Little Followed Company Earns Outsized Profits in Pet Industry

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

The pet products industry is populated by great businesses. Companies like PetSmart (NASDAQ: PETM) and PetMed Express earn stable margins and high returns on capital.

It is not hard to see why these companies are doing well; U.S. consumers reliably spend more on their pets each year than they did in the last. The trend has been marked by a steady climb in spending that shows little sign of tapering off.

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The fact that consumer spending on pets did not make any significant dip during the worst recession in the post-war era tells investors something important about the industry's clientele: (1) these customers are more affluent than the general population, so they can continue regular spending on pets even during sharp recessions, and (2) customers view pet spending as non-discretionary, or at least less discretionary than things like eating out.

This makes the industry extremely attractive to those who can dominate it. PetSmart has a defensible moat largely due to its first-mover advantage cornering the high-end pet supplies market. The company earns mid-20% returns on capital and margins that any retailer would drool over.

PetSmart is the largest company in a fragmented market; it mainly competes with small independent retailers that make good acquisition targets.

More importantly, PetSmart's revenue and margins held up during the recession, enabling it to continue growing while the rest of the country was in the red.

As a result of its strong competitive advantage and durable business model, the market has rewarded the company with an 18 earnings multiple. However, another -- lesser-known -- company is making waves in the same industry.

VCA Antech (NASDAQ: WOOF) is a growing and highly-profitable owner of animal hospitals and diagnostic laboratories. While both sides of the business are profitable, the diagnostic lab segment earns the highest returns on capital.

VCA competes with Idexx Laboratories (NASDAQ: IDXX) in diagnostic lab test for animals. Idexx benefits from being a large company in a fragmented industry. Its high and reliable margins enable it to produce north of $160 million in free cash flow each year on just $1.3 billion in sales.

Moreover, as diagnostic tests for animals become more complex, Idexx's margins will increase further along with its growing advantage over smaller labs with less investment in R&D. As a result, Idexx will likely remain at the top of the industry for years to come.

Luckily, VCA's strategy allows it to operate in the high-return diagnostic lab industry without having to butt heads directly with Idexx. Most of VCA's lab business comes from its own hospitals, not from hospitals that could easily switch to Idexx. This gives VCA a tremendous advantage that is available to no other company in either market.

Although the diagnostic lab side of VCA's business is the most profitable, its animal hospitals are profitable as well. Its animal hospital segment is essentially a roll-up of veterinary clinics that may have been part of a two- or three-clinic chain before it was acquired by VCA. The roll-up strategy has enabled VCA to achieve economies of scale in a highly fragmented industry.

Bottom line

The pet products industry is booming and the companies at the front of the pack are reaping most of the rewards. PetSmart, Idexx, and VCA Antech are successful because they are the largest companies in fragmented markets. These companies have achieved economies of scale that no other competitors can match. As a result, each company will continue to thrive as the industry booms.

Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends PetSmart 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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