InvoCare: Result 2017

Coffin suppliers must be doing it tough. Funeral company InvoCare is turning the screws on suppliers, and managed to shave 2% off its ‘cost of goods sold' in its 2017 result. In fact, the company managed to hold overall costs flat, which is a reasonable result given that salaries tend to rise with inflation.

Cost control has been a feature of InvoCare's recent results. Despite relatively anaemic revenue growth, expense reductions mean the company has produced decent-enough profit growth for several years now.

The 2017 year was more of the same. Excluding the effect of favourable accounting changes, InvoCare produced growth in underlying earnings before interest, tax depreciation and amortisation (EBITDA) of 7%.

But, as we have feared in recent reviews – see InvoCare: grave concerns? and English lessons for InvoCare – red flags are beginning to wave more vigorously. Expense reductions are set to become more difficult, while revenues have well and truly stalled.

Excluding accounting changes, revenue for the year to 31 December rose just 1%. Worse still, InvoCare's ‘Protect & Grow' plan is likely to make growth even more difficult in the short term.

To meet changing customer expectations – see InvoCare: grave concerns? – the company is spending a significant amount of money on refurbishing its sites. Capital expenditure almost doubled to $59m in 2017 – with much of that incurred late in the period – with another $100m or so to be spent in 2018.

Additional costs

The additional depreciation, amortisation and interest charges that will flow from this spending mean earnings per share will be flat in 2018 (according to management forecasts). But in 2019 it will get worse – at least $10m of these additional costs will hit the income statement.

The other issue is that the Protect & Grow refurbishments will hit market share in the short term. Management estimated that almost 400 Australian funeral cases were foregone in the fourth quarter of 2017, and that it expected each site refurbishment would reduce volumes by about one-third to one-half while closed. With 80 sites due for refurbishment in 2018, it will be a significant headwind.

What's also worrying is that management admitted pricing has been too aggressive, as we suspected in InvoCare: grave concerns?. The company will ease back on annual price increases and hopes to make up the difference by upselling other services – such as catering.

So we have a company that's losing share of a mature market that's now having difficulty raising prices. It's trying to turn its fortunes around with a significant capital expenditure program that will lift depreciation and interest costs in future years. It's not a position of strength.

How might this play out?

Well, in the short term we're worried that the disruption from Protect & Grow could be more significant than management expects. With revenue growth already poor and market share losses forecast, we suspect management's forecast of flat earnings per share could be optimistic. Competitors will be attacking InvoCare while it's distracted.

Real problem

But it's 2019 and beyond that's the real problem. Even if revenues begin recovering from a refurbishment-affected 2018, EBITDA is unlikely to grow sufficiently to offset the additional depreciation and interest costs flowing through. Changing customer expectations – including for funeral directors to become more like event planners – suggest InvoCare could also become a higher cost business than before.

Management was keen to point out that the two pilot sites the company refurbished last year have produced a greater than expected uplift in volumes. It's too early to draw conclusions, although some uplift should be expected.

We estimate the best case scenario for InvoCare is that earnings per share will be flat over the next two years, with single-digit increases from there. By contrast, management expects double-digit earnings per share growth to resume in the ‘medium to longer term'.

But the chances of a much worse outcome have also risen. It's now somewhat likely that InvoCare's earnings per share will decline in 2018 and 2019 as market share losses and additional costs bite.

Given these risks – and the lack of potential growth – InvoCare looks expensive on a price-earnings ratio of 26. If earnings do indeed decline, the stock will likely trade under $10.00. With our expectations for growth now much lower, the price guide is much too aggressive. We're reducing our Buy price to $8.00 and our Sell price to $12.00 (the latter reflects a price-earnings ratio of 22 for a relatively low-growth business).

This implies a downgrade to our recommendation. We recognise it will be a difficult decision for long-term shareholders, for whom the stock has been an impressive performer (including this analyst). Recent reviews provide more detail on our mounting concerns, so this downgrade shouldn't be a complete surprise.

It's important to recognise when a business is undergoing fundamental changes at a time when the share price allows no room for error. This describes InvoCare to a tee. SELL.

Disclosure: The author owns shares in InvoCare. Once the staff trading policy permits, he intends to sell half of his holding, which currently represents 1.4% of his family portfolio.