Description

Headline: Price war causing PETS to hemorrhage share and margin; EBITDA to miss near-term consensus by 35%.

Disclaimer: At the time of publication, the author of this article holds a short position in PetMed Express, Inc. (PETS).  This article expresses the opinions of the author. The author has no business relationship with any company whose stock is mentioned in this article.

The author of this article has a short position in the company covered herein and stands to realize gains if the price of the stock declines. Following publication, the author may transact in the securities of the company, and may be long, short or neutral at any time.  The author of this report has obtained all information contained herein from sources believed to be accurate and reliable. The author of this report makes no representation, express or implied, as to the accuracy, timeliness or completeness of any such information, or as to the results to be obtained from its use.  All expressions of opinion are subject to change without notice, and the author does not undertake to update or supplement this article or any of the information contained herein. This is not an offer to sell or a solicitation of an offer to buy any security.

Business Overview:

PetMed Express (PETS) sells veterinary pharmaceuticals and other pet healthcare products directly to consumers. ~85% of revenue is generated online (1800petmeds.com) with the remainder coming via PETS’ call center and catalog¹. Key products include flea, tick & heartworm preventatives, skin, dental, ear & eye care, vitamins & nutritional supplements, and medication for arthritis, heart & blood pressure.  

• Approximately half of PETS’ revenue comes from prescription (Rx) products. The company’s primary competition in this market comes from veterinarian practices, and increasingly, other online pet pharmacies which sell directly to consumers.  

• The other half of revenue is non-Rx, which can be purchased from a wide variety of mass market retailers in addition to the aforementioned Rx competitors.

• Of the ~$5bn Rx & non-Rx pet domestic veterinary pharmaceutical industry (size may vary depending on definition), veterinarians have ~58% market share, mass retailers have ~30% and the direct channel has ~12%. PETS has ~50% share of the direct channel, or ~6% overall¹.

Thesis:

On July 2nd, 2018 Chewy.com (a subsidiary of PetSmart), the dominant online pet supply retailer, entered the veterinary pharmaceuticals market with the launch of Chewy Pharmacy. Since then, Chewy has initiated a price war to rapidly gain share. Simultaneously, Amazon is adding SKUs in PETS’ categories, PetCo has partnered with Express Scripts to improve pharmaceutical sourcing, and Henry Schein is merging with Vets First Choice to increase the competitiveness of veterinarians in pharmaceutical e-commerce. We believe these dynamics have already caused PETS’ top-line growth to go negative in 3FQ19 to date (relative to +7.6% consensus estimate²), and PETS has been forced to cut prices on their top selling SKUs by an average of ~9%, which is causing material gross margin pressure.

We expect PETS to miss consensus FY 2020 (FYE March 2020) EBITDA expectations by 35% and force remaining bulls to capitulate by demonstrating that, in addition to slowing New Customer revenues, Reorder revenues are also at risk.

In the longer term, we believe PETS will be a structural share donor with contracting margins due to increasing competition from larger and more capable entrants. PETS’ historical sourcing advantage is deteriorating, leaving PETS highly vulnerable in a commoditized market place with ultimate price transparency. We believe fair value for PETS shares is in the mid-teens, ~40% below the current ~$25 share price.

Price War Timeline³:

• Chewy Pharmacy launched July 2nd with a modest price advantage over PETS

• By early September, Chewy lowered prices and opened a >5% average price gap to PETS on top SKUs

• By November 7th, Chewy cut prices by a further ~5%, forcing PETS to follow suit as, we believe, PETS began to suffer significant top line deceleration beginning in September (see next section)

• Over the past 3 weeks PETS has cut prices further, significantly reducing (but not closing) its gap to Chewy

Price War Impact on PETS’ Revenue Growth:

• Our proprietary consumer transactional data ensemble of 4 independent data sources⁴ that track consumer spend, which has a strong historical correlation with PETS’ revenue growth, has decelerated by over 10% on a YoY basis since 2FQ19

• This deceleration began in September, which coincides with the acceleration of Chewy’s aggressive price actions and explains why PETS’ aggregate 2FQ19 revenue was unimpaired

Immediate Threats:

A. New market entrants have ignited a price and market share war: We believe PETS is ceding material market share driven by a chain of events sparked by Chewy’s entry into the direct pharmacy channel. Below are the various competitive events in recent months that are contributing to sales and margin pressure:

1. On July 2nd, Chewy entered the pet pharmacy business. Chewy is a dominant force in the pet supplies e-commerce channel, commanding nearly 50% of pet food market share⁵. Purchased by Petsmart in April of 2014 for $3.4bn⁶, Chewy is a growth story that depends on top-line momentum to sustain its valuation.

• A cross-shop analysis of our aforementioned transactional data set shows that approximately 28% of customers who shopped at PETS also made a purchase from Chewy.com in the past 12 months, which is up from 21% the prior year. This puts the short and long-term defensibility of PETS’ Reorder revenue in jeopardy, as a steady drip of PETS’ customers are likely to notice the advantages Chewy has on price and service over time.

• Chewy has initiated a price war on PETS’ top selling SKUs in recent months to accelerate top line growth (see Price War Timeline section) and still maintains an overall price advantage over PETS despite PETS’ recent price cuts³.

• Chewy’s dominance in pet food and other supplies gives it a structural advantage over PETS as a one-stop-shop pet retailer now that it also carries nearly everything PETS carries.

• We believe that the Chewy.com web interface is more attractive and customer friendly than 1800petmeds.com. Chewy.com also has a superior reputation for customer service.

• Chewy is clearly targeting PETS’ customers directly and intentionally with aggressive promotional messaging and dominance of key google AdWords7.

• E.g. Google results on 11/14: Chewy is higher ranked when searching "1800 pet meds" with a more aggressive promo

2. In mid-November, Amazon ramps its SKU offering of pet medication: Amazon is increasingly focusing on the Pets category given its attractive, recurring frequency of visit:

• At the Global Pet Expo (the premier US annual pet product conference) in Orlando in 2017, there were ~3 Amazon representatives. In 2018, there were ~32.

• In December of 2017 Amazon launched Pet Profiles, in which members can upload details of their pet for Amazon to recommend curated offerings based on the animal, breed, gender etc.

• In May of 2018 Amazon launched a private label pet food offering under the name Wag.

We believe Chewy’s entry into the pet medicine category likely obligates Amazon to offer that category to ensure competitiveness in its offer to customers. On November 18th, we noticed for the first time that Amazon was offering 5 of PETS top 20 products (K9 Advantix ii, Frontline Plus, Advantage ii, Flea5x Plus and Seresto).

3. On November 19th, PetCo announces strategic partnership with Express Scripts (ESRX) that will provide “better care, cost and convenience,” per PetCo’s press release. PetCo has been in the pet pharmacy space since acquiring Drs. Foster and Smith in early 2015, and had been quiet in the space until this ESRX announcement despite PetSmart (their biggest rival) being in the pet pharmacy space since 2014 with its acquisition of Pet360. We believe PetCo’s sudden activity in this space is a sign that they see Chewy’s entrance into the category as a material threat, which may lead PetCo to ramp up its presence in pet pharmacy.

• ESRX itself independently launched an “Rx Pets” discount card in early 2018, offering an average savings of 75 percent off generics and up to 15 percent off brand medications. This is another indication that price competition is heating up in the pet pharmacy space⁸.

B. Publicly listed veterinarian Rx management platform on the horizon, intending to make vets more competitive in pharmaceutical e-commerce:

1. Over the past decade, vets’ share in medications has contracted from ~75% to 58%⁹. Most of that share went to mass retailers and the direct channel players like PETS. PETS’ revenue mix over the same period went from 30% Rx to ~50% today, making PETS a clear beneficiary of the share shift. We believe vets’ incremental share loss is less likely going forward, as the channel has been forced to price in parity with the internet driven by consumer price checking.

• We note that PETS’ direct channel competitors generate a much lower percentage of revenue from Rx, so PETS is most susceptible to any veterinary re-emergence in this space.

2. Henry Schein’s impending merger with Vets First Choice (announced April 23)¹⁰ will create a pure-play, publicly listed e-commerce vet prescription management platform which will drive better economics for vets by connecting vets with owners online to facilitate inventory management, offer online checkout/home delivery, and provide patient communication solutions. While it is difficult at present to quantify the impact, we believe this development could curtail vets’ share loss, which has been fueling PETS’ growth. Should veterinarians get serious about winning back share, they are in prime position to do so given their relationship with pet owners as a trusted information source at time and point of sale.

C. Customer Acquisition Costs (CAC) will continue to trend higher:  

CAC accelerated significantly in 2Q to $45/customer, +32% YoY (vs Q1’s +8% YoY), due to escalating online advertising costs (driven by Chewy’s promotional blitz) and faltering New Customer growth (-13% YoY in Q2)¹. Our research suggests that the market has become even more competitive in Q3, likely leading to further cost pressure and lower efficiency in PETS’ online advertising. On their Q2 earnings call, management indicated that they intend to reaccelerate television advertising going forward, likely due to being priced out of the online advertising market. Recall that PETS saved ~$3 million¹¹ (~5.3% of LTM EBITDA) in advertising expense in 2016 by moving away from television advertising. If PETS is forced to materially re-enter television advertising, SG&A may be pressured going forward in addition to gross margin. Furthermore, in the longer term, PETS is inherently at a disadvantage in television advertising versus larger competitors like AMZN, Chewy, and Petco because it cannot amortize the expense across a broader range of available product categories.

Structural Threats:

A. PETS’ Historical sourcing advantage is evaporating along with its competitive moat: PETS, the largest direct to consumer (DTC) player in the market, used to purchase a significant portion of its inventory from the "grey market," (e.g. distributors that would consolidate excess supply and sell in bulk to DTC players). In that world, PETS' relative scale and access to inventory was a structural sourcing advantage. However, today 3 out of the 6 large pharmaceutical manufacturers are selling directly into the DTC market. Therefore, barriers to entry are deteriorating and attracting more DTC competitors. Over the past decade, the number of DTC players has roughly tripled. It is widely accepted amongst industry participants that over the next few years, all large pharmaceutical manufacturers will be selling directly to the DTC channel. This development would further erode any advantages PETS still enjoys on both cost and inventory access.

B. PETS’ gross margins are structurally declining, excluding the recent benefits from next gen oral pet medications: PETS’ gross margins have declined steadily for many years due to increasing competition and price transparency, until the recent upturn driven by next gen oral medications.

We are now nearly two years beyond the introduction of these medications, and their one-time tailwind is already tailing off. We believe the next gen contribution was still in effect in 1H19, when the Company reported ~flat GM YoY vs expanding ~390bps in FY18¹, which suggests that net margin contribution from this category is petering out. This makes sense logically, as most of the pet parents who are going to switch from topical to oral medications have done so over the past two years.

C. Active vs. New Customer trends suggest PETS has been leaning on customer reactivation (a depleting resource) to prop up growth: We’ll leave it to readers to decide which basis is most appropriate, but below are the 10-k reported active customer numbers (defined as the number of customers who have made a purchase within the last two years).

Over this same period, “Reorder” revenue (defined as revenue generated from any customer that has made a previous purchase at any time in the past) is also increasing, while the number of new customers adds has been decreasing. We believe this is evidence that PETS is reactivating old customers (likely through highly targeted promotions).

While unclear when they’ll run out of juice in reactivations, we note that this is a depleting resource with diminishing returns over time. Given the uncertainty of when this will play out and the imperfect definitional comparability across active customers, new customers and reorders, we lean on a simple mathematical framework:

• Active customers have been flat since FY16

• Assuming reorders are approx. in-line with the company’s avg order value ($81 in FY16 and $87 in FY18¹), the implied number of reorder customers went from 2,414,400 to 2,615,100 in FY18, or 200,660 customers. This represents 9% of PETS’ active customer base, which implies active customers ex-reactivation was approx. negative 9% across the past two years.

• We caution that this contribution to growth is unsustainable in the long run.

Bull Case & Mitigants:

1. 85% of revenue from “Reorders” provides insulation from competition and stabilizing performance

• We believe that the sheer scale of the top line deceleration we began seeing in September could only be true if Reorder revenue is cracking along with New Customer revenue. We feel that Chewy’s marketing blitz, purposeful targeting of PETS’ customers, price competitiveness, and high cross-shop with PETS’ customers is likely already converting some PETS customers into Chewy customers. Further, as mentioned above, we believe PETS has already tapped its legacy customer base to reactivate re-orders and there may be less water to draw from that well going forward.

2. Pet supplies is a steadily growing category benefiting from the generational “humanification” of pets and growing pet adoption (+4% in 2017)¹²

• While this is obviously a positive, if PETS’ top-line growth is materially below the industry’s growth rate of +MSD, we believe this will serve as evidence that PETS is already losing share.

• The attractiveness of the category is itself the reason for why it’s likely larger competitors will continue to focus on it going forward.

3. Strong balance sheet with ~$4.25 cash per share and a dividend yield of ~4.3%¹

• We believe shareholders will never see this cash. Given our view of a deteriorating FCF profile (generating FCF in FY21 is a touch below the existing $22mm dividend), we believe management will prudently continue paying its dividend at its current rate and use the rest to invest in price and advertising in order to maintain the viability of their business.

4. Street estimates expect healthy growth in revenue (+8% in FY19), EBITDA (+6%) & FCF (+55%) alongside a stable, ~19.4% EBITDA margin¹

• We expect all the above to begin declining materially on a YoY basis starting in 3FQ19. See our estimates below.

5. The stock has already more than priced in the Chewy entry because it didn’t impact 2FQ19 results

• Our pricing data suggests that Chewy was not overly aggressive competitively when they launched in July. However, their price aggression and advertising campaign seems to have built steadily in the summer months. The cumulative effect of this campaign did not seem to materially impact PETS’ top line until September, which is a relatively low volume month within Q3. This explains why the overall impact on Q2 was muted, setting Q3 up as the undeniable inflection quarter.

• While the stock is –46% YTD, ~-50% from peak at $25/sh and optically trades cheaply on Street FY20E numbers (7.2x EBITDA / 10.9x PE)², on our FY20E base case estimates it trades at 11x EBITDA & 19.3x PE, well above the historical average multiples (pre-tick & flea benefit starting in 4Q17) of 8.1x and 15.8x, respectively. We do not believe investors are being compensated for the uncertainty of tenor and depth of pain given the shifted competitive landscape and believe it should trade at a discount to these historical metrics.

6. PETS invested in a new, state of the art distribution facility that is running at 50% capacity. If revenue continues to grow, incremental contribution margin is effectively gross margin

• We remind investors that if revenue declines instead of growing, operational deleverage will have the opposite effect. 

Price Target Framework:

We offer two different methodologies in attempt to fairly value PETS given the ongoing disruption, uncertainty and execution risk associated with current business trends. The following reflects financials in our base case model (see “Financial & Valuation Summary” below):

1. EV/EBITDA & P/E multiples suggest $17/share by FY20 (34% downside): Before the aforementioned next gen mix shift tailwind, PETS traded at 8.1x EBITDA & 15.8x PE on Street 12-month fwd estimates². Since this benefit is on its last legs and the business is no longer delivering gross margin improvement to investors, we recommend this as a starting point for any valuation analysis. We apply a ~20% discount to both multiples to better reflect unfavorable near-term trends, lack of visibility, and growing structural threats. This implies 6.5x & 12.6x 12-month fwd EBITDA & PE respectively, or approx. 6.2x ‘& 12.4x FY20.

2. Dividend Yield/DDM suggest $14/share by FY20 (45% downside): We believe PETS deserves to be valued on its dividend, and use a WACC that appropriately reflects a lack of visibility on FCF covering the current annual dividend of $1.08/sh post-FY21. Despite this view, we tend not to be overly academic in this phase of the analysis. After seeing and appreciating the risks we perceive, a reasonable view for the market to come to is a dividend yield of ~7.5%, which puts the stock in $14 range.  

Financial & Valuation Summary^1,2:

Appendix: PETS Vs. Chewy Pricing Study Data¹³:

Catalyst

The market is cognizant of the looming, longer-term secular threats facing PETS’ business, as reflected in the mid-20s short interest, but not fully appreciative since financial performance has been steady in recent history (EBITDA growth of +40% in FY18 and +8% in 1H19¹).

However, we believe 3FQ19 will be the inflection point. This quarter will serve as a litmus test for how protected PETS’ operational and financial model is. We believe results will indicate that the PETS business model is under severe pressure and is likely destined for ongoing contraction for the foreseeable future.

We believe the preponderance of the following indicators will support our view once PETS reports Q3 numbers:

• Revenue will decline on a YoY basis (vs St at +7.6% YoY² & the pet supply industry growing +MSD), making it the first quarter of negative revenue growth since 2FQ16

• Gross margins will decline ~125bps YoY (vs St at -25bps YoY²)

• Reorder revenue growth rate will slow sequentially from 1H’s rate of +11% YoY20

• Customer acquisitions costs will accelerate to ~high $40s-$50/customer, or +45-50% YoY (vs $45/customer, +32% YoY in and $40/customer, +8% YoY in 1Q¹)

• Despite this rise in customer acquisition costs, we expect new customer revenue to further its decline from 2Q’s -10.5% YoY (vs 1Q’s +4.5% YoY¹)  

Footnotes:

¹ Company filings

² Bloomberg

³ Proprietary pricing study; see appendix for details

⁴ Reflects credit card,  debit card, bank statement and e-commerce receipt transactional data

⁵ Statista

⁶ Record news article

⁷ The reader can replicate our research by googling (in private browsing mode to avoid cookie-based advertising) various key words like Pet Medicine, 1800petmeds, Heartgard, Trifexis, Advantix, etc. On such terms, we have typically seen Chewy hold the top advertised position, frequently with a 30% off promotion

⁸ Inside Rx press release

⁹ 58% metric sourced from Company investor presentation

¹⁰ Vets First Choice press release

¹¹ Hoover’s

¹² American Pet Products Manufacturers Association (APPMA)

¹³ The data for Early July is from the July 9th Craig Hallum downgrade report on PETS. The data for Late August / Early September comes from the Waybackmachine.com, which is why not all dates for this column are identical but range between late August and early September. The data for November 7th and November 25th comes from online price checks we performed manually on those dates. In order to select this basket of 12 top selling SKUS we used the list of 18 top SKUs PETS lists on its homepage and included every SKU for which we were able to reliably fill in each data column from Early August through November 25th.