It's been an ugly couple of years for Petco (WOOF).
Shares of the diversified pet products retailer are now down 90% from their peak (the 2021 initial public offering). A number of factors have combined to send the stock plunging.
The pet industry boomed during the pandemic, but in the economic reopening, demand has weakened as consumers shift their spending to other areas, especially those that were off-limits during the pandemic like travel and dining. Discretionary spending has gotten tighter in an inflationary environment. That's spelled trouble not just for Petco but also for peers like Chewy, which recently hit an all-time low.
But it's not just category-level demand that's plaguing Petco. Profit margins have also taken a dive. In the fiscal 2023 third quarter, gross margin fell from 39.8% in the year-ago quarter to 36.8%. The company lost money even on an adjusted basis with a net loss of $14.5 million compared to an adjusted profit of $30.0 million last year.
Management responded by promising to cut costs, targeting $150 million in cost savings by the end of 2025, but the stock still plunged 29% on the report.
Image source: Getty Images.
It's not all bad
While the overall numbers are clearly a problem for Petco, the company is making progress on key strategic initiatives. Third-quarter revenue from services, which include veterinary visits and grooming, rose 15% year over year. That's important because the segment builds customer loyalty by helping to grow the company's membership program, Vital Care Premier, which now has 672,000 subscribers.
It's also growing its veterinary program, adding 433 vets in the quarter (up 21% year over year), and the number of pets seen by these vets rose 17%. Digital sales continue to increase, up 5%, and sales of consumables were also positive, up 1.5%.
Management aims to deliver profitability improvements in 2024 by responding to changing customer buying patterns as the earlier benefit from COVID stimulus payments has run out. It also said the upfront cost of labor and logistics to get new products on shelves has impacted profitability, though it expects to see a benefit from those moves next year.
Why this could be a great buying opportunity
Petco stock may have collapsed, but this isn't a company that's about to go out of business. It's the second-largest pet products chain in the country by locations, just behind PetSmart. And it's well ahead of the No. 3 company Pet Valu.
There's no risk the pet products industry is going away. Not only are pets an enduring business, but it tends to be recession-proof as pet owners still need to spend on their pets in a down economy.
In other words, Petco is facing mostly temporary hurdles, some self-inflicted and some from changing consumer demand, but the stock is priced as if the business is fundamentally broken. It now trades at a price-to-sales ratio of just 0.14, an unusually low valuation even for a retailer.
To put that in perspective, if the company had a profit margin of just 1%, it would have a price-to-earnings ratio of 14. If it's able to generate a profit margin of 2% or even 3% (as it has previously), then its P/E would fall to 7 or 5, respectively, at the current stock price and revenue level.
The higher the company can drive that profit margin, the higher the stock price will go, not just for valuation reasons but because it will reflect a stronger business.
Management's turnaround plan sounds credible: Add brands that customers want, even when it lowers gross margin, and cut costs and drive efficiencies where available. Consumer discretionary spending won't be down forever, and most investors now expect interest rates to start coming down next year, which will also give Petco's bottom line a boost by reducing the interest expense on its variable-rate debt.
While the company has a lot of work to do to repair the business, the stock looks significantly undervalued at the current price. Petco stock may be risky, but investors who can stomach the uncertainty could be rewarded with a multibagger down the road.
