In my family, we've recently developed a new Sunday ritual. Most every weekend now includes a trip to the local strip shopping center to stock up on goodies at specialty mini-supermarketTrader Joe's (and no, it's stillnot public), where our 2-year-old acquires a free helium-filled balloon from the cashier in exchange for our buying, oh, about $171,502.59 worth of groceries. Then we take the toddler over to pet nirvana Petco (NASDAQ:PETC) to spend half an hour cooing over the mice, hamsters and adopt-a-cats . and then another half-hour trying to drag her away from said menagerie.
Essentially, the store serves as a free petting zoo for window shoppers -- and perhaps that's part of Petco's problem. It's drawing too many lookie-loos and not enough high-margin buyers.
When last we checked in on Petco, the company was in the midst of a continuing share-price slide. Its shares had fallen 40% over the past year against a 5% rise in the value of the S&P 500. Petco's continuing share price freefall was partly due to the company's disappointing guidance for Q3, despite hitting analyst targets for its second-quarter earnings. Last year, the company had booked $0.39 per share in profits in its third quarter. Analysts expected a significant decline this year -- $0.36 per share -- but were stunned to hear the company promise even less: just $0.25 to $0.28 per share. (Analysts have since lowered their own expectations accordingly and expect the company to report roughly $0.26 per share in profits tomorrow.)
Strangely, everyone seems to agree that the company isn't doing half bad on the sales front. Analysts predict a better-than-9% increase in sales over the year-ago quarter. It's just that the margins are going to take such a sizeable hit in Q3, primarily from shipping costs related to September's hurricane-induced fuel cost spikes, that even those greater sales are expected to yield disappointing profits.
That brings us to valuation. As bad as the "accounting earnings" picture is shaping up, Petco's true cash profits look even worse. Over the past four quarters, Petco has booked $82.5 million in GAAP profits, but its free cash flow has amounted to just $40.8 million. At its current market cap of $1.3 billion, the company currently trades at about 32 times free cash flow. However, analysts expect long-term earnings growth of just 18% per annum -- a number that could come down if tomorrow's earnings report is as bad as currently feared. As far as Petco's share price has already fallen, its valuation is still far above its projected profits growth rate, this Fool suspects that both may have further to fall.
For further Foolish musings on Petco and rival PetSmart (NASDAQ:PETM), read:
- PetSmart Needs Some Love
- Foolish Forecast: PetSmart Checkup
- PetSmart Bites Back
- Riding Wild With Petco
PetSmart is a recommendation of Motley Fool Stock Advisor.
Fool contributor Rich Smith does not own shares of any company named above.
