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Morningstar | Mild Winter and Benign Flu Season Continue to Weigh on InvoCare’s Sales, FVE Falls to AUD 16.00

Wide-moat-rated InvoCare’s earnings are likely to come under further pressure in the second half of fiscal 2018. Accordingly, we have trimmed our fair value estimate by AUD 1.00 to AUD 16.00 per share. The mild winter climate and benign flu season have resulted in an abnormally low death rate, and consequently softer volumes. The trend has seen the death rate in the Australian market declining by 6% on the previous corresponding period, or pcp, in the June to August period, and falling by as much as 8% in InvoCare’s key markets. Management estimates the number of deaths during September declined to an even greater extent.

These challenges were flagged at the interim result and industry volumes were soft (down 1% on the pcp). Management indicated if these conditions persist, operating EBITDA would decrease by mid-single digits, which we factored into our assumptions. However, the trading conditions since first half have been more challenging than previously expected. Volumes deteriorated further during winter, along with softer pricing due to more aggressive competitor discounting. We now expect normalised EBITDA and EPS to decline by 8% and 12%, respectively, in fiscal 2018. We’ve trimmed our EPS projections by around 5% on average for the next five years, and now forecast high-single-digit growth on average beyond fiscal 2018.

Despite the earnings pressure, the shares remain undervalued relative to our revised fair value estimate, and the long-term outlook is still positive. We continue to believe most of the challenges the company is facing, and the reasons for the recent profit warnings, are temporary. The abnormally low death rate is unsustainable. While this rate can bounce around from year to year depending on weather and other factors, it will inevitably revert to the long-term average over time. We expect an uplift in volume from the mid-2020s, spiking to between 2% and 3% on average, reflecting ageing demographics.

As highlighted in previous periods, price increases are more difficult to achieve in declining markets. Accordingly, we expect pricing to remain flat in fiscal 2018, compared with our previous expectation and the long-term average of 3%-4%. The lack of volume incentivises smaller players to aggressively discount to steal market share and make up the shortfall. However, we continue to believe over the long term Invocare’s premium brands will command a price premium. As the death rate reverts to more normal levels, we expect pricing increases to also resume. In the meantime, the company is focusing heavily on its cost base to help mitigate some of these top-line pressures.

We are pleased the company continues to consolidate the fragmented funeral service market. The firm has made two acquisitions since the half year result in August, bringing the total number of acquisitions completed in 2018 to 11 across both Australia and New Zealand. This is expected to contribute around AUD 25 million in additional group revenue on an annualised basis, or 6% of sustainable revenue base, equivalent to almost 2% market share. This should alleviate concerns the company would struggle accumulating market share with the arrival of Propel Funeral partners. Over 50% of the market is composed of small independent operators, and we believe the market is fragmented enough for both firms to continue consolidating without engaging in a bidding war.

The Protect and Growth 2020 initiatives are progressing on track, and approximately 40% of the portfolio is expected to be renovated by fiscal 2018 year-end. Upon reopening, the three renovated pilot locations showed strong volume uplift, and we expect similar performance from the newly renovated stores, most of which are already meeting and/or exceeding management’s expectations. After completing a major refurbishment program, reinvesting in the brands, and cutting costs where possible, the company should be in a better position to continue taking market share, while benefiting from recovering industry growth.