PETC report



April 18, 2005

Ian Madsen, MBA, CFA, Editor

imadsen@

Tel: 1-800-767-3771, x 417

155 North Wacker Drive ( Chicago, IL 60606

PETCO (PETC – NASDAQ) $30.36

Note to reader: All new comments since last report are highlighted.

Overview

PETCO Animal Supplies (PETC) is a leading specialty retailer of premium pet food, supplies and services with a commitment to quality animal care and education. PETCO’s strategy is to offer its customers a complete assortment of pet related products and services at competitive prices, with superior levels of customer service at convenient locations, by hiring pet lovers and training them to become counselors to their pet loving customers.

PETCO operates over 700 neighborhood stores in 47 states and the District of Columbia, as well as having a leading destination for online pet food and supplies at . The PETCO foundation, PETCO’s non-profit organization has raised more than $18 million since inception in 1999. More than 2300 non-profit grassroots animal welfare organizations from around the nation have received support from the Foundation.

PETC is expected to grow sales and EPS considerably over the next several years through store expansion, mid single digit comps, margin gains, and lower interest expense. The strong PALS customer loyalty program and ongoing investment in its store base contributes to the company’s ability to generate consistently solid same store sales. PETC has reported comps of 4.6% or greater for the past 47 consecutive quarters. The company’s continuous merchandise mix shift, away from lower margin food products to higher margin live animals, supplies, and services, has allowed PETCO to drive additional profitability through its existing store base.

|Key Positive Arguments |Key Negative Arguments |

|PETCO’s track record of outstanding comp sales gains continued in the fourth|The leveraged capitalization resulted in a substantially higher debt ratio |

|quarter. |than its peers. |

|PETCO is one of the fastest growing sectors amongst the retailers. It has a |Increased competition from Wal-Mart, Supermarkets, PetSmart, and others in |

|favorable store expansion potential. |the discount channel might steal share from PETCO. |

|PETC’s “Think Adoption First” campaign is leading to growth in customer |Low return on invested capital versus other hardline retailers |

|loyalty. |Performance of remodeled stores turning out to be below expectations. |

|There is room for margin expansion given strong same store sales. |Weather issues impact sales performance from time to time. |

|PETCO is trading at an attractive valuation. | |

|PETCO opened 17 new stores in 4Q, with greater focus on customer centricity,| |

|all new and remodeled stores based on new Pisces format. | |

|PETCO is well positioned to continue to gain market share in the highly | |

|fragmented $28 billion pet food, supply, small animal, and services | |

|industry. | |

|The company’s efficient distribution network and its ongoing logistics | |

|enhancements continue to drive strong inventory turns and reduce the need | |

|for safety stock. | |

PETC’s fiscal year ends January; all calendar references are to the fiscal year.

Sales

The analysts (CIBC, Harris Nesbitt, Johnson Rice, Legg Mason, Morgan Stanley, RW Baird, SG Cowen, Smith Barney, and UBS) expect PETCO to increase sales by 14% in 2005 and by 11.9% in 2006.

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Net sales in the fourth quarter of 2004 were $492.3 million with a comparable store net sales increase of 5.1%. The comparable store net sales increase in the period comes on top of a 5.6% increase in the prior year's fourth quarter. Overall, net sales increased 10.9% over the fourth quarter of fiscal sales in fiscal 2004 were $1.81 billion with a comparable store net sales increase of 6.2%. The comparable store net sales increase comes on top of a 5.6% increase in the prior-year period. Overall, net sales increased 12.5% over fiscal 2003.

PETCO indicated that the company had a relatively slow start to the fourth quarter in the election doldrums of November. Solid holiday sales in December accelerated into January. However, in the second half of January, harsh winter storms in the northeast and unusually rainy weather on the west coast negatively affected customer traffic and diluted comp sales for the quarter. The sales performance to date in the first quarter of fiscal 2005 resumed to levels consistent with expectations.

The company opened 17 new stores during the fourth quarter, along with 10 remodels. A majority of the openings in the fourth quarter included Kids-R-Us locations, which had been delayed due to legal issues and some impact in South Florida due to the hurricanes. For 2005, the Company plans to open 90 new stores, or 70 stores net of closings and relocations. The Company also expects to remodel 50 stores in 2005 versus 50 remodels completed in 2004. With increasing market opportunities, both in suburban and under penetrated urban areas, the Company now projects the potential for 1,500-1,600 stores.

Management anticipates comp store sales growth of 5-6% in 1Q05. Management indicated Q1 sales to date have returned to normal levels following disruption from late-Q4 storms and have tracked expectations. Comps drivers for Q1 should include continued growth in services, marketing, more reformatted stores, and merchandising. The new Pisces store format should support sales growth in 2005 and beyond, with increasing benefits over time as the concept is implemented across a larger percentage of the base. Inflation in pet food should continue to support comps in Q1, although the contribution to growth may be less than that of recent quarters. According to CPI data, prices for pet food rose 2.7% in Q4, which compared to 3.4% in Q3 and 4.3% in Q2. One analyst (RW Baird) believes the inflation rate may be lower in Q1 due to a higher year-ago comparison.

See the PETC earnings model spreadsheet for more detail on the company’s revenues.

Margins

Analysts (CIBC, Harris Nesbitt, Johnson Rice, Legg Mason, Morgan Stanley, RW Baird, SG Cowen, Smith Barney, and UBS) expect PETCO’s margins to continue expanding in 2005.

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Fourth quarter summary: For the fourth quarter pro forma operating margin was 11.7%, an increase of approximately 40 basis points over the prior year period. A 90 basis point decrease in selling, general and administrative expenses as a percentage of sales was offset by a 50 basis point decrease in gross profit margin to produce the overall increase in pro forma operating margin.

Gross profit margin was 36.0% for the fourth quarter of 2004. Excluding the lease accounting corrections, pro forma gross profit margin was 36.3%. Initial gross margin improved 70 basis points from the continued change in mix from lower margin pet food to higher margin categories. Higher distribution costs decreased gross margin by 55 basis points primarily related to recent penetration into new markets, such as South Florida, where initial entry costs have been high. Occupancy costs associated with the delay in new store openings and increased store closing costs decreased gross margin by 75 basis points.

One analyst (RW Baird) expects gross margin expansion to continue in 2005, fuelled by product innovation and merchandising in higher-margin supplies, rapid growth in services, further penetration of super-premium brands of food, customer segmentation via PALS, and the new store format. The 2005 SG&A ratio is projected to be near flat due to spending on growth initiatives.

See the PETC earnings model spreadsheet for more detail on the company’s profit margins

Earnings Per Share

The Digest EPS averages are $1.80 and $2.13 for FY05 and FY06 respectively.

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PETC reported a fourth quarter EPS of $0.55, which increased 18% versus last year’s EPS of $0.47. This was in-line with guidance of $0.54-$0.55. For the full year EPS was $1.51 compared to $1.18 last year.

Management guidance for 1Q05 EPS is $0.33. For the full year, guidance is $1.82-$1.83 excluding a $0.01-0.02 impact from lease accounting.

Majority of the analysts have reduced their 2005 EPS estimate based on higher tax rate and lease accounting changes.

See the PETC earnings model spreadsheet for more detail on the EPS estimates.

Target Price / Valuation

The target prices range from $36 (UBS) to $47 (Piper Jaffray). The analyst (UBS) with the lowest target price has valued it using the P/E multiple of 22x 2005 EPS estimate, while the analyst (Piper Jaffray) with the highest target price has valued it by using the P/E multiple of 21x FY06 EPS estimate. Majority of the analysts have valued their target price by applying P/E multiple of forward EPS estimate and have mostly rated them as positive or neutral. No analyst has rated the stock as negative. The average target price is $41.20.

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Go to the valuation tab of the PETC earnings model spreadsheet for more detail on the brokers’ valuation methodologies and individual price targets.

Long-Term Growth

Analysts believe long-term growth will fall within the range of 18 %( CIBC) and 22 %( Smith Barney).The high and low forecasts could be viewed as extremes, with most analysts estimating a 20% growth. The long-term average growth is 20%.

One analyst (Piper Jaffray) continues to view PETC’s square footage growth opportunity favorably. PETC increased its long-term store potential from 1250 to 1500-1600 after reassessing the opportunity for expansion within existing markets as well as newer markets like the Southeast. This long-term target sets the stage for several years of store growth at 10% annually.

Management is pleased with its initial rollout of the next generation store format, Pisces, and indicated the metrics remain on track with expectations. The Pisces format utilizes enhanced signage, wider racetrack layout to encourage customers to tour the entire store, and more theatre in stores (i.e. aquatic tanks in the center of stores). Including new stores and remodels, 72 stores were set with the Pisces format in 2004.

PALS remain a powerful driver of customer traffic and sales. To enhance the program, management introduced the Top Dog program in nine test markets. This program recognizes the top PALS customers (in regards to sales, number of visits, and profitability) with additional rewards and benefits. This program represents the next step in maximizing customer profitability.

The number of pet owners in US keeps increasing as two major pet owning segments of the US population continue to grow: 1) families with young children and 2) empty nesters. Also unlike other segments of retail, pet owners will consistently purchase food and supplies for their pets regardless of changes in the macro-environment. In fact in the tougher times, pet owners may actually feel a stronger emotional attachment to their pets, which could drive increased purchases.

One analyst (Lehman Brothers) is optimistic that PETCO is well positioned to continue to gain market share in the highly fragmented $28 billion pet food supply, small animal, and services industry, which they estimate could grow by 6% annually. The analyst believes that the following catalysts will drive the performance of PETCO shares, particularly as it relates to the intermediate and long term: 1) a strong market position in a growing niche retail sector. 2) favorable store expansion potential 3) consistent and stable operating performance and 4) the ability to improve operating margins given a young store base.

Individual Analyst Opinions

POSITIVE RATINGS

Bear Stearns – Outperform ($43): Report date 03/11/05

The analyst maintains ‘Outperform’ rating on PETC based on the strong customer loyalty program and ongoing investments in its store base contributing to the company’s ability to generate consistently solid same-store results.

CIBC – Sector Outperformer ($42): Report date 03/11/05

The analyst believes that SSS should remain robust supported by both new stores and remodels. The analyst views any short-term weakness as a buying opportunity and hence maintains ‘Sector Outperformer’ rating on PETC.

Goldman – In-Line: Report date 04/15/05

Rating lowered from Outperform to In-Line.“Underlying fundamentals in the pet business remain solid, but we see limits to multiple expansions relative to our group”.

Harris Nesbitt – Outperform ($44): Report date 03/11/05

The analyst continues to believe that PETC will outperform its peers in the specialty retail industry as the company continues to gain market share and leverage its sales growth into higher earnings and cash flow growth.

Johnson Rice – Overweight: Report date 03/15/05

The analyst believes that the business outlook remains solid given the Company’s consistent execution and solid industry fundamentals.

Lehman – Overweight ($40): Report date 03/11/05

The analyst believes the following catalysts will drive the performance of PETCO’s shares, particularly as it

relates to the intermediate and longer-term: 1) a strong market position in a growing niche retail sector,2) favorable store expansion potential, 3) consistent and stable operating performance; and 4) ability to improve operating margins given a relatively young store base.

Piper Jaffray – Outperform ($45): Report date 04/15/05

The analyst believes that PETC is well positioned to deliver 20%+ EPS growth annually through mid-single digit same-store sales growth, 8%-10% square footage growth, and modest margin expansion.

RW Baird – Neutral ($37): Report date 04/15/05

“We are downgrading PETC to Neutral from Outperform. While under-accrual of expenses may be an isolated incident that is being addressed properly, we expect lower confidence in financial controls to represent an overhang on valuation in the near and medium term”.

Smith Barney – Buy ($42): Report date 03/11/05

The analyst maintains a ‘Buy’ recommendation on PETC based on a strong 4Q earnings report and recent share price weakness.

Think Equity-Buy ($45): Report date 03/11/05

The analyst upgrades PETC shares from ‘Accumulate’ to ‘Buy’ as sales per square foot improved, pro-forma operating margin expanded, debt declined, and inventory turn over increased.

NEUTRAL RATINGS

Legg Mason – Hold: Report date 03/11/05

The analyst believes that the company has strong footage growth, strong comps, and general operating margin expansion trends. The analyst will be watching for consistency in higher service growth and consumer migration to Pisces format to become more bullish.

Deutsche Bank – Hold ($38): Report date 03/11/05

The analyst anticipates PETC’s stock to rise on a strong Q404 result. The analyst prefers to continue to watch shares for a better entry point and hence maintains ‘Hold’ rating.

NEGATIVE RATINGS

None

Not Rated

SG Cowen: Report date 03/11/05

“We believe that the return to normal mid-single digit comps since the start of 1Q05, along with the company’s outlook, refute the concerns about secular weakness stemming from the slowdown in sales at the end of 4Q04. The stock should respond favorably to PETC’s results and guidance, particularly after the weakness in recent days. We continue to view PETC as one of the better growth stocks in hardlines retail and maintain our

opinion that PETC can appreciate by 10%-15% relative to the market over the next year.”

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Research Digest

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