PetSmart Helps Dogs (and Owners) Find Happiness

August 25, 2012 /

Times may still be tough. But that’s no reason to skimp on the adorable family pooch.

Why not give your loyal pal the best? Premium organic food, an irresistible hunk of rawhide, a softer cushion to lay his furry head. Even day camp to while away those lonely afternoons while you’re mysteriously busy at work.

It’s warm and cuddly thinking of this sort that is filling the coffers atPetSmart ( PETM ), a food products retailer that has built a chain of more than 1,200 stores.

In the second quarter, reported in mid-August, PetSmart topped analyst estimates in continuing steady sales growth and even better earnings growth. Sales grew by just under 9%. Earnings, at 71 cents, were up by 33.5%.

In an unsteady retail environment, PetSmart has been a very steady performer. Sales at stores open a year or more were up 7.4%. That followed a rise of 7% in the first quarter. Same-store sales have been up 5% or better each of the last six quarters.

And why not? A recent visit to a Boston-area PetSmart revealed a friendly, laid–back atmosphere where shoppers strolled through the aisles with their curious leashed pets. One handsome, well-behaved hound stopped to peer intently at a chatty parrot perched safely behind glass.

Canine Cuisine

His owner then got to explore four long aisles packed with a staggering display of canine cuisine. Everything from familiar Alpo to “antioxidant rich” kibble with prebiotics to aid digestion. Some of the 30-pound bags boast a “grain-free formula.” Others tout low glycemic index.

Displays cater to every pet need, real and imagined. There is the wide array of squeaker toys in every mammalian shape. And shouldn’t you check out the anti-microbial water filtration systems? Catering to the style-conscious pooch (well, owner, actually) are the Martha Stewart branded fabric collars.

And walled off from the sales floor are rooms for training and grooming as well as special day care and overnight kennel facilities.

Pet care clearly has gone upscale. And the shift to premium product has helped pad sales and margins at PetSmart.

Consumables, chiefly food, represent more than half of PetSmart sales. And of that 53%, roughly 70% are channel-exclusive, meaning that pet food manufacturers sell them only to specialty retailers. These are typically what’s known as “super premium” foods with higher or specialized nutritional content.

“Super premium channel-exclusive foods continue to be our fastest growing category,” Chief Operating Officer David Lenhardt told analysts Aug. 15.

Also growing nicely is revenue from such services as grooming, training and boarding. A decade ago, services represented just 5% of PetSmart revenue, noted KeyBanc analyst Bradley Thomas. Last year, they accounted for 11%, and in the latest quarter 11.8%. Hard goods, which notably include toys, accounted for about one-third of all revenue.

It’s a potent mix that has allowed PetSmart to prosper. But it may also contain the seeds of trouble down the road. Successful businesses always attract competition. And this is much the case with pet supplies.

Competition is expected from two sources. On the one hand, mass marketers likeWal-Mart ( WMT ) have long eyed pet supplies as a growing category.

And despite the much-lampooned collapse a decade ago of online pet supply hopeful Pets.com, online omnivoreAmazon ( AMZN ) has been gearing up for a major push. One problem with Pets.com was that it simply cost too much to store and ship 30-pound sacks of low-cost kibble. The economics never made sense.

But the shift to premium food may have altered the equation. The price points and high gross margins on such fare may now justify shipping, noted William Blair analyst Daniel Hofkin. “On high-ticket food brands, there’s enough dollar value to absorb shipping costs,” he said.

KeyBanc analyst Thomas believes Amazon may have the distribution efficiency to make online pet retailing work. “Amazon.com today has 26 million square feet of distribution space. This is not Pets.com that PetSmart is competing against,” he noted.

But Joan Storms, an analyst with Wedbush Securities, contends that even with premium products, pet food doesn’t make all that much sense for online providers. “It still leaves the online provider with very low profit margins.

And Amazon cannot offer the in-store browsing experience — the bird cages and fish tanks, for example — that entertain pet owners.

Says analyst Storms of PetSmart: “It’s an enticing shopping experience.”

To date, online retailers still have, by most estimates, only mid-single-digit market share. PetSmart also has its own online sales unit.

If anything, online is a threat still making its way over the horizon. Thomas sees a very low risk to PetSmart over the next couple of quarters. But he does see risk growing over time.

“As you look out five or 10 years, we see very high risk,” he said.

Wal-Mart Threat

Thomas is less concerned over the threat from mass-market retailers like Wal-Mart. Though Wal-Mart is already a large seller of pet food, Thomas believes it will struggle to challenge the PetSmart stronghold in super-premium brands. Mass-market merchants, he says, may have trouble procuring product. “If you’re a premium pet food manufacturer, you can get better margins selling to PetSmart than to Wal-Mart,” he explained.

With over 1,200 stores in the U.S. and Canada, PetSmart is not in super-expansionary mode. Analysts expect square footage growth of just 2% to 3% a year.

To some degree, this reflects the chain’s move toward somewhat smaller new stores. Thomas sees it as a sign of fiscal discipline. “They are not ones to open stores simply for the sake of top-line growth,” he said.

Analysts believe PetSmart can sustain mid-single-digit revenue growth and better earnings growth. Hofkin, for example, thinks PetSmart can achieve 11% annual operating earnings growth, with an added kicker from share repurchases.

PetSmart does have one secret weapon. To judge by the tugging and straining on all those shopper leashes, canine store visitors are very pleased with the merchandise.

 

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