Those retail investors sniffing around stocks in the pet supply business are suddenly wishing they had already taken a bite. The No. 2 player in the market, Petco Animal Supplies ( PETC), announced Friday that it agreed to be acquired for about $29 a share by a private investment group. The deal offers shareholders a whopping 49% premium to Thursday's closing price of $19.45, and the shares closed up 44%. Shares of Petco's chief rival, PetSmart ( PETM), shot up almost 9% in the wake of the announcement as investors took a second look at this promising segment of the retail sector. Is it too late to get in on these puppies? "Even after today's increase, shares of PetSmart still look significantly undervalued," says Morningstar analyst John Owens. "We consider PetSmart to be the leader, by far, in this growing industry. It has big advantages over Petco, and the Petco transaction only signals that there is value in these companies that wasn't being recognized by the market." Now trading at about 15 times Wall Street's 2007 earnings estimates, PetSmart isn't sporting the kind of rich valuation that is commonly granted by investors to retail chains with its level of growth potential. With 850 stores in the U.S., compared with Petco's 775, PetSmart plans to open 90 stores this year. It plans to add 90 to 100 stores annually in the coming years, and it ultimately targets a domestic store count of roughly 1,400. Meanwhile, the company also has a high-margin services business growing at a consistent 20% clip that includes grooming, training and boarding for pets. This helps differentiate the stores from general merchandisers such as Wal-Mart ( WMT) and Target ( TGT) that dominate the $36 billion pet supplies business. It also sets it apart from Petco and mom-and-pop pet stores, which don't have the floor space or the capacity to offer such an array of options to customers.
PetSmart's stores are about 70% bigger than those of its rival, and they're generally located in the kind of regional shopping centers that are home to America's burgeoning big-box retail industry. This requires customers to travel further to shop at a PetSmart, as opposed to the typical Petco store, which can be found in neighborhood shopping areas alongside local grocery stores and dry-cleaners. But it also allows the chain to offer lower prices and more products and services to the nation's growing population of pet fanatics. "With its bigger, recently reformatted stores, PetSmart delivered $206 in sales per square foot in fiscal 2005 compared with Petco's $185," Owens said in a recent report. "With solid cash flow and a stronger balance sheet, PetSmart should be able to fund expansion at a faster clip, leading to greater market share and scale advantages." Unlike Petco, PetSmart runs 32 so-called "PetsHotels," which it markets as a friendlier option for boarding dogs than a traditional kennel. Instead of cages, these locations keep dogs in "suites," offering such amenities as "poochy cots," hypoallergenic lambskin blankets and even a TV tuned in to a pet channel. Cats can stay in "kitty cottages" that have connecting doors and glass windows. In additional to the hotels, the company has six "Doggie Day Camps," where customers can leave man's best friend for a day of exercise and grooming. It projects that it could eventually operate 300 such hotels and 40 day camps in the U.S. The company also offers veterinarian services at hundreds of stores through a partnership with Banfield, The Pet Hospital. For its first quarter, PetSmart reported its gross profit increased 11%, to $310 million. That included a 30.7% gross margin, down from 30.9% in the prior-year quarter. The decline reflected sales growth from its pet services offerings, which have lower margins, but are more profitable on an operating basis. PetSmart has increased its operating margins from 0.7% in 2000 to 8.3% last year, which beat Petco's 7.1% margin.
Revenue rose 12% for the first quarter to $1.01 billion, with a 3.7% increase in same-store sales. "Customer traffic at the stores remained healthy, despite the headwinds of rising gas prices and waning consumer confidence, and the pet services business continued to deliver strong growth, with sales up 27%," Owens said in a report. "Over the next five years, PetSmart will be able to deliver double-digit sales growth quite easily." Petco's $1.8 billion buyout last week from Leonard Green & Partners and Texas Pacific Group was largely due to the steady cash flows it generates. Retail, in general, has been an attractive sector for buyout mavens who are flush with cash and looking to lever up public companies that can handle more debt. But any anticipation that PetSmart could also fall prey to that trend is nothing more than speculation. Also, with the market showing a new tendency to move lower on economic concerns about the strength of consumer spending, investors are losing their appetite for retail stocks -- particularly of the growth variety. But PetSmart could have some unique staying power in a downturn, since its services appeal to high-end customers who are becoming emotionally attached to their pets. Americans own 359 million pets, including 164 million cats and dogs, according to the American Pet Products Manufacturers Association, and
spending on pets has doubled over the last decade -- a secular trend that shows no signs of slowing. "Consumers are spending more and more on their pets and treating them more like family members," says Bruce Richardson, a PetSmart spokesman. "We are riding that wave." With specialty chains like PetSmart and Petco capturing only about 15% of the pet supplies and services market, these companies both have ample room to gain share. Aside from their stores, both reach customers through catalogs and Web sites, and they have customer loyalty programs like PetSmart's new PetPerks card, which opens up new marketing channels. "Some people have argued that this industry is recession proof, although I don't believe that entirely," says Owens. "Customers will scale back on pet spending in a downturn. They're not immune to macroeconomic pressures, but we think these businesses are solid enough to survive during difficult times and really prosper in stronger economic times."