Stockwatch: A 'buy' signal, or screaming 'sell'

Does a drop in the AIM-listed shares of £700 million veterinary services group CVS Group merit buying into? Or is a softer trading statement, followed by a placing to prop up the show, more likely a 'sell' signal?

There's also a wider question about whether a plethora of "buy-to-build" groups now reflect risks similar to the late 1980s when acquisitions were in vogue. Most analysts say the 1987 stockmarket crash did not reflect the real economy; it was down to "portfolio insurance"trading. But it was also a timely reaction against 1980s excesses, which caused plenty of over-stretched companies to fall apart come the early 1990s recession.

True, accounting reforms have closed some loopholes encouraging aggressive practice, and non-executive chairmen counter a focus of power in CEOs. But there's a similarity in the way balance sheets show strain and highly-valued stocks are exposed to any slowdown in the underlying business. This time around, interest rates have been much lower and for longer, guaranteeing pain when they do rise, given corporate/personal debt levels are higher even than 2007.

Specifically, regarding CVS Group, it appears dependent on acquisitions, at least to deliver anywhere near the growth rates investors look for.

When "buy-to-build" works, and eventually doesn't

The modern aim is typically to "rationalise a fragmented industry", achieving economies of scale from buying inputs for example, hence avoiding the risks of over-stretched conglomerates. "Focused diversification" has, however, met its own strains recently, with outsourcers feeling the pressure of government spending and FTSE 250-listed Dignity becoming complacent towards online rivals.

On the face of it, there isn't a lot of benefit to sweeping vets' practices into a listed group. Pet-owners appreciate quality of care, more likely seen to derive from a private clinic than a plc. CVS has introduced cross-selling of pet insurance, food, drugs and even funerals, though, in due respect, it operates seven referral centres across the UK - hospitals offering top-quality care - a competitive advantage.

But the biggest financial driver is exploiting a valuation gap on which it can acquire vet practices - in recent years, on about 8 times annual cash flow up to 10 times currently -helped by relatively cheap long-term debt and, more recently, share placings. While the latest one at 1,075p was a discount to recent market prices, it represents 23 times projected earnings for the year to June 2018, assuming they do double (see table).

Management cites a £40 million pipeline of acquisitions and, indeed, the music could continue a few more years given CVS's modest 14% share of the UK small animals' veterinary market.

Attractions in acquiring vet practices

Pre-1999, vets had to own their practices, but de-regulation has seen the emergence of corporate buying. There is inherent motivation to sell out for a lump sum: while vets can earn decent salaries, it's far less easy to sell/pass on the business - younger vets nowadays loaded with student/mortgage debt and vets' offspring may be seeking a fresh career.

Secondly, vet practices ought to offer relatively good quality earnings. Pet owners often want the best for their animals; supposedly a third of British people are in single households, likewise older people may appreciate the company that pets offer. Animal shelters do tend to report influxes during hard times, but checking CVS's annual reports over 2008-10 the group's organic progress was good.

Disappointment last November

The AGM was told of July to October total sales up 20.6% (after acquisitions) but like-for-like up only 4.3%, "reflecting greater general uncertainty in the UK economy and some shortage of clinicians in the UK." Like-for-like sales were only 1.5% without the contribution from Animed Direct, the UK's biggest online seller of drugs which is high-growth albeit low-margin. CVS plans to attract more clinicians by raising salaries, hence prices, which assumes overall demand proves sticky. Time will tell.

The stock thus fell 44% from its 2017 high, to 830p, as classic "ex-growth" fears deflated a forward price/earnings (PE) ratio near 32 times. The latest £60 million placing at 1,075p bolsters prospects, but CVS's financial balancing act will get trickier if Brexit and inflation/interest rates hurt consumers. Should underlying trading continue to lack vigour, the stock is exposed to drop again, a prospective yield of 0.5% offering no prop.

In fairness, the placings are relatively recent

CVS has evolved progressively: founded in 1999 and floated in 2007 at 205p, its shares rising seven-fold by last November. In due respect, high prices relate also to a modest 64.1 million shares issued, a healthy sign affirming strong cash flow profile (see table) and mitigating the need to issue shares for development, at least until the acquisitions rate has quickened. At end-2016, £30 million was raised via a placing at £10 a share.

The market has lapped up the story, a positive bias in its stock reflected by an annual average historic PE well over 50 times (see table). Fine, so long as the music continues.

Last Friday's interims reported earnings per share (EPS) down 25% to 7.8p due to intangible assets amortisation, deferred considerations and costs of acquisitions, weighing. Writing back amortisation, however, operational cash flow rose 37% to £26.5 million. A dichotomy of "normalised versus reported" earnings tends to get tolerated for so long as an acquirer's story is overall strong. If not, then this can also weigh on sentiment.

As vets realise they are in demand and practices get dearer, CVS is diversifying into equine treatment where there is lower competition to buy practices, also into the Netherlands.

Beware balance sheet issues

At end-2017, intangibles represented 203% of net assets, quite inevitable anyway for an acquirer of "people businesses". I'm more concerned by a lack of explanation in the accounts, where trade payables (money owed to suppliers etc) exceed trade receivables (money due in) by £20 million or 58%. Thus, despite cash-at-bank rising to £10.3 million, the company's debtors can't promptly be settled. Such an acid test may be harsh but begs the question also whether profits are being enhanced by delayed payments.

By way of comparison at Carillion, its end-June 2017 trade payables were 69% in excess of receivables, and suppliers complained bitterly about 120 days payment practices once the company entered liquidation. Not to suggest CVS is built on sand, rather that all companies should justify such a material imbalance, in notes to the accounts.

Of £127 million debt at end-2017, 97% was long-term, the £1.7 million interest charge clipping 21% off operating profit. There was also a £200,000 "amortisation of debt arrangement fee" within £1.9 million interim finance expenses. Deferred income tax liabilities edged up 8% to £16.6 million. Thus, a placing looks as if it was prudent anyway, to bolster finances.

Potentially more a'short' than a'long'

Call me cautious, but I think all this adds up to investors reckoning CVS shares have had their best run. If the UK economy doesn't weaken, then spending on pets and further acquisitions may prop up the show, but the market will see through this if like-for-like trading remains stalled.

Yes, the chairman bought £91,150 worth of shares last December at 911.5p, taking his holding to 110,000 shares, but in a mass of detail on the 1,075p placing, it's not clear if any directors/managers bought at all.

I would not touch CVS until at least another update, and despite no disclosed short positions, it's one to watch for further downside if Brexit and interest rates disrupt consumer spending. Avoid.

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