Description

Petco Health and Wellness (WOOF) is an interesting long-term investment at current levels. The company is the best bricks and mortar operator in the pet products space, which is a secularly attractive one, and is growing online and expanding its omnichannel capabilities. It also has a growing veterinary services business – which I admit to being initially skeptical of - but further due diligence has made me change my tune.

WOOF stock is down 70% from its all-time high in early 2021 as it is facing tough comps from the pandemic in the supplies part of its retail business, which is both discretionary and tied to the pet adoption cycle.

Petco went public (again) in 2021 at a time of peak growth and was valued with a peak multiple (which wasn’t a great set up for near-term performance). Its margins have been under pressure, primarily from this mix shift. Buying depressed margins that can rebound is often a good strategy with retailers, with the giant caveat that you must make sure the margins aren’t in secular decline for structural reasons and also that the overall concept isn’t in the process of dying at the hands of the fashion gods or fickle consumers. Neither of those caveats apply to Petco, which is a steady low to mid-single topline grower, with occasional bursts well above that, and which sells a lot of basic consumables/replenishable items (food, litter, etc.) and has almost no fashion risk.

Additionally, this is a company that has gone private via leveraged buyout not once but twice… which perhaps implies there is a long-term floor under this stock from PE.

I think time will fix a lot of Petco’s wounds (tough comps when it comes product mix, which is dragging down margins as well as temporarily dilutive aggressive growth in the vet hospital business) and you have some nice optionality in the vet business. The new rationality in the Silicon Valley and in how investors treat unprofitable tech and consumer tech is also a positive for Petco, since pet products are a very tough place to make money with a centralized ecommerce model (food bags are heavy and expensive to ship!). The lack of speculative money pouring into unprofitable upstart competitors is a positive for market incumbent Petco.

Pet Industry Background

The pet industry was $119 billion in 2021 in the U.S., with consumables comprising the largest piece, with vet care and supplies the next biggest pieces.

Source: Petco 2021 AGM Presentation

The pet industry has also been one of the most attractive ones in CPG, with growth over the last decade averaging in the high single digits. As a result, M&A activity has been heavy in the pet food area, with General Mills’ acquisition of premium food maker Blue Buffalo a prime example.

A lot of what’s driving this growth is premiumization, with consumers trading up to higher quality – and higher priced - foods and treats for their cats and dogs, in a bid to improve their longevity, health, wellness, and quality of life. The key driver behind the premiumization trend is that pets in America are increasingly viewed as a member of the family, and their people see themselves as “pet parents” as opposed to pet owners. And among the growing cohort of young Americans who are opting to be childless by choice, many are embracing pet parenthood.

The anthropomorphizing of dogs and cats has been good for the pet industry, translating into annual growth that outpaces that of the economy and most broad consumer spending categories:

Source: Petco 2021 AGM Presentation

There was a big surge in pet adoption activity during the pandemic when people were stuck at home, and despite the occasional alarmist article about people returning their pandemic pets upon society reopening, the vast majority of these companion animals are still in their new homes… and will be for the rest of their lives. The pandemic increase in pet ownership created a 10– to 15-year tailwind (no pun intended!) for the industry.

Another thing in the industry’s favor is that young people tend to spend more on their pets than their parents and grandparents do. A recent study showed that in 2021, Gen Z pet owners on average spent approximately twice as much on their pets than baby boomers did.

Petco Company Description and Competition

Petco is an omnichannel retailer with more than 1500 stores and an ecommerce business. Within its stores, it has a growing services business that offers grooming and training. Petco also operates 257 vet hospitals in its stores. Its topline performance has been incredibly consistent, with the first quarter of 2023 representing its 18^th consecutive quarter of same store sales growth (or 12^th consecutive quarter of positive comps for brick-and-mortar stores).

Petco is really trying to be a one-stop shop for everything a pet parent could need to keep their pet happy and healthy. Not only can you get food and toys there, but also see a doctor, get a vaccine, pick up a prescription, or get a haircut. No one else in the pet retail industry has brought healthcare/vet into the stores to the extent Petco has.

Its primary competitor in pet specialty is privately held (but once public) PetSmart. Petco and PetSmart have similar business models, but Petco tends to carry a fuller range of premium products and therefore cater to a higher end, wealthier customer (an attractive and less cyclical demo when it comes to pet expenditures). Petco also eschews all low-end products that it deems unhealthy for pets and has cleared the store of such products. Privately held and franchised Pets Supplies Plus is also a national player in pet specialty. Mom and pop specialty pet supply stores are still out there, but many have closed. In some markets, Petco could compete with Tractor Supply (TSCO) in some categories.

Walmart (WMT), Target (TGT), Costco (COST), and grocery stores are also big players in pet consumables (and to a lesser extent supplies). But the product selection at these mass stores is way more limited in choice and range than what Petco offers. These mass retailers are not particularly competitive in food versus Petco, as most premium pet food companies pursue a strategy of limited and tiered distribution.

Online, Chewy (CHWY) is a major force and has done a tremendous job growing sales and building customer loyalty, although the company has only recently turned profitable and has gross margins under 30%, over 10 points lower than Petco’s. Being a purely online player in the pet space is a tough business because of the high cost of shipping heavy bags. Petco’s store base offers a competitive advantage versus a centralized distribution center in fulfilling online orders. Instead of using third party shipping and logistics companies to move products over a long distance, Petco can fulfill orders locally from its stores and keep last mile delivery in-house (and minimize how many miles goods have to travel).

Amazon (AMZN) is also a big player in pet products online, but there is obviously no visibility into how profitable this business is for them – but my strong suspicion is not very. North America margins in the first quarter at Amazon (which includes everything except for AWS – so ecommerce, Whole Foods, Amazon Prime Video, etc.) were only 1%, and I would guess that online pet products are below average on margin within this division.

Because of its attractive secular growth characteristics, the pet space has always attracted a lot of ecommerce investment (think back to Pets.com in Web 1.0 for those who were doing this in 1999-2000!). So the return to reality and the renewed emphasis on profitability and not just topline growth is a net benefit for Petco, because they will likely have to deal with fewer market players doing uneconomic things in the next five years than they did in the prior five years.

Recent Events

Petco has been the victim of an extremely margin dilutive mix shift over the last several quarters. When all those pandemic puppies were brought home, there was a big load-in on supplies – things like crates, toys, food bowls, leashes, etc. These carry much higher margins – as much as 2x the gross margin of consumables like food and litter. Most supplies are consumer semi-durables… they don’t get replaced very frequently, in contrast to the lower margin consumables that have to be constantly replenished.

When pet adoptions surged, so did Petco’s gross and EBITDA margins. In 2020-2021, Petco enjoyed several quarters of gross margins in the 42%-43% range. In mid-2022, gross margin started to drop, first to 40% and now to 39% in the first quarter. Some of this was inflation, some of it was mix shift. The first quarter was particularly bad on the margin front.

One could easily bucket Petco in with the “pandemic winners” that are falling back to earth… but it’s important to note that unlike most pandemic winners that have had a fall from grace, Petco has never had a topline problem. Sales have held up and even continued to grow – it’s all been a margin problem, with mix shift being the primary culprit.

Tough comps will however eventually anniversary. I believe Petco is going through a speed bump within a broader set up that is one of the most attractive in retail. I think they are good operators and their movement into services and vet care is smart for both driving traffic and visit frequency, but also in building customer loyalty. They do a great job in private label products, and success here is accretive to gross margins.

The Vet Hospital Business

I was originally skeptical of this business, thinking that well-heeled pet parents wouldn’t want to get healthcare for their fur babies through a big corporation or a retailer. After conducting interviews with industry experts and following the early KPIs… I have concluded my gut instinct was wrong. Plenty of pet parents will choose convenience over snobbery and anti-corporatism.

One big issue in the vet business is the scarcity of vets. Petco has a lot to offer a vet who is interested in delivering care and less interested in being a business owner. Petco also offers a lot of flexible options, such as the ability to work part-time. The majority of young graduates from vet school are now women – this wasn’t the case in the past – and the ability to work a less than 40-hour week has been a good recruiting tool for Petco with vets that have young children. Corporate benefits packages can also be attractive compared to those offered in a small practice. Management noted that the number of new vets recruited in the first quarter into the Petco ecosystem was up 60% year over year.

Petco’s vet hospitals lose money in their first year, breakeven in the second, and by year 5, the goal is a 20% EBTIDA margin. Growing this business over time should ultimately be very accretive, as the margins in the retail business are much lower (high single digits). Growing the vet business is in the short-term, however, a drag on margins.

Valuation

I think Petco can get to approximately $7 billion in revenue in FY27/CY26 (Petco has a January year-end) without any heroic topline assumptions. This estimate is basically in-line with where street estimates are, if they went out that far. I assume EBITDA margins can get to 9%, implying $630 mm in EBITDA. I think a fair multiple for a big box retailer that is a market leader, sells a lot of consumables, operates in a consumer spending segment with a good secular growth backdrop, etc. would be 10x, which gets you to a $18 stock in three years – so basically a double in 3 years.

To come up with that 10x multiple, I looked at historical multiple ranges for retailers operating in categories with similarly attractive secular growth and strong market leadership positions (e.g., ULTA) and retailers that have a mix of consumables and discretionary items, with good customer loyalty (e.g., TGT). I also looked at the valuations on the two Petco LBOs.

They could probably do better than my targets if you add in the benefits of deleveraging over time.

If you look at how vet businesses are valued, Petco looks even cheaper. Petco Services will generate about $1 billion in revenue this year and grew 25% in the first quarter. Services includes grooming, classes, and vaccine clinics in addition to the vet services, but Vet is the biggest part of services. The PE market for vet practices has been active and at very healthy multiples. As an example, in late 2021, L Catterton spent somewhere between $750 mm and $800 mm to buy vet hospital operator Alliance Animal Health, which had $39 million in pro forma EBITDA at the time.

It’s a rough exercise – and PE multiples may have come down from the 20X EBITDA they were reported to be a year ago – higher interest rates can do that. Petco is probably at a $750 million run rate (growing 25%) for its vet business, which would imply $150 million of pro forma potential EBITDA at scale. But even if PE would only factor in $75 mm in EBITDA and pay 15x for that now, that’s still over $1 billion in value versus the company’s enterprise value of $3.8 billion. If you backed out $1.1 billion from the EV and $75 million from the EBITDA, the retail business is only 6x EBITDA.

I think there are massive synergies in the vet business living within the retail business (traffic building, share of wallet, loyalty for retail and low customer acquisition costs, attractive working environment/corporate benefits for vets – who are in short supply), so I am not suggesting they could or should spin or separate. But it’s worth nothing that healthcare-oriented investors are out there paying a lot for vet businesses because of the growth and secular set up, and this fact is probably underappreciated by the retail analysts who generally cover this company, and are probably comparing it to Target, Home Depot (HD), Best Buy (BBY), AutoZone (AZO), or dollar stores.

While not core to the investment thesis, Petco has notable charitable initiatives including in-store pet adoptions (executed in partnership with local non-profits), free vaccinations, and lost pet search services. In the first quarter, Petco Love placed 100K animals in homes and delivered 240K free vaccines. Since starting its Petco Love Lost program, Petco has reunited 20K lost pets with their families. While there is no direct short-term financial derivative from these good works, I do believe this commitment to animal welfare builds Petco’s reputation and credibility in wellness, which can increase customer loyalty and goodwill, which can over time translate into sales and market share.

Risks

Petco went public after an LBO, so it carries relatively high leverage for a retailer, at a touch over 3x. I’m comfortable with this level of leverage in this instance because of the high mix of staple, non-discretionary items it sells, that along with secular industry factors supports a long history of steady topline growth.

As with any retailer, macroeconomic headwinds to the consumer – inflation, rising rates, increasing layoffs, etc. – are a concern. But consumables and vet services are not things that get cut unless a lot of other things have been cut first.

Short interest is high here at 20%. It was as high as 30% when the stock was higher. The shorts were right that short-term earnings estimates had been too high. The last two quarters were both very disappointing. I’m not sure why the shorts are still there and what the thesis is down at these levels. Perhaps they think there are more quarterly misses ahead, or they are betting on the financial leverage catching up to them. High short interest to me is a red flag worth noting but it can cut both ways. If the shorts are wrong – or were right but overstayed their welcome – the red flag can turn into an upward catalyst in a hurry.

Private equity sells stock. The controlling shareholder/financial sponsor still owns 38% here. I am playing a long game here, so I am ok with waiting out (or buying opportunistically) on temporary supply-demand driven stock dislocations.

Competition. Limited distribution dog foods could turn around and decide to go into Target (unlikely) or Chewy or Amazon could start doing irrational things with pricing and promotions (I think less likely than it was a year ago). But anything is possible in retail/ecommerce.

Catalyst

• Mix shift away from supplies anniversaries and then starts to normalize
• Vet hospitals mature and go from drag on company-level EBITDA results to an accretive factor
• Deleveraging over time