Are Pets the Most Resilient Demographic?

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The dream of every long-term investor is to find a stable of "back pocket" stocks -- companies that have a reasonable and durable thesis, are fairly or undervalued, and are growing faster than the overall market. A dozen or so of these stocks can lead you down the yellow brick road to a relaxing retirement.

Specialty retailer PetSmart (Nasdaq: PETM  ) may well deserve a place in that stable. There's a prevailing notion that Americans may scale back on themselves when times are tough, but they will never, ever scrimp on their four-legged, finned, or winged housemates. PetSmart's results over the past several years are an affirmation of that perception.

The best-kept antirecessionary secret
Sales, EBITDA, and free cash flow have all risen in each of the past four years, smack dab in the middle of the nastiest recession we will (hopefully) ever see in our lives. Operating margins have remained steady in the face of cost pressures, thanks to growth in the company's line of private-label food and products, and a steady rise in the sale of lucrative pet services.

The American Pet Products Association, an industry trade group, echoes the resiliency of the pet demographic. The total market has more than doubled since 1998, to an estimated $47.7 billion in 2010. Other surveys confirm that more than 60% of U.S. households own pets, and pet owners have household incomes higher than the national average.

Recent results confirm trend
PetSmart continued a run of impressive quarterly reports with its recent Q3 earnings, as net income rose 20% from the year prior. The top line grew 7.2%, to $1.4 billion, thanks to comparable sales growth of 5.6%.

Also boosting revenue was 8.7% growth in the burgeoning services segment, which includes everything from grooming, training, veterinary, boarding, and day camp (yes, you read that last one right). Services have been steadily growing as a percentage of overall sales, and now make up more than 10.7% of the top line, bringing their fat margins in tow.

PetSmart management has also made some decidedly shareholder-friendly moves, quadrupling the quarterly dividend over the past couple of years (from $0.03 to $0.125), and extending the share repurchase agreement to $350 million, which runs through 2012. Some $210 million remains on the authorization.

State of the competition
Foolish law states that any stock is only as good as its ability to stand above the competition. The biggest threat comes from uber-retailers such as Wal-Mart (NYSE: WMT  ) , Target (NYSE: TGT  ) , and Costco (Nasdaq: COST  ) , which have been beefing up their offerings of consumables such as pet food, treats, and litter, exactly the products that make up more than 50% of PetSmart's sales.

But the big-boxers and supermarkets generally offer just the mainstream brands, leaving the premium and prescription markets to PetSmart and its smaller, fragmented competition in the specialty space. Petco is pretty close to a pure competitor in terms of scale and offerings, but since the company went private in 2006 investors can no longer compare the two side by side.

What may be PetSmart's sharpest competitive weapon is its PetPerks customer loyalty program, which I can say from experience is spookily effective. The company uses purchase histories and data to create targeted advertising, coupons, and other offers that create the "sticky" customer every retailer craves.

Share price at all-time high ... so now what?
Investors often see a stock's new all-time high as a natural decision point. Is this my time to pare back and/or exit, or is this the long-awaited breakthrough toward a two-, three-, or more-bagger future? PetSmart shares had knocked on the $35-level door twice before, first in late 2004 and again in mid-2007. The stock finally broke through the longtime resistance level in the beginning of the fourth quarter, and has stabilized in the upper $30s since.

This doesn't mean we're in nosebleed valuation territory. The forward P/E of 16.6 is quite reasonable given a five-year estimated annual growth rate of 15%, and those estimates have been generally moving in one direction -- up. More than 60% of analysts covering the stock have raised their 2011 estimates in the past month as PetSmart exceeded expectations and upped guidance.

Investors should, as always, conduct their own due diligence, but few retailers show the kind of defensive benefits offered by PetSmart. Many Fidos will have Christmas stockings just as full as Mom and Dad. Pets have been treated well during the recession, and I think they will be treated even better in a recovery.

Ryan Barnes owns shares of Costco. Costco and Wal-Mart are Motley Fool Inside Value selections. Costco and PetSmart are Motley Fool Stock Advisor picks. Wal-Mart is a Motley Fool Global Gains recommendation. The Fool owns shares of Costco and Wal-Mart. 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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