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Morningstar | Soft Industry Volume and Funeral Home Closures Weigh on InvoCare's Near-Term Earnings

While fiscal 2018 is shaping up to be a more challenging year than we had previously expected, we maintain our AUD 17.00 per share value for wide-moat-rated InvoCare. The company's interim 2018 operating EBITDA was flat at AUD 54 million and is tracking marginally below our full-year expectations, mainly due to soft industry volume, and some pricing weakness. Whereas operating EPS declined by 7% to AUD 21.6 cents per share, reflecting higher depreciation and interest expense a consequence of the major reinvestment program. The board declared an interim dividend of AUD 17.5 cents per share, down 5% on the previous corresponding period, or pcp.

Despite the near-term earnings pressure, the stock is undervalued at the current price. Most of these challenges are either temporary in nature (the store closure for refurbishment, and lower prices) or cyclical (the decline in the annual number of deaths), both of which will be overcome in the near term. Notwithstanding causing some temporary disruption, the Protect and Grow initiatives are showing some positive signs, with a volume uplift of almost 30% at the three renovated pilot locations. The outstanding refurbishments are progressing with 40% of the network to be complete by the end of fiscal 2018, and upon completion the performance of 70% funeral homes exceeded or met expectations. InvoCare should emerge from the program with a completely refreshed service and product offering, in a great position to resume growing market share, and better ability to justify its premium pricing.

Moreover, the decline in the annual death rate (negative 2% compared with 1.5% long- term average) 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 in the near term, until around the mid-2020s at which time we expect volumes to spike to between 2% and 3% on average, reflecting a bump in the elderly population. The weaker case volumes also kept margins flat during the first half, with negative operating leverage offsetting lower cost of goods sold. Despite this near-term weakness, we also expect EBITDA margins to improve by around 2% to approximately 28% by fiscal 2022, underpinned by the ongoing reinvestment program and accompanying efficiency gains.

Year to date performance is tracking broadly in line with guidance provide in May 2018 (operating EBITDA in line with fiscal 2017, and EPS down by low-single digits). However, this guidance was premised on the death rate reverting to more normalised levels, which hasn't been the case. Management has flagged potential downside to this guidance if the death rate does not increase. In our base case, we don't expect a short-term correction, and now forecast operating EBITDA and EPS to decline by 4% and 8%, respectively, given the abnormally low number of flu cases, and warmer than normal winter period. Apart from fiscal 2018, we expect earnings per share to grow at a high-single-digit pace for the next five years, composed of a resumption of 3%-4% annual increase in case average, around 2% in volume, and the remainder through cost cuts and market share gains.

The company has ramped up its pace of acquisitions during the past six months, securing an additional 1% market share in Australia and around 4% in New Zealand (albeit off a much smaller base). We project the firm's share of the Australian and New Zealand market at around 40% within the next 10 years, up from 33% currently, through a combination of acquisitions and greenfield expansion. While management does not disclose the price paid for each individual acquisition, they've indicated the acquisitions are EPS-accretive, and specified that three acquisitions were completed during the half, the largest being Hope & Sons. Based on this information, and assuming each acquired business has an EBITDA margin within 2% of InvoCare's 26%, we believe InvoCare paid around 9 times EBITDA on average. This is relatively attractive given InvoCare trades at around 13 times fiscal 2018 EBITDA, and these acquisitions form an integral part of the firm's growth strategy, likely to deliver synergy opportunities, such as sourcing efficiencies. Most of these acquisitions were in the regional areas in which InvoCare is significantly under-represented. This gives us comfort the market is fragmented enough for InvoCare and its main rival Propel Funeral Partners to continue consolidating without engaging in a bidding war.

Disappointingly, the Australian average price per case decreased by 2%, although the factors driving this decline aren't overly concerning. The main contributor are lower industry volumes, as previously mentioned the unseasonably low death rate, particularly in New South Wales and Victoria which typically command higher average case prices than other states. Additionally, the lower volumes have stimulated more aggressive price discounting from competitors (seeking to offset the lower volume), which InvoCare responded to by discounting its own offering to defend share. However, this mainly occurred at the lower and of the price spectrum, whereas we believe the premium White Lady brand should continue to maintain its price premium, which underpins the firm's wide moat rating. A less favourable sales mix also weighed on price, with market share gains in the lower cost Simplicity and Value brands.

Despite the weaker return in the prepaid funeral funds under management, or FUM, portfolio we continue to believe this is an attractive aspect of InvoCare, as it provides a low-cost source of funding, which only needs to outperform cost inflation. Statutory earnings fell by 50% on the pcp to AUD 19.1 cents per share, although the primary reason for this was fiscal 2017 FUM earnings benefiting considerably (AUD 24 million) from noncash property investment revaluations, which were not repeated during the current period. While these earnings don't impact the company's operating performance, the annual FUM mark to market will undoubtedly contribute to swings in statutory earnings. During the current period, the FUM earnings marginally exceeded the FUM liability increases, which is far from a disastrous outcome. The portfolio is invested across equities, property, cash, and fixed interest and we expect it to comfortably generate returns above inflation over the long term, with the difference retained by the company. Our main concern is that prepaid contracts sold continue to exceed redemptions, as they have in the first-half fiscal 2018, with the FUM balance increasing by around 10% to over AUD 550 million.