What Makes PetSmart So Fetching

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For the full-year fiscal 2009, we expect PetSmart to post sales growth of 8.0%, driven by an increase in square footage of nearly 10% and comp-store gains of approximately 3.0%, partially offset by the loss of one selling week (fiscal 2008 was a 53-week year). We expect operating margins to narrow approximately 30 basis points as a slight leveraging of selling, general, and administrative (SG&A) expenses is more than offset by a modest decline in gross margins. After taxes at 38.2% and a 5% reduction in shares due to repurchases, we project EPS of $1.52. For fiscal 2010, we forecast sales to rise an additional 8.5%, driving EPS to $1.74.

Valuation

PetSmart shares are essentially flat thus far in 2008, as relatively solid earnings results over the past two quarters have, in our view, been largely offset by investor concerns over the slowing economy and questions about the likelihood of management delivering on its strong projections for the back half of fiscal 2009. While we share those near-term concerns (our fiscal 2009 EPS estimate of $1.52 is at the low end of company guidance's range of $1.51-$1.59), we believe the stock presents a compelling buying opportunity.

At 15.4 times our fiscal 2009 EPS estimate, PetSmart shares are trading at a modest discount to the S&P MidCap 400 Index average of 17.4 times and a substantial discount to the stock's historic average of 19.1 times over the past three years.

We also believe the shares look attractive when growth is factored in. With the industry providing a strong backdrop of 5%-6% growth, we think the company, through continued store growth and expanded services offerings, will achieve high single-digit sales growth and EPS growth of about 14% over the next three years. By our projections, PetSmart shares trade at a p-e-to-growth (PEG) ratio of approximately 1.1 times, a discount to the S&P MidCap 400 Index average of 1.2 times.

Our discounted cash flow (DCF) valuation suggests an intrinsic value of $30 for PetSmart shares. This value, which is also our 12-month target price, is about 28% above the recent price, and approximately 20 times our fiscal 2009 EPS estimate.

Corporate Governance

We have an overall favorable view regarding PetSmart's corporate governance. Several of the practices we view positively include: board control by a supermajority of independent outsiders; the lack of a poison pill; nominating and compensation committees that are entirely composed of independent outside directors; and all stock-based incentive plans have been approved by shareholders.

However, while the company has not had any recent restatements of its financial results, it has recorded several one-time gains and charges over the past year, which we would prefer not to see. We also do not favor the lack of cumulative voting rights for shareholders, and that the board is authorized to increase or decrease the size of the board without shareholder approval.

Investment Risks

There are several risks to our recommendation and target price, in our opinion.

PetSmart may have difficulty securing attractive real estate locations while pursuing its expansion strategy. PetSmart stores are generally located in sites co-anchored by other strong destination superstores and typically are in or near major regional shopping centers. Furthermore, new store growth may cannibalize sales at existing stores. Should PetSmart fail to find attractive locations, sales and earnings growth might disappoint investor expectations.

Further weakening in consumer spending could adversely affect sales. While we believe that a majority of PetSmart's sales are insulated from an economic slowdown, we think demand for high-margin pet supplies and services offerings such as Doggie Day Camp and PetsHotels might suffer.

Lastly, if new initiatives such as PetsHotels and Doggie Day Camp fail to attract the traffic that PetSmart anticipates, margin expansion could be more muted than what we project.

Analyst Souers follows shares of specialty retail companies for Standard & Poor's Equity Research Services.