Not coffin' up for InvoCare

Last year our recommendation to sell InvoCare could be summarised easily: disruption from the company's Protect & Grow investment program would hit earnings and stress the balance sheet.

As it turns out, earnings did fall sharply in the year to December 2018. Underlying earnings before interest, tax, depreciation and amortisation (EBITDA) fell 17%, and although accounting changes make comparisons difficult, underlying net profit fell by considerably more than the 20% we expected in our last review.

The balance sheet did get stressed, with net debt to EBITDA rising to 3.0 times. Operating cash flow fell 36%, while the company spent $130m on acquisitions and Protect & Grow. As only 35% of funeral locations have been renovated, the balance sheet didn't leave much room to move.

Add to that an unusually large 3.1% fall in the death rate, and 2018 turned out to be a particularly disagreeable year. No wonder InvoCare's share price fell as low as $10.20 in December. At that point our Sell call was looking spot on, with the stock having fallen 28% since the initial downgrade.

But the market has a habit of thumbing its nose at you - at least in the short term. Since then, the stock has jumped and now sits around $14.00 again. We're back to where we started.

Death rate normalising

Indications that the death rate is normalising seem to have been largely responsible. It's to be expected - there's nothing as certain as death.

Some early success at InvoCare's refurbished locations has also helped. As management highlighted: the earnings 'uplift over a "do-nothing" scenario is ahead of expectations'. However, it's premature to call Protect & Grow a complete success yet, as smaller locations are underperforming. That suggests the company might need to spend more than expected on bigger, brighter venues.

So we suspected a capital raising might be on the cards. With the share price surging again - helped along by positive management commentary - the company has taken advantage, with a $65m institutional placement at $14.00.

A follow-on share purchase plan is now underway. Small shareholders will be able to buy up to $15,000 of new shares at the lower of $14.00 or the volume weighted average share price over the five days to 5 April.

In case you're wondering, with the share price at $14.00, the share purchase plan isn't particularly enticing. Normally it only makes sense to participate if the share purchase plan price is at a reasonable discount to the share price. We suspect InvoCare will have trouble raising the $20m it hoped for under the share purchase plan and will have to be content with the $65m raised under the institutional placement.

Cutting it fine

The trouble is, we're not sure InvoCare has raised enough. At least another $100m must be spent on Protect & Grow over 2019 and 2020, which means InvoCare might be pushing up against bank covenants again next year. And that's assuming the company avoids making acquisitions.

Of course, another capital raising is always an option. But we've seen plenty of companies that end up regretting not raising enough capital.

What's important now is that EBITDA increases sharply in 2019, because higher depreciation and interest expense, and a lift in shares on issue, will be headwinds for earnings per share growth. However, there should be a tailwind from a normalisation of the death rate, as well as good results from the Protect and Grow locations already refurbished.

We currently expect around 50 cents in earnings per share for 2019, which would be a 10% increase on 2018 (under the new accounting standards, which have boosted InvoCare's earnings). The stock still looks expensive on a prospective PER of 28.

There also remain significant risks. Protect & Grow could falter, or the company could lose market share if competitors take advantage of the disruption. With 65% of the network still to be refurbished, there's a long way to go.

InvoCare will issue a trading update at its annual general meeting on 14 May. The market is now looking through to a potential earnings recovery, which admittedly looks a little more likely than we thought last year. However, the stock looks expensive given the risks. At current prices you can ignore the share purchase plan and our recommendation remains SELL.