Should You Swim With PetSmart's New Shark?

Last week controversial hedge fund Jana Partners announced plans to shake-up PetSmart (NASDAQ: PETM  ) , while revealing a large stake in the retailer. Jana has pushed for radical changes at other retailers like Walgreen  (NYSE: WAG  ) recently, as a means to boost stock prices over a short time frame. 

With that in mind, can this move help the Foolish long-term investor? 

What happened?
Last Thursday Jana announced it had taken a 9.9% stake in PetSmart. According to Mike Troy of Retailing Today, Jana "indicated it plans to have discussions with the PetSmart board and management to review strategic alternatives such as a sale of the company, improving operating performance and the company's capital structure, and how to return significant capital to shareholders." Jana also suggested it may seek to make changes to PetSmart's board. On Monday, PetSmart announced it would consider all options, including a sale.

Jana is investing in PetSmart because it feels the stock is undervalued, but should it really be pushing PetSmart to change its business? This type of activism typically arises at woefully mismanaged businesses. 

It's hard to argue with PetSmart's long-term results
PetSmart is not a bad business by most measures. It simply had a bad first quarter, as most retailers did. For the quarter earnings rose 6.1%, and sales were up 1.1% year over year, but comparable sales slipped. Jana describes itself as "event driven," meaning it looks for unique opportunities to swoop in and unlock value in a business. Is one bad quarter enough of an "event," for Jana to have a say at PetSmart's table?

Both revenues and returns on capital have grown substantially at PetSmart over the past five years. For every dollar that investors put in to PetSmart, it gives us 37 cents back, or 37%, of that capital (that's what ROIC is). While we don't actually get to touch all that money, it gets reinvested in the business which (in theory) benefits all share holders, long-term.   

PETM Revenue (Quarterly) Chart

PETM Revenue (Quarterly) data by YCharts

Jana wants PetSmart to give share holders more of that capital now, rather than use it for reinvestment. While there's nothing wrong with dividend payments, demanding that a good business spend its cash immediately can be a sign of short term thinking. Now that PetSmart is considering placating Jana, perhaps Foolish investors should be worried. The chances are good that Jana is more interested in PetSmart's short-term stock price than its business. 

Life with Jana is too short
For a peek into what life with Jana is like, let's take a look at its relationship with Walgreen. For months Jana's Barry Rosenstein has pushed a tax loophole that he believes Walgreen "should clearly be looking at." Thanks to Walgreen's merger with Switzerland-based Alliance Boots, Walgreen could actually move its corporate headquarters and skip out on paying some U.S. Corporate taxes. It's exactly the "event-driven" scenario that Jana seeks to unlock (what it calls) value. 

After months of pressure led by its large shareholder Jana, Walgreen is now seriously considering renouncing its U.S. corporate citizenship to boost shareholder returns. This naturally has led to some fierce criticism. Andrew Ross Sorkin, of the New York Times recently criticized the audacity of Walgreen's even considering this, because the chain has received "$16 billion in annual revenue from the government (via medicare and medicaid), and had recently negotiated $46 million in corporate income tax credits from the state of Illinois." 

Aside from bad PR, this type of activity isn't good for Walgreen's business. Management should be focused on improving service, delighting customers, and investing in its employees. That's what sets great retailers apart in the long-term.

While some are critical of Walgreen CEO Gregory Wasson, most executives act this way amid the pressure of activist investors. Wasson has had to spend his time battling for control of Walgreen, and to do so he's focused on rewarding activists in the short term. For the past six months, and some would argue two years, Walgreen hasn't been focusing on improving its business. It's been trying to avoid the tax man. 

Stay focused on businesses
While I'm sure that Jana bought PetSmart, on some level, because of the fundamentals, that's not what sent the stock up 12.5%. The stock was up because activists typically bring lay-offs, buyouts, dividends, or mergers. The problem is that we can't rely on any of this financial engineering any more than we can rely on stocks to go up or down. All we can rely on is the certainty that this will be a distraction for PetSmart's management. 

If Jana's plans don't work out, there's no telling what business we'll be left with a few years from now. Swim with caution.

Leaked: Apple's next smart device (warning, it may shock you)
Apple recently recruited a secret-development "dream team" to guarantee its newest smart device was kept hidden from the public for as long as possible. But the secret is out, and some early viewers are claiming its everyday impact could trump the iPod, iPhone, and the iPad. In fact, ABI Research predicts 485 million of this type of device will be sold per year. But one small company makes Apple's gadget possible. And its stock price has nearly unlimited room to run for early-in-the-know investors. To be one of them, and see Apple's newest smart gizmo, just click here!


Read/Post Comments (0) | Recommend This Article (1)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 3022196, ~/Articles/ArticleHandler.aspx, 10/21/2014 5:21:12 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement