Five stocks to watch in November
As CVS (see below) and other groups consolidate veterinary practices, thereby giving themselves more clout, their suppliers are feeling the pressure. Dechra Pharmaceuticals has responded by selling its distribution business, National Veterinary Services, which was no longer growing, to focus entirely on developing and manufacturing pharmaceuticals.
The company has the widest range of pain and sedation drugs for companion animals of any animal health company in Europe, and also operates in six other categories; but faster-growing emerging economies in Asia and Latin America are demanding higher-quality meat, not better care for pets.
That is one of the reasons Dechra acquired Eurovet in 2012. Now it plans to use livestock products acquired with Eurovet as a ticket into emerging markets where, once it has established a presence, it may also be economic to sell drugs for pets. Attitudes towards companion animals in these countries may change too, as they grow richer.
High levels of profitability, strong finances helped by the sale of NVS and past growth all suggest the company will succeed. But Dechra says livestock pharmaceuticals are less profitable than those for companion animals because the market, dominated by seven global companies, is very competitive. Growth may not come as easily as it has in Dechra's European niche.
Like human pharmaceutical companies, much depends on its ability to develop new drugs that can be defended with patents – a lengthy and uncertain procedure.
On an earnings yield of 4% the shares are far from obviously cheap, because investors expect growth to continue.
CVS is using its experience and buying power as the UK's biggest operator of veterinary practices to profit from just about every veterinary service, from healing pets to cremating them.
Nearly 90% of turnover is from 252 local veterinary practices, which CVS owns and operates. The rest coCmVeSs from five laboratories, Animed Direct (an online supplier of medicines direct to pet owners) and two pet crematoria.
Its most obvious advantage is scale. CVS has 11% of the small animal veterinary market, which enables it to operate shared facilities with modern diagnostic equipment, own-brand (MiPet) generic medicines, the Healthy Pet Club loyalty scheme, out of hours services, referrals to three of its own specialist surgeries, and cremation.
Diversifications such as MiVetClub, Pet Medic Recruitment (a veterinary recruitment agency) and MiPet medicines are new, and unproven. They may indicate that CVS is exploring less costly paths to growth than buying more veterinary practices, although CVS acquired 14 surgeries in the financial year ending June 2013 and has signed an £10 million borrowing facility to fund future expansion.
Judging by its return on capital of 18%, CVS is a solid business. That may enable it to remain sufficiently profitable to reward investors prepared to pay even a slight premium. A 5% earnings yield is not attractive, though, and its growing debt could be a sign of problems to come.
Animalcare is another company enhancing medicines to enhance profits. It develops generic veterinary medicines for companion animals and sells them to veterinary practices, predominantly in the UK. It has two secondary businesses, contributing about 20% of turnover each. One supplies ID microchips; the other a wide range of pet products, from surgery disinfectants and equipment to insurance.
Generic medicines are by definition the same as the original medicines they copy, so Animalcare is going a stage further in the quest for profit. Through ‘Project Sustain', it's enhancing the pharmaceutical proper- ties of the medicines it supplies. This, the company hopes, will give it intellectual property it can protect, although the first products are not scheduled for launch until 2016.
Until then the company expects modest growth from cosmetic differentiation - altering the packaging, flavouring, coating and sizing to make medicines more appealing - and the launch of more generic medicines.
In the year ending 30 June 2013, the company grew sales 10% and profit 25% due to the reintroduction of the analgesic Buprecare (after a contract manufacturer abruptly ceased production in 2012) and the launch of two new generic medicines.
ID microchip sales are falling. Although the government has mandated that all dogs are chipped by 2016, some charities do the chipping for free. Animalcare says it can profit by marketing other products to the chip owners it has on its database; however, it admits it cannot differentiate some pet products from competitors' equivalents, and it is withdrawing these over time.
With an earnings yield of 7%, the shares look considerably cheaper, but Animalcare has further to travel on the path to differentiation.
ECO ANIMAL HEALTH
Eco Animal Health has changed more over the last decade than any of the other veterinary companies surveyed this month. It has disposed of a raft of businesses to focus on drug development, and one drug in particular.
The company's principal products are Aivlosin, an antibiotic for the treatment of respiratory and enteric (intestinal) diseases in pigs and poultry, and Ecomectin branded treatments for internal and external parasites.
Its biggest markets, responsible for at least 64% of sales, are in Asia, although the 9% of sales it makes in North America should grow as Aivlosin was launched there in 2012.
In common with other drug manufacturers, the company is moving away from undifferentiated generic drugs, which puts the spotlight on Aivlosin. So far, it has been approved in the US in specific circumstances only; but Eco anticipates authorisations for a wider range of indications in future.
However, expansion in North America is coming at a cost. The active pharmaceutical ingredient in Aivlosin is manufactured in China, a long way from the company's US and European markets. This has required Eco to tie up cash in stock while it distributes the drug, which the company financed by raising £12 million in an institutional placing in October.
Aivlosin now accounts for 70% of revenues, which makes Eco something of a one-product company. In its defence, that one product looks like a good one – it's patented and the company cites studies showing it's both faster and more efficacious than rivals.
But on an earnings yield of just 5%, the shares look pricey.
Having found good companies, but no obvious value in the veterinary sector, the final share joining the Watchlist this month is from a different industry. FW Thorpe designs and manufactures light fittings, which are increasingly complex because of the introduction of LED technology requiring printed circuit boards.
Its main business is Thorlux, which earns 80% of turnover and 90% of profit supplying lighting to schools, hospitals, warehouses and factories. Other subsidiaries supply shop lighting, emergency exit signage, cleanroom lighting, and decorative lights.
Thorpe is an old-fashioned company, still run by descendants of its founder, with a focus on first-class products and excellent customer service. Its commitment to doing things properly is evident in the balance sheet, which is replete with cash.
Twenty-five% of sales in the year ending June 2013 related to LEDs, and the bulk of new products are LED, which still has a higher initial cost than incandescent and fluorescent lighting but promises to be more energy-efficient and longer-lasting.
Profitability is high, but it has been declining since 2008. This may be a sign of the times. With budgets constrained, local authorities and companies may be prevaricating over changing their lighting systems to LED, which would be expensive initially.
Eventually the more lucrative work should come, but cheap imports may be a threat. Thorpe says the competition is unlikely to be as reliable or as efficient, given that its products have a five-year warranty, but customers may not always have such high expectations. Unlike companies such as Dialight (profiled in June's Share Watch), which specialise in LEDs, Thorpe must also support its traditional lighting range.
There are risks, but the company appears to be making the technological transition smoothly. The shares are probably good value on an earnings yield of 9%.
This feature was written for our sister publication Money Observer
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.