From Pooches to Profits

October 19, 2009 at 2:00 am 1 comment

Dog Sprawl

Oh, I’m sure you’ve seen them – those nauseating people that willingly accept facial tongue baths from their pets and dress them up in ridiculous costumes. Hey, wait a second… I guess I’m one of those annoying people too.  My wife and I were just debating which Halloween attire we should get for our dog…Cound Dogula or Barkenstein? But we are not the only fanatics humanizing our pets, as Petsmart (PETM) recently outlined in their recent analyst day. Sixty-two percent of U.S. households own a pet and if you just add up all the cats and dogs, the total reaches 171 million pets.

This is no small business – according to PETM, the industry exceeded $43 billion in 2008, spanning a whole variety of products and services, including food, veterinary care, supplies, and grooming/boarding services. PETM is collecting its growing share of the market at 14%, and I expect this share to increase over time.

What’s fueling the growth of the sector? For one, demographics is a contributor. As many Baby Boomers have become “empty-nesters” (kids move on) over time, they tend to fill that void with a pet. In addition, many working marriages have pushed having kids to the back-burner and choose to substitute a furry baby as a surrogate.

These trends have translated into vibrant growth for PETM over the years. The company has over 1,150 stores and 738 Banfield veterinary partnership locations, not to mention a significant rise in hotels. No, these are not the Four Seasons, but rather pet hotels that you can board Fido in when you take that family vacation to Hawaii or where guilt-ridden families can drop your friend off for doggy Day camp. These 156 pet hotels, which are included as part of PETM’s “Services,” continue to gain traction as they plan to open 20 new locations per year. Currently, services represents 11% of PETM’s sales (up from 8.8% in 2006), growing faster than overall sales with a significantly higher profit margins than the corporate average.

Plenty of headroom for PETM to expand in this large growing market.

Source: Petsmart 2009 Analyst Day

Not everything is peachy keen as the company acknowledges the negative impact of unemployment, lower discretionary consumer spending and higher savings rate. As a result, PETM’s high margin “Hardgoods” category has gotten clobbered lately – even with more stable sales in non-discretionary categories like “Food.” Despite the economic developments, the company is not sitting on its hands. Not only are they focusing on driving sales through store pet adoptions (approaching four million on a cumulative basis), but the company is also reaping the rewards of its Pet Perks customer database to optimize sales performance. Petsmart has even taken a page out of Costco’s (COST) book with its focus on private label brands.

Beyond sales growth initiatives, the company has also been tightening their spending belt. For example, PETM is reducing capital expenditures from 6.4% of sales ($294 million) in 2007 to an estimated 2.2% ($120 million) this year. In addition, PETM is working on process improvements, space optimization, labor scheduling, and other cost-cutting initiatives.

The fruits of these labors are creating results. Just last week at their analyst meeting, PETM raised their 2009 earnings per share forecast to a range of $1.43 – $1.51 (from previous estimate of $1.37 – $1.45). Based on 2010 Wall Street estimate of $1.54, PETM’s stock currently trades at a reasonable 16.5x P/E multiple. On a free cash flow basis, the multiple on the estimated $226 million this year is even more attractive (see my article on cash flow investing).

Halloween is just around the corner, so maybe beyond picking up a doggie cardigan for the crisp fall weather, maybe you should consider some PETM shares too.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management and its client accounts have no direct position in COST shares at the time this article was originally posted. Slome Sidoxia Fund does have a long position in PETM shares at the time this article was originally posted. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

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