Whether you seek the companionship of a 1-ounce Budgie bird or a 160-pound Caucasian Ovcharka dog, PetSmart (NASDAQ:PETM) tries to offer everything necessary to keep your feathered, furred, scaled, or cuticled friends (if you're into arthropods) as comfortable as possible. Given how strongly people feel about their pets, it's not surprising that the company hasn't buckled under the pressure of recession, though markets did give its second-quarter financial results an icy reception.

At first glance, the release was reasonably good. PetSmart's earnings rose 4.6% to $0.31 per share last quarter. Although comps were up a meager 0.8%, sales jumped over 5% to $1.31 billion. But margins were weaker, and what really spooked investors was the company's downward revision of full-year guidance. Following last night's announcement, PetSmart's stock was down over 10% today.

Earnings grooming
While both top and bottom lines improved, there were weaknesses in PetSmart's quarterly results. Both gross and operating margins contracted, disappointing investors who would prefer to see company fundamentals continue to improve rather than reaping below-the-line windfalls resulting from fluctuating tax liabilities and interest payments.

Although its pet services segment's sales jumped 10%, the segment makes up less than an eighth of PetSmart's total revenue. Pet services provide a way for the company to differentiate its retail business from stores like Wal-Mart (NYSE:WMT) and Target (NYSE:TGT), which also sell pet supplies. Grooming drove double-digit growth in the services segment last quarter, with its PetsHotel and animal training businesses staying weak.

Dog gone
PetSmart now carries more than $500 million worth of capital lease obligations on its balance sheet, with just over $180 million in unrestricted cash. But that doesn't worry me as much as the ongoing sales pressure and margin reductions implied by management's revised guidance. It also doesn't help that anyone can walk into a Kroger (NYSE:KR) store and find a perfectly sufficient, albeit spartan, selection of pet supplies. Company management also cited a correlation between lower housing starts and lower demand for pets.

Once you factor in competition from privately held Petco, as well as wildcard sellers like Amazon.com (NASDAQ:AMZN) and eBay (NASDAQ:EBAY), you get a clear sense of the challenges that PetSmart faces on the retail side. As I see it, investors should give this beast a wide berth until the economy shows real signs of improvement.

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