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Morningstar | More Pain Before Gain, as Monash Operating Leverage Reduces and Margins Contract; Lowering FVE. See Updated Analyst Note from 27 Aug 2018

No-moat Monash IVF's full-year fiscal 2018 results were mixed and highlighted the negative impact of lower volumes on EBITDA margins given lower operating leverage.  After adjusting for one-off costs of AUD 1.2 million, largely related to legal fees and recruitment of key personnel, reported net profit after tax, or NPAT, of AUD 21.4 million, down 27.9% year on year, was slightly below our forecast of AUD 23.2 million. Although average revenue per blended fresh IVF cycle was albeit 5% higher than expected, at around AUD 13,892, group EBITDA margins came in at around 25.3%, 630 basis points below our forecast EBITDA margin of 31.6%.

The firm's 12% decline in domestic volumes was largely in line with our forecast for a 10% fall, primarily driven by impact of a high-volume fertility specialist departure in the Victorian IVF business back in September 2017, but we were surprised by the level of negative operating leverage in the business. Moreover, while we expect the recruitment of new specialists in Australia will bode well for volume growth, we expect recovery to previous levels will take time given ramp up times and the large hole of nearly 1,500 cycles we estimate for the outgoing specialist. As such, we've reduced our estimated profitability over the medium term.

Near-term earnings growth also looks to remain more muted than we expected, with management guiding to a 15% decline in first-half 2019 earnings compared with first-half 2018, given the inclusion of one quarter of activity from the departed key fertility specialist in the prior period. NPAT for fiscal 2019 is expected to be flat, and we have reduced our EBITDA margin expectations for the business to an average 26% over the next four years, from around 30% previously. As a result, we have cut our fair value estimate by 16% to AUD 1.35 per share from AUD 1.60. At current levels, however, we still see shares as undervalued.

Our revised forecasts have fiscal 2019 volumes for the domestic IVF business at 8,424, down from 9,149 previously, after adjusting for the expected negative impact of 367 cycles on the first half. Nonetheless, we maintain our long-term volume growth of 3%, reflecting target demographic growth rates and continue to assume Monash’s pricing power remaining stronger than peers given its narrow focus on the premium end of the market, leading to 2% contribution from pricing uplifts.

We also remain positive on the growth opportunities in Asia given the rising middle class and growing demand for IVF. International IVF services, albeit only 6% of group revenue, now including six fertility specialists, and performed well, increasing revenue by 40.5% to AUD 6.2 million, driven by a 23.2% rise in fresh IVF cycles to 849 from 689 in fiscal 2017. We think increased capacity at the new facility in Kuala Lumpur, Malaysia, and the doctor recruitment drive currently under way bode well for increasing operating leverage and represent upside to our group forecasts. Assuming one fertility specialist is added per year managing an average of 164 fresh cycles generates a five-year volume growth rate of 12%.

Monash does not disclose detailed financials for its diagnostic activities. However, from a volume perspective ultrasound services performed broadly in line with our expectations, growing 0.9% year on year to 75,457 scans, from 74,808. But we continue to think the diagnostic business is heavily skewed toward the ultrasound service, which we view as more commoditised than assisted reproductive services. Although the segment provides diversification benefits, thereby lowering inherent volatility of the IVF businesses, and notwithstanding the complementary nature of noninvasive prenatal testing and preimplantation genetic screening, we consider the ultrasound services largely commoditised and assume an underlying EBITDA margin of around 23%. Our five-year revenue CAGR for the ultrasound division remains unchanged at around 2.9%.

Loss of IVF volumes negatively impacted operating leverage in fiscal 2018 resulting in a deterioration of group EBITDA margin to 25.3% from 31.6%, and balance sheet strength, which nonetheless remains in good health. Net debt/EBITDA increased to 2.46 times, up from 1.88 times in fiscal 2017, but remains well below bank covenant levels of 3.5 times. Similarly, interest cover, as defined by EBITDA divided by interest, softened to 11.1 times from 14.8 times in fiscal 2017 but well above bank covenant of over 3 times. Net operating cash flow from operations, however, remained stable on an aftertax basis, with free cash flow increasing by 2.1%. Management cited debt capacity of AUD 57 million could be used to fund growth by acquisition with Western Australia the most likely region to be targeted. The company declared a full-year dividend of AUD 0.06, representing a payout ratio of 65.9%, in line with policy guidance range of between 60% and 70%.