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S&P expects the pet products retailer to expand its market share, and ranks the stock a strong buy
From Standard & Poor's Equity ResearchPetSmart (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. Furthermore, we think an increased reliance on high-margin services offerings and a return to more "normalized" consumer spending levels should help to reverse the recent unfavorable mix shift. We believe PetSmart has the long-term potential to drive operating margins of nearly 9%, boosted by continued underlying industry growth, expansion in services, and improved pricing power as it continues to gain market share.
Phoenix-based PetSmart is the leading specialty provider of products, services, and solutions for pets. In fiscal 2008, PetSmart had an industry-leading $4.7 billion in revenue. The company opened 100 net new stores in fiscal 2008, and operated 1,008 retail stores in North America on Feb. 3, 2008.
Company stores typically range in size from 19,000 to 27,000 sq. ft., and carry what PetSmart considers a broad selection of high-quality supplies at everyday prices. More than 10,500 items are offered, including nationally recognized brands, as well as an extensive selection of private brands. The product assortment is complemented by a selection of services. Virtually all of its stores offer complete pet training services and pet styling salons.
In addition, PetSmart offers full-service veterinary hospitals in 685 of its stores. Medical Management International, an operator of veterinary hospitals, operated 673 of the hospitals under the registered trade name of Banfield, The Pet Hospital. The remaining 12 hospitals are located in Canada and are operated by other third parties.
Merchandise, which accounted for 90% of retail revenues in fiscal 2008, consists of pet food, treats, and litter (41%), pet supplies and other goods (47%), and live pets (2%). PetSmart emphasizes premium dog and cat foods, many of which are not available from supermarkets, warehouse clubs, or mass merchandisers. It also offers national brands found in supermarkets and pet stores.
Pet services represented 10% of revenues. Grooming and training are offered in virtually all PetSmart stores. PetsHotel provides boarding for dogs and cats, 24-hour supervision, an on-call veterinarian, temperature-controlled rooms and suites, daily specialty treats and playtime, as well as day camp for dogs. As of Feb. 3, 2008, PetSmart operated 97 PetsHotels within retail stores, and it expects to expand this concept to 435 hotels. The Doggie Day Camp concept is available at all PetsHotel locations.
The pet industry serves a growing market, and we expect industry revenues to increase at 5%-6% over the next five years. The American Pet Products Manufacturers Assn. (APPMA) estimated the 2007 market at $41.2 billion, up more than 140% since 1994, and projects 5.3% growth in 2008, to $43.4 billion. Based on the 2007-08 APPMA National Pet Owners Survey, more than 71 million U.S. households, or 63%, own a pet.
The pet product industry can be divided into the following categories: food, supplies/medicines, veterinary care, pet services (such as grooming or boarding), and purchases of pets. The APPMA estimates that in 2007, sales of food and treats for dogs and cats, the largest volume category of pet-related products, approximated $16.2 billion, or 39% of the market. Pet supplies and medicine sales accounted for about 24% of industry sales. Veterinary care, pet services, and purchases of pets represented approximately 25%, 7%, and 5%, respectively, of the market.
Increasingly, pets are being treated like family members, according to the APPMA. While discretionary spending by consumers is likely to slow in 2008, precipitated by rising gasoline prices, a decline in home equity loans and refinancing, and burgeoning debt levels, we believe that pet retailers are somewhat insulated from these pressures. If pets are considered part of the family—and are treated as such—we think this subindustry should be able to weather the negative economic issues that are currently hurting most retailers.
We project earnings per share of 29¢ for the coming July quarter (which we expect to be reported on Aug. 13) on sales growth of 8.5%, including comp-store growth of 2.0%. We expect gross margins to narrow approximately 150 basis points because of unfavorable mix shift comparisons and higher distribution costs.
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.
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.
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.
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.