Greencross: The good, the bad, and the goldfish
Does putting vets inside shops really make sense? Here we examine the promise and pitfalls of the pet care industry.
By Graham Witcomb ·
19 Jul 2017 · 10 min read
Dr Glen Richards never set out to be a multi-millionaire. The small-town vet couldn't have known that his Townsville practice – founded in 1994 and named Greencross – would eventually grow to be Australia's largest network of vets and specialty pet stores.
It took Richards 13 years to grow his practice from one clinic to five – it took just 10 years more to add the next 159. Over two decades, Greencross has grown and merged its way to a $700m company, with over 164 veterinary clinics and 237 retail stores, mostly under the 'Petbarn' banner.
Integration model has merit
Margins and sales improving
Amazon may be a threat; debt the real worry
Richards stepped down from his chief executive role in 2014 – he remains a director – but the business philosophy that propelled his success is still deeply rooted in Greencross: integration, integration, integration.
You could argue that business 'philosophy' is now too light a term; 'gospel' seems more appropriate.
Greencross's low-margin business model relies on high utilisation of its vet clinics, economies of scale, and lots of turnover at the retail stores. To accomplish this, the company aims to be a one-stop shop for pet needs.
In 2014, Greencross boldly merged with the Petbarn brand of retail pet supply stores. The idea was simple: put a vet inside every Petbarn, then cross-sell till the cows come home.
The plan worked
Greencross has already rolled out 25 in-store vet clinics, representing around 8% of clinic revenue. What's more, the company estimates that 'cross shoppers' – those who use both the vets and retail – now represent around 10% of customers but account for 23% of revenue and 27% of gross profit.
It's still early days and Greencross is the first Australian company integrating vets and pet stores, but the strategy has a good track record overseas.
In the US, there's PetSmart – the largest pet retailer in the world – where 60% of its 1,500 locations include a vet and retail store. In the UK, there's Pets at Home, which has more than a third of its 325 stores co-located with a veterinary practice. Both companies earn higher margins and returns on capital than Greencross – so if Greencross is taking a page or two from their strategy books, the more chapters the better.
The veterinary services market is currently worth around $2bn a year in Australia, while pet supplies is worth around $5bn. In 2016, Greencross's retail division earned $540m in revenue, while its vets earned $195m, so the company has a market share of around 10% in both segments (see Chart 1). There's still plenty of room to grow in this highly fragmented industry, and management has a long-term target of 350 retail stores and 120 in-store vets.
Greencross's size also gives it more leverage to squeeze out cost advantages when purchasing supplies, such as fish food and chew toys, but most savings are passed onto customers. The company's profit margin is a measly 4.7%.
Management hopes the integration of vet clinics and Petbarn stores will change that and, given the higher spending pattern of cross-shoppers mentioned above, it has a fighting chance. The earnings before interest and tax (EBIT) margin has gradually increased from 7.0% in 2014 to 9.8% in 2016, thanks to more sales from higher-margin veterinary services and less discounting at the retail stores.
Excluding acquisitions, revenue rose 4.4% in 2016, which is nothing to write home about but still decent on a same-store sales basis. Far more encouraging is the cash flow situation. The 2016 result was the company's first to show positive free cash flow, which hit $36m before acquisitions (see Chart 2). Unfortunately, that's still a paltry margin of just 4.9%.
Nonetheless, there's a strong case that the lack of free cash flow is only a temporary, and indeed predictable and desirable, problem. Greencross spent $39m opening and fitting out 21 new stores and 23 new clinics in 2016 (a similar amount is likely to be spent this year). If we exclude this 'expansion' capital expenditure, the capex required to maintain existing operations was only $21m, which means underlying free cash flow of $57m.
However, expensive store openings that drain free cash flow aren't the source of the company's problems but the reason for its success. New store openings increase future earnings power – and, with a return on invested capital of around 11%, we're happy to part with a little free cash flow in the short term while it can be put to work growing the business.
Where to buy a goldfish
What might go wrong? Margins could contract if the Aussie dollar declines, making the import of cheap dog toys and flea medicine more expensive. Retail sales also show some degree of cyclicality; if the economy hits a snag, don't expect people to indulge their pets with expensive grooming and treats as they would in good times.
And then there's the ever-fattening elephant in the room – Amazon. The online retailer has a large and growing selection of pet supplies, and its recent push into Australia could make sales growth more difficult for Greencross. Thankfully, Greencross has a few things that should offer some protection compared to other specialty retailers, such as JB Hi-Fi and Myer (see Amazon and the Aussie hit list).
Firstly, just over a quarter of the company's revenue is from veterinary services, which can't be delivered online. The co-location strategy should also help drag people into the retail stores, where impulse buying can work its magic.
Secondly, while we do expect Amazon to poach sales of small, high value products – such as the ghastly assortment of knitted dog sweaters – many of Petbarn's products are cheap and bulky. Why shop online and pay postage fees, which may be more than the cost of purchase, when you can take home a few goldfish and a bag of kitty litter right now? Amazon won't make life easier for Greencross, but we won't lose much sleep.
Dirty balance sheet
The major risk is not Amazon; it's debt. In 2015, net debt jumped from $28m to $237m following the merger with Mammoth Pet Holdings (owner of Petbarn). Greencross assumed Mammoth's $74m of existing debt, then borrowed heavily to fund a slew of acquisitions, including 15 vet clinics and City Farmers' 42 bulk pet supply stores. It was a busy year.
Greencross recently refinanced its $400m debt facility, which pushes its expiry date out to 2020. Net debt fell slightly at February's interim result to $223m, but management has indicated that it will continue to use debt to fund acquisitions and growth. The long-term trend is up.
That wouldn't necessarily worry us were it not for the fact that interest payments already consume a fifth of operating profits in today's low-interest rate environment. Refinancing and rising interest rates are a significant long-term risk, and you can throw the company's additional $355m of lease obligations onto the risk pile too.
Unfortunately, Greencross's share price is a long way from offsetting these concerns. The stock sports a price-earnings ratio of 16 based on consensus estimates for 2017 earnings, with a 3% dividend yield. A dirty balance sheet, however, means the current dividend needs to be taken with a pinch of catnip – one bad year of earnings and it will probably be cut.
While there's enough to like, Greencross doesn't strike us as being particularly undervalued given the risks. We'll keep an eye on the stock as it could make for an interesting future opportunity, but for now we'll be watching from the sidelines.
Graham Witcomb
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