Note that PETS’ fiscal year ends in March. Also, be forewarned that most web data is notoriously imprecise, so use numbers as directional indicators rather than exact readings. Apologies, the bulk of this work was done last month, but could not be posted until now for a few reasons. Instead of undertaking an update of the whole document, which we found oppressive due to the length, we have made a few notations instead where things have changed. In terms of changes, the share price has moved down since the work originally done, and the web data is obviously fast changing and fluid. Happy to discuss new developments in the messages section. Also of note, our work suggests the recent Tramadol accusations are speculative at best (and probably wrong), even though that would be good for the short case.
PETS operates 1800petmeds.com, billed as the largest pet pharmacy in America. They are an internet-based pet meds retailer with some legacy telephone/catalog business that is churning off. They sell both OTC products as well as prescription meds.
We’ve been following the PETS situation for almost two years now and believe it is finally time to initiate a short position. While many of the prior short accusations levied against the company around industry structure are perfectly valid — adversarial relationship with manufacturers, grey market sourcing risk, vet pushback, no moat, price-based competition — we believe the only thing that matters is credible web-based competition, which has for the first time arrived in the form of PetSmart.
PetSmart flipped the switch on their redesigned website on June 30th. The new website prominently displayed a revolving banner ad for their pharma offering and now has a navigation bar in which pharmacy is a new category (and entirely new section of their website).
The website change itself is not a big deal, except that PetSmart also blitzed a sophisticated web marketing campaign starting around the end of July that we believe will devastate PETS traffic and conversion.
PetSmart’s pharmacy push is sophisticated and likely to capture a large share of the high ROI sales PETS has been exploiting. As a primarily search-driven enterprise, PETS will have the choice of either seeing their growth slow/reverse or adjusting their discounting with resultant margin impacts. Marketing cost efficiency will also worsen over time and pressure their margins.
Driven by temporary earnings beats and aided by technical factors, the stock market has credited PETS with a valuation that implies high double digit growth with fat margins into a wide-open eCommerce market. Oddly, Street expectations imply 5% revenue CAGR and 10% EPS CAGR for a company trading at ~30x P/E and 3-4x sales. While these numbers on the surface appear achievable, even beatable, in a modeled upside case, such forecasts don’t come close to justifying the valuation. Once it becomes clear (again) that PETS is at best a single-digit growth company with no pricing power, we see 50% - 75% downside inside of one year. PETS’ market is just a profit pool that is too ripe for the picking, and the major competitors, of which there are many, will absolutely not let PETS own this space alone.
How Did PETS Beat Earnings?
PETS crushed revenue and earnings expectations the past two quarters after years of mediocre performance, sending the stock into the stratosphere: ~30x 2019 P/E and ~3-4x 2019 EV/sales. Investors can’t get enough of pets and eCommerce. Like crack, this combination is impossible to resist even when Wall Street has been unwilling to pin large growth numbers on their forecasts.
As we checked into recent performance drivers, it became clear that the ASP leap and the margin shift from ~30% GM to ~35% are primarily due to a few key prescription flea & tick products, which are both higher ASP and higher margin. The CEO said as much on the recent conference calls, calling out “next generation” medicine as the key drivers of top line.
Comparing prices on new meds, particularly prescription meds, to old meds (many of which are OTC) on equivalent treatment regimes, it is immediately obvious that they are far more profitable, costing 50+% more than the prior generation treatment for the same regime. Incremental efficacy seems to be debated in the community, but the convenience factor of chewables vs. topicals, for example, is not in doubt. Not surprisingly, animal health is a HSD/LDD revenue growth driver for Zoetis, Merck and friends, and management commentary confirms growth in many of the products we will discuss below.
First off, for PETS to do well, not only do vets need to prescribe these new products (which they are doing in droves, because, why not, when it generates fatter margins?), but a growing % of consumers also need to shaft their vets by asking for a prescription and going online to buy their drug supply. Search traffic trends bear out that this is happening (2 year data below). These terms were selected for being prescription with low SEM competition and high PETS paid search placement, but there are others.
Relatively, Bravecto, Nexgard and Apoquel far outpace other medicines in terms of search frequency and growth. This is also true when comparing search trends vs. OTC. Thus, it is no surprise that in May, Bravecto and Nexgard ranked in the top five organic and/or paid keyword search traffic drivers to PETS’ website. May (flea season) and August data both shown below, source: Similarweb.com.
Per Similarweb, search dominates PETS web traffic sources at 65% vs. 18% direct (ie. typing in their website URL). Social media, referrals and other web traffic represent the rest of web traffic at 17%, and so search should be a decent proxy for marketing effectiveness. Notably, PETS usually shows up as the #1 spot paid search advertiser in any Google search for the key prescription products, as well as numerous other keywords related to pet medications. It also fills most of the top picture ad spots. Curiously, it also showed up as the #1 organic web result at one time for Bravecto and Nexgard (no longer, but still top 3).
Note PETS highlights in SEC filings that ~17% of sales come from non-internet sources. While it is hard to track other sales channels (telephone, catalog, apps, etc.), management is clear there is no spending on telephone/catalog and these customers are churning off slowly. The company is 100% transparent that all of its advertising dollars are being spent on the internet, the majority in search, after having cut all TV spend in 2015. Although impossible to quantify precisely, we believe the search percentage is higher than Similarweb suggests, or at least has higher relevance, based on discussions with company.
Why Is Prescription Important to PETS?
If you search for any non-prescription pets meds online, you will find an incredible assortment of companies offering these products. Depending on product, they may include Amazon, Chewy.com, PetCo, PetSmart, 1800petmeds and numerous others. This doesn’t mean this category is not profitable for PETS, as their paid advertising on several popular products indicates they have found good ROI, but it does mean that brand name retailer competition is fierce and margins are lower. These OTC products can also be found at your local pet store, and often general goods retailers such as supermarkets as well. PETS does not disclose profitability or mix of prescription vs. OTC, but the industry structure, not to mention management confirmation of a GM differential, makes it clear supernormal margins are to be found where competition is light, which is prescriptions for the reasons described in the next section.
Are Prescription Competitors Sleeping?
Maybe. Active web competitors include Petco (which offers pharma through drsfostersmith.com, whom they bought last year) and less well known players like PetCareRx, Valleyvet and Allivet. They all pretty much carry equivalent product, often at discounts to PETS. At one point, we understand Canadian pharmacies were very popular, but that trend seems to have died down. Note that thanks to big pharma always looking out for the little guy, pet owners cannot walk into their local brick & mortar shop to get prescriptions filled. It’s either the vet or online.
For a long time, PetSmart had negligible pet meds presence despite recently buying out Chewy.com (the dominant eCommerce pet supply store), buying Pet360.com (small online pet pharmacy) previously and having a vet center located within many of its physical stores. That all changed on June 30th. See screen capture on June 29th vs. today. The key changes are 1.) “pharmacy” is now a navigation bar category of its own, and 2.) one of the 4 giant revolving banner ads is now an advert for the same. [Note the banner ads rotate, and one of the 4 may not be highlighting the pharmacy as of any given time. It was gone for a while, but just came back when we looked today.]