Pet Trends Breed New Family Members & Growth for PETM

by Jacob M. Kilstein

PetSmart, Inc.

Pet trends breed new family members & growth for PETM.

BUY
Ticker: PETM
Price: $57.50
Price Target: $117.00

Investment Thesis

• PetSmart (PETM) has moderate growth with same-store sales increasing 2.7% in 2013 YoY and is opening new stores, with 55 added in 2013.

• The retailer endured the recession, is growing margins and can withstand economic headwinds as consumers increasingly view pet care as staples.

• As a market leader, PETM has the ability to compete using cost reduction, brand recognition, and a fast-growing online sales model.

Business Overview: PetSmart is a retailer that sells pet supplies and services. It also sells small pets and runs an adoption network. It has two operating segments: merchandise and services.

• Merchandise
o   Dog and cat food, including high-margin private labels.

• Services
o   Grooming
o   Daycare/Boarding/Training

Strategic Positioning: 1) PETM boosts margins on organic food, grooming, and day care/PetsHotel as customers spend more on pets and view them more as companions/family members. 2) The largest pet retailer breeds employee and customer loyalty, allowing it to keep prices and margins high. Repeat grooming services get more dollars spent per store visit. 3) With the purchase of Pet360, PETM improves its lackluster online presence to compete with AMZN at a growing rate.

Industry:

• Overview: Pet sales are growing at 5% annually and are a $37 billion U.S. industry. Pet staples like food and litter are sold online but expensive to ship, making physical stores indispensable. Recurring services like grooming drive 12% of sales but increase the in-store dollar spent. Trends point to a higher level of pet care – almost as family members – that make premium organic food lines contribute to higher margins.

Macro Factors
o   Lower gas prices > more discretionary spending
o   Growing pet ownership
o   Higher spending per pet

• Competition
  o   PetCo (Private) – Bought out in 2006. Store location strategy alike.
  o  WMT – 16.49 P/E
  o   TGT
  o   COST- 29.35 P/E
  o   AMZN – Primary online competitor. A one-stop shop for a household.
  o   PetMed Express (PETS) – 18.6 P/E
  o   Chewy (Private) – Online vendor delivers recurring monthly food and supplies, a trend PETM is behind on.

Catalysts

Upside

1. Leverage – If a buyout occurs, debt financing is at lifetime lows and should be easy to handle while focusing management on execution.
2. Strategy – PETM plans for a $200mm cost reduction by 2016, $130mm from OG&A. House brands make up 30% of sales. Michael Massey, the new CEO coming from Payless Shoes, pointed to employee enthusiasm boosting customer loyalty differentiating the store from its general store competitors, like WMT. Massey said, “It’s harder to get associates pumped up about selling $19 shoes. People are opting to work here because they love pets.” A wide adoption program also serves as PR.
3. Growth plans – PETM can more aggressively integrate online sales with its stores. With the purchase of Pet360, PETM makes up 40% of all pet web traffic and e-commerce is up 70% YoY. New store growth and high margin services, like grooming and boarding, are also part of the strategy.

Downside

1. Low-cost competition from WMT, COST and AMZN. PETM’s e-commerce has lagged.
2. Merchandise has driven gross margins down 4 straight quarters.
3. Comps over last 3 quarters are poor. Square footage growth is low.

[Edit: Added 3/12/15]News

PetSmart was bought for $8.7 billion, $83 a share, 39% above its unaffected price on July 2.

The market shows continued value in “staple” retailers with healthy balance sheets. PETM has $230 million in cash and no LT debt. At 9.1x TTM EV/EBITDA, the valuation is in line with most hardline retailers. (Best Buy, at 5.6x EV/EBITDA, may be ripe for another takeover attempt.)

After shareholder pressure from Jana Partners et al., PETM agreed to be acquired by BC Partners. The PE firm replaced the CEO with Michael Massey, the former Payless Shoes head. The company reported profit for the latest quarter of $1.32 up from $1.28 YoY.

Recommendation

With increased growth from macro trends and planned cost cutting, we like the stock and rate it a BUY.

Valuation

Valuation is difficult given limited public competitors and the specialty nature of the pet business vs. general stores like WMT and TGT. That said, PETM spors a 14.65 P/E. AMZN and TGT have negative P/E’s and therefore P/E is meaningless. But blending WMT’s 16.49, COST’s 29.35, and other specialty retailers ULTA, with 37.8, and ANF with 28.6, with PETM’s July ’14 TTM EPS of $4.173, yields a 28 P/E and a $117 price target. That seems hefty given increased competition but rumors of a takeover may command a premium, with credit available at record lows. PetCo was in a similar situation when it was bought out. With its strategic implementation, $117 can’t be far off.