Has mean-reversion for this £1 billion veterinary services provider CVS Group (LSE:CVSG) overshot on the downside following the Competition and Markets Authority’s investigation into vet prices and practices?
I last wrote on CVS with a “sell” stance when trading around 2,400p in October 2021, given it had soared from around 800p in March 2020 to a (then) recent high of 2,770p. It seemed a hysterical valuation linked to the boom in pet ownership during Covid – the number of UK cats and dogs rising 15% to 24 million in this period alone. Yet price/earnings (PE) multiples in the thirties looked excessive.
The price fell to around 1,600p by March 2022, since when it has traded in a volatile-sideways range: up to around 2,100p last June – before the CMA bombshell on 7 September meant a plunge to 1,470p. While writing yesterday, an apparent chart “bowl” this month became more a “hockey stick” as the stock kept rising in response to strong annual results to 30 June – up nearly 7% to 1,610p.
Results affirm the CMA’s mission
Despite CVS and Pets at Home Group (LSE:PETS) complaining about the difficulties to recruit vets – requiring higher wages to attract more into the industry – these are stonking numbers.
On a statutory/reported basis, there is a 63% hike in after-tax profit to £42 million on revenue up 10% to £608 million – generating earnings per share (EPS) up 62% to near 59p. On CVS’ adjusted basis, EPS rises 12% to 96p, which is a 5% on the consensus expectation.
Mind that assumptions about what is appropriate to “adjust” vary and can have a material effect. Unsurprisingly, when a group is acquisitive in people businesses, it means intangible assets and their amortisation, although costs of expansion tend to get treated as “exceptional”.
Within a big jump from £62 million operating profit to £121 million adjusted EBITDA, the chief write-back is £50 million for amortisation (but also impairment and “profit on disposal” against a modest £9 million exceptional costs such as “business combinations”. It becomes rather subjective, but I tend to regard adjusted pre-tax profit as nearer £75 million which, after £12 million tax, gives £63 million net profit and EPS of 88p – hence a trailing PE around 18 times.
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Such a rating is manifestly more attractive than two years ago and will fall (assuming constant stock price) given CVS’ ongoing expansion, and declaration of the new financial year starting well with continued momentum. Unless there is a serious recession, demand for pet care is going to persist.
Yet the numbers and CVS’ industrial approach to what has historically been a caring profession of partnerships are precisely why the CMA has ended up acting.
It is unclear quite what will be the substance of response beyond recommendations on specific practices. The profession justifies its rising prices on the need to attract more surgeons and higher costs of medicines/consumables, similar to dentistry.
Cost of sales remain stable as proportion of revenue
CVS cites a near 7% rise in vets employed during the year “against a continued backdrop of constrained availability of vets across the industry”. It seems likely this will keep upward pressure on wages, as you would expect if a market economy is functioning to attract more into this area of work.
Yet despite this and CVS citing “investment in people”, cost of sales (which contain wages) have risen 10% to £346 million, albeit precisely in line with revenue at a stable ratio of 56.9%. If more vets are required, this ratio is likely to rise.
Regulators are concerned that higher prices relate to industry concentration (acquisitions of veterinary practices by commercial groups as owners retire), but there is the tricky aspect of needing to attract more personnel to deal with all the animals.
While independent practices accounted for 89% of the UK veterinary industry in 2013, this fell to 45% by 2021 and has coincided with the cost of vet services rising faster than the inflation rate.
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Yet for example I find the cost of a bi-annual dental check-up has risen from £40-something to near £100 the other day for a 20-minute inspection and minor consumables used.
The rebound in CVS shares implies market sentiment is over the initial shock of 7 September about the CMA investigation when CVS dropped from near 2,100p to 1,475p five days later. Traders are reminded of its strong earning power in a wider context of higher interest rates bearing down on most industries.
Yet the investigation is liable to reduce the pool of interested investors, at least if they are aware of the three years it took for the CMA to derive a ruling for the funeral industry.
CVS likes to proclaim its adjusted EBITDA margin edging up to 20% (versus circa 5% rising to over 10% at the reported level, see table) albeit helps to justify regulatory attention.
CVS Group - financial summary
Year end 30 Jun
|Revenue (£ million)||167||218||272||327||407||428||510||554||608|
|Operating margin (%)||5.9||5.4||6.3||5.4||3.8||4.3||7.9||7.8||10.2|
|Operating profit (£m)||9.8||11.8||17.2||17.7||15.6||18.5||40.1||42.8||62.3|
|Net profit (£m)||6.8||7.0||11.5||10.7||8.2||5.7||19.3||25.7||41.9|
|Reported EPS (p)||11.6||11.4||18.2||16.0||11.6||8.1||27.3||35.9||58.5|
|Normalised EPS (p)||11.6||12.3||18.2||15.4||11.9||12.5||27.3||48.0||88.1|
|Operating cashflow/share (p)||31.6||45.6||47.1||56.0||58.6||110||85.2||106||118|
|Capital expenditure/share (p)||11.1||18.8||21.9||16.0||18.3||17.6||23.5||34.2||59.2|
|Free cashflow/share (p)||20.6||26.8||25.2||40.0||40.4||92.3||61.7||71.8||58.8|
|Earnings cover (x)||3.9||3.3||4.1||3.2||2.2||0.0||4.2||5.1||7.8|
|Net debt (£m)||46.2||93.1||100||69.0||102||161||149||140||178|
|Net asset value (£m)||39.1||46.6||88.0||158||163||167||191||217||257|
|Net asset value/share (p)||66.0||77.7||138||224||231||236||270||306||360|
Source: historic company REFS and company accounts.
Near 25% return on equity justifies growth strategy
I derive my assumption on return on equity and strategy from my reckoning of around £63 million true net profit; hence the board is correct to retain earnings and invest for growth, even using modest debt at higher interest cost.
This is even at the early stage of a five-year plan initiated last November – focusing on organic growth with investment in people and facilities, plus further acquisitions in the UK and abroad.
It is helped by operating cash flow up 13% to £85 million, with a rise in conversion from profit to cash of 70% from 65%, in line with target.
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Yet this was insufficient to cope with a 122% rise in investment to £100 million - £58 million of which comprised acquisitions, otherwise chiefly on new facilities and equipment. Consequently, net financial debt is up from £35 million near £71 million.
Additional to £92 million long-term financial debt are £107 million of lease liabilities, such that the net finance charge rose 24% over £8 million – still modest, if you compare with £121 million EBITDA than £62 million operating profit.
A modest 7% rise in the dividend to 7.5p per share will see the total cash paid out rise to over £5 million.
The risk would be if the pay-out has not risen by the time the CMA might force some change – or say the growth in pets falls due to recession – then the stock will drop if still seen essentially as a growth play.
Risk/reward is attractive for now, but in two years’ time?
CVS’ dynamics are attractive. A first acquisition was made in Australia this last July, having determined this market particularly attractive given “low levels of corporate consolidation, favourable market dynamics and strong similarities with the UK.”
Again, however, there is justification for the CMA’s inquiry given the mercantilist way in which pet care is described.
My sense for further upside is affirmed by the stock continuing to rise to near 1,650p this morning. For a “buy” stance, however, I find one needs to be confident this group can remain in growth mode beyond two years, post the CMA conclusions and where the pet population stands then. Hold.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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