GXL investment thesis, page-3

Your comment about sustainability is an interesting one - i assume you mean 'sustainable' in the sense of GXL being able to fund its growth plans without recourse to shareholders or without increasing debt.

According to their own announcements, GXL is "on track for sustained self-funded expansion by end of FY18". I interpret this comment to mean that, in approximately 18 months, GXL will not be drawing on debt or issuing equity to finance its funding commitments, which are: 1) dividends (50% of underling NPAT), 2) maintenance capex (approx $20m p.a.), 3) growth capex of ~$30m p.a. (20 new stores @ $1.2m each, 15 in-store clinics @ $0.5m each - source is management pres of 22 Sep, 2015), which admittedly assumes no established clinic acquisitions albeit it seems clear that the established vet market is overheated at the moment and GXL is focused on in-store co-locations.

To be self-funding with those capital funding requirements, i back-solve earnings as follows:

- EBITDA of $125m
- $15m interest costs
- $20m cash maintenance capex, approximating $20m accounting D&A
- Gives $90m EBT, less 30% tax ($27m) gives $63m NPAT
- Pay out 50% ($31m) as dividends, and then self-fund ~$30m expansionary capex requirement without drawing debt or issuing equity, leaves cash flow neutral, i.e. self-sustaining.

It's important to note here that i don't think they are saying they'll do $125m EBITDA in FY18; what i think they are saying is that their EBITDA run-rate at the end of FY18 will be $125m annualized. They are growing around 10% p.a., so FY17 they probably enter the year doing around $102m EBITDA run-rate and will exit FY17 doing around $113m run rate (hence the average for FY17, i.e. what they report, will be in-between those two figures, which jives with what they are guiding to, i.e. roughly $107m); then for FY18, they enter the year doing $113m EBITDA and exit the year right on the self-funding milestone, i.e. about $125m EBITDA.

If my interpretation of management's "self-funding" comment is broadly correct as laid out above, then FY18 EBITDA works out to around $120m, which given the same interest costs and capex spend as laid out above, leads to FY18 underlying equity cash flow of (120-15-20-26) = 59m, or 59/790 on today's market cap = ~7.5% FY18 FCFE yield. I'm not aware of too many stocks with a 2-year forward FCFE yield of ~7.5%, with a long organic expansion platform using a proven model. And, by the way, if management deliver that, i don't think the market is going to continue pricing GXL on the >6% forward FCF yield it currently is.

Of course, these numbers are predicated on management actually hitting their targets and getting ~10% EBITDA growth 2 years straight, and this isn't necessarily a lay-down misere. That said, i don't feel it's hugely demanding on GXL when you take into account:

- Store maturity profile: GXL say it takes 5-6 years for newly established stores or clinics to reach maturity, which means that any store built post FY12 is at least somewhat immature, i.e. should be growing sales faster than outgoings. At end of FY16, they had 221 retail stores, 42 of which were acquired as City Farmers, and 22 of those 42 CF outlets were less than 2 years old at acquisition, but given that acquisition was 2.5 years ago, i now consider most of the City Farmers to be 'mature'). So, stripping out City Farmers, there were ~180 Pet Barn / Animates stores at end of FY16, and given there were only 95 retail stores at end of FY12, i calculate that approximately 40% of Greencross' retail network (i.e. about 90 of 220 stores) is immature. With this as context, and with market growth in pet care spending being somewhere between 3-4% p.a. depending on which statistics are picked, it really shouldn't be overly difficult for GXL to deliver SSS growth faster than outgoings growth (which i assume is around 2.5-3% p.a.) for the next 2-3 years as their store network continues to mature.

- Continued gross margin growth through private label sales and better supplier terms. I don't expect the gross margin on the retail side to continue to expand at the rate it has in the last 2-3 years because it looks like most of the low-hanging fruit (i.e. driving private label sales in underperforming City Farmer outlets, going from zero to 20% private label sales) has been picked. That said, even a more modest 25-50bps gross margin expansion per year for 2-3 more years would have a substantial impact on EBIT margins.

I see those as the primary drivers for the next ~2 years as the business moves toward self-funding growth, but what excites me longer-term (~5 years) with GXL is the ability for management to create something approaching a 'category killer', whereby SSS continue to grow faster than operating expenses for years as market share is stolen either from smaller pet chains who simply can't compete with the sophistication and scale of the GXL offering, or from supermarkets who can't compete on range or service. In summary, i see the current share price as offering a favorable bet because the business should be able grow solidly in the next 2 years without performing any miracles or too much difficulty (i.e. downside protection), but the long-term upside is potentially large (i.e. create something approaching a category killer, in which case ROICs on the existing asset base will be far in excess of the ~9% currently being generated, and management can continue to organically deploy capital without issuing equity or levering the business).

The current share price, for me, potentially reflects a few different big-picture assumptions:
1) GXL management is broadly right, but market participants don't really understand the near-term growth trajectory of this business and its relatively low-risk nature (i.e. maturation of existing store network)
2) GXL management have no credibility (i.e. they are lying about self-funding by end of FY2018, and they are lying about their ability to organically roll out stores and co-locations at 20% ROICs), so the market is choosing to ignore what management has publicly stated in many of its communications with the market
3) market participants are expecting significant near-term downturn in pet retailing, or a sudden and substantial change in the industry's competitive dynamics (i.e. someone shows up and decides to spend hundreds of millions of dollars to attempt to compete with GXL).

Obviously, i am of the view that (1) is most likely, but we shall see...