PETsMART versus Petco-The Debate

Pet ownership in America grows at about twice the rate of the human demographic. This basic approximation has driven the growth of pet retailing. This growing marketplace is very compelling because of its growth and its relatively unconsolidated nature. The largest participant in the industry is PETsMART (PETM) holding about 11% market share followed closely by PETCO (PETC) with about 6% market share.

The industry has come under increased scrutiny lately as value pricing on some SKU’s by PETCO resulted in some Wall Street downgrades of PETsMart stock.

A recent Motley Fool post seems to have promulgated further concern.Since year-end, PETM is actually up about 4.3% (total return) versus a decline of about 9.6% for PETC, but the recent downgrades of PETM have diminished PETM’s lead.

In my view, PETM stands out from its superstore competition with the broadest offering of services that is available in the industry. PetsHotels, pet grooming, Doggie Day Care, dog training and access to full veterinary care provides a much broader experience than any other retailer can. Translate broader experience into greater selling opportunities. Its loyalty program, PetsPerks was modelled after the loyalty program of Harrah’s (HET) generally believed to be one of the most successful loyalty programs known in marketing. The program is designed to increase the average spend by each customer without sacrificing gross margins.

PetsMart is in the midst of a remodelling program which should bring greater focus on its service offerings. Remodelled stores have demonstrated much improved same store sales comparisons. The remodelling costs are minor at between $50K and $100K per store. So far, 170 of over 800 stores have been remodelled.

A recent Citigroup report highlights the strong impact that the service side of this business can provide.The service business has grown by over 25% CAGR in the last five years. The services side represents only about 8% of sales at this point but I believe this will grow substantially over the next five years to some 15%. There is a leveraged benefit to these services. According to Citigroup, PetHotels have provided a 25% lift to same store sales at maturity as well as significant improvement in store operating margins of some 430 basis points.

The impact to profitability at the margin can be substantial. Taking your dog in for a grooming, often results in additional sales of grooming accessories, toys, and shampoos. According to the Citigroup report, incremental revenues of 25% arise from a PetHotel, but of greater importance, pre-tax margins lift from 8.1% to 12.4%. Pre-tax income per square foot lifts a very impressive 94%. The rollout of hotels is accelerating. Starting with only 7 stores in 2004, to a year-end 2005 total of 32, PETM should have a count of over 60 hotels by year end 2006.

The economics of PETM don’t really require much improvement. The essential story is one of free cash flow generation, a better model, in my view, than that of PETC.

Pet Superstore Cash Flow Characteristics

$millions	2006	2005	2004	2003	2002	2001
PETC
Revenues	$1996.1	1812.1	1610.4	1476.6	1300.9	1151.2
CFFO	$164	172.6	156.9	133.5	79.8	55.9
CFFO/Rev	8.22%	9.52	9.74	9.04	6.13	4.86
Capex	$124.2	124.4	98.7	56.0	60.3	72.6
Capex/CFFO	75.73%	72.07	62.91	41.95	75.56	129.87
PETM
Revenues	$3760.5	3363.5	2993.1	2695.2	2501.0	2224.2
CFFO	$324.3	282.6	245.8	223.7	190.0	110.7
CFFO/Rev	9.10%	8.4	8.21	8.3	7.6	4.98
Capex	$165.7	143.0	171.9	163.7	105.1	44.9
Capex/CFFO	48.41%	50.6	69.93	73.18	55.32	40.56

The picture that this presents, in my opinion, demonstrates that PETM has superior financial flexibility to effect change. Long term debt to total capital for PETM represents about 27% versus about 44% for PETC. Generally, cash flow from operations is somewhat higher relative to revenues for PETM versus PETC. Finally, PETC appears to be spending a significantly great proportion of cash flow from operations in capex as it endeavours to grow. PETM’s superior free cash flow yield is almost twice that of PETC’s.

PETM has demonstrated improving Return on Invested Capital sequentially over the last five years to a current 14%. The ROIC has shown little variance despite the introduction of the remodelling programs and the step-up in the construction of PetHotels. PETC on the other hand, despite a higher ROIC of 18% in the last quarter, has experienced a steady decline in its ROIC over the last several years when ROIC’s were 24-27%.

PETsMART has utilized its substantial cash flow in value creating ways. In June of 2005, PETM announced a share buyback program of up to $270 million to be completed by the end of 2006. There is about $100 million left in authorization. As well, the company pays a small dividend of 12 cents per share. PETCO has an authorization, which commenced in March of 2006, to buy back up to $100 million in stock and has completed about $19 million in the first quarter.

Working capital management at PETM came under some suspicion in the fourth quarter as inventories were up 18.4% YOY compared to a sales increase of only 13.4%. It appears that most of this was a build up in inventory for a new distribution center it opened in August of 2005, as well as a program to avoid stock-out situations in its stores. There is room for improvement here as PETM’s investment in working capital for each incremental dollar in sales has been about 7.5% compared to PETC’s 5.5%.

On an EV/EBIT basis PETM is trading at 11.4 times TTM EBIT and 7.5 times EBITDA. Given its strong free cash flow characteristics, its improving ROIC, and its innovation in adding margin opportunities through its new services, I find the business very attractive.

The threat of PETCO going into an everyday low pricing strategy to match PETsMART seems to be the great bugaboo over the stock. PETCO sales growth slowed last year and it has cut prices on a few SKU’s. There remains a price differential according to several analyst reports that is now about 10% versus 15% previously...PETM still offers the cheaper price. BUt remember that despite PETCO’s 10% higher prices, this is still 10% below that of the average grocery store. The grocery chain share of the pet food marketplace is 48%...there is plenty of room for both of these companies to gain share rather than butt heads with one another.PETsMART’s loyalty program which is just coming into fruition can continue to build sales and average ticket. A good offset to PETCO’s price cutting.

Other competitors loom...WalMart (WMT) and Target TGT) are both expanding the space dedicated to pet supplies, but mostly at the lower end foods rather than other supplies. The destination store with its massive selection should continue to outperform the general merchandiser with a few hundred square feet of space to dedicate. Again, I believe that the service offerings of PETM should continue to draw customers.

Overall, I like the strategies that are being employed here. Analysts estimate long term growth for Petco between 8 and 20% with a consensus of 15.11%. For PETsMART, the growth estimates are slightly higher at 14-20% with a consensus of 17.78%. At current prices, in my opinion, PETM is discounting less than 10% growth or alternatively a significant and permanent drop in operating margins. I have a difficult time finding much credibility in either scenario.

Disclaimer: I, my family, and some clients have a current position in PETM. Neither I, my family, or clients have a current position in PETC.