Monash IVF: the cost of efficiency

Hope is a powerful motivator. A quarter of all Australian IVF treatments are to assist women who are over 40. Roughly 7,300 women in this age group took the challenge in 2015; some 44 of them tried 10 or more times. Unfortunately, one of the more sobering statistics in IVF is that fewer than 1 in 17 attempts by a woman over 40 will result a live baby, and the odds jump to 1 in 100 if they're over 45 (see Chart 1).

Ask any patient and they'll have an opinion: Monash IVF is either a medical miracle or a dangerous promoter of false hope. The assisted reproduction industry has extremely motivated customers and that's good for profits. Whether or not an IVF cycle results in pregnancy, however, makes little difference to Monash's bottom line; what matters is that patients keep trying.

Owning an IVF business is a little like owning an airline. You have large upfront and fixed costs so you need high utilisation – a constant stream of patients (or passengers) – to make the operation profitable, but each additional IVF cycle (or fare) adds a little more to the bottom line than the last.

Monash has 22 fertility clinics and 17 ultrasound imaging sites; these are the ‘client facing' parts of the business. The company also has two specialised diagnostic laboratories, five service centres, three day hospitals, and one central headquarters.

The value of Monash's network comes from having a large number of consulting clinics that drive volume through the fixed-cost labs and operating theatres. As cycle volumes improve, so too do margins, which means more money is available for marketing and research.

Scale provides value to both the specialists and patients; it's no coincidence that the industry has gradually congealed into a few large companies – the four largest IVF providers account for 85% of the market and Monash has a 22% share. Few other healthcare specialties are this concentrated.

Incentives

Typically, business models that rely on high utilisation and economies of scale don't raise any ethical dilemmas. No-one is banging down Ansell's door for trying to sell more gloves so that it can get the most from its factories. Monash, on the other hand, is trying to hit two targets with one arrow: the wellbeing of patients and the financial wellbeing of shareholders.

Financially incentivising doctors to churn through patients is illegal, and Monash's fertility specialists are just like you and me, complete with a moral compass. Every doctor takes an oath to put the patient first.

Still, Monash has some subtle ways of incentivising its doctors to ensure utilisation rates remain high and the business grows. In 2016, the company introduced a new long-term incentive for fertility specialists (50% cash and 50% Monash shares) with two performance hurdles. The first is the ‘Practice development award', which ‘recognises the consistent development of a fertility specialist's practice at above industry [cycle] growth rates'. The second is the ‘Key doctor award', which is based on the doctor achieving at least 250 cycles per year for four years.

It's too early to know what effect the new scheme will have on cycle numbers, but the incentive is clear: perform more cycles and you'll get more money. For the cynical, doctors could be tempted to sign-up patients whose chance of success is minuscule.

Efficiency problem

Nonetheless, management is at least trying to address what is clearly an ongoing efficiency problem. The company averaged 100 fresh cycles per specialist in 2017, down from 114 three years ago. Larger competitor Virtus Health managed 149 cycles per specialist in 2017.

At first, we were tempted to put this down to a different procedure mix – maybe Monash's doctors are doing more secondary cycles or frozen embryo transfers. But no matter which way you cut it, Monash performs fewer services per doctor: total patient treatments came to 16,064 in 2017, or around 180 treatments for each of its 89 doctors. The same figure for Virtus is 284.

We don't have much of an explanation for the difference, only a few disparate pieces of evidence. In 2014, management said Monash had ‘a group of relatively new fertility specialists who provide significant capacity to grow patient treatment volumes'. At the time, the company said some 66% of treatments were performed by fertility specialists under the age of 55. That's relatively youthful for the field: 60% of gynacologists (the broader specialty) in NSW are older than 50, and 30% are over 60.

Could it be that Monash's younger, less seasoned doctors just aren't as efficient as Virtus's older cohort? There's no material difference in success rates, which hover around the 30% mark for both companies, so it's worth noting that any age and efficiency difference has little impact on the client's experience. Efficiency is only a problem for shareholders.

With the new incentive scheme in place, increasing cycle numbers is likely to be at the top of many doctors' minds, and certainly a target for new chief executive David Morris – previously Cochlear's chief strategy officer – who takes the reins in November. Over time we expect Monash's efficiency to improve as its younger doctors become more established, which should boost margins due to the high fixed costs of running a fertility clinic.

People intensive

That's good news because the term ‘clinic' can be used interchangeably with ‘cash cow'. Monash's clinics generate prodigious amounts of free cash flow.

The company isn't a ‘capital intensive' business that needs to keep reinvesting profits in expensive machinery or infrastructure. More than two-thirds of its operating costs are employee and clinician salaries; if anything, it's ‘people intensive'.

Over the past three years, Monash needed to reinvest only 19% of its operating cash flow in physical assets, compared to 44% for pathology provider Sonic Healthcare or 56% for hospital operator Ramsay Health Care. Profits matched free cash flow almost one-for-one.

More of Monash's cash is available to pay out as dividends, make acquisitions or buy back shares. This is important because despite what any other metric says, Monash's valuation ultimately depends on the cash you get out of it – not the manipulable and volatile net profit figure you see on the income statement.  

Monash's management expects net profit in 2018 to be ‘broadly in line' with the 2017 financial year. Nonetheless, the IVF industry has roughly doubled over the past ten years and the growing tendency for women to postpone having children until later in life all but guarantees demand for assisted reproductive services will increase; we expect long-term growth in the mid to low single digits.

We need a wide margin of safety before upgrading Monash, but with a dividend yield of 5.5% and a price-earnings ratio of 12, the stock isn't trading too far above our recommended Buy price of $1.40. For now, though, we're sticking with HOLD.

Note: The Intelligent Investor Equity Growth and Equity Income portfolios own shares in Virtus Health. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.

Disclosure: The author owns shares in Virtus Health.