Taking on Kong (and His Brother)

“The stock market is a device for transferring money from the impatient to the patient.”  Buffett

Doing research on a company that appears to be vastly more expensive than you would pay for it and then waiting might be one of the hardest things in investing.  Both parts of that action are hard.  First, you have to force yourself to do the research when you know you will most likely not take action.  Second, after having done the research, you have to force yourself to maintain the discipline not to do anything.  

This is a preface to a discussion of Heska.  Disclosure: I do not own this now and based on my research thus far, I would not be willing to buy at current prices.  However (insert your favorite farming quote about planting now and harvesting later).

Heska does a few things, but as in most investment situations, you need to be focused on what matters most.  This point alone would eliminate 200 page slide decks from the investment world.  In this case, Heska’s Other Vaccine and Pharmaceuticals business is a side gig.  In this unit, Heska operates as a contract manufacturer for third-party branded animal health pharmaceuticals.  It’s a low margin business that contributes to the top line, but not much to the bottom line.  Give it five years and this business will be sold as “non-essential.”  So, this is all I will say about that line of business.  

The second line, which contributes 83% of Heska’s revenue and roughly 81% of their operating profits is their Core Companion Animal Health.  Within this unit, my focus right now is currently the veterinary blood testing unit.  By the end of next year, this unit will probably contribute 95% of the total operating profit of the company.    

This business is incredibly simple when you strip it back to what it is.  Veterinarians (“vets” as in pet doctors, not military persons) do various tests on animals, similar to what humans have.  In humans, most of the tests are sent to “reference labs” that run scale operations and have incredibly sensitive and accurate machines.  Think Labcorp and Quest.  However, in vet clinics, a lot of these tests can be done in-house with less expensive equipment (I am obviously simplifying the subject somewhat).  This in-clinic testing was made possible on a massive scale by Idexx Laboratories, who still remains the 800-lb gorilla in the industry.  Abaxis came in to challenge Kong and quickly gained share as an alternative supplier of in-clinic diagnostic testing.  However, oligarchies are typically only good for the few participants and not the customers.  In this case, Idexx and Abaxis were happy to play nice with ever increasing prices and high profit margins.  This is almost exactly what happened in the razor-razorblade world with Gillette and Schick.  (Hint: the margins on those razors are incredible).  

Enter Heska.  

If you are a vet and paying $10 per “test” with a back-end machine maintenance contract for $400 per month (and a few others fees that you aren’t even sure what you are being charged for), how does this offer sound to you: How about you switch to our machine with a no fee maintenance agreement and $5 per slide?  And if you act now (or later, it doesn’t matter), we will give you the machine for free!  The specific fees in this case are complicated with maintenance contracts, supplies, and delivery costs.  However, Heska is undercutting Idexx and Abaxis by a large amount, probably around 50% “out the door.”  Additionally, Heska is making the switching costs zero as they give the machines away for free with a no-fee maintenance agreement.  

The offer is really too good to refuse.  Heska has tripled its size in the past two years since it has revamped its machine line-up and started its current Reset program (with free machines and no fee maintenance contracts).  These numbers are rough, but there are 25,000 vet clinics in the U.S. and Heska has grown from 3% (750 clinics) market share to 9% (2,250) in the past two years.

Here is the dilemma that Idexx and Abaxis (jointly, “Top Dogs”) are currently facing.  As each new vet contract comes up for renewal, the Top Dogs can either price match Heska and basically cut their operating profits in half (this is my rough estimate from speaking with vets who have switched) or continue to milk their supply and hope its current crop of vets do not switch.  

The Top Dogs can easily price match Heska given the margins on their products, however, their operating profits would drastically decline.  So, they have a choice: maintain market share and suffer drastic margin pressure or lose market share, but maintain profit margin on the volume that remains.  This is very similar to the choice that Gillette and Schick face right now, but the Abaxis and Idexx can answer this question slower as each vet comes up for renewal.  They can cherry-pick, to some extent, the high volume and high-end clinics and perhaps stave off some of Heska’s growth.  (High-end vet clinics may be less sensitive to the price of the Top Dogs because they mainly pass along the costs, including a mark-up, to their customers).   

Questions:

Obviously, the valuation is a big question mark and I will get into that later, however, I always assume Mr. Market’s manic-depressive tendencies will provide me an opportunity to buy it at a better price.  

Other questions:

Why hasn’t everyone switched?  Are there reasons that certain vets aren’t switching, in which case the total addressable market is not 25,000 clinics, but potentially much smaller?  First, there is a lot of inertia.  People are unsurprisingly pretty lazy.  They just don’t want to switch.  It’s not broke(n), so why fix it.  The few people I have talked to did mention that there were some things that they could not do on their Heska machines that they previously could do, but the cost savings outweighed the benefits of these marginal tests.  Additionally, the Top Dogs bundle “reference labs” into their fees, which is nice and something Heska currently does not offer.  So far, I do not think this is a deal breaker for a large majority of vets, however, that could be a sticky point as Heska grows.  Alternatively, I think Heska could add those reference lab services with minimal capital expenditure.    

Supplier Strength:

The suppliers of the “inputs” to the testing products and equipment may exert some leverage on Heska as it grows.  As Heska grows, some suppliers may see the profit being left on the table and seek more favorable agreements with Heska.  I am still trying to understand how much of the inputs are single-sourced or could be easily sourced from different suppliers.  

The economics of this business model are surprisingly interesting when you simplify it.  Heska “invests” (i.e. gives away) the cost of a machine (between $2-3k) and then earns a royalty on its use over the course of the next 5 years, which is basically the estimated usefulness of the machine due to technological obsolescence.   Invest $3k in machine capital and earn $1.5k over the course of its first year in operating profit equates to an excellent return on capital.  (All of these numbers are only illustrative, not actual figures).

The financials look something like this.  Remember I am completely ignoring the “OVP” products since I think that is not the main part of this company.  These are the financials for the CCA portion of the business.  

2015 2016 2016 2016 2016
Full Year Q1 Q2 Q3 Q4 Total
Revenue $84,249 $21,418 $23,642 $26,376 $31,199 107,398
Operating Profit $4,911 $1,554 $2,806 $3,544 $5,140 13,045
Operating Margins 7.26% 11.87% 13.44% 16.48% 12.15%
Revenue Growth 10.38% 11.56% 18.28% 27.48%
Operating Growth 80.51% 26.32% 45.04% 165.62%

 

2017 Projections  1  2  3
Revenue $124,795 $149,753 $187,192
Operating Income $21,215 $26,956 $35,566
Revenue Growth 0.00% 20.00% 25.00%
Operating Margins 17.00% 18.00% 19.00%
Operating Multiple 32 25 19

The projections just above are just that, projections.  However, the interesting part about Heska’s business model is their clients agree to 5-year minimum purchase agreements.  Since this new program started in 2014, it’s almost guaranteed that Q4 revenue and operating profit will carry over at equal levels to Q1 2017.  This is reflected in scenario 1.  If Heska continues to add new clinics, we will see growth as projected in scenario 2 and 3.  Additionally, the operating leverage present in the model is fairly dramatic given the low SG&A that goes into the “in-force” clinics.  Once they are signed, there is not a lot of costs.  As you can see in the 2016 numbers, the operating margins increased fairly dramatically from 7% in Q1 to 16.4% in Q4.  My three projections contemplate potential operating margin expansion from 17% to 19% from Q4 2016 of 16.4%, which isn’t a gigantic assumption.  This doesn’t seem like a stretch, but at some point, the operating leverage might not be as dramatic as it was in 2016.  As you can see, under the flat revenue growth projections, Heska is fairly expensive at 32x EBIT (note: Heska has about $100m in NOLs, so they won’t pay taxes for the next 2-3 years depending on their operating growth).  If revenue grows 25%, Heska will be valued around 19x EBIT, which is still fairly expensive, but certainly more reasonable.  In short, Heska’s current valuation implies a lot of future growth, but Mr. Market will almost surely provide us the opportunity to bid on this asset at a much more reasonable multiple.

There are a few other points to this company that are interesting and I would like to discuss in a subsequent post.  

First, the company is also selling imaging equipment now, x-ray and ultra-sound machines.  It is attempting to sell them in a similar razor-razor blade model, however, I think they may abandon this practice and try to bundle the imaging and diagnostic equipment into one sales pitch and price the products so competitive that Idexx and Abaxis, without the imaging equipment, just can’t or won’t price match.  

Second, the CEO, Kevin Wilson, seems to have a solid background, having sold his previous diagnostic imaging company to VCA Antech (the 800-lb gorilla in the clinic world), which is incidentally being acquired by Mars, Inc. this year (ticker: WOOF–great ticker).  

Third, I have had a few calls with clinics who have switched, but I just recently (thanks, John) realized that I should also call some clinics that have not switched.  I am going to update that after I talked to a few of those.

Fourth, there are probably questions that I have not even thought of, so I will come back with those answers after I think of the questions.

How I found this idea: One thing I find fascinating about investing is how cumulative it is.  After having read a lot of Buffett stuff when I first began investing (while in law school), I read up on Sequoia Fund, whom he had recommended to a few people when he shut down his partnership.  One of their holdings at the time was Idexx.  I didn’t really understand their diagnostic machines at the time and since they were a new player introducing their own technology, I quickly put it in the too-hard pile.  A few months back, I looked at Henry Schein and one of their old press releases mentioned that they had signed an agreement for distribution with Heska, so I put it on a list to study and only recently got around to doing it.  If you glance at the stock chart for Heska (it has doubled since I wrote it down), you might wonder what other names are gathering dust on that list of ideas to look at.  Sadly, probably not another Heska.

Summary: Heska looks like a promising opportunity that will almost certainly be less expensive in the future and I will continue to do research to see if it is as good as it looks initially.  I like the fact that Heska is providing a good value to their customers.  This is a highly underrated attribute of investing (drug dealers are highly profitable, but I am not sure a drug dealer roll-up would be a valuable investment in the long run).

This investment idea will really turn on one question.  Most investment situations, no matter how complex some 200 page slide deck make them appear, usually turn on one or two questions.

The question here is whether the Top Dogs will be willing to sacrifice near term profit margins to compete with Heska on price.  If not, Heska will continue to take share and the investment will work out.  If Idexx and Abaxis start matching Heska on price, Heska’s growth will slow and the current valuation will prove far too costly.  I don’t know the answer to that question yet, but it is always helpful to know the right question and as my childhood G.I.Joe’s used to say, “Knowing is half the battle.”

If any of you know any veterinarians or vet techs, who work in vet hospitals or stand-alone clinics, I would love to speak with them.  Also, I created a #hska channel on slack if you want to discuss this company further.  Our Slack team is starting to pick up some momentum, so come join us…..


Matt Brice is the portfolio manager of The Sova Group, LLC. Matt can be reached at matt@thesovagroup.com. 

 

 

 

 

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