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Ron Baron Comments on Covetrus

Covetrus, Inc. (NASDAQ:CVET) is a leader in animal health technology and distribution. The company was formed through the combination of two predecessor entities, privately held Vets First Choice ("VFC") and Henry Schein Animal Health ("HSAH") which merged in early 2019. The company, which was rebranded to reflect its broader capabilities, is led by the legacy VFC management team.

We are enamored with the global animal health market, and have successfully invested in the space for over a decade. We estimate that the global animal health market exceeds $150 billion in annual revenue and grows at a mid-single-digit rate. Growth is driven by powerful secular trends, including the humanization of pets and the growth of middle class consumers in emerging markets. We also view the veterinary health care market as structurally superior to the human health care market. Unlike human health care, there are no government payors and few third party commercial insurers. Pet owners pay for products and services using cash rather than insurance, which helps eliminate reimbursement risk, and enables the industry to implement modest annual price increases. Additionally, industry regulations promulgated by the USDA rather than the FDA are less stringent than in the human space.

Legacy VFC created a software solution to help boost the low refill rates for animal medications. It developed an integrated platform that uses data to identify gaps in care and then contacts pet owners to improve refill compliance and enhance medication completion rates. Veterinarians that work with Covetrus can offer their customers convenient reminders, multi-channel ordering capabilities, and home delivery. This results in enhanced pet health, improvements to the pet owner's experience, and growth for the veterinarian's practice. This is particularly helpful to veterinarians seeking to stem prescription leakage to online/retail competitors. Legacy VFC's software and fulfillment business has been combined with legacy HSAH, the world's largest veterinary distribution business. HSAH, with over 65 years of operating history, serves over 100,000 customers in over 100 countries with a sales force of over 1,200.

We think the combination of VFC and HSAH is highly synergistic. We believe that Covetrus will leverage its vast distribution footprint to accelerate growth of the company's technology and online fulfillment platform. Similarly, we believe its software and distribution will allow Covetrus to take market share from distribution competitors without similar capabilities. We expect vet consolidators, an increasingly large share of the market, to be early adopters. Finally, we see a virtuous cycle where improved medication compliance helps increase foot traffic to veterinarians' offices. This should help improve practice revenue and drive increased use of the consumables supplied by Covetrus.

We expect attractive margin expansion for the combined Covetrus. We believe that Covetrus management will take a more aggressive view of cost reduction and integration than legacy HSAH management, resulting in lower selling, general and administrative expenses. We see attractive selling leverage from the combined business leveraging the vast installed base of customers and captive field sales people. Finally, we believe that software and online fulfilment businesses are inherently more profitable than traditional distribution, resulting in margin accretion over time as these parts of the business grow faster.

Shares of Covetrus have come under pressure in the early days following the transaction. This is typical of spin outs, as financial results tend to be noisy, cash integration costs can be high, management distraction is at its peak, and the shareholder base turns over. We have sought to take advantage of this dislocation, which we view as temporary. We believe that as some of

these early distractions abate, and growth accelerates, we will be rewarded with multiple expansion in addition to attractive earnings growth.

From Ron Baron (Trades, Portfolio)'s Baron Growth Fund second-quarter 2019 shareholder commentary.
This article first appeared on GuruFocus.