OurPet's: A Tempting Adoption Target

|
About: OurPet's Company (OPCO), Includes: AMZN, WMT
by: William Matson, CFA
Summary

Strong focus on development of proprietary non-food pet products - pet products companies with non-food exposure have been popular takeover targets in recent years.

Solid revenue and profitability growth at a 14.6x P/E – YOY sales and operating income growth of 13.7% and 30.1%, respectively, for quarter ended 6/30/17 (2Q17).

Extraordinary YOY 2Q17 growth in e-commerce (77.5%) and international sales (55%).

Current 2.9x price/book value is based on sub-$1 million GAAP valuation of intellectual property (less than 10% of total book value).

OurPet’s fits well with Amazon strategy of increasing vertical integration, proprietary branding, consumer data generation, and focus on affluent markets.

Focused on development of proprietary non-food pet products, not commodities

75% of OurPet’s (OTCQX: OTCQX:OPCO) revenues are generated by products covered by OPCO patents, 170 of which are either issued or pending.

Aside from allowing OPCO to enjoy higher margins than would otherwise be the case, its proprietary products and underlying intellectual property serve to discourage competition in a variety of significant niche markets. Examples of these benefits include:

- the Play-N-Squeak toy for cats, which is covered by OPCO’s patent for a “simulated mouse toy having a prerecorded sound chip.” An action based on this patent ultimately resulted in the competing Prowlin’ Mouse cat toy being withdrawn from the market.

- Durapet pet feeder and water bowls, whose patented technology “relates to non-skid material permanently bonded to the base of metal pet bowls.” The company has successfully enforced this patent against a variety of competitors, and it began licensing the technology to at least six other companies in 2016.

- the MetalShield method for “electrically depositing metals such as chrome on special plastic.” Among its features are its luxurious finish, chip resistance, being dishwasher safe, being inhospitable to bacteria, avoidance of toxic chemical release when exposed to food, and enabling of elaborate designs.

- Switchgrass Natural Cat Litter with BioChar, which can “convert animal feces into an odor-free fertilizer in less than a minute.” This product was developed in partnership with Israel-based Paulee Cleantec.

- the SmartScoop “intelligent litter box,” which uses Bluetooth technology in automating the litter scooping task. It senses when a pet exits the box and then waits 15 minutes for the litter to fully clump before scooping the litter. This saves pet owners time, as well as reducing odors. In addition, the SmartScoop system includes an app which monitors and records pets’ elimination behaviors. This data may then be forwarded to veterinarians and allow early detection of health issues such as diabetes.

The SmartScoop is just one example of OurPet’s use of Bluetooth/Wi-Fi technology to improve connectivity between humans and pets. Other applications include automated processes for providing pets with food at designated times, as well as monitoring of pets’ eating and drinking behaviors for preventive health care purposes. Use of OPCO’s SmartLink Tag allows the company’s intelligent litter box, pet feeder, and pet water systems to distinguish between animals in households with multiple pets.

Growth at a reasonable price

Sales and profitability growth has been accelerating recently. YOY revenue and operating income growth for the quarter ended 3/31/17 (1Q17) were 5.8% and 15.8%, respectively. For the quarter ended 6/30/17 (2Q17), these YOY figures were, again respectively, 13.7% and 30.1%. Despite expectations of 4% annual growth in pet industry revenues through 2020 and little reason to believe that OurPet’s will not – at the very least – match the industry growth rate, its P/E multiple is, again, only 14.6x.

Supporting the thesis that OPCO’s growth will be sustained at or above the industry growth rate are vast areas of untapped market potential, both online and internationally. The company’s e-commerce effort, which now accounts for 16% of revenues (roughly $1,000,000), has made extraordinary progress of late, with 2Q17 revenues up 77.5% YOY (an increase of about $437,000).

Meanwhile, only 10.5% of OPCO’s revenues ($648,000) were derived from outside the U.S. during 2Q17, a 55% YOY increase. Given that the great majority of the company’s products are non-perishable and are otherwise suitable for shipment to a worldwide market, non-U.S. customers are likely to account for a growing share of OPCO’s future sales.

Significantly, its non-skid pet bowl technology has recently begun generating revenues through licensing to a small number of non-U.S. companies. In addition to whatever revenue contributions may result, this development suggests that OPCO’s trove of intellectual property may well be monetized through similar licensing deals to an increasing extent in the future.

Moreover, it’s not hard to imagine the company’s proprietary technologies being applied in markets other than pet care. Of particular interest are its advances in bonding plastics to metal and vice versa, as in its non-skid and MetalShield innovations.

OPCO investors also get their money’s worth in terms of quality assets. The company’s price to book value ratio is a modest 2.9x and would be significantly lower if its GAAP balance sheet reflected the true economic value of its intangible assets. The company’s intangibles, which include OPCO’s extensive patent holdings, are carried at less than $1 million, well under 10% of total stockholders’ equity.

Takeover possibilities

OurPet’s is, arguably, the last remaining pure play, non-food-focused, publicly traded pet products company based in North America. As such, it is a potentially inviting acquisition target for a variety of strategic buyers.

Businesses with significant involvement in non-food pet products have been popular takeover targets in recent years.

Examples include:

2017

Chewy – acquired in 2017 by PetSmart

PetCoach – acquired in 2017 by Petco

2016

Dog-a-holics - acquired in 2016 by Bentley’s Pet Stuff

IT’S A PETS LIFE - acquired in 2016 by Bentley’s Pet Stuff

The Pet Outpost - acquired in 2016 by Bentley’s Pet Stuff

2015

Animal Health International – acquired in 2015 by Patterson Companies

Bionic - acquired in 2015 by Outward Hound

Dallas Manufacturing Company – acquired in 2015 by Central Garden & Pet

Petco – acquired in 2015 by CVC Capital Partners and Canadian Pension Plan Investment Board, having previously been acquired in 2005 by TPG Capital and Leonard Green & Partners

Petstages – acquired in 2015 by Outward Hound

2014

Drs, Foster & Smith – acquired in 2014 by Petco

Pet360 - acquired in 2014 by PetSmart

PetSmart – acquired in 2014 by private equity investor syndicate

Though Amazon (NASDAQ: AMZN) has yet to follow the lead of PetSmart and Petco by acquiring a pet products business, an Amazon buyout of OPCO would be consistent with its growing interest in vertical integration. According to a recent Forbes article, Amazon now “offers private brand products for everything from batteries to baby wipes and diapers,” its rationale being that “private and exclusive brands create a reason for the consumer to buy through Amazon as opposed to going elsewhere.”

In addition, Amazon’s marketing efforts are largely data driven and would benefit from access to data regarding pet owners’ buying habits with respect to consumable non-food pet items such as OPCO’s cat litter and chew toys. In this case, the data would allow Amazon to be more precise in timing its sales offers to coincide with consumers’ need to buy more of these items. And, of course, once Amazon has its figurative foot in the door, it has an opportunity to upsell consumers on additional products in its vast array of SKU’s, pet-related and otherwise.

It also bears mention that OPCO is no stranger to Amazon, which has been a major beneficiary of OurPet’s rapidly growing e-commerce revenues. As the Forbes article points out, the Whole Foods acquisition was motivated to a significant extent by an opportunity to upsell the affluent Whole Foods customer base. Amazon’s data most likely indicates that those who are paying $24.99 for a 10 pound bag of cat litter or over $100 for an “intelligent litter box” are similarly affluent.

Nor should Walmart (NYSE: WMT) be overlooked as a potential suitor, inasmuch as significant amounts of OurPet’s products have been sold both through Walmart stores and via Walmart.com. Though the synergies immediately available to Walmart through an OPCO acquisition are less compelling than those achievable by Amazon, such a move by Walmart could be seen as a sensible defensive maneuver to prevent Amazon from gaining an upper hand in yet another product category. It’s important to recognize the potential ripple effect on Walmart from losing ground to Amazon in its pet supply business. Losing sales in this area to Amazon also means losing sales of products in seemingly unrelated categories, due to the upselling opportunities that would come Amazon’s way at Walmart’s expense.

Note, however, that as of 6/30/17, insiders owned 29% of OPCO (5.84 million out of 20.15 million shares, assuming conversion of preferred shares), with CEO Dr. Steven Tsengas and his family holding well over 4.7 million shares. Thus, any acquisition of OPCO would likely need to be undertaken on friendly terms, especially given the critical importance of Dr. Tsengas and his son to the company's R&D efforts.

I have no inside knowledge as to how amenable the Tsengas family might be to a takeover. My suspicion, however, is that combination with a much larger suitor – such as an Amazon, PetSmart, Petco or Walmart – might be attractive to them. This could give Dr. Tsengas and his son the ability to focus on developing new products and technologies, as well as more resources with which to finance rapid growth, leverage the innovations they develop, and make these innovations accessible to larger numbers of users.

Target price and associated risks

I believe OPCO should trade at $5.00, based on a forward 12 month EPS estimate of 15 cents and a P/E multiple of 33.

My forward EPS estimate was derived from increasing trailing 12 month EPS of 11.7 cents (as of 6/30/17) by projected earnings growth of between 25% and 30%. This projection, as well as a target P/E multiple of 33 are especially reasonable given that OPCO’s 6/30/17 YOY trailing twelve month net income growth was 83.5% (i.e. from $1,282,258 to $2,353,375).

According to yardeni.com, the Russell 2000 Growth Index currently has a P/E of 33.1. Since OPCO's earnings growth compares favorably to the index, the OPCO target multiple of 33 is, if anything, conservative.

The risks to these targets are significant, but primarily attributable to OPCO's diminutive size and the needs associated with financing its growth. The pet supply marketplace is relatively free of significant slumps in consumer demand, and to the extent that it is affected by major technological change, OurPet's has been an industry leader in this area.

The company's balance sheet is relatively strong, with a current ratio of over 7x. OPCO does, however, require a great deal of cash to support its growth, as its receivables and inventory balances, in total, are roughly equal to six months sales. As of 6/30/17, roughly $2 million in borrowings on its line of credit had been drawn down (secured by receivables and inventory).

In the event that OPCO were unable to either sufficiently expand its borrowings in the future or decrease its receivables/inventory investment relative to sales volume, its ability to grow would likely be adversely affected. As of 6/30/17, though, OPCO's credit line had $3 million in unused borrowing power.

Of greater concern is OPCO’s reliance upon the passion and creative genius of Dr. Tsengas and his son for developing new products. Whereas large companies typically have deep benches of interchangeable technical and management talent ready to step in should a key employee resign or become incapacitated, this is not feasible in companies of OPCO’s size.

Moreover, such companies are far more prone than multi-billion dollar businesses to losing large percentages (if not all) of their value due to adverse developments associated with entry of new competitors, changing consumer tastes, or management missteps.

Despite the sizable company-specific risks that individual microcaps like OPCO entail, though, their average performance as a group has been extraordinary over the years. So long as investors are properly diversified and able to live with volatility, their losses on microcaps that go to zero tend to be far outweighed by those that thrive.

This article is part of Seeking Alpha PRO. PRO members receive exclusive access to Seeking Alpha's best ideas and professional tools to fully leverage the platform.

Disclosure: I am/we are long OPCO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.