Three strikes for InvoCare

It's fortunate Benjamin Franklin cheated death with his dangerous kite experiment in 1752. Had his risk-taking proven fatal, his line about the certainty of death and taxes would never have been written.

Perhaps it wouldn't have mattered. Franklin was wrong about taxes anyway, never having imagined the Double Irish or the Dutch Sandwich. It now looks like he may have been misguided about death too, at least when it comes to funeral provider InvoCare these past few months.

Last week InvoCare announced that the number of deaths in Australia was down 5.9% over the June to August period and even more in September. It's a 'very unusual' decrease, said management, which attributed the decline to a mild winter and an effective flu vaccine campaign.

This marks InvoCare's third profit downgrade this year. With the lower volumes set to knock at least $17m off revenue, underlying earnings per share - prior to the accounting changes mentioned in earlier reviews - will fall by more than 20% to around 42 cents in 2018. This is certainly worse than we imagined at the time of the first downgrade.

With the stock trading at $12.10 and therefore on a forecast (underlying) price-earnings ratio of 29, you may be wondering why it's defying gravity. A 20% decline in earnings is of course no small matter. Well, as the market often does, it's looking through to recovery.

Managing expectations

InvoCare was careful to call its ASX release a 'Funeral Market Update'. The company wants you to think the death rate is the only problem. And the death rate should return to trend eventually, allowing InvoCare to catch up some of the revenue lost in 2018.

It would be much more worrying if the Protect & Grow refurbishment strategy was faltering or the company was losing market share. But the company insisted that neither was the case, and so far the market seems to be taking that assurance on face value.

We will too - for the time being. However, market disruption of any sort comes with risks. Lower funeral volumes mean competitors will be willing to discount to attract business. InvoCare did highlight that price increases were hard to achieve in the current climate.

Our concern, however, is not with 2018. We've mentioned before the heavy additional costs - in the form of additional depreciation, amortisation and interest - that will hit 2019 and beyond. Debt-financing a massive refurbishment program appears to have been a necessary evil, with the costs to hit the income statement over time. Protect & Grow is effectively a capital expenditure catch-up program.

To offset these costs, InvoCare must grow the earnings before interest, tax, depreciation and amortisation (EBITDA) line significantly. If, for some reason, InvoCare finds its market share under threat, if Protect & Grow falters, or the death rate remains below trend, the market's expectations for a recovery might be misplaced.

EBITDA will need to grow by about 15% in 2019 for net profit to be flat. But companies with flat net profit growth don't usually command price-earnings multiples near 30.

Risk of disappointment

Any further disappointment, including any hint that EBITDA won't rise strongly in 2019 (which we won't know until next year), means the stock will come under further pressure. The current multiple implies net profit will bounce back in 2019, something we're much less sure about than the market appears to be.

However, the chance of a market dislocation similar to what occurred with Dignity plc in the United Kingdom is probably receding. The industry structure in Australia is much more favourable to InvoCare and, according to management, Protect & Grow 'continues to perform strongly'.

With that in mind, we're raising our Buy price from $8.00 to $9.00. That represents a price-earnings ratio of 21 on what are likely to be depressed (underlying) earnings for 2018. This Buy price however still assumes that Protect & Grow is successful and that market share increases over time.

Our view, however, is that the market remains too optimistic about the earnings growth benefits from a recovery in the death rate, as well as Protect & Grow, over the next 18 months. Our recommendation therefore remains SELL.