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What’s In The Pathology Deal For Sonic And Primary?

Australia | May 17 2016


-Substantial rent savings
-Neutralises bulk billing cuts
-Concerns over GP reaction


By Eva Brocklehurst

The Commonwealth government and Pathology Australia have reached an agreement, whereby rent reforms for Approved Collection Centres (ACCs) will be introduced to counter the cuts outlined to bulk billing incentives in the Mid Year Economic and Fiscal Outlook (MYEFO).

The measures could support pathology earnings by up to $50-60m, Macquarie maintains, if they are successful at reducing collection centre rents. The broker estimates that the average rent for a collection centre could fall to $12,000 from $70,000 today. With Primary Health Care ((PRY)) and Sonic Healthcare ((SHL)) having around 2,000 centres each, this amounts to a substantial saving.

The government will introduce provisions to clarify the meaning of market value and link this with relative commercial rents. Information required to register ACCs will be expanded to allow for assessment by the Department of Health as to whether an application is compliant. No mention of an appropriate rent was made but Macquarie notes that Pathology Australia has been lobbying for a 20% limit above the local per-square metre rate.

The removal of bulk billing incentives will commence at the date that the changes to the regulatory framework take effect. The government has also promised not to change the pathology services table for the next three years without consultation with the sector. The legislation is expected to be implemented from January 1, 2017.

Cuts will be effective in the second half of FY17 while the rent benefit will accrue over 12 months as licence renewals are staggered through the year. Macquarie observes it will be FY18 before earnings tailwinds are experienced and FY19 before the full benefit flows through.

So, what does the end result mean for providers? Credit Suisse previously included a 50% impact from the bulk billing cuts in the government's MYEFO, with the introduction of patient co-payments, and now introduces reduced rents on centres. This results in a neutralising of the removal of incentives.

There are some assumptions that need to be made, the broker acknowledges, such as general practitioner (GP) referral rates for pathology being unchanged despite reduced rental income. The broker upgrades Sonic Healthcare on the back of the news, to Neutral from Underperform in keeping with its rating on Primary Health Care.

Macquarie retains Neutral ratings on both Sonic and Primary, highlighting the uncertainties that exist. Obstacles to achieving the desired outcome include the government failing to win the upcoming election, rent reductions being offset in other ways to compensate GPs for directing pathology to a specific provider, and whether other loopholes to the legislation are found.

On the back of the agreement, Citi reinstates the forecasts for both stocks that were in place prior to the MYEFO cuts were announced. The broker maintains a Neutral rating for Primary and a Sell rating for Sonic. Morgan Stanley on the other hand believes there is increased upside risk for the stocks now, with the ability to charge increased co-payments potentially at risk but with greater benefit from the win on rents.

The broker highlights the lack of reaction from general practitioners so far, given the non-indexation of their funding is extended to FY20. A reduction in collection centre rents may further undermine the profitability of their industry.

Addressing ambiguities to better define fair market value for collection centre rent has potential to reduce the overspending on rents, which UBS estimates is more than $150m per annum. The broker highlights this as a vexed issue for some decades, with no legislation seemingly effective and operators finding ways around it. In return the industry ha agreed not to expand co-payments.

If the government is re-elected on July 2 it will call a moratorium on any opening of new collection centres. UBS suggests this has potential to create a race to open new centres in the next six weeks – if labs are prepared to bet on a Coalition win. The broker also notes the broader potential impact in that owner GPs stand to lose income.

Regardless, the broker considers the election of either major party will neutralise the impact of cuts to Sonic Healthcare and Primary Health Care, given that Labor rejects cuts to the bulk billing incentives all together. What remains is a timing issue around rent reviews and any issues regarding effectiveness of the enforcement of regulations. UBS notes there were no comments on incentive cuts to diagnostic imaging and assumes the policy is unchanged.

Sonic Healthcare has four Buy, three Hold and one Sell (Citi) rating on FNArena's database. The consensus target is $20.23, suggesting 7.0% downside to the last share price. Primary Health Care has one Buy (UBS) and seven Hold ratings. Consensus target is $3.46, suggesting 4.3% downside to the last share price.

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