Wednesday, April 13, 2016

Virtus Health

Business and Industry Overview

Virtus Health Ltd (“Virtus”, “VRT”) is a steady dividend grower I found while scanning through Australian stocks.

Virtus operates In Vitro Fertilization (IVF) clinics. Fertility specialists contract with Virtus to use the clinics for IVF and related operations and get a split of the revenue. When a couple gets an IVF at Virtus, they pay the bill initially but gets heavy reimbursement from the federal government (Medicare and EMSN) as well as Private insurance if they have it. As a result, Virtus’ revenue is AUD 10,000-14,000 per IVF cycle but typical out-of-pocket costs for each patient is 1/3-1/2 of the total price.

The Australian assisted reproductive services (ARS) industry is concentrated. The top 3 players Virtus, Monash IVF, and Genea owns over 70% market share and are all privately owned. ARS are mostly provided by private clinics as there are virtually no public sector fertility clinics in Australia. Virtus is the biggest of the three with ~1/3 market share. At the local level VRT is even stronger since it is number one or number two in its geographies.

Why I Like It

There's lots to like about the industry and specifically Virtus. You have a product that is naturally price inelastic (we’re talking about babies here), good market structure, and very long growth runway due to demographics.

The industry structure is a big attraction for me as new entrants will have difficulty recruiting fertility specialists. This is the key to market share gains. But there are only some 300 odds fertility specialists in Australia and they are typically under contract with the big three.

Australia’s low birth rates provide Virtus a long growth runway. Those data were cited extensively in IPO prospectuses so I won’t recite them here.

Acquisitions have been sensible and generally at below 10x earnings. As a result return on incremental capital is solid low-mid teens. Management has been good about returning excess cash in the form of dividends.

My plan to make money with this stock is buy and hold, let the company accrete value over time and receive dividends in the interim. That should give 5-15% IRR over the next few years, maybe even decades.

Risks and Mitigants

What might change my mind? If the key risks turn out worse than expected: government funding risk, lower price competition, and alternative technologies.

By “funding risk” I mean risk that government will reduce reimbursement for IVF, or reduce subsidies for private insurance. Despite the chaos in Australian politics I have actually gotten comfortable here. First, unlike other benefits that add to expenses for the government, an IVF actually creates a future tax payer. 

Second, in the extreme and unlikely case where funding is removed and patients pay 100% out of pocket you're talking about AUD 10,000-14,000 per IVF cycle, a lot of couples would still pay. Keep in mind Australia is one of the wealthiest countries on Earth and typical clients are women in their late 30’s, who tend to be well educated and have sound financial positions (which is often why they delayed starting a family in the first place)

Competition is a bigger worry. Primary Health is in the market with low end $500 or even $0 out of pocket services. There has been some impact on Virtus' lower price, less service clinic but management indicates their full service IVF is still going strong. Industry IVF cycle growth have been higher than normal since Primary Health’s entry, so it would seem that they enlarged the pie by drawing in new customer segments. 

Primary only has two IVF clinics so far and I think scaling up and signing up doctors will be tough. I don’t see why doctors would leave a high priced practice for a low end one.

Longer term tail risks is that an alternative technology emerging to replace IVF. Also if IVF success rates (currently ~25-30% for women in late 30's) improve then people would need less service.

Why Virtus and Not Monash IVF; Catalysts

I prefer Virtus because Monash has business concentration risk with 1/3 of IVF cycle from 5 doctors. It also hasn't really been exposed to competition from Primary Health, which only recently opened a clinic in Melbourne. Yes, Monash IVF does have higher margins mostly due lower employee benefits, but Virtus is not a provider of low cost commodity services and in fact there's something positive to be said about paying your employees well.

“Self-help” earning opportunities are available in the next year or so. The company’s Singapore operations can swing from loss to profit (management indicated this can happen in a couple quarters). One of the Ireland Clinics had some temporary staffing issues in FY1H16 which has been addressed. VRT can also benefit from general ramp up of new facilities and younger doctors as they grow their reputation and attract new clients.

Australian budget comes out in May and we will have more color on the government funding risk then. The technicals are not great - the stock is coming upon a resistance zone at $7.0-7.25. But I’m inclined to ignore that and hold even if it gets there.

I have a 2-3% position right now with average cost basis of $6.56. Virtus trades at 15-16x forward earnings. Accounting earnings tracks cash flows well and leverage is moderate at 2-2.5x EBITDA.

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