Why PetSmart Shares Are Rallying

PetSmart operates in an industry with a lot of momentum. That momentum stands to accelerate even further now that a well-known activist investor has taken a sizable stake in the company.

Jul 8, 2014 at 6:00PM

PetSmart (NASDAQ:PETM) is a company with some undeniable tailwinds. The industry it operates in, pet care, is booming and is nearly recession-proof. Americans have proven their willingness to spend almost any amount of money to keep their furry friends happy and healthy. There's an abundance of data to reinforce this.

The U.S. government reports that nearly three-quarters of American households own a pet. Moreover, industry trade group the American Pet Products Association, which has tracked spending on pets for 20 years, calculated that Americans spent $55 billion on their pets just last year. The pet industry isn't slowing down, either, as spending could reach $60 billion this year.

Not surprisingly, then, industry players of all sorts are benefiting. This includes PetSmart and other pet-health-care providers like Zoetis (NYSE:ZTS), the largest global animal-health company.

The strength of the industry has attracted lots of attention recently. Shares of PetSmart jumped 13% on July 3 when it was revealed that a prominent activist investor took a large stake in the company. Read on to discover why you, too, should be excited about PetSmart's future.

A booming industry
Activist investor Jana Partners has taken a nearly 10% stake in PetSmart and is looking to do something big. The options it will pursue include a possible sale, according to The Wall Street Journal.

The investment looks extremely shrewd, not just because of the strength of the broader industry but also because PetSmart was trading at an unwarranted discount recently.

PetSmart's stock sold off earlier this year when it reported disappointing first-quarter results. Earnings per share clocked in at $1.04, representing 6% growth. However, revenue growth totaled just 1%, and same-store sales, which measure sales at locations open at least one year, actually fell 0.6% year over year.

Even more disappointing was the company's outlook for the current quarter as well as the rest of the year. PetSmart believes it's likely that same-store sales will decline this quarter, too. For the full year, management expects flat same-store sales and total revenue growth only in the low-single digits.

This represents a significant reduction from the company's prior forecast, which explains why shares declined after earnings. Management previously expected 2%-4% same-store sales growth for the full year. PetSmart also cut its earnings projections for 2014. The company now expects to earn $4.34 per share this year, down from $4.48 per share previously forecast.

Opportunity knocking
But writing off the company entirely because of this is a huge mistake. Management attributed the near-term weakness to the poor economic conditions in the first quarter brought on by brutal weather in the United States. These look like short-term speed bumps rather than any serious deterioration of the business.

PetSmart's long-term story is alive and well, and that's what Jana Partners sees. Last year marked the fourth straight year of double-digit earnings-per-share growth, and the company's earnings before taxes hit a record high. PetSmart generated $615 million in operating cash flow, which it used to reward shareholders handsomely. The company repurchased $464 million of its own stock and raised its dividend by 18%.

Jana Partners is looking for more significant capital returns, in addition to the company considering a sale. Since PetSmart generates a lot of cash and pays only a 1.4% dividend yield, there's definitely room for greater distributions. Options at the company's disposal could include a special dividend or even bigger share buyback authorization.

Zoetis, which was spun off by big pharma giant Pfizer, is also reaping the rewards of loyal pet owners. Revenue and diluted earnings per share increased 5% and 16%, respectively. Zoetis is doing particularly well in Asia Pacific, where its 7% revenue growth outperformed its operations in other geographies. This is a great opportunity considering that Asia Pacific accounts for just 16% of the company's sales. That means the opportunity for further growth is enticing.

PetSmart's momentum building
PetSmart has a lot working in its favor right now. It's a highly profitable company with a business that throws off a lot of cash, and it operates in an industry with strong economic tailwinds. Investors are benefiting too because of shareholder-friendly management that buys back a lot of stock and gives strong dividend increases.

Momentum could accelerate further now that Jana Partners is on board. PetSmart may pursue a sale or some other major strategic partnership in the near future, meaning future gains might still be in store. Stay tuned to what is sure to be an exciting road ahead for PetSmart.

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Bob Ciura has no position in any stocks mentioned. The Motley Fool recommends PetSmart. 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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Jun 12, 2015 at 5:01PM

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