Description

PetMed Express Inc. (PETS)

I believe that PetMed Express Inc. (PETS) is a classic value trap and an attractive short. PetMed Express Inc. (a.k.a. "1-800-PetMeds) is America's largest pet pharmacy, marketing prescription and non-prescription pet medications for dogs, cats, and horses direct to the consumer through three primary sales channels: national television, online, and direct mail advertising campaigns.

Company History and Background:

In 1996, PetMed Express Inc. was born when PETS' founders observed a fundamental flaw in the pet medication supply chain that they chose to exploit using a very simple, yet innovative marketing strategy and business model.
The flaw in question they noted was that the historical pet medication supply chain structure was entirely too fragmented, local in nature, and complex. This inefficiency resulted in pet owners paying needlessly high prices for pet medications from their local veterinarians that were capable of being reduced to much more reasonable levels given the implementation of a more efficient, scalable supply chain. The traditional supply chain involved local veterinarians (numbered in the thousands) purchasing pet medications from local/regional distributors (numbered in the hundreds) who were assigned exclusive distribution rights to particular geographical areas by pet pharmaceutical manufacturers (e.g. Bayer). Purchasing pet medications directly from the pharmaceutical companies/manufacturers themselves has always been out of the question. Nonetheless, PetMed Express would still come up with an industry revolutionizing way to simplify and improve this discombobulated and inefficient system.

PETS did so by devising a strategy that would ultimately result in it controlling the lion's share of the highly fragmented $6 billion pet medication market (currently PETS hold a 6% market share) while at the same time enabling consumers to save money (20% on average) on pet medications if they were willing to purchase them directly from PETS 1-800 toll-free number or website rather than their local veterinarian's office.

How did they do so? The company began by building a corporate headquarters and a single national distribution center in South Florida that would use existing express mail transportation infrastructure to market pet medications on a national scale at greatly reduced prices. PetMed was able to undercut vets' prices because its national scale and greater order quantities allowed it to source its' pet meds at far lower prices than any local vet could secure. PETS' value proposition was extraordinarily simple, concise, and effective. PetMed would market discount medications directly to its target demographic of 30 to 65 year old female pet owners via 15 to 30 second national cable TV spot ads that stressed the company's ability to offer pet owners the same name brand pet medications that they usually purchased from their local vets' office at 20% average discounts and the added convenience of having the order shipped for free (on orders $39 and up) to their front porch just 24-48 hours later.

One quick glance at PETS financials over the last decade makes it abundantly clear how well its business model has resonated with consumers. PETS road to success however was met by an embittered, hostile vet community that was furious that it had to either cut prices and/or lose customers as they typically received about a quarter of their yearly revenues from pet medications. But the PETS success story marched on and it ended up going public in the early part of the 2000's. Sales grew at a 20%+ CAGR for the better part of the last decade, growing from just $32mm in FY2002 to $240mm in FY2010. As a result, PETS generated a reputation in the investment community as an incredibly consistent, growth stock with a penchant for exceeding Wall Street expectations. The most fervent of bulls view its business model as infallible/recession resistant because revenue and EPS both grew at impressive clips throughout the Credit Crisis.

Product Lines Summary:

PetMeds product offerings can be summarized into three categories:
1. Non-Prescription Medications (OTC) - 65% of Total Sales: This segment encompasses your basic OTC flea and tick control products, bone and joint care products, vitamins and nutritional supplements, and hygiene products. Traditionally, ~65% of total sales is derived from non-RX pet medications, with the vast majority of the former coming from just three main flea and tick control meds: Frontline, Advantage, and Advantix.
2. Prescription Medications (RX) - 35% of Total Sales: Heartworm treatments, thyroid and arthritis medications, antibiotics, and other specialty medications, as well as generic substitutes. Prescription medication revenue tends to carry higher gross margins than non-prescription meds and is inherently more stable because the concentration of competition is heavily skewed towards the fragmented, higher-priced veterinarian market rather than facing competition from big box retailers. Further, the company's license to sell RX meds in all 50 states is regularly noted as a significant competitive advantage. Despite its redeeming qualities, the overall positive effect on consolidated operating profit from RX meds tends to be rather muted as, anecdotally (not disclosed by the company), the margin gap between the two is not materially wide and because non-RX sales (@65% of mix) dominate the overall sales mix anyways.
3. Pet Supplies - 0% of Total Sales: This segment is a brand new endeavor by PETS and is currently immaterial to the investment case as testing on the accessories/supplies business has only begun over the last two quarters. Though immaterial, its existence merits mentioning as the CEO has noted focusing on this segment as a future growth driver. There are two reasons that I think an increased push to supplies will be ineffective in offsetting the declines in the traditional pet medications business. First, per the CEO, the gross margins on accessories average around 30%, which is well below the current companywide margins of approximately 37%. Second, because the company's name is 1-800-PetMeds, any effort to promote the supplies business is likely to be misleading, expensive, and challenging given its' traditional advertising medium of 15 to 30 second TV spots doesn't allow much time to promote the overwhelming number of supplies SKUs.

While PetMeds currently carries a broad array of individual items (over 750 product SKUs currently sold on its website), as previously mentioned the bulk of its sales come from just 3 non-RX flea and tick meds (Frontline, Advantage, and Advantix) and 1 prescription heartworm medication (Heartgard).

Short Investment Thesis:

Solely due to its fabulous historical growth and record of stability, investors are still enamored with the PetMed's story and, as such, have completely missed the large storm clouds forming on the horizon. Before delving into the short's argument, I will play devil's advocate by outlining the bull case (which is based solely on projecting that PETS' historical stability and growth rates return in the future). Finally, I will return to reality to explain how the good old days for PETS investors are likely in the rearview mirror and why I think it makes an excellent short candidate.

Bull Case Examined: Historical Operating Metrics 2002 to 2010

1. Revenue: Bulls salivate over the consistent growth, stability, and visibility of PETS revenue stream because 80% of total sales are from orders from existing customers (reorders). 5 Year Revenue CAGR of +17%.
2. Gross Margins: High and steady as a rock for the past ten years at ~40%.
3. Operating Margins: Grown consecutively every year from FY2002 (2.3%) all the way to the highest level in company history in FY2010 (17%).
4. Customer Acquisition Costs (CAC): A metric computed as Advertising Expense/New Customer Adds measuring the company's effectiveness and discipline in growing the customer base through advertising. Slightly more volatile metric due to fluctuations in scatter ad rates but fairly steady in the mid-$30 range.
5. Low Market Share and Perceived Competitive Advantage: With only a 6% share in a highly fragmented $6 billion pet medication market and a competitive advantage versus its local veterinarian competitors, bulls believe PETS can continue to steal share and grow to the moon organically.
6. Net Cash per Share of $3, No Debt, 3% dividend yield, and a history of share buybacks round out the bull case on the stock.

Short Case Examined: Headwinds for PETS as far as the eye can see

If the majority of investors left the punch bowl and instead examined the past two quarters results in detail and with a discerning eye, they would realize PETS is no longer a growth company but rather a company in secular decline. At a minimum, I find it impossible to be upbeat about the future for PETS because the current company fundamentals are falling apart at the seams and the competitive environment they are operating in today bears absolutely no resemblance to its former golden days. Most importantly, the key competitive advantage it held versus local veterinarians and that led to all the growth in the past is now meaningless in comparison to the potential destructive effects caused by PETS having to compete head-to-head on price with behemoth mass merchant retailers like WalMart in their core business of non-RX flea and tick control medications. Common sense and logical reasoning would suggest that the vast majority of its non-RX business (@65% of total sales) has reached an inflection point and is poised for low/no growth at best or at an extreme potentially completely at risk given their competitors' drastically lower price points. Amazon entered the non-RX pet medicine space two years ago (online only), Costco one year ago (both online and retail), and, most significantly, WalMart entered the business in Q1 FY2011 (June). Additionally, PetSmart is new to the business and announced on its conference call that it intends to garner a 14% share in 12 months. As a result of all the new competition, top line growth at PETS has vanished as competitors have forced them into aggressive sales promotions just to maintain share. As previously mentioned, this represents a stark contrast to the past as PETS has historically held a major competitive advantage in both RX and non-RX because the only alternative was to pay 20% more for the same meds from your local vet. This is certainly no longer the case and competitors (both online and offline) in the non-RX business regularly sell the big 3 flea and tick control meds (Frontline, Advantage, and Advantix) at 15-20% price discounts to PETS. Please see the attached pricing comparisons for PETS compared to its other online competitors. Simply put, PETS is selling commoditized products at 20% premiums and is faced with a simple choice: lower prices and destroy margins or keep prices high and lose market share - not an enviable position.

Prior to Q1 FY2011 (June), PETS had met or exceeded Wall Street expectations for 13 straight quarters. That streak, along with its record of no YOY quarterly revenue or EPS declines, came to an end in Q1 as WalMart began to sell flea and tick medicines (online and retail). Further, more pain is forthcoming as WMT has yet to roll out the flea medicine Advantage but is scheduled to do so in the near future (only Frontline is currently being sold at WMT). Revenue and EPS were down (3.6%) and (11.2%) respectively in Q1 FY2011 (June) and down (1.9%) and (20.5%) in Q2 FY2011 (September) on a much easier comp.

Key operating metrics deteriorated across the board (save for one or two) at an alarming pace in 1H FY2011. The overall LT viability of the business model is in question as PETS is facing severe pressures on both the revenue and expense lines that show no sign of abating anytime soon. Further, management has acknowledged that new competition is the root of their troubles several times on the past two quarterly conference calls.

1. New customer orders were down (26%) and (21%) YOY, respectively, in Q1 and Q2. Q2 marked the fifth straight quarterly YOY decline in new customer orders. This data point is key and does not bode well for future revenue growth as new customer orders are a well-known leading indicator of existing customer orders (reorders). It is only a matter of time before the weakness in new orders carries over to reorders (which are higher margin and account for 80% of total sales). Negative reorder growth YOY would be a significant catalyst for the short seller.

2. Average order size was down (2.3%) and +1.0% in Q1 and Q2, respectively. This metric has held up surprisingly well given management commentary regarding weak demand levels and price-sensitivity (trading down) amongst its' customer base in addition to the heavy sales promotions it's been running.

3. Revenue from Reorders has never been negative YOY in company history and is a stalwart of this business model. Up +10% and +4% in Q1 and Q2, respectively. Deceleration in Q2 and 5 straight quarters of declining new customer adds make this a focal point going forward. Any negative comps here would more than likely send the stock spiraling down.

4. Customer Acquisition Cost (CAC): Up +20.9% and +39.3% YOY in Q1 and Q2, respectively. CAC of $46 in Q2 was the highest in the company's history. Management noted on the call that its expects CAC to remain elevated in the low $40s range over the next two quarters due to continued pressure on media costs from congressional elections and the holiday season. Any effort to skimp here will severely damage revenue growth but maintain margins; aggressive budgets in markets with high scatter ad rates will sacrifice margins in exchange for revenue growth. Even the positive relationship between advertising and new customers is in question with CAC +40% y/y in Q2 while new customers were down (21%).

5. Advertising Yield (measured as the ratio of New Customer Revenue/Total Advertising Costs) of 1.56x in Q2 joined several other metrics in the distinguished category of the worst showing in the company's history. This was a particularly negative, and surprising, metric because management has historically maintained the advertising yield at a very steady 2x or greater ratio. Consensus opinion had long held that PETS would refrain from all incremental TV advertising if scatter rates push this ratio below 2. Willingness to aggressively spend in such high ad rate environments suggest to me that management is worried about the ability to grow the top line and indicates that they are willing to sacrifice the margins to do so.

6. Gross/Operating Margins both deteriorated significantly as well (GMs down -140BPS in both Q1 and Q2) and (OMs down -40BPS and -310BPS YOY, respectively, in Q1 and Q2) because PETS was unable to pass on increasing product and advertising costs to customers. The greater scale and 20% lower price points of its competitors forced PETS into aggressive sales promotions to try to maintain share but came at the expense of margins. 

Summary and Price Target:

The central question that is crucial to any investment thesis on PETS is "Can management stop the bleeding"? Bulls will point to 10 straight years of solid execution as evidence that the past two dismal quarters are just temporary setbacks and point to the clean balance sheet and respectable dividend yield as margins of safety. However, bears realize that once the snowball starts rolling downhill it becomes very hard to reverse, particularly when WalMart et al. can afford to be loss-leaders in your core business to gain market share while PETS most certainly cannot. One way or another, I believe PETS has painted themselves into a corner because they will either have to sacrifice growth or margins but cannot have both with price gaps that are so far above the competition. Finally, I am amazed that even after the second straight dismal quarter, PETS stock still trades at over 16x consensus FY2011 EPS of $1.00. Moreover, the Street is still looking for 6% revenue growth and EPS growth of 9% in FY2012 which I view as highly unlikely given the continuation of competitive pressures that aren't going away anytime soon. A 16x forward P/E is far too high of a valuation (represents the midpoint of its historical 12-18x forward P/E) and incredibly generous for a company with negative top line and EPS growth for the foreseeable future and a broken business model. Accordingly, I believe the shares should trade down to $11.50 over the next 12-24 months (equates to 10x my 2012 EPS of $0.85 + $3 net cash/share), or down over 30% from today's level.

Risks:
1. Pet supplies business becomes a successful avenue for new growth and positives in this segment outweigh pressures in the non-RX medication segment.
2. Advertising rates fall dramatically from today's levels and PETS is able to drive better than expected revenue growth from increasing ad spend.
3. Average order size increases if the economy and consumer confidence/wages increase.
4. The company gets bought out at a substantial premium. At just a $350mm market cap, I believe competitors would have already gladly absorbed this business if there were significant barriers to entry, but I find it doubtful when competitors can steal PETS customers for free rather than buy PETS' existing customer base at a premium.
5. PETS is able to increase gross margins by securing products directly from manufacturers rather than distributors. However, this would also bring down revenue growth due to lower ASPs.

Catalyst