In March, we wrote an article outlining why Covetrus (CVET) may be severely unappreciated and undervalued by the market. Since then, it has delayed an earnings report, which caused the stock to plummet. We were worried at that time that the delayed reporting was a sign of something bad to come, but our fears were allayed after seeing the report, which shows continued execution and increases our conviction.
Q1: An update
At first glance, Covetrus's results aren't impressive - it reported a slight revenue decline YOY. However, this includes several strong one-time headwinds that depressed results. Most notably, FX affected overall growth by 4%. Overall organic growth on a constant-currency basis would've been 3%.
In North America, rebate classification reduced growth by 1%; in APAC, a lost manufacturer relationship reduced growth by 10%; and many other region-specific headwinds further depressed results. Without these one-time items, growth would likely be much higher.
Despite the disappointing revenue growth, other KPIs performed very well. Enrollments on Covetrus's prescription management technology increased by 18% YOY, and comparable store partner sales increased 22% YOY. This is great for the company. If its customers are doing well and increasing in numbers, Covetrus stands to benefit significantly as it collects fees from its customers.
Vets First Choice revenues increased over 51% YOY when normalized. Although Vets First Choice is currently unprofitable, its growth is quite impressive and will likely be a huge driver of the company's future revenue growth.
Profitability also looked very underwhelming. Adjusted net income was only $13mil for Q1. However, the profitability of the main business was dragged down due to Vets First Choice, which is a fast growing but unprofitable company. It did not help that synergy capture projected by management is expected to be mostly in the back half of the year due to seasonality.
Overall, although earnings were disappointing, we are hopeful about future earnings growth as management was very optimistic regarding future earnings growth, which we'll discuss below.
Covetrus's future looks quite bright. Management mentioned that it plans to expand Vets First Choice to multiple new geographies, which it believes is a huge opportunity.
Again the launch of Vets First Choice in APAC and Emerging Markets is a high priority and a really compelling opportunity long term. - Q1 earnings call
Another highlight is that Covetrus plans to enroll 3,000 new veterinarian practices this year. This is twice the growth rate that it experienced in 2018, and we believe this is a sign that management is extremely optimistic about long-term revenue growth.
Profitability is likely to improve substantially as well going forward.
Management expects adjusted EBITDA of $250-300mil in 2019, or 10% growth from 2018 levels. Future adjusted EBITDA growth is likely to be driven by synergy capture, which management believes could reach $100mil in three years. Doing the calculations, that would mean Covetrus could get up to $320mil in adjusted EBITDA by 2022, which would represent over 10% growth YOY assuming there is zero revenue growth.
As revenue growth is expected to improve as witnessed by these recent sales trends at the end of Q1 and starting in Q2, we see improved EBITDA off the Q1 level with a further step-up in the second half of the year as our recent investments in innovation start to scale. - Q1 earnings call
Balance sheet remains strong
Covetrus's balance sheet and liquidity continue to be quite strong after the spinoff, as most of its long-term debt isn't due for five more years. The current ratio remains around 2, and management has stated plans to deleverage over the long term by using over $50mil of non-GAAP free cash flow generated this year. Overall, the balance sheet should be strong enough to help support growth plans.
Although the company looks like it's valued highly for a business with little earnings and little revenue growth, both of these items are slated to increase significantly going forward.
Seeing that Covetrus has a subscription type offering, we believe it should trade at multiples of peers like Cerner (NASDAQ:CERN). Its long-run revenue growth is likely to be greater than Cerner's due to its small size, but to be conservative, we'll use Cerner's multiple. If Covetrus trades at Cerner's P/S multiple, it should trade at around 4x sales, or $3.6bil.
An investment in Covetrus doesn't have many risks. The company's high switching costs and economies of scale mean that most customers are likely to stick with Covetrus, especially as it is the market leader in the US and is extremely beneficial to its customers (As shown from 22% same-store sales increase mentioned earlier).
We believe the main risk for Covetrus is bad execution. With bad execution, a lot of shareholder value can be destroyed, especially since CVET is still a small company with such a large market to tap.
Covetrus is executing well so far. Management has given fairly optimistic guidance, and we're confident that revenue growth should accelerate in the next few years as Covetrus upsells to customers and continues to build the customer base. As it moves towards maturity, CVET should get more profitable as well. Overall, Covetrus seems undervalued now.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.