PetsMart's Animal Attractions

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Based on a recent survey by a pet-products industry group, three-quarters of dog owners and more than half of cat owners consider their pets like children or family members. While we at Standard & Poor's Equity Research think consumers' discretionary spending will likely slip in 2005, we believe pet-supply retailers are well insulated from economic pressures. After all, if pets are considered part of the family -- and are treated as such -- it stands to reason that consumers would cut back on other discretionary outlays before they scrimp on Fido and Fluffy.



That bodes well for pet-products retailer PetsMart (PETM; recent price, $27). Based on what we see as strong industry fundamentals, favorable demographic trends -- including rising pet ownership and greater spending per pet -- as well as company-specific positives such as valuation, we have a 5-STARS (strong buy) ranking on PetsMart. We also think its fast-growing service offerings, a strong balance sheet, and attractive growth prospects make the shares even more appealing.



PetsMart is the leading U.S. retailer of pet food, supplies, accessories, and professional services. As of Jan. 30, it operated 726 retail stores in the U.S. and Canada. Its stores typically range in size from 19,000 to 27,000 square feet. They carry the industry's broadest line of products, with over 12,900 stock-keeping items. This product assortment consists of nationally recognized brand names, as well as an extensive selection of private brands. PetsMart anticipates opening 100 new stores in fiscal 2006 and will likely continue its aggressive store growth until it meets expected saturation at about 1,400 stores.



NEW EDGE. The retailer complements its extensive product assortment with a selection of value-added pet services, including grooming, pet training, boarding, and day camp. Virtually all of the stores currently offer complete pet-training services and feature pet-styling salons that provide grooming services.



PetsMart's boarding services and day camp are relatively new offerings. PetsHotel provides boarding for dogs and cats -- 24-hour supervision, an on-call veterinarian, temperature-controlled rooms and suites, daily specialty treats, and play time -- as well as day camp for dogs. PetsMart tested its first two PetsHotels in 2002 and, as of Jan. 30, operated 16 PetsHotels within retail locations as well as one stand-alone unit. It expects to open 12 new PetsHotels in fiscal 2006 and 20 more in fiscal 2007. It's currently still testing Doggie Day Camp service, which began in October, 2004.



While services accounted for only 7% of revenues in fiscal 2005, these offerings are growing well in excess of 20% per year. We think they provide the retailer with substantial competitive advantages.



DOGGED LOYALTY. In addition to its broad product assortment and services offerings, full-service veterinary hospitals are located in approximately 430 stores, offering routine examinations and vaccinations, dental care, a pharmacy, and routine and complex surgical procedures. Medical Management International, in which PetsMart has a significant ownership interest, operates substantially all of these hospitals. PetsMart receives licensing fees from MMI for the space in its retail stores occupied by veterinary services.



PetsMart is also in the midst of rolling out its loyalty program through a Pet Perks loyalty card. Available in over 300 stores, this card helps the company track consumer data and preferences, as well as building loyalty from shoppers.



The pet-product industry serves a large and growing market. The American Pet Products Manufacturers Assn. (APPMA) estimates the 2004 market at approximately $34.4 billion, an increase of over 100% since 1994. Based on the 2005/2006 APPMA National Pet Owners Survey, more than 69 million U.S. households, or 63%, own a pet, up from 62% in 2002. In addition, 45% of those households own more than one type of pet.



ROOM TO ROAM. According to the APPMA, the industry, excluding equine, veterinary services, and catalog and e-commerce sales, is expected to grow at a compounded annual growth rate (CAGR) of 6% through the end of the decade, providing a strong base of growth for pet supplies retailers such as PetsMart.



PetsMart's store count in North America is approximately the same as that of rival Petco Animal Supplies (PETC; Buy; $30) as of Jan. 30, 2005, but with almost double the square footage. This size advantage gives PetsMart stores the ability to provide a wider range of services offerings -- a competitive advantage, in our view, which should help drive strong customer loyalty. In addition, since services as a whole are growing faster than the industry in aggregate, we believe they provide the outfit with another way to procure future growth.



PetsMart directly overlaps with Petco in more than 40% of cities where it has a retail location -- which is a relatively low figure. Currently, we believe consumers focus more on convenience than price when visiting pet stores. While there's plenty of room for each of these companies to grow,consumers may begin to focus more on price as locations of both stores become more prevalent.



IN THE BLACK. From our research, we have concluded that PetsMart prices its products at a significant discount to Petco, and its prices are only slightly higher than discount stores like Wal-Mart (WMT; Strong Buy; $48). However, PetsMart's broad selection of pet-supply products dwarfs Wal-Mart's offerings. This suggests to us that as store growth continues to ramp up sharply, PetsMart could possibly capture additional market share as price becomes more of a differentiating factor.



The retailer's balance sheet is very solid, in our view, with no long-term debt and just over $400 million in cash and short-term investments, representing nearly 25% of assets. Despite a large increase in capital expenditures supporting store growth, we forecast that free cash flow will be in excess of $75 million in fiscal 2006, and greater than $100 million in fiscal 2007 and beyond.



Operating margins have been increasing at an aggressive clip over the past few years, yet we believe there's room for further expansion. Operating margins of 8.4% in fiscal 2005 increased significantly from the 6.2% generated in fiscal 2003. However, even after accounting for stock-option expenses, we're forecasting operating margins of 8.5% in fiscal 2006 and 9% in fiscal 2007. We believe continued growth in services and the leveraging of expenses over a greater sales base should result in further expansion.



A LOOK AHEAD. Share purchases by PetsMart's COO and two directors within the past month suggest to us that insiders believe the shares are undervalued. The most recent time insiders had purchased shares was in August, 2004, and we view recent insider buying positively.



We're projecting EPS of 23 cents in the coming April quarter (results are expected to be announced on May 18). Based on our view of approximately 14% sales growth and slightly improved margins, we see fiscal 2006 EPS increasing 21% on a comparable basis, to $1.26. Our fiscal 2007 EPS estimate is $1.51.



PetsMart has chosen to expense stock options in the company's coming fiscal quarter, ahead of the imposed deadline by the Securities & Exchange Commission. Our fiscal 2006 and fiscal 2007 Standard & Poor's Core EPS estimates of $1.26 and $1.51, respectively, reflect the company's decision to expense options. This decision contrasts with Petco, which has chosen to delay the expensing of options for the time being. Therefore, we caution that current Street comparisons between the two are not on an apples-to-apples basis.



Shares of PetsMart are down approximately 25% thus far in 2005, precipitated, in our view, by slightly weaker-than-expected sales and a confusing earnings report released in March. In addition, consumer-discretionary stocks in general have been under pressure recently, due to investors' concerns over a slowing economy -- and how that might affect discretionary spending.



BUILDING OUT. The shares are trading at 21 times our fiscal 2006 EPS estimate, well below the retailer's historical average of approximately 30 times but at a slight premium to Petco and a modest premium to the S&P MidCap 400.



We think PetsMart's balance sheet is strong, with nearly $3 in cash per share and no long-term debt. While the planned opening of 100 new stores as well as 12 new PetsHotels in fiscal 2006 should be highly capital-intensive, we remain confident that PetsMart will continue to repurchase shares in an active and timely manner, as well as potentially increasing its dividend. The $150 million share repurchase plan, announced in September, 2004, is effective through the end of fiscal 2006.



The shares don't appear undervalued to us based on p-e alone. However, once growth is factored in, the stock looks even more attractive, in our opinion. We believe that strong industry growth and PetsMart's aggressive push to open new retail stores will lead to robust sales and earnings growth at least through the end of the decade.



SHOCK ABSORBERS. We're forecasting just under 19% earnings growth over the next five years, giving the retailer's stock a current p-e-to-growth (PEG) ratio of 1.1. While this is only a slight discount to the S&P MidCap 400's current rate of 1.2, the growth part of the equation for PetsMart is far greater and provides the real impetus for purchasing the shares, in our opinion.



Moreover, should the economy weaken further, we believe PetsMart may still accomplish this growth due to its insulation from economic pressures. In addition, while Street EPS estimates for most outfits still don't account for stock-option expenses, estimates for PetsMart do -- providing, we believe, a potential catalyst for the shares relative to the index once all companies' EPS estimates incorporate option expensing.



Our 12-month target price of $33, which is based on discounted cash-flow analysis, implies potential appreciation of more than 25% from current levels.



NOTABLE RISKS. We believe PetsMart's corporate-governance practices are sound. It expenses stock options and has an entirely independent board of directors (with the exception of its CEO). In addition, we think executive compensation is reasonable, and insiders accounted for less than 5% of total shares outstanding as of April, 2004. On the downside, its board of directors has adopted many anti-takeover provisions, including a poison pill, and shareholders don't have cumulative voting rights.



Several risks to our recommendation and target price exist. PetsMart may have difficulty securing attractive real estate locations as it pursues its aggressive growth strategy. The stores are generally located in sites co-anchored by other strong destination superstores and typically are in or near major regional shopping centers. Should PetsMart fail to find attractive locations, sales and earnings growth might disappoint investor expectations.



A slowdown in consumer spending could adversely affect sales. While we believe that a majority of the company's sales are somewhat insulated from an economic slowdown, demand for services offerings such as Doggie Day Camp and PetsHotels would probably suffer if consumer spending were to slow. Growth of the store base may cannibalize sales at existing stores, and new locations may not achieve the same sales results that current stores do.



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're projecting.