9-Dec-2020:  CCZ Equities Research: Apiam Animal Health Limited (AHX.AX): Let sleeping dogs lie

Analyst:  Louis Bannon, email: [email protected], Phone: +61 2 9238 8236

• Recommendation: SELL
• Target Price: 39cps (Initiating coverage)
• Market Capitalization: $84m
• Index: N/A
• Share Price: 75cps (71.5cps on Fri 11-Dec-2020)
• Sector: Industrial

Report:

• Company overview: Apiam provides veterinary services and products in rural VIC, NSW, QLD, TAS, SA and WA through a network of ~50 practices and 150 vets. It generates ~70% of its revenue from agribusiness (feedlots, dairy and pigs) and the remaining 30% from companion animals (pets). We appreciate the attractive components of this business and further appreciate that drought has been the root cause of industry problems.
• Tailwinds: Recent and expected rainfall is reviving grain and pasture production. This means lower cost of inputs in feed. In turn, this drives growth in feedlots, pigs and the dairy industry. Further, AHX has developed high quality subscription style revenue streams within its dairy offering (ProDairy) and pets (Best Mates). The uptake has been promising. It is worth adding that the latter two segments – dairy and companion animals – have the highest combined services and product gross margins. Despite this, we think the asymmetric risk is still unfavourable:
• Insufficient FCF generation: Since listing 5 years ago, AHX has generated $4.4m of FCF (subtracting lease payments). In that time, it has drawn on $32m of debt and spent $50m on acquisitions.
• Organic decline & capital structure: The benefits of scale – such as volume discounts on medication procurement or shared IT systems for practice management – has merit. However, organic revenue has declined since FY17 ($87m to $84m in FY20). Further, Apiam is geared at 36% (covenant was recently relaxed from 35% to 45%). Our estimates suggest that the business can support ~$20m of debt funded acquisitions before breaching its gearing covenant. ROIC (including goodwill) has been ~5% over the last 3 years. FCF return on invested capital was 2.7% in FY20.
• Earnings quality:
  • (1) Increasing inventory days (up 50 days to 120 days) suggests demand could be decreasing despite wider industry revival;
  • (2) Capitalisation of development costs: were introduced for an upgrade in IT systems. These have led to:
  • (3) Depleted cash conversion: 55% in FY20, or 50% two-year rolling;
  • (4) Related party transactions: are meaningful in aggregate and quantum has doubled on three properties (19% CAGR growth since FY16).

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