Is there still any question that pets are seen as more than just animals to most people in the United States? I'm convinced that plenty of dogs and cats in this country have it a lot better than I do -- and I'm not just talking about not having to work for a living. No, it's no longer "a dog's life," at least not in the way that it used to be.

Dogs and cats are increasingly kept indoors, fed specialty food, dressed in sweaters when there's a chill in the air, and given fancy Christmas presents. Heck, some even got dressed up for Halloween! And PetSmart (NASDAQ:PETM) has been all over this trend from the get-go. PetSmart's focus is to become a trusted merchant for "pet parents" looking to attend to all aspects of care for their special furballs. With more than 60% of U.S. households owning at least one pet, the sales of pet food, supplies, veterinary care, and pet-related services is now an industry grossing more than $35 billion annually.

After the market closed on Wednesday, PetSmart announced earnings for the third quarter. You can read the details of the quarterly results in our Fool by Numbers feature, but in short, things continue to move forward. Third-quarter earnings per share came in at $0.23 per share, beating management's midpoint guidance and analysts' consensus estimates of $0.21. Same-store-sales growth was a strong 6.8%, and overall sales rose 14%. Though one-time costs (primarily related to refreshing stores) and an unexpected $3 million store closure kept operating margins from heading north, company managers are confident that the investments they are making now should pay off down the road.

In addition, the company spoke about the upcoming departure of CFO Tim Kullman. This departure is not expected to be disruptive to operations; Rich Smith covered the details in his pre-earnings forecast.

Driving PetSmart's growth this quarter were:

  1. Continued store growth and store upgrades.
  2. Ancillary service offerings.

My, how big you're getting!
At the end of the third quarter, PetSmart had 887 stores in North America. While this is a fair number of stores, it's only about 60% of the 1,400 total stores that the company believes it can reasonably grow to in North America. As management believes that the company has only a 10% overall market share, it stands to reason that there is still plenty of room to add new stores.

After tacking on 100 net new locations in 2005, PetSmart is anticipating a total of 83 net new stores this year and up to another 100 net new stores in 2007. According to PetSmart's 2005 10-K filing, each of these new stores adds $3 million in sales to the company's revenue in the first year and then grows 19% to 21% in its second year and another 11% to 13% the year after that.

In addition to the "smart" pace at which PetSmart is adding new stores, it's also upgrading stores to make them more convenient for customers and drive more sales. Over the past two years, the company has been working on refreshing its existing stores using a new format, dubbed "Eagle II," which highlights key products within the store and improves the in-store pet-training facilities. On the call, President and COO Bob Moran noted that company officials had completed their planned store refreshers for 2006 and would continue the project with another third of its stores next year, with the remainder addressed in 2008. He went on to say that results from stores that have already undergone the Eagle II makeover have been promising and that the new format appears to be driving increases in merchandise sales and pet training.

A cozy place to stay
A big part of the PetSmart story right now is the continued rollout of services, especially its full-service luxury pet boarding offering, PetsHotel. The full menu of services, including grooming, training, boarding, and "day camp," was up 25.4% year over year. These service offerings are still less than 10% of the company's total revenue and are actually dilutive to gross margins, but they are growing faster than the core business and are roughly twice as profitable as merchandise in the operating margins.

While services in general have been good to PetSmart, especially as the company continues the Eagle II project, most of the company's locations already have grooming and training facilities on site. On the other hand, the PetsHotel concept is still in its infancy, with only 57 locations currently open. The uptake and return on this new business has been so good, though, that Moran announced on the call an expansion of the company's original target for total hotels from 300 to 435.

In addition to being built in with new stores, the company is also taking advantage of expired lease agreements to find larger sites for existing stores, so that PetsHotels can be added on. For locations where a full-size hotel might not be appropriate, company officials are also testing out a concept for smaller-sized hotels. By the end of 2006, they expect to have 62 total hotels open, including two of the smaller versions, and 2007 should see another 30 full-size hotels and five more of the smaller ones. According to the numbers Moran gave on the call, the metrics that the hotels deliver are impressive -- he said that, at maturity, the hotels are expected to drive a 29% increase in sales, a 99% increase in net income, and a 440-basis-point jump in operating margins for the stores where the hotels are located.

Is that a flea I see?
Yesterday, the Goldman Sachs analyst covering PetSmart downgraded the stock from "buy" to "neutral" on valuation concerns while simultaneously bumping up his price target from $30 to $32. Trading at 24 times trailing-12-months EPS and 23 times full-year 2006 estimates on forecasted long-term growth of less than 18% annually, it's tough to argue that the stock isn't fairly valued. Of course, management is more than prepared to take rewarding shareholders into their own hands: Kullman noted that the company is fully prepared to continue to return cash to shareholders through dividends and opportunistic share repurchases.

Though the stock saw some weakness yesterday after the downgrade, PetSmart is heading into its seasonally strongest, and most profitable, quarter. On Wednesday's call, CEO Philip Francis says the company "better prepared for this holiday season than ever before," so I wouldn't be too surprised if there aren't many dog days in the near future.

Agree? Disagree? Let the world know on Motley Fool CAPS, the Fool's new stock-rating community, where PetSmart, a Motley Fool Stock Advisor recommendation, is currently a four-star-rated stock.


Fool contributor Matt Koppenheffer knows that every dog has its day but not everyone gets a dog-day afternoon. He does not own shares of any of the companies mentioned. The Fool's disclosure policy is always well groomed.