Greencross merger lifts risk profile

The market capitalisation of Greencross (GXL) is set to swell by nearly 2.5 times as the veterinary services group pursues a merger with privately-owned pet products retailer Mammoth Pet Holdings.

The massive dilution sent the stock falling 2.8% this morning to a 2½-week low of $6.30 as Greencross will issue Mammoth owners around 52.6 million shares to buy the company.

Greencross is aiming to create a one-stop offering that combines veterinary and retail services under the same roof. Management assures investors that the concept is tried and tested in markets like the United States and Europe.

However, investors should not assume that Greencross is on a winning formula. Combining two great businesses always looks good on paper, but history has shown us that the synergies do not pan out in most cases and companies with a “conglomerate” type business won’t typically trade at a premium to the market. In fact, these companies tend to trade at a discount.

This is because merging two businesses in different industries requires a different type of skillset as it fundamentally changes the nature of the organisation in terms of the core skills required to drive the business forward.

Greencross acknowledges this by putting Jeff David as the new chief executive of the group. David is the co-founder of Mammoth and a Greencross director, but it remains to be seen if he can get the most out of the marriage for shareholders as managers tend to underestimate the difficulties in running such merged entities.

Shareholders have to also wonder if pursuing such an ambitious merger is a tacit admission from Greencross that it is running out of growth options. Greencross has grown significantly in the past few years by acquiring independent vet clinics – a strategy it is efficient at.

Venturing into a new area always carries risks and shareholders should not assume Greencross’ risk profile will be the same over the next year or two as it moves to integrate the businesses.

This in itself shouldn’t be too concerning, if not for the fact that Greencross is trading at a fairly big premium to the market due to its good track record in building its traditional business. The stock is trading on a one-year forecast price-earnings multiple of 25.5 times, or nearly 40% above its global peers.

But if management can make the merged business live up to its full potential, the rewards are large. Greencross is forecasting total sales of $440 million and earnings before interest, tax, depreciation and amortisation (EBITDA) of over $50 million in 2013-14 compared with last year’s figures of $106.7 million and $14.5 million, respectively.

It shouldn’t be loss on investors that Greencross is likely to still look relatively expensive compared with stocks like PetSmart, a leading US pet services group with a similar business model, even if it hits its earnings target.

Greencross is part of the Uncapped 100.