Teresa Rothaar

MHR 7830 – Final Project

Pretend that PetSmart has hired me as a financial consultant.

Based on an analysis of PetSmart’s financial statements, and any relevant supplementary information about the company and its operating environment, identify areas in which PetSmart is performing well and advise management on any problem areas.

PetSmart’s annual report comes out in April, and includes data from the previous fiscal year ending January 30/31. Thus, the 2011 report was not out at the time I completed the project; I used the 2010 report.

Note: as an alumni of Temple University, I was able to access the Mergent Online database through their library.

PetSmart is profitable, creditworthy and investment-worthy. It serves a specialty niche—pet products and services—that has continued to grow rapidly even as other retail sectors have fallen victim to the poor economy.

PetSmart has strong financial statements and ratios. Its Net Sales, Gross Profits and EPS grew year-over-year. It does need to work on Times Interest Earned and P/E.

While PetSmart needs to keep an eye on up-and-coming competitor Wag.com (owned by Amazon), PetSmart has established a competitive edge that would be difficult for a competitor to duplicate. Since Wag.com operates solely online, it cannot compete with PetSmart in the areas of veterinary services, grooming, boarding and other services.

Founded in 1986, headquartered in Phoenix, AZ, and incorporated in Delaware.

Stock ticker: PETM.

Largest specialty retailer of products, services and solutions for pets in North America – has 14% - 15% share of pet industry dollars.

Sells consumables (i.e., pet food and treats), hardgoods (i.e., cat litter, dog collars, pet accessories), and freshwater tropical fish, birds and small animals (mice, hamsters, etc.).

Does not sell dogs or cats, but most locations set aside an area for local animal rescues to hold adoption events.

Some locations offer grooming services, boarding (PetSmart PetsHotels), and veterinary hospitals (under the trade names Banfield and The Pet Hospital).

As of January 30, 2011, PetSmart operated 1,187 retail stores, 180 PetsHotels, and 768 veterinary clinics (including 11 operated by 3rd parties in Canada), and had 47,000 employees.

Facilitated 403,000 in-store pet adoptions in 2010.

In addition to brick-and-mortar stores, PetSmart also sells goods through its website, petsmart.com.

According to a 2011-2012 survey by the American Pet Products Association (APPA), 62% of American households own a pet, equating to 72.9 million homes.

Contrast this to the 56% figure in 1988, the first year the survey was conducted, and 62% in 2008.

Despite the worsening of the economy, pet ownership and spending continues to grow. The APPA estimates Americans spent approximately $50.84 billion on their pets in 2011, up from $48.35 in 2010, and only $17 billion in 1994.

Unlike other retail sectors, which have been hammered by the poor economy, the outlook for PetSmart and other pet-related businesses is bright.

Pet retail industry is highly competitive; can be organized into 8 categories:

1.Warehouse clubs/mass merchandisers.2.Grocery stores.3.Specialty pet supply stores.4.Independent pet stores.5.Veterinarians.6.General retail merchandisers.7.Catalog retailers.8.Ecommerce retailers.

Private corporations (most notably Petco), small, independent retailers, and regional chains (i.e., PetKraze and Concord Pet Supply)

Target Wal-Mart Central Garden & Pet Company

Many premium pet food manufacturers do not allow their brands to be sold in grocery stores, warehouse clubs or other general mass merchandising stores; they wholesale exclusively to specialty pet supply stores, veterinarians and farm and feed stores.

Only 10% of PetSmart’s products are available in the mass channel.

Further, PetSmart’s unique relationship with Banfield allows them to sell medical pet foods—available only through veterinarians--in locations with Banfield Hospitals.

The semi-exclusivity PetSmart has with premium brand manufacturers, along with its ability to sell medical pet foods at locations with Banfield hospitals, gives it a competitive advantage that would be difficult to duplicate.

The availability of veterinary care, grooming and other pet services in many locations further differentiates PetSmart and helps drive sales of hard goods; customers like one-stop shopping, and this is what PetSmart offers pet parents.

However, competitors such as Target and Wal-Mart are much larger in terms of overall sales volume, and thus have access to greater capital.

A consumer shift to premium pet foods, which began in 2008, amounts to over 50% of total pet food sales. This could mask declines in other areas. Further, the incremental benefit could be topping out.

Amazon launched Wag.com in July 2011. Prices on Wag.com are cheaper than PetSmart, especially for Amazon Prime customers (who get discounted shipping), plus consumers have the convenience of shipping heavy items to their door. However, shipping costs of heavy, inexpensive items is what fueled the infamous Pets.com implosion.

A growing number of food poisoning recalls in recent years involved tainted pet foods. PetSmart was named as a co-defendant in a number of lawsuits related to pet food recalls.

While these suits are close to resolution, and PetSmart does not feel they will have a material impact on its finances, the threat of future recalls—and further litigation—remains.

So far, PetSmart has not been significantly negatively impacted by minimum wage laws or major labor issues, especially compared with competitor Wal-Mart.

PetSmart was named as a co-defendant in a labor-related lawsuit in California. PetSmart believes the suit is without merit and continues to defend it; the eventual outcome is uncertain.

Like all other businesses, PetSmart is at risk from the uncertainty surrounding the Patient Protection and Affordable Care Act, as well as the volatility of global capital and credit markets.

Ratio 1/30/2011 1/31/2010 Industry Avg.

Quick Ratio 0.62 0.62 0.55

Current Ratio

1.96 1.89 1.84

Inventory Turnover

6.85 6.65 7.22

Total Asset Turnover

2.32 2.22 1.9

The quick and current ratios are good for the retail industry, averaging higher than the industry as a whole. Inventory turnover is a bit low for the industry, but is still acceptable, and has improved since 2010. Total asset turnover is very good for retail, especially considering that most of PetSmart’s products are non-perishable.

As PetSmart is a retailer that collects payment at the time of sale, not on credit terms, Average Collection Period is not applicable. Average Payment Period cannot be analyzed because the average credit terms PetSmart receives from its creditors is not available.

Note: all ratios are from most recent annual reports; competitor data courtesy of Mergent Online. Industry benchmark ratios courtesy of BizStats.com.

PetSmart stacks up well against its competitors, especially considering that a direct comparison is impossible because its competitors don’t exclusively focus on pet products. Wal-Mart is a big player in the grocery industry (explaining its ultra-low quick ratio and extraordinarily high inventory turnover ratio). Similarly, Central Garden & Pet Co. sells lawn, garden and outdoor supplies in addition to pet products. PetSmart’s Total Asset Turnover is superior to that of Target and Central Garden & Pet Co., and is close to Wal-Mart’s.

Ratio 1/30/2011 1/31/2010

Debt Ratio 0.53 0.52

Times Interest Earned

3.05 3.14

Fixed-Payment Coverage

1.56 1.45

Gross Profit Margin 29.06% 28.47%

Operating Profit Margin

7.53% 6.92%

Net Profit Margin 4.21% 3.72%

EPS $2.01 $1.59

ROA 9.73% 8.23%

ROE 20.47% 17.12%

P/E 21.2 21.4

M/B $5.59 $3.52

Examining 4 Areas:

1.Liquidity & Activity

2.Debt3.Profitability4.Market

The liquidity & activity ratios for the firm look good when compared to its direct competitors and the industry as a whole.

Current & quick ratios have remained stable for the past 2 years. PetSmart does not appear to be in danger of not satisfying its short-term obligations.

Inventory Turnover & Total Asset Turnover have slightly improved year-over-year, and Total Asset Turnover is higher than the industry average. PetSmart is making good use of its assets to generate sales.

PetSmart’s Debt Ratio increased slightly year-over-year. It has financed >50% of its assets with debt, but this is not unusual for a large retailer of off-the-shelf merchandise; stores must be well-stocked.

Times Interest Earned has gone down year-over-year, and at 3.05 is on the low side. PetSmart needs to increase its EBIT to get this number closer to 5.0.

Fixed-Payment Coverage went up in 2010. PetSmart has enough money to meet all fixed-payment obligations.

Gross, Net and Operating Profit Margins all went up in 2010.

EPS, ROA and ROE all went up considerably.

PetSmart is increasing profits each year, and increasing its returns to its stockholders. There are no red flags when looking at the profitability ratios.

Price/Earnings went down a bit from 2009 to 2010, indicating that investors lost some confidence in the firm. However, the ratio did not plunge; it went down by only 0.2.

Market/Book Value went up considerably in 2010—by over $2.00—indicating that investors feel that PetSmart will earn high returns relative to its risks.

Strengths – PetSmart’s liquidity & activity measurements are good both for the industry and when benchmarked against its major competitors. Its Debt Ratio is expected in retail, and its Fixed-Payment Coverage is good. Its profit is increasing and its Market/Book value is good.

Weaknesses – PetSmart needs to get its Times Interest Earned Ratio up; it is currently hovering just above 3.0, the acceptable minimum. P/E went down in 2010, and PetSmart needs to keep an eye on this and make sure it doesn’t keep decreasing.

PetSmart has strong financials, with no major red flags. Its Net Sales, Gross Profits and EPS continue to grow. PetSmart operates in a niche—pet products and services—that has continued to expand despite the poor overall economy.

Other than Times Interest Earned, and possibly P/E, all of its financial ratios look good. The firm is profitable, creditworthy and investment-worthy.

Because of its partnership with Banfield, its expansion into pet-related services like boarding and grooming, the semi-exclusivity of many of its hard goods, and its catering to the high-end pet market (while not ignoring the budget-minded customer), PetSmart has carved a unique niche in a highly competitive industry.

It would be very difficult for a competitor to emerge and duplicate what PetSmart has done. While Amazon’s Wag.com is an up-and-comer in the industry, since it is an e-tailer, it cannot compete with PetSmart in the areas of pet services (veterinary, grooming, boarding, etc.).

Further, it is unlikely that premium pet food brands will agree to sell to Wag.com; they want their products to remain semi-exclusive so as not to devalue their brands/labels.

While the incremental benefit from premium pet food brands may be topping out, PetSmart continues to grow its pet services, which is still an area ripe for expansion, particularly the PetsHotels boarding service.

While it cannot ignore its competitors, the biggest risks to PetSmart are in areas it cannot control, such as manufacturer recalls, the uncertainty of U.S. healthcare legislation, and the volatility of global credit markets.

So far, PetSmart has not only survived, but thrived during the economic storm. Jim Cramer of CNBC’s “Mad Money” recently recommended PETM stock, citing the same strengths (the focus on luxe brands, expansion into pet services, etc.) discussed in this report.

PetSmart 2010 Annual Report (Published April 2011) - http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9OTE5MDB8Q2hpbGRJRD0tMXxUeXBlPTM=&t=1

APPA – Industry Statistics & Trends - http://www.americanpetproducts.org/press_industrytrends.asp

PetSmart on Yahoo! Finance - http://finance.yahoo.com/q?s=petm&ql=1

PetSmart is Getting Targeted by Hedge Funds – The Motley Fool, January 31, 2012. http://beta.fool.com/sumzeroresearch/2012/01/31/petsmart-getting-targeted-hedge-funds/1509/

From Diapers to Pets, Amazon’s Quidsi Introduces Wag.com – TechCrunch, July 6, 2011. http://techcrunch.com/2011/07/06/amazon-quidsi-wag-com-pets/

Miscellaneous Store Retailers Industry Benchmarks, BizStats.com - http://www.bizstats.com/corporation-industry-financials/retail-trade-44/miscellaneous-store-retailers-453/show

Salmonella Lurks in Pet Foods, Too, The New York Times, August 11, 2011. http://well.blogs.nytimes.com/2011/08/11/salmonella-lurks-in-pet-foods-too/

Cramer: Put PetSmart Stock On Your Radar, CNBC, February 13, 2012. http://www.cnbc.com/id/46373423

Mergent Online – accessed through the Temple University Library’s proxy. http://libproxy.temple.edu/login?url=http://www.mergentonline.com

Financial Ratios – FindOutInfo - http://www.findoutinfo.com/direct/CD001?stylesheet=USE315.xsl

PetSmart on Morningstar Financials - http://quote.morningstar.com/stock/s.aspx?t=PETM&region=USA&culture=en-us