I bought GXL on 30 June 2012 at $0.965. At the time it was a...

I bought GXL on 30 June 2012 at $0.965. At the time it was a significant holding for my small portfolio. My investment thesis was predicated on value and growth. The stock was trading on a P/E of 7.9 with a fully franked dividend yield of 6.2% and an ROE of 11%-13% since listing. Greencross typically purchases veterinary practices at 4-5 times EBITDA, contracting the vendor to work in the business for another 2-4 years with some acquisitions having a deferred settlement for a portion of the purchase price. These acquisitions were typically earnings accretive in the first year.

The company’s debt-equity ratio was 68%. A little higher than I normally tolerate, but I was prepared to accept that gearing based on the premise that the veterinary business is somewhat stable and insulated from broader economic volatility (i.e. it’s not a cyclical business). Management owned just under 43% of the company, which gave me additional comfort that our interests were aligned.

Using a DCF model with conservative assumptions I valued the business at $1.45 to $1.60 per share, putting the business on a historical P/E ratio of 12-13 times FY11 earnings. Which I consider a reasonable multiple for a business of GXL’s size at the beginning of a long journey to consolidate the veterinary industry.

Fast forward 6 months to their December 2011 financial report. The debt-equity ratio had increased to 80%. Management had aggressively purchased 15 veterinary practices since 30 June 2011, well in excess of their stated strategy of one per month. Free cash flow did not pay for these acquisitions, it was completed through a combination of borrowings, a 50% unwritten DRP, the issuance of shares for some acquisitions, such as the increased stake in the Animal Emergency Hospital (AEC) and acquisitions with a partially deferred consideration.

The constant issuance of shares to fund acquisitions and the underwritten DRP is going to be continually dilutive to shareholders. I understand that it is necessary if they are to fund rapid growth in their practices, but my preference would be for a sustainable model of purchasing practices from free cash flow and debt without materially increasing the debt-equity ratio. If the company wants to grow faster, cut the dividend.

Like-for-like revenue growth was an uninspiring 1% for the half year.

The earnings guidance table released on page 1 of their half year result presentation also bothered me. Providing earnings guidance of 15.0 to 16.0 cents per share for full year seemed to me like a fairly precise range. Are earnings really that predictable for a veterinary business in the current domestic economic environment? Maybe, but it made me feel a little uneasy. If management realize in June 2012 that EPS is likely to be outside that range, they have extra incentive to engage in creative accounting.

Similarly, the frequent interviews released of the MD talking up their growth, strategy etc. just felt a little like cheerleading the share price. This assessment may be unfair, but again it made me uneasy.

My other key concerns were:
1) The back log of deferred settlements for acquisitions already made; and
2) How the business will perform when the vets who have sold their practice to Greencross finish their employment with Greencross. In my experience, when I visit a vet, it is a personal experience. Generally the vet is also the owner of the business and the customer service, care and overall experience is consistent with an owner-operator. When the employment contracts with Greencross which typically lock in the previous owner for a set period of time ends, I worry that the quality of customer service will also decline.

On 2 March 2012, two business days after they released their half-year results, I sold at $1.69. The very next trading day, the stock hit $2.00 per share.

I notice that in May, Greencross made another acquisition, this time of a Pathology business. Although no longer an owner of the stock, I think this acquisition is a little unusual. There is still a long way to go in consolidating practices across the country and I feel that the pathology business although potentially complimentary is a distraction/diversion from their stated strategy.

Today, GXL closed at $2.30 or 14.8 times the mid-point of their full year earnings guidance. Does the current price offer the investor a margin of safety? Does it compensate you for the risks in the business? I don’t believe it does.

I consider myself a conservative investor and I place a lot of emphasis on value stocks. GXL was a value and a growth stock when I first purchased shares, today it is firmly in the growth category.

So what are your thoughts? Will I regret selling GXL in 5 years time? Is my assessment reasonable?