Description

SHORT VCA Antech (WOOF). I apologize as I have been procrastinating on this write-up for a couple of weeks, during which time the stock has fallen by 10%-15% (…on no news). But it’s still significantly overvalued in my view.

I.               Business Description

WOOF’s Animal Hospital segment owns and/or operates 609 full service animal hospitals in the United States and Canada, employing ~3,000 veterinarians.

WOOF’s Laboratory segment owns and/or operates 56 veterinary diagnostic laboratories across the United States and Canada, which provide outsourced testing services for urine, blood, stool, and other samples taken by veterinarians at point of care.

The company also owns a couple of smaller vet-related businesses which are immaterial in size and value.

II.            Thesis

WOOF derives 79% of its revenue and 56% of its pre-corp EBIT from its Animal Hospitals division, which superficially appears to be a nice business with stable demand for its services, and a long-term history of both organic and M&A-driven growth. However, in reality, this business has declining ROIC (already below any reasonable estimate of cost of capital at ~5%), and is losing customers/market share due to a long-term strategy of aggressive price increases, as well as a commercial culture that results in upselling and high turnover amongst service providers. Moreover the company’s acquisition strategy appears to be geared towards achieving revenue growth targets at any price. I believe WOOF’s animal hospital segment in worth somewhere in the range of $834m and $1.04 billion.

That valuation range for the Animal Hospital segment implicitly suggests that WOOF’s Laboratory segment (19% of sales, 43% of pre-corp EBIT) is trading at 20.5x – 22.5x EBIT. The laboratory business is facing an intensifying competitive environment that will erode market share, margins, and ROIC over time.

It’s always hard to put a discrete value on a business whose results are likely to deteriorate, but to provide a price target, I think a reasonable trading range for WOOF is between $18.00  and $22.75 per FD share, 25% - 40% below yesterday’s closing price of $30.31. There could be significant incremental downside if WOOF’s results deteriorate faster than expected.

III.          Catalysts

This is a slow money idea for slow money people. The catalysts, if there are any, are (i) the marginal buyer of the stock won’t be very excited to own this troubled company at prevailing prices, resulting in a decrease in the stock price; and (ii) over some indeterminate period of time, the company’s profitability, margins, and ROICs will decline to a degree that wall street can’t ignore.

IV.           Capitalization

Share price: $30.31

FD shares outstanding: 89.5 (88.2 basic, 1.2 options dilution)

Mkt Cap: $2,711 million

Cash: $145.7 ($125 b/s, $20.7 options proceeds)

Debt: $619.6

EV: $3,185.7

V.             Low quality growth at animal hospitals

WOOF’s animal hospital revenue growth and SSS profile is very attractive based on a quick glance. The company has grown revenue at a 13.6% CAGR over 12 years, with excellent comps in all but the worst years of the great recession, per the chart below:

Source: Company filings, CapitalIQ

However, a closer look at the composition of the company’s same store sales figures reveals that in fact the SSS comps have not been high quality growth, but rather have been driven entirely by sizeable annual price increases, which have offset significant declines in order volumes. In fact, the company has had same store volume declines every year since 2001 (as far back as I bothered looking), and has only ever shown an annual SSS increase due to aggressive price hikes:

Source: Company filings

The next chart shows the components of SSS, indexed to 1.00 in the year 2000. Clearly this is imperfect math on a portfolio-wide basis given that the company is acquiring, opening, and closing new hospitals every year, but we can accurately conclude that a hospital open in 2000 has lost 28.4% of its order volume (presumably a good proxy for customers), and has only posted revenue growth due to an 89.6% increase in pricing:

Source: Company filings, rightlanedriver analysis

This is certainly an alarming set of trends in a vacuum, but one could argue in the absence of additional data that the company has merely taken advantage of significant pricing leverage in an industry with declining volumes. So to close that loop, I dug up the below industry data to proxy for veterinary industry volume trends, which shows that the absolute number of households owning pets in the US increased by 24.4% from 2003 to 2011. The portion of households owning multiple dogs also increased from 11.8% to 17.1%. Given these data and the stable stochastic nature of demand for veterinary services, it seems reasonable to assume that unit demand for veterinary service should have increased by at least 24.4% over the same time period. Yet from ’03 – ’11, WOOF’s order volumes declined by 21%, suggesting a significant loss of market share.

(Source: Packaged Facts; US Census Bureau)

VI.           Alienating customers through upsells, price increases, inconsistency of service providers

The primary driver of WOOF's market share loss is most likely the aggressive pricing strategy that the company has adopted in order to meet wall street growth and margin expectations. WOOF locations are generally the highest priced service providers in a given area, which is largely responsible for declining aggregate volumes, with an est. 65% of stores losing customers each year. Such a pricing strategy can clearly improve financial results in the short run, but in the long run, the benefits of elasticity will reverse as customers find their way to the veterinarian across the street, forcing WOOF to cut prices in order to try to win back customers. In the 3Q13 call transcript, Robert Antin (CEO) actually stated that the company is already starting to do this for services that are “more shoppable or competitive.”

This competitive dynamic has become more pronounced over time as the vet industry has added capacity at a rate that has exceeded marginal demand for their services. I have included a couple of links to industry reports suggesting that there is significant excess supply of vets willing to provide services at the price point that pet owners are willing to pay. The most likely economic reaction to such dynamic is price competition, yet WOOF has persisted with its pricing strategy.

https://www.avma.org/KB/Resources/Reports/Documents/Veterinarian-Workforce-Final-Report-LowRes.pdf

https://www.avma.org/KB/Resources/Reports/Documents/WAG-report_Workforce-Implicatn-Recommend_2013.pdf

However – and I bring up this point this whilst fully aware that there have been several debates on VIC over the merits of consumer reviews – WOOF hospitals have some of the worst reviews I have ever seen on the usual websites (yelp, google), with myriad complaints of excessive pricing, aggressive upselling, high turnover, etc. Current and former employees echo consumer complaints on glassdoor (http://www.glassdoor.com/Reviews/VCA-Antech-Reviews-E2106.htm) and other similar employee review sites. If you are interested in this idea, I recommend spending some time reading through reviews for a random sampling of WOOF locations. There appear to be some real quality/consistency of service issues, which might not exist at more tightly owned competitor facilities.

VII.        Low returns on invested capital

Excluding price increases, >100% of WOOF’s Animal Hospital revenue growth has come from acquisitions. This wouldn’t be necessarily bad but for the fact that WOOF is forced to pay high prices for acquisitions in order to support its revenue growth treadmill, which has driven down ROICs to a level well below any reasonable estimate of WACC. The chart below suggests that WOOF's Animal Hospital segment is actively destroying shareholder value, with worsening trends:

Source: Company filings, CapitalIQ, rightlanedriver Analysis

Please note that on the ROIC chart above, I am using [Segment EBIT * (1 – 40% tax rate) / Segment assets]. The segment assets likely include some amount of cash which, if removed, would cause these numbers to increase ever so slightly. Also, for the Segment EBIT after including corporate expenses (the yellow bars), I have simply allocated corporate expense to the segment based on the segment’s contribution to pre-corp operating income in the given year. Imperfect math, perhaps, but the answer is going to be directionally correct.

VIII.      Valuation of Animal hospital

Ultimately the value of the Animal hospital division is entirely dependent on the degree to which the secular pricing/volume issues described above impact the financials in the future. If for example WOOF has to begin cutting prices across the board to try to chase customers back, profitability could rapidly decline and this division could be worth as little as tangible book value.

In the meantime, to put a number on it, I think it is conservative to the short case to ascribe an 8% - 10% unlevered free cash flow yield to the division’s $83.4 million of unlevered fcf (after corporate allocation, assuming a 40% tax rate), resulting in a valuation range of $834 million to $1.04 billion.  If my thesis is totally wrong and this company can grow organically at 2% without destroying future value through acquisitions, than perhaps UFCF could be capitalized at 6% (roughly, 8% WACC less 2% perpetual growth), for a bull case valuation of $1.4 billion.

IX.           Lab business

Given the current EV of $3.2 billion and the above valuation of the animal hospital division, the market implicitly ascribing WOOF’s Laboratory segment a value of $2.1b - $2.4b (for the purposes of this write-up, I ascribe $0 value to the company’s All Other segment, which accounts for ~2% of EBIT). At such level, the implied value of this unit is 20.5x – 22.5x EBIT, a high multiple for any business (though surprisingly, not that far off from where IDXX and ABAX are trading).

Dodger123 did an excellent write-up on IDXX in Dec 2012 about the dynamic in the Laboratory segments’ market, which I recommend reading to get more color. I believe that his/her thesis is accurate and that it will continue to play out over the near-mid term. To summarize, WOOF and IDXX have long dominated this industry, and have enjoyed excellent margins and ROICs due to a growing market, favorable distribution contracts, and significant geographic coverage. However, this market is slowly approaching maturity and a new competitor, Abaxis (ABAX), entered the space in 2011 and has started to gain significant share from smaller hospitals via an aggressively priced mail order strategy (whereas IDXX and WOOF are primarily local/route-density based, which allows a faster turnaround time). As ABAX increases in size, it will start to open more labs and compete directly with WOOF and IDXX for larger accounts. So far the market appears to be maintaining price discipline, but as the growth of the overall pie continues to slow, I suspect this discipline will erode.

The laboratory segment has high margins (61% EBIT after corp) and ROIC (~27% in 2013 after corp, taxed at 40%), and thus there is a long way for economics to fall if/when price competition intensifies. To get to a price target, I assume this segment is worth 12x – 14x 2013 EBIT (after corp) of $104.3, for a total value range of $1.25 billion to $1.46 billion.

X.             Total value range

Again, valuation on this business is little more than an estimate. Directionally I think it is clear that the stock is overvalued given the legitimate concerns about these two business segments, but it is unclear how long it will take for aggregate results to materially erode. To get to a price target, I ascribed a value of $834 million to $1.04 billion to the Animal Hospital segment, and $1.25 billion to $1.46 billion for the Laboratory segment, for a total equity value of $1.6 billion to $2.0 billion after deducting net debt, or $18 - $22.75 per share.

Catalyst