Falling in love with big trends and ignoring company fundamentals and valuations is a dangerous investment trap. By the time you hear about a new trend in the popular media, professional investors are often set in the stock, and the valuation has captured the upside.
That is not to say trends are unimportant. Assessing industry attractiveness can make a critical difference: think of those who bought online advertising companies such as Seek and REA Group, and those who persisted with traditional media companies such as Fairfax Media and Ten Network Holdings.
But it is too simplistic to buy stocks on the basis of a strong “top-down trend” without assessing the company’s ability to capitalise on that trend through its business model, sustainable competitive advantage and financial performance – and how its value compares with price.
In-vitro fertilisation is a trend that has captured investor imagination. IVF is an assisted reproductive service that treats patients who experience infertility or cannot conceive naturally. An IVF cycle may involve administering a hormone to a woman, collecting her eggs, using sperm to fertilise the eggs in a laboratory, and watching the harvested eggs develop before transferring them to the uterus.
The IVF industry has had strong growth in the past decade. A growing female population, better awareness, and social acceptance of IVF have increased demand for assisted reproductive services. A big driver is the social trend of women having babies later in life when, statistically, it is harder to conceive naturally – meaning assisted reproduction services are needed for some people.
It is hard to see any of these trends changing soon. If anything, more competition among IVF providers should, in theory, lead to better affordability and accessibility. Also, medical breakthroughs are expected to increase IVF success rates and encourage more couples to use this service.
Virtus Health has much to gain from these trends. With 34 fertility clinics, it is the leading provider of assisted reproductive technology in Australia and one of two large IVF providers (the other is the respected Monash IVF Group). Virtus provided 35 per cent of the 39,870 IVF cycles in Australia in 2012.
Investors could not get enough of Virtus when it listed on ASX in June 2013 after raising $338.7 million in a float. Its $5.68 issued shares hit a 52-week high of $9.20 and are now $8.60.
Part-owned by a private equity firm, the float was so successful that some commentators believed it was the turning point for an IPO market that, at the time, was languishing, and that it restored confidence in a market that was sceptical about buying private equity-vended assets after the disappointments of the Myer Holdings and Collins Foods floats.
Predictably, Virtus’ success is encouraging other IVF-related floats. The Monash IVF Group was due to list as this week, just as this column was written. It raised $315.9 million after the IPO was several times oversubscribed, such is the demand for high-quality IVF providers.
Micro-cap IVF-related player Reproductive Health Science came to ASX in April via a reverse merger. It has developed a test utilising microarrays to assess embryos for chromosomal abnormalities before implantation as part of an IVF cycle. Its 20-cent shares at re-listing are 21 cents.
Australia’s largest medical centre operator, Primary Healthcare, has flagged the possibility of entering the IVF market by offering the service through its private clinics. Some analysts believe Primary Healthcare could undercut existing IVF operators on price, given its scale.
Value investors could ask if the recent rush of IVF corporate activity is because of the industry’s stellar prospects, or to cash in on Virtus’ post-listing success. I suspect the reason is a bit of both, and that investors need to tread warily given Virtus’ valuation.
The IVF market has attractive fundamentals. As the population ages, and people marry and have babies later in life, demand for IVF will rise. Greater social acceptance of IVF should also lead to more single women and same-sex couples using assisted reproductive services.
Australia is now the world’s second-largest user of IVF services, relative to its population, and about one in six couples use assisted reproductive services. Australia is also one of few developed countries that provide substantial government funding for IVF treatment.
The average patient costs for a stimulated IVF cycle is $10,000, with up to half available as a rebate through Medicare and private health insurance. Costs rise when extra services, such as intracytoplasmic sperm injection (ICSI), which involves selected sperm being injected into a harvested egg, are needed.
IVF clinics have a strong business model compared with many healthcare service providers. The vast majority of IVF cycles are completed in private clinics rather than public hospitals, meaning lower costs, shorter waiting times, and less upfront and ongoing capital to sustain them.
Right or wrong, IVF providers have higher pricing power because their services typically appeal to higher-income earners who are prepared to pay bigger out-of-pocket fees, to conceive.
There is also potential to add extra services and improve profit margins as technology develops. Genetic testing of embryos and longer stays in day-hospitals are potential add-ons, and there is little doubt that medical breakthroughs – Australia has been a global IVF pioneer – will spur demand.
An increase in the uptake of private medical health insurance is also positive for IVF demand. Medicare does not cover all aspects of fertility treatment, so those with appropriate private health cover will find IVF is more affordable.
The IVF industry strong barriers to entry. Assisted reproductive services is a people and technology business: a new low-cost competitor would have to recruit embryologists, specialists and other skilled IVF workers, many of whom work at Virtus or Monash. The IVF provider’s brand and reputation are also vital as patients desperate to conceive understandably choose large, established providers with better access to latest technologies.
Virtus clearly has a strong position in an industry with favourable long-term growth prospects, and good barriers to entry. And it has powerful tailwinds in demographic, social and technology trends that are driving more people to use IVF.
But the reality is that growth in the IVF industry is likely to slow, albeit from a high base. Business forecaster IBISWorld predicts the fertility clinics industry in Australia will have 8.2 per cent annualised growth in 2013-18, from 11.1 per cent in the preceding five years.
With Virtus and Monash accounting for about 71 per cent of the local IVF market, there is less scope to grow through acquisition of smaller players, compared with previous years when the industry was more fragmented. Watch the big IVF players expand offshore, as Virtus is doing in Singapore and Ireland.
Moreover, IVF revenue is less defensive than widely realised. That is, a sluggish economy can weigh on demand for IVF services, especially when high out-of-pocket expenses are involved. Some small fertility clinics say demand for IVF has eased in the past few years, and the service is clearly not immune to a sub-par economy.
Profit margins are another issue. The industry’s barriers to entry would be unlikely to stop a potential competitor with the clout of Primary Healthcare. It has the scale and balance sheet to undercut industry incumbents by adding fertility clinics to its extensive medical centre network.
However, Primary Healthcare would mostly likely expand the IVF market by making it more affordable, and by raising awareness of this important healthcare service. It may not make big inroads in the market of Virtus or Monash because it will appeal to patients who are more price sensitive. Virtus is also exploring a low-cost model of IVF care in 2014.
Rising labour costs for Virtus and other IVF providers are another concern for profit margins in coming years.
That does not mean Virtus cannot continue to expand rapidly in Australia or overseas as it exports its intellectual property in IVF services. But its valuation is arguably factoring in an industry outlook in Australia that has gone from excellent to very good in the past few years.
Virtus’ Return on Equity (ROE) is expected to hover between around 15 per cent in the next three years, according to a consensus analyst forecasts.
In fairness, Virtus only listed last year and it has plenty of strong growth options to pursue, especially overseas. It is one of those stocks you hope does well, for it if does, more people who need help to conceive will receive it, and higher success rates for IVF cycles will help everyone.
Its look expensive, on a forecast Price Earnings (PE) multiple of 17.5 times FY15 earnings, according to consensus analyst forecasts. But the valuation reflects Virtus’ growth prospects, and the multiple is lower than that for other healthcare operators, such as Ramsay Health Care, which has an expected FY15 PE of 23 times.
Sceptics would argue Virtus should trade at a discount to Ramsay, and that it looks fairly valued at current prices. Morningstar values Virtus at $9.50 a share and, like several other analysts, has a ‘hold recommendation. That looks about right.
For those who invest with their head rather than their heart, the listing of Monash IVF looks a good opportunity to gain slightly cheaper exposure to the IVF industry, depending on its share-price performance post listing.
Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at June 25. 2014.
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