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Unhealthy Expectations

Unhealthy Expectations

As the share market has surged in recent years, many private businesses have conducted Initial Public Offerings (IPOs). We are always sceptical when a business comes to market in search of capital to fund a buyout of current shareholders, particularly if the seller is Private Equity.

Even if one performs intensive and thorough research on the business’s past and future, the seller will always be in a more knowledgeable position and buying from someone who’s more informed than you, means that by default, you’ve got your work cut out.

Indeed each new IPO gives us added reason to be more prudent. This is especially true when it comes to forward projections of earnings which many of these deals and valuations can be anchored (sold) upon.

Unfortunately, we’ve seen numerous IPOs fall short of their projected earnings in the first 12 months as a public entity, blaming all forms of external factors (even the weather!). Of course, once a business fails to hit short-term targets or guidance, the share prices will weaken materially as a less optimistic reality is accepted. This can be painful and is obviously best avoided.

We will not invest capital unless we can at a minimum be certain we will get our capital back before we even consider if we can generate a return on our investment. So when we assess an IPO with Wayne Greztsky (hockey stick) style forecasts, we apply heavy discounts and perform our own intensive modelling to ensure a more “independent” view of the company’s prospects.

This ensures unfortunately that we participate in very few IPOs because accounting for a known fact that positive bias will exist when you’re incentivised heavily to get the deal done, can often lead to savage revisions.

To digress a little, health care is a key thematic we follow closely. People are living longer, and as a result there will be a constant demand for products and services that arrest the natural deterioration of our bodies. There are many companies that focus on extending the life of their patients, but one IPO in 2013 was a company that focused on the creation of life.

That same business was well-positioned to capture a growing trend in Australia of women delaying the birth of children until they could afford it. The average age of women giving birth is now 30 years, but this advancing age leads to a material reduction in fertility. If this trend continues, then demand will continue to grow for Assisted Reproductive services (ART).

Virtus Health (ASX: VRT) is the business that caught our eye in 2013. It provides ART services, such as IVF treatment, through a network of clinicians, scientists and researchers. The company was exposed to longer-run earnings potential due to favourable demographics and a well-regarded specialist network. We did however note an important issue when readjusting its earnings forecasts from those which were kindly prepared for us.

An instant red flag is raised whenever strong, abnormal growth is generated in the years preceding a float. Virtus’ core growth drivers were simply the recruitment of specialists and their ability to source and perform IVF cycles.

In the year before its IPO, Virtus materially bolstered its network with 14 specialists. These specialists, unsurprisingly, brought in their own patients which contributed to earnings growing by 27 per cent.

To the casual observer, this would appear to be a high growth business, and could be worthy of a higher price. Conversely, we considered that earnings was highly correlated with the number of specialists and therefore questioned its sustainability.

Sure enough, in the preceding year prior to the strong growth, we discovered that only two net specialists were acquired, and that in the year following, earnings only grew by 1.6 per cent. On this basis, it was difficult to justify high future earnings growth without an associated increase in referring doctors. After all, a doctor’s ability to refer patients is limited by the amount of hours in a working day.

Accordingly, we then focused on analyst projections. The company had only planned to add three doctors in the foreseeable future, yet earnings growth rates in excess of 20 per cent per annum were being applied. Unless Virtus could rapidly increase scale in surgeries or add new services, it would become quickly obvious that more specialists would need to be acquired.

As such, we chose to be conservative in our forecasts, and considered that the offer price provided a sufficient margin of safety to warrant investment. Yet when the company floated on the ASX on 11 June 2013, the market exuberantly considered that the higher growth projections were more appropriate, we subsequently took advantage of that and disposed of our holding.

The company has recently downgraded its guidance, rebasing its forecasts from mid-teen growth to mid-single growth. It has taken a number of years, but it seems that our reservations were justified.

Russell Muldoon is the Portfolio Manager of The Montgomery [Private] Fund. To invest with Montgomery, find out more.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.


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  1. There may be a bit of a sleeper issue that analysts of listed IVF companies should have a look at. It potentially could have a significant impact on valuations. Just as cardiac surgeons/hospitals have differing success/survival rates in open heart surgery (and these are publicly available in some jurisdictions), different IVF clinics have different success rates (number of cycles attempted per pregnancy). A recent Health Report programme (http://www.abc.net.au/radionational/programs/healthreport/ivf-fertility-data-kept-from-public/6461218) indicated that there is some disquiet within the profession about a large variation in success rates; this data exists, but is not released publicly (at this stage), however, it sounds like some pressure might be coming for that to happen. My question would be, what is the pregnancy rate of listed company ivf cycles versus private clinics? It might be fine, or then again.. If it turned out that, pressure to put through as many cycles as possible (commercial imperative) was leading to lower clinical standards and pregnancy rates, and this becomes public knowledge if IVF clinic league tables become a reality, the impact on valuations might material.

    • Russell Muldoon

      Hi John, any business lives or dies on their ability to deliver what the consumer ultimately needs – in this case, a successful pregnancy. Recent announcements by Monash IVF (who pioneered the treatment with the Monash University in the 70’s) and Virtus put the current success rate is around the 30% mark. Success levels (pregnancy rate per embryo transfer cycle) have improved over time, from high teens in 2000 as diagnostic tools and treatment protocols have improved.

      Note that figures used by MVF for example are calculated from data published by the Australian Institute of Health and Welfare, Assisted Reproductive Technology in Australia and New Zealand Reports, 1995 – 2011.

      Heres a link to the presentation, see slide number 7.


      From an outsider looking in, I have no reason to question the corporate governance of MVF or VRT at this stage. As per industry any industry, there are bound to be some individuals attracted for their own self-interest ahead of their patients. Sad but true.

  2. Patrick Poke

    I really enjoy reading about the successful investment decisions that the fund has made such as this, McMillan Shakespeare and Sirtex – it really goes to show what a high quality manager Montgomery is. I’d be very interested to hear more about the mistakes that have been made also, while it might not seem like a good marketing move, I think being comfortable with sharing your mistakes also shows a level of honesty that’s important from a manager – Warren Buffett is a good example of someone who always talks about the mistakes they’ve made.

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