Australia’s market leader in funeral services, InvoCare (ASX: IVC) has had its Morningstar fair value estimate trimmed by AUD 1.00 to AUD 16.00 per share after the death rate fell to an abnormally low level in the June 2018 to August 2018 period.

The fall is attributed to the mild winter climate and benign flu season, and InvoCare management estimates the number of deaths during September declined by an even greater extent.

Australia’s market leader in funeral services, InvoCare has had its Morningstar fair value estimate trimmed

Although these challenges were flagged at the interim result and industry volumes were soft – down 1% on the previous corresponding period – trading conditions since the first half have been more challenging than previously expected. Volumes deteriorated further during winter, along with softer pricing due to more aggressive competitor discounting.

Morningstar EPS projections have therefore been trimmed by around 5% on average for the next five years and we now forecast high single-digit growth on average beyond fiscal 2018.

Wide-moat rated InvoCare’s earnings are therefore likely to come under further pressure in the second half of fiscal 2018 even though it is the largest provider of funeral, cemetery and crematorium services in Australia, New Zealand and Singapore.

Morningstar analyst Daniel Ragonese says, “Despite the earnings pressure, the shares remain undervalued relative to our revised fair-value estimate and the long-term outlook is still positive. We continue to believe most of the challenges the economy is facing – and the reasons for the recent profit warnings – are temporary.

“The abnormally low death rate is unsustainable,” says Ragonese. “It will inevitably revert to the long-term average over time. We expect an uplift in volume from the mid-2020s, spiking to between 2% and 3% on average, reflecting ageing demographics.”

In addition, the Australian market is still sufficiently fragmented for InvoCare and fellow consolidator Propel Funeral Partners to continue acquiring independent operators. Collectively, the two firms account for 40% of the market and this is expected to increase to around 60% by fiscal 2022.

We believe that InvoCare has yet to fully leverage its scale but this is about to change, with management also seeking to better integrate shared services. A large component of the benefits is expected to arise through more competitive prices for coffins, food, beverage and transport.

About 10% to 12% of InvoCare’s funeral services are prepaid and Morningstar attributes a value of AUD 1.00 per share to the prepaid business.

Branding is a double-edged sword for InvoCare. On the one hand it consistently generates return on invested capital above its weighted average cost of capital, reflective of its market position, reputation and strong brand equity. On the other, as InvoCare has a brand that relies on reputation and trust, any suggestion of financial greed or client exploitation could be damaging.

 

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Roger Balch is a contributor for Morningstar Australia.

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