Picture this: an entrepreneur of a small company raises $20 million and lists it on ASX. Management uses that capital to buy other privately owned companies in the same industry.
The entrepreneur knows the industry is full of tiny operators or, in business-speak, is “highly fragmented”. Several owners are eager to sell and the entrepreneurial venture, cashed up after the capital raising, has a first-mover advantage in the race to create industry scale.
As the venture buys smaller businesses, it becomes more profitable. Head office and other fixed costs are spread across a larger number of businesses and earnings rise. Better still, those newly acquired profits are valued on listed-company valuation multiples.
Simply, the ASX-listed company, trading on a Price Earnings (PE) multiple of 10 times, buys privately owned companies for, say, 4-5 times their earnings. But the sharemarket values those earnings on a PE multiple of 10, creating a sharply higher valuation for the venture.
As its market capitalisation rises, the entrepreneurial venture raises equity capital through a share issuance and banks are eager to lend. Now with a bigger balance sheet, the venture goes on an acquisition spree, to supercharge its earnings and valuation.
The market cannot get enough of the stock. It has a straightforward story based on acquiring others businesses and consolidating its industry. Earnings are growing quickly, brokers are raising equity capital and banks are lending money. What’s not to like?
Then the party stops. Abruptly. Competitors enter the fray, pushing up the price of acquisitions. Owners have more potential buyers, so expect a higher price. Also, the entrepreneurial venture starts to acquire lower-quality businesses because the best ones have been bought.
Worse, the management team is struggling to integrate so many rapid acquisitions. One or two deals sour, damaging the brand and making it hard to buy other businesses.
Previous owners of the acquired businesses are cranky. They received equity in the new venture as part-consideration for the sale of their business. The share price is tumbling and so is their wealth. They worry that the new owners could blow up years of their hard work.
As the share price plunges, the company must raise equity capital at a much lower price to survive, diluting existing shareholders. Bankers are no longer eager to lend and there is talk that the entrepreneurial venture could breach its debt covenants. Key executives resign.
Welcome to the world of “industry roll-ups”, a strategy that can work exceptionally well on the way up when acquisitions run smoothly, and horribly on the way down. A strategy investors fall for too often, despite so many spectacular failures over the years.
Some of the market’s biggest disasters have been industry roll-ups that grew too quickly. Think ABC Learning and its ill-fated acquisition spree. Or troubled law firm Slater + Gordon, which grew quickly through acquisitions and made a disastrous one in the United Kingdom. Lately, Retail Food Group, which bought pizza and coffee chains, is under immense pressure.
Domino’s Pizza Enterprises, which for the most part has done a terrific job of corporatising a fragmented pizza takeaway market here and overseas, has lost some of its shine. Intellectual property services firm IPH, also consolidating its industry, has been thumped.
I recall several accounting and wealth-management consolidators in the ‘90s that turned out to be landmines. They, too, issued equity like confetti to buy businesses, sold a good story to a gullible market and took on more than their management could handle.
I could go on with examples of industry roll-ups that went from the market penthouse to outhouse in quick time, when the truth emerged. But you get the drift: high-flying, serial acquirers that talk about “consolidating fragmented” industries need extra care.
That’s not to say all consolidators should be avoided. Some industries are fragmented and lack economies of scale because there are few large players. Dentistry is an example: thousands of one- or two-person practices and only a few good corporate players in the sector.
Veterinary services is another. Australia has many tiny practices that would benefit from being part of a larger group that can spread fixed costs, invest in technology, introduce new products and cross-promote others, and building a larger brand that attracts more customers.
Done well, sensible industry roll-ups can drive sustainable wealth creation. Four roll-ups stand out: dentistry acquirers Pacific Smiles Group and the smaller 1300 Smiles, a well-run company and steady performer for shareholders over the past 10 years.
Chart 1: Pacific Smiles Group
Source: The Bull
Chart 2: 1300 Smiles
Source: The Bull
In animal health and wellbeing, Greencross, which has vet clinics and Petbarn retail outlets, looks undervalued. The smaller National Veterinary Care has also grown steadily through acquisition of privately owned clinics and has good long-term prospects.
Chart 3: Greencross
Source: The Bull
Chart 4: National Veterinary Care
Source: The Bull
Each of these four industry consolidators is down on its 52-week high. Having reviewed their earnings results, I cannot see any fundamental reason for the extent of the falls.
Greencross looks the pick of them. The former market darling has slumped from a 52-week high of $7.35 to $5.38, even though its recent half-year result broadly met market expectation and the company reaffirmed its guidance outlook. The market is worried that Greencross will lose significant market share to online competitors, such as Amazon, but this fear is overstated.
Longer term, Greencross is superbly placed to benefit from “pet humanisation” trends. We’re spending more on pets, favouring premium products and outsourcing services, such as grooming, training and accommodation, to specialist providers. Animal pet insurance is creating new markets and spurring demand for pet products and services.
An average share-price target of $6.09, based on the consensus of nine broking firms, suggests Greencross is undervalued at the current $5.39. Macquarie values Greencross at $6.30 and Morningstar has a $6.50 fair-value target.
Greencross is more than an industry roll-up play. The co-location of vet clinics and Petbarn retail outlets has terrific long-term potential, though will weigh on costs in the near term.
Cross-selling pet services and products is a smart strategy that gives Greencross scope for faster growth in coming years and more sustainability compared to traditional acquisition plays. It’s one of the few industry roll-ups that could roll on for years, creating shareholder wealth.
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• Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article you should consider the appropriateness and accuracy of the information, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at March 14, 2018.
