The launch of Covetrus Inc., Maine’s largest publicly traded company in terms of sales, was hailed as a boon to the state economy and another sign of great things to come for the Portland area’s growing animal health industry.

But since the Portland-based veterinary technology and services firm’s February initial public offering, most of the news surrounding Covetrus has been negative, including an investor lawsuit filed in September that accuses the company of securities fraud. While providing only a one-sided account, the lawsuit offers a possible explanation for Covetrus’ disastrous launch.

Filed Sept. 30 in U.S. District Court for the Eastern District of New York, the legal complaint describes Covetrus’ initial public offering as a poorly planned debacle by a disjointed company fraught with financial and operational challenges that its executives attempted to downplay or hide from investors to generate positive interest.

After forming from the merger of Portland-based Vets First Choice and Melville, New York-based Henry Schein Animal Health, the company’s Aug. 13 earnings release for its first full quarter of operation fell far short of analyst expectations and led to a stock sell-off that slashed the company’s share value by 40 percent in a single day. Covetrus also revised its previous earnings outlook for the year from $250 million to $200 million, citing unanticipated merger-related costs and a slowdown in customer activity.

The value of Covetrus shares has fallen even further since then and is down by about 75 percent from the initial public offering price of roughly $43 per share. On Sept. 4, the company announced its co-founder and chairman David Shaw, founder of Westbrook-based Idexx Laboratories Inc., was stepping down from his role as chairman, although he remains a director on the board.

Nearly a month later, a Covetrus institutional investor, the City of Hollywood (Florida) Police Officer Retirement System, filed a lawsuit seeking class-action status that accuses the company and its top executives of securities fraud. More than a dozen other class-action law firms have issued calls for additional plaintiffs to join the case or file their own lawsuits.

Although the legal complaint’s narrative is based on unconfirmed allegations by disgruntled investors, it makes a number of damning claims about the company. Covetrus declined to discuss the allegations, citing the pending lawsuit.

At its launch, Covetrus was saddled with $1.2 billion in new debt and was incapable of performing basic administrative functions, for which it signed agreements to pay former parent company Henry Schein Inc. to perform on its behalf, according to the complaint. Covetrus executives promised to wean the company off its roughly 80 transitional services agreements with Henry Schein as quickly as possible, it says, but they later indicated the contracts would be in place on a “recurring” basis.

The complaint also alleges Covetrus co-founder and CEO Benjamin Shaw and Chief Financial Officer Christine Komola overstated the company’s ability at launch to manage and distribute inventory to its global customer base, while understating the amount of cash Covetrus would need to invest to bring its supply chain infrastructure up to the required level.

Shaw and Komola indicated to investors that the integration effort was further along than it really was, and they downplayed the impact on earnings of online competition and the loss of a major customer prior to the initial public offering, the complaint says.

“Covetrus fundamentally misrepresented the company’s business outlook, particularly related to the newly combined companies’ infrastructure and capabilities as well as the true costs of becoming independent from Henry Schein,” it says. “In addition, Covetrus made false and misleading statements about the financial health of the company, including unsupported financial guidance, and falsely assured investors of the success and progress of the integration.”

SAME SALES, HIGHER COSTS

Covetrus executives celebrated the company’s stock listing on Feb. 8 by ringing the opening bell of the Nasdaq stock exchange in New York’s Times Square. They touted the combination of Vets First Choice and Henry Schein Animal Health as a sensible move that would create one of the world’s largest and most respected animal health companies with a global customer network and complementary services including software, prescription management and product distribution for the veterinary industry.

Covetrus was created by the merger of Vets First Choice and a spinoff of the animal health division of health care products and services firm Henry Schein Inc. Vets First Choice was founded in 2010 by Benjamin Shaw and his father, David Shaw. The company’s primary contribution to the veterinary market was its development of a pharmacy management and prescription fulfillment system for independent veterinary clinics that allowed them to better compete with large, online retailers.

Vets First Choice received city approval in fall 2018 to build a five-story, 170,000-square-foot headquarters for Covetrus in downtown Portland. The facility is expected to provide office space, a pharmacy, fulfillment center, and software and data science labs. It is designed to have space for 1,500 employees – 1,200 more than the company’s current Portland employee base of roughly 300.

Based on the combined revenue of Vets First Choice and Henry Schein Animal Health in 2018, Covetrus would have generated about $4 billion in revenue that year, making it the largest publicly traded company in Maine from a revenue standpoint. In August, the company reported second-quarter revenue of $1.01 billion, consistent with sales a year earlier.

What wasn’t consistent was its profitability. The company reported a quarterly net loss of $10 million for its first full quarter of operations, compared with a net income of about $29 million in the same quarter of 2018.

According to the legal complaint, the Covetrus balance sheet differs significantly from those of its two constituents prior to the merger, with one notable difference being that Covetrus is carrying a large amount of additional debt. As part of the merger, Covetrus took on $1.2 billion in new long-term debt, most of which went to Henry Schein Animal Health parent company Henry Schein Inc. as payment for its animal health division, it says. The debt was disclosed publicly at the time of the initial public offering.

“Previously, Henry Schein’s animal health business only had $23 million in long-term debt,” the complaint says.

Another difference is that Covetrus is now spending millions of dollars each quarter on integration-related costs, including payments to Henry Schein Inc. for the transitional services agreements, according to the complaint. It says the company revealed in August that it would have to spend roughly $40 million in 2019 on such investments – $15 million more than it previously had estimated – including $10 million to $15 million in “recurring” operating expenses, meaning that those expenses would be repeated in 2020.

Covetrus executives have said synergies between the two merged companies should net the combined entity $100 million in cost savings by the end of its third year of operation, but the precipitous fall of Covetrus’ stock price is a clear sign of investor skepticism in the wake of its disappointing second-quarter earnings report.

BURDEN OF PROOF

In a conference call with financial analysts following the earnings report’s release, company executives attributed the unexpectedly poor results to factors including unexpected costs, a recent decline in veterinary visits in North America, increased competition and a Brexit-related sales decline in the United Kingdom.

At the time, analysts following Covetrus expressed surprise and skepticism that a marketwide slowdown in the veterinary sector adequately explained the company’s poor financial performance.

On Aug. 16, Credit Suisse cut its price target on Covetrus stock and said the explanation of a lackluster demand for animal health services was “a dynamic that is a disconnect from other constituents and our survey work, suggesting (Covetrus) may be ceding share to other distributors and alternative channels.”

Credit Suisse also noted that Covetrus’ negative earnings growth was “a far cry from initial (positive double-digit) growth aspirations.”

The legal complaint alleges Covetrus executives changed their story in August regarding the impact of losing a large North American customer, Los Angeles-based VCA Inc., which operates a network of roughly 750 animal hospitals in the United States and Canada. VCA dropped Henry Schein Animal Health as its primary supplier in January, just prior to the Covetrus launch.

According to the complaint, Komola said at the time that the VCA account “was a low-margin account and it was sales, yes. But margin, it won’t impact things significantly.”

But in the analyst conference call following the release of Covetrus’ second-quarter earnings report, Komola said the loss of VCA “weighed heavily on organic growth in Q2 by 3 percent.”

Covetrus executives acknowledged in the August conference call that they had previously underestimated the cost of integrating the company’s two halves, saying they had gained additional insights while implementing their integration plan. The investor complaint questions why it took the company so long to figure out what the integration would actually cost.

“Defendants also acknowledged that their previous statements regarding infrastructure were wrong, revealing that now, six months after the merger, they were finally ‘at a point where we have detailed plans and understanding of the level of infrastructure investment we need to make and how these costs break out,'” the complaint says.

Attorney Peter Murray of Portland-based Murray, Plumb and Murray, who is not involved in the Covetrus lawsuit, said that in order to succeed, the plaintiffs would need to prove that Covetrus executives knowingly misrepresented, exaggerated or suppressed relevant information about the company’s current financial situation at the time they made the statements. In the securities world, companies are legally protected if they make predictions based on an honest assessment of the current situation, and those predictions later turn out to be wrong.

The plaintiffs also would need to prove they made decisions to buy or hold Covetrus stock based on the falsely stated information, and that they were harmed by buying or holding the stock, Murray said. The most common outcome in a successful securities class-action lawsuit is that the parties negotiate a settlement to pay out to the negatively affected investors, he said.

“If you don’t have a whistleblower, then you need to have at least some kind of circumstantial evidence that would suggest there was a suppression (of damaging information), such as if when the information is ultimately let out, it’s of an event that occurred far enough beforehand that you figure the company must have known about it earlier than that,” Murray said.

The legal complaint makes it clear that the plaintiffs believe the incorrect statements made by Covetrus executives do not fall under the federal “safe harbor” for forward-looking statements, and that the defendants knew they were misleading investors when they spoke about the company’s current financial situation and its future.

“To the extent that the statutory safe harbor is determined to apply to any forward-looking statements pleaded herein, defendants are liable for those false forward-looking statements because at the time each of (them) was made, the speaker had actual knowledge that the forward-looking statement was materially false or misleading,” the complaint says.


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