Stock Mart: PetsMart

Since taking the helm of pet-supply retailer PetsMart (PETM) just over a year ago, Philip Francis has set about putting in place some seemingly obvious initiatives that have been sorely neglected.

For instance, before the company opens a new store, management must show that the location will generate specific returns on capital. Under the previous management team, stores were opened because "they looked good," says Neil Watanabe, chief financial officer.

"Today it is profitable growth," Watanabe adds. "Before it was just growth."

This combination of sales increases and expense reduction is one reason John Glass, an analyst with Deutsche Banc Alex. Brown, calls PetsMart one of the best retailing turnaround stories this year. (His firm hasn't performed recent underwriting for the firm.)

"The same-store sales are accelerating, they have a mounting cash balance and this is a great margin expansion story that hasn't even started yet," Glass says.

By 1997, Phoenix-based PetsMart had expanded to 348 superstores from just two nine years earlier. (Today, the company runs 558 stores in the U.S. and U.K.) Sales in fiscal '97 totaled $1.5 billion, up from $369 million in '94, the company's first year as a public entity. From its July 1993 IPO, the stock appreciated 196% to 29 7/8 by September 1996. But it hasn't seen those lofty levels since, closing Friday at 10, up 7/32, not much higher than the IPO price.

The race to dominate the dog-food market left the company with an inadequate infrastructure. With no thought given to centralized distribution, the stores were forced to act as mini-warehouses and ended up choking under too much inventory. Boxes of kitty litter were stacked to the ceiling, making it hard for customers to find what they needed.

Then came the acquisition of PetsMart direct, a catalog company, followed by the company's first international foray with the purchase of PetsMart U.K.

The company's systems groaned under acquisitions that spread it too thin, too fast. For the year ended February 1998, the company lost $35.9 million, or 30 cents a share, on sales of $1.2 billion.

Out went the old management and in came Francis, who learned his trade running a supermarket chain. One of his first strategic moves was to hire Donaldson Lufkin & Jenrette (DLJ) to explore the possibility of divesting that unfortunate U.K. acquisition. Watanabe, the CFO, says the company expects to make an announcement on the issue when it reports its fiscal second quarter in August.

On the operations side, Francis set about eliminating excess merchandise. He trimmed nearly $10 million in inventory, payroll and carrying costs related to buying, storing and moving all that stuff.

To understand the importance of carrying less inventory, one money manager who owns the stock but declined to be named points to inventory yield, or gross profit divided by inventory, which he calls a leading stock price indicator. When the yield is rising, chances are a company's stock will soon follow. PetsMart's inventory yield hit a low of 144% in the 1998's fiscal first quarter. It rose to 163% in the most recent fiscal first quarter.

Next, Francis is turning his attention to distribution to create a more centralized buying system that should allow the company to expand operating margins over the next 16 months, Watanabe says.

Francis also has been instrumental in winning back a contract for Nutro, a popular dog-food brand that accounted for 4% of the company's sales in fiscal 1992. That was before PetsMart's former management lost the business to a competitor over a dispute with the privately held manufacturer on how to market the product.

"Nutro will add 1% to 2% to their same-store sales alone," says Glass, the analyst. "It was a coup for them to get that."

That should help PetsMart meet the First Call consensus estimate of 40 cents per share this fiscal year, double what the company earned last year. And sales at stores open at least a year are expected to increase by about 7% for the period, the CFO says. Price-to-sales, another measure of value when less than one, is just 0.52.

Determined not to be "Amazoned" by the Internet, PetsMart has partnered with idealab! for an e-commerce site that will launch in July and will make use of the company's catalog business for back-end fulfillment.

"It's a fallen angel," says the money manager, whose 12-month price target is 16. "And there are not that many values in retail today."

It seems like PetsMart, which has already been through the dog-and-pony show, is finally learning to heel.

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