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Has PetMed Express Contracted Fleas?

By Steve Alexander of MagicDiligence

NEW YORK ( MagicDiligence) -- There are many things to like about PetMed Express (PETS - Get Report), the largest American company focusing primarily on mail order pet pharmaceuticals.

The company, better known as 1-800-PetMeds, offers about 750 different products for dogs, cats, and horses, with about 70% of sales coming from non-prescription medicines and the rest from prescriptions. PetMed sells directly to pet owners, with about 70% of orders coming through its Web site, and the rest through phone, fax, and mail orders.

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PetMed has outstanding financial metrics, with more than $70 million in balance sheet cash vs. no debt. The business model is very efficient, with low capital requirements leading to high returns on capital. Average five-year return on equity is over 28%, with return on assets averaging an impressive 26%.

Management has been generous about returning capital to shareholders too. Share count has been reduced by over 2% annually over the past three years, and the dividend was recently boosted 25%, yielding an attractive 3.2% at current share prices.

Since 2006, the company also has generated solid growth in both revenue and margins. The five-year compound annual growth rate in revenue is 11%, and operating margin rose from 13.2% in fiscal 2006 to 17% in fiscal 2010, leading to a 15% CAGR in operating earnings.

Vets control over 75% of this $3.5 billion market. PetMed has been able to achieve success through classic retail standbys -- lower prices, better selection, and superior customer service. PetMed generally offers prices 10% to 15% below the vet's office, and its wide array of products can help customers find less costly or higher quality alternatives for non-prescription needs. Using these advantages as a foot-in-the-door, PetMed has enjoyed strong repeat business, helping to drive decent and profitable growth.

The company's strong financial health, shareholder friendliness, and decent position in a niche market lead me to give it a positive recommendation, but I do believe there are better choices in Magic Formula Investing right now. Here's why.

The biggest problem with PetMed is that it looks like it has stagnated. Revenue growth is going in the wrong direction -- last quarter it fell 2% from the 2009 quarter, not impressive when you consider the recessionary conditions last year. Even worse was profitability. Operating margins declined to 12.6% vs. 15.7% a year ago, leading to a 21% decline in operating income. It was the second quarter in a row that the company suffered declines. The business trend, as they say, is not our friend here.

It appears that new competition from all sides is taking its toll. Customers can now drive to Wal-Mart (WMT - Get Report) or click to (AMZN - Get Report) and find the same pet medications for even cheaper than PetMed offers. Direct competition has also emerged from companies like Drs. Foster & Smith, another online pet outfit which has managed to both under-price PetMed on pharmaceuticals and offer other pet supplies as well. This new competition is in addition to PetMed's historical nemesis -- the vets themselves. Vets have dropped their prices on meds and have continued to discourage customers from purchasing pet medications online.

Against these threats, I haven't seen anything from management that indicates it has a plan in place to re-ignite growth. The dividend hike and another new $20 million share repurchase will appease some shareholders, but the fact is that the stock isn't worth much more than it trades at today without growth.

The problem is that it isn't clear what management can do to ease the issues the company is currently experiencing. Better marketing (PetMed advertises on the cheap) may help the top line, but would cut further into margins. Lowering prices is probably not a good strategy, considering the scale and diversity of its big-box competitors. The company operates at a competitive disadvantage.

I'm afraid PetMed is likely to experience declining metrics for a few years before bottoming out at a reduced level of profitability. Even giving the company the benefit of the doubt and modeling in meager growth, my fair value estimate is only about $17 a share, an 11% premium (with the dividend) to current prices.

Alexander owns no position in any stocks discussed in this article.
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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