Synopsis:

• Pets at Home (“PETS LN” or “PETS”) has traded off ~30% since going public in March 2014[1]
• Underperformance in stock has been driven by weakness in PETM; however, the extrapolation of PETM issues to PETS is misguided
• Concerns regarding online and grocery competition are overstated and we expect PETS earnings to grow mid to high-teens on HSD/LDD top-line growth for the next several years
• Despite being an exceptionally high quality retailer with over 10 years of consistent positive SSS history, PETS now trades at ~11x our CY15 earnings estimate, making it one of the cheapest UK specialty retailers
• Company highlights
  • Underappreciated margin drivers from strong ramp in services segment and mix shift within food business
  • Highly visible unit growth (expect to expand square footage by HSD for several years) with strong new store economics (~30%+ ROICs on new stores on stores opened in the last three years)
  • Significant private label penetration provides boost to margins (over 40% of PETS products are own/private label) and strong private label brand positioning enhances customer loyalty (PETS’ Wainwright private label brand has loyal following and ~10% market share of UK pet food)
  • Strong growth in VIP loyalty program (grown from 200k members at the end of 2012 to ~2 million members as of FY14, generating over 60% of overall revenue from VIPs, and VIPs spend over 35% more per trip)
  • Trades at a ~30% valuation discount to comparable growth UK specialty retailers and at a ~20% valuation discount to secularly challenged UK specialty retailers, suggesting that the market is simply missing the high quality nature of PETS’ business model
  • Stock has 75%-140% upside potential by FY16 (March) and limited downside given the high recurring free cash flow yield (~9% on our CY14 FCF/sh estimate and ~11% on CY15 FCF/sh) and cheap valuation

Company Description:

Pets at Home operates in the UK small animal pet care market which includes pet food (including grocery food, advanced nutrition food and treats), non-food pet products (including health and hygiene related products, small accessories and large equipment), veterinary services, grooming services and pet insurance.  The company estimates that the entire market was worth ~£5.4 billion in 2012 of which the company estimates that it had a 12% market share as of 2012. The company’s estimated shares in the UK pet food, non-food products and veterinary services markets in 2012 were 12.6%, 32.3% and 5.9%, respectively and the company has increased its share across all these categories since 2009. As of September 2014, Pets at Home was the clear market leader in terms of store numbers with 386 stores and an average retail space of ~6,600 square feet per store.

Situation Overview:

• Pets at Home is a recent IPO and is listed on the London Stock Exchange
• KKR acquired the business (from Bridgepoint) in 2010 and took the company public in March 2014.  KKR still holds a substantial stake in the business and given PETS’s trading performance since the IPO, KKR is highly motivated to move PETS’ stock price in the right direction
• At the time of its IPO, PETS was priced at 245p per share but has since traded to ~170p per share despite posting strong maiden results and continuing its strong trajectory of new store openings and vet practice rollouts
• PETS has a 10+ year history of positive same store sales, the dominant position in the UK pet specialty retail sector, an attractive unit growth story, and a substantial margin expansion opportunity as it rolls out veterinary and grooming services to its stores
• PETS management is also highly incented to generate strong earnings growth; management’s compensation plan is 75% linked to EPS growth, with management only receiving its full bonus targets if PETS achieves 17.5%+ EPS growth
• Consensus expectations appear too low, with the sell side expecting less than a 10% EPS CAGR over the next several years despite the company’s LSD positive comps, HSD square footage growth, gross margin expansion, and EPS-linked management incentive plan
  • The company’s growth algorithm is simple: ~300bps+ SSS growth + ~800bps of square footage growth = ~10% top-line growth, combined with 20bps+ of gross margin expansion through the rollout of services = mid to high-teens EPS growth for the next several years
  • Based on our model, we think that sell side EPS numbers are too low by ~10% in FY15, ~15% in FY16, and ~25% in FY17
  • Despite having a clear path to mid to high-teens EPS growth for the next several years, PETS trades at only ~11x FY16 (~CY15) EPS, a substantial discount to comparable UK specialty retailers (which trade at a median valuation of ~15x).  While we do not believe PETM is a perfect comp to PETS given that PETS has a far more dominant position in its home market, PETM trades at ~15x CY15 EPS.  We believe PETS should trade at a premium to PETM to reflect its superior market position and operating history.  PETS also pays a ~3.5% dividend yield and generates a recurring (ex-growth capex) free cash flow yield of ~11% on our CY15 free cash flow per share estimates
  • The risk-reward at current levels is highly attractive.  Our base case March 2016 target price for PETS is 300p, representing ~75% upside from its current price of 170p.  Our upside case March 2016 target price for PETS is 405p, representing ~140% upside.  Our downside case March 2016 target price for PETS is 150p, representing ~12% downside

The Bear Case:

• The woes of PETM (and the broader US pet specialty retail industry) have weighed on PETS with a number of sell side brokers making the case that the structural headwinds facing PETM are likely to impact PETS as well; as a result, PETS’ multiple has meaningfully de-rated since it came public.  PETS today is one of the cheapest retail stocks in the United Kingdom
  • We note that despite PETS’ 10+ year history of positive SSS, it trades at a 30% P/E multiple discount to comparable UK retail unit-growth stories
  • We further note that PETS is currently being priced at a ~20% valuation discount to secularly challenged UK specialty retailers; for example, both WH Smith and Home Retail Group (which have seen revenue declines for the past several years and operate in the clearly secularly challenged categories of books and consumer electronics, respectively) both trade at a ~20% P/E multiple premium to PETS
  • Bears on PETS also point to the company’s high EBIT margins as being unsustainable due to PETS’ concentration in pet food (~50% of sales are in pet food).  We view the bears’ concerns around PETS’ margins as being misguided for four primary reasons:
    • First, we view the extrapolation of PETM trends to PETS as fundamentally flawed due to structural differences in the competitive environments in which the two companies operate.  PETS enjoys a far superior market position and more attractive margin profile than PETM because PETS is far larger than any of its competitors (PETS has almost 2x more stores than its next 5 biggest competitors while PETM competes directly with Petco)
    • Second, the secular shift towards “better for you” advanced nutrition pet foods is in the earlier innings in the UK than in the US.  Advanced nutrition foods have higher ASPs and higher margins than traditional pet foods and therefore are both a comp and margin driver.  These “advanced nutrition” foods are comp’ing in the mid-teens for PETS and we expect this robust growth to continue given that the UK is still underpenetrated in advanced nutrition foods relative to the US
    • Third, PETS in the process of rolling out high margin services offerings (vets/grooming) across its store base which we expect will help the company expand its gross margins (management anticipates gross margins will expand 20bps per year as a result of the rollout of services)
    • Finally, PETS’ high concentration of private label products (44% of total store products and over 33% of food sales) provides the company with structurally higher margins given that it is able to recapture manufacturing/wholesaler margin on private label sales.  Wainwright, the company’s exclusive private label food brand, has ~10% market share of UK pet food and is a well-recognized and trusted branded within the UK
    • As a result of being a “broken IPO”, PETS has been left for dead by investors.  It has also become a popular short amongst investors looking to play the PETM internet disintermediation thesis outside of the US.  While we acknowledge the internet disintermediation threat to PETS exists, we note that this threat has existed for several years (through companies such as Ocado).  Despite the existence of online competition over the past decade, PETS has still been able to post strongly positive comps while sustaining low-teens operating margins.  In fact, nothing in PETS’ historical financial performance and margin structure suggest that the company is secularly challenged
    • Ultimately, PETS is a high quality retailer with strong growth prospects, but due to its illiquidity (<£500K ADV), small float, and broken IPO status, the stock has traded poorly, creating a compelling opportunity for deep value investors

Detailed Thesis:

• Clear market leader and specialist retailer in attractive and growing UK pet care market
  • PETS is the only national retail chain of scale in the UK offering an extensive range of pet products and services
    • PETS is a secular play on the “humanization” of animals which continues to play out in developed markets (i.e. animals are being fed higher quality food, pampered with services, and in many ways are looked upon as “children” within households in terms of pet owner spending behavior) but the market structure in the UK is potentially more attractive than the structure in the US given the market appears to be in its earlier innings and PETS is the only scaled player in the market
    • The UK market is highly fragmented…after PETS with 12% leading market share and 386 stores, PETS’ next five largest competitors have a total of 225 stores between them
    • Relative to the US market, the UK market also appears to still have a higher participation rate from grocers (grocers comprise 56% of the UK market versus 35% in the US) and we expect grocer share to shrink over time and converge to levels seen in the US as pet owners increasingly see value in the breadth of SKUs offered at specialists versus mass merchants
    • Advanced nutrition food is also still relatively underpenetrated in the UK relative to the US (8% versus 15%), and organic/healthy food is also underpenetrated in the UK relative to the US (2% versus 9%) suggesting that there are product innovation cycles that have yet to play out in the UK which will provide support to PETS’ comp over the next several years
• The pet market in the UK is attractive and has demonstrated consistent growth
  • The market has generated positive growth for the past 10 years and is expected to grow at 4% over the next 4 years
• PETS has consistently comp’ed positively for the past decade, even comp’ing positively through the recession
  • Despite weak macroeconomic conditions that have persisted in the UK since the recession, PETS has continued to comp positively (LSD) demonstrating the resilience of the business model
  • The company has generated share gains across the largest segments of the pet market (pet food, non-food pet products, and veterinary services) in every year since 2009
  • We expect that PETS should continue to gain share from grocers and other non-specialists, as well as from independent grooming providers and veterinarian offices
  • Unique and differentiated product offering helps to drive comp and fend off non-specialist / internet competition
    • Given PETS’ specialist focus, it is able to offer a much wider range of SKUs than mass merchants (PETS carries an average of 5,400 SKUs within stores and offers 8,100 SKUs through its website with plans to continue expanding the range of SKUs offered online)
    • The company is strong in the advanced nutrition food category in which it sees very limited competition from mass merchants and grocers given mass merchants can only dedicate limited shelf space to pet related SKUs
      • The types of customers that shop for advanced nutrition category also tend to spend more on accessories, grooming, etc. so PETS has opportunity to continue to capture greater share of wallet from these customers
• The company also generates a large proportion of its sales from exclusive SKUs
  • Over 50% of PETS’ top 4,000 SKUs by sales volume are unique to PETS
    • ~44% of the company’s products are own label and private brands – the company is the only UK specialist pet retailer with an extensive own label - for example, the company’s Wainwright brand has national brand recognition in the UK
      • PETS’ own label and private brand food brands generated 33% of PETS gross store food revenues
      • The company estimates that the Wainwright brand has ~10% share of the UK advanced nutrition pet food market
      • Substantial new store rollout potential (25-30 stores per year, representing HSD square footage growth)
        • The company expects that it can expand its portfolio of stores from 386 to 500+ over time, in-store vet practices from 174 to 450 over time (including retrofits), its standalone vets from 117 to 250 over time, and its grooming salons from 146 to 300 over time
        • The company has opened an average of 30 stores per year for the past three years and is on track to open ~25-30 stores in FY15
        • The company is guiding towards store growth of 25 stores per year going forward
        • The company has never closed a store (outside of four relocations)
        • Expansion of range of services into grooming/vet will drive greater share of wallet from customers and margin expansion
          • The company’s veterinary revenue model is “capital light” and attractive to both the company as well as to vets considering joining the PETS platform
            • PETS utilizes a unique JV structure to capitalize its vet practices
              • Veterinary surgeries are generally established on a joint venture basis between PETS and the joint venture partner responsible for each surgery. Each veterinary practice is a separate company, jointly owned by Pets at Home and a veterinary joint venture partner, the veterinary joint venture partner having economic ownership of the practice and Pets at Home receiving fee income for the provision of back office services
              • Each of the PETS’ joint venture partners takes responsibility for the running of the surgery and pays a percentage of surgery revenues to PETS (for managing administrative and head office functions), plus service charge income payable to Pets at Home for the cost of space occupied within a Pets at Home store
              • PETS generally contributes £30k of capital to the JV, the vet contributes up to £90k, and a bank loan funds the balance
              • In exchange, PETS earns a rental stream from the JV, and once the bank loan is fully paid off, also earns 15-17% of the JV’s revenues as a fee
              • This results in the veterinarian at maturity earning an industry leading salary of ~150K GBP after expenses and remittance to PETS
              • Therefore the incremental margins on this business are exceptional for PETS
              • The company has under 4% market share in the vet market, and under its unique JV economic structure, it should be able to displace many independent vet practices because it can offer a pipeline of clients to vets as well as an industry leading compensation level
• Service and veterinarian offerings only recently became a focal point for the company (since 2010) and as a result these offerings are not yet fully ramped…while gross margins in the Services segment today is ~24% (versus a merchandise margin of ~56% and company-wide margin of ~54%), the company sees substantial expansion to this level over time
  • The vet practice gross margin currently hovers at ~40% but the company expects this to expand to north of 60% as its vet practices mature and vets hit the sweet spot of the maturity curve
  • The grooming margin is currently in the single digits range but is expected to also expand significantly as grooming salons mature (not quite as high as the vet practice, but still substantial margin improvement with maturity)
    • The grooming business only started in earnest in 2010 and tends to lose money in the first year, so this business should see margin expansion as it matures in the 2014-2016 timeframe
• The company also estimates that stores which are retrofitted to include grooming/veterinary services generate 100bps of incremental comp despite having less floor space dedicated to retailing products (due to higher footfall resulting from the introduction of services into a store)
  • This should help neutralize the impact of cannibalization as the company expands its store-base
  • New store economics are compelling
    • The company has generated ~30%+ ROICs on new stores (3-yr payback periods) on stores opened in the last three years and expects to continue to drive these growth rates
    • Growing loyalty program creating a stronger and more personalized relationship with members and driving comp
      • The company instituted a VIP program in 2012 and has had tremendous results with the program, growing its user base from only 200k (~10% of revenues) in November 2012 to 1.9m members (~60% of revenues) in February 2014
      • Today, ~60% of transactions are completed by VIP customers who on average baskets spend 22GBP versus a company-wide average of 16GBP
      • This should also provide a boost to comp and also help the company as it expands its online offering by providing it with a captive customer base to sell into
      • Highly incented management team that has set conservative guide posts for public debut
        • We believe the company is providing very conservative guidance to the Street in an effort to make sure it can hits its guidance in its public debut
        • We believe there is comp upside to management’s guidance of ~250bps for multiple reasons:
          • Management’s guidance of a 300bps comp builds in no expectation of an improving macroeconomic backdrop in the UK (which we believe is beginning to show signs of life),
• We also believe there is margin upside to management guidance
  • Management assumes very minimal gross margin expansion (20bps p.a.) despite a shift towards higher margin services and a potential rebound in accessories sales
  • Accessories sales (which are gross margin accretive) are also still off prior peak (currently representing ~45% of all non-service revenue versus ~50% in FY08/09) 
  • Management guidance calls for 20bps of gross margin expansion annually but only 10bps of EBITDA margin expansion which feels conservative as we expect there should be more operating leverage in the model
• We view management guidance as highly achievable barring an economic slowdown
• Management’s compensation plan is also 75% linked to EPS growth, with management only receiving its full compensation plan targets if it can hit 17.5% EPS growth in FY15 (well above Street models of ~10-12%)
• Potential pan-Europe expansion opportunity
  • While management has yet to flag this opportunity, PETS may be able to expand its concept into other regions of Europe given the strength of its brand within the UK

Key Risks:

• Online disintermediation
  • PETS already generates over ~2% of its sales from its own online business and its online business is growing 100%+ annually
    • PETS’ website is the most visited online pet retailer website in the UK
• We note that PETS’ most obvious online competitor is Ocado (a UK online grocer) – however, the SKU overlap between Ocado and PETS is minimal (Ocado does not play in the advanced nutrition and specialty food categories) and furthermore we note that PETS’ online pricing is actually better than Ocado’s on a per unit basis as PETS is able to strike deals with food manufacturers for unique SKUs that come in larger sizes, allowing PETS to effectively compete against the Ocado’s and Tesco’s of the world by offering better pricing per kilo of “grocery brand” food to customers
• Consumer weakness
  • While the pet category appears to be relatively resilient given the humanization of animals, accessories sales may suffer in a downturn as could services…nonetheless, the company managed to comp positively even through a prolonged period of economic weakness in the UK
  • Market saturation/inability to hit store growth targets
    • The company’s valuation bakes in expectations for store growth – if the company’s markets are more saturated than management expects, then either comps will suffer as a result of cannibalization or square footage growth will disappoint
    • With that being said, given PETS’ impressive free cash flow generation, we believe that the company will have ample cash flow to return to shareholders should it ultimately find less opportunity for growth which will provide a floor to the stock price
    • While recent comp momentum is promising, comp store sales have shifted from running in the HSD level prior to 2010 to LSD today which raises some concerns around whether the company is saturated within the UK
      • Comp had been running in the ~800bps range prior to FY2010, and has slowed to ~300bps in FY14…management attributes the decline to cannibalization (100bps of decline), a very muted inflationary environment (300bps of decline), and one-time product regulatory shifts that benefited the comp in the two periods prior to 2010 (100 bps of decline)

Comparable Valuation Analysis:

• UK specialty retailers with square footage growth are relatively scarce with Dunhelm, Sports Direct, and Halfords being the most direct comps…Halfords plays in the automotive parts market which is relatively less attractive with respect to end-market growth compared to PETS
• PETM market structure is very different given it competes against Petco; the UK market is also less saturated than US market from a store perspective
• We have included WOOF and GXL as comps; as PETS successfully ramps its services business, we believe the stock will warrant a multiple somewhere between specialty retail and veterinary services

Target Price:

• Target price as of March 2016 below (1.5 years out) and based on FY17 earnings per share
• Given the margin expansion opportunity at PETS and the scarcity of square footage growth stories in the UK, we believe that PETS is likely to re-rate towards our upside case and therefore has the potential to generate greater than a 2x return on capital in a ~2 year period

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[1] This report written as of 9/25/14 and all figures and stock price returns calculations are based on 170p share price

• PETS is holding an analyst day at the end of October during which it will provide the market with greater detail on its rapidly growing and high margin Veterinary Practice business which will help alleviate market concerns over the sustainability of PETS’ operating margins

• At management’s own discretion, PETS very recently added an interim trading update to its financial calendar (scheduled for October 24^th) to provide the market with an update on its 1H15 financial performance.  Given the weakness in the stock over the past few weeks, we expect that the market will react positively to in-line or better results