Investors are right to beware small-cap companies that grow quickly through acquisitions. Many “industry consolidators” have come unstuck over the years after buying too many businesses too quickly and integrating them poorly.
They had a great story to sell investors: raise capital on equity markets, roll up smaller competitors in a larger enterprise, and apply public-market valuation multiples. Better still, using a rising share price to fund part or all of the acquisitions.
But all too often, the consolidators pay too much for businesses as competition rises, too many issued shares weighs on Return on Equity, and there is too much debt. Shareholder wealth is destroyed.
Pleasingly, the track record of small-cap industry consolidators is improving. 1300 Smiles and Pacific Smiles are impressing as they buy smaller dental practices and consolidate a fragmented industry. I covered both stocks for The Bull in May 2015.
Another column favourite, National Storage REIT, continues to buy self-storage operators or manage their facilities, most recently in Perth. The self-storage industry, characterised by a large number of small players, is ripe for consolidation as growing urbanisation leads to rising storage demand. National Storage REIT has a one-year total shareholder return of 29 per cent.
Veterinary group Greencross is another standout consolidator. I have followed it for some time, but felt it had become too expensive after soaring price gains and that better value was to be found elsewhere. My mistake. Its five-year average annualised total return (including dividends) is 61 per cent to August 2015, Morningstar data shows.
Better value is emerging. Greencross has fallen from a 52-week high of $10.78 to $6.99, amid market fears of rising competition in the veterinary industry, and rising valuation multiples as new publicly listed entrants pay higher prices to secure clinics.
Chart 1: Greencross
National Veterinary Care is raising $30 million in an Initial Public Offering and was due to list on ASX as this column was written. Its listing would see a second veterinary aggregator with access to public funding emerge, and a stronger rival to Greencross. There is talk that a few private equity firms are considering roll-up strategies in the industry. The big surprise is that it has taken them so long.
I doubt new entrants in the vet space will lead to sharply higher prices, as baby boomers sell their practices. The sector has also had good access to capital for some time and well-run clinics have been in strong demand. Moreover, new acquisitions of vet clinics are having less effect on Greencross’ earnings as it diversifies, rolls out new practices, and cross-sells more products and refers more services.
Greencross has had a remarkable 18 months. The Mammoth merger, City Farmers acquisition and growth have transformed it from a standalone vet business into an integrated pet-care company and increased its size sixfold.
Greencross’ 2014-15 result, released this week, was in line with market forecasts. Still, it was a solid result that alleviated a few market fears, some about slowing growth. Greencross bounced a few per cent, in a weak market, on the release.
Revenue rose 45 per cent, net after-tax profit was up 77 per cent, and earnings per share rose 43 per cent. Pet stores and clinics expanded 35 per cent to 332 locations. Outlet growth will slow sharply in 2015-2016 and more synergies will be captured in the next full-year result.
Greencross needs high earnings growth to justify its valuation. But there is no doubting the value of its market-leading position in the growing vet industry. Greencross estimates its addressable market is approaching $9 billion and will be worth $11 billion by 2020.
Greencross said it had a positive trading start to this financial year and it expected to deliver strong organic-led growth in 2015-16. Put another way, the benefits of a huge period of mergers and integration should start to flow through in the next full-year result.
Of the eight brokers who cover Greencross, three have a strong buy or buy recommendation and one has a hold. The median price target is $8.16.
Macquarie Equities Research has an outperform recommendation and a $7.60 12-month target. It wrote this week: “Greencross remains well positioned as a market leader in an attractive market to deliver 15 per cent-plus earnings growth. We see FY16/17 as the first year it will materially benefit from the revenue synergy opportunities presented from the original merger of the pet and vet format.”
Greencross is not a screaming buy, but further price weakness to $6.50, amid broader market falls, would make it among the market’s better small-cap opportunities.
Tony Featherstone is a former managing editor of BRW and Shares magazines. The column does not imply any stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at August 12, 2015.