Description

CVS Group owns the largest network of veterinary surgery centers in the U.K.

They report in four segments, but since 92% of their EBITDA (before overhead) comes from veterinary practices this writeup will exclude any meaningful analysis of their lab, crematoria, or online-sales businesses.

CVS’s basic value proposition is to relieve from veterinarians the burden of running the business side of their practices, allowing them instead to focus more of their time on animal care. Versus smaller competitors, their size and superior execution allows them to enjoy purchase and efficiency benefits, which allow them to invest in customer / veterinary satisfaction while still delivering high returns on capital to shareholders. A pet owner’s relationship with his/her veterinarian is in some sense analogous to parents’ relationships with their child’s pediatrician: they tend not to switch flippantly, and rarely withhold the delivery of reasonable health care even in times of economic hardship. For these reasons CVS enjoys a relatively stable demand for its services and a decently-loyal customer base.

CVS’s basic growth strategy is to be the buyer of choice for retiring vets looking to sell their practices. Because of their scale they can get cost synergies on purchased practices (via favorable pricing terms from vendors, a reduced need for on-site support personnel, and back office efficiencies gained via centralization) and therefore tend to see effective purchase multiples decline as the acquisition ages. Historically they’ve paid about 4-8x EBITDA for acquisitions.

In a maintenance scenario (wherein they grow from price and not volume):

The company should earn about 165mm in revenue during the next 12 months at a normalized EBITDA margin of 15.5%. This is a couple of points higher than their reported margin, and reflects the estimated effect of newly-acquired vet practices fully ramping up to a (higher) corporate-wide margin level. From this 25.5mm NTM EBITDA estimate, subtract about 4.5mm in maintenance capex to get unlevered pretax free cash flow of 21mm. Subtracting out 1.5mm of interest expense and assuming a 22% tax rate, their normalized earnings power is about 15mm, or 25p per share. On a 460p share price this gives a normalized earnings yield of about 5.5%. Topline growth in maintenance scenario should be about 2-3%, EBITDA growth should be slightly better at 3-4% given some operating leverage, and EPS growth should be about 4-5% given financial leverage. Therefore an investor would get about a 10% IRR (5.5% earnings yield + 4.5% growth in perpetuity) if he took the firm private, never sold it, never expanded its capacity, and paid himself the free cash flows in perpetuity. This maintenance IRR goes up slightly if you allow for the benefit of negative working-capital making free cash flow greater than earnings (in positive-growth scenarios).

In regards to their growth spend:

CVS is likely to pay 5-8x EBITDA for future acquisitions. Given their ability to get cost synergies, over time EBITDA margins on newly-acquired practices (typically at low double-digits) can progress upward (to the high-teens). Factoring this in, acquisitions at 5-8x will deliver 12-18% unlevered yields (growing at 3-4%) and yields of 15-30% on a levered basis (growing at 4-5%).

In regards to a range of IRRs expected under different scenarios, see the table below, which assumes that acquisitions will continue for 5 years, after which the business transitions to a maintenance scenario:

Sources of Upside (not included in above valuation scenarios)

1)      In the U.K., ownership of large-animal veterinary practices (delivering equine and livestock care) is more fragmented than practices delivering companion animal care. As CVS gains experience in this area, it will be positioning itself to enjoy significant upside as a consolidator of this market.

2)      Significant growth in healthy pet club (subscription) membership will de-risk the revenue stream, build loyalty and elevate pets’ lifetime revenue levels.

3)      Additional crematoria capacity should come online at high ROIC via cross-selling to existing veterinary customer base.

4)      Adding capacity for specialty veterinary medical practices and after-hours emergency care lets them internalize this business, which is presently lost via referrals.

5)      Significant EBITDA contribution could result from growth in their online Animed business, which enjoys meaningful operating leverage.

Threats

1)      Cost structure is largely fixed (personnel salaries, rent, utilities). A 1% decline in revenue translates into about a 6% decline in EBITDA.

2)      Vets who sell their practices to CVS may try to re-establish a new practice nearby, notwithstanding non-compete clauses.

3)      Continued consolidation of industry may eventually drive up acquisition multiples.

4)      Recent positive comps might be caused by a cyclical expansion, thus making normalized earnings power lower than present levels.

5)      A steep downturn in the UK economy will cause a reduction in the level of care demanded by pet owners.

6)      In any particular local market a competitor could destabilize pricing to win share.

Catalyst

Upside scenarios (above) begin to unfold.