PETQ - PetIQ: Looking Smarter If Margins Return

2023-06-21 18:40:41 ET

Summary

• PetIQ, Inc. has seen strong growth since its public offering, even as realistic margins are lackluster.
• The company is essentially largely breaking even for years now, as realistic earnings are badly needed given leverage being apparent on the balance sheet.
• Shares look cheap, but are only cheap and safe if real margins can be delivered upon, which requires real execution.

Early in 2021, I wondered if shares of PetIQ, Inc. ( PETQ ) were a smart investment with shares trading at levels in the mid-thirties. Since its IPO in 2017, PetIQ has turned out to be an acquisition machine, operating in a compelling and growing industry. So far, the good news is leverage was high and earnings were complicated, and while the promise of the business was seen, I was not willing to initiate or hold a position.

A Recap

PetIQ is a producer and distributor of veterinarian pet prescription, medication, OTC drugs and preventatives, typically used for dogs and cats. Given the humanization trends, apparent before the pandemic already, these products were in demand, as the distribution model of PetIQ was rather distinctive. Instead of targeting the consumer through Vet clinics, PetIQ was getting these products to consumers through retailers, resulting in massive savings for customers by cutting out an expensive middleman.

At the time of the IPO, the company generated about $200 million in revenues, but this changed as the company acquired VIP Petcare in 2018. With this deal, the company could start to sell through clinics, standing in contradiction to its earlier strategy, although the deal was set to create a $450-$500 million business, with EBITDA margins seen at nearly 10%.

The promise of this deal and to grow to a revenue base of $600 million by 2020, created a runway for earnings to advance to $1.25-$1.50 per share, making me a buyer at $20 early in 2018, a position which I swiftly sold at $35 later that year.

2019 sales of $529 million were solid, although EBITDA of $41 million came in a touch light, resulting in earnings of around a dollar per share. The company guided for further growth, especially as the company acquired Perrigo Company's (PRGO) animal health business in a $185 million deal, boosting 2019 sales to $709 million and EBITDA to $61 million, but it settled the business with a near quarter of a billion net debt load as well. On the back of these deals, the company guided for 2020 sales to advance to $800 million, accompanied by 10% EBITDA margins.

Early in 2021, the situation was as followed. The company had 25 million shares outstanding which traded at $36, granting the business a $900 million equity valuation, or $1.3 billion enterprise valuation as the company incurred a bit more debt following a deal for Capstar. With EBITDA projected around a hundred million, leverage was seen around 4 times. I pegged earnings potential at $1.60 - $1.80 per share, yet given that these were heavily adjusted earnings, I was quite cautious overall.

What Happened?

After PetIQ shares peaked in the lower forties in early 2021 it has been all downhill. In fact, shares traded at just $7 in September of last year. While shares doubling to the $15 level marks a big recovery, this is still a low level based on historical standards.

Fast-forwarding to March 2022, the company posted 2021 results. While a 20% increase in full year sales to $932 million looks solid, margins were lagging in a major way. GAAP operating earnings of $16 million were more than eaten by interest expenses, resulting in a $16 million GAAP loss, equal to $0.57 per share. The company managed to produce an adjusted EBITDA number of $93 million, for margins of 10%, and while I am happy to adjust for $22 million in amortization charges, many other adjustments were not fair. This left very little realistic earnings power. Promising was that net debt of $370 million had come down a bit.

For 2022, the company guided for sales to improve modesty to $985 million, with adjusted EBITDA seen up to $100 million. This was followed by a period of turmoil, including leadership turnover and softer performance, evidenced in the actual results as released earlier this year. Instead of growing, full year sales ticked down a bit to $921 million.

If not for a goodwill impairment charge, operating earnings would have improved a bit to $27 million, as full year adjusted EBITDA only came in at $78 million. Net debt ticked down a bit to $352 million, badly needed given the lack of real operating profitability. The company gradually has seen some dilution in the share count as well, now operating with more than 29 million shares outstanding.

The 2023 guidance called for sales at a midpoint of a billion dollars, but this comes after the company announced a bolt-on deal for Rocco & Roxie, a deal set to add $29 million in sales. On the back of this deal and organic growth, EBITDA would improve to a midpoint of $89 million.

What Now?

After seeing no real profits in 2021 and 2022, the current year is not expected to be (materially) profitable again. These continued disappointments make it hard to put a reliable valuation on the business. The 29 million shares command a $435 million equity valuation at current levels of around $15 per share, for a near $800 million enterprise valuation, with leverage reported at 3.7 times.

Trading at less than a 1 times sales multiple, PetIQ stock feels cheap based on the sales numbers, but remember that this is largely a distribution business with lower gross margins (and thus expected lower operating margins as well). While for now real earnings are not seen, and they have not been seen for years, shares feel cheap, but some real margins have to be delivered upon.

I furthermore find it telling that PetIQ, Inc. continues to pursue dealmaking, pushing up leverage, which is quite indicative of the ambitions of the management team and their priorities, which makes me simply cautious.

Quite frankly, I do not perceive the company to be of high quality, but PetIQ, Inc. shares do look cheap for those with an above-average tolerance for risks here, certainly after a solid start to the year.

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