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2 Small Caps pursuing healthy growth

When it comes to business, bigger is almost always better.

It’s true that a large business may risk losing the personal touch, and the consumer experience can become homogenised. Those potential downsides notwithstanding, size produces scale, and in the competitive marketplace, scale can be a huge advantage.

The most obvious example of this reality is the grocery sector. Woolworths (ASX: WOW) and Wesfarmers (ASX: WES) -owned Coles are able to extract cost savings through a high volume supply chain, negotiate better deals with suppliers on the basis of higher volumes, and can afford to invest more in promotions and marketing, given the larger sales base over which they can ‘spread’ that investment.

Economies of scale
The quest for scale (and growth, its enabler) can drive out-sized returns for a company (and its shareholders) because each dollar of additional sales requires comparatively less additional expenditure to deliver it – and should improve both total profit and profit margins along the way.

Returning to our supermarket example again, once the store is built, the fixtures and fittings installed, and the light and power paid for the year, those costs don’t grow if the sales in that store increase. That makes each extra dollar of sales much more profitable.

Unchecked, growth can be dangerous
Done well, there’s much to be said for – and much to be earned by – companies which can harness the opportunities that scale presents. Equally, many businesses have been sacrificed on the altar of ill-disciplined growth – and you only have to look to the failed ABC Learning for an example of what can go wrong.

Professional services, as a broad category, is the latest sector of the economy waking up to the benefits of scale.

In the vanguard of ‘aggregation’ in this area are the financial planning and funds management firms which are either being bought out, or joining planning ‘networks’ which provide marketing clout, access to research, and software and systems to streamline the workload of a financial planner.

Healthcare steps up to the plate
The health area – for humans and pets – is also starting to believe in the benefits of aggregation. While still in its infancy, this movement is one that may well enjoy the same successes as the financial planning firms.

1300 Smiles Limited (ASX: ONT) is a Queensland-based dental practice aggregator, which is both buying existing dental practices and setting up new ones, by providing a corporate structure, and employing dentists and support staff to work in those practices.

In a similar vein, Greencross Limited (ASX: GXL) is purchasing existing veterinary surgeries and applying a similar model – taking the headache out of running the practice and letting the vets focus on looking after their patients.

Both businesses are finding fertile ground for acquisitions, with current practitioners looking to realise a profit from the practice they’ve built, and with newer entrants into both professions apparently less keen to commit to their own practice than their predecessors. Of course, this is a generalisation, but the growth to date is indicative of the potential of the market.

Early days
Of course, risks remain – practitioners may sell to an aggregator, only to open a competing surgery down the road or across town. The service levels may fall, as employees don’t have the same incentives as owner-operators. So far, these two companies have been able to successfully navigate the pitfalls, but they are ever-present, and shouldn’t be ignored.

Both 1300 Smiles and Greencross are relatively small businesses, with a combined market capitalisation of just over $120 million. They are still relatively young in corporate terms, and growth hardly ever goes smoothly – there are likely to be bumps in the road over the coming years.

In addition, current and potential shareholders should expect both companies may need to raise capital to fund some of that growth, and should be prepared for capital raisings which may dilute their shareholdings and/or require additional investment to avoid that dilution. It may not happen, but it pays to understand the possibility.

Foolish take-away
If the aggregation model can be implemented in the dental and veterinary sectors with anything like the success of the financial planning industry, it is likely to attract competitors, and there is no guarantee either of these companies will come out on top.

That said, the first-mover advantage should be considerable, and both businesses are in the box seat. If they can avoid overpaying for acquisitions, and ensure they continue to deliver operationally, the future for 1300 Smiles and Greencross appears bright.

Are you looking for more quality stock ideas? Readers can click here to request a new free report titled The Motley Fool’s Top Stock For 2012.

Scott Phillips is The Motley Fool’s  feature columnist. Scott owns shares in Woolworths. The Motley Fool’s purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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