We've followed PetMed's progress for at least several years and believe the company is one of the best we've come across: >70% repeat customer business (an effective annuity), no debt, mid-teens operating margins, healthy free cash flow, limited capital requirements, and an incredibly high return on net operating assets (RONA) of 76% (and ROE of 31%). In addition, PetMed is benefiting from favorable secular trends as more pet owners order medications and supplies online instead of making purchases at vets (to dismay of vet owners). Excess cash generation enables share buybacks and, to-date, management used approximately $30 million to repurchase 2.3 million shares at an average price of $13.04 per share during fiscal 2008-09. We see management as shareholder friendly, although insiders own only 3.0% of shares outstanding per the company's fiscal 2009 proxy statement. Corporate governance is also good, with four out of five directors independent (80%), an independent chairman of the board, and each board seat elected annually.
March quarter revenue of $48 million increased 19% Y/Y and fiscal 2009 (end March) revenue of $219 million grew 17% Y/Y, with diluted earnings per share of $0.25 and $0.98 up 20% and 19%, respectively. The Wall Street consensus forecast for fiscal 2010 is for revenue of $244 million (+11%) with earnings of $1.09, both of which appear low versus our model. PetMed reports June quarter results this coming Monday before market open.
We first established a PETS position during 1H08 in the low teens with an intrinsic value estimate of $17 per share, up approximately 40% from our average cost basis. However, on the back of solid results, shares rallied smartly to $18 and touched $19 in November. We never like to realize short-term capital gains, yet PETS moved too far, too fast, and we opted to take advantage of investor enthusiasm to exit our position. Our decision was made easier since we had the opportunity to reallocate capital into lower priced merchandise amidst the market swoon. We hoped for an opportunity to come back into PETS at more reasonable prices.
Last week, in the mid $14s, we decided to re-establish a position with the intent to scale in over time, preferably at even lower prices. PETS three-year graph is shown below:
At $14.50, the stock was trading at 15 times 2008 earnings (7% yield) and 13 times our estimate of 2009 earnings (8% yield). On a P/E basis, we can envision PETS trading at an 18 to 20 times multiple given the company's consistent, profitable operating model, implying a $20 to $23 fair value. We rely on absolute valuation criteria to make our purchase/sale decisions, but can't help noting that certain online retailers, from large to small, trade at much higher multiples. Amazon (AMZN, $84.55) trades at 54-times trailing EPS and 41-times forward EPS, while Drugstore.com (DSCM, $1.93) has no positive earnings or free cash flow, yet fetches a market cap of $193 million. PETS is an incredible bargain relative to these names.
From a free cash flow perspective, we believe earnings quality is high and, aside from variable working capital needs (inventory), expect FCF to generally track earnings over time since low D&A is fairly comparable to low capital expenditures. The company's working capital requirement can consume cash because of growth and corresponding inventory needs (as in fiscal 2009). We expect the difference to narrow over the medium term and note that FCF for fiscal 2008 was very close to net income.
We normally prefer to purchase companies with a FCF yield north of 10%. However, we made an exception for PetMed (6-7%) because of the company's high quality business model. Based on consistent results over the past five years and growing repeat business, we have high confidence in our forecast of future free cash flows, which imply a current fair value in the mid- to high-$20s (assuming 10% WACC, 3% terminal growth), more than supporting our P/E based valuation. The delta in FCF derived values results from different near- to medium-term growth assumptions. Increasing the discount rate to 12% still yields a fair value of approximately $24.
Key risk factors noted in PetMed's 10-K include the following:
- Competition - plenty of small me-too players (perhaps a"couple dozen" per management), plus Doctors Foster and Smith with annual sales of $230 million (large catalog business).
- Reliance on third party distributors - major suppliers do NOT sell directly to PetMed and the company must purchase products from a number of third party distributors, presenting both supply and pricing/margin risk.
- Resistance of veterinarians to authorize prescriptions and even discourage purchases from online or mail-order vendors such as PetMed -- we've heard of the latter case where a vet had signs posted warning against such purchases.
New customers acquired
Total accumulated customers (1)
(1) includes both active and inactive customers
In addition, we know that management prudently manages total advertising costs relative to new customer order revenue to protect margins. Lastly, reliance on third party distributors is mitigated by sourcing the same product through multiple suppliers (management explains that this can also be a strength, serving as a barrier to entry) and PetMed is working to obtain direct supply relationships with manufacturers. We suspect that increased volumes may allow this to happen.
According to a 6/08/09 management presentation (link here - at an investor conference captured with Sonic Foundry's Mediasite), PetMed garners 6% of the $3.6 billion pet medications market with other mail order/online vendors at 5%, for total mail order/online share of 11% (please see slide below). Management believes the market will develop in similar fashion as the human pharmaceutical market and the mail order/online market for contact lenses, where channel share is approximately 19%. Implication: assuming constant PetMed market share, the company's revenue could nearly double from current levels. Assuming constant margins and share count, earnings could also nearly double (although share count should decrease with likely future buybacks). To accommodate future growth, PetMed spent an incremental $2 million in fiscal 2009 above normal annual maintenance capital expenditures of $750 thousand to $1 million to approximately double distribution capacity.
Finally, we think PetMeds might meet Charlie Munger's definition of a great company. In this regard, a 9/02/08 SmartMoney article entitled "Warren Buffett's Best Man" includes the following commentary and advice from Mr. Munger:
- Sit on Your Assets, if You Can - While most investors associate Buffett and Munger with finding good stocks cheap, Munger points out that quality can trump price. "If you buy something because it's undervalued, you have to think about selling it when it approaches your calculation of its intrinsic value," he says. "That's hard. But if you buy a few great companies, then you can sit on your ass. That's a good thing."
Disclosure: long PETS, SOFO.
© 2009 Jeffrey Walkenhorst
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