A pairs trade is when you are long one security, and short another.  The variety of a pairs trade can differ in terms of dollars, number of shares, or differing ratios on either dollars or shares.  There are many criteria one should consider before a pairs trade is placed, there are also several risks that must be addressed beforehand.  This educational piece addresses some of the criteria.  Due to the educational theme, please do not construe the information to follow as a recommendation to buy/sell any security mentioned.

Why is MWIV (MWI Veterinary Supply, Inc.) trading at over $50/share while AHII (Animal Health International) is trading at $2.32/share?

Some investors may look at this as a potential Long/Short Pairs Trade opportunity, shorting MWIV and buying AHII; obviously this is dependent on being able to sell MWIV short. (If you are unaware of what this entails, please feel free to contact us)

Both companies have essentially the same business models; selling animal health products to veterinarians.

AHII has more full-time employees (by a slight margin) so they are similarly sized companies, despite the fact that AHII’s current market cap is approximately $56.4 million while MWIV’s market cap is $615.81 million.

AHII IPO’d (it has been around as a private company since 1954) for over $12/share. At that time, MWIV was trading at around $33/share

On June 5, 2008 (pre- Bear Stearns collapse and ensuing credit crisis), AHII was trading at $6.49/share, while MWIV was trading at $39.04/share. AHII got a couple of downgrades in November 2008 (after it had held up pretty well during the October Crash; stock price was $6.39 on 11/3/08 prior to downgrade) and sold off down under $2.00 while the market was continuing to tank over the ensuing 2 weeks. AHII got as low as $0.81 in March of 2009 (when every stock and their brother was at all-time lows; MWIV was trading in the low $20’s during this time for comparison) before bouncing slightly. Since then, AHII qualifies as a stock that the market has “forgot about”. Remind to write sometime about how these forgotten stocks and the frequency in which they can be found are the strong argument against efficient markets.

Anyways, since mid-2009, AHII has traded between $1.20 and $2.90. And its current price of $2.32, it is trading at 35.7% of its pre-Bear Stearns Value. By comparison, the S&P 500 is now trading at around 75% of its pre-Bear Stearns value and the Russell 2000 is worth about 80% of its value on 6/5/2008. Meanwhile, MWIV has appreciated over 28% in that same time period.

One could try to make the argument that MWIV is a far superior company that just prints money; or at least that is the argument that the market has made over the last 2+ years. However, looking closely at each firm’s revenue and profit streams and other fundamentals paints a much different picture that does not begin to account for such a wide spread between the two companies’ valuations.

During the last 4 quarters, MWIV has earned $2.32/share (0.54, 0.53, 0.63, 0.62 in each q respectively). For the year ending 9/2010, analysts expect MWIV to earn $2.43/share and in the year ending 9/2011, expectations are for earnings of $2.74/share. In the year ending in 9/2009, MWIV earned $2.02/share.
Revenue estimates for MWIV for the current year (9/2010) are $1.18 billion and for next year (9/2011) are $1.34 billion. Revenue over the last 4 quarters is $1.02 billion. Gross Profit over the last 4 quarters is $134.66 million and EBITDA is $52.6 million.

According to the most balance sheet, MWIV has $866,000 in cash and debt of $27.78 million (or about 32 x cash, which is indicative of a highly levered company). MWIV does not pay a dividend and only 6.92% of its shares are held by Insiders.

Other Fundamental Data for MWIV:

Price/Sales:    0.60
Price/Book:    2.75
Return on Equity:    13.77%
Book Value Per Share:    $ 18.20
Short Ratio:    9.50

Now, let us take a look at AHII and try to figure out why the company is valued at only about 9 % of MWIV’s valuation….

During the last 4 quarters, AHII has earned $0.21/share (0.01, 0.02,0.10, 0.08 in each q respectively). For the year ending 6/2010, analysts expect MWIV to earn $0.29/share and in the year ending  in 6/2011, expectations are for earnings of $0.41/share. In the year ending in 6/2009, MWIV earned $0.24/share.

Year-ends for the 2 companies do not match up but we can sort of set up a side by side comparison of earnings and estimated earnings:

Analyzing the above chart, we can see that AHII earnings are currently about 14.8 % of MWIV and are expected to rise to over 16 % by next year. Because future price movements SHOULD really only be dependent on future earnings, this data suggests that AHII could  be trading at about $8.00/share based on MWIV’s current stock price of $50.16.  OR it suggests that MWIV could be trading at around $16/share based on AHII’s current valuation.

Using market caps, instead of stock prices, the implied valuation for AHII based on MWIV is between $91 million and $98 million. With 24.33 million shares outstanding, this implies AHII should be trading between $3.75 and $4.03, which is still a 61 + % premium to AHII’s current share price.

The above analysis is obviously a redundant, yet more detailed way, of comparing Forward PE’s. Without a lot of public companies in this line of business, comparing AHII and MWIV is the most relevant analysis but it is hard to pinpoint where exactly the valuations of the two firms should drift towards going forward.  Accordingly, it should be noted that MWIV has a Forward PE of 18.31 while AHII is trading at a Forward PE of 5.66. The market as a whole usually trades in a Forward PE range of 10-14.

Revenue estimates for AHII for the current year (6/2010) are $668.29 million and for next year (6/2011) are $708.95 million. Revenue over the last 4 quarters is $659.46 million. Gross Profit over the last 4 quarters is $58.7 million and EBITDA is $12.0 million.

So, AHII’s revenues have been and are expected to be about 50-60 % of MWIV’s. Considering both companies are similar in size (# of employees), this isn’t great, but it also doesn’t explain MWIV’s operations being worth more than 11X that of AHII. Additionally, over the last 4 quarters, AHII’s gross profits are about 43 % those of MWIV. Which again, isn’t efficient but it no way explains the huge valuation discrepancy between the two firms.

According to the most recent balance sheet, AHII has $1.74 million in cash (more than twice the liquidity of MWIV) and debt of $146.67 million (or about 84 x cash, which is bad because it means that AHII is significantly more levered than MWIV; however this is only an issues if AHII is no longer a profitable company which there is no indication of that being the case). AHII also does not pay a dividend but a whopping 35 % of its shares are held by insiders.

Other Fundamental Data:

Honestly, AHII’s ROE is alarmingly bad. However, large negative numbers are usually associated with companies that are cyclical or have had a couple of huge recent write-offs or do not consistently earn profits quarter after quarter. AHII is consistently profitable, so this number is most likely the result of a one-time adjustment. And ROE needs to be considered along with the other metric listed above, in which AHII may be undervalued compared to MWIV.

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Tags: AHII, Bear Stearns, IPO, MWIV, pairs, short

This entry was posted on Friday, July 9th, 2010 at 3:34 pm and is filed under Education. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.