Dr Lal Path Labs IPO Review: Valuation is a big red flag

Dr Lal Path Labs IPO Review: Valuation is a big red flag

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The much-awaited Dr Lal Path Labs IPO will open on 8 December and retail investors have a good reason to look forward to this public issue, thanks to a discount of INR15 per share. The company has set the price band of its IPO between INR540 and INR550 per share. At the upper end of the price band, the public offer of 11.6 million shares will mobilize INR6.3 billion. Dr Lal Path Labs is the biggest player in diagnostic and pathology laboratory space and a well known name. This is another reason for investors to have high expectations from this IPO.

Kotak Mahindra Capital and Citigroup Global Markets India are managing the issue.

According to the draft red herring prospectus filed by the company, Dr Lal Path Labs IPO will be purely an offer for sale (OFS) which means there are no new shares being issued by the company. As a result, all issue proceeds will go to existing shareholders.

Issue Details

IPO dates 8-10 December 2015
Price Band INR540-550 per share
Issue Size INR6.26 – 6.38 billion
Offer for Sale 11,600,000 shares
Lot size 20 shares

Among the prominent selling shareholders are Dr Arvind Lal (1.26 million shares) while Dr Vandana Lal plans to sell 2.06 million shares. Nevertheless, the biggest number of shares will come from Wagner Limited which aims to reduce its shareholding in the company by 5.86 million shares. Another 1.47 million shares will be offloaded by WCF (Westbridge Crossover Fund).

The two private equity investors hold a combined stake of nearly 31% in the company and will continue to remain onboard despite the partial sale. Following the IPO, the shareholding of Wagner and WCF will come down to 9.2% and 12.9% respectively. For IPO investors, this is a positive as both investors see more upside in the company.

We believe that the increasing prescription of diagnostic tests and services by healthcare providers in India, combined with the growing focus on early detection and prevention of chronic and lifestyle diseases, such as diabetes, hypertension, heart disease and cancer, creates a significant market opportunity

What makes Dr Lal Path Labs interesting?

Just in case you missed seeing the omnipresent Dr Lal Path Labs collection centers, here are more reasons to consider investing in the IPO. Dr Lal Path Labs operates is the market leader in an unorganized industry where several new big players are emerging. These include Thyrocare, SRL Diagnostics and Metropolis Healthcare, among others. Incidentally, Thyrocare is also an IPO candidate.

Dr Lal PathLabs operates through a nation-wide “hub and spoke” network that includes a national laboratory in New Delhi, 171 other clinical laboratories, 1,554 patient service centers and over 7,000 pickup points as on September 2015. During the fiscal year ended March 2015, Dr Lal PathLabs collected and processed approximately 21.8 million samples from approximately 9.9 million patients.

These are big numbers but let’s not forget, healthcare remains neglected in India, by individuals as well as the government. The chart below clearly states that India not only lags behind developed countries in healthcare expenditure but is also behind several developing ones. At 6% of GDP, even Vietnam spends more than India on healthcare.

However, growing awareness in recent years, as well as easy accessibility of quality healthcare services in recent years has resulted in growing demand in this space. As a result, this is a growing industry with no signs of the growth abating anytime soon.

Healthcae Expenditure

Ok, show me the money

There is no need to look beyond the company’s financial performance to understand just how well the industry is growing. Over the last five years, Dr Lal Path Labs has been posting higher sales and profits which is a remarkable feat. Another important figure to look out for is the profit margin which has continued its upward movement, except a few interruptions. There are no listed peers of Dr Lal Path Labs to benchmark these profit margins to; but as a rule of thumb, anything in double digits on a nationwide scale is good.

Dr Lal Path Labs’ consolidated performance (in INR million)
FY2011 FY2012 FY2013 FY2014 FY2015
Revenue 2,380 3,430 4,544 5,601 6,625
EBITDA 574 873 1004 1407 1588
Net profit 295 451 556 802 949
Net margin (%) 12.4 13.1 12.2 14.3 14.3

Source: Dr Lal Path Labs RHP

However, the situation is not that good for the six month period. According to the red herring prospectus, the company earned INR374 million for the six months ended 30 September 2015 on revenues of INR4.07 billion. This means that the company’s profit margin in the latest period stood at just 9.1%. The reason: higher tax outgo. While the revenue growth is impressive, the massive dip in profit margin has got us worried. Since companies often have no control on external factors like taxation, higher taxation may become a normal feature in years to come.

Conclusion

As mentioned above, Dr Lal Path Labs IPO is first of its kind in India but that does not mean the company can ask anything in terms of valuations. In FY 2015, the company had diluted earnings per share (EPS) of INR11.5 which puts its valuation in the range of 46.9 – 47.8 times of annual earnings. This is diametrically opposite to the PE ratio of 27.1 asked by Alkem Laboratories, another successfully company which is bringing IPO this week. In our review, Dr Lal Path Labs’ valuation is too high for any industry, despite the absence of any listed peers. This kind of IPO mispricing has caused severe burns to investors in the past, especially in the Coffee Day Holdings and Power Mech Projects which continue to trade below their allotment price.

Read Also: Alkem Laboratories IPO is the “cure all” pill for investors

The company ended the FY2015 on a high note but has failed to maintain the momentum in the six months. As seen above, Dr Lal Path Labs’ margins are under pressure now and at the same time, there are no evident trigger to boost the margins going forward. Margins in the industry are only going to go down as more and more players enter the business. The IPO’s pricing on the basis of six month performance is going to be even more unreasonable.

Although retail investors stand to get a discount in the IPO, this is a case of stretched valuations which practically nullifies the novelty premium. We have been proven wrong earlier this year with our call regarding InterGlobe Aviation, which went on to do very well on listing. However, no one can deny the importance of capital preservation when it comes to investing. As a result of this analysis, we believe the overpriced Dr Lal Path Labs IPO is an inferior choice for investors. As investors have a choice this time, Alkem Laboratories IPO simply remains a better option for investors (you can go through our review here).

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I agree, this stock is overvalued.

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