This Industry Leader Is Significantly Undervalued

Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When you think of industry leaders, you generally think about companies like Johnson & Johnson and ExxonMobil. However, the enormous companies that make up the Dow Jones Industrial Average are not the only great wide-moat businesses available to invest in. For instance, VCA Antech (NASDAQ: WOOF), an animal hospital and laboratory roll-up, is a terrific company with an enormous competitive advantage.

At first glance, VCA's $1.9 billion market capitalization does not look cheap. The company trades at 13.4x 2011 free cash flow and 9x EV/EBITDA. However, a closer examination reveals a long history of consistent profitability that is unmatched by even the bluest of blue chips.

Long History of Stable Profits

Before we get into a discussion of VCA's competitive advantage, I want to show you just how remarkable its track record is. Here is VCA's free cash flow margin since 2002:

<img src="/media/images/user_13490/woof-fcf-margin_large.png" />

Many investors would look at 2009 and 2010 and start to worry that the company was falling off a cliff. But perhaps a statistical observation will help ease concerns. VCA's average free cash flow margin for the period shown in the graph is 9.63%. The standard deviation of the company's free cash flow margin is 1.18%. Statisticians tell us that if you divide the standard deviation by the average, you get a measure of volatility called the coefficient of variation. So, for VCA Antech, we divide 1.18% by 9.63% to get a coefficient of 0.12.

A coefficient of 0.12 is meaningless unless we can compare it to something else. General Electric's (NYSE: GE) coefficient is 0.20. IBM's is 0.17. This is incredible if you think about it. A low-key animal hospital roll-up has steadier margins than these industry giants. GE is an industry stalwart that is the market leader in most of the markets in which it competes. It was an early adopter of Six Sigma and lean manufacturing, which enabled it to best its competitors. Now it has one of the most stable free cash flow margins in the country, and yet VCA Antech's margin is even more stable.

Superior Competitive Position

VCA Antech does not earn steadier margins than GE and IBM due to superior management. Instead, VCA has a superior competitive position in its industry than the latter two companies. The animal hospital industry is highly fragmented; most hospitals are locally-owned with maybe only two or three at most in a local chain. VCA's hospitals are not necessarily better than their competition, they're just more profitable. Economies of scale allow VCA to earn higher margins than its local competitors.

In addition to economies of scale, VCA also benefits from the constant flow of dollars spent on pets. Despite a 9/11, a bursting housing bubble, and a couple of recessions, Americans continue to spend more each year on their pets.

<img src="/media/images/user_13490/pet-spending-in-us_large.png" />

This suggests that spending on pets is not seen as a discretionary expenditure in the minds of pet-owners, which means that VCA Antech does not have to worry about a huge drop-off in business during a recession. This should make all investors want to own an animal hospital.

Besides local hospitals, VCA's only significant competition comes from Idexx Laboratories (NASDAQ: IDXX). Idexx does diagnostic testing for animals but does not own animal hospitals. The laboratory side of the business produces higher margins than the hospitals, but VCA's integrated approach takes advantage of synergies between the two.

One piece of concern for VCA is Idexx's practice management software has gained hold of animal hospitals around the country. Animal hospitals who use Idexx's software also use it for diagnostic testing. Not only does this still share from VCA's lab testing business, but it may make it more difficult for VCA to acquire and integrate an animal hospital if the acquired hospital uses the Idexx software. As a result, Idexx has a high degree of customer stickiness.

Valuation

VCA has averaged a 9.63% free cash flow margin since 2002. We have already discussed how stable its margins are, so I think we can be sure it will earn at least this much per dollar of sales going forward.

The company earned $1.65 billion in revenue over the last four quarters. The company's organic growth is not significant -- it grows by acquiring local animal hospitals. So $1.65 billion is a good, conservative estimate of revenue going forward.

If the company earns a 9.63% margin on $1.65 billion in sales, it will earn $159 million in free cash flow. An industry leader with an enormous competitive advantage deserves a 15x free cash flow multiple, which puts the value per share at $27. At a recent price of $21.86 per share, VCA Antech represents a promising investment.


titans8904 has no position in any stocks mentioned. The Motley Fool recommends VCA Antech. The Motley Fool owns shares of General Electric Company and International Business Machines.. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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