VCA Antech, an Analyst's Fond Memories

When cyclical shares and even healthcare peers find ruff going, WOOF perseveres.

(Stocks in this article: NASDAQ: WOOF, NASDAQ: POOL, NYSE: HD, NYSE: WMT, NASDAQ: GTRC, NASDAQ: SEIC, NASDAQ: ISRG, NASDAQ: TSCO, NASDAQ: MATK, NASDAQ: PFCB, NASDAQ: QUIX, NASDAQ: JKHY, NASDAQ: COHR, NYSE: PLT, NYSE: PPD, NASDAQ: NTRS, NYSE: WL)

As I scanned over my watch list in the midst of the market chaos of August, like most of you I stared at a sea of red. However, in the middle of the bloody mess, a green light shone through like a ray of hope. It was my old friend VCA Antech (NASDAQ: WOOF), a company I discovered while working as an analyst at Standard & Poor's.

At S&P, I was charged with a special role as an idea generator. I had to go out there and find great new ideas for our handful of institutional clients. There were times when I held responsibility for 10% of our 100 or so “strong buy” ideas, and I typically returned well for management. In fact, I was ranked internally as the best strong buy stock selector over four years, and second over the five years I was free to do so through 2004. My average annual return on those strong buy ideas was 23% over the five years through 2004, compared to a negative 3.8% average annual loss for the S&P 500 Index over that same period.

Anyway, to the point…
I came into my coverage in the first half of 2000, not the best time to take over a group of stocks filled with my predecessor’s favorite tech and telecom ideas, most of which flailed into nothingness in the years that followed. On one ill-fated morning just after inheriting the group, it became plainly obvious to me that an overhaul was necessary. One of the tech names with no earnings had dropped 20% on a disappointing quarterly report, and the Technology Group Head was on the phone screaming at me to do something. Well, I did in fact.

I remade that group and filled it with quality names, companies with real earnings that were modestly valued in comparison to their growth. These value stocks fit the GARP (Growth at a Reasonable Price) profile that I thought was appropriate for the time. But there was more to it than that. These were companies operating businesses I considered so viable and opportune I would own outright if I could. VCA Antech (NASDAQ: WOOF) was one of the names I added to coverage during my time driving performance at the firm. It’s really a special little company in my view.

VCA Antech has a distinct advantage over health care rivals, and also exhibits near operational immunity to economic troughs. During my time on Wall Street, I came across some great names, and as I left my old firm in July 2005, my favorite was WOOF. The stock was more than an isolated winner though, rather, it represented just the latest example of a proven business model I sought out. I will outline that model for you at a later date, in one of the books I'm planning to write.

VCA Antech operates the largest veterinary business in the country, while at the same time providing the most comprehensive laboratory services for the pet health care industry. The company’s over 435 animal hospitals in 38 states represent the broadest coverage within the industry. WOOF employs more than 1,600 veterinarians and more than 130 board-certified specialists. Through Antech Diagnostics, the company offers a complementary nationwide network of laboratories to serve the growing diagnostic needs of vets and pet owners alike.

I learned from Peter Lynch that companies that compete in fragmented markets against mom and pop shops, tend to gain advantages from economies of scale. How do you think Home Depot (NYSE: HD) went from a penny stock (adjusted for splits) into a behemoth of American retail. What do you think made WalMart (NYSE: WMT) the giant it is today? Now, WOOF’s market is nowhere near as large, but it has a nice little niche to grow into still. Some $18 billion was spent on animal health care services in 2004. Sure, and why not, some 63% of American households own at least one pet. And even though WOOF operates as the industry leader in veterinary hospitals with its 435 locations, it operates in a fragmented market comprised of over 22,000 hospitals nationwide. So, there’s plenty of room to grow.

And grow it does, with a goal to add 20-25 hospitals per year, mostly through acquisition, adding revenues of $35 to $40 million a year. However, every once in a while, Bob Antin, WOOF’s charismatic CEO gets antsy and grabs a larger organization. For instance, in June WOOF closed on its $153 million acquisition of Healthy Pet Corp. The operator of 44 vet hospitals was generating revenue of about $80 million on its own.

I say Bob is charismatic, because I got a chance to meet the man during a trip to California. If I recall correctly, he was wearing shorts, and I remember for sure that there was a basketball hoop, with hardwood floor, right smack in the middle of the cubicle filled corporate office. I admire a guy who keeps it real, while also rewarding shareholders with value-added growth. WOOF typically takes acquired inefficient operations and fits them into their own operating plan. In the process, the management team squeezes more juice out of the same orange, or asset.

In its most recent quarter, WOOF posted 17.7% revenue growth on a 17.4% increase in lab revenue and 17.5% animal hospital segment growth. Acquisitions aided hospital growth significantly, but same-store hospitals still grew revenue an impressive 6.6%. Margins expanded thanks to continued operating leverage, and the company earned $0.42 a share, $0.02 ahead of expectations. Management also took the opportunity to raise guidance for the full year, hiking the revenue outlook to a range of $1.14-$1.15 billion, from $1.08-$1.09 billion. Earnings expectations were raised as well, to $1.35-$1.37 a share, from $1.31-$1.35.

Like we said before, as WOOF grows against mom and pop rivals, it gains economies of scale. For instance, think about your neighborhood veterinary hospital. Consider how you know about its location. It’s probably from haphazardly driving by it on your way home one day. That hospital’s customer base is probably made up of people just like you. Thus, it draws customers from a limited geographical area. But, a larger company like VCA Antech has the ability to leverage capital to advertise, and draw customers from a greater distance. It can also build brand appeal, and win clients via reputation. That’s an economy of scale. Another example is the ability to purchase supplies in bulk at discount. Mom and pops just can’t compete against that.

WOOF trades at a P/E of 30.2X its trailing 12 months’ EPS. Since we are right smack in the middle of the year, we can fabricate a make shift forward 12-month consensus estimate, without actually having the quarterly figures. This is something I use to do as analyst for companies I did not follow, and thus didn't have earnings models for. It can, however, err in estimation if there are seasonal variances in earnings. Averaging WOOF’s $1.40 ’07 estimate with its $1.62 estimate for ’08, gives us a make-shift figure for the 12-months through June of ’08 of $1.51, and WOOF trades at 26X this estimate. The company’s earnings have grown at a 26.9% average annual pace over the past five years, but analysts have forecast a 16.5% pace for the next five. A downshift in speed makes sense, because of the logical difficulty to move a larger ship. In other words, growth usually slows as companies get larger. But, we bet that if you looked at the growth estimate five years ago, it was probably also significantly lower than the 26.9% WOOF actually achieved.

What we’re saying here is that the estimates are probably conservative. The consensus is looking for just 15.7% growth in ’08, and that’s coming off this year’s 20.7% estimate and is despite the large acquisition WOOF has undertaken. Heck, with only one month’s contribution from the acquired 44 hospitals of Healthy Pet, WOOF managed 20% EPS growth. As an analyst, I would apply a 20% growth forecast here to the forward P/E estimate of 26X, and consider that conservative. That gives us a PEG of 1.3, which is reasonable to pay for the quality and reliability of earnings WOOF offers in today’s environment.

Over the past four years, WOOF has traded at an average P/E of 28.9, below it’s current 30.2X. If it can achieve that same average P/E over the next 12 months, thus we would apply it to our $1.51 estimate, then the stock should be worth about $43.64 a year from now. The thing is, my discounted cash flow model would always forecast a higher value than this back of the envelope stuff, and I trusted my DCF model. I would typically average out the values generated by my various models or assign probabilities to them to generate one target estimate. I would assign probabilities when I viewed the importance of specific models different. However, cost of capital and required rate of return are in flux nowadays, so I’m not sure the DCF model would provide a much higher estimate now. If we go with the conservative figure based on WOOF's average P/E, that’s still 11% above the intraday price I'm seeing on my screen on August 29th. I would take that return in a market like today's.

In case your interested in some of the other names I liked as an analyst, they included SCP Pool (NASDAQ: POOL), Guitar Center (NASDAQ: GTRC), SEI Investments (NASDAQ: SEIC), Tractor Supply (NASDAQ: TSCO), Intuitive Surgical (NASDAQ: ISRG), Martek Biosciences (NASDAQ: MATK), Evergreen Resources (since acquired), P.F. Chang's China Bistro (NASDAQ: PFCB), Quixote (NASDAQ: QUIX), Jack Henry (NASDAQ: JKHY), Coherent Inc. (NASDAQ: COHR), Helix Technology (since acquired), Plantronics (NYSE: PLT), PrePaid Legal Services (NYSE: PPD), Northern Trust (NASDAQ: NTRS), Wilmington Trust (NYSE: WL) and a bunch more. Remember, those were different times, and after a fresh review, I might not like the same names now.

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