCH P a g e 3

4 DLP is setting up another two reference Labs at Kolkata and Lucknow Dr. Lal PathLabs has been granted land in New Town, Kolkata, covering an area of approximately 1,500 square meters, by the West Bengal Housing Infrastructure Development Corporation Limited, for construction of regional reference laboratory in Kolkata. The majority of clinical laboratories and other business premises, including patient service centers and local corporate offices, are leased. Typically, the leases range from five to seven years. With an aim to ramp up its capabilities in routine & specialized tests in its core markets similar to its Delhi clinical facilities, the company has decided to construct a 50,000 square feet regional reference lab in Kolkata. This lab is expected to be commissioned by Sep 2017 at a capex of ~Rs 50cr. One more such lab is expected to come up by H2 FY19 in Lucknow. Thus, these two labs would enhance DLPs revenues substantially in the coming years. This would have twin benefits of raising DLPs brand equity in a big way and de risking its business with reduced dependency on its New Delhi facilities for specialized testing. PSC quickest way forward for expansion Dr. Lal has swiftly expanded its Patient Service Centre (PSC) network from 824 in FY13 to 1,559 in FY16, of which 1,475 are exclusive franchisees. Management has indicated that the trend to expand through PSCs is likely to continue in the coming years as well. This enables the company to: a) expand geographically with minimum capital pressure and also increase brand awareness; b) raise volumes that will boost asset utilisation, and c) increase volumes, which will lead to better bargaining power with suppliers and thus lower input cost. DLP provides technical, personnel and marketing support to these franchisees and also requisite consumables and collection materials. The agreement ranges from a period of five to nine years and it operates under a revenue sharing model. Premium valuations justified given strong growth; Recommend BUY with TP of Rs 1235 We initiate on Dr. Lal PathLabs with a BUY recommendation with a target price of Rs 1,235. The company is one of the key players in the organised space of a highly fragmented market. We see DLP to be key beneficiary on the shift toward the organised space. While other players Thyrocare, Metropolis and SRL will provide stiff competition, an expanding geographic footprint should ensure that growth rates remain unaffected as Dr. Lal s brand building starts to deliver in the form of higher business from standalone centres. Furthermore, the hub-and-spoke business model ensures a low capital outlay and quick initiation of labs. Dr. Lal PathLabs has posted 21% revenue and 30% PAT cagr over FY13 16 and we expect the momentum to continue over the next 2 3 years. We forecast 21% revenue cagr over FY16-19E led by growth from across the board all the geographies. We expect smaller geographies like West and South to exhibit faster growth given the smaller base. As per management commentary, we believe that company would maintain margins 25-26% in the next 2-3 years. Private Client Group - PCG RESEARCH P a g e 4

5 Margins would remain compressed given company is opening newer labs, rationalising its PUPs and to open another two reference labs. We foresee company to post 21% PAT cagr over the same period. Company has 172 labs as Mar2016.We expect company to add labs over FY16 19E with nominal rise in revenue per laboratory. We build in 19% revenue and 21% PAT cagr over FY15 18E with ~230bps margin expansion. We like the underlying business on the back of robust growth in revenues/pat over past 4 5 years along with sustained revenue visibility. Dr. Lal PathLabs has corrected ~28% from its peak of Rs 1280 and now it is trading at attractive 33x FY19E earnings and 20x EV/EBITDA. We believe that DLP s long term growth potential remain intact given superior Brand equity and execution track record. A strong brand franchisee, stellar return ratios in the range of 30-35%, robust balance sheet and free cash flows justify premium valuations. The company s secular growth story and superior return metrics make a compelling long-term story. We recommend investors to BUY Dr. Lal PathLabs in the range between Rs 890 to 960 with sequential targets of Rs 1090 and Rs 1235 over the next 4 quarters. Risks and Concerns The performance, growth & integrity of the Dr. Lal Pathlabs brand name relies on the performance of franchisees which control more than 90% of the 1,559 centers as on FY16. Any major allegations related to Tests / Quality can be severely damaging to the brand equity of DLP which functions in a competitive B2C market where quality & trust play a major role. Competitive pressures from both unorganized players which form ~ 85% of market as well as rise of more regional & pan-india chains can lead to undercutting of prices, suppressing margins. While the diagnostic healthcare services industry in India is presently not subject to extensive governmental control, the government could introduce more stringent regulations. Any changes in regulations or introduction of price controls for the larger benefit of society could have a material adverse effect on DLPs business, operating revenues & cash flows. Any interruptions in DLPs Delhi national reference laboratory or its information technology systems which form the backbone of its entire business model could lead to serious disruptions in operations & profitability. Technology adaptation has been one of the strengths and Company has successfully rolled out new tests on contemporary technology platforms in the past. With continuous availability of new technologies, DLP needs to remain competitive by ensuring swift adoption of such new technologies with focus on benefits and returns. Private Client Group - PCG RESEARCH P a g e 5

6 Financial Summary (Rs Cr) FY14 FY15 FY16 FY17E FY18E FY19E Sales EBITDA Net Profit EPS (Rs) P/E EV/EBITDA RoE Comparison with Other Diagnostic Players Diagnostic Chain Presence Accrediations Laboratories Market Cap (Rs cr) Dr. Lal PathLabs India, Middle East, Nepal, Malaysia NABL, ISO,CAP,CDC (USA) SRL Diagnostics India, Middle East, Nepal, Africa and Maldives NABL, ISO,ICAL, CLIA,APLAC 265 NA Thyrocare* India, Nepal, Bangladesh and Gulf countries ISO,CAP, NAGL Metropolis India, UAE, Sri Lanka, South Africa NABL, ISO,CAP, CLIA (USA) 150 NA, NA not listed on Exchanges, * Operates through centralized Lab at Navi Mumbai Private Client Group - PCG RESEARCH P a g e 6

7 Rs Cr PCG RESEARCH Revenues to post 21% cagr over FY16-19E FY14 FY15 FY16 FY17E FY18E FY19E EBITDA and PAT trend over FY14-19E FY14 FY15 FY16 FY17E FY18E FY19E EBITDA PAT Robust Return Ratios (%) FY14 FY15 FY16 FY17E FY18E FY19E RoE RoCE Laboratory Count # FY13 FY14 FY15 FY16 Private Client Group - PCG RESEARCH P a g e 7

8 Rs Cr Rs Cr PCG RESEARCH PSC addition trend over FY # FY13 FY14 FY15 FY16 FY19E Revenue Split (%) North South West East Northern Region revenue trend FY14 FY15 FY16 FY17E FY18E FY19E Revenues trend for Western Region FY14 FY15 FY16 FY17E FY18E FY19E Private Client Group - PCG RESEARCH P a g e 8

9 Segment wise Diagnostic centres breakup (%) 15 Projected Growth of Indian Diagnostic Industry 70 Rs. '000cr Standalone Hospital Based Diagnostic Chains 10 FY14-15 FY17-18P Three Different Models Hospital Based Centres Diagnostic Chains Diagnostic Centres located within Hospitals. Mostly owned by Hospitals and also given third parties to manage the same. Privately Owned Diagnostic Centres with two or more centres. Operates through Hub and Spoke Model of Collection Centres Standalone Centres Single Diagnostic Centre. Majority has small scale of operation and offer basic diagnostic tests Private Client Group - PCG RESEARCH P a g e 9

10 Income Statement (Rs Cr) FY15 FY16 FY17E FY18E FY19E Net Revenue Growth (%) Operating Expenses EBITDA Growth (%) EBITDA Margin (%) Depreciation EBIT Other Income Interest PBT Tax RPAT Growth (%) EPS Balance Sheet (Rs Cr) FY15 FY16 FY17E FY18E FY19E SOURCE OF FUNDS Share Capital Reserves Shareholders' Funds Long term Debt Net Deferred Taxes Long Term Provisions & Others Total Source of Funds APPLICATION OF FUNDS Net Block Intangibles Goodwill Long Term Loans & Advances Total Non Current Assets Inventories Trade Receivables Cash & Equivalents Other Current Assets (incl Curr Invests) Total Current Assets Trade Payables Other Current Liab & Provisions Total Current Liabilities Net Current Assets Total Application of Funds Private Client Group - PCG RESEARCH P a g e 10

11 Cash Flow Statement (mn) (Rs Cr) FY15 FY16 FY17E FY18E FY19E Reported PBT Non-operating & EO items Interest Expenses Depreciation Working Capital Change Tax Paid OPERATING CASH FLOW ( a ) Capex Free Cash Flow Investments Non-operating income INVESTING CASH FLOW ( b ) Debt Issuance / (Repaid) Interest Expenses FCFE Share Capital Issuance Dividend FINANCING CASH FLOW ( c ) NET CASH FLOW (a+b+c) Key Ratios Key Ratios (%) FY15 FY16 FY17E FY18E FY19E EBITDA Margin EBIT Margin APAT Margin RoE RoCE Solvency Ratio Net Debt/EBITDA (x) Net D/E Interest Coverage PER SHARE DATA EPS CEPS BV Dividend VALUATION P/E P/BV EV/EBITDA EV / Revenues Dividend Yield (%) Div Payout Private Client Group - PCG RESEARCH P a g e 11

12 Rating Chart R E T U R N HIGH MEDIUM LOW LOW MEDIUM HIGH RISK Ratings Explanation: RATING Risk - Return BEAR CASE BASE CASE BULL CASE IF RISKS MANIFEST BLUE PRICE CAN FALL 15% IF RISKS MANIFEST LOW RISK - LOW & IF INVESTMENT PRICE CAN FALL RETURN STOCKS RATIONALE 20% OR MORE FRUCTFIES PRICE CAN RISE BY 15% YELLOW RED MEDIUM RISK - HIGH RETURN STOCKS HIGH RISK - HIGH RETURN STOCKS IF RISKS MANIFEST PRICE CAN FALL 35% OR MORE IF RISKS MANIFEST PRICE CAN FALL 50% OR MORE IF RISKS MANIFEST PRICE CAN FALL 20% & IF INVESTMENT RATIONALE FRUCTFIES PRICE CAN RISE BY 30% IF RISKS MANIFEST PRICE CAN FALL 30% & IF INVESTMENT RATIONALE FRUCTFIES PRICE CAN RISE BY 30% IF INVESTMENT RATIONALE FRUCTFIES PRICE CAN RISE BY 20% OR MORE IF INVESTMENT RATIONALE FRUCTFIES PRICE CAN RISE BY 35% OR MORE IF INVESTMENT RATIONALE FRUCTFIES PRICE CAN RISE BY 50% OR MORE Private Client Group - PCG RESEARCH P a g e 12

13 Price Movement Rating Definition: Buy: Stock is expected to gain by 10% or more in the next 1 Year. Sell: Stock is expected to decline by 10% or more in the next 1 Year. Private Client Group - PCG RESEARCH P a g e 13

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