Investing in megatrends can capture the imagination. Trends such as the ageing population, growth in Asian middle-class consumers, and urbanisation are compelling. But the hard part is finding undervalued stocks that benefit.
Megatrends, by their nature, run for years, and are usually well known and priced into markets. Often, they are overpriced into company valuations as latecomers get caught up in the hysteria. The slightest hiccup in the trend leads to sharp falls in stocks that are “priced for perfection”.
The In Vitro Fertilisation (IVF) trend is a good example. It is driven by the convergence of demographic, social and technology tailwinds: an ageing population, women having babies later in life, and innovations that have increased IVF success rates.
This trend caught the market’s imagination when Virtus Health listed on ASX in June 2013 through a $338 million Initial Public Offering (IPO) at $5.68 a share. The market could not get enough of Virtus: it hit $9.20 within a year of listing.
Chart 1: Virtus Health
VRT vs. All Ordinaries (XAO)
As so often happens, a big IPO success encouraged similar companies to list. The other dominant Australian IVF provider, Monash IVF Group, listed on ASX in a $315 million IPO at $1.85 a share in June 2014. Unlike Virtus, Monash mostly disappointed investors. It trades at $1.31.
Chart 2: Monash IVF Group (MVF)
MVF vs. All Ordinaries (XAO)
There are two lessons from these falls. First, that stocks can drop sharply when doubts about the strength of overhyped industries emerge. And second, take care when buying IPOs that capitalise on the success of a competitor’s listing, through a higher valuation.
This column outlined a preference for Monash IVF over Virtus, based on valuations at the time, in June 2014. Both stocks have disappointed, amid market concerns of slowing Australian demand for IVF, rising competition from new entrants, and lower profit margins because of a greater uptake of frozen over fresh embryos in assisted reproductive services.
Virtus was smashed after lowering earnings guidance by 10 per cent in June 2015. Stronger competition in New South Wales, storm damage at a clinic, continued weaker trading conditions in Victoria and Queensland, and higher costs in its Singaporean expansion weighed on guidance.
Virtus shed almost a third of its market capitalisation on the news, falling from $7.76 to as low as $5.16. Although the downgrade was disappointing, the concern was the rate of deterioration in earnings guidance of up to “teens” growth, to “low single-digit growth”. Remarkably, Virtus trades just below its issue price at $5.49.
The rapid deterioration suggested the IVF industry was slowing faster than the market anticipated and new entrants were taking more market share than forecast. Should this trend continue, Virtus’s earnings growth could fall further.
Predictably, Monash was hurt by its competitor’s news, even though it has less exposure in New South Wales, the market most troubling Virtus. It shed almost 30 cents in June.
The fear is two-fold: that both IVF providers continue to lose market share to aggressive new entrants such as Primary Health Care, which have lower cost structures, and that an anticipated rebound in IVF demand back to trend growth rates is delayed.
Those who thought IVF demand, like other healthcare services, was reasonably defensive and more immune to economic conditions have learned a costly lesson. The slowdown in the Queensland mining sector, for example, reduced IVF demand, Virtus said in August last year. Less job security and higher unemployment weakened demand for costly IVF cycles.
That’s the bad news. The good news is that the long-term drivers of IVF demand – people having babies later in life and a favourable Medicare environment – are intact. And sharply lower valuations for Virtus and Monash could be overstating short-term problems in IVF demand. Several of Virtus’s problems – for example, storm damage – are one-offs.
Virtus seemingly looks undervalued. It has the highest market share in a growth industry and excellent potential to expand offshore, yet trades on forecast Price/Earnings (PE) of about 12 times 2015-16 earnings, based on consensus forecasts. It should yield about 5 per cent, fully franked.
Four of the eight analysts that cover Virtus have a buy or strong buy recommendation. Three have a hold and one a sell. The median price target is $7.29. Morningstar has an accumulation recommendation and a $7.50 fair value for Virtus shares.
Monash IVF trades on a 2015-16 PE of about 10 times and is expected to yield 9.2 per cent based on consensus forecasts. A lower dividend is possible, so take care with the high forecast yield. Like Virtus, Monash looks cheap, but faces sluggish industry conditions and rising competitive pressures. Ongoing profit warnings and more signs that IVF is less defensive than thought could lead to PE multiples being further de-rated.
The temptation is to suggest the market has over-reacted with both stocks, particularly Monash, and that they are in value territory. But the speed of deterioration in Virtus’s earnings is concerning, as is market share losses to new entrants. Lower PE multiples look warranted as IVF stocks are priced more like slower-growth healthcare companies.
Nevertheless, both stocks deserve a spot on portfolio watch lists, in anticipation of improving value. Both are well run, dominate a long-term growth industry, are diversifying their earnings, and I rate Monash’s prospects to expand into markets such as Malaysia, which is many years behind Australia in IVF demand.
My hunch is both stocks will get cheaper before they improve or move sideways for a while. A period of earnings-growth consolidation is needed to ease market fears about industry growth, and it might be worth giving up on any early price recovery until more clarity about the outlook emerges from the full-year reports in August.
Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply any stock recommendations or offer financial advice. 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 July 23, 2015.