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Morningstar | Mild Winter and Benign Flu Season Weigh on Invocare’s Near-Term Results, but Outlook Is Improving

Wide-moat rated Invocare reported a soft, albeit well flagged fiscal 2018 result. Operating EBITDA declined by 4% to AUD 119 million, in line with our estimates. Underlying net profit came in at AUD 50 million, below our forecast although this was mainly attributable to higher depreciation and interest expense on the back of the refurbishment program and large number of acquisitions. As cautioned earlier in the year, case numbers were soft during the period, reflecting an unusually low number of deaths, in addition to temporary closures while renovations took place. Given the softer earnings, the final DPS was cut AUD 8 cents to AUD 19.5 cents fully franked. This resulted in total DPS for the year falling 20% to AUD 37 cents, below our AUD 40 cent forecast. While cutting dividends is not an optimal outcome, we agree with the decision to preserve the balance sheet health as a priority, and we continue to forecast an 80% payout ratio going forward, in line with the long-term average.

Despite cutting our fiscal 2019 NPAT forecast by 7% to AUD 55 million, we remain confident in Invocare’s long-term earnings outlook and maintain our AUD 16.00 per share fair value estimate. Pleasingly, the company flagged improved trading in the Australian funeral business in the final quarter of fiscal 2018, and early January 2019, signalling a normalisation of market conditions. While the annual death rate can fluctuate, the 3% decline experienced during the year (driven by the mild winter weather and benign flu season) is abnormally low, as the largest decline in almost 30 years. The probability of two consecutive years of declining number of deaths is extremely low, and we continue to forecast 2% annual growth on average during the next five years. Beyond this the outlook is even more positive, with the ABS forecasting 240,000 deaths per year by 2034, compared with approximately 160,000 in 2018, supported by ageing demographics.

The main question remains whether the Protect and Grow 2020 initiative will deliver sufficient earnings uplift to justify the cumulative AUD 200 million outlaid. We believe it will and are encouraged by the strong growth demonstrated by sites which have already gone through the refurbishment process. The five-year projected funeral case CAGR for the various location types range from 5% for refreshed shopfronts to 9% for enhanced funeral homes. We are pleased with the current progress as 76% of the Protect and Grow locations (as measured by EBITDA contribution) are performing either in line or outperforming expectations. At the current pace 43% of the locations are on track for completion by the end of 2019, while the majority should be wrapped up by the end of 2020. We expect the program to start generating incremental EBITDA from fiscal 2019 onward (offsetting the temporary closures) with the full benefit starting to take effect from 2021 onward.

We forecast the top line to grow at around 6% per year on average during the next five years, supported by: (1) a resumption of 1%-2% growth in the number of deaths, (2) a return to around 3% per year pricing increases, which should be achievable as the new shops open and industry volumes grow which should stabilise competitor behaviour, and (3) incremental market share gains. As revenue resumes growing, operating leverage and efficiency gains should help EBITDA margins to improve from the current 25% (fiscal 2018) back above 26% within the next three years. The soft volume and revenue during the year saw EBITDA margins contract by around 100 basis points during fiscal 2018.

As at end fiscal 2018 net debt was just over 3.4 times EBITDA, and while this is not alarming given the defensiveness of the business, it sits higher than the ideal level, albeit within the (undisclosed) banking covenants. The spite in debt reflects the opportunistic acquisition of 11 businesses across both Australia and New Zealand during the year. This is consistent with the firm’s strategy of expansion into the regional markets, where it is currently underrepresented with a modest 5% market share. Assuming the company doesn’t overpay for the acquisitions, we think this is a positive move allowing the firm to benefit from the additional scale and operating leverage. As earnings growth recovers, capital expenditure moderates, and the company divests noncore assets, next two years net debt should fall below 3 times EBITDA by fiscal 2022--a much more desirable level.