By Chris Shaw

Following a decision by the Federal Government to cut funding for pathology services in November of 2009 the players in that sector have been losing revenues.

According to Credit Suisse, recent increases in average patient co-pays suggest at least a partial clawback of those lost revenues. Despite this, it remains unclear by how much volumes need recover and whether or not additional co-pay increases are needed to restore industry revenue growth to historical rates.

Credit Suisse has conducted an analysis that suggests volume growth of at least 6% plus an additional 15% increase in average patient co-payments is required to return industry revenues to normalised levels.

This appears unlikely to be achieved in the short-to-medium term in the stockbroker's view. CS suggests the most likely outcome is 3% volume growth along with the 15% increase in co-pay amounts.

Even this may prove a challenge, as Credit Suisse estimates for volume growth to improve by 3% on a 12month rolling basis this implies 6% sequential growth for the second quarter of 2010. This would be at the high end of market expectations and is a rate of growth more likely to be achieved in FY11 in the broker's view.

Short-term Credit Suisse suggests the outlook for the pathology market remains unclear, especially when factors such as ongoing adjustments to provider co-pay strategies and a task force assessing the use of inducements to attract referrals are factored in.

What also won't help is an ongoing review of funding for pathology, which Deutsche Bank sees as likely to lead to the Government introducing further funding cuts at next year's budget. These should be small however, the broker expecting cuts of only 1-2%.

The other major factor impacting on the pathology market at present is the recent deregulation of collection centres, which Deutsche Bank suggests will drive up costs for the whole industry. The increase in costs is likely to offset any benefits from an expected recovery in demand as doctor referral rates normalise in Deutsche's view.

Given the expectation of in increase in costs across the sector, Deutsche suggests the incumbents Primary Health Care ((PRY)) and Sonic Health ((SHL)) are most at risk given they have the largest positions in the market.

Industry data show 514 new collection centres have been registered to open, which would be an increase of 21%. Deutsche notes the listed players account for 70% of new openings, a level close to the broker's high case assumption. This suggests costs will also be towards high end of its assumptions.

Victoria appears to be the main battleground as existing group's defend their market share. Deutsche notes almost half of all the new centres will be in that market, while openings in Western Australia also appear aggressive. New South Wales appears to be being targeted by the second tier players.

Among the players in the sector, Deutsche notes Primary's move to open well over 100 new centres is an aggressive one as it implies the group is working hard to defend its market share position. Healthscope ((HSP)) has also been aggressive and in Deutsche's view looks likely to pick up market share in both Queensland and Western Australia.

Sonic has been more cautious but Deutsche remarks Sonic appears to have generally better balanced the location of its collection centres relative to its market share.

Following their respective reviews neither broker has adjusted its views on the respective listed plays in the sector, with Credit Suissse rating both Primary and Sonic as Underperform and Deutsche Bank having Hold ratings on both. Deutsche also rates Healthscope as a Hold, while Credit Suisse is currently restricted on the stock.

The FNArena database shows Sentiment Indicator readings for both Primary and Sonic of 0.1 and for Healthscope of 0.3.

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