Description

I believe PetMed Express is a melting ice cube.  I believe competition will continue to erode the company’s returns and think it is unlikely the company will grow its Gross Profit dollars again.

Background

PetMed Express has been written up as a short twice on VIC- once in 2010 by tombrady and again in 2013 by MJS27.  You can visit those write-ups for a bit more of a background on the company.  The story hasn’t changed all that much, but I think it’s evident from the past two quarters that 1) the competitive dynamics are bad and worsening, and 2) the company is over-earning (as management takes a hatchet to Advertising Expense to deliver positive earnings growth).

PetMed Express is an online retailer of prescription drugs (44% of sales), Over-the-Counter drugs and supplies (55% of sales) for pets.  ~20% of the company’s sales still come from customers dialing 1-800-PET-MEDS and ordering product.  It is an undifferentiated retailer in an increasingly competitive space.  Gross Margins have decreased by 560bps over the past ~5 years, and the company’s 12.6% LTM EBIT Margins still appear “too high” considering peer retail margins and the lack of barriers to entry in the industry.

The company does not offer a strong value proposition to its customers- it is neither the most convenient option nor the cheapest.  Manufacturers of prescription and over-the-counter drugs refuse to sell product to PETS, forcing them to procure from distributors on the grey market.  After PETS earns its relatively high Gross Margin, there isn’t enough room for PETS to be the cheapest alternative.  Currently, the company cannot compete on price with the brick and mortar retailers that have a fair degree of overlap in their product assortment (Walgreen/Target/Costco/etc.).  Interestingly, it’s unclear that the consumer currently realizes this, but this is likely to change over time.  Additionally, SKU comparisons against other similar websites show a consistent and shockingly large disparity in the listed prices.  I think this is unsustainable given the commodity nature of a lot of the SKUs, and expect the consumer to become increasingly price-aware.  While the company offers over 3,000 SKUS, a significant portion of sales are attributable to 100 SKUs- mostly the popular flea and tick and heartworm preventative brands—these are a good place to start if you want to do price comparisons (Frontline Plus, K9 Advantix II, Advantage II, Sentinel, Revolution, Rimadyl).  PETS also has a total of 1 Distribution Center, conveniently located in Pompano Beach, Florida (versus, say, an Amazon with 69 DCs).

Managing Earnings

PetMed’s 1Q16 results paint a clear picture of the go-forward trends of the business.  The company’s sales declined by a little over 1%, Gross Margins contracted by 70bps y/y (Gross Profit Dollars declined 3.4%) and yet the company managed to grow EBIT/Net Income/EPS by 16% y/y.  How was this possible?  Advertising Expense as a % of Sales decreased 260bps y/y.  After modestly cutting Advertising Expense for 6 consecutive quarters, the company cut Advertising by 25% y/y in 4Q15 and 20% y/y in 1Q16.  Put differently, the cut in Advertising Expense in 1Q16 accounted for 156% of the company’s Earnings growth.

I obviously don’t think this is sustainable.  Management claims that they are mostly cutting Television Ad Spend where the declining ROI makes it not worth their while.  However, the cut in Ad Spend is clearly having a negative impact on the business.  New Customers were down 20% y/y in 1Q16 and New Order Sales (sales from new customers) were down 14% y/y.  Interestingly, in the 2014 Letter to the Shareholders, the CEO’s stated goal for FY15 was to improve New Order Sales (New Order Sales ended up declining 6% for the year).  The charts below paint a clear picture of management capitulating on attempting to acquire new customers, in favor of boosting current reported earnings.

In addition to managing earnings through cutting advertising spend, I think the company may be attempting to inflate Gross Margins by holding off on procuring inventory.  While admittedly, inventory growth for this company tends to be pretty volatile (far more volatile than any other retailer I’ve seen), year-over-year Inventory growth was down 12% in 3Q15, down 30% in 4Q15 and down 17% in 2Q15.  The company uses the weighted average cost method cost flow assumption, and Cost of Goods have been inflating (due to mix).

Competition

In the company’s March quarter, Gross Margins declined by 200bps y/y (from 35.9% to 33.9%).  Management fully attributed this to more aggressive pricing, specifically calling out more aggressive pricing on over-the-counter meds.  The Gross Margin deterioration slightly improved in the June quarter (down only 70bps y/y), yet when asked about competition on the conference call, the CEO commented, “The over-the-counter medications, especially the flea and tick topicals, are highly competitive and the market is crowded”.  I agree with the CEO and believe competition is fierce- as there are many more similar pet-focused websites with great user interfaces than just a few years ago, brick-and-mortar retailers have substantially improved their omni-channel capabilities and veterinarian pricing has improved.

Secular Headwinds

I think declining sales from their ‘Contact Center’ (people dialing the 1-800 number) and ‘New Orders’ provide a natural headwind to PetMed’s business that may be tough to overcome.

In FY15, Contact Center sales were 20% of total sales and declined 7.6%.  Assuming 500bps of this is secular decline (vs. temporary demand weakness), that’s a 100bps drag on the top-line that isn’t going away (particularly as the company eliminates Television Advertising)

In FY15, New Order Sales were 17.3% of sales and declined 6% y/y.  Assuming this continues to decline at 500bps per year, and assuming the vast majority of New Orders aren’t being placed through the 1-800 number, this would be an additional ~90bps drag on the top-line.

Combined, the Contact Center Sales and New Order Sales could be nearly a ~200bps drag on the top-line.  This would mean that just to deliver Zero consolidated sales growth, Reorder Sales would need to grow over 3%.  So how are things looking on the Reorder front?  Reorder sales grew by 1.8% in Q1.

Insider Sales

Insider Sales have meaningfully accelerated this year relative to the levels from 2010-2015.  Year-to-Date, Insiders have sold ~$2.5 million of stock in the open market.

Valuation

The valuation is not overtly expensive, though I still find it to be very high relative to other secularly-challenged retailers (though admittedly with much less fixed costs).  PETS trades at 18.3x LTM EPS and 16.8x consensus FY16 EPS.  Excluding the ~$2.88/share in Net Cash on the company’s balance sheet as of Q1, those multiples drop to 15.1x and 13.9x.

Free Cash Flow Conversion has historically been strong for the company (as it spends nearly nothing on CapEx), averaging around 100% of Net Income.  Note Free Cash Flow was meaningfully inflated in FY15 due to the aforementioned inventory liquidation.

Given the lack of organic growth in the business, the poor customer value proposition, the increased competition and the elements of over-earning, I still find the short to be a fairly compelling risk-reward at this price

Catalyst

Continued negative sales growth,  lapping large reductions in Advertising Expense