Virtus Health Ltd Financial Analysis Date: VRT $7.15 Disclosure: Contact: W: www.pupresearch.com.au E: info@pupresearch.com.au T: +61 3 9214 2 1 5-Jul-213 No Holding at Time of Report
VRT Overview Virtus Health (VRT) is a leading provider of reproductive health services, primarily IVF cycles. The business also operates diagnostic labs and day hospital facilities that are used in conjunction with these services. The business was formed through the merger in 28 29 of three state based fertility businesses: - IVF Australia (NSW); - Melbourne IVF (Vic); and - Queensland Fertility Group The merger was undertaken with Quadrant Private Equity, who sold their 46% stake in an IPO in June 213. VRT - Divisional Sales Specialised Diagnostics 8% Assisted Reproductive Services 79% Day Hospital 13% 2
VRT Profit History Since merging, the combined group has delivered strong growth in sales and profits. As a private equity structure, NPAT has been impacted by funding structures. VRT - Sales 25 2 15 1 5 29 21 211 212 213 214 VRT - Operating Earnings 8 6 4 EBITDA EBIT 2 29 21 211 212 213 214 VRT - Profit Trends (211 = 1) 2 Sales EBIT NPAT EPS (Adj.) 15 DPS (Adj.) 1 5 29 21 211 212 213 3
VRT Profit Drivers Although the statutory numbers have been boosted by the roll up, organic growth has been strong VRT - Sales 2 15 1 5 Statutory Pro-Forma 29 21 211 212 213 Although new Dr s are not as productive initially, revenue momentum has been sustained by higher prices. VRT - Revenue 25 2 15 IVF Cycles/Specialist Avg. Rev./IVF Cycle 15, 12, 9, driven by the higher number of reproductive specialists contracted to the group. VRT - Ave. Specialists Contracted 1 8 6 4 2 21 211 212 213 As an aside, it is worth noting the seasonality in the business due to the impact of holidays on H2 volumes. VRT - HY Earnings 3 2 EBIT Sales 12 8 1 6, 1 4 5 3, 21 211 212 213 H1 12 H2 12 H1 13 H2 13 4
VRT Earnings Quality Earnings quality is good, with no major issues. VRT - Free Cash Flow 3 2 1 6 4 Excellent cash generation Free Cash Flow NPAT (Pre GW) 29 21 211 212 213 and very strong operating cash conversion VRT - GOCF/EBITDA is a function of minimal capex requirements 12 VRT - Capex/Depreciation 9 6 3 15% 1% 5% Total Capex Depreciation 29 21 211 212 213 due to the negative working capital model of the business. VRT - Working Cap./Sales Inventory Receivables Payables Net Working Capital 2 % EBITDA GOCF -5% 29 21 211 212 213-1% 29 21 211 212 5
VRT Group Returns This combination of: - negative working capital; - minimal fixed asset investment; and - Goodwill which is purely a function of the historic roll up means organic investment in the business is minimal. Therefore, returns are driven entirely by margins and if revenue growth can be delivered, incremental returns are exceptional. VRT - Investment/Sales 3% 2% 1% % -1% 4% 3% 2% 1% % Fixed Assets Intangibles Net Working Capital 29 21 211 212 VRT - Margins EBIT Margin EBITDA Margin EBITDAR Margin 8% 6% 4% 29 211 213 VRT - ROFE Incremental Funds Total Funds 2% % 29 21 211 212 213 6
VRT Divisional Returns At first glance, the stability of the various cost lines for the business suggests that current margins are maintainable. VRT - Cost/Sales 4% 3% 2% 1% % Occupancy Employee Benefits Advertising & Marketing Other 29 21 211 212 However, there are three risks: - Firstly, are potential funding changes. Although out of pocket expenses are already high (25-5%), potential cuts in funding (including the recent increase in the EMSN cap) have the potential to impact both volumes and mix of higher revenue customers. - The introduction of the EMSN cap in 21 saw 1% volume declines, which highlights the second risk, being any potential leverage to the economic cycle. VRT - Cost/Sales 2% 15% 1% 5% % 15, 12, 9, 6, 3, Provider Consumables Associated 21 211 212 VRT - IVF Cycle Funding Breakdown First Cycle - Basic First Cycle - Advanced Out of Pocket Private Health Gv't (EMSN) Gv't (MBS) Second Cycle - Basic However, both these risks are likely to be only short term in their impact. Second Cycle - Advanced By far the biggest issue for margins is the sustainability of current pricing arrangements with the specialist providers. Provider fees currently represent ~16% of sales. With profits at 25% of sales, is there a risk that over time the Dr s will look to increase their share of the pie? 7
VRT Comparative Returns Certainly, margins look very high relative to other professional services healthcare businesses. The two most important case studies here are Vision Group and the radiology sector where after selling their businesses, the Dr s eventually reclaimed a large share of the pie. Note the radiology sector in particular has much greater capital requirements and potential scale benefits, yet still only commands sub 15% margins. Note that to the extent that the higher margins are caused by the 2% of VRT sales from diagnostics and day care facilities, this would also appear to be a case of overearning. Neither the pathology or hospital operators command margins >2% despite the much greater scale benefits in pathology and much greater asset intensity in Hospitals. Healthcare Prof. Services - EBIT Margins 4% 2% % 25% 2% 15% 1% 5% VRT GXL VEI SHL - Radiology PRY - Radiology 2 23 26 29 212 Aus. Pathology - EBIT Margin SHL PRY % Healthscope Symbion Gribbles -5% 1993 1996 1999 22 25 28 211 Hospitals - EBIT Margin 2% 15% 1% Healthscope Ramsay Mayne Nova Alpha 5% 8 Source: Company Reports % 199 1994 1998 22 26 21
VRT Industry Case Study Nevertheless, VRT s margins are consistent with peers: - Healthbridge Formed by the merger of Repromed and Monash IVF; - Genea, (owned by 17 Dr s and staff). However, margins of the precursor businesses of these groups show much more variability. IVF Aus & Qld Fert were precursors of VRT, and the margin profile of the latter prior to Virtus ownership raises some concerns. Prior to private equity ownership, the owners of these businesses could chose to take their earnings in either wages or dividends. If we restate margins including dividends as a cost of sales, then the transformation from private ownership to private equity is stark. In essence the Dr s have swapped their salary for an upfront payment via the sale of their businesses to private equity and the public market. Reproductive Services - EBIT Margins 4% 3% 2% 1% % 5% 4% 3% 2% 1% % Virtus Health Healthbridge Genea - IVF 25 27 29 211 Reproductive Services - EBIT Margins IVF Australia QLD Fertility Group Monash IVF Repromed 45% 3% 15% 23 25 27 29 211 Reproductive Services - EBIT Margins Adj. for Dividends IVF Australia QLD Fertility Group Monash IVF Repromed Genea A good trade for the current Dr s but what of the next generation who can no longer participate in equity ownership? 9 % -15% 21 23 25 27 29 211
VRT Dr Employment Whilst there is a strong likelihood that over time Dr s will demand a much higher share of the revenue pool, in the short term this is mitigated by the duration of employment contracts and share escrow periods. Initial contract terms are for 5 years. With the majority of Dr s contracted pre FY 1, this five year period will be rolling off. Note 5 pre FY 1 Dr s have already retired. VRT - Specialists Contracted 1 8 6 4 2 FY 13 FY 12 FY 11 FY 1 Pre FY 1 21 211 212 213 214 5% of pre-listing shares are escrowed for specialists (i.e. ~13m shares). Terms of escrow release are: - 3% in each year post listing; - 2% at age 63 (or two years post listing if Dr is, or will turn, 63 in this period); - 2% at retirement. Furthermore, Dr s may retire after age 61 without any impact on their share escrow arrangements. 3% of Dr s (who perform 43% of the volume) are >55 yrs of age. VRT - Age Profile of Specialists <45 45-55 55-63 >63 37% 18% 32% VRT - Share Ownership Prior Shares 13% Post Fertility Specialists 25.7 18.3 Scientists 1..6 Mgmt/Staff 1..7 Quadrant Funds 25.9 - Other Existing 2.3.2 New - 59.6 Total 55.9 79.5 Source: Company Reports 1
VRT Balance Sheet VRT will list with a balance sheet that is fully geared, given there are essentially no tangible assets in the business. (note net debt for total VRT group prior to listing was ~$2m chart reflects statutory accounts). This is justified on the current earnings of the group, with interest cover at 5x and fixed charges cover >3x. However, this relies on the current margins of the group being maintained. Viewed as net debt/sales (i.e normalising for margin), VRT s debt levels are the highest in the sector. Therefore, whilst at current levels of earnings and cash generation, debt service obligations and dividend payout (~65% target) are ok, there is little flexibility should margins come under pressure. VRT - Net Assets 4 3 2 1-1 VRT - Debt Coverage 8 6 4 2 1.5 1. 29 21 211 212 213 Fixed Charges Cover (EBITx) Interest Cover (EBITx) Interest Cover (EBITDAx) Other LT Assets Intangibles Net Curr. Assets Fixed Assets Net Debt Source 29 21 211 212 213 Healthcare Prof. Services - Net Debt/Sales VRT VEI PRY GXL SHL.5. 1995 1998 21 24 27 21 213 11
VRT Valuation On earnings metrics, VRT is priced for solid medium term growth with a high teens PER. And low teens EBIT multiple on a fully geared balance sheet. More concerning is the >3x multiple of forward sales, which implies both revenue growth and current margins are achievable. VRT - PER 25 2 15 1 5 VRT - EV/Earnings 2 15 1 5 213 214 EV/EBITA 213 214 EV/EBITDA VRT - EV/Sales 5 4 3 2 1 213 214 12
VRT Comparative Valuation Whilst VRT s earnings multiples are comparable to others in the sector Healthcare Professional Services EV/EBITA 3 2 1 VRT GXL VEI SHL PRY CAJ 1998 2 22 24 26 28 21 212 214 Source: Bloomberg.. It is by far and away the most expensive stock in the sector on a multiple of sales. Healthcare Professional Services EV/Sales 8 6 4 2 VRT GXL VEI SHL PRY CAJ 1998 2 22 24 26 28 21 212 214 Source: Bloomberg 13
VRT Conclusion VRT has a solid position in the reproductive health industry. The industry itself has some favourable demographic characteristics that support top line growth. In the short term, there are some potential risks to volume from a slowing economy and limited ability to exercise any pricing power given extent of recent price increases and impact of reduced Medicare funding. However, by far and away the biggest issue is the sustainability of group margins as the current arrangements with Dr s roll off over the next few years. Margins are well above comparable professional health services businesses. Compounding this, the balance sheet has been geared to reflect current margins, and valuations are capitalising current earnings at low teens EBIT multiples. None of this suggests an attractive risk/reward proposition. 14
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