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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.
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