We believe the U.S. veterinary industry is facing a number of challenges going into 2023. This includes our expectation for a shallow recession in the first half of 2023 that could lead to reduced discretionary spending amid labor shortages, rising interest rates, and elevated inflation. Providers will likely face pressure on revenue growth and margins. This is in stark contrast with the height of the pandemic when the pet adoption rates increased and pet owners held extra savings (from government benefits and reduced travel and entertainment spending) and spent more time with their pets.

We believe investor interest in the veterinary industry has increased and we now rate four veterinary providers, two animal pharmaceutical companies, and a distributer, in addition to pet retailers. The industry faces long-term tailwinds like inelastic demand, growth of pet ownership, and higher spending per pet. With the risks and challenges mentioned above, overall we see some downside risks to the ratings in 2023.

Below, we answer some of the common questions relating to the U.S. companion animal veterinary space, including our view of risks and opportunities, pet adoption trends, labor shortage challenges, the acquisition environment, and specialty versus general practices.

Frequently Asked Questions

How is the veterinary industry positioned coming out of the COVID-19 pandemic?

Our ratings on veterinarian companies were negatively skewed during the early stages of the pandemic because of lower patient volumes and the rapid pace of acquisitions that resulted in high leverage and low cash flow generation. The industry evolved through the pandemic from a state of disruption to a rapid rise of pet adoption and pent-up demand. As a result, spending across the pet industry reached around $124 million in 2021, up from about $90 million in 2018 (per American Pet Products Association; see table 1). Additionally, the number of U.S. households that have at least one dog (69 million homes) increased to 54% in 2020 from 50% in 2018 (see "Current Trends in Pet Spending 2021-2022", Sept. 28, 2021).

However, in 2022, trends were once again more challenging because of a tough labor market (for both support staff and doctors) and a drop in patient volumes from labor shortages and difficult comparisons against 2021. Pet owners' priorities have shifted since the height of the pandemic, spending more time in the office and traveling. Pet adoption rates have declined, which along with a tight labor market, will result in low-single-digit declines in patient volume in 2022. We believe this will lead to slower topline growth and put pressure on margins in the near term, despite strong pricing power at or above inflation.

Table 1

In 2023, we expect volume will remain flat or decline slightly as we head into a shallow recession. That said, weaker volume will likely be more than offset by higher prices such that organic revenue growth will be in the low- to mid-single-digit area. This pricing power is one of the competitive advantages for the pet industry because demand is relatively inelastic. Moreover, we still view the veterinary industry favorably given the following tailwinds:

• Millennials make up the majority of dog owners and we expect Gen Z will grow as a major demand driver for the next five years as they enter the workforce and their salaries increase, offsetting some of the pull forward demand in pet adoption during the early days of the pandemic.
• We think inflation likely peaked in the second half of 2022, although consumer spending is still likely to decline in 2023;
• A big portion of households with a new pet have income of more than $100,000, and were financially the same or better;
• Although a recession could delay pet ownership, we believe it is temporary. According to the American Pet Products Association, total spending in the pet industry during the downturn in 2008, including on food, supplies, veterinary care, live animal purchases, and other pet care services, increased 5.4% from 2008 to 2009.

Will a recession affect veterinary health spending?

We expect high inflation followed by a recession will lead to lower discretionary spending in the veterinary industry, including lower adoption rates and fewer vet visits for current pet owners. We expect 5% to 9% increase in prices at clinics will offset a low- to mid-single-digit drop in patient volume. We believe households will have less discretionary spending power as they spend more money on groceries and other essential items rather than nonessential pet services . Overall, we expect organic revenue will be slightly better than what we observed during the 2008-2009 financial crisis (flat to low-single-digit decline in revenue) because employment is stronger and consumer confidence is higher than the last financial crisis (see table 2). Households saved more money during the early days of the pandemic and that should help maintain spending on animal care.

Table 2

To assess how the vet industry will perform in a recession, we ran two different scenarios of varying severity. Under scenario 1 (5% drop in revenue and 1.5% drop in margin for 2023 base case), we think Romulus Intermediate Holdings 2 Inc. (PetVet) could breach our downside triggers. Under scenario 2 (5% drop in revenue and 3% drop in margin for 2023), we think all four companies could be at risk of breaching our trigger for a downgrade. It is important to note that just because a company touches the downside triggers may not warrant an immediate downgrade depending on how quickly we believe a company could turn performance around. We will also examine the reasoning for any cash flow deficits (i.e. whether it is one time or on-going business issues) as well as liquidity (including any upcoming debt maturities) to determine whether to downgrade a company, and especially to the 'CCC-' category.

Table 3

Observations for scenario 1:

• We apply 5% revenue drop from our base-case scenario, which we believe is conservative given our observations in the last financial crisis that organic revenue only declined at a low-single-digit rate at large vet clinics.
• Vet clinics typically have a relatively high variable cost structure as doctors typically have a commission pay structure and support staff are paid hourly. This cost structure allows the company to maintain margins when topline growth slows.
• Our outlook on Romulus (PetVet) is negative there is little room within the current rating for margin deterioration.
• For the three companies that do not breach the downside triggers, free cash flow to debt declines to around 1%, which indicates little room for further deterioration.
• We already build in a rising interest rate assumption (4% base rate for 2023) in our base-case scenarios for all four companies.

Observations for scenario 2:

• All companies exceed the downside triggers.
• We believe the veterinarian clinics have strong pricing power and will likely increase prices above inflation given demand is relatively inelastic.
• All of these companies have revolvers available; we would focus on liquidity and determine whether the cash flow deficit is temporary or a long-term issue when deciding whether to downgrade the companies to the 'CCC' category.

What does a roll-up strategy (consolidation, for example) at very high multiple mean for credit risk?

Acquisition multiples have been rising for the last few years by about a turn annually to a current average around 12x-15x EBITDA depending on the target from about 6x-7x a few years ago. The high multiples reflect solid organic growth prospects, low capital requirements, and mostly cash pay at the time of service. The high multiple creates higher execution risk because synergies need to be captured quickly to achieve return on investment hurdles and to keep leverage metrics in a reasonable range. The consolidator also must have strong protections to retain key staff because it is currently difficult to recruit veterinarians. In a rising interest rate environment, it puts even greater pressure on execution as multiples have remained elevated. This is especially challenging for 'B-' rated companies since they do not have a material cash flow level. Although multiples have stabilized since the beginning of 2022, 12x to 15x is high relative to other industries with heavy consolidation (such as dental, home health, and home care). We think the pace of acquisitions will slow somewhat until interest rates decline because sellers are unlikely to lower asking prices and acquirers will have a difficult time accessing capital at a favorable rate. This will be a short-term credit positive for the industry since acquisition-related expenses make up a significant proportion of cash flow. However, we expect the rated companies to use any excess leverage capacity for acquisitions once the markets are more favorable, given the industry has considerable consolidation opportunities as smaller independent operators still make up about 85%-90% of the industry. we believe multiples could decline if interest rates remain high for an extended period, but we currently expecting rate cuts in the second half of 2023.

Some veterinary companies have issued preferred equity to help finance acquisitions, which we typically view as debt-like and include in our leverage calculations. Although the preferred equity typically does not require cash interest payments and does not impact cash flow, it often has a high paid-in-kind (PIK) rate, which gives the company high incentive to replace it with lower yielding debt. We believe rapid issuance of preferred stock could pressure the sustainability of a capital structure even with modestly positive cash flow, given the need to eventually take out the preferred shares with debt that typically pays cash interest. Therefore, we believe the organic EBITDA growth is critical to sustaining vet consolidators' strategies with very high leverage, including preferred equity, and we generally expect solid growth due to strong pricing power and good economies of scale.

Table 4

What is our view of specialty versus general practices from a credit perspective?

Advancing technology and pet owner demand are increasing the sophistication of veterinary services. Doctors can now focus on different areas of care such as dentistry, cardiology, oncology, microbiology, and ophthalmology. Prices and margins for specialty care are usually higher than general practice due to the complexity of procedures and constrained supply of specialist veterinarians. However, as specialists receive additional training beyond veterinary school, it will be much harder to hire and replace a specialist than a general doctor, especially in remote areas, creating some operational risk for specialty operators. Specialty practices usually command premium acquisition multiples due to higher margins and rarity. Of the companies we rate, SVP Holdings LLC and Midwest Veterinary Partners LLC are mostly general practice, while Pathway Vet Alliance LLC offers a mix of general and specialty and Romulus mostly focuses on specialty services. In terms of our rating analysis, we do not have preferences of specialty over general practice because it depends on the company and the general economic conditions. Growth in specialty practices outpaced general practice early in the pandemic as pet owners delayed nonessential procedures. We expect this trend to reverse course as boarding, grooming, and other activities pick up. However, we note that specialty services tend to be more cyclical and customers may opt out of expensive nonessential procedures during a recession. We believe larger consolidators tend to have higher margins and are better equipped to weather downturns since they have economies of scale and can handle large fixed corporate expenses (such as marketing, human resources, IT systems).

What are the labor challenges in the industry?

Providers are facing challenges hiring and retaining support staff and veterinarians like many other industries. We believe companies will need to raise wages and benefits to attract and retain talent even with the expected recession, likely burdening margins going forward. Although we expect price increases to generally offset or even exceed wage increases, we have lowered our forecasts for margins and cash flow in 2022 and 2023 due to higher expenses relative to our earlier expectations.

We believe general wages for less-skilled support staff are low and workers could find another job easily elsewhere given the tight labor market conditions. A job in this sector could be stressful support staff turnover was high across most vet clinics during the pandemic. This could limit the number of patients a clinic can handle in a day, reducing topline revenue growth. Most vet companies have raised wages and benefits to maintain staffing levels, and we believe the labor trend has improved somewhat headed into 2023.

We believe it is harder to replace a doctor than support staff, especially for specialty clinics, since supply is much lower (there are 32 accredited schools in the U.S.). Some vet operators offer equity incentives for doctors with vesting periods to align incentives and improve retention. Furthermore, we believe most doctors have received salary increases over the last couple years, but most clinics will continue to face a challenging labor market for vets in 2023 mostly due to limited supply.

Other Research

• Current Trends in Pet Spending 2021-2022, Sept. 28, 2021