If you are a pet owner, you've probably heard of PetMed Express (NASDAQ:PETS), which operates under the retail name of 1-800-PetMeds. With the pet supply industry being increasingly dominated by large brick-and-mortar retailers such as PetSmart (NASDAQ:PETM) and Petco, PetMed's direct-to-consumer model is an attractive alternative for consumers seeking convenience and competitive pricing.

In this edition of Fool on Call, we will investigate the company's latest quarterly earnings conference call to get a better understanding of the current state of its business. The discussion will center on these areas:

  • Advertising
  • Customer service

The cost of acquiring customers
One of the first things that initially stood out to me during my investigation of PetMed's business is that while it is growing -- net revenues in the quarter increased 21% compared with the same period a year ago -- I have doubts about whether it is growing quickly enough. Given both its e-commerce business model and its smaller sales base (total sales this period were $31.4 million), one would think that PetMed's growth should be stronger. Consider that PetSmart, with sales of just more than $1 billion in its third quarter, also saw double-digit growth, at roughly 14%.

PetMed's unimpressive growth relative to its supersized competition immediately raises a red flag for me. Apparently, I am not the only one concerned. Following the release of its latest results, investors dropped the stock by approximately 15% in recent trading. PetMed's management is also concerned, as indicated in remarks made during the conference call.

The prepared remarks left a little to be desired, since only the CFO spoke, and he kept strictly to financial data. But within that financial data and, even more, within the remarks made during the question-and-answer portion of the call, we find evidence of management's concern over sales growth and accompanying customer acquisition.

During the third quarter, the company added 130,000 new customers, a 23.8% increase from new customer acquisitions in the third quarter last year. Additionally, customers are spending an average of $75 per order, which is up from $74 in the year-ago period. And increasingly, most of these sales are coming from the company's website, which represents 63% of net sales, up from 57% this time last year.

We see some nice trends here: New customer growth is higher, the average retail order is slightly higher, and a greater percentage of transactions is taking place on the more cost-effective e-commerce platform. The warning sign, however, is that the company is spending substantially more to acquire these new customers.

The company spent $4.8 million on advertising in the quarter, compared with $3.2 million last year -- an increase of 50%. Moreover, the cost for acquiring each new customer increased to $37, compared with $30 in the year-ago quarter. "We were more aggressive to capture market share," admitted CFO Bruce Rosenbloom.

It is nice to see the company increase its new-customer count by almost 24%, but if it has to increase advertising costs by 50% to achieve this, the new customer growth suddenly doesn't seem all that impressive. Not surprisingly, analysts were all over this issue during the Q&A portion of the call. When asked whether the company will continue to be as aggressive in its advertising spending going forward, CEO Mendo Akdag stated, "We will be more aggressive."

Yet another analyst noted that the company has recently moved to employing a celebrity spokesperson in its ads (Betty White from The Golden Girls) and asked whether this shift in strategy was indicative of a tougher competitive environment. Akdag responded, "If you look at our nine-month [sales] growth, it is 16%, so we'd like to grow higher than that." He added, "So that was one of the factors in the decision."

Akdag specified that over at least the next three quarters, shareholders should expect to see more aggressive ad spending. No projected percentage increase was given, however. These costs will be primarily allocated toward TV and online ads, with television receiving a majority of the money.

The cost of making customers happy
On top of the rising cost of acquiring customers, PetMed is also facing increased costs to keep them happy. Higher staffing levels were one of the reasons for the increased general and administrative expenses as a percentage of sales; G&A increased to 12.8% of sales for the quarter, compared with 11.8% last year. Rosenbloom states that more staffing was needed to "be able to offer better service during our upcoming peak season."

Looking out over the next 12 months, we should expect to see a trend toward higher G&A expenses. The costs will be most noticeable during the off-season (the third and fourth quarters), Akdag said.

The website is another aspect of making the shopping experience enjoyable for customers. Here, the company is also making a substantial investment. Over the past year, it has spent roughly $1 million on its new e-commerce platform. Look for an additional $300,000 to $500,000 in capital expenditures related to the platform in fiscal 2007.

Concluding thoughts
You would normally expect to see e-commerce outpace the sales growth in its brick-and-mortar counterparts, simply given the nature of the burgeoning world of the Internet. But I find PetMed's sales growth in fiscal 2006 to be a concern.

PetMed's management is aware of the problem, in terms of increased advertising expenses and higher staffing-related costs. Through a combination of both, management is hopeful that it will not only acquire new customers at a faster rate, but also keep those new customers satisfied and coming back for more. Thus, it is in re-orders that management is hoping to eventually recoup on the back end some of these higher up-front costs.

The pet-supply industry is big-time business, and PetMed is the dominant online player for non-food pet supplies. But can it maintain its dominance in light of Petco and PetSmart, as well as large discount retailers such as Wal-Mart (NYSE:WMT), all making their own moves in the online pet market? And secondly, will the costs of maintaining its dominance outweigh the potential gains?

Shareholders will want to pay close attention to these matters over the next 12 months, as that's when we should gain more clarity on these very questions.

For related Foolishness:

  • VCA Antech (NASDAQ:WOOF) playing dead?
  • The Motley Fool sits down with PetSmart's brand-communications manager to talk about the current state of its business.

PetSmart is a Motley Fool Stock Advisor selection. To find out all the reasons why, take a free 30-day trial.

Fool contributor Jeremy MacNealy has no financial interest in any company mentioned. Wal-Mart is an Inside Value pick. The Motley Fool has a disclosure policy.