Traditional brick and mortar retailers seem to face more intense online competition every year. Given the challenging consumer spending environment—particularly during the highly promotional holiday shopping period—2013 was an especially tough year for many.
The weak holiday sales have resulted in numerous downgrades of retail stocks. Among them was PetSmart (PETM), the leading retailer of pet products and services in North America, which was downgraded by several analysts last month, citing weaker holiday traffic trends and expectations for increased online competition ahead.
However, PETM has been fairly unscathed by the growing dominance of online retailers over the years. The simple reason for this is the fact that no one has been able to stay in the business of selling 50 pound bags of dog food at a discount while also providing free shipping for very long. Additionally, demand for its products tends to be fairly inelastic and less affected by consumer spending trends.
That's why I believe the stock is undeserving of the sharp sell-off it has had so far this year and why I expect the strong growth the company has enjoyed over the past several years to continue in 2014.
PetSmart's 1,314 stores, which are strategically located at sites co-anchored by strong destination mass merchandisers, sell high-quality pet supplies consisting of roughly 11,000 distinct items. Through its Web site it sells an additional 10,000 items. PETM complements these product offerings with a wide selection of pet and veterinary services that promote repeat visits to its stores and creates cross-selling opportunities.
PETM has three business segments. The merchandise segment (88.5% of third quarter net sales) sells pet products that generally fall into three main categories: The consumables category (54.5%) includes pet food, treats and litter with an emphasis on super-premium, premium and therapeutic dog and cat foods, many of which are not available in grocery stores or warehouse clubs. The hardgoods category (32.4%) consists of pet supplies such as collars, leashes, health care items, grooming and beauty aids, toys and apparel, pet beds, pet carriers, aquariums and habitats. The live pets category (1.5%) is comprised of fresh-water fish, small birds, reptiles and small pets.
The services segment (10.9% of third quarter sales) provides a range of pet services, including full-service grooming (such as precision cuts, baths and nail trimming), pet training, and daycamp and boarding at its PetsHotels.
Through its 21% equity stake in Banfield Pet Hospital, PETM also offers routine examinations and vaccinations, dental care, pharmacy services and surgical procedures in many of its stores. The other segment (0.6% of third quarter sales) consists of license fees and reimbursements for specific operating expenses charged to Banfield.
Total third quarter net sales rose 4% year-over-year to $1.7 billion, benefiting from persistently strong demand for natural foods, grooming services and PetsHotels. Comparable store sales grew 2.7%. The merchandise, services and other segments saw sales increases of 3.9%, 5.2% and 7.4%, respectively, to$1.50 billion, $184.2 million and $10.5 million. Due to better sales mix, the operating margin expanded 45 basis points to 9%. Net income grew 12.0% to $92.2 million or 88 cents per share, which beat the consensus estimate by 2 cents.
PETM's stock has not had a good start to the year. First, it could not escape the sell-off in retail stocks earlier this month spurred by the wave of disappointing sales reports over the holiday shopping season. It was also downgraded by several analysts primarily on concerns over slowing store traffic trends and the expectation for increased competition from Internet-based retailers such as Amazon.com Amazon.com. As a result, shares are down about 10% since the end of 2013.
PETM is certainly not immune to weak consumer spending trends. In fact, coupled with the negative impact of unfavorable weather conditions across the nation—especially in the past month—I would not be surprised if its fourth quarter results fall slightly shy of the consensus estimate.
Furthermore, I concede that the potential for greater competition from the Web is an ever present threat. This has already taken down well-known retailers, such as Blockbuster and Circuit City, while also grabbing substantial market share from other brick and mortars, including Staples Staples, Radio Shack and Best Buy Best Buy.
But I strongly believe that investors are overestimating the impact of these concerns. The sale of pet food and supplies tends to be less discretionary in nature, resulting in relatively inelastic demand. This is likely due to the fact that spending on pets typically represents a small portion of total household budgets and is centered on food and other consumables, which must be purchased regularly. As such, I think the negative impact of the softer holiday sales trends will be less significant than the stock's recent drop implies.
In terms of online competition, I want to note that the Internet retail market is fairly mature with well entrenched players in virtually every product category. However, pet supplies has been one area where this is not the case. A key reason for this: the economics just aren't there. That is, it has been very difficult to make a profit selling pet food at a price competitive enough to sway consumers while also offering free shipping. Many have tried and failed. While the economics of this business may have improved somewhat over the past several years, I believe this remains largely true today.
Furthermore, PETM has been placing more emphasis on growing its own Internet site as part of a larger omnichannel strategy aimed at simplifying the overall customer shopping experience and driving traffic to its stores. For example, it added real-time online inventory availability information for consumables so customers can find out if a specific item is available at their local store. For this reason, I view the threat of online competition as fairly muted.
At the same time, I am optimistic on the prospects within PETM's services operations, which have continued to grow at a faster pace than its overall core business and represent a key competitive advantage over both online and traditional retailers that sell pet merchandise, such as Target Target and Costco.
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