Bell Potter report, page-3

text of report....this is sourced from Morningstar and is not created by Bell Potter. Morningstar considers GXL undervalued with a Fair Value of $8.00 as at Aug 23rd 2017

Bulls Say.
Even during the depths of the global financial crisis, pet spending proved to be resilient, and we believe many consumers see this category as nondiscretionary. Positive industry dynamics, including the humanisation of pets and increasing spending per pet, should underpin the growth of the sector in which Greencross operates. OFew retailers can match Greencross' integrated business model. Its product variety, unique array of services, and specialised customer service provide a platform on which cross-selling and crosspromotional opportunities will drive future growth. These features differentiate the company.

Bears Say.
Greencross operates in a highly fragmented market with few barriers to entry. Therefore, competitors could aggressively roll out stores, increasing the competition for new stores. A wellcapitalised competitor could attempt to replicate Greencross' integrated business model. OMass merchants, such as supermarkets and grocery chains, have a presence in the pet category. These competitors hold substantial scale advantages and may choose to price pet consumables as a loss leader to drive traffic.

Greencross is Australia's largest veterinary services and pet retailing provider, with more than 130 clinics and 220 stores. The company listed in June 2007 and was originally a consolidator of veterinary practices. However, in January 2014, the company acquired Mammoth, the owner of pet retailers Petbarn and Animates, resulting in Greencross becoming Australia's largest integrated pet-care company. Subsequently, the firm acquired another pet retailer, City Farmers, in July 2014. Following these acquisitions, the company's strategy is to consolidate its two fragmented industries: veterinary services and pet accessory and food supply. It plans to increase its market share in both businesses from its current 8% to 20%, which we view as achievable, given the fragmented nature of these industries. Despite Greencross' success to date in acquiring clinics at attractive prices and consolidating the industry, there are few barriers to entry. It has benefited from first-mover advantage and a strong competitive position with highly fragmented vendors and favourable industry trends. However, we believe the industry will attract aggregators, and that Greencross will experience greater competition. The absence of such aggregators to date is a major factor behind the company's success. Another factor is Greencross' growth from a low base; despite this rapid growth, it still has only 8% market share. We view scale benefits from centralised administration, supply-chain efficiencies, and cross-selling opportunities as insufficient to confer sustainable competitive advantages, and hence we do not believe the business possesses an economic moat. Greencross benefits from positive industry dynamics. The humanisation of pets and gradual increase in household disposable income are likely to underpin a continued increase in spending per pet. The pet industry is estimated at AUD 8.7 billion in Australia, with AUD 2.5 billion being spent on vet services, AUD 4.5 billion on pet products, and AUD 1.7 billion on other pet services, such as pet insurance, grooming, and crematoria. Australia has one of the highest levels of pet ownership in the world, with 63% of households estimated to have a pet and 60% of these regarding their pets as a member of the family. Although dog and cat populations have been declining for two decades, the amount of money spent per pet continues to rise, more than offsetting the population decline. According to the Australian Bureau of Statistics, pet food and pet product sales growth have outpaced the broader retail market during the past five years, growing at 5% versus 3.5%. Key competitors include other specialist pet-care retailers, such as Best Friends, Pet Stock, and independent stores, with a combined 46% market share, followed by supermarkets such as Woolworths, Coles, and Aldi, with a combined 44%. Greencross Veterinary operates more than 130 clinics, mostly comprising general practices, with some specialty and emergency centres, vet pathology labs, and pet crematoria. The vet services industry is highly fragmented. Greencross' market share is currently at 5%, with the next largest being Healthscope and IDEXX Laboratories, with a combined share of 1%. The rest of the industry is made up of small single-practice businesses and government animal health laboratories. With an abundant supply of qualified personnel, the dynamics are favourable for corporatising vet practices. We expect Greencross to continue its strategy of acquiring one to two practices per month. The company has generally targeted more established practices, paying acquisition multiples of 3.5-4.5 times earnings before interest and tax. However, it is prepared to pay more for vendor employment commitments to ensure a smooth transition for practices, with vendors able to participate in profit share programs. Greencross does not own real estate, instead leasing properties from practice owners or landlords with lease terms of five years. About 75% of revenue is from general consultations, with 20% from product sales and the remainder from pathology, crematoria, and specialty services. Greencross Retail has a 8% share of the fragmented pet retailing market, with a long-term target of 20%. It has a sourcing agreement with Petco, a specialty pet-care retailer with more than 1,200 stores in 50 states across the United States, enabling it to leverage Petco's sourcing scale and product development. We believe the Mammoth acquisition will strengthen the business model through greater scale and synergies. The company has identified AUD 1.5 million of both cost and revenue synergies. Cost synergies will be derived from increased scale, which will lead to improved procurement terms and greater private-label penetration. Revenue synergies will be derived from cross-selling between Greencross' clinics and retail stores via targeted marketing, increased store rollout, and co-locating new clinics into existing and new retail stores.

Analyst Note Chris Kallos, CFA, Eq. Analyst, 22 August 2017

We are reducing our fair value estimate for no-moat Greencross to AUD 8.00 per share, from AUD 8.50, after the company reported full-year results in line with market expectations. NPAT of AUD 43 million was slightly below our forecast for AUD 46 million largely due to higher cost of goods sold and SG&A expenses driven by an increase in veterinarian salaries and investment in the group’s loyalty program. Gross margin, as a result contracted by 30 basis points to a still healthy 55.4%. Our revised valuation follows increased capital expenditure guidance by management to fund an aggressive rollout of in-store veterinary clinics and specialist & emergency hospitals plus further investment into technology and continued rollout of the refreshed group loyalty program. As a result, we expect capital expenditure to remain elevated at around AUD 70 million for the next three years before trending back to historical levels, compared with our prior AUD 50 million forecast. Nonetheless, at current levels, the shares are trading at a 25% discount to our intrinsic assessment and are therefore undervalued, in our opinion. The three operating segments of Australian Retail, Australian Veterinary, and New Zealand delivered like-for-like sales increases of 4.3%, 4.8%, and 4.9% respectively. The largest division Australian Retail, representing 62% of group revenue, grew top line by 10% overall underpinned by the growth of private label brands which accounted for more than 21% of sales. We forecast top-line growth in the Retail division of high-single digits in the medium term supported by further expansion of the network and the success to date of the revitalised loyalty program.

Economic Moat Chris Kallos, CFA, Eq. Analyst, 22 August 2017

We do not view Greencross as having an economic moat. Its management team has an impressive record of acquisitions and has rapidly expanded the business. However, we do not view a solid management team and disciplined acquisition criteria as competitive advantages sufficient to warrant an economic moat. To date, Greencross is the only aggregator in a fragmented industry with low barriers to entry, and in the long term, Greencross' success is likely to attract competition. With clinics acquired on multiples of around 4 times operating earnings, competitors could outbid Greencross for acquisitions and still generate excess returns on capital. Despite Greencross' growing market share, we view its current size as insufficient to warrant an economic moat, and at present, its return on invested capital is marginally higher than its weighted average cost of capital. However, as it builds scale through its store/clinic rollout, revenue growth will be elevated and exceed cost growth. Products are mostly imported, with the company implementing an efficient distribution platform to funnel products across Australia. This distribution platform lends itself to improving returns on capital as the revenue base builds, with higher sales volumes reducing the unit cost of distribution. We expect the company to continue adding clinics/stores to increase market share and scale, which will enable it to generate returns marginally above its cost of capital at the end of our five-year forecast period. Whether these excess returns are sustainable is questionable. While we view Greencross' business model as replicable with low barriers to entry, there are no other vet/retail aggregators in Australia, and the largest vet aggregator is a collective of just six practices. Given its first-mover advantage and a lack of competition, we do not rule out the possibility of the company developing sustainable competitive advantages in the future. Growing scale may lead to cost advantages through gaining better terms and discounts from suppliers. It may also lead to greater brand awareness and trust in the differentiated retail service offering, to the point where pet owners develop a strong preference to pay higher prices for premium-quality food and healthcare products. This may be due to the higher quality and health benefits of premium products over the budget products available in supermarkets. Greencross is well placed to benefit from premiumisation, with private-label penetration poised to grow materially (it is currently less than 10% of sales). Higher pricing may also occur because of the convenience of the integrated offering of taking a pet to the vet, having it groomed, and buying it food, all under the same roof. For now, these potential moat sources are insufficiently developed to warrant an economic moat.

Valuation Chris Kallos, CFA, Eq. Analyst, 22 August 2017

Our fair value estimate for Greencross is AUD 8.00 per share. This implies fiscal 2018 price/earnings of 21.0 times, enterprise value/EBITDA of 11.0 times, and a free cash flow yield of 1.5%. Our weighted average cost of capital assumption of 8.2% is based on a cost of equity of 9%, reflecting average levels of business cyclicality. For the five years to fiscal 2022, we forecast 10.7% EPS growth; however, this is largely dependent on the rate of acquisitions and new store rollouts and the firm's ability to fund these in the capital markets. We view this as reasonable, considering that the company intends to add 15-20 stores and a similar number of clinics each year for the next five years and is still a relatively small player in a fragmented market. Management's operational expertise has led to margin expansion in recent years. However, as the company adds more clinics and stores, along with expanding its private-label lines, we expect margin expansion to resume. We forecast an average EBITDA margin of 13.6% over the next five years, versus an average of 12.9% over the past three years.

Risk Chris Kallos, CFA, Eq. Analyst, 22 August 2017

A large part of Greencross' future growth lies in its ability to find acquisition opportunities; therefore, a dearth of acquisition opportunities or increased competition for acquisitions could increase the multiples Greencross has to pay. To date, Greencross has benefited from a lack of competition for assets, and has made disciplined acquisitions; however, this is an easily replicated model, and considering the low barriers to entry, Greencross' success is likely to encourage competition. A further risk around acquisitions is that they can hide performance issues in the underlying business, as new clinics/stores are potentially less profitable than existing locations and may cannibalise sales. Healthcare services consolidators also have risks around retaining specialists--vets in the case of Greencross--as well as keeping them motivated and productive. In the longer term, we believe increasing competition from mass merchants, online vendors and grocery stores could hinder Greencross' ability to grow profitably. The company is highly dependent on pet enthusiasts spending an increasing amount on a per-pet basis. If pet humanisation trends ever diminish, Greencross could experience a drastic decline in sales. Challenging economic times could also diminish consumer demand for more discretionary items, including premium supplies and services. Greencross is also affected by fluctuations in the exchange rate in its retail business, as most goods are purchased in U.S. dollars. Therefore, depreciation of the Australian dollar is a likely earnings headwind.

Management Chris Kallos, CFA, Eq. Analyst, 26 April 2017

Our stewardship rating for Greencross is Standard. Under previous CEO Glen Richards, the company aggressively acquired clinics at a rate of one to two per month, resulting in sales trebling during the past five years. While EPS has grown at 24%, it has lagged operating income growth of 68% because of the dilutive impact of numerous capital raisings, while return on capital has fallen from 8% to 6% as rapid expansion of the store network is yet to mature. Richards is a veterinary surgeon who bought his first practice in Townsville in 1994. He is a cofounder of Mammoth and was a member of a co-op with 15 practices that moved to a corporate model in 2007. He stepped down from the CEO role in February 2014, but he remains on the board as an executive director, being the managing director of the veterinary services segment. He was replaced by Jeff David, a cofounder of Mammoth and director of Greencross since 2007 until August 2015; David was in turn replaced by Martin Nicholas, who had been CFO of Greencross for more than a year. Prior to his tenure as CFO at Greencross, Martin Nicholas held the position of CFO at Study Group International and Finance Director for Rentokil Initial PLC. Chairman Stuart James is a highly experienced executive, with skills in the financial and healthcare sectors. He was the CEO of the Mayne Group from January 2002 to January 2005. He joined the Greencross board as a nonexecutive director in October 2009 and, after the merger of Greencross and Mammoth, was elected as the chairman of the group. The board has extensive industry experience, comprising eight directors, seven of whom are nonexecutive. The directors have a broad range of experience across a number of industries, including veterinary services, manufacturing, grocery retailing, property management, pet-care retailing and finance, all relevant to Greencross. The board and senior management have significant shareholdings in Greencross, owning about 20% of the company