What Makes PetSmart So Fetching

S&P expects the pet products retailer to expand its market share, and ranks the stock a strong buy

by Michael Souers From Standard & Poor's Equity Research

PetSmart (PETM; recent price, $23) carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy). Our positive outlook on the shares reflects our view of strong industry fundamentals as well as company-specific positives such as a compelling valuation.

PetSmart operates more than 1,000 stores in North America and is the pure-play leader in the fast-growing pet product industry. We think PetSmart differentiates itself by competing effectively on price with discount retailers such as Wal-Mart (WMT) and Target (TGT) and with grocery stores (PetSmart prices are typically 10% higher than discount retailers and about 10%-15% lower than grocery stores), while offering superior selection and customer service. In addition, when compared with its closest pure-play competitor, privately held PETCO Animal Supplies, we find that PetSmart's prices are typically about 10%-15% cheaper, although PETCO has historically been known for aggressive promotional markdowns on select items to drive traffic. PetSmart strives to be an everyday low-price provider, and regularly checks pricing points at competing stores to ensure customers are receiving value.

Furthermore, we believe PetSmart's vast array of services such as grooming, training, veterinary care, overnight boarding, and day camp for dogs sets the company apart from its competition and helps drive strong customer loyalty. PetSmart stores are approximately twice the size of typical PETCO locations, allowing the company to devote space to animal hospitals and overnight boarding, known as PetsHotels. We think these additional offerings (as well as lower price points) make PetSmart the favored one-stop-shopping selection for pet owners.

Outrunning Its Rivals

All in all, we think PetSmart boasts a variety of products and services that no competitor can match, and we expect the company to expands its market share. While PetSmart has been adding locations at an aggressive clip (square-footage growth approximated 11% in its most recent fiscal year ended January, 2008), PETCO has closed about 20 stores over the past quarter, and we think it has also abandoned tests to offer boarding services. In our view, PETCO is hindered by a balance sheet encumbered by debt, limiting its ability to spend freely on new store growth and other capital-intensive projects. Any additional weakness at PETCO should translate into outsize market share gains for PetSmart, by our analysis.

While PetSmart is certainly not immune to economic pressures, we believe it is somewhat insulated from them. More than 40% of its sales are made up of food and litter, and we foresee stable but increasing demand in this category, driven by rising pet ownership and greater expenditures per pet. Services growth, led by grooming and PetsHotels, have also been impressively resilient, in our view, rising 22% in PetSmart's recently announced April quarter. Only demand for high-margin supplies has shown recent weakness, as consumers have cut back on items such as apparel and bedding for their pets. Overall, PetSmart sales have remained strong despite weak economic conditions, and the company posted a 2.9% increase in comparable-store sales in the April quarter (on top of a 4.0% comp a year earlier).

In fact, PetSmart has yet to record a negative comp-store sales showing in the face of the economic downturn, a feat that few specialty retailers have been able to accomplish, in our estimation. We project that comp-store sales will increase approximately 3% in fiscal 2009, aided by the lapping of last year's relatively weak results in the fiscal third and fourth quarters.

Although we project operating margins to slip slightly, to 7.2%, in fiscal 2009, down from 7.5% in 2008, because of a product-mix shift away from high-margin supplies to consumables and increased occupancy and distribution costs, PetSmart appears well positioned for future margin expansion in fiscal 2010 and beyond. It plans to slow growth of new stores by 20% in fiscal 2010, which should allow the company to better leverage expenses on a lower comparable-store growth rate.