Dominant and defensive, but thinly traded

Note: We consider Provet to be an excellent business trading at an attractive valuation, but it is quite illiquid. This makes it harder to action buy and sell orders, meaning it is unsuitable for shorter-term investors. Members that are comfortable with the illiquidity should take a patient approach to buying as any spike in demand will drive an unsustained price spike.

In the current market environment of increased volatility we are more focussed on larger blue-chip companies. This is simply because smaller companies tend to be thrown around considerably more during these stormy times. That’s not to say that good opportunities don’t exist at the smaller end of the market. Indeed, we recently met with a small company that operates a very attractive business.

There are not many management teams that can report constant sales and earnings growth over the last decade, including through the GFC. Veterinarian wholesaler Provet has however achieved just that. The company has not only demonstrable defensive characteristics, but a proven ability to grow. The really interesting aspect of the story is that Provet still has considerable growth opportunities ahead.

Provet has only been listed since March this year, but the company’s history actually dates back to 1982. While Bananarama and Men at Work were topping the Australian pop charts, five Vets decided to take control of their supply requirements.

Provet started with a single purpose built pharmaceutical warehouse with 3 staff. Today the company employs 330 people, operates a distribution network of 13 warehouses and even provides products and services to about 40 different countries. Like so many great companies before it, Provet has grown far beyond the expectations of its original founders.

Business Model

Provet is Australia’s largest veterinary wholesaler with about 47% of the Australian market. Wholesale Operations is the core business segment, providing pharmaceuticals, pet nutritional products and other consumables and equipment to veterinary practices. Pharmaceuticals and nutritional products contributed 70% and 17% of the company’s 2009 sales respectively.

Provet imports its product wholesale from major international pharmaceutical companies. No single company represents more than around 20% of Provet’s supply requirement each year, which reduces the potential for disruption in its supply chain to impact Provet’s ability to meet its customers’ needs.

Provet’s purchases are then sent to its various distribution centres, of which there are 10 in Australia and 3 in New Zealand. The company operates its own fleet of delivery vans in metropolitan areas and uses freight services elsewhere to achieve a 4-24 hour turnaround time from order notification to delivery.

Veterinary customers have the option of dealing with an Account Manager, or placing orders through the Provet system. This is as simple as scanning the product barcode and uploading the order into the system. Customers are incentivised to use the system because it provides other benefits such as inventory management.

About 30-40% of the company’s orders are currently received through the system and we would expect this to grow over time. Automated ordering such as this of course enhances efficiency to the benefit of Provet’s profitability.

In addition to pharmaceutical products, Provet also provides management services to veterinary practices. These include inventory management, electronic ordering and training services, which are incorporated into Information Technology, and Training and Consulting business segments.

The value-add services that Provet provides its customers are a key point of difference from its competitors. This not only draws veterinary practices to Provet in the first instance, but also makes its customers less inclined to use alternative suppliers simply because Provet is more integrated into their business. This is particularly so for those customers which use the electronic ordering system.

The veterinary supply market currently generates sales of about $500 million in Australia and $120 million in New Zealand. The broader animal health market, which includes retail products currently sold by the likes of Petbarn is much larger, at about $5 billion in Australia alone.

Provet’s only other nationwide competitors are Lyppard which controls about 27% of the market and Cenvet with about 17%. Acquisitions have been a core component of Provet’s growth strategy in the past and there’s little doubt that management would like to add Lyppard or Cenvet to the list of conquests.

We would expect Lyppard to be a little too large for Provet to slip it past the ACCC, but an acquisition of Cenvet on the other hand is probably achievable. If Provet does make a significant acquisition we would not be surprised if Cenvet was the target.

IPO

Although Provet has been in existence for almost three decades, the company was privately owned until its ASX debut in March this year. The listing wasn’t a standard IPO (Initial Public Offering) in that new shareholders only accounted for 2.16% of the post-IPO share capital.

Rather, the company’s listing was associated to the sale of a 19.90% stake to private equity company LCW. This left the existing shareholders with 62.23% and the directors with 15.71%.

The IPO was therefore essentially a “compliance listing”, whereby a company lists on a particular stock exchange without raising significant capital. The listing is simply designed to provide liquidity to enable the existing shareholders to sell their shares should they choose to do so. The listing should also enhance Provet’s value as its secondary market becomes more liquid.

The equity raising provided Provet with $14.3 million net of costs, which management used in part to pay down debt and bolster the coffers ahead of a possible acquisition in the future.

Financials

Provet’s sales and earnings profile over the last decade has been quite phenomenal. The company’s sales have grown annually from $69.1 million in 2000 to $282.7 million in the year to 30 June 2010. The company’s bottom line earnings have expanded from $1.3 million to $6.7 million during that same period.

Management has not allowed additional costs to creep into the business as Provet has grown. This is shown by the expansion of the company’s net margin from 1.8% in 2000 to 2.4% in 2010. There has been some variability through the preceding years, with the best result of 3% achieved in 2006. This was however due to a number of abnormal items including an asset sale and foreign exchange gain, rather than an unsustained spike in operational performance.

Provet’s balance sheet leaves little cause for concern. Net debt to equity stood at just 3.1% as at 30 June 2010, while operating earnings covered the interest expense by a more than comfortable 20.8 times. The balance sheet de-geared substantially from last year’s net debt to equity of 42.9% following the capital inflow from the IPO. The fresh capital contributed to the boost in Provet’s equity base from $39 million to $60.5 million, while also facilitating the repayment of $9.5 million of debt.

Management

A key qualitative factor that can often be over-looked when analysis focuses on the numbers alone is the calibre of management. Provet is not found wanting in this regard. Chief Executive Officer Nigel Nichols is a Vet by trade and therefore intimately understands the needs and wants of his customers. Mr Nicholls was appointed CEO in 2005 after serving as a non-executive director since 1995.

As one might expect, Chief Financial Officer Chris Lowndes does not have a veterinary background having gained his accounting charter at PWC in the early 1990s. He subsequently took on various senior financial management positions from 1998.

Chief Operating Officer Joe Best is similarly not a Vet, but has worked in the industry for many years, starting with Veterinary Medical and Surgical in 1982. This company was subsequently acquired by Provet in 1995. Mr Best has also served as both the Director and Vice President of the Veterinary Manufacturers and Distributors Association. So to say that he has a good understanding of the industry would be quite an understatement.

Valuation and Summary

The stock went “ex” a 6 cents per share dividend today, which is scheduled to be paid next month. This takes the full year dividend payment to 8 cents, equating to a historical yield of around 5.4%. Given Provet’s earnings growth profile we would not expect to see the dividend cut next year and annual increases of 1 cent are possible.

At a market capitalisation of around $64 million, Provet’s historical price to earnings ratio is around 9.5 times. The ratio looks even better when one considers the company’s ongoing growth potential. The lack of liquidity in the stock does justify a lower valuation than would otherwise be the case, but Provet remains attractive even considering this factor.

We are initiating coverage of Provet with a buy recommendation, but repeat the caveat that Members will need to exercise patience when buying and selling the stock.