Dr. Lal PathLabs. Prescriptive-Preventive-Protective, but too expensive. December 04, Institutional Equity Research Pharmaceuticals India

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1 Dr. Lal PathLabs Prescriptive-Preventive-Protective, but too expensive Dr Lal PathLabs (DLPL) is the second largest diagnostic chain in India with 172 clinical laboratories, 1,554 patient service centers and over 7,059 pickup points as of 1HFY16 through hub and spoke model. Though the company has Pan India presence, more than 72% of its revenue comes from North India region. Going forward the growth will primarily be driven through inorganic routes and hospital labs as DLPL looks to expand its presence across geographies. Through this oer, the company plans to sell stake of 14% (10% by TA and Westbridge) and balance by promoters. Key strengths DLPL has grown by 2.8x with profit growth over 13% in past 5 years. Sales of 20.7%, EBITDA at 27.5% and PAT margins at 14% excluding the ESOP charge over FY Most of the equipments company use is on pay per test basis so that the capital allocation is not higher. Early detection and prevention has given rise to new branches of diagnostics, namely Prognostics and Predictive Diagnostics. These branches of diagnostics are pretty significant, as companies have been formed based on these oshoots of diagnostics. Key Concerns Currently 85% of the market is unorganized posing a threat to the branded retailers. The trust and confidence of its customers are fundamental to its business and failure to maintain that could adversely impact its repute Growth strategy of expansion across India may amplify its impact on cash flows Issue Details Pre-Issue Paid up Cap. (Rs mn) 813 Post-Issue Paid up Cap. (Rs mn) 824 Post-Issue Mkt Cap. (Rs bn) at 45.4 upper price band BRLM Registrar Kotak Securities and Citi Global Link Intime Pre-Issue Pattern % Promoter 68.7 Public 31.3 Post-Issue Pattern % Promoter 58.7 Public 21.3 Oer for dierent categories % QIB 50 HNI 15 Retail 35 Promoters Dr. Arvind Lal and Dr. Vandana Lal Objects of the issue To achieve benefits of listing the equity shares. This will enhance company s visibility and brand image among its existing and potential clients. Diagnostics have a hard time extracting value-based pricing Outlook and Valuation We reckon that while its franchise model is asset light on balance sheet, it is highly dependent on performance of franchisees and business partners. Further, while there has been an increase in evidence based treatments, lack of comprehensive and stringent framework exposes the vulnerability of large chains in this business. At the lower end of the price band, the company is valued at 46.6x FY15 PE, which is expensive given the highly fragmented market and low entry barriers in the sector. Though we like the fundamentals and remain confident of its immense business potential, we suggest investing at lower levels. Key Financials (Rs mn) FY11 FY12 FY13 FY14 FY15 Total Income 1,806 2,557 3,540 4,194 5,036 Growth (%) EBITDA ,386 1,560 Margin (%) Net Profit NPM (%) Diluted EPS (Rs) Source: Company, RHP Research Analyst: Sapna Jhawar Contact: (022) sapna.jhavar@relianceada.com 1

2 Risk factors Highly fragmented market with intense local competition Lack of comprehensive and stringent regulatory framework About the company Dr Lal PathLabs, incorporated in 1995 and headquartered in Delhi is India s first diagnostic service provider to get listed on Indian equity bourses. The company oers patients and healthcare providers a broad range of diagnostic and related healthcare tests and services for use in core testing, patient diagnosis and the prevention, monitoring and treatment of disease and other health conditions. Initially, the business was established by Dr. S. K. Lal, who commenced the business of providing pathology services and maintaining blood bank in the year Until recently, before getting converted into public company, it was operating as partnership firm with 50:50 shares between Dr. Vandana Lal and Brig. Dr. Arvind Lal. Company oers 3,368 diagnostic and related healthcare tests and services and is capable of performing substantially all of the diagnostic healthcare tests and services currently prescribed by physicians in India. It has built a hub and spoke network that includes National Reference Lab in New Delhi and presence across major cities such as Delhi, Mumbai, Bengaluru, Chennai, Hyderabad and Kolkata. Company follows franchise model for its patient service center and thus follows asset light model. Exhibit 1: Key management personnel Promoters Brig. Dr. Arvind Lal Dr. Vandana Lal Dr. Om Prakash Manchanda Mr. Dilip Bidani Source: RHP Remarks Chairman and MD with over 20 years of experience in diagnostic business Whole time Director with over 20 years of experience Whole time Director and CEO CFO Key Strengths Network coverage across India DLPL has built a national network comprising National Reference Laboratory in New Delhi, 172 clinical laboratories, 1,554 patient service centers and over 7,059 pickup points as of 1HFY16 through hub and spoke model. The company s network has coverage across India, including metropolitan areas of New Delhi, Mumbai, Bengaluru, Chennai, Hyderabad, and Kolkata. A long operating history, nationwide network, and a reputation for providing quality diagnostic healthcare services position DLPL well to leverage growth in the diagnostic healthcare services industry in India. The size of the diagnostic healthcare services industry in India was estimated at Rs377bn (US$6bn) in FY15. The industry is projected to touch Rs600bn (US$9.6bn) by FY18E. 2

3 Exhibit 1: DLPL network coverage FY13 FY14 FY15 1HFY16 No. of samples collected and processed (mn) % yoy change No. of patients (mn) Clinical Labs Patient service centers 824 1,064 1,340 1,554 Owned Franchise 776 1,009 1,271 1,475 Hub and Spoke model indicates asset light model DLPL follows a Hub and Spoke model to scale its business. With an established presence in North India, the company now plans to scale to other parts of India through construction of regional reference laboratories, including a large regional reference laboratory in Kolkata and smaller clinical laboratories and complementary patient service centers. The above mentioned model ensures better profitability and higher asset turnover ratio keeping the balance sheet in check. Besides, the equipments used for testing are leased under a reagent rental model and can be replaced / upgraded. This model lowers capital expenditure since the company does not have to upfront for the equipment and lock up capital in assets. Exhibit 2: Revenue geography-wise Revenue (Rs mn) FY13 FY14 FY15 1HFY16 North 3, , , ,956.0 East South West International Total Sales 4, , , ,050.0 Source: RHP Strong Financials DLPL s sales/ebitda/pat grew at 29%/29%/34% CAGR respectively over FY However, margins have been sloppy impacted by demand supply scenario and investments for expansion of diagnostic portfolio. Nonetheless, given the asset light model, DLPL boasts of high ROEs at ~33% in FY15. Inorganic growth for expansion The company has undertaken few smaller acquisitions and explored various partnerships for hospitals alongwith the franchise model. These have aided in increasing patient base, customer reach and achieve economies of scale. Besides, the diagnostic industry is highly dependent on latest technologies inorder to extend complex services in the field of chronic diseases. DLPL is yet to expand services in genetics, molecular and oncology testing amongst other chronic therapies. With a well-balanced balance sheet, an inorganic expansion will aid in maintaining quality services across therapies, making DLPL a one stop solution provider. 3

4 Key Concerns Highly competitive business environment The diagnostic healthcare services industry in India is highly competitive and has low barriers to entry. The absence of stringent regulations and low entry barriers has also helped small pathology labs and radiology centers proliferate across the country. Prices for services, geographical reach and timely and accurate reports remain critical for business. With ~48% of market share in FY15, standalone centers dominate the diagnostics industry. Besides, hospital based labs have 37% market share. This leaves the diagnostic chains with a paltry market share of 15% which is further dominated by regional chains. Diagnostics have a hard time extracting value-based pricing The diiculty of communicating value and then sharing in that value (be it cost savings or better outcomes) is significant, making many diagnostic models more of a high volume, low cost commodity business where scale is essential. Further, unlike chronic or routine therapeutic use, there are many single use tests on the genetics side, oneos on acute settings, etc that make for challenging price-to-value considerations. Failure of brand replication across India The company plans to construct and open several new clinical labs including regional reference labs and patient service centers in India. Higher gestation period can result in a divergence between the future revenue production of a new facility and the current expenses being incurred in connection with its opening, thereby aecting the margins and profitability. Besides, a significant portion of the business comes from North India. Failure to replicate the success of brand name in other geographies could adversely impact the business. Highly dependent on technological advancements To stay ahead of the competition, diagnostics centers have to constantly upgrade their technology. However, these upgrades not only involve significant capital investments but also increase maintenance costs. This significantly increases cost overheads for service providers. Moreover, two versions of certain equipment could have a significant price dierential, making it diicult for service providers to upgrade. This is especially the case for smaller players who face paucity of funds. Key Challenges 1) The key secular challenge to the industry is lack of innovation relative to its healthcare peers like the Pharmaceuticals, Biotechnology and Medical Devices industries. While minimal expenditure on R&D buys the participants lower operational costs, it almost always costs them on the gross margin line, as products tend to be undierentiated. However, currently this low innovation-low risk model is working well for the industry since its healthcare peers that spend substantially on R&D are experiencing decreased R&D productivity, thereby earning a lower than ever return on investment. 2) Weak competitive positioning: With minimum regulation and relatively lower capital expenditure requirements, as compared to its other healthcare peers, new market entry in this industry is easy. Though achieving growth and a large scale can be challenging for a new entrant, with either a geographically committed customer base or a new diagnostics indication, the entry is easy. Competitive rivalry is strong, as, with the exception of niche labs, service dierentiation is low. The key dierentiation among the major players is cost advantage and/or relationships with payers. Within the Lab industry, independent labs have faced sti competition from hospital labs. Independent labs have not gained share over hospital labs, even though within independent labs SRL and Metropolis have gained market share. 4

5 Indian diagnostics industry In the spectrum of healthcare delivery services in India, diagnostic services play the role of an information intermediary, providing useful information for correct diagnosis and treatment of patients diseases. Diagnostic services would have a lower share in overall healthcare spends, yet play a vital role in identifying problem areas and major illnesses. The size of the diagnostics industry is at ~Rs377bn in FY15. Overall market for wellness and preventive diagnostics was 6-8% of the total diagnostic services market in FY15. Industry estimates expect the diagnostics industry to grow by a CAGR of 16%-17% over the next three years. The industry can also be separated into urban and rural centers. Urban centers typically have modern facilities (at public and private hospitals, clinics, standalone centers and diagnostic chains) and higher prices for tests. Rural centers largely primary health centers, government dispensaries and private dispensaries generally have small scale facilities and carry out basic tests where ticket sizes are usually lower than those charged in the urban centers. Exhibit 3: Big four diagnostic chains in India Company Investors Stake % Amount Year (Rs mn) Thyrocare CX Partners , NVP 10 1, ICICI venture 2-3 NA Dr Lal Pathlabs Westbridge Crossover NA NA TA Associates 16 2, Westbridge&TA Associates NA 2, Metropolis ICICI venture Warburg Pincus , SRL Diagnostics Sabre Capital NA Avigo Capital Partners NA 1, Jacob Ballas Capital & IFC NA 3, Source: RSec Research Outlook and Valuation We reckon that while its franchise model is asset light on balance sheet, it is highly dependent on performance of franchisees and business partners. Further, while there has been an increase in evidence based treatments, lack of comprehensive and stringent framework exposes the vulnerability of large chains in this business. At the lower end of the price band, the company is valued at 46.6x FY15 PE, which is expensive given the highly fragmented market and low entry barriers in the sector. Though we like the fundamentals and remain confident of its immense business potential, we suggest investing at lower levels. 5

6 Profit & Loss Statement Y/E March (Rs mn) FY11 FY12 FY13 FY14 FY15 Net Sales 2,373 3,422 4,517 5,579 6,596 Total Expenditure 1,806 2,557 3,540 4,194 5,036 Cost of Materials ,177 1,392 Personnel ,016 1,344 Others 820 1,258 1,629 2,002 2,301 EBITDA ,386 1,560 % chg (% of Net Sales) Depreciation& Amortisation EBIT ,113 1,278 % chg (% of Net Sales) Interest & other Charges (9) 11 (1) (56) (90) Other Income (% of PBT) Recurring PBT ,192 1,397 % chg PBT (reported) ,192 1,397 Tax (% of PBT) Minority Interest Adjusted PAT % chg Less: Extraordinary item(ei) Reported PAT % chg (% of Net Sales) Fully Diluted EPS (Rs) % chg

7 Balance Sheet Y/E March (Rs mn) FY11 FY12 FY13 FY14 FY15 SOURCES OF FUNDS Equity Share Capital Reserves& Surplus 878 1,109 1,570 1,512 2,598 Shareholders Funds 928 1,160 1,621 2,315 3,411 Minority Interest Total Loans Total Liabilities 1,158 1,241 1,763 2,520 3,601 APPLICATION OF FUNDS Net Block ,085 Capital Work-in-Progress Goodwill on consolidation Investments Current Assets ,805 2,577 Cash ,057 1,482 Loans & Advances Other current assets Current liabilities ,120 Net Current Assets 4 22 (182) 838 1,457 Miscellenous Expenditure Net Deferred Tax (3) (2) (2) (0) 0 Total Assets 1,158 1,241 1,763 2,520 3,601 7

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