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%.
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: