Ann: Chairman's Address to Shareholders, page-28

@Jimmy_C

Like you, I like the demand dynamics of the assisted reproductive services sector, albeit that it has a cyclical overlay.

And like you, I sense, it is the supply side that I think the market has undergauged since these stocks listed. When I read the prospectuses of both MVF and VRT some years back, my overarching sense was that these companies were over-earning. Even from this point I think the 2 industry leaders will continue to cede market share at the margin to players able to provide a rudimentary service, i.e., the low-cost end.

So I fully expect the return fade to continue. However, I don’t believe it will be a structural decline to perpetuity. It will reach some sort of asymptote at some stage, is my view.

Reason being is that the purchase of ARS is not an economically rational one, meaning that MVF and VRT - with their brand resonance and credentialisation as having the superior expertise and quality of research - will still be the go-to service providers for couples with complex conception issues (which comprises the vast bulk of the market).

I think it is pretty easy to compete with MVF and VRT at the lower end of the complexity spectrum, but the infrastructure and expertise required to service more advanced cases is difficult to replicate, I think.

So I don’t think the entry barriers are universally low, other than at the commoditised end.

And, besides the lower end where competition is currently fierce, things are far more benign in the areas where MVF and VRT come into their own, i.e., where the solutions more complex and less commoditised.

Now where the low-cost market stabilises I’m not sure, but the way I look at these businesses - if they were operating in a stable competitive environment- in valuation terms is as follows:

They are highly cash-generative businesses with leading market positions and meaningful pricing power, operating within favourable industry demographics. Those attributes usually connote premium-to-market valuation multiples.

As I said, I don’t know exactly where earnings will stabilise for MVF and VRT (I think that some of their most recent financial pains are self-inflicted, especially for MVF).

So, because I’m not able to accurately forecast future earnings, what I do is I inductively solve for what future earnings level is being factored into the current share price.

To do so, I work backwards from my admittedly-crude starting point of a P/E of, say, 15x (not overly extravagant, I don’t think, in the context of a market multiple of somewhere around 16x-17x ... although I think the market is currently around 2 P/E points overvalied).

The maths is relatively simple:
A $1.27 share price corresponds to a $300m market cap.

Capitalising earnings at 15x yields NPAT of $20m.

Which is some two-thirds of FY2017’s level.

In other words, for MVF the market is pricing in a ~30% fall in profitability, which would undo all the growth achieved since IPO.

Intuitively, that sounds a bit harsh to me.

Which is why I have started building a position.