PetSmart Will Need to Get Smart

The second-quarter earnings season gets under way this afternoon, with Alcoa reporting results after the closing bell. In the meantime, U.S stocks are slightly lower Tuesday morning, with the benchmark S&P 500 and the narrower Dow Jones Industrial Average (DJINDICES: ^DJI  ) down 0.6% and 0.7%, respectively, at 10:15 a.m. EDT. Nevertheless, the mood in equity markets is buoyant, as this statistic demonstrates, courtesy of Dealogic: Global equity issuance in the first half of the year reached $490.7 billion (with the U.S. contributing 29% of the total), up 21% from the same period last year. Even as more companies join the public markets, one company might be headed in the opposite direction: In a letter to the board of directors of PetSmart (NASDAQ: PETM  ) dated yesterday, one of the retailer's largest investors called for the company to consider selling itself to a private equity buyer.

Source: Wikimedia.

In making this request, Longview Asset Management, which owns 9% of the company, is joining activist hedge fund Jana Partners. Last Thursday, Jana disclosed that it had become PetSmart's largest shareholder, having built a 10% stake, and called for the pet supplies retailer to consider a sale or other alternatives to return significant capital to shareholders. PetSmart shares rose 12.5% on Thursday and a further 2.5% yesterday.

Jana Partners is a canny, value-driven activist. As its name implies, Longview is not a not fast-buck artist. As the money manager states on its website: "We invest as long-term business owners rather than short-term traders" (moreover, all Longview employees own the same equity portfolio as Longview clients). Longview has been a PetSmart investor since 2005.

In its letter, Longview argues that it advocates this tack because "our research suggests that Petsmart is likely to be valued much more highly by private market participants than by its current public market investors; the record of successful private equity acquisitions of pet companies, together with currently highly accommodative debt markets, supports a high valuation relative to the current stock price."

Jana and Longview may think that PetSmart could make an attractive merger partner for No. 2 pet supplies retailer Petco. Leonard Green and TPG took Petco private for the second time in 2006, paying 16.9 times forward earnings per share at a time when financing conditions were highly accommodative. Conditions are highly favorable today: PetSmart shares are valued at 14.6 times estimated EPS for the fiscal year ending Feb. 2, 2016.

It is easy (and even reasonable) to be skeptical of investors pushing for the sale of a company, but, in this case, Jana Partners' and Longview's interests are well aligned with those of individual shareholders. To prove that Longview is not simply interested in a quick profit, it has indicated a potential willingness to roll its existing stake into a privately held entity. Furthermore, combining with Petco would make a lot of sense -- scale matters in this business, particularly as competition with Internet retailers, including, intensifies. It PetSmart isn't sold, expect the company to raise its game -- and its cash return to shareholders.

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Alex Dumortier

Alex Dumortier covers daily market activity from a contrarian, value-oriented perspective. He has been writing for the Motley Fool since 2006.

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8/27/2015 4:35 PM
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PetSmart CAPS Rating: *****