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Don't Get Caught Up In Short-Termism With PetSmart

So PetSmart's (NASDAQ: PETM  ) growth slowed and same-store sales turned negative. Does that mean this long-term outperformer is past its best days? Hardly. The market sent PetSmart shares down more than 8% in Wednesday's trading upon release of its fiscal first-quarter earnings. While the earnings themselves weren't too bad, management put in a painful twist after mentioning that the rest of 2014 won't show much in the way of comparable-sales growth and somewhat anemic top-line growth.

Still, investors need to keep in mind the long-term industry tailwinds here, as well as the operating advantages that PetSmart offers. Its service business is unparalleled with a built-in audience for expansion. The company generates heaps of cash flow that would have most retailers dancing in the streets. Get your tail out from between your legs, investors.

Poor vision
Dogs don't have the best distance eyesight, and neither do investors. For four out of the past five years, PetSmart has been a top-performing retailer, climbing from $20 per share to more than $70. As usual, the market awarded an ambitious valuation, and the past few months have been a somewhat sobering decline. Market mania aside, though, this company has the benefit of being the leader in an industry that's predicted to grow comfortably. For one thing, pet ownership numbers are pegged at a CAGR of 2.2% through 2018, while pet care spending estimates are even higher at 4%.

Pet services are growing even faster than that, and PetSmart is in prime position as it continues to build out its grooming and vet care, as well as unique offerings such as PetHotels.

So, though this year is proving to be a challenge for PetSmart, the view from 30,000 feet looks quite good. And keep in mind that this "tough" year will still generate between $600 million and $650 million in operating cash flow, according to management. PetSmart's market cap is around $5.6 billion, giving it a price-to-operating cash flow ratio of 9.4 on the low end.

What to watch
The fastest growing and most appealing part of the business is pet services, yet these still represent a small fraction of the company's total sales -- under 12% in the most recent quarter. Costs appear well managed at present, so a key thing to watch will be how quickly PetSmart can scale its services into more locations and into customers' routines. Pet product sales shouldn't turn down substantially (management expects flat figures for the year), but it's important to see that the company is making the right moves with its merchandising. Interestingly, smaller stores aren't growing in number, so the big-box players should be able to take an even greater market share.

In all, PetSmart is still a great-looking business to own. Current assets are nearly on level with total liabilities, and the valuation looks fair with an EV/EBITDA of roughly 7.1. The company still has a very healthy return on investment, and despite its short-term challenges, it will continue growing in the long term. Consider this market pullback an overreaction at best.

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Michael Lewis

Michael is a value-oriented investment analyst with a specific interest in retail and media businesses. Before coming to the Fool, Michael worked with private investment funds focusing on deep value and special situations. Currently living in the media capital of the world--Los Angeles, California.

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12/31/1969 7:00 PM
PETM $0.00 Down +0.00 +0.00%
PetSmart CAPS Rating: *****