Description
This submission is less about choosing PetSmart as an investment and is more an idea about investing in the pet retail sector in general. The pet retail sector is blessedly small--two major publicly traded companies. The following looks mainly at PetSmart but includes details on Petco, the runner up in the sector.
Welcome to PetSmart. It as a big box pet supply/grooming services/veterinarian services/obedience training/grooming one stop for the life of your pet.There are two pet retailers publicly traded in the pet retail sector--Petco and PetSmart. PetSmart is a little bigger box than Petco
Is it just me or has there been a bit more coverage in the financial media of pet retailers and pet hospitals? I can think of at least 5 or 6 articles over the past few months commenting on the rise of pet ownership and the increased spending on pets by pet owners. A short piece on some television program recently highlighted the increasing sales of expensive pet accessories. It appears that pet fashion may soon rival clothing retailers. Featured were $800 pet carrier purses, Burberry coats and a $15,000 bridal gown (probably a little over the top).
How do PetSmart and Petco fit in? The following are excerpts from an interview with talk show host Marc Morrone from Business Week
Q: According to the American Pet Products Manufacturers Assn., spending on pets and pet-related products now tops $34 billion, up from $17 billion a decade ago. What's fueling such growth?
A: The fact is that dog and cat food was sold mostly in grocery stores. Now, there's a whole lot more stuff to buy for our pets. When I opened my store in 1978, my bird-toy section was four feet long. Now, it's 40 feet. And when I was a kid, I could only buy one cat collar. Now there are a million things to buy for cats. People have always loved their pets, and they have the money to buy things.
Q: Many contend that this kind of spending( on pets) is because more and more people -- empty-nesters, baby boomers, and those delaying marriage and childbirth -- consider their pets a member of the family, or even a substitute child. True?
A: I would agree 100% with that. It's the same thing -- whatever makes people happy. If someone wants to think their pet is their baby and the pet is happy and a manufacturer comes up with toys for that pet, then it's a win-win-win situation. I would never judge someone for thinking that about their pet that way.
Q: How are the big companies like Petco and Pet sMart affecting the industry?
A: It's like Home Depot-- they come in and places go out of business. There are some things, like price, where you just can't compete with the big boxes. Coming down the road, you see a lot of small companies are being bought up by the big ones. They are more aware of what the public wants.
Why pet retailers?
What drives the pet industry? Both chains comment that the 62% of houses that now own pets should continue to increase. The usual suspects are the baby boomers who get blamed for every economic trend that is predicted to occur over the next 25 years. Suffering from empty nest syndrome, they are expected to increase numbers of pets. There are also the children of the children of boomers who have been raised in companion animal homes and will be acquiring hamsters, guinea pigs, fish, dogs and cats to care for supported by their parents. Finally we have grown more comfortable with humanizing our animals. We don’t have so many barn cats and yard dogs that fend for themselves as our rural ancestors did. We feed our pets designer food, buy them habitats, dress them and take them to vet for illness and trauma. It is big business and predicted to get bigger. Who would have guessed 25 years ago the Westminster Dog Show would become a major sporting event covered on television with an avid viewing audience? People love their cats and dogs. And they aren’t afraid to spend.
Back to PETM
As of January 30, 2005, PETM had 726 retail stores in Canada and the US.Stores are slightly larger than Petco typically ranging in size from 19,000 to 27,000 square feet. Petco operates 716 stores at 12,000 to 15,000 square feet on average. Both have plans to end up with around 1400 to 1500 stores which would double the size of both operations.
These are the two largest “pet stores” in the US. The rest of the industry is fragmented among privately owned pet stores and every grocery store, buyer’s club, Walmart, Costco, Sam’s Club and 7/11 that sells pet food and cat litter.
PetSmart started operations in 1987 with 2 stores. It came public in 1993 with an IPO of 21.6 million shares. They have financed expansion with multiple stock offerings. Along with splits the offerings have increased shares outstanding to around 147 million. PetSmart has more than twice the market cap of Petco. They have been a fast growing business with a big growth spurt in the 1990’s.
Store growth since 2002
2004 2003 2002
Store count at beginning of fiscal year 643 583 560
New and relocated stores opened 92 67 27
Closed stores (9) (7) (4)
Store count at end of fiscal year 726 643 583
Ten years ago(1995) PETM had 262 stores and by 2000 that had nearly doubled to 533. Revenue per share in 1995 was $10.13 and that too nearly double to $19.97 in 2000. It was an impressive growth record over 5 years. Since 2000, they have opened an additional 200 stores, dropping to 50% increase in locations. The estimate is that it will now take 10 years to double to 1400 stores and this may be the limit of their growth. The company will continue to see the revenue from growth added to their comps. When they stop adding new locations the main contribution to growth in revenue will be comps and those run in the mid single digits. Looking at growth in revenue of 12%(see table) it would appear that growth is around a 50/50 split between new stores and comps. That is about what Petco does too.
Compounded growth rates for 10 years (since 1994)
Revenue 12.63%
net 19.94%
Revenue per share 8.64%
EPS 15.37%
# shares 3.68%
Growth rates have been double digit for ten years--very impressive record. Revenue per share is less impressive as they tend to dilute shareholder earnings with increases in stock at an almost 4% clip per year over 10 years. They have not taken on much debt(except capital leases) but they do issue shares for capital and buy them back. The issuance of shares has slowed substantially since 2002.
Business segments
The business “segments” include pet food which has the lowest margins(especially the premium brands), pet supplies (such as collars, leashes, grooming supplies, carriers, toys), pet services(veterinarian, obedience training grooming, daycare) and sale of pets.
The returns per segment are:
2004 2003 2002
Pet food treats and litter 39% 39% 42%
Pet supplies 51% 51% 49%
Pets 3% 3% 3%
Services 7% 6% 6%
Increase in services are important as these are the highest margin products. They also have full service small animal hospitals in 430 stores. The arrangement is with a successful chain(privately owned) Banfield. It is worked through a wholly owned subsidiary known as Medical Management International-- a third party operator. Petco does not provide such extensive vet services.
Comps, sales per square foot and increases in revenue per year are(fiscal year):
2004 2003 2002 2001 2000
Sales/sq foot $ 205 $ 197 $ 188 $ 175 $ 163
Sales growth 12.4% 11.1% 7.8% 12.4% 5.4%
Increase in 6.3% 7.0% 9.6% 6.5% 1.3%
comps 6.9 7.5 8.1 7.2 5.7
growth sales/sf 4% 4.8% 7.4% 7.4% --
Some of the numbers from Petco for comparison
2004 2003 2002 2001 2000
sales/sq foot 194 190 188 180 177
Sales growth 12.5% 9.1% 13.5% 13.0% --
number of stores 716 654 600 561 528
turns 7.2x 7.8x 7.7x 7.4x 6.7x
comps 6.2% 5.6% 8.0% 8.6% 6.4%
growth sales/sf 1.1% 4.4% 1.7% 5.4% --
Both have shown steady same store sales, increasing sales per square foot and fairly steady increasing number of locations. Given that both stores are increasing storefronts and yet increasing sales per square foot simultaneously, the growth seems reasonable. The market and demand for pet supplies and paraphernalia appears to be able to support reasonable growth in both chains.PETM has a slight edge in growth in sales per square foot and in comps.
Petco has commented the grocery stores are the biggest losers in the competition.
Payables/inventory as an indication of leverage with vendors. Petco is slightly ahead of PetSmart currently.
2004 2003 2002 2001 2000
PetSmart 39% 42% 40% 34% 42%
Petco 49% 46% 44% 40% 37%
Adding stores generates $3 million in sales per store in the first year. Comps growth comes in at a range of 19% to 21% in year two, 11% to 13% in year three, 7% to 8% in year four and 5% to 6% in year five.The final tally will be around 1400 stores and in 2005 they will plan to open 100. That gives them $300 million in sales growth for 2005 from new stores alone.
Net sales increased 12.4% to $3.4 billion for 2004 compared to $3.0 billion for 2003 due to the addition of 83 net new stores and a comparable same store sales increase of 6.3% for the year. Services sales also increased 24.4% over the prior year amounts.The increase in service sale is important as these sales carry higher margins and services such as the Doggie Day Camp are in their infancy and may add significantly to growth in the next few years as they expand.
Capital leases are debt
The capital leases are accounted for on the balance sheet as long term liability. The current maturity is $6.6 million and long term is $244.2 million.
Leverage
As with any retailer that leases property rather than owns, debt should be looked at both inclusive of capitalized lease expense and without. They are able to meet rent expense while continuing to increase net income, same store sales,sales per square foot and grow at the pace they have set.
PetSmart has significant debt in the form of operating and capital leases.
Operating lease expense capitalized is 1.84 billion and capital lease expense is $244 million for a total of $2.1 billion. PetSmart has built a lot more shareholder equity having been a publicly traded company since 1993 and has a decade worth of growth over the 3 year old Petco. Petsmart combined(capitalized leases +debt) D/E is 2.2 and D/D+E is 64%. This is not overleveraged and they have easily covered these expenses.
Petco has a large operating lease obligation also. Because they are a recent addition to the market, shareholder equity is small and I would look for these numbers to improve as shareholder equity accumulates and they continue to pay down debt.
PETC debt ratios without capitalized leases:
Debt/equity= 1.3
Debt/debt+equity 57%
Shareholder equity has been growing since the IPO. It had been a negative value until 2003. I would look for these ratios to continue to improve as the debt decreases and the company increases equity.
When leases are capitalized the ratios make the company appear to be overleveraged:
PETC:
D/E= 7.1
D/D+E = 87%
The “debt” represented by the leases does not appear to be capable of putting either operation at risk. Of course the amount due in current and future rents impacts the bottom line. Neither company has plans to convert to owning a majority of store fronts. Petco has recently purchased 15 Kids “R” Us boxes and is nearly ready to open the the final store.
As for rent, PETM is paying $12 per square foot and PETC $16. As a percentage of revenue PETM pays 6% of revenue in rent and PETC pays 8.2%. PETM pays less per square foot in rent and makes more per square foot in revenue. The revenue per square foot for PETM is also increasing at a greater rate.
How PETM raised some capital
In July 2002, they issued an offering of 14,500,000 shares plus an over-allotment
option of 2,175,000 shares. On August 5, 2002, they completed the sale of the 1,317,416 shares of common stock for $13.40 per share, resulting in proceeds, $16.9 million. On August 12, 2002, the underwriters exercised the over-allotment option and purchased 2,175,000 additional shares for $13.40 per share for $27.8 million. In 2002 the number of shares jumped from 112.6 million to 140.8 million.
And there was a large conversion of subordinated notes that added to common shares--19,797,000 shares.
Activity since 2002 in stock issue as follows
2004 2003 2002
Proceeds from issuance of common 39,955 36,007 71,114
stock
Net repayments of notes receivable -- -- 4,487
from officers
Purchase of treasury stock (79,998) (34,977) --
Proceeds have been $147 million in raised capital from shares instead of lines of credit used.
Repurchase is $115 million and dilution from the end of 2001 is at 30%--even with repurchases. Some of course is from options, but in general, issuing equity to raise capital has been a bit expensive for shareholders.
They had $200 million in notes issued in 1997. It was repaid except for 19.8 million shares converted to cover the remaining $173.5 million. The biggest increase in number of shares was in 2002. There have been no further borrowings on lines of credit.
And speaking of options, as a percentage of total common shares, total options outstanding is 7.7%--not especially high. Dilution in shares per year since 2002 has been around 2.5%. Most of shareholder dilution came from issuing common shares for capital.
Comparison of ratios between PETM and PETC
Annual income statement ratios for PETM show constant growth in revenue and net and increasing margins
2004 2003 2002 2001 2000
Growth, revenue 12.4% 11.1% 7.8% 12.4% --
Growth, gross income 15.3% 14.7% 17.5% 28.7% --
Growth, operating income 18.6% 42.7% 152.6% 308.8% --
Growth, net income 26.4% 58.2% 829.2% 110% --
Growth, Basic EPs 24.4% 49.8% 675.9% 53.1% --
Growth, diluted EPS 24.4% 52.2% 648.1% 53.9% --
Growth, COGS 11.1% 9.6% 4.6% 7.8% --
Growth, op exp 0.0% 8.1% 2.2% -- --
Margin Data
Gross margin 30.8% 30.0% 29.1% 26.6% 23.3%
Gross operating margin 8.4% 7.9% 6.2% 2.6% 0.7%
Net margin 5.1% 4.5% 3.2% 0.4% -0.9%
PETC ratios also show steady growth and increasing margins. The operating margins and net margins are a little lower than PETM.
2003 2002 2001 2000
Growth, revenue 12.0% 13.5% 13.0% --
Growth, gross income 19.4% 17.5% 17.2% --
Growth, operating income 49.8% 189.0% 137.3% --
Growth, EBIT 67.5% 189.0% 137.3% --
Growth, net income 101.2% 240.8% -10.0% --
Growth, Basic EPS 435.7% 285.0% -200.0% --
Growth, diluted EPS 454.0% 285.0% -200.0% --
Growth, COGS 8.7% 11.8% 11.3% --
Growth, SGA 19.8% 12.7% 15.1% --
Margin Data
Gross margin 33.2% 31.2% 30.1% 29.0%
Operating margin 8.3% 6.2% 2.4% 1.2%
Net margin 3.9% 2.2% -1.8% -1.8%
Returns on equity are difficult to compare. PETC has very little shareholder equity at present. PETC has superior returns on capital.This also is skewed by the very small amount of shareholder equity.
2004 2003
PETM
ROE 18.0% 19.5%
ROA 10.3% 11.0%
ROIC 14.2% 16.1%
PETC
ROE 60% 60%
ROA 13% 6%
ROC 26% 10%
Banfield pet hospitals
This really sets PetSmart apart from Petco. They have set up a wholly owned subsidiary(MMI) to collect rent from a well-respected animal hospital chain--Banfield. Petco offers minimal veterinary care mostly in the form of vaccinations.
MMI charges licensing fees for the space used by the veterinary hospitals, and
it is treated as a reduction of the retail store’s occupancy costs. PETM records occupancy costs as a component of cost of sales in the consolidated statements of operations. Licensing fees are determined by fixed costs per square foot, adjusted for the number of days the hospitals are open and sales volumes achieved. They recognized licensing fees of approximately $13.1 million, $10.5 million and $8.3 million during fiscal 2004, 2003 and 2002.
Rent snafu
A lot of retailers got hit with new GAAP enforced rent/leasehold improvement rules. These actually were on the books but widely ignored. Leasehold improvements were being abused and counted as rent holidays and being amortized over periods longer than the term of the lease. This caused restatements and delays and PETM was no exception. Petco had been doing it right and no restatement was necessary.
Now instead of rent holidays which lower rent on a straight line basis, it is now deferred rent. So that expense(rent) is higher.And the adjustment is not from time of signing a lease but from time of occupancy so the line is shorter and the cost per period is higher.
Amortization is now shortened up to the term of the lease and that also makes the expense higher per period(shorter time to recognize amortized costs) This was a somewhat aggressive way to deal with leasehold improvements, but everyone(almost) was doing it that way.
Tenant improvement allowances were recorded as reductions to leasehold improvements and capital expenditures in investing activities on the consolidated statements of cash flows rather than as deferred rent liabilities and as a component of operating activities on the consolidated statements of cash flows.
What is PETM worth
An existential question not easily answered. They have come approximately halfway through their announced terminal growth. If they stop at 1400 stores, then they are going to almost double in size from the present business model. The growth will likely be slower. They doubled in 5 years between 1995 and 2000. The next 700 stores are estimated to be opened at a pace of 100 per year. Openings the past three years ranged from 27 to 92 so who can really say? It is quite likely that the double will take 10 years. Wall Street does not reward slowing growth so its quite likely the price per share will not experience the rapid rise it did during the 90’s. Still, they appear to be capable of slow reliable growth. And they pay a small dividend.
At the current of $28.82 per share, they are well below the 52 week high of $36.24
Market cap $4141 million
Trailing PE 24
Forward PE 19
P/S 1.2
P/B 4.3
Enterprise value/EBITDA 9.95
Predicted 2005 earnings expected to grow at 20%. The newly rolled out Doggie Day Camp may be a catalyst for better growth. These stand alone facilities in testing are doing better than anticipated. It is a place for working pet owners to leave their pets during the day.The PE multiple is on the high side as a value stock and a few cents off in earnings spread across 143 million shares will hurt. No room for error.
A discounted cash flow:
Current free cash flow to equity is 71¢
Growth for 5 years estimated at 12%. If they add 100 stores per year, this is actually 14% growth year one drifting down to 9% by year 5. However in 5 years these stores deliver increased comps more than twice that of established stores so growth remains slightly higher the first five years of life. As the openings decline and the comps go down they may end up around 6% per year. I gave them 3% and a transition of 10 years.
Present value of FCFE 5 years $4.32.
Present value of 10 year transition $9.28
Terminal value $17.55
Value of stock $31.16
Whether or not you ascribe to DCF models, it at least gives you some idea of the value under a certain set of assumptions. They are trading at a slight discount. The margin of safety is around 10%. This is not a 50¢ dollar, but there are blessed few of those that I have found in the current market. The saving grace is they are in a business that continues to grow and have a fine track record of steady growth, and improving margins. There is not a lot wrong with the company and they appear to be well-managed. I was a bit disappointed to see them accounting for leasehold improvements aggressively causing restatements. Petco had no such trouble.
In order to see how the value of Petco compared under a similar set of assumptions the following discounted cash flow was done.
Cost of equity 9.8%
EPS $1.43 next year it will be around $1.80 by their estimate. This is 26% growth but I took CAGR for the last 3 years and used 14.5%.
Current free cash flow to equity is $1.16
Present value of current free cash flow is $6.84
Present value of transition to 3% growth is $7.34
Present value of terminal price is $26.79
Value of the stock is $40.98
PETC is trading at a much larger discount by a discounted cash flow. Of course DCFs are based on a lot of assumption but the assumptions for both were fairly similar.PetSmart looks like the better operation by the numbers--D/E, sales per square foot, growth in sales per square foot, percentage of rent to revenue. Petco is not far behind however and trading at a discount larger than PETM, may in the long term prove to be the better investment. I also approve of PETC’s early pay down of debt and am impressed that the number of shares has remained relatively constant not diluting shareholder value. Given the choice between debt in the form of lines of credit and issuing common shares, I tend to like debt(if interest rates are good) as a less expensive form of leverage compared to issuing large numbers of shares.
I like this sector and see it as providing predictable steady growth over the next decade as both chains grow. Both predict their endpoints will be an approximate doubling in size. Both would seem to be on a ten year schedule to get it done. PETC and PETM both deliver consistent positive comps and growth in sales per square foot. Both chains appear to have little trouble financing steady numbers of store openings annually and there has been little evidence of cannibalization or saturation in either operation.
PETC trades at a discount compared to PETM, but has operational numbers that are not up to PETM’s.
Catalyst
Probable doubling of operation over 10 years
Pet retailing is a growth industry showing solid increases
Increasing high margin pet services
Big box pet retailers represent a threat to a fragmented industry
Recent decline in price per share on no news