Primary Health Care (ASX:PRY) shares have been under pressure recently. Since our last research report on 10 July, the shares have fallen nearly 10%. Are we still concerned about the business and is there further downside for the share price?
Overview of Primary Health Care
Primary Health Care is a diagnostic service provider covering General Practice, Pathology, Imaging, Dental, IVF and other allied services. The Company predominantly provides services under a bulk-billing model with funding flowing under the Federal Medicare Benefits Schedule (MBS).
The Company operates three divisions: Medical Centres, Pathology and Diagnostic Imaging. The Pathology division is now the main contributor to group earnings. It accounted for 45% of group EBITDA in 1H18, with this portion progressively increasing over the last few years. This was as the EBITDA contribution from the Medical Centres division (currently 35%) has been decreasing over this period.
Can the Medical Centres Division Lead a Turnaround?
A key factor behind the underperformance in the share price in recent years has been a multitude of issues within the Medical Centres division. By way of background, in 2016, PRY transitioned its business model for General Practitioners (GPs). This was where the Company introduced more flexible contracting arrangements to cater for GPs wanting to move away from upfront cash payments (and associated tax implications) in return for a higher percentage of gross billings and the increasing portion of female GPs.
Under the terms of the more flexible contracts, GPs retain ~65-70% compared to ~50% under the previous upfront model. The increased flexibility in contracts also allowed the Company to target part-time GPs who did not want to commit to a five-year contract (or after-hours work).
Whilst this change to the business model was expected to improve the division’s financial performance, gross billings per GP (on a FTE basis) has declined. There are also challenges in growing the number of GPs (on a FTE basis), given that, firstly, the portion of females (as a percentage of the total GP workforce) has been increasing (thus increasing the demand for more flexible contract arrangements). Secondly, older/more experienced GPs continue to retire or leave PRY’s businesses, which need to be replaced by newer/younger GPs.
In summary, we consider that a turnaround in divisional performance to be challenging and protracted. This is especially as the Company is also having to invest significantly in systems and processes. These include investing in continuing medical education programs for GPs and the transformational program currently in place (“Project Leapfrog”). The benefits of this are not likely to be evident until the medium-term at least.
In addition to the challenges in the Medical Centres division, there are other factors likely to continue weighing on sentiment.
1. Margin Pressure Evident in Other Divisions
Over the past few years, margins for the Pathology division have faced both revenue and cost pressures. This includes significant rental cost inflation following deregulation of pathology Approved Collection Centres (ACCs) in 2010. In addition to this, there have also been changes to referral rules for specific MBS items along with weaker referrals due to uncertainty surrounding various Government policy changes.
We expect margin pressure to continue. The potential for lower pathology collection centre rental costs (i.e. from re-negotiation of existing contracts) is unlikely to be enough to offset higher consumable costs and the change in the pathology test mix to lower-margin testing.
2. High Demand For Capital
We consider that the level of net debt on the balance sheet remains high. This is given that the Company has to balance a number of competing demands in its capital; in particular having funding capacity for potential acquisitions, greenfield expansions, investing in essential infrastructure and payment of dividends. While the Company has indicated that potential acquisition targets in South East Asia are being explored, PRY has heavy, continued investment in long-term greenfield projects. These could restrict any potential acquisition opportunities.
3. Uncertainty Regarding Underlying Earnings
PRY has consistently booked a large percentage of non-recurring costs below the line. Since FY15, the Company has on average recorded 40% of its underlying EBIT as a significant “non-recurring” item (24% in 1H18).
4. Outcome of Dorevitch Dispute
In March 2018, the Fair Work Commission (VIC) completed hearings associated with PRY’s Victorian pathology business (Dorevitch). This was relating to a wage dispute between certain Dorevitch workers and Dorevitch. A decision, which was expected by the end of June 2018, has yet to be delivered. While the outcome of the hearing is difficult to predict, new (higher) wage agreements that could be implemented as compensation would have an impact on FY19 net profit, although this is difficult to quantify.
When we last looked at PRY in early July, we noted that it was sitting on a support line. However, we commented that “we are concerned by how the share price accelerated downwards last month … There is therefore a higher-than-normal risk that it breaks support and heads lower again to the lower $3’s.” We have now seen PRY break support. This means that there is a high chance that it continues to the low $3’s. For the short term at least, we expect further downside. Investors therefore have time to sit on the sidelines.
Michael Gable is managing director of Fairmont Equities.
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