Petco PETC
September 19, 2005 - 6:27pm EST by
thistle933
2005 2006
Price: 23.07 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,350 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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Description

Petco offers an opportunity to invest in a category killer retailer marked down after disappointing investors this summer by breaking a 49 quarter streak of strong comparable store sales growth. Despite many analysts and investors finding fault with flat to 2% comps, significant insider buying has occurred at $22/share. At the current price of $23, you are buying trailing free cash flow yield ex-growth spending of 8-10%, plus the opportunity to have management double the store base – which looks like an excellent use of capital given high historical ROICs, driven by decent margins and some of the best inventory turns in retailing.

Kitkat919 posted PETM as an idea in May, and I refer VIC users to that write-up for a lot of statistics. PETC has gotten cheaper since May, but is it cheap enough?

More Pets Than People

Americans have a lot of pets. More than 60% of US households have a pet, and 75% of these households have more than one. Some estimates place the number of pets at well over 300 million, or more than the human population.

There is ample evidence of a growing humanization of pets. An American Animal Hospital Association survey found that ¾ of Americans would go into debt to provide for their animal’s well-being. Nearly a third of people – and ½ of single people - told the AAHA that they rely on their pets more than anyone else in their lives for companionship and affection.

Other statistics (I’m not a pet owner) – ½ of dogs sleep in their owner’s bedrooms, and of these, ½ sleep in their beds. Interestingly, one’s likelihood of owning a dog increases with one’s level of education and income. Maybe getting married later is an issue – you can insert your own pop psychology.

Also interesting is that apparently the life expectancy of a dog goes from 7.5 years to 12.5 years given better food and health care. Spending money on your pet makes a big difference, and that is meaningful to a lot more people than it used to be.

Many VIC members worship at the Munger altar – so we can ask his two favorite questions: what is going on here, and why?

Anyone interested in pet retailing should read the beginning chapters of Jon Katz’s “The New Work of Dogs”, which argues pretty convincingly that various unhappy trends in our society – people getting older without their children around, people staying single longer, people getting divorced or fired more often – are leading to a more powerful bond between owners and their pets. It’s not hard to think of personal examples of people easing loneliness by relating with their pets, and I suspect that this trend is unlikely to reverse easily.

Dogs in particular have been bred for more than 10,000 years to protect their human masters. It seems pretty likely that dogs have evolved an ability to connect with humans that is finding more of a role given modern society’s stresses. That the dogs are in it for the food is more than a little sad for their owners, but has not stopped PETC and PETM from making a lot of money off of this emotional connection.

Lots of Profits

Up to this summer the economic results for PETC and PETM have been exceptional. Kitkat laid out a lot of statistics, but the key ones I focus on are ROICs (defined as EBIT over average debt, capital leases and equity):

Year PETC PETM
2001 28% 11%
2002 35% 22%
2003 41% 26%
2004 49% 24%

PETC’s returns are distorted upwards by the accounting for the Leonard Green and TPG recapitalization in late 2000. But the trend is clear, and can also be seen in increasing inventory turns and strong free cash flows that have funded store growth as well as debt repayment from the recap (the main debt left outstanding is an issue of 10.5% notes callable in late 2006).

These returns reflect 8-9% margins and rapid inventory turns. Not a lot of retailers manage to get 7x inventory turns, but both concepts have put in place regional distribution centers that allow rapid restocking across many thousands of SKUs. It’s hard for a small store or grocery store to match this.

These returns are also despite rapid new store builds by both companies. The average PETC store has a 6% contribution margin in year one, growing to 16% in year 5. Maturation as planned of the 81 new stores PETC opened in 2004 (12% of the starting store base) would add another 120 basis points of EBIT margin (10% of margin across 12% of stores), and thus increase ROIC by another 670 basis points.

Moreover, the industry structure suggests a lot of room for growth. PETM is the largest player, but only has 10% share. PETC is the #3 player, with 6% share. Both concepts appear to have the ability to double their store base, and also seem likely to benefit from the maturation of hundreds of stores they have built over the last several years. Five percent growth in pet spending has been a big part of the historical five percent comps, and growth has exceeded the market due to new stores.

Who are the new stores taking business from? Grocery stores and 9,000 independent pet specialty stores have about 80% of the market. Versus a grocery store or independent small store, a big box retailer offers many more SKUs, helpful and pet-oriented staff, and lower prices. It seems likely that big box retailers will continue to take share in this space – this has been the story of US retailing for decades now.

But What About New Entrants?

Anytime you see high ROICs in retailing, you should worry about others entering. It’s too easy to have a Sam Walton wandering the aisles and figuring out the business.

Given the presence of both PETC and PETM, and the head start they have, I think the likelihood of another big box specialty player emerging is low. US big box retailing does not have a lot of successful #3 players. A new entrant would have to do something different, and that is not obvious. Anyone remember the sock puppet?

More worrying is the mass channel. Wal-Mart is the #2 player, with 8% of the market. This sounds frightening, but their sales are almost all of their Old Roy dog food to lower income consumers.

I’d never given any thought to the composition of pet food, but it’s interesting to google “Iams” and read some of the first entries to come up. Iams is the leading brand of specialty pet food, and used to be distributed exclusively through PETC, PETM and smaller pet stores. In 1999, Procter & Gamble bought the company, and in 2001 P&G began selling the brand at Wal-Mart and Target. Iams sales spiked by half as the number of doors went from about 1,000 to almost 4,000, but sales have been flat since, and PETC management claims that 2/3 of sales are still through the specialty channel.

I’m not sure that P&G anticipated www.iamscruelty.com, and it is interesting that Wal-Mart and Target have not managed to attract any other specialty food brands to make the jump.

This seems like pretty good evidence that the specialty food category is enough of an emotional sell to be immune to greater entry by the discounters. This is central to the bull case for PETC, and under some pressure given higher gas prices (discussed below as a key risk), so anyone investing in this should walk some store aisles to develop their own view.

My local Target currently stocks Purina, Iams, and a private label brand, and has four aisles with perhaps 500 SKUs of food, toys, leashes, etc. The local Wal-Mart stocks Old Roy (the largest pet food brand, and apparently made of all sorts of cheap and nasty things that give dogs gas, according to PETA) and Iams. There is one aisle of poorly stocked leashes and toys. Help or advice in both places is basically non-existent. Both presentations are aimed at a shopper with a broader list who is quickly looking for a 40 pound bag of cheap dog food.

The PETC experience is 12-15,000 square feet of store space, with 10,000 SKUs. There is only a 5-10% SKU overlap with Wal-Mart and Target, and prices are perhaps 8-10% higher. Note that with the exception of Iams, none of the food offerings are available at a discounter or grocery store.

The typical PETC customer is an upper middle income shopper who visits once every three weeks to buy specialty food for her dog. There’s a good chance she thinks she saved her dog from abuse - Katz’s book talks this, and you might try googling “pet rescue” in quotes – 550 thousand entries today).

PETC operates the largest loyalty program in pet retailing – its PALS program. There are 11 million members, and their spending makes up 75% of sales. Discounts to PALS members appear put pricing on an equivalent basis to pricing found at Target or Wal-Mart, although comparison is difficult given the minimal SKU overlap.

The food at PETC is in the back, and offers a wide range of choices – is your dog overweight? Flatulent? A bulldog? Temperamental? Prefers organic fare? There are a lot of choices for a doting pet parent (amazingly, some 80% of American pet owners apparently call themselves “Mommy” or “Daddy” when addressing their pet).

In the front of the store are toys and supplies, which make up 65% of PETC sales. There are also services such as grooming, training and day care. These make up 5.5% of sales, but are 10% of sales in some stores, and are growing at 20% annually across PETC as a whole. Services are high margin, and differentiating.

The key to the success of the model has been the tendency of the PETC customer to buy a toy or a service on most of her visits. This model is a familiar one to any student of the drug store or warehouse club segments – the treasure hunt for something special for Fido is an exceptionally profitable one for PETC.

A Bad Summer

After being recapitalized by the buyout firms, PETC came public again in February 2002 at $19/share. The buyout firms have sold all of their shares in four secondary offerings:

May 03 9.0m shares $20/share
June 03 1.9m shares $22
June 04 5.0m shares $32
Oct 04 6.9m shares $35

After touching a high of almost $40 in January, PETC shares dropped to $22 in August, and currently sit at $23/share. Investors reacted in particular to the company’s second quarter comparable store growth of 2.5%, which was a break in a 49 straight quarter record of 4.7% or higher. Management has also guided towards comps of 0-2% for the third quarter.

Investors seem to have come up with two bear cases. First, that Target is entering the space with more than a couple of aisles of merchandise. I have seen no evidence of this, and PETC management told investors during the 2Q call that their stores next to Targets were doing fine.

The second concern is that higher gas prices are causing a change in customer behavior that will ultimately hurt PETC margins. PETC has worked to increase the share of sales made up by toys and supplies to 65% from 58% in 1996, and is targeting 70%. This has been good for margins, as there is minimal overlap with other retailers, and gross margins are 50%+ compared with 15-25% on food.

PETC management has recently surveyed PALS members, and has found that their visit frequency in the early summer months had fallen from something like once every three weeks to once every 3 ½ weeks. They also observed higher checkout amounts, and more sales of larger SKUs of food. The risk therefore is that higher gas prices will lead customers to consolidate their shopping trips into fewer visits, leading to fewer impulse purchases of high margin toys and supplies. PETC’s margin improvement over the past five years could go into reverse.

I think that this concern is overblown. First, $3 gas will lead many consumers to trade-in their SUVs, a process which will take some time but will help shopping frequency (less gas and smaller trunks). Second, the shock of $3 gas may well wear off – PETC customers are not low end Wal-Mart shoppers. Gas going from $1.50 to $3/gallon will cost the average US household an additional 2% of pretax income. PETC customers, and especially PALS members, appear to be at least at an average income level. Walk a PETC food aisle, and you’ll get a sense of the demographic - it takes money to pamper your pet with organic food.

Finally, it seems a good bet that PETC customers value the emotional connection with their pets more strongly than the 1% of income that cutting miles driven by ¼ would save. I can think of three single women for whom this would be true even at 3% of income. There is some price of gas that impairs this relationship, but I think it is higher than $3/gallon.

Valuation

PETC has been generating free cash flow despite new store builds of 10-12% annually. The following are free cash flows as reported and also excluding the amounts spent on store builds. Stores are leased, but require capital of $525K for fixtures, and $200K of inventory.

Year Reported Ex-Growth
2000 9 36
2001 24 58
2002 77 119
2003 61 104
2004 53 108

(Note that since the IPO in 2002, the company has repaid more than $225m – about $4/share - of debt using internal cash flow, while growing the store base by 36%)

Free cash flow for 2002-2004 excluding growth spending averages $1.89 per share, or a yield of 8.2% on the current share price of $23. If you assume store maturation as historically experienced, you can easily argue that the yield ex-growth spending is 10%+.

Note that I have kept spending for store remodeling in the $1.89. The company has been remodeling ~50-75 stores per year since 1999, as it is good for comps and ROIC.

One might assume that all cash flow is used to grow stores at 10% annually for three years, and therefore that the $1.89 grows to $2.50. This would be conservative given recent experience of positive free cash flow even after paying for 10-12% store build. But making this assumption, and valuing resulting 2008 free cash flow of $2.52 at 12x – which seems reasonable given secular growth – gives a share price of $30.

If one assumes 15% growth reinvesting all free cash flow, one gets a share price of $34. Note that 15% growth in stores for three years does not get to a full nationwide store base. Note also that the $1.89 does not include individual store maturation (but it also does not include downside from fewer treasure hunt visits).

Insiders

The top three managers own 5% of the company, almost all in the form of outright shares. They have been granting options equal to 2-2.5% of the company each year, which is not great, but not terrible.

More worrisomely, management has been regularly selling through 10b-5 programs that began in July 2002. A charitable explanation would be the desire for liquidity after living through a recap. Another charitable point is that the most recent sales were at $28/share, and they seem to have stopped given the recent share drop. Still, I don’t like to see management selling at all.

More happily, the Leonard Green guy on the board – who stayed despite his firm selling out – apparently likes the company’s prospects. In late August and early September, Leonard Green’s main investment fund bought $40m worth of PETC stock at $22 per share. This is just 2% of the $1.85 billion committed to that fund, but not a terrible sign.

Why Is It Cheap?

- Breaking a streak of 49 straight quarters of good comps – a no-no with a certain kind of investor.

- Investors are focusing on EPS for 2005, which will come in at perhaps $1.40, relative to $1.37 last year. Is it still a growth story? But EPS overlooks the strong cash flow generation of the business, which is masked by spending on new stores, and by the maturation curve of recent stores.

Risks

- Gas goes to $5/gallon
- I am wrong about people's emotional connections
- Target enters in force (hard to see, but always possible)
- Poor capital allocation by management (they've done well so far, but debt is near paid down, and tricky things can happen to retailers as they near saturation)

Catalyst

- Upper middle income pet owners get used to $3 gas
- Several quarters of good cash flows
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