Hedge Fund News Gooses Pet Retailer's Shares

 PetSmart's shares shot up Thursday after Jana Partners, a $10 billion hedge fund, disclosed that it has accumulated a 9.9% stake in the firm. In its Schedule 13D filing, Jana said it will discuss with PetSmart's board the potential to improve operating performance; alter PetSmart's capital structure to return more capital to shareholders; and/or explore the sale of the company (most likely to private equity).

There is no change to our $71 fair value estimate as a result of this announcement, since we do not currently incorporate a takeout premium into our valuation and would wait for more concrete details before we do so. However, the pet industry is no stranger to the M&A market, as the number-two specialty pet retailer, Petco, has been taken out and is still owned by private equity firms. Additionally, we see how PetSmart could be an attractive takeout target, given its leading position in the specialty pet market, assorted mix of fast-growing premium channel-exclusive items (which are generally withheld from most general brick-and-mortar retailers), small debt burden, and stable free cash flow through various points in the economic cycle.

The shares had recently traded down as a result of slowing sales momentum and concerns that the firm is vulnerable to increased competition from general merchants (including both mass and grocery retailers) and online retailers. However, we believe PetSmart has carved a defensible competitive position worthy of a narrow economic moat, and we expect the firm will overcome these hurdles to generate long-term growth in the robust and growing domestic pet market.

Even after Thursday's stock price bump, the multiples do not appear out of line for a potential takeout target, at 8 times our projected fiscal 2015 EBITDA and a 7% free cash flow yield. In fact, PetSmart's shares are still trading at historically low multiples because of concerns about emerging competition, which private equity bidders may see as a rare opportunity. Nevertheless, we suspect the shares will trade more on M&A speculation than long-term fundamentals in the near term, so we would advise investors to analyze the situation with caution.

Growth in Premium Categories Bodes Well
PetSmart has captured approximately 17% of domestic pet merchandise spending, almost double that of its closest direct peer, Petco, according to Nielsen estimates. We believe PetSmart has carved a defensible niche in the fast-growing premium pet category, earning it a narrow Morningstar Economic Moat Rating, and we expect it will continue to consolidate share in the growing pet retail market.

The 2007-08 dog food recalls catalyzed growth in the premium dog category by exacerbating food-quality concerns. Growth in the premium dog aisle has since decelerated, but we expect premium pet categories will continue to outpace the industry, as the ongoing humanization of pets drives growth in existing premium products and makes new niche categories viable for the mass market. These trends are particularly beneficial for PetSmart, since premium brands are not generally available at discount retailers, lessening the threat of price competition, and its basket of services has attracted an affluent customer base that is more likely to migrate to the premium aisle.

PetSmart's same-store sales growth has slowed over the past year and a half, from 5%-7% to the low single digits, stoking concerns about the potential for further downside. We do not expect PetSmart to return to 5%-7% comps anytime soon, as it will lap tough comparisons and is likely to experience modest deceleration in the premium dog category while facing a tepid retail environment. Still, we remain optimistic that PetSmart can sustain long-term 2%-4% comp growth, above both the pet and general retail industry, since we view the humanization of pets as a long-term growth driver that is in its middle innings.

The slowdown has also stoked concerns about the current impact of online retail, especially as Amazon has expanded its pet offerings via its Wag.com subsidiary. While we are wary of e-commerce's long-term potential, we believe its current impact is overblown, since the low value/weight and dimensions of most pet consumables severely increase the incremental cost of shipping door to door and limit online retail's ability to meaningfully undercut brick-and-mortar prices.

Differentiation Makes the Moat
We believe PetSmart has carved a narrow economic moat that stems primarily from its strong intangible assets in the specialty pet retail market. We credit the executive team for cultivating a broad suite of premium products (including both proprietary and third-party brands) and services that help differentiate the consumer's shopping experience and attract a relatively affluent customer base. This differentiation is important, because most premium pet brands carry channel-exclusive prohibitions in their distribution contracts, limiting their availability at discount and mass retailers. As a result, the appeal of discount retail is severely constrained in the premium aisle, even though they can charge 5%-7% lower prices on comparable grocery aisle products (according to management's estimates), as both their product selection and quality perception lag their specialty peers'. Specialty retailers are able to further differentiate themselves by customizing their shopping experience in ways mass merchandisers are unlikely to imitate, such as by allowing customers to bring their pets into the store and promoting services including veterinary hospitals, adoption, and hotels.

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While Nielsen estimates that PetSmart captures approximately 17% of the domestic pet industry's product sales, IBISWorld estimates PetSmart generates roughly 40% of the specialty pet retail market's sales, roughly double that of Petco. Consequently, we believe PetSmart's scale in the premium category is considerably greater than any of its competitors', providing the firm meaningful bargaining power over its premium product vendors. PetSmart can leverage these advantages to offer competitive prices over other specialty retailers (5%-10% lower, according to management estimates) and is able to leverage its retail presence and brand to promote its own proprietary products, which now represent approximately 25% of sales.

The threat of e-commerce competition in the pet category has been a persistent concern for PetSmart, since the majority of pet consumable products are nonperishable. However, management estimates that e-commerce generates less than 4% of the industry's revenue, as it is very difficult to profitably distribute 20- to 50-pound feed bags door to door, given their low value/weight and dimensions ratio. Consequently, we expect the value of pet e-commerce will be convenience, rather than price, as the cost of shipping should continue to curb online retail's ability to profitably undercut PetSmart's pricing on consumable items for the foreseeable future. PetSmart is more exposed via other product categories, such as high-value veterinary medicine and hardgoods, but we believe its differentiated shopping experience (as one of the few places that allows customers to bring pets) and suite of services will continue to attract valuable traffic to its stores.

Competition Could Be a Concern
We assign PetSmart a medium fair value uncertainty rating. Increasing competition from mass merchants, warehouse clubs, and grocery stores could hinder PetSmart's ability to grow profitably. In particular, the rapid growth of premium grocers, such as Whole Foods, could steal share from PetSmart's most profitable consumer. These competitors are encroaching upon the premium consumables market and may be able to break some of PetSmart's exclusive distribution contracts with premium vendors.

The shift toward smaller store concepts could also prove to be a mistake, if the new stores fail to offer the same product variety and services that PetSmart is known for. The new stores could also be less profitable than existing locations and may cannibalize sales at existing locations. Competition from online vendors will probably continue to pressure the hardgoods category and could threaten the consumables category as shipping heavy goods becomes more efficient. In the past, PetSmart was forced to recall several products because of food contamination. Future outbreaks could diminish PetSmart's brand and sway customers to choose alternative vendors. PetSmart is highly dependent on a small population of pet enthusiasts who spend much more on pet-related goods than the average pet owner. If pet humanization trends ever diminish, PetSmart could experience a much more drastic decline in sales than its peers. Challenging economic times could also diminish consumer demand for more discretionary items, including premium supplies and services.

Sensible Strategy Strengthens Brand
We assign PetSmart an Exemplary Stewardship Rating. In our view, management has proved to be highly adept managers of the specialty pet retail business, as the firm has successfully capitalized on the secular humanization of pets and growth of organic food products. Company initiatives, such as the consumables reset, have increased traffic to stores and expanded high-margin product sales. We hold a favorable view of PetSmart's current growth strategy as well, since we think it is wise to focus on the profitable high-end pet owner rather than attempting to compete with discount retailers for the price-sensitive consumer. In our view, these moves strengthen PetSmart's retail brand and will help the firm defend itself against increased competition from emerging discount retailers and premium grocers.

However, PetSmart has experienced fairly significant management turnover recently. Former president and chief operating officer David Lenhardt assumed the CEO role from Robert Moran, who stepped down from his chairman and CEO roles in 2013. Joseph O'Leary, the former senior vice president of supply chain, resigned shortly after being promoted to the president and COO roles, causing Lenhardt to eliminate the COO role and assume the president position. Carrie Teffner, the former CFO of Weber-Stephen Products (a manufacturer of barbecue grills and accessories), replaced Chip Molloy as CFO in 2013.

In our view, Moran and Molloy helped sculpt PetSmart's current premium focus and prudent capital-allocation strategy, so their departure is an incremental negative and creates some uncertainty during the transition period. We are wary that so much turnover has occurred in such a short time frame and are concerned that it could suggest execution issues during the transition. However, we believe the executive team has established a sensible strategy, and Lenhardt is well equipped to execute it.