Why PetSmart's Turnaround Plan Will Work

Shares of PetSmart (NASDAQ: PETM  ) tanked after the pet-products retailer reported its first-quarter results on May 21. The pet-products retailer cut its guidance and the Street didn't like that. The shares went for more than $65 at the end of the day on Monday, May 19, but they started falling even before the results came out on Wednesday. The shares were below $56 at the end of the day on May 22. The first-quarter results also included a few other items of concern for investors.

PetSmart's lousy first-quarter results
A drop in comparable-store sales is bad enough, although the 0.6% figure that PetSmart reported wasn't a huge drop. What's worse was that transaction count declined 2.2%. This indicates that PetSmart still managed to make more money from the customers who did show up, but the retailer's pricing power could still come under more pressure. In the earnings press release, CEO and President David Lenhardt blamed, "a challenging and volatile consumer environment and a competitive market." At least PetSmart didn't blame the weather.

The main thing that scared off investors was PetSmart's guidance cuts. The pet-products retailer now expects second-quarter EPS of $0.92-$0.96 and full-year EPS of $4.29-$4.39. Back when PetSmart released its earnings for the fourth quarter of 2013, it had predicted full-year EPS of $4.42-$4.54.

The pet-products retailer had also expected comparable-store sales growth of 2%-4% for the year; it now expects flat comps for 2014. It definitely looks like PetSmart expects tough competition in 2014.

Price competition
The bears think that Amazon.com (NASDAQ: AMZN  ) will take away PetSmart's customers by selling pet food at lower prices. With 17.1% short interest on April 30, there are a lot of PetSmart bears right now. So I looked over the Blue Buffalo pet food prices at both retailers. Many of the prices were very similar; a few times, PetSmart even came out ahead. A 24-pound bag of BLUE Freedom Grain Free Large Breed Adult Dog Food, for example, was selling for $48.99 at PetSmart (discounted from $54.99) and $53.99 at Amazon.com (discounted from $58.99).

This shows that PetSmart can compete on price with Amazon.com for online orders, even with the higher overhead that results from PetSmart's store base. The price check also showed that Amazon.com works with Petco to fulfill pet-food orders; like PetSmart, Petco has stores all over the United States, so PetSmart can't use its bricks-and-mortar stores to gain a delivery speed advantage over Amazon.com. However, the PetSmart earnings call shows that the retailer has another way to fight back against Amazon.com.

The conference call
I wanted to check the call to see if PetSmart said anything about the fight going on between Blue Buffalo and Nestle Purina. It turns out that PetSmart has something that could help it fight off Amazon.com and reduce its dependence on Blue Buffalo at the same time, and it's something that has been effectively used by other big-box retailers recently. On the call, David Lenhardt mentioned this three-pronged strategy: "expanding our proprietary and exclusive products and services, growing our most valuable customers and connecting with pet parents in an authentic and personalized way." The first item could be key to fixing PetSmart's problems.

Lenhardt went on further to note that PetSmart sells a large number of exclusive and proprietary products, and these items generate 36% of the retailer's revenue. He then said that the company plans to drive double-digit growth in this area over the next three to five years. It sounds like PetSmart's planning to sell more private-label products. This would limit the price-matching power of Amazon.com and reduce PetSmart's dependence on other suppliers. PetSmart has a private-label natural brand of its own called Simply Nourish -- the brand includes dog and cat food and also extends into vitamins and supplements. Right now, PetSmart has 61 products for dogs and 25 products for cats available under this brand.

A premium private-label brand can be a very powerful and effective tool. Consider Whole Foods' 365 brand or Kroger's Simple Truth brand. Brands like these allow retailers to compete on price while capitalizing on their own reputations for quality, and retailers can also extend them into categories throughout their stores. Simply Nourish might be the key to turning around PetSmart's fortunes.

Foolish takeaway
PetSmart had a disappointing quarter, and its underwhelming guidance suggests that conditions will remain tough in the near future. However, this pet-products retailer may not be as vulnerable to online price competition as the bears think. In addition, with the dramatic fall in share price much of the bad news has been priced in at this point. If PetSmart succeeds in proprietary and exclusive products and keeps building up its Simply Nourish brand, it could still be a solid long-term investment.

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