What You Can Learn From An Unusual Investment

If you are patient, you *can* get both high quality and low price

Covetrus is a good case study of how my idea generation process works and over time translates into new ideas for the partnership. The company was a spin-off from a healthcare company, Henry Schein, one that I had followed for 15 years. The business being spun-off was the global Veterinary Distribution business which distributes drugs and supplies to veterinarians. It wasn’t a normal spin-off, but rather it was a combination of a spin-off with a merger with another company, a rapidly growing young company that provided Software as a Service (SaaS) to vet clinics that allows veterinarians to fulfil consumer demand for pet medications via mail and thus recapture a portion of the spend that is leaving the vet channel for online retailers.

When the spin-off/merger occurred in February 2019, the stock began trading around $40. It was perceived as a very attractive, high-growth company – and with good reason. The core vet distribution business is very stable, recession-resistant, and had a history of organic sales growth of 6% over the last dozen years. It is an oligopoly with 3 main players and enjoys attractive returns on capital and free cash flow characteristics. The SaaS business was annualizing ~ $200M in revenue and growing around 40% per year. It was still early in its adoption curve and was reinvesting all of its profits into growth. While it wasn’t currently making any money, at scale the business model should be capable of much higher profit margins than the distribution business, with a much lower capital intensity. The market quickly became enamored with a stable business with a nice growth opportunity on top.

I took note of the spin, read the filings and listened to the company’s presentation, but decided to pass on the stock. It was a typical combination for the market at the time – good business, good growth, very high price. Definitely not a bargain and not what I look for as an investor. The company was now on my watchlist, which I use as one of the four sources of new ideas in my idea generation process.

As the stock drifted down into the low-$30s, I took another quick look. The company was still too expensive in my view and was affording nowhere near the kind of margin of safety that I look for. I passed again.

With the stock reaching mid-$20s in the summer of 2019, I decided to do a deep-dive into the business. I re-read the filings and built a detailed financial model. I also reached out to the management team and scheduled a meeting with the CEO and CFO at their headquarters. Having met for 2 hours with the CEO and CFO, I left with a mixed impression. I still thought the business was high quality and had interesting growth possibilities. However, the CEO didn’t have a good explanation for why organic sales growth in the core distribution business was rapidly decelerating and approaching negative levels. I also didn’t leave our meeting with an impression that he had a strong intrinsic motivation for the business, something that I have observed as very important and frequently present in the best animal health-related companies. When I got back to the office I moved the company to the back burner and again passed.

In August 2019, the company reported a weak quarter with organic sales declines in the distribution business. Management lowered guidance and the stock plummeted to the mid-teens. When the spin took place, the company issued a substantial amount of debt in order to issue a dividend to the parent company, Henry Schein. The debt took the form of an amortizing term loan with a leverage covenant for Debt/EBITDA levels that were getting tighter over time. At the time, this debt seemed very appropriate as the core business was non-cyclical, growing and management was forecasting meaningful synergies. Now, the core business was shrinking, and with a highly fixed nature of the cost structure, profits were declining at an even greater pace. With the lower profit expectations, we were now approaching levels where the debt covenant could be triggered.

The market understandably panicked. The same stock that was trading near $40 not too long ago was now at $15. The narrative was now not about glamourous growth but about structural erosion of the core business to online competition and possible violation of debt covenants leading to a disaster. How things change in 6 months!

Just because a stock falls a lot does not, in and of itself, mean that it’s a good investment. Many a stock have fallen drastically on their way to zero. The challenge is always to find situations within my circle of competence where the expectations discounted in the stock price are far below my view of the company’s likely future. With that in mind, I dug in to the two key issues: risk of secular erosion and the risk to the balance sheet from violating the debt covenant.

Pulling up the filing that governed the covenant for the term loan, I was pleasantly surprised. Consistent with the recent loose credit market conditions, that covenant language was very permissive. For example, management only had to announce cost cuts or synergy actions in order for their pro-forma results to count towards profit in calculating the leverage ratio for the debt covenant. Further scenario stress-testing led me to conclude that between this and other actions management could take (e.g. slowing down the growth in the VFC business in order to temporarily generate profits to avoid violating the debt covenant), the risk of financial distress was low.

The more difficult question was the nature and the degree of secular erosion facing the core vet distribution business. Should I interpret the recent organic sales declines as the beginning of long-term decline of the industry and the company? Or was it a temporary problem likely to be resolved? Investing in secularly declining businesses is a tough endeavor that is rarely likely to meet with success. The stocks of such businesses are rarely cheap enough, and it is very hard to manage a declining business. So I decided that if my research led me to conclude that the core business is in secular decline that I would pass on the stock. A combination of structurally shrinking sales, a fixed cost structure and financial leverage can be deadly to any company.

There were three structural threats to the business that I wanted to examine:

1. Secular sales decline due to a rapid shift of pet medications (over two-thirds of what the company distributes) to the online channel at companies such as PetMeds.com and Chewy.com

2. Internal turmoil and departure among key salespeople as a result of the spin/new management/reorganization

3. Threats from supplier consolidation among animal pharmaceutical manufacturers

To address the risk of secular sales declines, I dug into results being produced by competitors. I also started to study the online pet drug retailers. The two main competitors were producing positive sales growth. This was encouraging, as if there were secular erosion, it should affect all of the players. My research into the online pet retailers led me to conclude that they were slowly taking share, but that the magnitude of that channel shift was too small to account for Covetrus’s distribution sales shrinking in the most recent quarter. It was likely to be a long-term headwind that would lower the growth rate, but it certainly didn’t explain the sudden deceleration in the company’s sales.

If secular substitution trends weren’t the culprit of sales declines, then what about turmoil among the salesforce? The biggest risk I saw here was if the best producers had left for competitors. I approached researching this in two ways. First, I used LinkedIn to find all of the past and present company salespeople. I was pleasantly surprised to find that there was very little turnover. That didn’t mean that it couldn’t come at a future point, but sales departures weren’t the reason for the recent poor performance. I then scheduled a call with one of the two major competitors. My goal was to find out if they have seen increased sales force turnover at Covetrus or if they were in the process of hiring away major salespeople. I was again pleasantly surprised. The competitor thought that it was just management screwing up and losing focus on blocking and tackling rather than sales force turnover that was causing issues at Covetrus. They have not seen an increase in resume flow, and they would not be able to hire those salespeople in many cases anyway, as there were non-compete agreements in place. The competitor re-affirmed that this segment of their business was healthy and growing, and they didn’t see the issues at Covetrus as permanent.

Finally, a study of past and present supplier consolidation did reveal that they were becoming more consolidated and would likely have higher bargaining power. The best distribution businesses are like a bridge across a river. Ideally, you want there to be only one bridge, no other way to cross the river, many customers on one side wanting to cross the bridge and many destinations for them to go to. In this case, the customer base was very fragmented which is good. However, the increased supplier consolidation was a negative. That being said, the industry itself, with three main distributors, was still more consolidated than the suppliers, and so I expected this to be a moderate headwind rather than a major blow to profitability.

Summarizing my findings, I did not find evidence of deep structural issues. On the contrary, there were several indications that the issues were mostly temporary and could be fixed over time. My conclusion was that this was not as high-growth or as good of a business as it had been over the prior decade, but that it was still quite a good business with positive organic sales growth in its future.

As I finished the above research, the company put out a surprise announcement. They were firing the CEO and replacing him with a board member who had experience leading a small healthcare company as acting CEO. The stock plummeted to single digits. The market interpretation was that this was bad for the business and perhaps a sign that the company’s results would be even worse than anticipated next quarter. I had never felt that the old CEO was particularly key to the business. If anything, some of the decisions he made likely led to the problems that the company was experiencing. The fact that the board was acting quickly was good news. Too many boards wait for activist pressure while the business suffers before making changes.

In my view, this was, or was close to the point of maximum pessimism. The market’s view on the business now drastically diverged from my well-researched assessment. My base case intrinsic value was around $30 per share and the stock was trading at less than one-third of that appraisal.

No matter how thoroughly I research a company, there is always the chance that I am wrong. Given the financial leverage, I thought that the next 6-12 months would be crucial to testing my belief that the balance sheet could withstand the temporary pressure and that the issues were indeed temporary. Because the price was so low, and because the downside if a company goes bankrupt is always 100%, I decided to initiate a position in combination with a put option hedge. The combined cost of the stock and the hedge was ~ $10 compared to my base case value estimate of ~ $30. By using the hedge I was eliminating the possibility of total loss on a 5% investment at a relatively small cost to the partnership.

The investment thesis began to play out, with organic sales stabilizing and then growing. The market, realizing that it had over-reacted, re-rated the stock substantially higher over the course of 2020. We were able to sell our shares for ~ 3X our purchase price, with a meaningful profit for the partnership.

Of course, not all investments are going to be successes, and I have written plenty about my past mistakes. However, the narrative that we are hearing all too often these days - that you need to pay a fancy price in order to get a quality company - is a false one. If you are patient, you can have both. But it’s rare, and you have to do your homework in advance.

If you liked this article, please “like” and share this article. If you are interested in learning more about the investment process at Silver Ring Value Partners, you can request an Owner’s Manual here.

About the author

Gary Mishuris, CFA is the Managing Partner and Chief Investment Officer of Silver Ring Value Partners, an investment firm that seeks to apply its intrinsic value approach to safely compound capital over the long-term. He also teaches the Value Investing Seminar at the F.W. Olin Graduate School of Business.

Note: An earlier version of this article was published here.