Shares in CVS Group (LON:CVSG) fell 25% today as the H1 trading update put out today warned that full year EBITDA would be ‘materially’ below expectations. As a potential growth share, the market has fallen seriously out of love with this share, and the share price has more than halved in the past six months alone:
Today’s share price drop takes us to 483p, which is about one third of the 1,450p seen in at the highs of November 2017. And as we can see from the P/E ratio given out by Google Finance, the valuation then would have been expecting big things in the future.
Perhaps this is not too difficult to understand why when we consider the company: CVS Group operate vet practices and other related products such as animal diagnostic services, crematoria and pharmacy business – a universal market considering that pets are a worldwide thing. Despite this, in most countries the companies that provide these services are spread out, and fragmented – a veterinary practice might only expand to cover a small geographical area.
CVS have been seeking to form a larger chain of businesses, which would generate operational leverage as well as savings in economies of scale. Additionally, existing smaller businesses could be bought up at far cheaper rates, and becoming a known name in the field could offer significant brand advantages.
The method of creating this is rather than competition, to acquire businesses outright and integrate them into the group. For the past few years CVS has been an buying almost non-stop, and this is reflected in revenues, which have doubled to £327m in the space of four years.
But in recent months, the market has really marked this share down, and is now pricing in cynicism that things might not work out.
The warning comes in a trading update summarising H1 results. The first parts are good:
In H1 2019, the Group’s total sales increased by 23.7% and like for like sales (“LFL”)1 increased by 4.0% both compared to the financial half year ended 31 December 2017 (H1 2018).
Within the Practices Division, sales have increased by 23.9% and like-for-like sales have increased by 3.2% compared to H1 2018. In addition, Laboratory Division sales increased by 6.3%, Crematoria Division sales increased by 11.3% and Animed Direct sales increased by 16.2% compared to H1 2018.
Like-for-like stats are very important in groups where the number of branches are growing quickly.
This starts to turn with the announcement of headwinds:
As a result of a number of actions taken, CVS continues to see a gradual improvement in clinical vacancy rates for both vets and nurses compared to the start of the financial year. However, as previously highlighted the Group remains heavily reliant on locum cover given the continuing industry-wide shortage of vets. Consequently, employment costs in H1 2019 are well above H1 2018 due to the increase in sales as noted above, combined with above inflation salary increases and a significant increase in market rates for locums.
And further bad news with regard to the latest acquisitions:
Over the past two years, CVS has acquired 24 practices in The Netherlands and has diversified into Farm and Equine practices. Early performance from these newer divisions has been disappointing with financial results falling short of our expectations. In all these divisions, financial performance has been adversely impacted by the poor support of pharmaceutical companies and we continue to push for transparent and appropriate pricing.
In light of the above and certain other cost increases, the Group expects to announce EBITDA3 for H1 2019 that is broadly flat compared to H1 2018.
Despite the flat H1, this isn’t the story for the whole year, as it gets worse:
Given the financial performance in H1 2019, CVS now expects full year EBITDA to be materially below current market expectations.
This obvious has bad news for the bottom line, because depreciation and amortisation will continue regardless. Given that the outlook was strong in the previous annual report, this seems to be promising a substantial miss.
It is not all bad news for CVS, and previously there were good signs that their expansionary model was working. In the past couple of years they have been acquiring veterinary practices at the rate of one per week, and given the fragmentation of the market, getting them into a standardised group is a much more difficult task than something like a retail shop would face.
The increase of revenues and especially like-for-likes also suggests that they are doing this without too much of a loss on business, suggesting either that the local market is captive (there tends not to be price wars between vets, after all), and/or that they are making incremental gains with better cross-selling opportunities from their other related businesses.
On the flip side, when it comes to groups that are acquiring other businesses, it becomes relevant to how this is being funded, and how these are being accounted for, as EBITDA tells us very little about financial stability. Here, CVS have funded their acquisitions with a mixture of debt and equity: £58.9m was raised in 2018 via an issue of shares, and they have banking facilities totalling £190m comprising of a fixed term loan of £95m and a revolving credit facility of the same. The trading statement makes the comment on cash:
As at 31 December 2018, CVS had net debt of £116.8m and bank covenant leverage4 of 2.4x. The Group remains comfortably within its covenants and continues to generate positive operating cashflow.
So there seems to be ample room for the strategy to continue for a while, although even the mention of the word covenants might make some nervous. Debt is not automatically a bad thing – if the returns on investment exceed the cost of capital it can be worthwhile, but it does introduce more risk. As we have seen so many times, heavily indebted companies can unwind very quickly.
This kind of level of debt makes the balance sheet quite weak, because balancing it out on the other side are assets. But in the case of CVS most of them are not tangible. For instance in the past year, we could count £115.5m in tangible assets and £203.5m in intangibles. The growth in these has been rapid as we can see:
These assets are generated on acquisitions, with goodwill being the excess paid over the book valuation. I am not too clear what the patient records are as the exact levels of profitability of targets is not disclosed by CVS, but I am sure it would relate to the consideration paid to acquire the business.
Anyway the point is that these intangibles lie on much more uncertain ground than the tangible assets, as it might be the case that in the case of a poorly performing acquisition the values of these would have to be impaired.
It is notable that goodwill is not impaired at all, and patient records are being impaired at a slow rate over the life of the asset (methodology not disclosed). This may be a source of bad news in the future.
The cashflow statement corroborates the story so far: the company is spending way more than it earns on acquisitions, but this is being funded by equity and debt, but there is clearly money to be made:
This is an interesting business, although it could be argued that with the recent decline in share price, shareholders believe that the current wave and rate of acquisitions is destroying shareholder value rather than creating it. With net debt up to £117m, without another equity raise, it seems certain that the level of expansion will soon have to stop, and the focus then would be on performance.
One oddity seems to strike me from their annual report, and that is the spread of practices:
An expansion into a totally different country appears to be a very tough call to make, where practices and local customs might vary tremendously. With only 2 veterinary practices in London, it might have been thought that entry to this market would have been considerably smoother, easier to integrate into the group and also easier to manage than a few in a different country. The recent comment in the trading update indicates that perhaps CVS were not willing to pay the asking prices of individual practices, but with the current financial climate this might represent a new opportunity.
Whether they have the remaining cash to fund the current business and take on London is another matter. It does seem that soon there will be a point where the figures will not reflect the increasing amount of surgeries and acquisitions, and perhaps we have yet to find out whether CVS have paid too much for their latest acquisitions. There is no real way of knowing now, because the metrics are not disclosed.
Despite this I quite like the business; the UK are a nation of pet lovers and this doesn’t seem set to change any time soon. And the long-term predators could even turn prey for a larger company if the share price continues to fall. Whilst the balance sheet is weak I feel the share price will always be on shaky foundations and the dividend insecure while there is so much debt but over the longer term I don’t see them failing. 4/5.