A smooth delivery for Virtus?

If ever there was a people business, it’s Virtus Health. This is a company that pays people to help people make new people. When it starts trading on the ASX next week, more people (us) will get the chance to participate in this grand enterprise – at a distance and with no need of any donations.

Virtus is the largest Australian provider of ‘assisted reproductive services’ (ARS), with a share of about 35% of the national market and about 44% in its home markets of New South Wales, Victoria and Queensland.

By far the most common service is an ‘IVF cycle’, which involves administering a stimulating hormone to a woman, collecting the eggs, clinically fertilising and developing them in a lab before transferring them into the woman’s uterus.

Around 40% of IVF cycles result in pregnancies for women up to the age of 34, falling to 16% for those aged 40-44. Any excess healthy embryos from an IVF cycle can be frozen and used in subsequent cycles. In fact, Virtus’s second most common service is a ‘frozen embryo transfer’ in which such embryos are thawed in a lab before being transferred into a woman’s uterus.

Rapid growth

Australia’s first successful IVF child was born in 1980. Last year, about 40,000 cycles were undertaken by 24,000 women, resulting in about 12,000 babies. The number of cycles has grown at about 10% a year from 2000 to 2009 but then hit a roadblock when a cap was placed on Medicare funding.

Growth returned in 2011 and 2012 but only at about 6% a year. Only now has the number of cycles returned to 2009 levels (see Chart 1). Virtus expects healthy future growth, helped by a growing female population, women tending to have children later and improved success rates.

A typical IVF cycle will cost between about $10,000-$14,000, with Medicare covering about $6,000, private health insurance about $1,000 and the patient picking up the remaining $3,000 to $7,000. Virtus conducted 13,816 cycles in the year to June 2012, with average revenue per cycle of $12,420 providing total revenue of $172m, as Table 1 shows.

Of that, doctors’ fees amounted to $24m in 2012, or about 22% of total operating costs. Other staff including nurses, diagnosticians and administrative staff accounted for $50m, or 40% of operating costs. All up, the company made net profit of $25m in 2012, amounting to earnings per share of 32 cents.

This is expected to increase to 33 cents in 2013 and 39 cents in 2014, putting the stock on a current year price-earnings ratio of 17 at the issue price of $5.68, coming down to 15 for next year. That sounds more than reasonable.

The company expects to start paying fully franked dividends, of between 50% and 70% of net profit in 2014, giving the stock a fully franked yield of slightly more than 4% at the issue price.

And the story gets even better. Virtus requires very little capital: of total capital employed of about $350m at June 2012, $326m was goodwill. No wonder the return on capital employed is over 100%. Plus retained earnings should exceed the requirements for investment, so debt should fall and the payout ratio increase.

Private equity sellers

On the face of it, this is a great opportunity: a market leading company in a growing industry, with high returns on capital and a reasonable-looking price tag. Yet several things make us uncomfortable.

The most obvious is the debt. Despite $127m flowing to Virtus as a result of the offer, the company will still carry net debt of $143m. With interest cover forecast at about six times for 2014, that’s perfectly manageable, and no doubt it’s there to juice up returns. But high-quality businesses shouldn’t need to juice up their returns.

It’s especially galling because new investors are putting up $339m under the offer – more than enough to pay off all the debt. But $212m is going to selling shareholders, including Quadrant Private Equity, which is selling its entire 46% stake.

This is another worrying sign, because you’d think that Quadrant wouldn’t want to leave too much on the table for the likes of us. And you’d be right, but rather than try to price stocks at outlandish PERs, private equity sellers tend to be more subtle, extracting cash and restricting investment, leaving a company that is, as they say in Texas, ‘all hat and no cattle’.

No research

This brings us to our biggest concern. Virtus spends hardly anything on research and development. There is mention in the prospectus of about $3m a year being spent on sponsoring research programs, but at less than 2% of revenues, this is little more than a hat tip. Other leading biotechnology companies, such as CSL and ResMed spend 8%; Cochlear spends well over 10%.

Yes, these companies rely entirely on their proprietary technology. And whilst Vision Eye Institute and 1300 Smiles for example, don’t spend anything on R&D it hasn’t done them much harm.

But compared with IVF, with a success rate of only about 28% in 2010, dentistry and eye surgery is far more established. How can Virtus expect to remain at the forefront of its field without substantial R&D? Genea for example, the major competitor to Virtus in Sydney, spends about 8% of its revenues on R&D.

The float has apparently been comfortably oversubscribed and will probably rocket to a premium when it starts trading on 14 June. But this looks like a company ill-prepared to take advantage of the opportunities before it, one primed to look attractive in the short term. Where that leaves long term investors is anyone’s guess, which is why we suggest you AVOID.