Markets & Finance

Pet Spending Purring Along

By Nilus Mattive Standard & Poor's recently adjusted its recommended sector weightings and now suggests investors underweight consumer-discretionary stocks. The reason: Interest rates and energy prices might hurt consumer spending. But the sector has at least one bright spot, and it has to do with dogs.

No, we're not talking about underperforming stocks. We mean canis familiaris -- and all the other varieties of pets that Americans love to pamper.

NO SCALING BACK. S&P equity analyst Michael Souers is bullish on the stocks of three companies that serve pets and the owners who love them. Why? The numbers paint a very enticing picture. According to the American Pet Products Manufacturers Assn. (APPMA), sales of pet products topped $34.4 billion last year, more than doubling the level seen in 1994.

Based on a recent survey, more than 69 million U.S. households, or 63%, own a pet. Of course, one isn't always enough -- 45% of those households own two or more.

The dog remains the most popular nonhuman companion, with more than 43 million households owning one. In 2004, households spent an average of $1,571 on Fido. Cats follow close behind, with almost 38 million homes cleaning up furballs. However, since they usually come 10 to a tank, freshwater fish are the most populous pet in the U.S. The APPMA estimates 139 million of them are swimming in 14 million homes.

The pet-product industry falls into the following categories: food, supplies and medicines, veterinary care, pet services such as grooming or boarding, and outfits that actually sell pets.

"INSULATED FROM PRESSURES." The APPMA estimates that dog food, cat food, and treats represented 41% of the market in 2004, with pet supplies and medicine sales accounting for 24%. Among other categories, veterinary care fetched 23%, pet services 7%, and purchases of pets 5%.

Souers expects the industry to keep growing like an overfed cat. He projects a compound annual growth rate of 6% through the end of the decade, excluding equine, veterinary services, and sales through catalogs and the Internet.

"Pets are being considered more like family members than ever before," Souers says. "As a result, we think sales of pet products should be somewhat insulated from the economic pressures weighing on other consumer-discretionary items." In other words, a choice between new shoes and taking your sick dog to the hospital isn't really a choice at all.

DIVIDEND INCREASE? In the retail segment, Souers thinks PetSmart (PETM

; recent price, $25) is well-positioned. He has a 5 STARS (strong buy) recommendation on the shares and points out that the company has pioneered several high-margin services businesses, including overnight boarding.

Souers expects PetSmart's gross margin to widen modestly, benefiting from its price-optimization software, economies of scale, and a shift from lower-margin pet-food sales to selling higher margin products.

In the analyst's opinion, the company's balance sheet is strong, with nearly $3 per share in cash and no long-term debt. He thinks the company will continue to repurchase shares and foresees a possible dividend increase in the next year. The shares currently pay a dividend of 12 cents annually.

LOYALTY PROGRAMS HELP. Souers also likes PetSmart's rival Petco (PETC

; $21), which he ranks 4 STARS (buy). Petco operates more than 700 large pet-supply stores in 48 states and the District of Columbia. As Souers sees it, the company will gain market share from independent pet stores and supermarkets. He projects a sales gain of 11% for fiscal 2006 (ending January) and thinks the company's service businesses, especially grooming, will show particular strength.

Both PetSmart and Petco have loyalty programs, and Souers believes this will help keep customers coming back for more.

But pet ownership isn't just about kibble and chew toys. According to industry data, consumers spent more than $18 billion on animal health-care services in 2001. Souers expects that number to rise consistently as diagnostic testing for animals increases in popularity and expands in scope.

PROWLING FOR CLINICS? To capitalize on the trend, the analyst recommends purchasing the shares of 4 STARS-ranked VCA Antech (WOOF), which operates veterinary diagnostic laboratories and freestanding, full-service animal hospitals. He expects the company to generate revenue growth of 23% in 2005.

More important, Souers says, VCA Antech currently operates only 365 of the approximately 17,000 veterinary clinics in the U.S. In his view, the company will be able to continue increasing its presence through acquisitions.

Mattive is senior editor of Standard & Poor's weekly investing newsletter, The Outlook

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