Boring Portfolio

Where We're Going
With VCA

by Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (May 10, 1999) -- On Wednesday, we talked more about Veterinary Centers of America (Nasdaq: VCAI), pointing out a very simple model that put the company's value at about $16 per share at present. I just wanted to remind readers that there are some assumptions in there that make the model as unrefined as a stalk of raw sugar cane is to a bottle of rum. I just wanted to first illustrate how an annuity with perpetually increasing payments is valued, discounting at an equity market rate of return. I'm not saying this particular model presents a refined way to look at a company, as I explained that the model reflects no operating leverage in the business when there is indeed hefty operating leverage in the business model.

To clarify, operating leverage (distinct from financial leverage) exists where an "X" percent increase in revenues results in a percentage increase in operating income equal to a multiple of that "X" percent. The major variable in determining the value of Veterinary Centers, then, is the pricing power, which allows the company to raise prices at a multiple to increases in the Consumer Price Index (CPI).

I've been collaring people everywhere I go, asking them what they've spent on their pets in the past and what sort of price increases they'd countenance in the future. I've run into virtually no one that says they'd have a problem paying $1.28 five years from now for veterinary care that costs $1 today. At a 5% rate of yearly real increase in prices, that's what it works out to be.

I have to consider, however, that people's reactions to questions of that sort are not reliable data. People regularly answer polls in one way and then act in a contrary manner. Plus, I can't assume this as a condition of competition that holds up. Non-affiliated veterinarians would probably not raise their prices at this rate, and the competitive gulf would widen. Not that customers would leave VCA at the drop of a hat, but if given a reason to do so, it would be much more likely to seek out other providers.

Bottom line, people act in strange ways when it comes to healthcare. Expectations of the level of service in relation to the price paid are, I believe, irrational. That's not something I would want to deal with down the road, and that's something we would have to factor into the model here. Accordingly, we have to figure out what the franchise value is WITHOUT 5% yearly price increases 20 years out. Furthermore, we have to figure out the franchise value without additional acquisitions. It helps to figure out what a company looks like in a steady state before we start to build in additions to the capital base. However, there's no way in the world that you can put a firm value on it without adding in acquisitions. You can look at almost any company in this way, by the way. You look at the annuity value of the present company and then you look at the value of the company with additional investments.

That's kind of what the P/E ratio aspires to, and in general, it's not the worst way to look at a company, but here's the rub with VCA: The company currently does not beat its cost of capital. Indeed, it underperforms it by a wide margin. If you assume that will always be the case, that's not the sort of business you want to get involved with. But the revenue elasticity (I'm expressing this in a different way here -- elasticity exists when a 5% increase in prices results in at least a 5% increase in revenues) over a large fixed cost base is supposed to take care of this. The negative ROIC - WACC (return on invested capital less the weighted average cost of capital) spread is assumed to close at some point and turn positive. If that weren't the case, then the company would always trade at a discount to invested capital, and each addition to invested capital would actually kill value. In case this is sounding foreign, I would recommend reading Bennett Stewart III's The Quest for Value: The EVA Management Guide.

The way we think about things, we don't just discount earnings. We also discount the cost of capital necessary to generate those earnings. So if a company never bears its cost of capital, then it's not going to build shareholder value. I think an EVA model is perfectly suited for this sort of enterprise, actually. It works extremely well in ferreting out the value of a company involved in the consolidation of an industry. Again, though, doing the numbers is pretty simple. The harder part will be in figuring out the issues of whether people will continue to patronize a veterinarian that is limited in the courses of treatment he or she can prescribe, whether vets are really happy with the decision to sell their practices and will think about the company in an entrepreneurial way, and whether this is or is not a PPM (physician practice management) situation. I'm pretty confident that we don't face legislative problems, but it's the customer satisfaction issues that we need to come to grips with.

In short, I'm pretty much hoping to get some input on how people feel about their customer relationship with VCA. If veterinarians have anything to add on these issues, that would be great, too. I'm going to take a field trip to talk with a VCA vet and I'm also hoping to talk to a vet that's not affiliated with VCA. We're open to commentary and welcome it on the Boring Portfolio board 24 hours a day, 7 days a week. Until we've done some more talking with people involved in the situation, we'll conduct further research in the Boring Port board and we'll pick up the issue here again when we have further progress to report.

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05/10/99 Close
Stock Change   Bid
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    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96    109.25   356.05%
  8/13/96  200 Carlisle C    26.32     47.25    79.49%
  4/20/99  230 American P    28.95     33.00    13.98%
 12/31/98    8 Berkshire   2244.00   2491.00    11.01%
   2/9/99  100 Gateway 20    72.38     66.75    -7.77%

    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  24581.25 $19191.26
  8/13/96  200 Carlisle C  5264.99   9450.00  $4185.01
 12/31/98    8 Berkshire  17952.00  19928.00  $1976.00
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   2/9/99  100 Gateway 20  7237.50   6675.00  -$562.50

                             CASH    $999.27
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