PetSmart Remains a Well-Priced Investment Idea

PetSmart has quietly outperformed the market in recent years, but is the company a buy today?

Jul 3, 2014 at 9:00AM

Shares of PetSmart (NASDAQ:PETM) have quietly outperformed the market over the past five years. Spending on pets reached a new high of $56 billion in the United States during 2013, and most analysts expect that number to continue to grow each year for the foreseeable future. With an integrated suite of merchandise and services that include training, grooming, boarding, and veterinary services, PetSmart is a one-stop-shop for pet owners in a way that competitors such as Amazon.com (NASDAQ:AMZN) and Wal-Mart (NYSE:WMT) cannot match.

With shares of PetSmart drifting near 52-week lows, is the company a buy?

The growth thesis has stalled
While spending on pets continues to increase, PetSmart's growth has plateaued in recent quarters. During the first quarter, revenue increased just 1.1% and comparable-store sales declined by 0.6%. The decline in comparable-store sales is particularly concerning in comparison to the 3.5% comparable-store sales growth reported a year ago and the 7% growth reported for the first quarter of 2012. 

For retailers, the other half of the growth thesis is openings of new locations. Despite successful trials of its smaller-sized stores, PetSmart opened only seven stores during the first quarter to bring the company's total to 1,340. 

Petsmart

Source: Wikimedia Commons

To combat the recent slowdown, management has plenty of ideas to reignite growth that include a continued focus on services (which grew 4.5% in the first quarter), exclusive brands, higher-end products, and an expanded web presence. 

Competition from numerous sources
While management has a plan to revitalize growth, it will not be easy given the competitive environment. PetCo is seeking to provide direct competition to PetSmart's all-in-one approach to pet needs. Large bricks-and-mortar stores such as Wal-Mart continue to offer pet supplies; while superstores and grocery stores have limited inventory, they do offer competitive prices and the convenience of purchasing necessary products without making a separate stop.

In terms of convenience, it is hard to match Amazon.com's free delivery on thousands of pet supplies which includes heavy bags of food. Online competition from Amazon.com and others has definitely been noticed by PetSmart management; the company recently began to offer everyday free shipping on orders over $49 (including food). Additionally, PetSmart's website has been more aggressive in its promotional offers.

To differentiate itself from Amazon.com and target online competitor PetMed Express, PetSmart has also improved its online pet pharmacy services through improved selection and refined user experience.

David

David Lenhardt-Source: PetSmart.com

New management team
In addition to competition, many bearish arguments relating to PetSmart highlight the fact that the company replaced both its CEO and CFO a year ago. While senior management turnover is noteworthy, it is also important to look a little deeper. The new CEO, David Lenhardt, has been with the company since 2000. During his 13-year tenure, he has gained increasing levels of responsibility and held the title of President and COO just prior to his promotion to CEO last year. 
 
While Lenhardt may be new to his role, the company's employees already have a favorable impression of him as measured by his 81% approval rating on Glassdoor.com. A rating of 81% puts Lenhardt among the top CEOs in the country, and this approval rating has a strong correlation to market-beating stock returns.
 
A look at valuation 
As the current bull market has driven the average price-to-earnings ratio of the S&P 500 above 19, PetSmart has seen its earnings multiple contract in recent years as illustrated in the chart below:

PETM PE Ratio (TTM) Chart

PETM P/E Ratio (TTM) data by YCharts

For the first time in almost five years, PetSmart is trading at a multiple lower than that of Wal-Mart. At a trailing P/E of less than 15 and less than 13 times next year's earnings, PetSmart is trading at a discount to both its competition and the broader market.
 
While its growth has stalled, PetSmart is still generating strong cash flow:

PETM Free Cash Flow Yield (TTM) Chart

PETM Free Cash Flow Yield (TTM) data by YCharts

PetSmart's 7.3% free cash flow yield is significantly higher than those of Wal-Mart and Amazon.com; while Amazon.com is investing heavily in future growth at the expense of current free cash flow, the comparison to Wal-Mart excellently illustrates PetSmart's discounted valuation.
 
Returning value to shareholders
PetSmart's 7% free cash flow yield provides the company with significant financial flexibility. PetSmart has put plenty of this money back into the pockets of shareholders with a consistently growing dividend. PetSmart's dividend yield of 1.4% may not make it a strong income investment quite yet, but the company has increased its dividend by 650% since the beginning of 2009. With a payout ratio of just 22%, future dividend growth is likely.
 
While PetSmart's revenue grew just 1.1% and net income grew just 1.3% during the first quarter, the company was able to drive earnings-per-share growth of 6.1% thanks to an aggressive share repurchase plan. The company repurchased over two million shares at a cost of $130 million during the quarter. The company has made a consistent effort to decrease the number of outstanding shares, which is a very tax-friendly way to return value to shareholders.
 
Interesting investment opportunity
With the market discounting shares of PetSmart based on a weak first quarter and concerns about competitive pressures, investors are presented with an interesting investment opportunity. The first quarter's results were not great, and neither was the guidance for the second quarter; if this is the beginning of a long-term trend, investors would have valid reasons to discount PetSmart. Likewise, signs that competition from Amazon.com and Wal-Mart are having a meaningful impact on results are another important risk to monitor.
 
However, the sky isn't falling quite yet. The current valuation is an excellent opportunity for investors who believe that smaller-sized stores and expansion of PetsHotel beyond its current 200 locations can help return the company to its historical growth rates. The company still has a leadership position, a tailwind from the ongoing pet industry growth trend, and a history of market-beating returns. A weak quarter or two do not change the long-term investment thesis for the company and the recent decline in share price creates an attractive value point for shareholders looking ahead five years or more.
 

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Brian Shaw owns shares of Amazon.com and PetSmart. The Motley Fool recommends Amazon.com and PetSmart. The Motley Fool owns shares of Amazon.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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