Take Advantage of the Booming Pet Economy: PetSmart, Inc. (PETM)

Despite all of Bob Barker’s pleading at the end of the Price is Right, the pet population is exploding! As the number of pet owners rises, spending is rising even faster. The market size has doubled on a real basis in the last 20 years. In 2012, Americans spent over $52 billion on animals. That number is expected to rise to $74 billion by 2015.

(Source: The Atlantic)

There are several ways you can invest in the booming pet economy, but one company stands out to me: PetSmart, Inc. (NASDAQ:PETM)

The last bastion of brick-and-mortar retail

Retail stores have been suffering at the hands of e-commerce giant Amazon.com, Inc. (NASDAQ:AMZN) for some time now. The growth of the online retailer is a key driver to the expansion of the greater than $1 trillion e-commerce industry. However, the pet industry has proven a tougher customer for Amazon.

PetSmart, Inc.That’s not to say Amazon isn’t a significant threat in the pet supply business. Its Wag.com website launched a couple years ago and features a huge selection of products, and offers the usual Amazon perks – great prices and free and fast shipping.

However, pet owners seem to buck the trend of increasing online sales. Even Petmed Express Inc (NASDAQ:PETS) is starting to see sales plateau after growing revenue by an average of 15.8% per year over the last decade. Earnings growth slowed to just 5% for the company in 2012, and is expected to rise just 1% in 2013.

The limitations of online retail are quite evident in the pet supplies category. Not much can beat the personalized (animalized?) recommendations from knowledgeable in store staff at specialty retailers like PetSmart. PetSmart has grown into a one-stop shop for pet owners providing food, toys, and other supplies as well as grooming, boarding, training, and veterinary services. Not to mention you can get your next pet there too.

But really, pet owners love going to PetSmart, Inc. (NASDAQ:PETM) because their pets love it! While barking at the mailman as he delivers a package full of food, toys, and medicine is fun, it’s a far cry from going for a trip, meeting other animals, and getting a special treat at the end of it all.

The real competition

A much bigger threat to PetSmart is big-box retailer Wal-Mart Stores, Inc. (NYSE:WMT). As it’s just started expanding into the pet supplies business with food and toys, there’s still a lot of potential for Wal-Mart to capitalize on the booming pet industry by adding more pet-friendly store sections.

Currently, Wal-Mart doesn’t control the mind space of pet owners. However, it’s just a successful marketing campaign away from seeing packs of four legged creatures coming through its doors. Wal-Mart definitely has the pricing power to undercut PetSmart, which makes it a serious threat. I think it’s just a matter of time until we see a bigger push on Wal-Mart’s part.

The PetSmart Advantage

In 2009, when the U.S. was just entering a recessionary period, PetSmart started offering pet owners new upscale products such as organic food and specialty pet furniture. The idea of increasing high-end merchandise while facing a dismal macroeconomic environment is pretty counter-intuitive, but the results speak for themselves. Sales have increased nearly 8% annually for the past 4 years.

What’s more, the increase in high-end merchandise sales means higher margins for the company. From 2009 to 2011, the company improved its gross margin by 100 basis points from 28.5% to 29.5%. In its most recent four quarters, gross margin grew to 30.2%.

While big retailers might be able to snatch up customers looking for value, PetSmart has already started addressing a much more lucrative customer. Aside from high-end merchandise, PetSmart has an excellent foothold on in-store pet services, which comprise more than one-third of the pet-economy. This is one of the fastest growing segments of the company, as sales improved 8% in the third quarter last year.

Finally, PetSmart is just starting to grow internationally. Last year, the company entered a licensing agreement with a Korean retailer to sell its branded products. The agreement is a relatively low-risk low-cost approach to testing its brand identity in a foreign country with a similarly booming pet population.

A ‘Smart investment

PetSmart currently trades at a historically high P/E ratio. With its trailing P/E still floating above 20, it’s well above its 5-year average multiple of 18.5. However, the earnings growth continues to look strong, resulting in a forward-looking PEG ratio of 1.0.

I believe that the increase in relative price for the stock is completely justified as the company has proven it’s more than capable of outpacing the growth of its competition. However, just like any high P/E stock, even the slightest bit of bad news could cause the stock to stumble.

When PetSmart reports earnings on March 6, a miss on either the top or bottom lines could present an excellent buying opportunity. However, I expect it to continue its long run of earnings beats, so there may be no better time to buy than right now. If it goes down, you can always add to your position.

The article Take Advantage of the Booming Pet Economy originally appeared on Fool.com and is written by Adam Levy.

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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