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Morningstar | Virtus Health Faces Domestic Challenges by Growing Offshore

No-moat Virtus Health reported results broadly in line with expectations after a challenging second half that was marred by market share losses in the price-sensitive markets of Queensland and Tasmania, offset by growing contribution from burgeoning offshore operations now in four countries. Reported net profit after tax of AUD 30.8 million on group revenue of AUD 262.1 million, up 2% and 9%, respectively, tracked our forecast of AUD 31.7 million and AUD 266 million, respectively. We are maintaining our fair value estimate at AUD 6.35 per share, which implies shares are undervalued at current levels.

Australian IVF performance remains mixed, with the disruptive impact of Primary Health Care leading to market share declines in price-sensitive Queensland and Tasmania, offset by growth in key markets of NSW and Victoria. Total IVF cycle numbers in fiscal 2018 declined by 3.4% to 15,235 cycles for Virtus Health. At a product level, Virtus’ full service activity declined by 2.5%, with its low-cost offering, TFC, also declining by 9.2%. However, the firm enjoyed a 70-basis-point increase in EBITDA margin to 30.7%, stemming from a 2.9% increase in average total revenue per cycle, coupled with disciplined cost control and restructuring initiatives, mostly in Virtus’ Victorian operations.

We think Virtus continues to command pricing power for now in the full-service segment of the market, given what we consider to be the most integrated service offering compared with listed peers, owing to its 63 diagnostic labs and seven day-hospital assets. However, with Primary Health Care flagging an entry into the day-hospital market this week, we see increasing competition in the full-service segment limiting pricing, which is set to come under pressure over the medium term. Subject to raising AUD 250 million in equity capital, Primary intends to buy a network of 15 day hospitals. We think this will support Primary’s move in the full-service market, thereby increasing pricing competition. As such, we have decreased our pricing assumption to 0.25% from 1% previously over the next five years.

Nonetheless, we remain comfortable with our base-case long-term volume growth assumption of 3% for Virtus, based on the forecast growth of the target IVF cohort--namely, the group's target demographic segment of Australian women aged between 25 and 54, and population projections of women aged 31 years of age, the current median age of new mothers in Australia. On a combined basis, considering our lowered pricing outlook, we forecast five-year revenue CAGR for the Australian division of 2%, down from 3% previously.

In contrast, international expansion, largely via acquisition, delivered strong revenue growth of 17.6% to AUD 44 million, representing 17% of the group’s revenue mix. We remain positive on prospects for Virtus in various geographies, given the opportunity for consolidation and proposed changes to government funding of Assisted Reproductive Services in Ireland. As such, we forecast five-year revenue CAGR for offshore operations of 10%, which we expect to represent around 23% of group revenue mix on a collective basis by 2023.

From a balance sheet perspective, Virtus remains in reasonable shape with forecast net debt/EBITDA in fiscal 2019 of around 2.52 times, given the 18% increase in long-term debt related to offshore acquisitions in Denmark and United Kingdom in second-half 2018. This is a new gearing high for the company and reflects an aggressive push into offshore markets. Given strength of cash from operations, up 42% year on year to AUD 55 million, we forecast net debt/EBITDA trending down to 1.91 times by fiscal 2020. As such, we remain comfortable with the company’s ability to continue paying dividends at a payout ratio of around 69%.