"In this world nothing can be said to be certain, except death and taxes" – Benjamin Franklin's famous quote is mentioned regularly when investors discuss the merits of investing in InvoCare Limited (ASX: IVC).
InvoCare owns and operates funeral homes, cemeteries and crematoria around Australia, New Zealand and Singapore. It is Australia's leading operator and owns some of the most well known and trusted brands in the sector including White Lady Funerals and Simplicity Funerals. Interestingly, InvoCare has moved to expand its operations into the much larger and more lucrative US market.
There appears to be a perception in the market that the defensive nature of this funeral business means that companies like InvoCare will always prosper despite constantly changing economic conditions. And while this is true for the most part, there is no such thing as a guaranteed return in the stockmarket and even the most defensive companies are not immune from this.
For example, investors who purchased InvoCare shares in August of this year will now be sitting on a loss of around 20% – that investment is not looking so defensive anymore.
Investors now need to ask – "Is this a temporary fall in the share price or the start of a more worrying trend?"
The best starting point to answer this question is to look at what are the possible causes for the recent share price slide.
In my mind, there are four separate issues that could be impacting the share price right now:
1. Higher than expected US start up costs – InvoCare reported a higher than expected first half loss for its US operations of AUD $1.5 million. The company was expecting a full year loss of USD $2 million but now expects this to blow out to USD $3 million. While the size of these figures may be small, it demonstrates the challenges the company faces in trying to take market share away from existing, more established providers.
2. Subdued growth– InvoCare reported comparable operating earnings growth (EBITDA) of just 4.9% in its most recent half. Comparable funeral case volumes increased by 2.5% and total revenue increased by only 6%. When the US loss making operations are included, the group actually reported a 11% decline in net profit. The nature of InvoCare's business means it is hard to achieve double-digit earnings growth organically. The death rate may be highly predictable, but the current rate is just not high enough to achieve strong earnings growth without large price increases and further acquisitions.
3. Stretched balance sheet – InvoCare is currently holding more than $241 million in long term debt and has a debt to equity ratio of more than 130%. With the current gearing level so high, it may be difficult for the company to raise additional funds for further acquisitions.
4. Priced for strong growth – Even with the recent fall in the share price, InvoCare is still trading at a substantial premium to the broader market. At a price-to-earnings ratio of nearly 25, the market will expect the company to deliver a much improved performance over the medium term as its recent growth rate will not sustain such a high valuation.
Foolish takeaway
There is no doubt that InvoCare is a high-quality business with excellent defensive qualities but one that faces some short term challenges. Personally, I think it is too early to tell if the company's venture into the US will be successful and there still remains doubts in my mind over how the company will achieve earnings growth that can justify such a high valuation.
For now, I will be happy to wait on the sidelines until InvoCare's share price is substantially cheaper or there is further proof that earnings growth will be boosted by its recent venture into the US.
