It’s something we’ve thought a lot about. These companies’ business models rely on convincing doctors to sell their clinics and become contractors, who are then paid a fixed fee per cycle. The doctors often sign short-term contracts with non-compete agreements that span a year or two. But, ultimately, a doctor can just walk away – often taking their clients and revenues with them.
Doctors have fewer choices of where to work
Scale lowers costs and boosts demand
Largest operators have sustainable competitive advantage
A perfect example occured last month when Monash lost one of its most senior doctors, which is expected to cause a ‘high-single digit’ cut to earnings in 2019. And things can get far worse than that. Vision Eye Institute, an operator of ophthalmology clinics, wrote off more than $100m of goodwill between 2010 and 2013 after its doctors walked out en masse.
Do Virtus and Monash face a similar risk? We don’t think so, and here are three reasons why.
To start, the power of doctors – at least from the company’s perspective – isn’t a function of their education and skills, but of supply and demand. A good measure of that balance is the time a patient waits to see a specialist.
The median wait time for all elective surgeries in Australia is 71 days. We couldn’t find the comparable figure for IVF specifically, but it takes nearly half that time – just 39 days – to see a gynecologist, which is the core specialty of most IVF doctors. This suggests that relative to other healthcare professions, the IVF industry has a more favourable ratio of doctors to patients, which makes it easier to recruit new doctors or find replacements for those who leave.
There are other more powerful forces working in Virtus and Monash’s favour: automation and economies of scale.
Unlike most areas of medicine, IVF is as much a technology business as it is a people business. Between removing the eggs, fertilizing them, pathology testing, raising the embryos and implanting them into the mother, a whole suite of high-tech gizmos are used.
IVF is becoming more efficient, with improvements in robotics, diagnostics, microfluids, incubators, and embryo storage. The procedure is increasingly standardised and automated. Much as self-checkouts at your local Woolworths have shifted power away from cashiers to the company, Virtus and Monash’s shareholders will benefit from increasingly automated IVF.
What’s more, genetic tests and many other aspects of IVF typically rely on expensive equipment and this means there’s a benefit to having them perform as many tests and procedures as possible. Given that the labs are largely a fixed cost, each additional service performed lowers the average cost per procedure and improves margins.
With this in mind, it seems inevitable that IVF will follow the cost curve of most technology-intensive processes and get cheaper. True, treatment prices have been rising at the big operators in recent years, but we don’t expect this trend to last much longer – especially with the growing market share of budget and ‘low intervention’ IVF providers putting efficiency at the top of every executive’s to-do list. As IVF moves from being a luxury item to a commoditised therapy, cost cutting becomes the focus.
3. Pays to be big
Why, you might be asking, would declining costs encourage doctors to stay? Wouldn’t that just make it cheaper for them to set up shop alone?
As costs come down and procedures are standardised, it will be increasingly difficult for doctors to remain competitive on price because, as mentioned above, the big operators will have lower average costs as more volumes move through their labs.
What’s more, IVF is expensive and couples are working to a biological clock. Having a child is a major decision for clients and they only have a small window of opportunity – there’s a lot of trust put in the IVF provider, so people shop around for the best. Unlike, say, your choice of grocery store, convenience isn’t the deciding factor.
Can you think of another industry that requires a large up-front cost and a lot of trust? How about cars? Like the auto industry, IVF invests heavily in brands and marketing. Virtus and Monash together spent close to $9m on advertising in 2016, so it pays for a fertility specialist to be part of a large group, otherwise they’ll be overlooked by clients. The biggest companies have the biggest marketing budgets, which attracts the most customers, so there's more funding for research and marketing … and a virtuous cycle is born. Being big is a competitive advantage.
Industries characterised by strong economies of scale tend to consolidate into oligopolies, with small independent operators gradually bought out by the larger companies with whom they can no longer compete. And that’s exactly what is happening with IVF.
Over the past 15 years, the industry has gradually merged into a few large players, which was sped up in 2008/09 when private equity groups bought Virtus and Monash then quickly made several bolt-on acquisitions.
Assisted reproduction is increasingly moving towards a model of big purchasers (private insurers/government) buying from big providers (IVF networks/mega clinics). The little guy is being squeezed out, so doctors who choose to go it alone face a mounting headwind.
Three-quarters of all IVF cycles in Australia are now performed at either Virtus (36%), Monash (24%) or Genea (15%), and we expect that figure to grow. Pathology, with its even stronger economies of scale, is the only medical industry with a higher level of concentration.
The Fertility Society of Australia estimates that one in six couples of reproductive age suffer from infertility, yet only around 50% seek medical advice. Of these, only around half get the specialist treatment they need, mainly on account of the extremely high cost of IVF and limited coverage by Medicare.
As the industry consolidates and becomes more tech focused, economies of scale get stronger, and IVF becomes cheaper. This will put IVF within reach for thousands of couples who are currently unable to afford it. There’s still a huge untapped market for IVF, with potential to at least double the number of cycles performed each year.
This trend – in addition to the increasing prevalence of infertility due to women waiting longer to have children – should ensure demand for IVF grows materially over the next decade. We expect the three largest providers to take the lion’s share of this growth – and increase their collective slice of the pie too.
Monash’s management expects net profit to increase in the 2017 financial year, though it hasn’t given specific guidance. The stock trades on a price-earnings ratio of 13 based on consensus estimates for 2017 earnings and we continue to recommend you HOLD.
Virtus’s management didn’t provide specific guidance for 2017 either but it did warn that volumes and margins are likely to be hurt in Queensland, where Primary Health Care has recently opened a bulk-billing clinic.
The stock sports a price-earnings ratio of 15 based on consensus estimates for 2017 earnings, a free cash flow yield of 8.2%, and a fully franked dividend yield of 5.3%. Virtus has a superior market position, with economies of scale, healthy returns on capital and it throws off plenty of cash. We’re happy to pay a slight premium for it relative to Monash and we’re sticking with BUY.
Note: The Intelligent Investor 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.