Funeral home operator InvoCare is trading at a solid discount and offers compelling value for investors who are willing to stick with the business as it bounces back from covid.

That’s the verdict of Morningstar equity analyst Angus Hewitt, who says the wide moat company will gradually recover from the covid-induced drop in funerals and reaffirm its dominant position in the Australian death care industry.

Australia’s death rate from covid was low, and the flu season was virtually non-existent as rules such as social distancing, increased hygiene, and curbs on attendance at funerals led to a lower mortality rate.

However, the negative impact from covid will be temporary and mortality rates are tipped to normalise from calendar 2021, Hewitt says.

And the potential of the company’s pre-paid funeral scheme is underrated.

“InvoCare's leading market share and strong competitive position underpinning its wide economic moat, place the firm in a solid position to benefit from the expected recovery of the funeral market,” Hewitt says.

“We also believe the value of InvoCare's low-cost funding available through the prepaid funeral business is underappreciated by investors. At current prices, shares in InvoCare present a compelling valuation for investors willing to stay the course.”

At 11.30am on Tuesday, InvoCare was down 2.86 per cent, amid broader market falls, trading at $10.19. This represents a 31 per cent discount to Hewitt’s fair value estimate of $15.30 a share.

This valuation implies a fiscal 2021 consensus forward price-to-earnings ratio of 30, and a forward dividend yield of 1.19 per cent.

Brand, scale and pricing power

InvoCare (ASX: IVC) is the largest funeral, cemetery, and crematorium operator in Australia, New Zealand, and Singapore.

It owns a portfolio of 60 brands, including three national Australian providers: from its flagship brand White Lady, to its less expensive funeral homes Simplicity Funerals, and Value Cremations.

InvoCare’s scale also allows it flexibility on pricing. White Lady for instance offers services that can cost about 50 per cent more than a traditional InvoCare funeral, while at the other end of the spectrum, Simplicity Funerals cost about 10 per cent more than the average independent players.

2020 was a tough year, however, as government limits on attendance at funerals curbed its ability to offer the full range of services, and demand for higher margin, premium services fell in favour of cheaper services with streaming capabilities.

But the death care industry is fundamentally sound, Hewitt says. Death rates can fluctuate from year to year but remain consistent over the long run. Mortality rates are a function of the population size, average age, and life expectancy. Demand for InvoCare's services is underpinned by Australia's ageing population.

“Despite flu instances remaining low into calendar 2021, the death rate appears to be reverting to more normalised levels,” Hewitt says.

“Provisional mortality statistics from the Australian Bureau of Statistics indicate deaths are tracking modestly above historical (2015 to 2019) average levels in the first two months of calendar 2021.”

The proportion of Australians aged over 65 has increased to 14 per cent in 2020, from 12 per cent in 2010, and Hewitt expects this trend to continue.

This forecast supports a 2 per cent compound annual growth rate in deaths beyond the next decade. This is partially offset by gradually increasing life expectancy over time, which in Australia has increased from around 82 years to 83 years over the last decade.

And already the easing of restrictions has benefited InvoCare’s premium White Lady brand. Consequently, InvoCare is poised to deliver annual price rises of 2 to 3 per cent over the next decade, comparable with historical levels, Hewitt says.

Another key component of the business is prepaid funerals. Designed to remove the burden of funerals, the scheme allows acts as a low-cost source of funding and allows InvoCare to secure future sales.

Wide moat but a rival too

As the largest death care service provider in Australia, InvoCare has an estimated revenue market share of over a third. And it plans to increase this share with smaller bolt-on acquisitions.

However, despite its wide moat, which implies a 20-year competitive advantage, it does face competition in the form of Propel Funeral Partners.  

Propel Funeral Partners (ASX: PFP) is the next largest player with a 7 per cent share. Propel is aggressively gaining market share through acquisitions, heightening the risk of InvoCare overpaying for its own acquisitions.

InvoCare (IVC) v Propel Funeral Partners (PFP) - 1YR

A chart comparing InvoCare and Propel Funeral Partners over one year

Source: Morningstar Premium; data as of 1 June 2021

In the longer term, when the death rate dips below trend, as it did during the benign flu seasons of 2018 and last year, InvoCare's profitability can tighten given the high level of operating leverage, Hewitt says.