By Markos Kaminis There are several reasons why we at Standard & Poor's Equity Research Services like animal health care services provider VCA Antech (WOOF
; recent price, $19.50) and view its shares as attractive for the long term. We believe it possesses characteristics common to successful small-cap growth stories. In our view, VCA offers a viable service that targets a large and attractive market in which it maintains a leadership position. We believe the company has an established and reliable track record of successful growth, which we view as sustainable. These factors should drive long-term growth and VCA's stock, in our opinion.
We think recent concerns over competition, insider sales, and VCA's acquisition of Sound Technologies have provided investors an enhanced buying opportunity. Based on our discounted free cash-flow valuation, we view its shares as attractively priced. The stock carries Standard & Poor's highest investment ranking of 5 STARS, or strong buy.
MORE THAN DIAGNOSTIC TESTING. We believe VCA is the leading animal health-care services company in the world. According to management, the company operates the largest network of veterinary diagnostic laboratories and freestanding, full-service animal hospitals in the U.S. Its network of diagnostic labs provides sophisticated testing and consulting services used by veterinarians in the detection, diagnosis, evaluation, monitoring, treatment, and prevention of diseases and other conditions affecting animals. With the only nationwide veterinary-laboratory network serving all 50 states, VCA provides diagnostic testing for an estimated 14,000 clients, including animal hospitals, large animal practices, universities, and government organizations.
The animal hospitals offer a full range of general medical and surgical services for companion animals, as well as specialized treatments including advanced diagnostic services, internal medicine, oncology, ophthalmology, dermatology, and cardiology. It provides pharmaceutical products and performs a variety of pet-wellness programs, including routine health examinations, diagnostic testing, vaccinations, spaying, neutering, and dental care. VCA's 318 animal hospitals, supported by more than 820 veterinarians, had more than 3.5 million patient visits in 2003.
We believe its target market is large and presents attractive opportunities. According to the company, the U.S. population of companion animals as of 2001 had reached about 214 million, including about 131 million dogs and cats. Industry data indicate that more than $18 billion was spent on animal health-care services in 2001, with an annual growth rate of over 10.6% from 1996 through 2001 for spending on dogs, cats, and birds. The ownership of pets is widespread, with over 58% of U.S. households owning at least one pet.
As technology continues to migrate from the human health-care sector to veterinary medicine, more sophisticated treatments and diagnostic tests are becoming available to treat companion animals. We believe these new and increasingly complex procedures, diagnostic tests, and drugs are gaining wider acceptance as pet owners are exposed to these previously unconsidered treatment programs through literature and marketing programs sponsored by large pharmaceutical and pet-nutrition companies.
LOTS OF LEVERAGE. Unlike the human health-care industry, providers of veterinary services are not dependent on third-party payers to collect fees. As a result, veterinary-services companies don't have the problems of extended payment-collection cycles or pricing pressures from third-party payers faced by human health-care providers. Outsourced laboratory testing is a wholesale business that collects payments directly from animal hospitals, generally on terms requiring payment within 30 days of the date the charge is invoiced. Fees for animal-hospital services are due at the time of service.
Over 95% of VCA's animal-hospital services are paid for in cash or by credit card at the time of service. This has resulted in reliable cash flows. Over the past three years, VCA's bad-debt expense has averaged just 1% of total revenue.
Operating as a leader in a large, yet fragmented, market allows VCA the opportunity to leverage economies of scale as it consolidates small operators. It can better leverage advertising, vs. smaller rivals, and build brand value and customer awareness, in our opinion. The company can also leverage its size when making supply-and-equipment purchases. It can also leverage brand value and technological strengths to differentiate itself to achieve better pricing, if it so desires, or leverage cost advantages to be the low-cost industry provider, in our view.
BROADENING SCOPE. We believe competition finds profitable opportunity, and the increasing presence of VCA rival Banfield, The Pet Hospital is a sign of this situation. However, with a market as large as veterinary care, and one that is significantly fragmented, we believe there is room for two larger players.
During our visit to VCA this year, we gained some insight into management's strategic mindset. We believe the current growth strategy of acquiring veterinary hospitals will continue into the foreseeable future, and we think that makes sense with a large market opportunity still available.
We also believe the operation is seeking to broaden the scope of diagnostic testing by providing a higher level of diagnostic tools and tests. The acquisition of Sound Technologies in October, 2004, exemplifies that effort. Although the deal represents entry into manufacturing, we believe the addition of the technology will strengthen the capabilities of VCA's diagnostic and veterinary hospital businesses by allowing its veterinarians to take an X-ray or ultrasound onsite, and have a specialized technician examine it and provide a diagnosis. In the case of digital radiology, that diagnosis could be performed quickly from another location.
SOARING REVENUE. We forecast 2004 revenue growth of 23%, and 2005 growth of 17%. In the laboratory segment, we expect 12% growth in 2004 to be driven by same-lab growth on increased usage of diagnostic testing by veterinarians. In the animal-hospital segment, we forecast 26% revenue growth, driven by 4.5% same-hospital growth and by acquisitions, including that of National PetCare Centers. In 2005, we expect 11% revenue growth for the laboratory business, driven by same-lab revenue growth on expansion of diagnostic testing across the industry.
For the animal hospital segment in 2005, we look for a 15% revenue increase, absent the impact of the National PetCare Centers purchase from mid-2004, but driven mostly by other acquisitions. We expect same-hospital revenue growth in the low-single digits. The Sound Technologies buy in the fourth quarter should provide a boost to revenues with an immaterial impact on earnings per share in 2004 and a 1-cent increase in 2005.
Our forecast calls for pro-forma gross margins to narrow by 60 basis points in 2004, to 26.9%, reflecting the impact of National PetCare Centers. As the company brings acquired locations toward its own operating model, we see margins widening. For 2005, we see gross margins up 20 basis points. We expect the lab segment to benefit from increased tests per client, and we anticipate pro-forma segment gross margins to widen over time. Our pro forma expectations are the result of the company's alteration of reporting. It is now including depreciation and amortization in direct costs and corporate selling, general, and administrative expenses. We think pro-forma SG&A expenses should decline as a percentage of revenue in 2005, benefiting from economies of scale.
BETTER MARGINS. Despite increased interest expense on greater debt -- although at a lower cost of debt -- we forecast a net operating margin improvement of 20 basis points and EPS growth of 23% in 2004, to 74 cents, excluding charges. In 2005, we expect a 60-basis-point improvement in net margin and EPS growth of 22%, to 90 cents.
Our Standard & Poor's Core EPS estimates are 73 cents for 2004 and 89 cents for 2005. For this year, our projection is adjusted for a gain from a legal settlement and the expected impact of stock options. Our estimate for 2005 is adjusted for the expected impact of stock options.
Our 12-month target price for VCA of $29 is based on a blend of discounted free cash-flow (DCF) valuation and p-e-based metrics. Our DCF model forecasts 11% average annualized free cash-flow growth over 10 years with a terminal growth rate of 4%, and a weighted average cost of capital of 8.5%. Also, based on our view that the current debt-to-capital ratio is not likely to be maintained over the long term and is inappropriate for modeling purposes, our model assumes a target debt-to-capital ratio of 30%. Our DCF model finds intrinsic value for VCA shares at $31.
HUGE UPSIDE. In our view, there is an absence of suitable peers within the company's niche business, so we have not employed an industry relative metric to value the shares. We believe the high end of the p-e ratio range VCA has attained over the recent past is appropriate for a stable growth stock with the company's growth potential. The shares trade at about 27.6 times VCA's trailing 12-month operating EPS of 71 cents. If we apply this multiple to our forward 12-month EPS estimate of 87 cents, we arrive at a value of $24.
However, we believe the stock has been impacted recently by concerns over insider sales, a changing competitive environment, and the purchase of Sound Technologies. We believe VCA will recover following the solid operating performance we anticipate over the next 12 months, and view the multiple of 31 times our forward 12-month EPS estimate achieved earlier this year as reachable again. Applying that multiple to our forward 12-month EPS estimate, we calculate a price of $27. Blending our DCF-based value and our p-e-based metric, we derive our 12-month target price of $29, representing a nearly 50% appreciation opportunity over the coming year.
Risks to our recommendation and target price, in our view, include possible failure to maintain growth levels matching the company's historical rates or meeting our three-year growth projection of 20%. VCA also faces acquisition-integration risks, especially with National PetCare Centers. If margin improvement of acquired operations does not meet our expectations, operating results could fall short of our estimates.
DEBT'S SHADOW. If the synergies we expect from the acquisition of Sound Technologies do not materialize, or if the adoption of ultrasound and digital radiology as diagnostic tools for veterinarians is less than our estimate, earnings could be lower than our view. Any failure in its information-technology systems or disruption to its transportation network (including disruption resulting from terrorist activities) could significantly increase testing turnaround time, reduce production capacity, and otherwise disrupt operations.
Other risks, in our view: Competition in the companion animal health-care services industry could cause VCA to reduce prices or lose market share. The company could experience difficulties hiring skilled veterinarians due to shortages that could disrupt its business. The company's substantial amount of debt, as well as the guarantees of its subsidiaries and the security interests in its assets and those of its subsidiaries, could impair VCA's ability to operate its business effectively -- and may limit its ability to take advantage of business opportunities. Failure to satisfy covenants in its debt instruments would cause a default under those instruments. Analyst Kaminis follows stocks of emerging growth companies for Standard & Poor's Equity Research Services