PetSmart: Who's Eating the Revenue?
Board: Value Hounds
According to the 2014 APPA National Pet Owners Survey 68% of American households have pets, which amounts to about 82 million homes. In total, there are about 96 million cats and 83 million dogs owned as pets in the United States, and all of those pets need to eat.* On top of the basic needs of food and veterinary care is a multitude of "nice to have's" in the form of toys, leashes, shampoos, books, and vitamins that help swell the US pet industry into a half trillion dollar a year business.
PetSmart is the leader in the pet merchandise category with a 17% market share, almost double that of its nearest rival, privately-held Petco.** While PetSmart carries a range of products the store specializes in premium pet food and supplies, many of which can't be found at regular grocery stores. PetSmart's 1340 stores sell a combination of consumables (54% of sales), hard goods (33% of sales), and small pet sales (2%). Higher margin pet care like grooming, boarding, and training (11% of sales) rounds out the revenue pie chart. PetSmart also offers veterinary care through its 21% equity ownership in Banfield though this shows up on the income statement as equity income instead of as revenue. PetSmart also has an established online presence at PetSmart.com that will ship to the customer or allow for in-store pickup, allowing the customer in many cases to avoid shipping fees (which can increase the cost of a 30 pound bag of dog food by 40%).
PetSmart has managed a five year average return on invested capital of slightly over 20%, and there's no financial leverage if you don't count the capitalized operating leases for the stores. The business is a pretty stable one, even growing sales in the mid to high single digit percentages during the Great Recession (vs. low double digits before). Meanwhile, management has been regularly buying back shares over the years, with share count down 17% from five years ago.
The stock price is down recently due to lower than expected revenue growth, lower than expected same store sales growth, and reduced guidance for the full year. Ouch! Those things justifiably stoke concerns that PetSmart might be the next Best Buy/Office Depot/Barnes and Noble, a future victim of continuing inroads from online sales.
PetSmart's revenue growth has averaged almost 6.5% over the last five years but this has slowed recently to the low single digits. Part of this is due to PetSmart's reduced spending on growth (d&a charges are actually greater than capex these days), another part of this is due to volatile, non-business-related factors such as currency effects and weather (6% of revenue is made in Canada), and some is indeed due to increased competition in the premium pet food space, by management's own admission. For 2014 management is only forecasting low single digit sales growth though its still forecasting growth over the next several years of 4-6%, which should be achievable through a combination of 2-3% store count growth (last couple of years averaged 4%) and 2-3% same store sales growth (last five years averaged 4%). In my valuation I'm using the low end and setting growth to 4% over the next ten years, with 3% terminal growth.
Operating margins have been steadily climbing as depreciation and amortization charges gradually drop as a percentage of revenue due to reduced spending on growth and are now at 10%, up from about 7.5% a few years ago. D&A expense is only 3.4% of revenues as opposed to over 4% in 2011. Likewise, Capex is now only 2% of revenues, down from 4-6% in the early 2000's. Since store growth is already slowing, I don't give operating margins any more credit for increasing further (though they might) and leave operating margins at their current 10% in the valuation. I bring capex and D&A in line over the next ten years so that capex ends up at 2% of revenues and d&a ends up a little less than that at 1.8%.
Discounting those cash flows at 10% I get a valuation of around $76. At today's prices of around $61 that's a 20% discount to what I think is a conservative valuation of a debt-free, high return on capital business. Not dirt cheap by any means, but a fair price for a pretty good business. It's not cheap enough for me to want to buy but it's on my radar.
A large part of the worry surrounding PetSmart is how defensible its narrow moat of selling premium pet food and supplies really is. PetSmart faces well-financed, well-managed operators both online and at neighborhood storefronts.
Currently grocery stores like Kroger's, Costco, Whole Foods, and Wal-Mart don't carry the breadth of food and supplies that PetSmart does nor do they tend to carry the higher end brands of pet food. That said, these competitors have been making inroads into the premium pet food/consumables market, eyeing PetSmart's enviable ungrocery store-like margins and returns on capital. It's hard to know how far traditional grocery stores will delve into premium pet food.
There's also the threat of online competition from the likes of Amazon. Pet food has a low price/weight ratio which makes it expensive to ship door-to-door, possibly limiting its appeal. However, the appeal is apparently large enough that Petsmart has a successful online business through PetSmart.com and Amazon has also established a beachhead through its affiliate wag.com. Both wag.com and PetSmart.com offer free shipping on orders over approximately $50 (which is what a 30 pound bag of dog food tends to cost). Setting up test orders on both sites it looks like they're about neck and neck in terms of expense and number of items available.
I think the market is offering up a decent (but not great) price for a good business due to over-estimating future threats. For example, I can match my valuation estimate to the current share price if I estimate 2% sales growth, which would assume ongoing market share loss as PetSmart continues expanding store count by 2-3%. Another way to justify the current price on the shares is if margins dropped to 7% or so as prices needed to be significantly cut to match a competitor's. While these are possibilities, they seem like worst-case scenarios.
*From PETM 10-K.
*From Morningstar PETM writeup