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Why this small cap darling just got slapped with a downgrade from UBS

The once shining star in small caps land is losing its glitz on worries that its business model is being disrupted by the online shopping revolution.

This concern is one of the reasons behind UBS’ decision to cut its recommendation on Greencross Limited (ASX: GXL) from “buy” to “neutral” and lower its price target to $6.15 from $7 a share.

This isn’t hurting its share price though as the vet and pet products retailer is up a whopping 3.7% to $6.24 in lunch time trade, although that needs to be considered in the context of its underperformance over the past 12-months with the stock sinking 3.4% even as the S&P/ASX Small Ordinaries (Index:^AXSO) (ASX:XSO) jumped nearly 15%.

No doubt the better than expected trading update is helping Greencross win back some friends although the party may not last as UBS believes the online threat will take a big bite out of the stock.

“GXL has increased its focus on its online sales in recent periods. However, industry feedback suggests that price aggression from the online channel (e.g. Pet Circle, MyPet) is having a material impact on customer expectations,” said UBS.

“GXL has recently reinstated an online delivery fee ($4.95) and trialled online-only discounts, neither of which we view as sustainable over the long-term. We believe GXL will need to substantially increase its online investment and focus, and have cut our long-term store numbers from 400 to 310. We have also reduced forecast gross margins to allow for increased price competition.”

It’s notable that Greencross’ European peer, Fressnapf, recently had to cut prices on 300 core branded products due to online competition.

What’s more, Greencross is in the midst of a leadership transition with a new CEO taking the helm. This does introduce an element of risks although it could make the company an attractive takeover target as underperforming companies with a new leader tend to get the attention of suitors.

As it is, Greencross has already attracted a $6.75 per share bid two years ago, which was rejected by the company.

While the online threat is a significant risk, particularly now that US online shopping giant Amazon.com has landed on our shores, some retailers are proving that they can fight back. Electronics retailer JB Hi-Fi Limited (ASX: JBH) and Australian’s largest supermarket chain Woolworths Group Ltd (ASX: WOW) are two examples of retailers who are standing their ground against the foreign competition.

On the other hand, retailers like department store owner Myer Holdings Ltd (ASX: MYR) are under pressure and are struggling to redeem themselves.

The next few months will be critical for Greencross and its new CEO to show which camp they belong to.

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Motley Fool contributor Brendon Lau has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of and has recommended Greencross Limited. 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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