Life's only certainty suits Invocare

Especially for the super rich, clever accountants and cross-border loopholes can reduce the inevitability of life’s other certainty. Death isn’t so easily avoided, which is a great foundation for a business.

Invocare is the country’s largest funeral services provider with dominant market positions in Australia and New Zealand, plus a smaller presence in Singapore. As the beneficiary of a huge population growth tailwind, it’s also highly profitable.

Over the next few decades, the number of deaths each year in Australia will relentlessly rise, and at an accelerating rate (see Chart 1). About 140,000 Australians died in 2010, an increase of 10,000 from the number of ‘departures’ in 2000 and an annual growth rate of roughly 0.7%.

According to ABS estimates, the number of annual deaths will grow more than 1.5% per year between 2010 and 2020 and continue accelerating, peaking at 2.7% annual growth around 2030 before falling back to 1% by 2050. Enthralling as this growth might be, it doesn’t guarantee investment success.

Almost eight years ago, in response to overhyped investor expectations, Cashing in on the retirement boom (3 Aug 04) anticipated a substantial change of fortunes for many investors punting on Australia’s aging population.

Those investors missed a crucial point just as important as underlying market growth. Without a moat (or a lock, a competitive advantage or pricing power, whatever one might call it) increased competition either neutralises or more than offsets the effects of a growing market.

Invocare isn’t like that. Its moat is deep and broad, which means the near-certain growth rate in annual deaths should generate higher profit growth for the company for decades.

Take the company’s market share as evidence. National brands White Lady and Simplicity, plus 40 regional brands, together offer more than 200 funeral homes around Australia. With the recent acquisition of Bledisloe Group, the company now owns 16 brands in New Zealand.

Although market share statistics differ significantly by region, Invocare manages roughly one in three funerals in Australia and in some major markets like Sydney and Perth far more. Competition can best be described as gentlemanly. As one competitor put it in their submission to the ACCC arguing against Invocare’s ultimately approved acquisition of Bledisloe, families rarely ‘cross a major road, bridge, bushland or train line to find a funeral director’.

Inelastic pricing

Funerals aren’t considered a normal consumer purchase. We don’t shop around, which means pricing is inelastic. Reasonable price increases result in few sales lost to competitors. In effect, Invocare owns several hundred operations, each with their own substantial, local moat.

The company prefers to grow by acquisition precisely because of this fact. Geography, familiarity and reputation are so important to customers. Organic expansion, at least in established areas, rarely succeeds. These factors work to benefit Invocare’s existing infrastructure.

The moat is further deepened by its prepaid business. To avoid leaving their bereaved families with the expense, many people pay for their funerals well before they’re needed, locking in today’s price for the big day. The money sits in trust, producing a nice income stream for Invocare that’s also a hedge against future increases in the cost of delivering those services. More importantly, it guarantees future business for the company.

About 13% of the services Invocare delivers each year are prepaid, which explains how there’s over $300m sitting in trust today—almost one year’s worth of sales. With the exception of investment income (and an offsetting charge for the increase in expected delivery costs), the money doesn’t show up as revenue or profit until the services are delivered.

Invocare is also ‘vertically integrated’. That means the group owns 14 cemeteries and crematoria in NSW and Queensland, not that it buries people feet first. Again, many of these are local monopolies, especially in the more established areas of Brisbane and Sydney.

Together, these factors make it likely that, over the next decade or two, Invocare will at least maintain its current market share, if not grow it. (Small regional acquisitions are more likely as large ones probably won’t sneak past the ACCC.) In addition, it has the capacity to increase prices beyond the inflation rate. Management expects price growth of 3-4% a year, a figure that it has easily achieved in the past.

Predictable growth

Population growth and pricing power mean the company should deliver organic revenue growth of at least 6-7% before acquisitions (see page 5 of this conference presentation) over the next few decades. Including acquisitions (which will in future have less impact), the company has achieved sales growth over the past five years averaging almost 11%. And operational and financial leverage mean that underlying earnings per share and dividends should grow a little faster than organic revenue growth of 6-7%.

There’s the potential to expand margins, too. Bledisloe’s Australian businesses operated on a lower earnings before interest, tax, depreciation and amortisation (EBITDA) margin than Invocare’s existing businesses (16.1% versus 25.8% respectively in 2011) but under the new owners, the gap between these figures should narrow. There is probably some scope to increase its margins in New Zealand, too.

Invocare’s earnings per share are almost certain to be much higher in 10 years than today and higher still in 20 years. The company offers the sort of predictability and growth that few stocks on the ASX can match.

Unfortunately, the market is well aware of the company’s growth prospects. On a PER of 23 times, today’s investor is absolutely reliant on Invocare delivering significant profit growth. The fully franked historic yield of 3.8% needs to rapidly grow to provide an attractive total investment return.

Whether Invocare will generate the sort of profit growth to turn that yield into total returns over the very long term of say 7-8% (ho hum) or 10-12% (more interesting) is where even perfectly rational investors might differ. Our response is to wait for a bigger margin of safety.

But this stock deserves a place on your watch list. Much below $7.00 it would become more interesting, which is why we are commencing coverage and hoping for an opportunity. If you already own Invocare, don’t let it go cheaply. HOLD.