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Will you profit from the emerging pathology services duopoly?

Most Australians are aware of the supermarket duopoly; we buy the vast majority of our groceries at either Woolworths (ASX: WOW) or Coles, which is owned by Wesfarmers (ASX: WES). The main reason for this is that enormous economies of scale have allowed the two big players to offer lower prices than smaller competitors. Furthermore, their importance as buyers means that they can squeeze suppliers, and operate a high volume, low margin business model.

One of the main reasons their business model allows for such low margins is that the big supermarkets operate with negative working capital. This means that they sell produce in their stores well before they actually pay suppliers. Although there are legitimate criticisms of the supermarket duopoly, the end result is, undeniably, lower prices.

A different kind of duopoly is emerging in the pathology industry. The main players are Primary Health Care (ASX: PRY) and Sonic Healthcare (ASX: SHL). However, unlike the supermarkets, healthy competition is not leading to lower costs for consumers, because the government (i.e. the taxpayer) picks up the tab.

Now you won’t hear me complaining about taxpayer funded healthcare – I am grateful every day to have been born in a country that looks after the sick and injured. However, it’s undeniable certain inefficiencies arise. For example, the government subsidy makes pathology quite a high margin business, which has led to intense competition in the sector (but unfortunately no falling prices for the taxpayer).

It appears that the landlords are gaining the most benefit. When the industry was deregulated in 2010, the number of pathology operators ballooned, but before long landlords began charging rents far in excess of the going commercial rate. This has led to a situation where smaller pathology providers are going out of business. Katherine McGrath, the CEO of the Australian Association of Pathology Practices describes the rents as “clearly excessive” and a “serious threat to the viability of pathology providers.”

Indeed, even the third-biggest provider, Healthscope, appears not to be faring very well. At the beginning of 2013, the private equity backed number-three player was closing centres and making staff redundant (whereas Sonic and Primary were both merrily continuing their expansion). Such is the competitive landscape that the ACCC keeps a close eye on the sector. The regulator knocked back Sonic’s attempt to buy Healthscope’s Queensland centres in 2012 (but allowed the acquisition of the Western Australian centres).

Foolish takeaway

Primary and Sonic are hardly confined to the pathology industry. The former owns all manner of medical practices, including a network of general practices. The latter specialises in diagnostic practices, such as radiology and pathology, and is an international company, owning businesses in Australia, New Zealand, the UK, the USA and continental Europe. Shares in both companies are up over 20% in the last 12 months, comfortably beating the market in 2013.

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Motley Fool contributor Claude Walker (@claudedwalker) does not own shares in any of the companies mentioned in this article.

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