Description

Covetrus (CVET) is a mispriced special situation following the completion on 2/7/19 of the carve-out from Henry Schein (HSIC) and spinoff to shareholders of the Henry Schein Animal Health business, which merged with Vets First Choice in a Reverse Morris Trust transaction, with the resulting company named Covetrus, a pure-play animal health company.  Henry Schein shareholders own ~63% of CVET, and Vets First Choice shareholders own ~37%. I believe the mispricing is caused by several temporary issues, and a few underappreciated longer-term attributes.

Concerns / issues leading to investor concern and stock drop:

• CVET delayed the release of its Q1’19 earnings results—never confidence inspiring—and rescheduled its conference call (from May 9 to May 15), which led the stock to trade down.  They justified the delay as follows: “The rescheduled date will provide the Company, together with its independent accounting firm and transaction legal and financial advisors, with more time to complete and review the financial statement consolidation in order to file the first quarter 2019 10-Q simultaneously with the first quarter 2019 earnings release, which the Company believes is best practice. Importantly, this additional time does not relate to the Company’s business operations or the accounting for those operations but is a reflection solely of the complexities of the transaction and intra-quarter close of the carve-out of the Animal Health Business from Henry Schein and the subsequent merger with Vets First Choice.”
• Q1 GAAP financials included numerous anomalies (Vets First Choice included only as of Feb. 8, 2019, Q1’19 costs were based on direct costs associated with standalone operations after the merger was completed vs. Q1’18 allocations for direct and indirect costs derived from the consolidated financials of Henry Schein, FX, intercompany eliminations, revenue recognition adjustments for manufacturer switches from direct to agency sales in the U.S.), and both revenue and earnings were below expectations.
• The previously announced (Jan. 23, 2019) loss of a large customer in N. America (VCA was acquired by Mars in Sept.’17, and Mars decided to consolidate most of its veterinary distribution purchases with U.S.-based distribution competitor of HSIC; the contract was ~$100m in annual revenue, but low margin, and not material to earnings), and the loss of a manufacturer relationship in Q1 and Q4 2018 in APAC caused headwinds for the announced pro forma Q1’19 organic growth of 3% (although they overcame those two headwinds and delivered growth consistent with the overall market during Q1).
• Heavy debt load: $1.2 billion in gross debt ($1.13b net debt): 5.1x net leverage (LTM PF EBITDA).  Most of the cash raised with the debt was used to pay a $1.1 billion special dividend to Henry Schein prior to closing.
• Post spin-off selling by shareholders and funds that do not want to own a company much smaller than HSIC purely focused on animal health.
• The stock has continued to trade down following the earnings announcement May 15, and has fallen from a high of $50 to today’s close ~$25.

Underappreciated positive attributes overshadowed by the concerns above:

• At 17.8x EV / Pro Forma LTM EBITDA, CVET is not obviously cheap based on a first-pass screen (although it trades in line with the median and average of relevant precedent transactions—see below).  However, Vets First Choice has been unprofitable (LTM EBIT = -21 million; LTM EBITDA = -7 million) as it invests in growing its installed base, so CVET’s reported financials do not reflect VFC’s value as a non-earning asset, but over time, it will contribute meaningfully to the value of the company, but it appears to be being ignored today. 
• Underappreciated transition for HSIC’s practice management solutions from on-premise to cloud / SaaS, which is in its early stages.  7.5% of installed base is cloud-delivered / SaaS as of Q1’19, up from 5.4% as of Q1’18, and cloud PIMS now represents a majority of their new wins.  So CVET is early in the process of transforming its business from a perpetual software license model to a subscription SaaS model, a transition which led to meaningful multiple expansion for numerous companies (e.g., Concur, Adobe, Callidus, Aspen, Autodesk, Cadence, PTC, Microsoft) due to the increased visibility of the long-term recurring revenue and high customer lifetime values.  They view PIMS to be a strategic enabler and an important on-ramp for the Vets First Choice prescription management platform.
• Management team that has built significant value in the industry, and brings deep experience in veterinary medicine to a public vehicle to scale in the growing veterinary market:

             --The Chairman of Covetrus, David E. Shaw, was Founder / former CEO of Idexx Laboratories (IDXX: $23 billion market cap) and Founder / former CEO of Ikaria Pharmaceuticals (acquired by

               Mallinckrodt for $2.3 billion).  He was Co-Founder and Chairman of Vets First Choice. 

             --President and CEO of Covetrus, Benjamin Shaw (David’s son), was President, CEO and Co-Founder of Vets First Choice.

Clayton, Dubilier & Rice (CD&R) invested in Vets First Choice in July 2015 ($52m) and again in July 2017 along with Hillhouse Capital, Viking Global, Wellington, Rock Springs, and Sequoia Heritage ($223m), and CD&R is now the largest CVET shareholder with 10.13% of the company, and along with Hillhouse Capital and Viking Global, their combined stake is almost 18%.  Morgan Stanley owns 10.09%. S&P added Covetrus to the S&P MidCap 400 as of the start of trading on Feb. 11, replacing Dun & Bradstreet (DNB) in the index.

Following the transaction, directors and executive officers own 3.6% of the business, Ben Shaw owns 1.1%, and David Shaw owns 1.9%.

Background

Covetrus is a global animal-health technology and services company that enables veterinary practices to drive improved health and financial outcomes. Following the merger, Covetrus will continue HSIC's animal health business, which offers several veterinary practice management software systems and leverages its animal health distribution business in sales and service for the software.  Covetrus is headquartered in Portland, Maine, and has >5,000 employees in ~25 countries and ~100,000 customers in over 100 countries.

Henry Schein Animal Health (HSAH) is the world's largest and only global supply chain provider of animal health products and related services, with market-leading positions in North America, Europe, and Australia/New Zealand.  HSAH serves animal health practices and clinics with branded and generic pharmaceuticals, surgical and consumable products and equipment (~14,000 SKUs). HSAH active customers include ~90% of veterinarians in the U.S., and 70% of veterinarians in Europe and Australia/New Zealand. In addition, >50% of U.S. Animal Health practices (~16k) currently utilize Henry Schein's Practice Information Management Systems (PIMS) to drive office productivity and customer engagement, and worldwide, ~20k customers use PIMS—8 practice management solutions (on-premise and cloud—7.5% of installed base is cloud-delivered as of Q1’19) for appointment management, prescription management, inventory management, financial and clinical records, electronic medical records, patient treatment history, billing, accounts receivable analyses and management, and electronic claims processing.

Vets First Choice (VFC) is a leading provider of prescription management, pharmacy services, marketing solutions, and practice analytics for veterinary practice customers.  It enables veterinary customers to drive better prescription compliance, strengthen client relationships, and better compete with retail competition. The veterinary industry has responded enthusiastically to the solution due to the threat of market share cannibalization by online pharmacies.  VFC was launched by a team including the founder of veterinary testing company Idexx Laboratories (IDXX), and provides vets with a private-label website where pet owners can fill prescriptions. The vets take a percentage of the revenue, replacing some prescription drug revenue that has transitioned to retailers and online pet pharmacies.  VFC allows veterinarians to increase revenue (through better proactive prescription management) and reduce COGS (through HSIC sourcing) simultaneously. Adoption of VFC prescription management offers a predictable ramp-up period as customers create new active recommendations, prescribe medications, and drive client reorder activity, and it builds with refill, renewal, and auto-ship services, providing a good visibility into the ramp of utilization and revenue acceleration for these accounts.

VFC has ~8,000 (end of Q1’19) veterinary practices on its prescription management platform, and expects to deliver >3,000 enrollments in N. America in 2019, exiting the year with >10,000 clinics on its platform.  There are ~30,000 veterinary practices in the U.S. and Canada. When Ben Shaw was asked recently about growing penetration of the platform from ~33% to higher levels, “Is this the type of platform offering that you can see surpassing 80% or 90% penetration longer term both in North America and worldwide?” he replied simply, “Yes.”  

The sales force from HSIC (>1,200 sales professionals and sales in >100 countries) can now sell VFC into the rest of its ~100,000 customer installed base of supply chain customers.  VFC offers a pay-for-performance model, with no upfront costs for the vet practice, which reduces hesitation for vets to try the platform:

Medical compliance for veterinary prescriptions, including preventative medications, remains low at a time when the national incidence of flea, tick and heartworm disease is on the rise. This underscores the need to transform how veterinarians manage and engage their pet-owner clients to help drive greater preventative awareness and improve medication adherence.  Covetrus prescription management technology has demonstrated the ability to drive a 2-4x improvement in compliance for prescriptions. Streamlining this workflow through the tighter integration with the practice management system can help eliminate administrative burden, drive greater client engagement and improve health and financial outcomes.  

CVET’s services result in significantly better prescription compliance, reduced inventory, increased vet practice revenue, and improved practice profitability:

Vets First Choice increases total practice revenue by increasing in-clinic product revenue, total product revenue, and in-clinic services, and it has led to meaningful annual revenue growth for every annual cohort of customers:

While the animal health industry continues to grow, veterinarians face pressure tied to the growth of e-commerce and retail competition.  Covetrus helps veterinary clinics to defend this market by offering tools to help vets manage their practices and give customers the convenience of online shopping.  Covetrus provides and runs the white label websites that function as the online pharmacy for its vet partners, as well as software that helps the clinic manage its inventory and track prescriptions.  Covetrus has more leverage with manufacturers than individual vets have, so they can get manufacturers to agree to things like instant rebates and flash sales. Covetrus allows the vets to maintain or recapture prescription drug revenue, and collects a percentage of revenue as a service fee for refills.

In the U.S., pharmacy sales make up an average of ~1/3 of vet practice’s revenue.  Customers who want to buy medication online still need a prescription from a vet, and must either email or upload a copy, or have the online retailer contact the practice first, which offers vet practices a chance to sell the first batch on site and then direct customers to their own online service.  Most vets would rather handle prescriptions internally than write a prescription for customers to shop elsewhere. However, according to the American Veterinary Medical Association (AVMA), 40 states have adopted laws, regulations or guidelines that specifically or implicitly require veterinarians to provide a written prescription upon request in some circumstances, and today over 60% of vets write prescriptions for online pet pharmacy retailers.  So those pet owners can fill those prescriptions with PetMed Express, Chewy or other online providers.

HSAH / VFC Transaction Rationale

As VFC was building its business, management had stayed in touch with animal health distributors whom they had known for decades, and distributors (including HSIC) were aware of VFC’s progress as more practices adopted the platform.  VFC coveted the scale, resources, and supply chain capabilities of HSIC, and HSIC had expressed interest in providing better care and improved economics, and to integrate VFC insights with their global supply chain capabilities. The combination will redefine and grow the TAM with better insights, multi-channel client engagement, and integrated services that can accelerate demand and expand the category.

During an HSIC conference call on November 13, 2018, HSIC’s CFO described the rationale behind the spin-off and the combination with Vets First Choice, and the value proposition of the combined entity as follows:  

• During their strategic planning, they realized that “pure-play Animal Health companies command a much higher valuation than what’s embedded within Henry Schein.”
• Animal Health is a faster growing market (growing mid-single digits), and HSIC’s animal health business had been growing faster than the market, and they expected that to continue.
• Long-term growth rates are expected to continue to be strong, because the pet population is continuing to grow both in the U.S. and in other markets, and once someone gets a pet, they treat the pet as if it is part of the family, with health care services generally provided as needed for the pet.
• They looked at different alternatives to help unlock value for shareholders.
• They quickly looked at and dismissed selling the business, because their tax basis in the business was very low, so there would be too much tax leakage from selling the business, so they pursued a Reverse Morris Trust structure that would be tax-free for shareholders.
• While they were pursuing that, they had some discussions with VFC, and saw another opportunity to unlock shareholder value based on the synergies between the two companies (over $100 million of incremental operating income by the end of year 3).
• Henry Schein has always positioned itself with its customers as a trusted adviser, and now it can go to its customers and offer another value proposition in having Vets First Choice manage prescription management and identify opportunities where compliance and prescriptions are lower than they could be.  Most veterinarians really don’t communicate with their pet owners once they leave the practice, but this is an opportunity for the pet owner to continue to communicate and provide better care for their pet.
• VFC gets paid on a per transaction basis. The veterinarian didn’t have these income opportunities prior to working with VFC.

Market

The animal health market (including food, supplies, veterinary care, prescription and OTC medications, and other pet services and products) is impacted by growing companion pet ownership and care, as well as increased focus on safety and efficiency in livestock production, provides growth opportunities.  Pet ownership is widespread (~65% of U.S. households own a pet), and pets are living longer and being treated more like humans by their owners in terms of medical care.  

The global animal health market was in excess of $150 billion in 2017, including ~$30 billion of pharmaceuticals sold by manufacturers (source: CVET prospectus, industry analyst estimates).  Overall pet spending in the U.S. increased ~4% in 2018, to ~$73 billion, with food representing ~42%, veterinary care representing ~25% and pet supplies and medications representing ~22%. Spending on pets in the U.S. is estimated to exceed $75.3 billion in 2019 (another new record), compared with $60 billion four years ago (2015):

Source: American Pet Products Association annual survey

Industry growth is expected to be driven by factors including economic development and related increases in disposable income, increasing companion animal ownership globally, companion animals living longer, the strengthening bond between humans and companion animals and the increasing range and complexity of medical diagnostics, therapies and procedures for animals. Additionally, improving medical compliance can be an important source of future industry revenue growth. 

Veterinary care spending is projected to be $19 billion in 2019, and has been growing at a 5-6% CAGR in recent years.  Supplies/OTC Medicine spending is projected to be $16.4 billion in 2019, and has been growing at a 3-4% CAGR in recent years.  Food sales in 2019 are projected to be ~$32 billion, and they are growing ~4.5% annually.  

Veterinarians have the majority market share of the pet medication market (~58%), retailers have ~30%, and the mail order/on-line channel has ~12% (source: PETS investor presentation).  Although veterinarians hold a competitive advantage—many pet owners may find it more convenient or preferable to purchase pet medications and other health products directly from their veterinarians at the time of an office visit—veterinarians have seen their share of medications decrease as some market share shifted to retailers and the mail order/on-line channel.

~65% of households have a pet, the most common being dogs and cats, and there are ~73,000 veterinarians in private practice available to provide medical care for those animals (source: American Veterinary Medical Association), so there are ~1,100 households per private practice veterinarian in the U.S.  Overall demand and supply of animal health care services is a composite of many small markets, and the area from which each veterinarian draws clients might be smaller than a two-mile radius in urban areas, or as much as a 150-mile radius in rural areas.  

In most cases, the local markets are oligopolies, with relatively few sellers (veterinary practices) and many buyers (animal owners), which provides sellers with some pricing power, and setting price in line with those of other practices in the immediate area is a common veterinary practice pricing strategy.  The share of revenue from the suite of services of “wellness care” varies from 30-70%. Within wellness revenue, revenue from the sale of products (e.g., parasiticides (control fleas, ticks, mites, etc.), vaccinations, and food) is more than 35%, whereas revenue from veterinarian and staff labor accounts for ~17%.  In other words, sales of products rather than veterinary expertise are the main source of wellness revenue (source: Veterinary Information Network).  

According to a 2018 TD Ameritrade online survey of U.S. millennial pet owners, they were willing to spend up to $2,000 on average if their pet got sick, with dog owners prepared to spend more on their pets than what they expected to spend on their own healthcare.  Historically people were more likely euthanize a pet if it started to have a chronic condition, but that is now happening less often.  Most pet medical expenses are paid out of pocket, so the animal health care industry does not have to contend with as much pricing pressure from insurance companies. Although more pet insurance is becoming available, it is not yet widely used.  

The served market is currently underserved, with an estimated gap in care of $5+ billion of revenue.  Medical and service compliance in the veterinary industry are very low:

Competition

Principal competitors include the following:

• Animal Health Divisions of Traditional Distribution Companies: the MWI Animal Health division of AmerisourceBergen and the Patterson Veterinary division of Patterson Companies;

• Animal Health Focused Companies: national, regional, local and online distributors and technology vendors, as well as manufacturers of animal health products that sell directly to veterinary practices and retailers; and

• Practice Management Service Providers: IDEXX Laboratories (veterinary software was ~7% of IDEXX’s 2018 revenue, so while IDXX is CVET’s largest competitor in this segment, it is not a pure-play comparable for valuation purposes), the Patterson Veterinary division of Patterson Companies, and a number of regional and local competitors.

• Online Competition: CVET competes with pharmacies and other online delivery services for the sale of prescription and non-prescription companion animal and equine medications and other health products. Walmart, Amazon’s Wag brand, and Chewy.com com have taken meaningful market share for pet food, pet care products, and other pet supplies, and PetMed Express, Walmart (via WalmartPetRx.com and a planned 100 in-store animal clinics by the end of 2019) and Chewy Chewy have also been pursuing prescription medication sales, a key revenue source for veterinary practices, which both prescribe and sell drugs.  Competitors include Midwest Veterinary Supply, VetSource (Investors include VCA Animal Hospitals, Patterson Animal Health, and MWI Animal Health (AmerisourceBergen), Bain Capital Ventures), Wedgewood Pharmacy) and other veterinary pharmacy and online service providers. 

Valuation

At 17.8x EV / Pro Forma LTM EBITDA, CVET is not obviously cheap based on a first-pass screen (although it trades in line with the median and average of relevant precedent transactions—see below).  However, VFC has been unprofitable (LTM EBIT = -21 million; LTM EBITDA = -7 million) as it invests in growing its installed base, so CVET’s reported financials do not reflect VFC’s value as a non-earning asset.  Over time, VFC will contribute meaningfully to the value of the company, but it appears to be being ignored today.  

Through a combination of operating income growth and debt paydown via FCF (net of $100M of one-time integration expenditures during the first three years: standardizing core functions of HR, IT, and supply chain; new CRM tools and warehouse management solutions), I project net leverage to decrease to 2.5x by the end of 2021, and that today’s share price implies 10.5x 2021 EBITDA (including 2% annual FD share growth), a meaningful discount from relevant comps.

As an additional valuation analysis, I evaluated a sum-of-the-parts approach, valuing the core HSAH business based on an EBITDA multiple, and the faster growing VFC business based on a revenue multiple.  In 2021, a 12x multiple of 2021 HSAH EBITDA (~average of HSIC and Patterson), and a 4.4x multiple on 2021 VFC revenue, along with debt paydown and 2% annual FD share growth, implies a stock price of ~$49, 96% higher than today’s close.

Pro Forma Financials:

2018 PF revenue was ~$3.96 billion, more than 50% of which comes from the sale of pharmaceuticals.

2018 PF Adjusted EBITDA baseline (factoring in public company and standalone costs): $223 million ($210 million excluding stock-based comp).

CVET projects 2019 pro forma organic revenue growth of 3-5%, with 6-12% y/y pro forma adjusted EBITDA growth (off of 2018 pro forma adjusted baseline): $235-250 million, with double digit growth over the long term.

The company has modest long-term capital spending needs, and plans to use excess free cash flow to pay down the outstanding term loan.  They projected “at least” $50m in FCF in first 12 months, and expect EBITDA growth and declining cash outlays beginning in 2020 to drive rapid de-leveraging.  Their long-term goal is to achieve an investment grade rating, and the leverage target is 2.5x. There are no near-term debt maturities.

CVET projects “at least” $50 million in non-GAAP free cash flow during the first 12 months post-transaction close.

three-year adjusted EBITDA goals: $20 million in run rate incremental operating income by the end of year one, and >$100 million in run rate incremental operating income by the end of year three, with revenue value capture representing ~70% of the total.

The company has guided (and reiterated the guidance after Q1’19) that they expect revenue growth and operational synergies to grow annually such that by the end of year three, incremental operating income for the combined business will be in excess of $100 million run rate (run-rate exiting year one: $20m; run-rate exiting year two: ~$60m), driven largely by accelerated revenue growth from the adoption of the Vets First Choice platform across the HSAH customer base and significant opportunities to capture operational synergies.  Combined pro forma LTM EBIT (as of Q1’19) was $129 million. Consolidated organic growth was much stronger during the month of March (first full month of integrated operations) relative to the start of the year, and they are encouraged with the top line trends they have seen with the start of Q2.

Financial information for HSIC’s Animal Health Business (does not include Vets First Choice historical financials):

VFC does >$220 million in revenue, but they are continuing to invest to grow the scale of the business and forfeiting current earnings.  VFC prescription management revenue grew 51% y/y in Q1’19, and enrollments increased by 18% y/y. There is a predictable ramp-up period as customers create new active recommendations, prescribe medications, and drive client reorder activity, which builds with refill, renewal, and auto-ship services. So VFC has good visibility into the ramp of utilization and revenue acceleration for these accounts.

2018 Pro Forma EBITDA and 2019 Guidance:

Therapies under management is the key non-financial KPI for Vets First Choice, and it increased by >50% y/y in Q1’19. New initiated therapies and successful refills and renewals on subsequent dispensing events creates a subscription-like model and a level of predictability into future revenue outlook as the number of auto-ship medications represents a significant portion of daily revenues.

Financial Targets

Revenue Growth:

2019: 3-5% (>200 basis point headwind from previously announced customer/manufacturer losses) 

Long-Term Goals: High-Single Digits 

Adjusted EBITDA Growth:

6-12% off of Underlying 2018 Baseline of $223 million: $235-250 million

Long-Term Goals: Double Digits 

Precedent Transaction Analysis

Risks

• Competition: although VFC gives CVET a competitive advantage vs. competitors, the animal health distribution and pharmacy business is highly competitive, and will remain so.
• Leverage: Reasonably high leverage creates a substantial cash interest expense.  Management is focused on deleveraging rapidly.
• Merger integration: difficulty and management distraction inherent in the process of integrating the HSAH and VFC.  Some functions will continue to be provided to CVET by HSIC under a Transition Services Agreement (for certain supply chain services and various corporate support services), which is planned to extend for a period of up to 21 months following the closing.  Building these capabilities internally involves incremental costs and integration challenges.
• FX: ~49% of HSAH’s forma 2018 net revenue was to customers outside the U.S., so the weakening or strengthening of the USD could result in significant favorable or unfavorable translation effects when converting the operating results of non-U.S. business into USD.  Overseas costs bases serve as somewhat of a natural hedge, but not a complete hedge.
• Regulation: Possibility of changes to laws and regulations reducing reimbursement rates for pharmaceuticals and/or medical treatments or services, changes to the methodology by which reimbursement levels are determined. 

Summary

• At 17.8x EV / Pro Forma LTM EBITDA, CVET is not obviously cheap based on a first-pass screen (although it trades in line with the median and average of relevant precedent transactions—see below).  However, Vets First Choice has been unprofitable (LTM EBIT = -21 million; LTM EBITDA = -7 million) as it invests in growing its installed base, so CVET’s reported financials do not reflect VFC’s value as a non-earning asset.  Over time, VFC will contribute meaningfully to the value of the company, but its valuation appears to be being ignored today. 
• The transition for HSIC’s practice management solutions from on-premise to cloud / SaaS, which is in its early stages is also underappreciated by the market.  7.5% of installed base is cloud-delivered / SaaS as of Q1’19, up from 5.4% as of Q1’18, and cloud PIMS now represents a majority of their new wins.  So CVET is early in the process of transforming its business from a perpetual software license model to a subscription SaaS model, a transition which led to meaningful multiple expansion for numerous companies (e.g., Concur, Adobe, Callidus, Aspen, Autodesk, Cadence, PTC, Microsoft) due to the increased visibility of the long-term recurring revenue and high customer lifetime values.  They view PIMS to be a strategic enabler and an important on-ramp for the Vets First Choice prescription management platform.
• CVET’s proven management team has built significant value in the industry, and brings deep experience in veterinary medicine to a public vehicle to scale in the growing veterinary market:

             --The Chairman of Covetrus, David E. Shaw, was Founder / former CEO of Idexx Laboratories (IDXX: $23 billion market cap) and Founder / former CEO of Ikaria Pharmaceuticals (acquired by

               Mallinckrodt for $2.3 billion).  He was Co-Founder and Chairman of Vets First Choice. 

             --President and CEO of Covetrus, Benjamin Shaw (David’s son), was President, CEO and Co-Founder of Vets First Choice.

Catalyst

• Normalization of the y/y comparisons for the combined financials: full quarters of combined revenue and cost structure, end of the revenue recognition adjustments for manufacturer switches from direct to agency sales in the U.S.; end of headwinds from the loss of a manufacturer relationship in Q1 and Q4 2018 in APAC.
• End of post-transaction selling by shareholders not interested in holding the new CVET.
• Continued adoption of the Vets First Choice platform across the HSAH customer base, and realization of the projected operational synergies.
  • Market recognition of the ongoing and underappreciated transition for HSIC’s practice management solutions from on-premise to cloud / SaaS, which is in its early stages.