The Best Stocks to Buy in the Animal Health Sector

I think everyone is familiar with a stock pitch or a research report that mentions ‘favorable demographics’ as a key earnings driver. I certainly am. In fact, I’ve written articles that use the phrase, so I have no axe to grind on the issue. On the other hand, I think it is sometimes used to describe sectors like healthcare that so obviously have favorable demographics that the fact itself starts triggering a political or consumer backlash, which threatens the profit potential of the firms. Think of healthcare and reimbursement issues. In response, perhaps the solution is to find a demographic trend that operates underneath the radar of political action? I think the animal healthcare market is an option, and investors would do well to take a closer look.

I know some readers will be puzzled by why animal health should be demographically favored. The reasons are twofold. On the food side, the creation of a whole new middle class across myriad emerging markets will create an upsurge in the demand for protein, if historical trends are borne out. Inevitably, this will create animal health issues. Secondly, declining birth rates, increasing divorce rates, decreasing marriage rates and increasing numbers of single parent families will encourage the purchase (particularly in the developed world) of a furry friend in order to supplant emotional attachment to a partner or a kindling. Sad but true.

It’s time to look at a few investment options.



VCA Antech Disappoints

VCA Antech $WOOF is an owner and operator of animal hospitals and also runs clinical laboratories (veterinary only) throughout the US.

A quick look at revenues and gross profits:

Clearly the lab division is the highest margin business, but its revenues largely depend on footfall at the animal hospitals. Unfortunately, the story hasn’t been so positive lately here and particularly in the last quarter. Headline revenue growth in animal hospitals was up 17.4%, but most of this was due to acquisitions. The real story is told by same store revenue growth, which was only up a paltry .2%.

In addition, animal hospital adjusted gross margins fell to 15.2% compared to 18.2% last year.  Lab revenues only grew by 2.6%. As such, the company guided full year earnings to the lower end of expectations and the stock got hit hard. So what is going on here?

I think there are a couple of possible issues. The first is that the warm winter encouraged some pull forward in hospital visits as owners were more inclined to take their pets for operations/check ups then they seasonally might have done. Indeed, VCA did see a pickup late last year and then again in Q1. All of which created positive optics, encouraging some false optimism. No matter, weather effects are transient and it could be argued that the fall is a buying opportunity.

The second is that with this type of business, when a leading company gets involved in purchasing lots of smaller independents and consolidates them, the transition is rarely without disruption. For example, VCA is clear that it is not the cheapest animal hospital option so it may have faced resistance from the existing client base. Moreover, a purchaser cannot assume that it will be able to tap into the long running relationship that an animal hospital has with its client base. If the key staff have retired or a change of ownership has taken place, clients may well go elsewhere.

Of course, the company is saying that it believes it is largely to do with the weaker macro-environment and certainly the likes of Home Depot have seen this seasonal ‘pull-forward’ effect in its revenue numbers this year. We shall see.



Idexx Labs and PetSmart

One company that is somewhat backing up what VCA (and Home Depot for that matter) said is Idexx Laboratories $IDXX. It declared that patient visits grew by 4% in the last quarter with practice revenues growing by around 5.5%.  This seems fine, but it is a deceleration from numbers of 5% and 7% respectively in Q1. 

As for Idexx, I have long liked this company and I love the sector. Unfortunately, so does everyone else.

A good salesperson usually pitches the benefit of a product or service before he mentions the price. However, someone on a beer wallet doesn’t walk into a champagne store. In other words, should investors in this environment be paying 30x earnings or an EV/EBITDA ratio of 17.3 for a company forecast to generate low teens growth for the next couple of years? Not to mention one that has just lowered its full year guidance. I suspect the market likes the stock because of its focus on companion animals (83% of sales) and its growing diagnostics business. However, every stock has its price and it’s hard to argue that Idexx is good value.

Another stock that is good value in the sector is PetSmart $PETM. The trailing PE ratio of 24 makes it look expensive, but this company is very good at converting earnings into cash flows. Forecast growth rates look very impressive and the company appears to be able to do no wrong with revenues up 9.4% and gross profits up 12.6% in the first quarter.

I like this business and its prospects, however investors need to factor in a margin of safety, because in reality it doesn’t have a large business moat. Once a company like Wal-Mart $WMT decides to expand its offerings in any one category, the incumbents can expect to feel the pressure. Indeed, there is probably no other organization on earth that has a better handle on demographic changes and its effects on consumer spending than Wal-Mart.

The good news is that (so far) this hasn’t happened and PetSmart continues to perform. Gross margins expanded in the last quarter and the company is ideally placed to capture the top-line drivers discussed earlier. PetSmart will give Q2 results on August 15, and I would urge a bit of caution here. Home Depot, Idexx Labs, VCA Antech and, for that matter, Wal-Mart too have all seen this pull-forward effect due to warm weather, and it wouldn’t surprise me to see PetSmart report the same thing.



What to do With the Sector?

In conclusion, these are great companies operating in favorable long term end markets. VCA Antech is the most attractively priced and has a good balance of upside exposure plus competitive moat. However, it might be worth waiting to see if its issues are purely macro or due to some acquisition turbulence. Idexx is not cheap, but then again it never is.

As for PetSmart, investors would do well to look out for the next set of results. For those investors interested to look further afield, I would suggest taking a look at Dechra Pharmaceuticals in the UK and Virbac in France.