The new pathology duopoly

Primary Health Care and Sonic Healthcare are an oligopoly present investment opportunity, according to an article by Graham Witcomb, an analyst with Intelligent Investor, in The Sydney Morning Herald. He writes that the growth in productivity of Australian pathology has been spectacular. Rebates for pathology have, in real terms, fallen by about 60 per cent since Medicare began in 1984, and yet the businesses delivering these services have done extremely well.

Reliance rely on costly automated equipment forces companies to seek economies of scale.

Sonic Healthcare has a market share of 43 per cent and and Primary Health Care has 34 per cent.

On average, Australians receive 5.5 pathology tests a year. But patients are not the customers; referring doctors are.

Witcomb writes that in an industry where technical standards force consistency, the two companies motivate doctors with financial incentives.
Pathology labs cannot legally pay kickbacks to doctors for referrals but most medium to large medical centres have a space, sometimes just a couple of square metres, leased by a pathology group and dedicated to the collection of specimens.

The rent is an indirect financial incentive for a practice to be affiliated with a particular pathology network.

Sonic and Primary, with efficiency and cost advantages, could afford much higher rents than smaller operators and so rents rose dramatically. Those collection centres are now some of the most expensive real estate in the country.

The little guys have been progressively priced out of the market. The Australian pathology industry seems to be cascading towards a supermarket-style duopoly, which should make for some very tempting investment opportunities.

Sonic and Primary might now be able to push for lower rents with their increased negotiating power.

But there are risks. Medical practices are also consolidating into larger networks. The government’s recently announced Medicare fee cuts to lab and imaging services could strip $100 million in revenue from the industry.

Sonic’s foreign earnings are an increasingly valuable buffer. Primary has many things going for it too, but it has net debt of $1.1 billion.

Last September former clinician Dr Malcolm Parmenter became chief executive of Primary, replacing Peter Gregg.

Dr Parmenter was previously at Sonic, where he was head of Sonic Clinical Services.

Dr Parmenter spent more than nine years as chief executive of the former share-market-listed Independent Practitioner Network and more recently two years as head of Sonic Clinical Services.

Primary said that at IPN, Dr Parmenter oversaw a successful turnaround of the company and delivered a fourfold increase in shareholder value.

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