The Best Stock To Take Advantage Of This Booming Industry

Tim Begany's picture

Tuesday, February 9, 2016 - 12:30pm

by Tim Begany

When M&A specialist BC Partners took PetSmart Inc. private nearly a year ago, investors lost a top entree into the $60-billion pet products and services market. As a publicly traded entity, PetSmart showed strong growth and market leadership, and I'm certain it would have remained an excellent long-term investment if BC Partners hadn't snapped it up.

But with PetSmart out of the picture, those looking for a pure play on the pet care boom have much slimmer pickings. For example, despite a 4.5% dividend yield, I'm not a huge fan of nationwide pet pharmacy PetMed Express (Nasdaq: PETS) because its business has stagnated and total returns from its stock have been trailing the S&P 500's by a wide margin for years.

PetMed has the right idea, though, by being in the pet health market, where affluent consumers are increasingly willing to pay up for expensive tests and treatments. In that environment, PetMed might still be expanding if it was casting a wider net, like VCA Inc. (Nasdaq: WOOF).

While not a household name, VCA is quite large, with a $4-billion market cap that's 12 times larger than PetMed Express's. And it's taking full advantage of the growth opportunities available in pet health care, as well as handsomely rewarding shareholders. The past five years, shares of VCA soared by 98%,more than double the S&P 500's gain during that time.

From Humble Roots To National Player
Founded 30 years ago, California-based VCA started out by acquiring a single high-end animal hospital in West Los Angeles. Today, it's the nation's largest operator of freestanding, full-service animal hospitals and diagnostic labs, with about 640 of the former and five dozen of the latter across the country. VCA's 3,000 veterinarians care for almost nine million pets annually.

Of the company's nearly $2.1 billion of annual revenue, 79% is from the animal hospitals, which provide health examinations, vaccines and other routine care. Besides generating a solid income stream, these services offer ample opportunity to recommend higher-margin specialty care such as advanced diagnostics, dentistry and cardiology.

About 19% of the top line comes from the lab segment, an especially stable revenue source because it so thoroughly dominates the market for veterinary diagnostic tests. According to Morningstar, the segment serves more than 14,000 -- nearly two-thirds -- of the nation's 22,000 animal hospitals. Its client list jumps to over 16,000 when you include government organizations and veterinary practices that care for large animals such as livestock.

VCA dabbles in a few other areas, too, including marketing/communications services for veterinary practices and diagnostic equipment sales. There's also a small franchise operation offering pet services such as boarding, grooming and day care.

The firm weathered the last recession better than most, boosting sales an average annual 6.5% from 2007 through 2011 with no top-line declines in any of those years. Unlike many businesses, it stayed profitable throughout that stretch and only saw earnings fall by a relatively mild 21%.

Financial performance has since been hearty, with revenue and net income compounding by nearly 9% and 17% per year, respectively. At 8.5%, net margins are at five-year highs and more than twice the 4% industry average.

Operating cash flow of $292 million is enough to cover interest payments on existing debt 15 times over. A debt-to-equity ratio of 0.7, versus the industry average of 3.2, shows VCA relies far less on borrowing than the typical competitor.

A Healthy Outlook
With annual household spending on pets long rising at a high double-digit pace, I see a bright future for VCA, especially since many consumers express a willingness to shell out large amounts for their pets' health care. In a New York Times blog from 2010, the author cited a survey showing nearly a quarter of pet owners would pay a vet $5,000 to save a sick dog or cat -- and the economy was significantly worse at the time.

A 2013 article on the veterinary medicine website dvm360.com described a survey in which more than eight out of 10 pet owners said they "would consider paying almost any amount of money to keep their pet healthy." Nearly nine in 10 would eat out/go out less to provide better health care for their pets, the article added.

With market conditions so favorable, VCA remains plenty capable of financial performance similar to what it delivered the past few years. Acquisitions should provide a steady tailwind, as management has long been adept in identifying high-quality independent animal hospitals and obtaining them for reasonable prices.

Through the first three quarters of 2015, for example, the company bought 42 such hospitals with combined annual revenue of $90 million. Organic expansion prospects are also promising, as shown by same-store revenue gains in the 5%-to-6% range in recent quarters.

Risks To Consider: Nothing throws a wrench into forecasts like a recession, and many analysts say the next one may almost be upon us. Though VCA has shown resilience in such an environment, it's not immune to recession and will undoubtedly feel the effects next time around.

Action To Take: Despite global economic uncertainty, VCA Inc. remains an attractive pure play on the robust pet care industry. Because investors have been indiscriminately dumping the stock as part of the broader market downtrend that began in the middle of last year, valuations are now much more reasonable: The price-to-earnings ratio of 22 is more than a 24% discount the five-year average P/E of 29. With the broader market still looking quite vulnerable, building a position in VCA gradually through dollar cost averaging seems prudent.

P.S. Most people think you have to sacrifice growth for income. But a Texas baby boomer is holding 23 monthly dividend payers... and has seen her portfolio grow 50%. Get all the details here, including names and ticker symbols.

Tim Begany does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.