What You Might Not Know About Stocks in This Sector

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I’m a big fan of the animal health sector but not necessarily the stocks within it. The sector looks set for good long term growth as demographics and socio-economic trends are working in favor of increasing numbers of companion animals. Aging populations and increasing numbers of single parent families along with decreasing marriage rates all add up to the increased proclivity to acquire pets as a form of emotional supplicant. But how to benefit from this trend?

Sector Attractive but the Stocks are not, for Now

With that said, it is somewhat frustrating that the stocks within the sector do not seem particularly attractive. I first looked at the sector in an article linked here and at the time concluded a few things regarding the companies discussed. The central theme is that they all seem to have been affected by a ‘pull forward effect’ whereby the unseasonably warm weather in the winter encouraged visits to the vets, which then fell back in the second quarter. As ever, investors bought the false optic and then got disappointed.

I’ve summarized the key issues to look for going into earnings season from the stocks in the sector.

  • PetsMart (NASDAQ: PETM) needs to keep up high growth rates in order to justify competition, particularly as Wal-Mart (NYSE: WMT) and Amazon.com (NASDAQ: AMZN) are beginning to encroach on their marketplace.
  • Idexx Laboratories (NASDAQ: IDXX) needs to demonstrate its patient visits, and practice revenue numbers can snapback from the Q2 dip
  • VCA Antech (NASDAQ: WOOF) has to demonstrate that it can reaccelerate revenue growth in lab and animal hospital revenues and that it is dealing with competitive threats without destroying margins.

Now it’s time to look at the report card.

VCA Antech: Is Competition Starting to Bite?

I’ll start with VCA Antech, which, as the following graph demonstrates, generates most of its revenues from hospital visits, but the highest margins are in its lab operations. First up, revenues.

<img src="/media/images/user_12882/woof1_large.png" />

And now Gross Profits.

<img src="/media/images/user_12882/woof2_large.png" />

The story of VCA Antech’s results is of sequential improvement in margins, but that is surely to be expected after such a poor Q2. On a yearly basis, things don’t look so good. Lab growth rates were 5.2% (warm weather induced) but fell to 2.6% in Q2 and only increased 2.5% in Q3. Meanwhile, hospital growth rates increased 1.1% from being flat in Q1. Management talked a lot about the macro-economy amidst hope that it would improve, but I think there is a case to be made for its difficulties being part of the competitive environment.

Wal-Mart and Amazon.com are both expanding their pet related offerings, and offering prescriptions is a sure way to eat into the some of VCA’s revenues. Indeed, the animal hospital category is competitive enough already, and by its own admission VCA Antech is not the cheapest supplier out there. Of course, less hospital visits mean less revenue at VCA’s labs, so this is a significant challenge. Moreover, the company has been an acquisition binge and I think caution needs to be applied with this sort of thing. Small practitioners can always find a way to set up elsewhere in the locale, and it appears that the acquired businesses are lowering margins overall.

Idexx and PetSmart’s Report Card

In terms of animal health, Idexx pretty much confirmed that the Q1 pull forward effect was real. I’ve summarized patient visits and practice revenue growth below.

<img src="/media/images/user_12882/woof3_large.png" />

Unfortunately, it looks like there was no economy-led pick up in patient visits in Q3. Revenues in Idexx’s Companion Animal Group did grow 5.7%, but this was mainly due to 7% organic growth in lab diagnostics, consulting services and instrument and consumables. In turn, this was largely caused by a combination of acquisitions, price increases and geographic expansion. This is fine for Idexx but it is not indicative of a strongly growing marketplace. Throw in the hefty evaluation and it’s hard to conclude that Idexx is attractively priced.

PetSmart is the business with the most to lose from Wal-Mart and Amazon’s encroachment, however there is no sign of it hurting the company yet. On the contrary, comparable same store sales growth was at a healthy 7% and transactions rose 2.9%. It is interesting that PetSmart is able to generate such strong growth in sales. Clearly, it is doing the right things to leverage footfall, or maybe its customers come from a demographic that is more inclined to open up the purse strings?

The Bottom Line

I think there is clear evidence that competitive pressures are starting to hurt prospects at VCA Antech and the pull forward effect was a real one for the whole industry. Idexx is performing well, but the stock remains expensive. PetSmart remains the best stock in the sector, but I fear it is a matter of time before online competition from Amazon.com and in turn Wal-Mart starts to leverage its own footfall.

 


SaintGermain has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com and PetSmart. Motley Fool newsletter services recommend Amazon.com, PetSmart, Wal-Mart Stores, and VCA Antech. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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