Stockwatch: A 50% rebound warrants investigation

by Edmond Jackson from interactive investor |

After bouncing strongly off a four-year low, should investors keep buying this mid-cap share, or sell the rally?

I'm interested to re-examine £420 million AIM-listed veterinary service provider CVS Group (LSE:CVSG) following interim results to 31 December 2018, both the stock itself at 617p and also what it tells us about the current state of UK veterinary services. 

The latter is pertinent given I've recently favoured £800 million Pets at Home Group (LSE:PETS) from its share price low, whose strategy is to market pet products with veterinary also grooming services.

Inherent risks in a "buy-to-build" development model

Previously, I've suggested "avoid/overpriced" in February 2018 with CVS at around 1,100p after falling from 1,500p in mid-2017. Despite the chairman buying £91,150 worth of shares at 911.5p in December 2017, I was chiefly showcasing CVS as an example of classic risks with acquisitive companies.  

The game plan starts with talk of "rationalising a fragmented market" and, in the early years, helped by a low base arithmetically, can deliver rapid growth. Investors respond enthusiastically, pushing the stock to a high price-earnings (PE) multiple. That's despite little support from dividend yield and a balance sheet often weighed by capitalised goodwill (200% of CVS's net assets at end-2017), debt and swollen trade debtors (exceeding trade receivables by 58%) – as if the company could be massaging profit by delaying on suppliers.   

CVS has typified such a model: the table showing impressive earnings per share (EPS) growth, at least to 2017, and colossal annual average historic PE multiples in a 50-60's range as promoters try to keep the focus on future results as a group expands.  

Common sense should tell investors that, while veterinary services are a sound market, their growth is relatively steady, hence a moment of truth event when stock markets panic might imply the best days for CVS's growth rate could be over. That triggers a self-reinforcing stock downturn. Sometimes, however, investment value does result given the market's propensity to overshoot on the downside too.

Tighter UK market for veterinary surgeons

The stock performed a big sideways swing, then plunged from around 1,100p in late summer 2018, as if triggered by caution in the September prelims outlook statement when CVS said Brexit could cause issues for employment of European vets. Amid a general shortage of UK vets, this was liable to push up wages. 

Also, a plc like CVS had successfully attracted vets into its fold - who wanted to sell up and retire - but does a younger generation motivated by animal care want to be in a profits culture?

Source: TradingView Past performance is not a guide to future performance 

Last autumn and into 2019 the stock continued down despite CVS's year to 30 June and first four months of the new financial year showing good performance - albeit a discrepancy in sales between total and like-for-like sales, the end-November AGM being told of a 24.7% rise versus 4.7% like-for-like.  

There is diversification into specialist equine and lower-margin farm animal practices, but this could be interpreted as a bit desperate – to keep the acquisitions bandwagon rolling, thus prop up headline growth. Graduate recruitment rose 19%, a potential longer-term positive but can't mitigate the current dilemma.

Chairman and FD bought equity around current market price

On 3 December, the finance director bought £9,436 worth of shares at 650.8p and on 5 December the chairman added £30,800 worth at 616p to own 120,000 overall.  

But nearly two months later the price slumped briefly below 400p after a trading update cited higher salary costs and higher charges for locums (roving temporaries) as the vets shortage took economic effect. Despite sales up 23.7% overall and 4% like-for-like, "full year EBITDA will be materially below expectations" and various cost-savings were being pursued.  

Such a statement triggers atavistic fears over acquisitive groups; that expansion may have come too fast and the usual strains are emerging. Also, vendors spot a trend and get greedy: "Acquisition multiples sought by practice owners are increasingly above levels which will deliver acceptable financial returns."  

Management guidance turns more positive

At the February low of around 400p, and on a June 2013 basic EPS view, the stock was on 25 times earnings but, adding back goodwill amortisation, was 9.4 times, with a dividend per share (DPS) of 5p implying a yield of just 1.25%.  

While forecasts in the table for an EPS advance to 50p and 54p are dated 13 February, there's plenty of examples of them losing the plot in the mature phase of an acquisitions spree, but the stock had crept up to over 500p before interims. 

A rally above 600p is in response to CVS changing its outlook for a full-year outcome (to 30 June) more positively in the 29 March interims. Like-for-like revenues are up 5% over the equivalent eight-month period in the prior year; a slight increase (although despite one broker promoting the stock, claiming "improvement in gross margin", this is down from 46.5% to 42.0%).  

CVS Group - financial summary              
year ended 30 Jun           Broker estimates
  2014 2015 2016 2017 2018 2019 2020
Turnover (£ million) 143 167 218 272 327    
IFRS3 pre-tax profit (£m) 6.3 8.5 9.1 14.5 14.1    
Normalised pre-tax profit (£m) 6.3 9.7 11.9 17.5 17.1 38.5 40.6
Operating margin (%) 5.2 6.5 6.5 7.3 5.6    
IFRS3 earnings/share (p) 8.0 11.3 11.3 18.2 18.2    
Normalised earnings/share (p) 7.5 13.0 15.6 22.3 15.9 50.2 54.0
Earnings per share growth (%) 2.6 72.7 20.1 43.5 -28.8 216 7.6
Price/earnings multiple (x)         38.6 12.2 11.4
Historic annual average P/E (x)   50.5 57.2 66.2 53.4 34.3  
Cash flow/share (p) 29.4 31.6 46.7 47.8 56.0    
Capex/share (p) 9.2 11.1 19.3 22.2 17.2    
Dividend per share (p) 2.5 3.0 3.5 4.5 5.0 5.5 6.0
Dividend yield (%)         0.8 0.5 0.6
Covered by earnings (x) 3.0 4.3 4.5 5.0 3.2 9.1 9.0
Net tangible assets per share (p) -47.4 -67.7 -142 -124 -73.5    
Source: Company REFS              

Vets vacancies have been reduced from 12% to 8% over the last 12 months (to February) and in animal nurses from 7% to 4%. However, "Brexit uncertainty has had a detrimental impact on the recruitment of overseas clinical staff, with less EU veterinary surgeons and nurses willing to come to the UK afresh and some returning home."

So, the market is looking forward beyond interim figures showing adjusted pre-tax profit down by 5% to £17.4 million on revenue up 24% to £195.1 million, although headline profit is down 74% to £1.6 million.  

Such a disparity is due to £15.9 million of amortisation/depreciation within the different views of profit. Company REFS' sense for normalised profit is in between what CVS presents, and headline profit, such can be the dilemma of how to treat various costs. 

Broker comment promotes CVS shares as "exceptional value", albeit on the basis of 8x enterprise value to EBITDA comparisons, looking to June 2020, and using a takeover-type valuation model because "CVS is an obvious target for the industry consolidators". Odd, given the outlook statement proclaims CVS as being "the leading integrated provider of veterinary services in the UK."

Management says it has addressed key issues leading to first half underperformance, with "significant improvement in many areas where we had been experiencing operational and cost pressures." While they will hold back from paying high exit multiples, "we still have a strong pipeline of potential acquisitions and an interesting platform into Europe through our Netherlands and Republic of Ireland business." So, the market is giving the stock some benefit of the doubt.

Cash generation has reduced 26% to £19.6 million, not only due to lower operating profit but also "a reduction in trade and other payables", although this is essentially in terms of the ratio versus trade receivables, 139% versus 158% at end-2017, hence still an imbalance management doesn't clarify.

Debt is pretty constant: the long-term element rising to £129.1 million, that which is short-term reducing to £0.4 million, in context of cash rising to £12.7 million. Bank facilities were refinanced last September.

One for the watch list, warily

Though frustrating to have missed a 50% rebound from the 400p low a couple of months ago, this is due to improved guidance following the kind of warning that should rightly keep investors away from a mature acquisitions group, and one prone to sharp shifts in sentiment.

The crux issue is where CVS consolidates in terms of underlying earnings trend, and what rating this deserves. At about 617p, the ex-amortisation PE multiple may be in the low teens, even taking a more cautious outlook than forecasts in the table. 

I like the concept of veterinary markets as a sound business, but if this group is fundamentally mature, then growth investors are still more likely to exit and CVS will need to raise its dividend substantially.  

A delayed or soft Brexit based on the single market could benefit this stock as re-encouraging European vets to work here, though a hard Brexit won't help. So, by all means have CVS on the watch list, but for the time being: Avoid

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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