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Morningstar | Invocare's FVE Raised to AUD 17.00 to Reflect Lucrative Prepaid Funeral Business and Growing Market. See Updated Analyst Note from 20 Jul 2018

We raise our fair value estimate for Invocare by AUD 1.50 to AUD 17.00 per share, after taking a more bullish view on the company's future market share, and to reflect the increasingly valuable prepaid funeral business. The share price has been punished during the past six months, and we believe the market's myopic concerns are misplaced, offering an opportunity to invest in this attractively priced wide-moat company.

While the market is concerned about the threat of newly listed rival Propel Funeral Partners, the smaller rival is unlikely to pose any major threat. The domestic funeral market is sufficiently fragmented for both players to continue gaining share for the foreseeable future without stepping on each other's toes. We estimate both firms will account for 60% of the domestic market by fiscal 2022, up from the current 44%. Yet we forecast Invocare to maintain its dominant position, given its leading scale, market segmentation, and brand strength. Since Propel was listed on the ASX, Invocare has accelerated its pace of acquisitions, acquiring seven regional funeral operators during the past few months. This adds approximately AUD 15 million to group revenue, equivalent to around 1% in additional share of the Australia and New Zealand markets. This highlights the company's ability to continue consolidating for the foreseeable future.

The current share price implies no additional return on the AUD 200 million refurbishment program "Protect and Grow 2020." While this capital expenditure will dilute returns on invested capital, or ROIC, in the near term, upon completion of the program, we expect ROIC to return to the low teens, comfortably exceeding the firm's 7% weighted average cost of capital.

Moreover, the program will include cost-cutting initiatives, and we estimate it to lift group EBITDA margin by around 150 basis points to reach 28% by fiscal 2022. The company has spent the past decade accumulating market share, and we believe it has not yet fully leveraged its scale. This is about to change, with management seeking to better integrate shared services and more effectively leverage its scale when negotiating suppliers as part of the investment program. A large component of the benefits is expected to arise through more competitive prices for coffins, food, beverage, and transport.

Hidden value lies within the prepaid funeral business, which we value at AUD 1 per share in our base-case scenario. This assumes the asset allocation is unchanged at 20% equities, 16% property, and 64% cash and fixed income, which is conservative, given the highly stable nature of the funeral industry and predictable cash requirements. We also forecast the average contract life remains at 11 years on average, and that prepaid funeral sales account for around 10% of group sales, broadly in line with the historical average. The two key drivers of value are: (1) the asset allocation and consequential portfolio performance; and (2) the portion of sales that are prepaid. While there are several other variables, including the average contract life and cost inflation, we believe these are fairly predictable and are unlikely to change materially over the long run. Attraction to the prepaid scheme for consumers is the opportunity to minimise any financial burden on a mourning family, but also the favorable Centrelink treatment.

Invocare's moat is sourced from a combination of scale and intangible brand assets, which insulate it from competitors such as recently listed Propel Funeral Partners, while preventing similar challenges to those recently faced by Dignity in the United Kingdom. Management is investing heavily, refurbishing funeral homes, cutting costs, and bringing IT systems up to speed, all of which will further strengthen its already dominant position. We are attracted to the resilience of the industry, and ageing population drives an acceleration in demand for at least the next two decades.