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PetSmart (NASDAQ: PETM ) unleashed earnings after the market closed on Wednesday. The pet-centric retailer announced strong results, but the market didn't like what it heard. Why did the retailer's stock tumble?
In the dog house
If you look at PetSmart's reported numbers, you might scratch your head at the market's reaction.
- Same-store sales and margins continued to grow. For the quarter, same-store sales increased 4.6%. For the year, same-store sales grew 6.3%. Gross margin improved to 31.6% from 30.4%.
- Earnings were up 36% to $1.24 per share for the quarter. Analysts pegged earnings at roughly $1.21 per share on $1.89 billion in revenue. Instead, revenue increased 15% to $1.88 billion, a hair shy of what Wall Street wanted.
- The most recent quarter marks the 12th straight that PetSmart has reported double-digit profit growth.
- Return on invested capital, which currently stands near 33%, increased in 2012 and has doubled since 2008.
But shares slumped in after-hours trading. By mid-day Thursday, the stock was down 7%.
Even though sales growth has greatly outpaced the $52 billion pet care industry, PetSmart expects slower revenue growth in 2013. On every other metric, the company closely met or exceeded Wall Street's expectations. So why was the stock essentially banished to the backyard?
Like we've seen in the past, the market has super-high expectations for growth stocks like PetSmart. Last summer Chipotle Mexican Grill (NYSE: CMG ) reported revenues that fell short of expectations, and the stock plummeted 22% on the news. Just the year prior, the fiery burrito maker was crowned the top performing restaurant stock in the S&P 500.
Brand experts Interbrand deemed lululemon athletica (NASDAQ: LULU ) the fastest growing brand in 2012. Then, in mid-January of this year, the company reported improved fourth-quarter revenue and earnings guidance. The athletic apparel maker's stock dropped nearly 9% the week following the announcement.
Sometimes hot growth stocks just can't cut a break. And with the Dow trading at an all-time high, investors are demanding absolutely flawless corporate results.
Circling the dog park
Even though PetSmart has plenty of bark and bite, it still faces challenges. As we increasingly consider Mr. Snuggles a member of the family (and not just an animal), we're demanding the best for him by seeking out higher-quality pet foods. PetSmart sells prescription and various levels of premium pet food to meet this growing demand. These foods carry roughly twice the margins than their lower-tier counterparts. But big dog competitors are licking their chops.
Last summer, Wal-Mart (NYSE: WMT ) unleashed its first ultra-premium, private-label dog food. Its Pure Balance brand touts either lamb or poultry as its primary ingredient and contains no soy, wheat, corn, chicken by-products, artificial colors or preservatives. Wal-Mart's focus on ingredient quality and the scale of this retailing giant will allow it to bite into the $21 billion pet food industry. According to Wal-Mart, it sells enough dog food "to match the weight of an African elephant more than 27 times each hour." That's a lot of kibble.
PetSmart also faces serious online pressures from both Wal-Mart and Amazon.com (NASDAQ: AMZN ) . In fact, according to the recently published Placed: Aisle to Amazon Study, PetSmart faces strong threats from the e-commerce heavyweight. Amazon's Wag.com pet-centric website boasts more than 25,000 products, 5% back on pet food, and free two-day shipping for orders over $49.
The real differentiator
But what sets PetSmart apart from the competition is its in-store experience, mostly through its services. As the largest provider of pet services on the continent, PetSmart's sales from services have almost doubled during the past six years. Grooming and training are available in all PetSmart stores, with an increasing number of them offering veterinary services, boarding, and pet day care. In Q4 2012, PetSmart's services sales increased nearly 15%.
PetSmart services increase the frequency of customer visits, the amount of money dropped on our pets per visit, and profitability. Services drive PetSmart's margins substantially. For example, margins double when a dog is groomed and the "pet parent" buys a dog product versus when a pet parent buys only a dog product. Add boarding to the scenario, and the margin increases four-and-a-half times.
Foolish bottom line
During the past five years, PetSmart stock has returned nearly 48% annually, roughly four times that of the Nasdaq. I still think PetSmart possesses ample growth potential, mostly because of its differentiation through its store experience and services. And there's plenty of industry growth potential to support future growth for PetSmart. But the market is looking for perfection these days. As a result, I think investors should temper expectations.