Steadfast looks strong while Virtus grows

This week both Steadfast (SDF) and Virtus Health (VRT) announced half-year financial results to the ASX. Both reiterated full year guidance and announced dividends that were precisely in line with our expectations. Pleasingly, both companies are exhibiting growth, but both are also facing varying challenges. I am comfortable with both these businesses going forward.

Steadfast group – through the cycle growth

This was a transformational result for SDF, in that it included the contribution from large acquisitions made last year. Pleasingly, the company's cash profits have shown excellent growth, and the company reiterated full year cash profit and earnings per share (EPS) growth guidance. SDF is a seasonal business in terms of cash profits, and guidance implies a 53 per cent weighting to the second half, consistent with past results.

The company announced a 2.4 cent fully franked interim dividend, and confirmed our expectation that this payout is likely to represent 40 per cent of the full year dividend amount. SDF will trade on an ex-dividend basis on March 8, 2016. This infers that the final dividend will be around 3.6 cents, taking the full year FY16 payout to 6 cents fully franked. This is in line with our numbers, including the 40 / 60 split, and the foreseeability and strong predictability of this from management is a positive.

The market reacted positively to the SDF result, as the integration of acquisitions is ahead of management expectations, and the underlying result seems to indicate some stabilisation in premium prices across the general insurance market. This is something that SDF management had flagged in terms of the pricing cycle, and any further hardening in the market will benefit SDF in coming years.

Financial performance

SDF's net profit after tax and before amortisation (NPATA) was higher by 81 per cent, to $37.9 million for the half. This led to earnings per share of 5.10c, up 26 per cent on the previous corresponding period (PCP). As mentioned, SDF announced a 2.4c interim dividend, which is 20 per cent up on the previous corresponding period's 2c.

The Network Brokers division showed a healthy performance, with gross written premium (GWP) rebounding when compared to the prior half (2H15). This is one of the pleasing aspects of the result, as the pricing pressure in premiums is appearing to abate. When compared to 2H15, pricing grew by 0.1 per cent, following declines in the previous two rolling halves of 4 per cent and 7.1 per cent. This suggests a change in trend, and that the potential for premium increases at the big insurers is apparent in the future. Given that SDF has achieved an expanded scale and profitability through the down cycle, the company appears well placed to benefit from any hardening of the market for premium prices in the coming two years.

The underwriting agencies division benefitted from the contribution of acquired businesses, Calliden and QBE Agencies. The result was a lift in GWP of 273 per cent on the PCP, with the group being well established as the largest underwriting agency group in Australia. Management expectations for the full year are for GWP of above $765m, which would confirm that this division has doubled in size with the acquisition contributions. Pleasingly, commentary from management on these acquisitions is that they are performing ahead of expectations. Additionally, $1.5m in acquisitions synergies was disclosed to the market, with the expectation that further margin enhancement would be expected as the integration of these businesses continues.

Outlook and key take-away

This result signified that SDF's underlying business is holding firm through the cycle of downward pricing pressure. Given there are some early signs of stability in pricing for insurance premiums, the business is well placed. The acquisitions made last year were significant and this has shown through in the results. Pleasingly, the integration appears to be progressing well, with performance strong and some initial synergies being realised.

Cash conversion at SDF was strong at 100 per cent of underlying NPATA converted to cash. Cash flow from operations before movements in trust accounts was $47.1m, up from $21.1m in the PCP. This is a pleasing result and shows that earnings are being converted to cash.

From a balance sheet perspective, SDF remains comfortable, with gearing at 17 per cent of capital (corporate debt / corporate debt plus equity). Additionally, SDF has around $114m of funding capacity to explore further acquisitive growth.

Management has confirmed full year underlying NPATA and EPS guidance for the full year, being a range of $80-$83m and 10.8-11.2c per share respectively. This is in line with our expectations.

Valuation and risks

There are risks present for investors to consider at SDF, including the fact that the company's guidance assumes no adverse changes to the market for insurance premium prices, acquisition integration is expected to continue to add value, and no material acquisitions are made. I view these risks as low at present, and the indicators in terms of premium pricing appear to be more likely a positive catalyst than negative.

Given the strength of this result, and the commentary inferring that the pricing cycle is improving, I slightly upgrade forecasts for FY17 and lift our valuation from $1.68 to $1.74. SDF also maintains a buy recommendation.

Virtus Health – Solid growth and margin pressure abating

Fertility services business Virtus Health Limited (VRT) provided a solid financial report to the market last week, with revenue growth of 15.4 per cent to $132.2m. This was ahead of our expectations as the market overall saw strong IVF cycle volumes, particularly in the eastern states. Perhaps the best outcome from this result was that VRT appears resilient to the introduction of bulk billing services in NSW, allowing investors some comfort on future earnings margins.

Net profit after tax and minorities was higher by seven per cent from $16.7m in the previous corresponding period (PCP), to $17.9m this half. While margins were lower this half, much of this is down to a shift in mix as the company continues to diversify its earnings into diagnostic services and day hospitals.

A 14 cent fully franked interim dividend was announced, which was marginally above our forecasts for the first half. Shares in VRT will commence trading on an ex-dividend basis on March 31, 2016. This dividend will be paid on the back of earnings per share (EPS) of 22.13c, signifying a payout ratio of 63.3 per cent.

Geographical summary

The Australian segment of VRT's business continues to contribute the lion's share of earnings before interest, tax, depreciation and amortisation (EBITDA) at $39.038m, a 6.2 per cent increase on the PCP. While EBITDA margins declined from 35.3 per cent to 34.4 per cent, this was largely attributable to a change in mix of sales between full service IVF cycles and lower cost cycles at the company's low cost offerings in NSW, known as The Fertility Centre (TFC). Overall, this result bodes well for the future in Australia, and shows two major positive trends.

Firstly, margin declines have appeared to slow, with suggestions from management that the new bulk billing competition in NSW has opened a new segment of the market rather than directly competing with VRT's two offerings.

Secondly, the strong overall increases in cycle volumes in Australia (particularly in the Eastern states) are supportive of our view that there is a defensive element to demand for IVF cycles.

The international component of VRT's business is significantly smaller, with 1H16 EBITDA coming in at $2.35m, up from $1.189m in the PCP. This growth was driven by strong performance in Ireland, where EBITDA margins also declined due to some shortages in specialists at one of the clinics and lower margin revenues from pharmacy distribution. The Ireland expansion should be considered as progressing successfully, with the potential for further growth in FY16 and beyond.

In Singapore, the company continues to lag. For the half Singapore was a drag on earnings of around $0.6m, as a slow build in volumes continues to occur. VRT have estimated that the segment needs 30 cycles per month to hit breakeven, and that recent months (excluding February, which is impacted by Chinese New Year) have been only a few cycles away from hitting that mark. So, while Singapore remains a drag on the business, there is hope that earnings growth will come in FY17. Given the slower establishment of profitability in Singapore, I would expect the company to focus on investment to build into other geographies as a priority above expansion in Singapore itself, at least in the near term.

On February 25, I was fortunate enough to interview chief executive Sue Channon to discuss the business, industry trends and the most recent financial results:

Outlook and key take-away

This result was slightly ahead of our expectations. The revenue growth has been promising, and risks in terms of margin impacts from bulk billing seem to be abating. VRT possesses a relatively clean balance sheet, geared to a touch over 50 per cent in terms of net debt to equity, and headroom for investment of around $55m.

VRT don't provide guidance to the market in terms of financials. Nonetheless the outlook remains solid, with tailwinds in terms of long term cycle growth driven by demographic demand drivers. The Australian market experienced healthy growth in the first half, and we expect that the second half will deliver growth on its corresponding half from FY15. The dividend of 14c was ahead of my numbers, and I have upgraded my expectations for the full year dividends payout from 27 cents to 28 cents. This places the company on an FY16 DPS yield of just over 4.6 per cent, or 6.6 per cent including franking credits.

VRT's valuation has been upgraded from $5.41 to $6.12. This upgrade comes as a result of our view that the main impact from the introduction of bulk billing into the IVF market has been felt. Thus the company's earnings are lower risk from a market share and margin pressure perspective. We remain comfortable retaining a buy call on VRT and its position in the Income First model portfolio.