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This stock's growth trajectory may be off the chain

Glenn Freeman  |  12 Jan 2017Text size  Decrease  Increase  |  

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Mars' $10.4-billion purchase of US-based pet-care company VCA this week highlights the real potential for the outperformance of healthcare companies that serve our four-legged friends.


The transaction reinforces the attractive fundamentals of the animal healthcare industry in developed markets, and bodes well for the integrated pet-care business model of Greencross (ASX: GXL).

Greencross is a consolidator of the Australian veterinary industry, which is highly fragmented but ripe with opportunity, according to Morningstar's healthcare equity analyst Chris Kallos.

This stems from the high level of pet ownership in Australia, at around 63 per cent of households, compared with about 40 per cent in the United States, and the significant level of discretionary income spent on caring for pets in Australia.

"We estimate the highly fragmented Australian pet-care industry--including pet food, veterinary services and healthcare products--to be worth about $9 billion, and growing at low single digits. As such, we consider Greencross shares to be good value, trading at an 18 per cent discount to our intrinsic valuation assessment," Kallos says.

Broken down, around $2.5 billion is spent each year on vet services, $4.5 billion on pet products, and $1.7 billion on other pet services including pet insurance, grooming and cremation.

Greencross owns more than 130 vet clinics, in an industry that consists primarily of small practices with between one and three veterinarians, "giving Greencross further consolidation opportunities".

Kallos also points to a number of cultural trends that support growth in pet-care over the medium- to long-term.

"Pet care is a growing category, and industry tailwinds are likely to persist in the long term ... such as the increasing humanisation of pets, greater pet-health awareness, and the premiumisation of pet products," he says.

Many consumers see this category of expenditure as non-discretionary, with spending on pet care continuing even during the global financial crisis. According to the Australian Bureau of Statistics, pet food and pet product sales growth outpaced the broader retail market over the past five years, growing at 5 per cent versus 3.5 per cent.

Morningstar forecasts low-double-digit growth in underlying earnings before interest, tax, depreciation and amortisation (EBITDA) and net profit after tax for Greencross in fiscal 2017, and projects five-year earnings per share growth of 11 per cent.

"With 12 new retail stores in the first four months to October 2016, for a total of 233 stores, we remain comfortable with management's stated target of 20 new stores and 15 new in-store clinics for fiscal 2017," Kallos says.

"In-store clinics, a key element of the integrated model, provide several benefits, including improved foot traffic and cross-selling opportunities which should boost both sales and EBITDA per square metre on the floor space."

He sees this initiative as a key driver of Morningstar's forecast 50-basis point EBITDA margin expansion, tipped to reach 14 per cent by fiscal 2021.

Despite the opportunities that remain, the sector is not without its challenges. Kallos points to competition Greencross faces from Australian supermarkets and grocery chains, who have their own lines of pet category products.

"These competitors hold substantial scale advantages and may choose to price pet consumables as a loss leader to drive traffic," he says.

Key competitors include other specialist pet-care retailers, such as Best Friends, Pet Stock, and independent stores, with a combined 46 per cent market share, followed by supermarkets Woolworths (ASX: WOW), Coles--owned by Wesfarmers (ASX: WES)--and Aldi, who hold a combined 44 per cent.

The national shift towards higher-occupancy living arrangements, particularly in capital cities, may also present challenges, if it leads to a decline in the levels of pet ownership.

The total number of large pets has steadily declined over the last 20 years, though this fall has been more than offset by spending per pet, and growth in the ownership of smaller pets.

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Glenn Freeman is Morningstar's senior editor.

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