David's Stock No. 3

PetMed Express

Smartphone screens and heartworm medication for your dog have a lot in common. OK, they have nothing in common, except that pioneers willing to explore new ways of looking at each of them are worth keeping an eye on. PetMed Express [Nasdaq: PETS] aims to break pet owners of the bricks-and-mortar habit in the same way Netflix [Nasdaq: NFLX] convinced movie fans that they need not get in the car to pick up the latest video.

"I love a direct-to-consumer subscription model that's a pain to cancel rather than a pain to renew," David says.

A Business for the Dogs ... and Cats

In a nutshell, 1-800-PetMeds bills itself as the country's largest pet pharmacy, delivering prescription and non-prescription pet medications as well as health and nutritional supplements for dogs, cats, and horses at a savings to customers. Taking orders by phone, fax, or the Internet, the company is trying to make the purchase of pet meds easy, convenient, and economical. It offers the exact same stuff that you get from your vet, but you don't have to driver there every month when you run out of flea collars, heartworm pills, or Flys-Off for your horse. Especially for the items that require seemingly eternal refills, this allows PetMed to compete on convenience while its lower overhead and economies of scale allow it to undercut the vet on cost.

And the pet med market is nothing to sneeze at. According to research, 71 million U.S. households own a pet and we are spending nearly $50 billion a year on them. Of the $47.7 billion spent on pets last year, $3.7 billion went toward medication. A decade ago, this market was a near monopoly controlled by vets. Today, PetMed Express and its rivals are taking a healthy chunk, and they're doing their best to maintain customers through conveniences such as reminding you when Fluffy is running out of medicine and calling the vet for you to refill the prescription. Reorders account for 75% of sales. Created in 1996, PetMed struggled to gain traction, but today has a 6% market share, which puts it in the dominant position among mail-order businesses -- all of its competitors combined control 5% of the market.

Not Rolling Over

But vets still own 72% of the pet medication market. Major sellers of nonprescription meds and other pet supplies, such as PetSmart [Nasdaq: PETM], Wal-Mart [NYSE: WMT], and Amazon.com [Nasdaq: AMZN], also compete here. But PetMeds has the advantage of being a licensed pharmacy in all 50 states, which allows it to deal in prescription medications, where these others can't. The extra regulation that comes with being a pharmacy, combined with the 1-800-PetMeds brand and high customer satisfaction, has built the company a burgeoning moat.

Not everyone agrees. In fact, shares of PetMed Express are heavily shorted, weighing in at a high 25% short interest, which likely indicates that large institutional investors are betting against the stock. But the company has a low P/E, a head start on its competitors, a huge growth opportunity, no debt, a long-tenured management team, and a rabid customer base. David hasn't made up his mind which side is right, and he's certainly not ready to pull the trigger on a formal recommendation here. But he is intrigued by the business model and feels PetMeds is a company worth watching.

Catalysts

• As it showed when it decided it wanted to be the diaper king, Amazon.com has ample resources to put a hurting on a smaller player. While PetMeds holds the pharmacy advantage, watch for one of the big guys to try to swoop in, especially on non-prescription products.
• Keep an eye on the short interest. If the stock rises rapidly, it could lead to a short squeeze, in which prices shoot up quickly as those with short positions might have to liquidate to cover their position by purchasing the stock.
• Watch for an expansion of PetMed's product line to offer more pet food options and to a broader range of pets. That could help the company broaden its market and become a one-stop shop for pet owners.

David and Tom share a last name, Thanksgiving dinners, and a penchant for buy-and-hold investing. But how they reach their investing decisions is an entirely different process, culled from an entirely different set of companies that earn spots on each brother's watchlist.

Let's now look at three companies the younger Gardner feels merit your attention.