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Why Petsmart Looks Like a Smart Bet

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When it comes to our pets, there's no recession.

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The recession hasn't taken a bite out of Petsmart's (PETM) earnings, thanks to the company's ability to cut costs and slightly increase margins on essentially flat sales.

The nation's leading pet-supply retailer will report third-quarter 2009 earnings Wednesday. Last month, Petsmart increased its earnings estimate to $0.25 to $0.29 a share from $0.20 to $0.24 a share. Analysts look for $0.28 a share. The company expects to earn between $1.43 and $1.51 a share for the year, up from the revised estimate of $1.37 to $1.45.

In the second quarter, Petsmart's revenue increased by 5.4%, led by a 10.2% growth in services such as grooming, training, and boarding. Same-store sales, or sales at stores open at least a year, grew 0.8% as the company earned $0.31 a share.

Petsmart operates about 1,145 stores in the US and Canada, outpacing privately held PETCO's 950 stores in 50 states. Leonard Green & Partners and TPG took PETCO private in 2006 in a deal valued at about $1.8 billion. Petsmart also markets through catalogs and a website.

In general, Petsmart's stores tend to be larger than the competition's outlets at 20,000 square feet or more. This allows Petsmart to offer a wider selection of goods at better prices -- often beating the competition by about 10% -- while offering an array of services. The company offers veterinary care at about 60% of its stores through an agreement with Banfield.

The pet-services market is estimated at $4 billion a year, and Morningstar estimates that Petsmart now grabs about a 12% share and is poised to expand. Long-term, this will almost certainly increase traffic and boost sales while building goodwill and generating word-of-mouth recommendation among pet owners.

"In subsequent years, we expect mid-single-digit top-line growth stemming from low-single-digit comparable-store sales growth and about 30-40 net new store openings per year," R.J. Hottovy, an analyst for Morningstar, says in a research report. "…We expect operating, general and administrative expenses to remain relatively flat year over year because of tighter cost controls."

Petsmart's toughest price competition comes from major discount retailers -- not PETCO, regional chains, or mom-and-pop stores.

Walmart (WMT), Target (TGT), and Costco (COST) can't match Petsmart's range of products and services because the floor space isn't available, but major chains can use their scale to undercut Petsmart on selected items, such as food.

Price competition from Walmart, the nation's largest retailer, and the warehouse discount stores will force Petsmart to match prices on some items, and this will erode margins. But Petsmart is likely to retain its hold on high-margin items through exclusive licensing deals such as Animal Planet's toys and accessories.

Petsmart also faces price competition on basic pet-food items from major supermarket chains, including Safeway (SWY), Kroger (KR), and Supervalu (SVU). But Petsmart will retain its hold on most high-end products.

The long-term outlook for the pet business is strong, even in a downbeat economy (see Economy Goes to the Dogs). The American Pet Product Association estimates that 62% of US households, or 71.4 million homes, have a pet. Dogs are the most popular (45.6 million), followed by cats (38.2 million), and freshwater fish (13.3 million). Total spending on pets in 2009 is expected to reach $45.4 billion, up 5.1% from $43.2 billion in 2008 and up 59.3% from $28.5 billion in 2001.

There's likely to be more growth ahead as more young professionals delay starting a family and acquire pets. On the other end of the demographic chart, Baby Boomers are retiring and greater numbers may acquire pets as their leisure time increases. Many pet owners tend to humanize their critters, boosting spending on accessories such as beds, toys, and, believe it or not, football jerseys and other clothing.

Morningstar looks for the pet industry to grow in the mid- to high-single-digits for the "foreseeable future." Revenue will increase 4% to 5% this year, down from an 8.4% increase in 2008 due to fewer store openings and slower same-store growth.

"Petsmart will employ a multifaceted approach to gain market share, including new stores in underrepresented markets, expansion of higher-margin pet services, and focus on customer service," Hottovy says.

Competition in the sector will increase in the future, but Petsmart won't roll over for anyone.

For more on PetSmart, see Hoofy & Boo's always astute report.

No positions in stocks mentioned.
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