Is it time to dump Greencross Limited?

It's easy to fall in love with companies that have grown substantially through acquisitions, but Greencross Limited's (ASX:GXL) crash today is a reminder about the limitations of the business model.

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What do falling commodity prices have to do with pet care? A lot, according to Greencross Limited (ASX: GXL).

The pet services group issued a profit warning today that is in part driven by the waning Western Australian economy.

Greencross, which was once one of the small cap sector's biggest rising stars, tumbled 8.2% to $6.54 this afternoon as management revised down its underlying earnings per share (EPS) guidance for 2014-15 to between 33.5 cents and 35 cents.

I think the stock is likely to retest its 18-month low of $6.45 that it hit two weeks ago.

The group, which runs vet clinics and sells pet products, said trading conditions at its Western Australian outlets had deteriorated and would come in around $3 million below forecast. The state has 30 stores and represents about 15% of its total network.

However, Greencross has also been hit by a number of unfortunate factors, which management stressed are one-offs.

This includes supply chain disruption caused by a botched implementation of a new warehouse management system and extreme weather in Queensland and New South Wales over the past three months.

These two factors will account for a further $6 million to $7 million drop in expected revenue for the current financial year.

The news doesn't appear too bad given that Greencross will still be delivering EPS growth of 40% plus that would be the envy of many other companies.

However, the issue for stocks like Greencross is that they trade at a hefty premium to the market and any cracks in the business will lead to a painful de-rating of the stock.

Even with today's sharp fall, the stock is still trading on a 2013-14 price-earnings that's close to 30 times.

With the downgraded forecast, the P/E drops to around 20 times for the current financial year but that's still looks a little lofty to me given the situation.

I am not saying well run companies shouldn't command such premiums. Just look at Domino's Pizza Enterprises Ltd. (ASX: DMP).

But there's a big difference between the two examples that holds important lessons for investors. I am happy to pay 20 to 30 times P/E for a company with robust and sustainable organic growth but I don't think roll-up type businesses that have grown very substantially through acquisitions deserve to be put on the same pedestal.

Greencross fits into the latter category, as do other hot market favorites like childcare facilities operator G8 Education Ltd (ASX: GEM) and aged care facilities acquirer Estia Health Ltd (ASX: EHE).

The problem with growing primarily through acquisitions is that doesn't make for a sustainable business model. If these businesses want to trade on high P/Es, they need to show they can deliver high double-digit organic growth rates.

But don't get me wrong. I would be keen on buying companies with a good track record of finding and bedding down earnings accretive acquisitions. I just won't pay the same premium for them.

From that perspective, I think Greencross will become an enticing investment if the share price drops below $6.

Motley Fool contributor Brendon Lau has no position in any stocks mentioned. Follow me on Twitter - https://twitter.com/brenlau The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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