Description

 PetSmart (the "Company") is the leading specialty retailer of pet products and services in the US.  It offers a broad line of pet products and services, including grooming, training, boarding and day care.  The stores carry a broad and deep selection of pet supplies at everyday low prices.

 PetSmart was posted here at VIC a few years ago.  The write up does a good job describing the company, its main competitor, and the underlying dynamics and attractiveness of the sector.  Therefore, I will not necessarily repeat the market analysis and some specific information about the company.

 The Company has been effective at gaining share in this large ($45b), growing, and highly fragmented market.  It seems to me that their scale and breath give them an important competitive advantage.  PetSmart is the market leader.  It has over 1100 stores, more than $5b in revenue, and generates cash earnings in excess of $350 million or $2.75/diluted share.

 My point of view is that PetSmart has demonstrated tremendous resiliency and therefore at its current trading multiples it is cheap.  Further, in my opinion, fair value is no less than $30/share.

 Powerful business model

PetSmart has delivered consistent same store sales growth.  Even in this consumer recession, the Company has had positive comps every quarter.  Further, it has not had a negative year since at least 1998.  To me, this comp resiliency is remarkable; especially for a category considered discretionary.

 I also like the steady margins and solid returns on invested capital the company is able to produce.  Year-in and year-out, gross, operating, and ebitda margins come out respectively within compact ranges.  For example, ebitda margins oscillate between eleven and twelve percent.  In a similar fashion, returns on invested capital (defined as ebit divided by net assets excluding intangibles, cash, and short term debt) are around 30%.

 More importantly, it generates lots of cash.  Cash from operations is consistently around 8% of revenues.  Maintenance capital expenditures are modest; currently less than $60 million per year.  Thus, it has a very attractive cash flow profile.

 While revenue growth is expected to decelerate this year, capital expenditures have been halved.  And even at this reduced level, growth capital expenditures account for the majority of the total.  Revenue growth is expected to decelerate from low double digits until 2007, and 8% in 2008, to mid to high single digits this year.  It must be noted, however, that in the most recent quarter (1q09) growth was still 10%.

 Fair value is no less than $30

The business generates cash earnings in excess of $2.75/share.  I define cash earnings as cash from operations less maintenance capital expenditures.  If one would prefer to include total capex, this year the company is poised to generate free cash flow of close to $2.20/share.  Along the same lines, Ebitda - capex will likely come out close to $3.70/shr and Ebitda - maintenance capex north of $4.15/shr.

 Fast forward fourteen months.  Even assuming essentially no growth or operating improvement, by the end of 2010 the company will have generated enough cash to bring its net debt to zero.  This would mean that at $30 a share, the leading pet retailer in the US would be trading at very modest multiples, namely less than 8x Ebitda-capex and approximately 6x Ebitda.

 These multiples compare favorably to Petco's $1.8b acquisition in 2006 by Leonard Green and TPG at $29/shr.  At the time Petco had 817 stores, and annual sales of $2 billion.  With 57.7m diluted shares, $23 million in cash and $145 million of debt, the acquisition multiple was north of 8x trailing Ebitda.  It should be noted that these are very successful and sophisticated investors that are not prone to overpay.  In any event, and while not the relevant metric in my opinion, the P/E multiple was 23x at the mid-point of the $1.24 to 1.30 EPS guidance for that year.

 High P/E is misleading

It seems that the high p/e is one of the reasons for the skepticism in the market about this stock.  The company has guided EPS of about $1.50/shr, which would imply a p/e of 20x at $30 a share.  In my opinion the p/e does not tell the true story in this case.  As mentioned above, it is more telling to use cash earnings or ebitda-maintenance capex.  The only problem I see with cash earnings is that it excludes stock-based compensation expense; a grossly misleading practice followed by some.  Of course, one can always use economic cash earnings, which would adjust for stock comp.  Making this adjustment, the company ends up with close to $2.50/share of economic cash earnings.  Thus, at $30 a share the economic cash p/e would be 12x; very reasonable for a high quality business.

 I guess the other reason why the market is not too enthusiastic about this company is the apparently limited growth opportunities.  This seems a little of an exaggeration, as the company can still grow the store base by 30 to 50%.  Of more significance, however, is the expansion into services that the company continues to undertake.  Services only account for 10% of revenues.  The company has a relatively long runway to continue expanding the service segment.  For example, it only offers boarding services at 10% of its locations.  Lastly, the company can continue to increase the penetration of its private brands, which currently account for 17% of merchandise sales.  In any event, the investment thesis does not require significant growth or margin improvement.

 PetSmart has got moat

At a time when the great majority of retailers are experiencing negative comps, the fact that the company has consistently delivered positive comps is a sign of a great business.  Further, it is doing so with very modest margin pressure; and while continuing to generate lots of cash.  On this note, PetSmart recently completed a $300 million stock repurchase program, and raised its dividend.  In the current environment where the majority of companies have suspended their stock repurchase activity, this is a clear signal about the strength of the cash flow generation capacity of this company.

 The story on margin pressure is not complicated.  The company is experiencing softness in hard goods (collars, leashes, health care supplies, grooming and beauty aids, toys, and apparel, as well as pet beds and carriers), which account for 40% of merchandise revenues.  Consumables (pet food, treats, and litter), accounting for 57% of merchandise revenues, are doing better.  However, since hard goods generally carry higher gross margin, the company has experienced some margin pressure.  Offsetting this, services continue to show strong performance.  This overall dynamic seems pretty reasonable in light of the current economic conditions.

 While there are a myriad of competitors, it is hard to see how the company's leadership position in providing value, breath, and convenience to the consumer could be significantly challenged in the foreseeable future.  Other than PetCo, which has been #2 for quite some time, no other competitor comes even close to achieving the economies of scale and scope that the company enjoys.  This is particularly important during these times when consumers are more focused on value and convenience.

 Significantly cheaper than other consumer-discretionary stocks

PETM is significantly cheaper than most consumer discretionary stocks when adjusted for the resiliency of the business.  Granted, on an absolute basis it is not dirt cheap, or the cheapest it has ever been.  However, given where a lot of consumer discretionary stocks are trading, PETM seems pretty cheap.  For example, recently posted CCL is heavily indebted, has negative cash flow, has much lower returns on invested capital, suffers large price pressure, and its offering is way more discretionary yet it trades at much higher multiples.

Catalyst

 The Company delivers on this year's sss, margin, and cash flow guidance.