I have been writing about VCA Antech (Nasdaq:WOOF) for years, albeit not always on a consistent basis, and I clearly remember the baying, barking, and growling from longs when I used to question the company's valuation and business model. This was back when the stock traded in the $30s, mind you, and everyone believed that the veterinary practice roll-up model was bulletproof. Well, I wasn't short the stock then (nor am I now) and I wasn't being paid by hedge funds (nor am I now), but I was right - the business model couldn't support the valuation and investors who ignored the warning signs and hung on took a bruising. (To know more about stock valuation, check out: DCF Valuation: The Stock Market Sanity Check.)

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Nowadays, though, it is a different story. I still do not believe that business models predicated on continual acquisitions can work (it's been tried over and over again in people-medicine), but the fact remains that VCA Antech now has a leverageable installed base and an undervalued cash flow stream.

Sluggish Third Quarter Performance
VCA Antech posted revenue growth of over 7% this quarter, but virtually all of that upside was inorganic growth from acquired veterinary practices. While the hospital operations posted nearly 10% growth, same-store growth was just 1%, while the lab business grew just over 2%. If there was a silver lining to these results, it was that even at just 1% growth, this was the first positive same-store sales quarter in almost three years.

Profitability was even worse. Gross margin slid a bit on a consolidated basis as a modest improvement in the hospital business went for naught. Adjusted operating income fell 1%; although the hospital business's operating margin improved a bit and the lab business didn't fall off by much, "corporate overhead" grew more than 30% from last year's level.

Can This Model Work?
Investors who are inclined to do some digging will find that many "physician practice management" companies have risen up over the years, consolidated various kinds of medical practices, gone public, and then flamed out spectacularly once the acquisition growth story petered out. Simply put, the risk is that VCA Antech goes the same route. (For additional reading, check out: Analyzing An Acquisition Announcement.)

It certainly does not have to be this way, though. Unlike human medicine, bad debt expense is not a major issue for vets, nor is wrangling with insurance companies. Likewise, while some customers may be attracted to the convenience of clinics within PetSmart (Nasdaq: PETM), many pet owners want to take their pets to freestanding clinics or hospitals. On top of that, there are more diagnostic tests available for pets every year and having a captive lab is especially lucrative for VCA Antech - even if it does still trail IDEXX (Nasdaq: IDXX).

A Big Field with Few Options
No doubt part of what underlies the WOOF story is the relative lack of alternative investments. Pets are a huge business in America, but most investors rarely think past PetSmart, VCA Antech or IDEXX. That's unfortunate, as Abaxis (Nasdaq:ABAX), MWI Veterinary Supply (Nasdaq:MWIV) and Neogen (Nasdaq:NEOG) - though to be accurate, Neogen's animal business is small and really not at all targeted at companion animals.

Likewise, while well-known drug companies including Teva Pharmaceutical (Nasdaq:TEVA), Endo Pharmaceuticals (Nasdaq:ENDP), and Mylan (Nasdaq:MYL) make up meaningful market shares of the pet medicine trade, the animal health industry is not all that big of a market for them.

The Bottom Line
The biggest risk factor for VCA Antech is the health and popularity of its existing store base. Same-store growth has been an issue for this company for too long now to completely ignore it (even with a sluggish economy). So while VCA Antech likely can continue to post high single-digit growth on the basis of acquisitions, the company has to maintain its own internal growth for this stock to work.

Assuming that issue can be resolved, there's quite a bit to like here. The company has a history of producing decent (or better) free cash flow and the stock is still undervalued even if there is really no further leverage to find here. Although the glory days of VCA Antech's stock are in the past, sometimes investors can find good reasonably-priced growth names when the excitement has faded and valuations have become more reasonable.

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.