Who's the Top Dog in Pet Products?

According to figures from the American Pet Products Association, between 2007( when the economy was showing signs of slumping) through 2012 (when the economy was perking up), U.S. pet industry expenditures grew a very healthy 29.4%. This year, the APPA estimates that Americans will spend $55.5 billion on their pets.

A business model that stresses convenience
Consumers know PetMed Express (NASDAQ: PETS  ) by its widely-advertised phone number, 1-800-PetMeds. It has a direct-to-consumer distribution model which saves customers time because they don't have to visit a store for their pets' prescription and non-prescription medications and other health products.

For the second quarter ended Sept. 30, the company reported net sales of $60.5 million, up 4% from the same quarter last year. Average order size also rose, by $1, to $73.

Nearly 80% of the company's sales come through its website, and those sales were up 7.3% for the quarter. A key metric for PetMed Express is the pace of reorder sales, which increased 5.3% in 2013's second quarter. Increasing reorder sales tell us that the company makes it so easy to shop, customers don't bother looking for these products at other retailers.

Two margin factors offset each other. Cost of sales as a percentage of sales increased 150 basis points, but operating expenses as a percentage of sales dropped 140 basis points. Net income rose slightly to $4.2 million, compared to $4.0 million in 2012's second quarter.

Yes, you can be all things to all people -- actually all things to all pets
PetSmart (NASDAQ: PETM  ) had humble beginnings in 1987 as a retailer of pet food with two stores in Phoenix, Arizona. The company was called The PetFood Warehouse, offering food in large quantities for low prices.

This concept was new for its time. However, the company didn't take off until new management morphed it into the provider of a vast array of pet products and services -- including boarding, grooming, training and vet care -- in the large store format that we see today.

Today the company is the leader in specialty pet products retailing and operates 1,301 pet stores in the U.S., Canada and Puerto Rico.

In the second quarter ending July 31, PetSmart reported that total sales grew 5.3% to $1.7 billion compared with the same quarter last year. Comparable stores, those open at least a year, saw a sales increase of 3.4%. Service sales rose even more, 7.3%, but these account for only 12% of total revenue.

Cost of sales was steady at 69.8%. Operating cost management was excellent; as a percentage of sales it dropped 80 basis points. Higher sales and carefully controlled costs brought about a substantial increase in quarterly net income compared to 2012 -- 18.9% -- for a total of $93 million.

Store count rose by 52 year-over-year. The company ended the quarter with $353 million in cash and cash equivalents,

The company recently reaffirmed its full year guidance that total sales will grow between 3 and 4%, and EPS will be in the range of $3.88 to $3.98.

Are large retailers targeting the pet care market?
Target (NYSE: TGT  ) emphasizes its low prices and high quality goods, or what the company terms an upscale discounter strategy. Target operates 1,856 stores, including 68 in Canada.

Target stores devote considerable retail space to pet products. Its online store, Target.com, has even more products, and Target has a petRx department that offers pet medications through Target Pharmacies in its stores.

Target's second quarter results showed sales in its U.S. segment increasing 2.4% to $16.8 billion compared to the same quarter last year. Comparable store sales were up 1.2%. The company has lost some sales momentum; in last year's second quarter, comparable store sales increased 3.1%. In 2013's second quarter, the number of transactions at comparable stores actually declined 1.4% compared to last year. EBIT was basically flat year-over-year at $1.3 billion.


The company envisions that consumers will continue to be cautious because of "ongoing household budget pressures."

Full-year earnings guidance was cautious as well. Target expects EPS to come in near the low end of its previous guidance of $4.70 to $4.90.

What we learned
PetMed Express has a wonderful business model -- no store overhead! -- and seems to have turned the corner operations-wise, having reported a 7.6% increase in revenue in the first quarter followed by a 4% increase in the second quarter. The question is if it can keep its reorder business humming and bring in new customers through advertising.

I believe it can, so this company merits consideration.

I'm not certain that consumer confidence will be high enough to drive significant increases in sales at retailers like Target. Consumers' worries about the cost of health care rising are now piled onto all their other worries. Target would not be my top choice right now. 

It makes sense for large retailers to go after some of PetSmart's customers. However, PetSmart has several advantages that limit the effectiveness of competitors' efforts. The incredible selection of products that includes food, health care products, and toys can't be matched. In addition, the sales associates at PetSmart provide well-informed advice to help consumers make the right purchase decisions.

PetSmart has a secret sauce in the pet food market because certain premium pet food manufacturers will not stock their products in supermarkets and mass merchandisers -- only at retailers that are dedicated to pets.

PetSmart will continue to be a smart choice for investors. Given today's uncertain economy, it's best to run with the big dogs.

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