PetMed Express, d/b/a 1-888-Pe PETS
August 14, 2002 - 8:51pm EST by
wahoo824
2002 2003
Price: 2.07 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 42 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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Description

PetMed Express is a $42 million enterprise-value stock (debt free) that has posted substantial sales and operating improvements over the last four quarters. In addition, the company is on a legitimate trajectory to more than double sales and triple earnings in the next 2 years, funded entirely by retained earnings. This potential has been largely overlooked by investors, and consequently PetMed is a possible “five-bagger” trading at a value stock price (11.7X fully-taxed most recent quarterly earnings annualized).

Tempering my enthusiasm for PetMed are some above average business risks. However, over the next several quarters the company’s performance should be excellent and these business risks are unlikely to come to fruition. I suggest that investors acquire the stock now and hold it over the next six to eighteen months while the company climbs its growth curve and becomes more fully valued.

--Business Overview--
PetMed Express is a mail-order provider of prescription and non-prescription pet medication and health supplements to pet owners. PetMed promotes these products through their web site, telephone call center, and catalog using the “1-888-PetMeds” brand name.

The prescription, non-prescription, and pet health supplement market is approximately $3 billion in size growing at 10% per year. Historically, veterinarians were the exclusive distributors of these products to pet owners. PetMed is pioneering the mail-order delivery of these products, providing a convenient and cost effective alternative to purchasing from vets. As of now, PetMed appears to have no substantial mail-order competitors.

--Recent Turnaround--
PetMed Express was founded in 1996. The company experienced rapid sales growth and began trading as a public company on the OTC Bulletin Board in 1997. In late 1999, sales growth slowed and margins deteriorated. Faced with pending bankruptcy, the company secured $2 million in financing in late 2000 from a group of investors in exchange for about 67% ownership in the company.

In early 2001, the new investors released the COO and CFO, and reassigned the CEO/Founder to President. Mendo Akdag, who served as President and CEO of Lens Express from 1991 to 2000, was hired as the new CEO. Lens Express, with an estimated $100 million in revenue, is the second largest direct marketer of contact lenses behind 1-800 contacts, and has a business model very similar to PetMed’s.

In the second quarter of 2001, Mr. Akdag hired the remainder of his senior management team and refocused the business. They discontinued the non-pet health pet product line, discontinued the Membership Plan, paired down the SKUs to 600 from 1,200, conducted a sale-leaseback on the facility, and upgraded the call center technology. They adopted the “1-888-PetMeds” brand name and focused available cash on television advertising.

PetMed’s emphasis on television advertising worked exceedingly well, and has resulted in rapid customer growth and an admirable level of profitability.

--- PetMed Express (PETS) Recent Financial Performance---

3/01 6/01 9/01 12/01 3/02 6/02

New Customers ??? 39K 75K 77K 83K 121K
Total Customers 49K 88K 163K 240K 323K 444K

Rev. $2.9 $5.4 $7.8 $8.2 $10.6 $14.9
G. Margin 35% 36% 40% 43% 43% 42%
Op. Margin nm nm 1% 4% 9% 9%
Net (fully-taxed) ($1.1) ($0.7) ($0.0) $0.3 $0.7 $0.9

--Looking to the Future--

A key to this investment is having conviction in the sales and earnings potential. As a direct marketing company, PetMed’s revenue can be determined with a high degree of certainty by looking at four metrics.
I have evaluated each of these metrics and use them as the basis for my PetMed financial forecast.

1. Addressable market size
The prescription, non-prescription, and pet health supplement market is approximately $3 billion in size. A rule of thumb in direct marketing is that about 10% of an industry’s total sales can be conducted through the mail, suggesting PetMed has a $300 million addressable opportunity.

However, this 10% rate can vary significantly depending upon, i), how portable and standardized the products are, and ii), how much savings and convenience the mail order process provides over traditional outlets. Pet medications appear to rank highly on each of these measures.

i) Portability and standardization – Pet medications, like human medications, are small and lightweight, usually packaged in a container smaller than a paperback book. In addition, pet medications are often one-size-fits-all. This contrasts with a product category like clothing, where customer concerns about subjective issues such as size, color, and texture hinder mail order sales.

ii) Savings and convenience – Before PetMed, most pet medications – prescription and non-prescription – were available only through a veterinarian. PetMed’s prices are generally 15% to 25% below those charged by the vets. In addition, since the majority of PetMed’s sales are from non-prescription products, most customers don’t need a prescription and can completely avoid a visit to the vet. This saves the customer the $40-$75 cost of the appointment and an hour or two of free time.

These considerations provide further evidence that PetMed’s addressable market is at least $300 million, and perhaps much larger. With company sales at a $58 million run rate, and virtually no direct competition, PetMed appears to have room to more than quadruple sales without reaching saturation.

2. Cost of acquiring a new customer
It appears that the market is sufficiently large for PetMed, so the next consideration is how much it costs to find customers, educate them about PetMed’s service, and persuade them to make a purchase.

PetMed spends about three-quarters of its advertising budget on television and one-quarter on direct mail, online marketing, and other advertising channels. The effectiveness of PetMed’s advertising can be evaluated by looking at the cost of generating one new customer.

--- Advertising Investment Needed to Generate One New Customer ---
(Total Advertising Expense / Total New Customers)

6/01 9/01 12/01 3/02 6/02 Wght Avg
1-888 PetMeds $35 $19 $20 $17 $23 ~$22

1998 1999 2000 2001 Wght Avg
1-800 Contacts $59 $41 $42 $48 ~$46

1998 1999 2000 2001 Wght Avg
1-800 SendFTD $25 $44 $15 $11 ~$22

PetMed’s $22 per customer compares favorably with the customer acquisition rates seen by other leading direct marketing companies such as 1-800 Contacts ($46) and 1-800 SendFTD ($22). In addition, PetMed is consuming less than 1/10th of 1% of the advertising space available on its preferred cable channels, suggesting the company can increase television spending exponentially and still sustain similar customer acquisition rates.

3. Revenue per new customer
A new customer is someone who has made their first purchase during the quarter. Since PetMed’s average retail purchase is $70, it can be assumed that each new customer generates $70 of sales. Total sales from new customers can be calculated by multiplying the total number of new customers during the period by the $70 in sales per new customer.

4. Revenue per existing customer
An existing customer is someone who made their first purchase during a previous quarter. To encourage repeat sales, PetMed tracks customer purchases and related dosage indications to determine when customers are running low on their medications. PetMed then contacts the customers to remind them to order refills. The value of PetMed’s existing customer base can be evaluated by looking at the average sales per quarter from an existing customer.

--- Average Revenue Per Quarter From an Existing Customer ---
([Total Revenue – New Customers Revenue] / [Total Customers – New Customers] )
6/01 9/01 12/01 3/02 6/02 Wght Avg
1-888 PetMeds $53 $27 $16 $19 $20 ~$21

6/98 6/99 6/00 6/01 6/02 Wght Avg
1-800 Contacts $13 $14 $15 $13 $14 ~$14

6/98 6/99 6/00 6/01 Wght Avg
1-800 SendFTD $4 $6 $7 $5 ~$6

PetMed’s $21 of quarterly revenue per existing customer compares favorably with the rates seen by other leading direct marketing companies such as 1-800 Contacts ($14) and 1-800 SendFTD ($6). PetMed’s short operating history makes me wonder how customers will behave long term, but I think the consistency in purchase rates seen at 1-800 Contacts and 1-800 SendFTD suggests that PetMed should expect relatively stable rates going forward.

Financial Forecast

PetMed invested $2.8 million in advertising in Q1 Fiscal 2003 (ended in June). Management would not give a firm estimate of their advertising budget going forward, but PetMed is in a growth mode and I expect it will spend about $12 million total in fiscal 2003 and $16 million in fiscal 2004 before settling into a growth and income mode and spending about $10 million per year thereafter.

Using these advertising figures, and assuming that customer acquisition costs deteriorate slightly to $25 per customer (from $23), and repeat purchase rates deteriorate slightly to an $18 rate (from $20) yields the following customer and revenue forecast.

F2001 F2002| F2003 F2004E F2005E

New Customers ??? 274K | 489K 640K 400K
Total Customers 49K 323K | 812K 1.5M 1.9M
New Cust. Rev ??? $20M | $34M $45M $28M
Existing Cust. Rev ??? $12M | $36M $73M $112M
Total Revenue $10M $32M | $70M $118M $140M

Using these customer and revenue forecast, and assuming PetMed’s recent gross margin (42%), general and administrative expenses (14%) remain constant relative to sales (they are likely to improve) yields the following financial outlook for PetMed.

F2001 F2002| F2003E F2004E F2005E

Rev. $10M $32M | $70M $118M $140M
G. Margin 36% 41% | 42% 42% 42%
Op. Margin nm 3% | 11% 14% 21%
Net (fully-taxed)($2.8M) $0.8M | $5.0M $10.6M $18.2M
EPS ($0.28) $0.04 | $0.25 $0.53 $0.90
|
EBITDA ($2.5M) $1.4M | $7.9M $17M $29M
EBITDA Margin nm 4% | 11% 15% 21%

PetMed is positioned for tremendous growth, but it also has some above average business risks that need to be given due consideration.

--Risk: Product Supply--

About three-quarters of PetMed’s revenue comes from products produced by four pharmaceutical manufacturers. Each of these manufacturers refuses to sell directly to PetMed for fear of jeopardizing the attractive economics of their current distribution through veterinarians. Consequently, PetMed must purchase its inventory from wholesalers resulting in higher prices and supply/price uncertainty.

Despite this supply situation, PetMed has managed to support tremendous revenue growth and gradually improve gross margin to an attractive 42%. While margins would be higher if PetMed could purchase directly from manufacturers, the company still enjoys excellent economics under the current situation.

However, what concerns me is that a policy change by a manufacturer could substantially alter PetMed’s ability to secure inventory at attractive prices. Direct marketers of contact lenses, such as 1-800 Contacts and LensExpress, have recently faced very difficult economic conditions owing to a policy change by their main manufacturer (Johnson & Johnson), and it is important to understand how susceptible PetMed is to similar action.

Antitrust Considerations
The direct marketing contact lens sector has found legitimacy through anti-trust laws (until J&J's recent maneuver), and I thought PetMed could expect to find similar protection. Unfortunately, in PetMed’s case, it appears that a manufacturer, if it decides on its own without any coercion from its wholesalers, retailers, or competing manufactures, can: 1) choose not to sell to a particular class of customers (i.e. direct marketers), and 2) prohibit its distributors from selling to a particular class of customers. In effect, a manufacturer can control who does and who does not resell its products.

Economic Considerations
Seven key products constitute the majority – perhaps as much as 75% – of pet medication industry revenue. These products are: Heartguard (and its generic, Iverheart), Interceptor, Sentinel, Revolution, Advantage, Frontline, and Program. These products falls into one of three general categories – flea, heartworm, and combination flea/heartworm – as shown below.

Flea Heartworm Flea/Heartworm
Frontline (Merck/Murial) Heartguard (Merck/Murial)
Advantage (Bayer) Generic Heartguard (Virbac) Revolution (Pfizer)
Program (Novartis) Interceptor (Novartis) Sentinel (Novartis)
Within each category there are subtle differences between the medications (since they contain different active ingredients), but in general, any one medication within a category can be substituted for any other medication within that same category. In fact, veterinarians suggest that pet owners rotate their flea medication every year or so since the local flea population can build up an immunity to any one medication.

Since the products are largely interchangeable, the pharmaceutical manufacturers dedicate a good portion of their marketing effort to trying to gain the favor of veterinarians. Because many veterinarians are irritated by PetMed encroaching on their business, a manufacturer could attempt to endear itself to veterinarians by halting distribution to PetMed. The manufacturer would hope to gain enough new business from the veterinarians to more than offset the revenue that is lost by halting shipment to PetMed. So far, PetMed management says there has been no indication the manufacturers intend to stop distributors from selling to PetMed.

PetMed has 1-2% market share now. In several years, if PetMed is extraordinarily successful, it will have 5-10% market share. At 1-2% market share, or even at 5-10% share, PetMed is more of a nuisance to veterinarians than it is a threat to their profitability. So, if a manufacturer planned on stopping shipment to PetMed, it seems as if it would receive virtually the same amount of goodwill from vets now as if it waited several years. In addition, by acting sooner, the manufacturer would be conducting less business through PetMed and would therefore put less revenue at risk in making such a move.

So, it appears as if the risk/return calculation for a manufacturer becomes less attractive as PetMed increases in size. While this gives me some comfort, especially since PetMed has already been in business for five years, perhaps PetMed’s rapid growth is just now beginning to capture the attention of manufacturers, or perhaps there are other dynamics at work that I am not aware of.

Importantly, I think that the economic incentives for the first manufacturer to stop shipping to PetMed are far more attractive than for any subsequent manufacturer. If a second manufacturer quickly followed suit, the situation would indicate collusion and open both manufacturers to substantial antitrust liability. In addition, the second manufacturer would probably receive less goodwill from the veterinarians than did the first manufacturer, and, by not following suit, the second manufacturer could expect to pick up a portion of the PetMed business foregone by the first manufacturer.

Ramifications for PetMed
I believe that there is a good possibility that one of the manufacturers will decide to stop their distributors from selling to PetMed in the next several years. As mentioned above, about three-quarters of PetMed’s revenue comes from four pharmaceutical manufacturers. In addition, apparently no individual manufacturer constitutes more than about 25% of revenue. The loss of one of these manufactures would be a substantial negative for PetMed.

However, reviewing the three major product categories, there are multiple substitutes for each product. If a manufacturer were to stop shipment, PetMed could switch a good percentage of customers to alternative products. This would be relatively easy in the non-prescription flea products as well as between Heartguard and the generic Heartguard. It would be more difficult in the combination Flea/Heartworm category and with Interceptor because these products would require a new prescription from a vet.

Applying some numbers to this scenario, I think that PetMed could switch about 25% of a prescription product’s sales to alternative product(s), and 50% of a non-prescription product’s sales to alternative products. Also, in the prescription category, I think PetMed could switch about 75% of Heartguard users to the generic version of Heartguard, or vice versa.

In addition, in the contact eyewear industry, where J&J has stopped shipment to 1-800 Contacts, the company has been able to purchase J&J inventory directly from eye doctors at a price slightly below retail. 1-800 Contacts then resells the J&J product at a small gross profit, and breaks even after factoring in administrative costs. While there are some industry differences to consider, I think it is reasonable to assume that, like 1-800 Contacts, PetMed could secure restricted product and resell it at about breakeven.

Using the switching and breakeven assumptions from above PetMed could face the following consequences from their key manufacturers:

--Merck/Murial Products ~25% of sales--

Frontline (Non-Prescription)
Estimated portion of PetMed’s total sales: 15%
Estimated portion that could be switched to Advantage or Program: 50%
Estimated sales that would remain at breakeven: 7.5%

Heartguard (Prescription)
Estimated portion of PetMed’s total sales: 10%
Estimated portion that could be switched to generic Heartguard or Interceptor: 75%
Estimated sales that would remain at breakeven: 2.5%

Conclusion: If Merck/Murial decided to stop its distributors from selling to PetMed, about 10% of PetMed’s sales would be go from being profitable to being breakeven.

--Novartis Products ~20% of sales--

Program (Non-prescription)
Constitute an estimated 10% of total PetMed sales now
An estimated 50% of sales could be switched to Advantage or Frontline
So an estimated 5% of total PetMed sales would be at breakeven

Interceptor (Prescription)
Constitute an estimated 5% of total PetMed sales now
An estimated 25% of sales could be switched to Heartguard or generic Heartguard
So an estimated 3.75% of total PetMed sales would be at breakeven

Sentinel (Prescription)
Constitute an estimated 5% of total PetMed sales now
An estimated 25% of sales could be switched to Revolution
So an estimated 3.75% of total PetMed sales would be at breakeven

Conclusion: If Novartis decided to stop its distributors from selling to PetMed, about 12.5% of PetMed’s sales would be go from being profitable to being breakeven.

--Bayer Products ~ 15% of sales--

Advantage (Non-prescription)
Constitute an estimated 15% of total PetMed sales now
An estimated 50% of sales could be switched to Program or Frontline
So an estimated 7.5% of total PetMed sales would be at breakeven

Conclusion: If Bayer decided to stop its distributors from selling to PetMed, about 7.5% of PetMed’s sales would be go from being profitable to being breakeven.

--Pfizer Products ~15% of sales--

Revolution (Prescription)
Constitute an estimated 15% of total PetMed sales now
An estimated 25% of sales could be switched to Revolution
So an estimated 11.25% of total PetMed sales would be at breakeven

Conclusion: If Pfizer decided to stop its distributors from selling to PetMed, about 11.25% of PetMed’s sales would be go from being profitable to being breakeven.

In summary, if any one of PetMed’s key manufacturers were to take aggressive moves against PetMed, profitability would be reduced by between 7.5% and 12.5%. It would take PetMed some time to secure appropriate replacement inventory and switch customers, so the short term (1-2 quarter) impact could be greater. Depending upon the expectations built into the stock price at the time, the stock could face a substantial setback, but in the end, PetMed should be able to remain fundamentally sound and highly profitable.

I consider it unlikely that the four main manufacturers will ever grant PetMed recognition as a legitimate distributor. Nonetheless, management is working diligently to foster amicable relations with these companies. Another solution for PetMed could arise if generic substitutes become available for a larger variety of pet pharmaceuticals, but I do not know what the generic pipeline looks like.

--Risk: Legal Liability--

PetMed has a checkered legal past. They have routinely been disciplined for prescription violations and were fined by the EPA for importing mislabeled pharmaceuticals. In the last year, under the new management, the company has implemented a number of policies and controls that should help it avoid these issues in the future. While most litigation appears to be settled, the company is on probation in several states and faces modest liability owing to their previous violations.

Prescription verification

PetMed has received dozens of complaints, violations, and fines for improperly dispensing prescription medication. The vast majority of these complaints stemmed from PetMed’s Vet Referral Program. This program enabled customers who didn’t have a prescription to consult with a PetMed affiliated veterinarian over the phone to be considered for a prescription. PetMed claims this program was in compliance with applicable state laws, but a series of negative rulings against the company seem to indicate otherwise. In February of 2002, the Florida Board of Pharmacy ordered PetMed to discontinue the Program and pay $120,000 in fines, which it has done.

Some of the complaints also stemmed from PetMed’s verbal prescription confirmation process. Many vets claimed that PetMed had not called them to confirm prescriptions. Now PetMed records all calls to vets to so they have proof if a disagreement should arise. PetMed has taken a $60,000 reserve to offset future fines in this area.

Mislabeled product

Before 2002, PetMed sourced much of its inventory from distributors overseas. Many times the product was not labeled for U.S. distribution, so instructions and dosages were in the decimal system. This violates U.S. laws because it increase the risk that consumers will give the wrong dosage. While none of PetMed’s customers were harmed, the EPA demanded it cease distributing mislabeled products and fined PetMed $100,000. PetMed agreed to pay the fine and now sources all their supply domestically.

In March 2002, Novartis sued PetMed for distributing mislabeled Novartis product in 2001 and before. PetMed is in talks with Novartis and will probably resolve the case in the next several months with a nominal cash settlement.

--Valuation and Summary--

PetMed is a high growth, high margin, capital efficient company that is the leader in its segment. It has a proven management team that has made all the right strategic moves, and appears appropriately focused on building the company, not hyping the stock.

At the current price – 11.7X fully taxed most recent quarterly earnings annualized – virtually no growth is factored into PetMed’s valuation. But PetMed should more than triple sales and earnings over the next several years as it uses its already proven marketing methodology to expand its business.

Offsetting this tremendous growth is PetMed’s above average business risks – especially its supply uncertainty. Without above average risks, I would expect PetMed to trade at a valuation of about 25 times next twelve months earnings. With these risks, perhaps PetMed deserves to trade at a 25% or 50% discount to the normal multiple, or about 13 to 19 times next twelve months earnings.

6/02 6/03 6/04 6/05
Forward EPS $0.25 $0.53 $0.90 $1.14
High Multiple 19X 19X 19X 19X
Low Multiple 13X 13X 13X 13X

High Val./Shr. $4.75 $10.00 $17.10 $21.65
Low Val./Shr. $3.25 $6.90 $11.70 $14.80

Using a extremely conservative valuation approach, lets assume PetMed trades at only 8.0 times the most recent quarter earnings annualized...

6/02 6/03 6/04 6/05
Earnings (Q X4) $3.1M $5.9M $11.6M $18.0M
Earnings Mult. 8.0X 8.0X 8.0X 8.0X
Equity Value $29M $64M $131M $169M
Dil. Shares Out. 20.1M 20.1M 20.1M 20.1M
Value Per Share $1.44 $3.20 $6.50 $8.40

Catalyst

Move to AMEX or NASDAQ proper – PetMed currently trades on the OTC Bulletin Board. Management has indicated an interest in upgrading to a better exchange. This move would increase the company’s credibility and liquidity, opening it to more institutional investment.

Private share placement – PetMed’s 67% owner recently filed with the SEC to make their shares eligible for sale to the public. My understanding is that these investors plan to sell blocks of shares to institutional investors to increase the float and reduce their ownership below 50%. Keep in mind these investors are up over ten-fold since their investment less than two years ago, and will still own a substantial percentage of the company after any block sales.

Increased exposure to investors – I believe the primary reason PetMed is available at a attractive price is that very few investors have been exposed to the company. As exposure increases, I think the stock will appreciate.
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