Is the IVF market splitting in two? Perspective from InvestSmart

Is the IVF market splitting in two? - InvestSMART
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Is the IVF market splitting in two?

Virtus Health and Monash IVF are losing market share to a low-cost competitor, but that's providing an opportunity.

James Thiedeman spent much of the past few years stripping the bells and whistles from Monash IVF’s Mosman clinic. The chief executive was keen to copy the success of a new low-cost provider, Primary Health Care. Everything that once distinguished the clinic as ‘full service’ – whether it be a complimentary sandwich after the doctor retrieves the eggs, or your right to choose a doctor in the first place – was cut.
This was going to be Monash’s flagship ‘no-frills’ clinic, designed for infertile couples on a budget. The strategy proved successful, with low-cost cycles quickly growing as a proportion of the total. By the end of 2016, they accounted for nearly 6% of Monash’s sales.
Key Points

• Market is now two-tier
• Premium providers still have a place
• Prices may decline anyway

Then, just prior to his resignation earlier this year, Thiedeman did an about-face. All the frills were quickly stitched back on. Monash was to be a premium provider, the premium provider, complete with advanced technologies like egg screening, genetic diagnostics, and tea in the waiting room.
Monash IVF’s entry – and prompt exit – from low-cost IVF suggests the business model isn’t all it’s cracked up to be. And while larger competitor Virtus Health has chosen to operate both budget and premium clinics, it has been careful to keep branding and locations separate, not wanting to sully its premium image with a low-cost brush.
Bifur-what?

At the 2017 annual results briefing, management was asked whether budget IVF is creating a new market or is poaching customers from premium providers.
‘Yes, look, our view and our observation is we've seen bifurcation of the market. We believe it is a different type of patient who is availing themselves of low-cost services. Clearly, they're more price and cost-conscious. And I don't mean this in a disparaging way but they are less discerning about their choice of provider … we do believe it is primarily a different market segment which is being serviced by the low-cost providers,’ Thiedeman said.
This makes sense. IVF is a harrowing experience. Prospective mothers are pumped full of hormones, every attempt is more likely to fail than the last, and, in the background, there’s a biological clock ticking with increasingly loud strokes. A standard IVF cycle costs around $9,000 and women typically require three or more cycles to become pregnant. Even then, a clinical pregnancy isn’t the same as a baby in the crib: depending on age, only 50–80% of IVF pregnancies result in a live birth.

IVF is stressful and time sensitive. For this reason, assisted reproduction lends itself to premium providers. Yes, lower income earners may give budget clinics a whirl – any help is better than no help – but there are still plenty of couples wanting the best, with money to spend and no time to lose. Primary’s expansion is no more threatening than a McDonalds opening down the road from Tetsuya’s Restaurant in Sydney. There’s nothing wrong with McDonalds, it’s just targeting a different customer.
Pricing matters

We don’t expect budget IVF to have a large impact on full-service pricing. The question we’re still trying to answer, however, is whether prices and margins will come down anyway. There’s good reason to believe the underlying cost of therapy will decline, which would lower prices due to competition. All things being equal, lower prices would anchor Monash's and Virtus’s revenue growth.
Doctors and staff account for two-thirds of operating expenses, and there’s no reason to assume that wages are going to decline. However, new automations are being introduced to labs which are intended to increase the efficiency of fertility specialists over the long term (including the tongue-twistingly named ‘robotic intracytoplasmic sperm injection’).

In 2017, Monash averaged 100 fresh cycles per specialist, while Virtus managed 149, but we expect these figures to be materially higher in 10 years’ time. Assuming that efficiency gains outpace wage growth, the average cost per cycle should come down.
Virtus and Monash increased prices at around 2–3% a year over the past five years – reinforcing our view that Primary doesn't threaten pricing – and both managements are targeting similar price rises in the medium term. Over the long term, though, it’s not something we want to bank on. If anything, we expect price declines in the low single digits as the underlying cost of therapy falls.
Off-setting factors

So why aren’t we worried? Because IVF is a large, untapped market. Only around one in 20 women of reproductive age who are affected by infertility uses assisted reproductive services each year.
IVF is prodigiously expensive. Even after accounting for Medicare support, the out-of-pocket cost per live birth is around $15,000 for women under 35. For women over 40, it can easily surpass $45,000.
Israel is the only country in the world where IVF is entirely funded by the government, so it’s the best proxy for where utilisation rates should be if cost is taken out of the equation. In Israel, the number of cycles performed per capita is around 75% higher than in Australia.
If prices do decline over the long term, the increasing affordability of IVF should help to unlock that significant un-tapped demand. Any improvements in Medicare funding – not that we expect it – would speed up the process.
Look 10 years out

Even without funding improvements or lower prices, it’s still reasonable to assume cycle growth of around 3% a year or so. The number of women aged 35–45 is increasing at roughly 1.5% a year and the age at which women are choosing to have children is gradually rising, which is leading to increasing rates of infertility.
Virtus has a national market share of 36%, while Monash commands 24%. We expect these shares to decline over time as Primary expands the budget end of the market, but we don’t think that will impact profitability.
In any case, Monash and Virtus are working from positions of strength, with exceptional returns on tangible capital, clean balance sheets and economies of scale. What’s more, the two stocks are trading on forward price-earnings ratios of 10 and 11, respectively, with current free cash flow yields around the 7% mark. They are nowhere near risk-free, but we’re being well compensated for taking those risks.

If you have the stomach for large short-term swings in share price, there’s every reason to believe the long-term outlook for IVF is positive, and Monash and Virtus should be bigger, stronger businesses in 10 years’ time. BUY

Note 1: Monash and Virtus are exposed to similar risks and have similar return outlooks. If you want to invest in the sector, we suggest you spread your risk by owning both stocks as a 'mini portfolio'. Our recommended maximum portfolio weighting is 5% for Virtus and 3% for Monash, or a combined weighting below 6%.
Note 2: The Intelligent Investor Equity Growth and Equity Income portfolios own shares in Virtus Health, while the InvestSMART Australian Small Companies Fund owns shares in Virtus Health and Monash IVF. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.
Disclosure: The author owns shares in Virtus Health