k2The rise of PetSmart has been well chronicled on my blog and in my bi-annual pet industry report.  A well established track record of margin expansion, earnings beats and EPS growth has made the company a darling within the pet industry, the specialty retail community, and one of the most widely praised stocks of the post recession era (full disclosure: I do not own the stock, nor am I providing any stock advice herein).  Since November 2008, the stock has increased over 400% (versus 68% for the S&P 500).  PetSmart’s return on invested capital (ROIC) for this same period placed them in the 96th percentile of all publicly traded equities.  For every dollar management invested, it made over $0.30/annually during this period.

Those that follow the stock, as equity analysts, industry observers, and retail investors, have become conditioned to expect an endless stream of  good news and gawk at the stocks progression up-and-to-the-right.  When there were bumps in the road (e.g., 4Q2011) we found external factors to blame (i.e., commodity prices, weather, Europe, etc.).  That notwithstanding, PetSmart management seemed to have the Midas touch. So it came as a shock to many when Nomura Securities analyst Aram Rubinson downgraded PetSmart’s equity early last week, cutting his target price from $72/share to $55/share.  Rubinson had been sitting on a “neutral” rating, but now he was ready to tell his clients to reduce their holdings.   Prior to joining Nomura from hedge fund High Road Capital, Rubinson was a senior research analyst at Banc of America Securities, where he was the #1 ranked Hardlines Retailing analyst, according to Institutional Investor.

Rubinson’s downgrade sent PetSmart’s equity price tumbling 8.9%, 12% off its 52-week high.  The crux of Rubinson’s recommendation was as follows — Amazon.  His thesis was, largely, that Amazon would take share and put pressure on the company’s margin as PetSmart becomes forced to subsidize shipping in order to compete in a category that is migrating online.  This a bell I first rung, politely in 2008, with more fervor in 2011 and I practically pounded the table in November 2012.  My point is that while Aram has a large platform for broadcasting his opinion on PetSmart’s market opportunity, this was not new news.

Notably, Deutsche Bank raised their target price on PetSmart’s stock to $71 on November 15th after the company delivered another strong quarter. As part of their commentary they made is clear that margin and multiple compression was not of concern because.  Shortly thereafter, Barclays Capital upgraded the stock from equal weight to over weight.  Nine analysts have rated the stock with a buy rating, two have given an overweight rating, fourteen have issued a hold rating, and one has given a sell rating to the stock. PetSmart currently has an average rating of overweight and an average target price of $74.00.

Given that the Amazon issue has been on the table now for some time, why did the stock really take a turn south?

First, the stock was ripe for profit taking.  Again, the business has been on tear and the stock has followed.  At it’s peak, PetSmart traded at 19.0x foward year EPS and 9.0x forward year EBITDA, both significant premiums to the market (44% on a price-earnings basis).  This is the first substantive pullback since July 2010, but the drivers at that time were macro — Greece, double dip, etc.  PetSmart would report a strong quarter and raise full year estimates in August 2010.   So when the company announced a reshuffling of the management deck chairs (see below), traders used Rubinson’s downgrade as a reason to take profits that they could hide behind.

Second, the forthcoming management transition was poorly communicated and contains risk.   As part of a what we learned was a “planned management succession”, CEO Bob Moran is becoming Chairman while COO David Lenhardt gets the CEO job.  Further, Joseph O’Leary, Executive Vice President of Merchandising, Marketing, Supply Chain and Strategic Planning (that’s a long title), gets the nod as President and COO.  This comes on the back of CFO Chip Molloy’s previously announced departure in November 2012; he retires in March 2013.   Net net, this larger wave of changes caught the analyst community by surprise.  Moran had made no mention of near term retirement (he is 62 years old), and while this is largely an in-house promo parade, that program has not always been met with positive ends — see Coca-Cola Company circa 1997, Goizueta, Ivester, and Daft, which launched the iconic beverage company into a lost decade of stock appreciation.  Further, anytime a public company CFO departs it gives investors pause.  Molloy is only 50 years old.

Finally, Amazon, but not Rubinson’s Amazon.  Yes, Amazon is taking share in pets, faster than anyone would have anticipated but the fate of PetSmart does not hinge on being competitive in the delivery price of pet food.  The market has shown very little interest in pet food home delivery no matter what the perceived convenience or savings.  Tens of millions of dollars have been buried waiting for this market to arrive. Rather, the threat of Amazon and its online brethren to PetSmart is two fold.  First, online players are developing capabilities that will enable them to serve as a one-stop-shop for pets — food, consumables, products, medications (Rx and OTC).   On a value and convenience basis this will attract a tangible set of customers, especially as the e-commerce generation (those born after 1970) amasses further purchasing power.  Second, PetSmart has structural issues as it relates to its online efforts.  The company currently outsources its online efforts to GSI Commerce, an eBay corporation.  While this is fine for a general catalog online, to compete against Amazon, wag.com, Pet360 and others you need in house controls and capabilities.  PetSmart’s contract has years to run and it would take tens of millions of dollars to put in place the infrastructure necessary to control its own destiny online.  This makes the investment banker in me believe PetSmart will make a catch-up acquisition within the next two years.  Until then, management will continue to downplay the competitive threat while working tirelessly behind the scenes to limit the damage.

PetSmart remains a great company with a robust outlook.  However, there are cracks in the facade; cracks that it did not take an equity analyst to reval.  The company has tangible problems, but it has overcome challenges time and again.  While the recent equity price correction seems justified, it’s too early to say the company has peaked.

/bryan

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