Unleashing PetHealth's Hidden Value

| About: Pethealth, Inc. (PTHLF)

PetHealth (OTC:PTHLF), a Toronto-based company also listed as PTZ.TO, is in the nascent stages of its growth opportunity. The combination of steady growth in PetHealth's capital-light pet health insurance business, the accelerating growth in PetHealth's non-insurance businesses, and the powerful operating leverage provide for a highly asymmetrical risk/reward profile. Pethealth trades at an EV/ 2012E adjusted EBITDA of 3.3-4x and 5-6x 2012E free cash flow based on its current 34M enterprise value. These valuations are incredibly cheap given the characteristics of the business combined with a long runway for growth.

Business Description

PetHealth is a leading provider of pet-related services and products in North America with a small presence in the UK. Despite the small size of the company, PetHealth is diversified across many business lines. Beginning with its proprietary cloud-based software-as-a-service (SaaS) application, PetPoint, PetHealth provides the PetPoint software to shelters in return for exclusive distribution of their other products through those shelters. Because PetPoint is currently the primary operations management tool in over half of all shelters in North America, PetHealth has a significant competitive advantage for the distribution of their pet insurance, pet tracking microchips, and ancillary data services.

PetHealth's insurance business operates as a full-service agency model (sales, marketing, claims, adjudication, customer service), while relying on an underwriting reinsurer to manage the premiums. PetHealth maintains some exposure to underwriting through a limited profit/loss sharing arrangement.

PetHealth is also the leading wholesaler of pet microchips in North America due to its access to the market through shelters, and its exclusive distribution arrangement with North America's leading chip manufacturer, Allflex. Alongside the microchips is PetHealth's chip database, 24PetWatch.

Both of PetHealth's main components, insurance and microchips, have monopolistic characteristics. While insurance is generally a commodity business, PetHealth has a virtual monopoly on the distribution of insurance via animal shelters. Because animals that come from a shelter are rarely purebred, the animals are often healthier (purebreds are sick more often, due to inbreeding), which leads to much better loss ratios for PetHealth. As for the microchips, they are the largest pet microchip company in North America, once again thanks to their exclusive distribution through shelters. Additionally, combining its PetPoint data, insurance subscribers, and microchip database, PetHealth has records on over 11 M pets and/or pet owners. This company is clearly well positioned to continue growing and increasing revenue.

Business History

Pethealth was founded in 1998 and became publicly traded in 2001. Founder and CEO Mark Warren saw an incredible opportunity in the Pet industry and began raising money to capitalize on the opportunity. Mark has executed very well, is intelligent, conservative in nature, and hungry to win. Thus far he has succeeded, Pethealth was honored several times on a list of Profit 100's fastest growing businesses in Canada.

In 2010, Pethealth changed its strategy for marketing its insurance to new animal owners at the shelter. Previously they gave a free month of insurance coverage to all owners, and they recognized the revenue and a marketing expense in each month. They changed this to offering all adopters a free month of insurance, which forced the adopter to confirm with their email. This change created a short-term drop in insurance revenue growth, despite having a positive long-term impact on the business.

In its microchip business, PetHealth recently renegotiated its contract with their supplier, Allflex. They secured exclusive distribution rights to Allflex's newest technology, a new microchip about 1/3rd the size of current microchips, as well as lowered cost from Allflex. The new microchip is designed to be easier to inject in kittens and puppies. In addition, the business has been growing strongly as chips are becoming smaller, cheaper, and more popular to use. In fact, this segment of PetHealth announced 47% YOY growth in the month of February.

Valuation

Looking forward, PetHealth could see its revenue base double and EBITDA triple over the next 3 to 4 years. Today, the company's shares appear undervalued due to a combination of weak revenue metrics (because of a marketing change), low liquidity (it's closely held by insiders and a few long-time investors), and complex structure (several business segments relative to the size of the company). On the last point, it appears that there are a limited number of investors willing to undertake the analysis several different businesses inside a company with a market cap and revenue base of less than $50M. Yet they are missing out, as PetHealth's growth profile is incredibly robust while the overwhelming majority of the associated commercialization expenses are in the past, evidenced by their guidance for decreased capex going forward.

Looking at recent data for Q3 & Q4 2011, underlying, organic growth in the insurance business resumed (slow and steady-and partially obscured by the negative currency impact), and the business is showing strong profitability. The non-insurance businesses continue to grow strongly, (32% yoy in Q4) and non-insurance became cash flow positive for the first time in Q4. Consolidated revenue grew 12% yoy and consolidated EBITDA grew +43% in Q4, and we expect continued strong growth in 2012.

In 2012, PetHealth could generate $8-$10M in EBITDA and $6-$7M in FCF. Conceivably, the company could have $10-$12M in cash on its balance sheet at year-end 2012 and $8-$10M in EBITDA. It is very reasonable for a business of this caliber to trade at 8-10x ebitda, which would result in a $75-100mm enterprise value. All this in a growing industry garnering increased attention from investors. Management is credible, highly invested, and focused on long-term success. We suspect the company will explore opportunities to deploy what could be a meaningful cash position later this year.

My 2-3 year model that suggests a valuation in the range of $5-$6/share is likely based on a current intrinsic value of ~$2.50/share with anticipated growth.

There are a number of potential paths to much more aggressive numbers:

  1. The Petango Store could become a major prescription fulfillment or online pet products business
  2. The data business could grow to $5-$10M in annual sales versus the $2-3M anticipated over the next 2-4 years
  3. The microchip business could see years of consistent 15-20% growth
  4. PetHealth successfully acquires its way into growing either side of its business, or expands its business
  5. Major deal on data licensing

If any of these or a combination of these positive scenarios occur, there are paths forward to a revenue, and EBITDA base substantially in excess of that contemplated in this write-up and therefore a substantially higher stock price.

Revenue

2008

2009

2010

2011

2012E

2013E

2014E

Insurance

21

28

23

22

23

25

28

Non-insurance

6

7

9

11

16

23

28

Total

27

35

32

33

39

48

56

EBITDA (adj)

Insurance

5.3

8.2

6.2

5.9

6.6

7.2

8.0

Non-insurance

(1.8)

(2.5)

(2.5)

(.4)

2.5

5

7

Total

3.5

5.8

3.7

5.4

9.1

12.2

15

Capex

.5

1.3

1.5

2.5

1.8

1.5

1

FCF

3

4.5

2.2

2.9

7.3

10.7

14

Hidden Value

There are several aspects of value in PetHealth that are not immediately apparent, because they have not yet been realized. However, these hidden values show that PetHealth is far from a stagnant company, and there are many ways for PetHealth to continue growing.

The first opportunity is for them to monetize the database of 5M current subscribers and the additional 1M adoptions coming in every year. What would a large corporation pay to get in touch with 1M new adopted pets every year? There are three main groups that would be interested: food companies (Purina, Hills), pet pharmaceutical companies (Merck (NYSE:MRK)), and retailers (PetSmart (NASDAQ:PETM), Petco). Even if PetHealth charges only $1/adoption, that would lead to $1M in revenues from each of these groups at a 90%+ gross margin.

The second opportunity to realize additional value is through monetizing the database of microchip information for animal owners. When an animal is adopted, they are injected with PetHealth's microchip, which is then put onto PetHealth's database. While it is not mandatory to sign up in order to get your pet's information, PetHealth is charging $50 for access to this database. Even if we only assume 2% of owners sign up for this, that is an additional $1M of revenue at 90%+ gross margins (it will essentially all fall to the bottom line).

PetPoint software is a growing SAAS business with 1,750 clients. What would one pay for this? Let's assume they can charge $200/month for this software to the majority of these clients. If they lose a small percentage (assume they keep 1,500), that is $3.6M/year in revenue generated. SAAS businesses have been getting taken out around 5x sales, so this is a potential hidden value of $15M+. I am approximating the numbers here, but we have already seen this as a possibility since PetPoint is developing an "enterprise level" software that is more sophisticated which they will start charging for.

Petango.com is an online pet adoption website providing consumers with the ability to search or browse a database of adoptable pets. The competitive advantage held by Petango is that the pet data is fed directly from the PetPoint database and is updated in real time with no manual intervention. This stands in contrast to other adoption sites where a manual upload/update process is largely run by volunteers and the completeness and timeliness of the data can be questionable. This provides a substantial competitive advantage over Petfinder.com, who has over 75% market share and was bought out for around $35M in 2007. While Petango is certainly not worth $35M today, we believe it can take share over time, and Petfinder.com gives a proxy for what being a market leader in the adoptable search business is worth.

The combination of the PetPoint software used in over 1,700 shelters and used to process nearly 1M adoptions in 2011, the microchip database of over 5M subscribers and its insurance business combine to hold records on over 11M pets and/or their owners. The business potential of the data and services side of PetHealth's operations is nascent today with the opportunity to be commercialized with powerful results.

As adoption becomes an increasingly popular choice for those getting pets, PetHealth is well positioned to grow. In addition, the non-insurance side of the business is priced to grow rapidly in several different verticals. You are getting all this at less than 4x 2012 ebitda with a proven CEO at the helm who has grown this business impressively over the past decade.

Disclosure: I am long PTZ.TO.