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Morningstar | Greencross' Fiscal 2018 Was Soft Although Outlook Improving and Integrated Model Starting to Deliver

No-moat-rated Greencross' fiscal 2018 underlying EBITDA fell by 6% to AUD 98 million, albeit in line with our expectations, and the recent guidance. The main driver of the earnings decline was weakness in the Australian stand-alone veterinary and emergency clinics, although we are pleased the performance stabilised in the fourth quarter of fiscal 2018 and is now showing signs of improvement. Underlying net profit declined by 14% to AUD 37 million, slightly behind our estimates reflecting higher than expected depreciation charges. The board declared a final dividend of AUD 5.5 cents per share, taking the fiscal 2018 total to AUD 15.5 cents per share (fully franked), down almost 20% on the prior year, although maintaining a payout ratio of around 50%.

We've trimmed our near-term EBITDA estimates by around 5%, and project 7% annual growth on average during the next three years, reflecting a slower retail store rollout, softer vet sales, and the margin-dilutive impact of the new in-store clinics. However, our thesis and AUD 6.00 per share fair value estimate remain intact. Shares in Greencross continue to trade at a meaningful discount to our fair value estimate. We have long been advocates of the integrated model, the benefits of which are taking longer than expected to materialise. We do, however, expect margins to improve in the long run as the integrated stores mature, which should drive a rerating. Early success of this strategy is highlighted by the 8.5% like-for-like, or LFL, sales growth generated by the integrated sites during fiscal 2018, double the pace of stand-alone clinics. We also expect the company to add 15 new in-store clinics per year, for at least the next five years, at which point almost 50% of the retail network should feature, up from the current 20%. This rollout, along with growing LFL sales, are the key contributors of our high-single-digit vet revenue forecasts.

Overall, we are pleased with the performance of the core Australian retail business, which continues to deliver amid the challenging competitive landscape. The 5% increase in LFL sales is encouraging and reflects around 3% price growth and a modest growth in basket size. We expect similar levels of growth going forward, underpinned by accelerating online sales, and continued investment into the loyalty programs, and increased foot traffic on the back of the integrated services. During fiscal 2018, online sales grew by 70%, albeit off a low base, and currently represents approximately 3% of retail sales, broadly in line with industry average. Strong growth in click-and-collect transactions were a key driver of the online growth. While the company plans to continue growing the physical store network, we believe this will be less of a feature going forward. In fiscal 2018, only six new stores were opened, compared with around 20 per year during the past couple of years.

Retail gross margin also improved by 70 basis points to almost 48%, reflecting increasing private label penetration which is currently around a quarter of sales. The company will expand its private label offering into more premium categories, which should continue to support gross margin improvement, but also help customer retention. The company reaffirmed their operating cost savings target of AUD 10-13 million, during fiscal 2019, around half of which will be reinvested into the loyalty programs and digital capabilities. These cost savings, along with operating leverage and growing sales per square metre, should support at least 1% EBITDA margin improvement in the retail division to over 13% within the next five years.

While fiscal 2018 was a challenging year for the veterinary business, we are pleased the performance stabilised in the fourth quarter and is showing signs of improvement in early fiscal 2019 trading. While on an aggregate basis, vet LFL sales grew by 4%, it was specialist hospitals and in-store clinics which did most of the heavy lifting, offsetting a 2% decline in stand-alone clinics. We forecast veterinary sales to continue growing at a mid- to high-single-digit pace for the foreseeable future, which incorporates around 4% LFL sales per year, and ongoing rollout of vets within the retail stores. Australian vet EBITDA margins took a hit, contracting by over 350 basis points in fiscal 2018 to just over 10%, reflecting the margin dilution from immature in-store clinics, start up losses from new emergency clinics, and higher labour costs. While this is disappointing, we do expect to see margins improving back to around 12% long term, as the clinics mature, and reap the benefits of operating leverage.

At 2.7 times fiscal 2018 EBITDA, net debt is slightly higher than we would like although we are not alarmed by this. With improving earnings, strong cash conversion (over 100%) and a lighter capital expenditure pipeline, we expect net debt to return towards 2 times EBITDA within the next two to three years. Management guided to fiscal 2019 capital expenditures of AUD 50 million in total, down around 50% lower than prior years, although the focus will remain on improving the firm's digital capabilities, improving the retail offering through personalisation, improving the loyalty programs, and continuing to pursue the integrated model. The focus has shifted away from expansion of the physical retail store network, which it only aims to grow by three to five stores next year. From a strategic perspective, this makes sense, as these new initiatives should deliver the highest return on investment, while adapting to changing consumer preference.