Boring Portfolio

More on VCA
Looks Interesting

by Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (May 5, 1999) -- On Monday, we started to look at Veterinary Centers of America (Nasdaq: VCAI) and I got some great comments from veterinarians who read the piece. I was musing on pricing strategies, and the people who checked in set me straight on the way you price your services. The sweet spot in the industry is the price insensitive customer. That is, they'll bring in their pet for care whether you price your services at 2x the base price or 0.7x the base price. In other words, unless you're St. Francis of Assisi, you've got pricing power in this business.

If a person will pay "x" in year 1, then they're likely to pay 1.05x in year 2, 1.1025x in year 3, 1.158x in year 4, and so on. Sort of like a monopoly in newspapers or network TV in the 1950s, you have an annuity here with increasing coupons IF the demand inelasticity stays in force. A simple model (this links to a spreadsheet download) should illustrate this.

In 1998, VCA had operating income of $38.834 million. Tax that at 40% and then add back amortization of goodwill but not amortization of non-compete clauses. That works out to net operating income after tax (NOPAT) of $29.65 million in the base year. Now, assume that the patient population never expands or contracts, and assume no operating leverage in the business model, e.g., if revenues expand 5% per year, then so does NOPAT.

The 5% represents just a working number. (I'd like to look into this some more and get some more feedback from you on the Boring message board, if I could.) 5% represents the yearly pricing power that may exist in this business. If you don't expand invested capital and NOPAT goes up at 5% per year off the company's current $29.65 million NOPAT base, then the net present value of those cash flows, capping the terminal NOPAT at 10% in year 46, is $531.3 million. Deducting debt, the company would be worth $16.93 per share.

That assumes the patient base never grows, which I'm sort of dubious about. First, you've got natural population growth in the country. Then you're dealing with an aging population. I've heard some anecdotal evidence that people don't replace the family pet once the kids have moved off to school, but that really hasn't been my personal experience. I think people are getting to realize that pets are excellent therapy for senior citizens, as well. An active couple at 60 might not want a pet, but that might be a different story altogether at 70 years of age. Again, we can look into these trends.

Financially, though, the inelastic demand component to the company is pretty interesting. If VCA doesn't scare away its customers and valued employees with heavy-handed big-company management techniques, then you can pretty much count on the annuity stream increasing in value each year at a rate faster than general inflation.

Right now the company is not meeting its cost of capital, though. Return on invested capital is slightly above 5%. Enterprise value is around $466.95 million, at $14 per share, while invested capital is about $428.8 million, adding back amortized goodwill (which represents deployed equity and thus should never be written off, in my opinion), marking up some unrecorded goodwill from the Pets' Rx pooling, and adding back a little bit of written-off goodwill. Since the company is underperforming its cost of capital by a good deal and it's selling at a small premium of enterprise value to invested capital, the market obviously is discounting the company beating its cost of capital and making up the opportunity costs that it's currently losing. So, looking at the impounded assumptions in the share price, we could make the guess that the market holds to some extent the same thesis we do.

Here's the thing. We don't like roll-ups. I don't. Any management that thinks equity is free is off its rocker. I don't think this management team does, but I'll say this: there are a heck of a lot of managements that do think that. Why else is the financial landscape riddled with the corpses of so many roll-ups? If this company is serious about bringing value to the customer and adding to the value of the substantial goodwill on the balance sheet, then this company makes sense. I don't have a problem with goodwill at all, by the way.

From the 1934 edition of Security Analysis, Ben Graham had a short comment on the issue:

"It may be pointed out that under modern conditions, the so-called 'intangibles,' e.g., good-will, or even a highly efficient organization, are every whit as real from a dollars-and-cents standpoint as are buildings and machinery. Earnings based on these intangibles may be even less vulnerable to competition than those which require only a cash investment in productive facilities. Furthermore, when conditions are favorable the enterprise with the relatively small capital investment is likely to show a more rapid rate of growth. Ordinarily it can expand its sales and profits at slight expense and therefore more rapidly and profitably for its stockholders than a business requiring a large plant investment per dollar of sales."

I love that passage. It just flies in the face of the extreme Graham and Dodd zealots. (Random thought: Marty Whitman's new book is so WEIRD. Not that he's a Graham & Dodd guy -- I can't figure out what he is, actually). Anyway, I think this project is worthy of further investigation. I'd like to get some more input by talking with the company, visiting the properties, and finding out more about the way things are done. The financial modeling is really the last step, but there are issues that point to upside that I don't identify in the calculation of intrinsic value above. That's just a very simple annuity model.

By the way, Yi-Hsin Chang (TMF Puck) just got back from the Berkshire Hathaway (NYSE: BRK.A) annual meeting and has just filed another report to our 1999 collection. Plus, next week we'll have our interview with Robert Hagstrom, author of The Warren Buffett Portfolio and manager of Legg Mason Focus Trust. Yi-Hsin and I had a great talk with Robert last Friday, and since we're so packed this week with stuff, we're publishing it next week when more people will get to see it. I think the book is a very important contribution to investing literature, and I think you will enjoy the interview.

Have a good Wednesday night -- hope to see you on the Boring message board.

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05/05/99 Close
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    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96    110.97   363.23%
  8/13/96  200 Carlisle C    26.32     49.00    86.14%
  4/20/99  230 American P    28.95     33.25    14.84%
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   2/9/99  100 Gateway 20    72.38     66.63    -7.94%

    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  24967.97 $19577.98
  8/13/96  200 Carlisle C  5264.99   9800.00  $4535.01
 12/31/98    8 Berkshire  17952.00  19960.00  $2008.00
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