Petco's Stock Price Is Down, Should Investors Buy the Dip?

After a rough first half of 2020, initial public offerings (IPOs) came back with a vengeance in the back half of 2020 and into early 2021. The pet store chain Petco Health and Wellness (WOOF) benefitted from this insatiable appetite for IPOs when it opted to go public (again) in January.

However, after a brisk debut, Petco's stock price has tumbled and is now trading more than 26% below where it traded on its opening day. Should investors view Petco's stock price decline after its IPO as a warning sign or a buying opportunity?

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Petco's January 2021 IPO was its third try at being a public entity

For most companies, an IPO is a once-in-a-lifetime event. However, when Petco IPOed in January 2021, it was its third time going public!

The company has previously IPOed in 1994 and 2002. The reason behind this interesting fact is that the company has been acquired multiple times by private equity investors. Perhaps this pattern will play out again in the future if private equity investors continue to find the company attractive.

This time, Petco managed to go public at an $18-per-share price, which allowed the company to pull in $817 million from the offering. In the company's IPO prospectus, it noted that it intends to use most of the proceeds to repay debt obligations.

This makes sense given the company's private equity history. Private equity investors tend to load up balance sheets with as much debt as possible to increase their returns, and raising money from the public market is a great way to repay those debts while raising capital at a high valuation.

Image source: Getty Images.

Petco has managed to maintain solid financial performance

Petco's stellar performance in 2020 made for a great case to go public. Sales were up 11%, driven by growth in same-store sales along with segments such as e-commerce and vet services. In fact, the company was able to generate enough cash flow to cut its debt load in half during the year from $3.3 billion at the start of 2020 to $1.7 billion by the end of the year.

However, the company's gross margins did decline slightly due to increased costs related to the COVID-19 pandemic. For example, Petco had to supply masks to its store employees and take extra precautions in sanitizing its stores.

All this underlines the advancements Petco has made over the last three years. The company has invested over $300 million total and $150 million of that just in the past three years in building out its digital and e-commerce platforms. These investments appear to be paying off, as the company was well prepared to handle online business during the pandemic.

Petco stock has a tough valuation when making comparisons

The big knock for investors evaluating the attractiveness of Petco's stock is its valuation. Petco trades at a significant valuation premium to other retailers.

Data source: Yahoo! Finance. EV/Revenue = enterprise-value-to-revenue ratio. EV/EBITDA: enterprise-value-to-EBITDA ratio. Forward price-to-earnings (P/E) ratio.

A premium valuation is warranted due to Petco's faster rate of revenue growth and unique position to offer services on-site that cannot be done over the internet, such as dog training classes and pet adoption. However, the degree of the premium is questionable and probably has something to do with the hot market for IPOs leading to an overvalued share price out of the gate.

To illustrate, Petco initially sought an IPO share price target in the range of $14 to $17 per share. The IPO was actually priced at $18 per share -- above the range. And then the stock skyrocketed by 73% on its first day of trading.

The tremendous price increase was likely overdone, and the stock has come back down to a more reasonable price. The stock still trades above its original IPO price range, which indicates that the company could continue to trade lower if that IPO price was a more reflective marker of value.

Buy the dip on Petco?

Petco is certainly an interesting retailer with a strong national brand and a proven ability to perform in what is becoming a digital e-commerce world. The company has demonstrated financial strength to back it up.

However, it is important to separate a company's fundamentals from its stock price. Petco's stock benefited from a very healthy "IPO pop" that took the price too high, too quickly. While the stock has declined a great deal from its post-IPO high, it may continue falling, as it still trades richly compared to its retail peers. Now may not be the best time to buy.