Description

PetIQ has portrayed itself as a secular grower within the companion animal segment.  The bull thesis is as follows:

1. People are spending more on their pets.  PETQ sells stuff for pets.  So PETQ will grow as well.  PETQ will grow 30-40% in 2017, and keep going from there.

2. If the distribution system for veterinary Rx ever changes, PETQ will be well positioned to be a meaningful player.

3. “Compelling” valuation at 14x 2019 ebitda with “peers” at 13x with worse growth

I have a better thesis, but it is a bit involved so stick with me:

1. PETQ is a bad business

2. The parts of the pet industry to which PETQ is levered are shrinking

3. If veterinary Rx moves to a distribution system more similar to human Rx, then ABC/MCK/CAH will dominate the system, and PETQ will play no role

4. PETQ’s growth has been the result of illegal activity (patent violation)

5. PETQ’s CEO has a checkered past

PETQ is a bad business

2015 revenues/EBIT/FCF: $206m / $2m/ -$8m

2016 revenues/EBIT/FCF: $200m/ $0m/ -$3m

2017 revenues/EBIT/FCF: $270m/ $19m/ $7m

So, this was a no growth business in 2016 with zero profits.  Considering that PETQ makes private label/generic treats and medicines, and there are many other companies that do this, it is not surprising that margins are low.  Selling a commodity product to large retailers (Wal Mart, Costco, etc.) is a low margin game.  And PETQ has been growing in these channels by being very aggressive on price.  

I will come back to the 2017 growth later on, but suffice it to say that is the exception, not the rule.

PETQ’s categories are shrinking

Sure, people are spending more on their pets.  But really, they are trading up to premium pet food and spending more at the vets office since vets are treating animals more like humans-- running more tests and performing more procedures. PETQ basically has two products-- low end pet treats and generic topical flea and tick medicine.  Both of these categories are actually being substituted away from-- they don’t play in premium treats, and topical tick medications are losing significant share to oral and flea collars.

PETQ will not benefit if the distribution model changes

There is a piece of legislation that is floated in Congress every once in awhile that would require veterinarians to give a prescription instead of forcing them to buy medications directly.  This makes sense, and will likely happen eventually, but no time soon (Congress has a few things going on right now)-- my guess is ~5 years.  Currently, PETQ has a small vet Rx distribution business where they buy medications from veterinarians (grey market) and then distribute them through another company (Anda) to retail outlets.  If vet pharma companies were going to sell to CVS, Wal Mart, etc., they would sell directly and/or to the large distributors.  They would not sell to some random company that doesn’t even own the distribution, just because this company was handling this business when it was effectively illegal.  This is among the silliest arguments I have ever heard.  

PETQ’s growth is illusory

As I mentioned, about half of the business is the sale of topical flea and tick medication.  This year, because of a very mild winter, there was a record season for tick medicines (lots of ticks since the cold didn’t kill their hosts-- deer and mice).  Next season, since we will have a relatively cold winter, tick medication sales will be low (many people will not use the medication since it is expensive and not deemed necessary), and will have a negative comp.  Importantly, since topical tick medication is losing significant share to oral and collars (went from 50% of the market to 30% this year), the topical category should shrink dramatically in 2018.

Additionally, industry participants say that the channel is “stuffed to the gills” with PETQ products currently.

BUT NOW COMES THE GOOD PART

LET ME REPEAT, THIS IS THE GOOD PART

There are actually 2 main topical tick medications.  One is called Frontline, and it is declining in popularity as there are limited examples of tick resistance.  It is also off patent as of 2015, and so there are a lot of manufacturers of generic equivalents, including PETQ.  The newer one is called Bayer Advantix II, and this one is very much on patent.  How interesting, then, that PETQ started making a generic equivalent of Advantix this year, just in time to manufacture revenue growth for the IPO.  I estimate that sales of Advantix could have been $40-60m this year, which would account for basically all of the revenue growth we have seen.  

I have spoken with several competitors, who described this patent violation as blatant and obvious.  The formulation (solvent and insecticide concentrations) are identical.  But why, you might ask, would Bayer allow this?  Well, they aren’t allowing it… From the S-1:

In May 2017, Bayer Healthcare LLC and its affiliates (collectively “Bayer”) filed suit in the United States District Court for the District of Delaware, against CAP IM Supply, Inc. (“CAP IM”), our supplier of Advecta 3 and PetLock MAX, which we began to sell in 2017 as our value-branded alternatives to Bayer’s K9 Advantix II. Bayer alleges that Advecta 3 and PetLock MAX infringe a patent relating to K9 Advantix II. Bayer seeks unspecified monetary damages and an injunction against future sales by CAP IM of Advecta 3 and PetLock MAX to the Company. Although we have not been named in the suit, our license and supply agreement with CAP IM requires us to share with CAP IM the payment of defense and settlement costs of such litigation and allows us to control the defense of the proceeding. [CAP IM is their contract manufacturer]

Interestingly, this lawsuit is not mentioned in the sell-side initiation reports that I have seen!

There is precedent for what will happen here.  When Frontline patents were violated, the offending companies were forced to stop selling the product, pay fines/royalties, and exit the market (for 3 years).  In this case, Bayer has asked for a TRO, and i think it is very possible that this is granted in the next few weeks (final arguments were made last week).

Some quotations from market participants about this issue:

“Petiq is definitely in violation of the patents” and “everyone knows this”

“Reason they don’t have more competition is that they are taking too big a risk”

Petiq is “clearly infringing”

Has been told by colleague that used to work there that bayer has a “legalistic” right and wrong approach, not likely to settle: “they feel like this is a cut and dry case and they have been wronged”

PETQ’s CEO has a checkered past (to say the least!)

Cord Christiansen’s career seems to have been something like this:

2004-5, employee for the fraudster Tom Petters.  Claims he was defrauded by Petters as a “friend” and forced to file for personal bankruptcy (disclosed in the S-1).  He admits he “helped bring $1.7m in investors’ funds to Petters”.  

Left Petters in 2006, and started a company in which Petters invested, called Broadsign.  The CFO was Petters’ CFO.  Broadsign evidently managed a network of advertising screens in retail stores.  He steps down from Broadsign in 2007.  Broadsign files for Ch. 11 in 2012.

Then Petters collapses, and he gets into the veterinary business, starting a company called WTF distribution (not kidding).  This is a business that buys extra veterinary Rx from vets, and then sells it in the grey market.  He runs into some issues here in 2011, and changes business models, eventually settling on the PetIQ generics business model.

BUT (and this is all available on Bloomberg Law):

The bankruptcy trustee sued Cord in 2010, saying that the Petters paid him $2.5m in termination in 2006, which was fishy since his salary was only $195,000.

The Idaho securities regulator fined Cord in 2010 also for having sold unregistered securities.  Specifically, he sold promissory notes and used the investment proceeds to fund inventory financing.  THIS WAS THE BASIS OF THE PETTERS PONZI SCHEME.

He started WTF in 2009 and was sued in 2011 by ~ 30 veterinarians, who claim they delivered product to WTF and were never paid.  The plaintiffs’ lawyer refers to this as a “Ponzi scheme”.

http://www.ripoffreport.com/reports/true-science-tru-rx-true-lines-distributing-wtf-wholesale/internet/true-science-tru-rx-true-lines-distributing-wtf-wholesale-todd-stefaniak-cord-christen-906479

AND

In conjunction with the recent earnings report, Scott Adcock, a co-founder of the company, resigned retroactively as of October 31.  I wonder what he knows?

To Wrap It Up

Can I give myself two “10 star” ratings for this one?  Just kidding, 9 stars are fine.

I think what you have here is a company that, even if the results were real and sustainable, is massively overvalued (30x EBIT for no growth).  It will almost certainly miss 2018 expectations, its large shareholders will be dumping stock in the near future, and the true “bullish” arguments here are easily debunked.

But, I think recent results are not sustainable.  And so, I think it is actually worth $3 (5% OM on $200m of revs, 10x EBIT).  And that’s before the lawsuits…

The author of this idea and/or a private fund managed by the author’s firm had a position in this security at the time of posting and may trade in and out of this position without informing the community.

This write-up discusses general market activity, industry or sector trends, and other broad-based economic or market conditions and should not be construed as research or investment advice.  Readers are urged to consult with their financial advisors before buying or selling any securities.  The information included herein may not be current and the author has no obligation to provide any updates or changes. No representation, warranty or undertaking, express or implied, is given as to the accuracy or completeness of the information or opinions contained herein.

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Catalyst

They just reported a quarter that everyone knew would beat.  What are the catalysts going forward?

1. Lock-up period is waived.  Jan 17 is the official unlock but i think this gets accelerated, as EOS owns 40% of the shares and they aren’t dumb.  A few other private equity funds have also been long-time holders, and they will be sellers also.  

2. TRO is granted in lawsuit, likely by the end of the year

3. Everyone shorts the stock since they were just waiting for the quarter to be reporte

4. Numbers way too high for 2018, will re-rate as this is understood