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Monday, July 20, 2009

PetMed Express: Results Reaffirm Franchise Strength

Last week, we explained why we think PetMed Express (PETS, $16.65) is a fantastic franchise. We even went so far as to suggest that the company might meet Berkshire Hathaway (BRK-A, BRK-B) Vice Chairman Charlie Munger's definition of a great business, the kind where an investor might be able to purchase, sit back, relax, and hold as net asset value per share increases over time.

Not everyone agrees with this view for PETS. We understand that there are real risks with any business as things can change, whether through competition, creative destruction, and/or business model flaws. According to a Seeking Alpha post from May, pundit Jim Cramer said on 5/21/09 during his "Lightning Round" the following:
  • PetMed Express (PETS): "We've not been a fan of that...it is too competitive...with Wal-Mart coming in."
For sure, competition is a real threat to any retailer and there is a graveyard full of retailers that once thrived. And, Walmart (WMT) - IF it does enter the pet medications - would likely reach a different demographic than PetMed, whose customer base is skewed toward mid/high income families and females (acknowledge: cash strapped consumers of all socioeconomic strata could seek cheaper alternatives).

As noted in our earlier post, another risk factor is PetMed's reliance on third party distributors for access to all products since most drug vendors will not sell directly to the company. Yet, given ever larger volumes moving through PetMed, we suspect that current third party suppliers are likewise realizing increasing sales/profits and are happy with the relationship, even while vets loathe the secular shift that is diminishing their profitable medications business.

Also, a reader pointed out (thank you), that some major pet medications may come off patent over the next year or so, potentially leading to increased generic competition and lower prices (and revenue - part of the bearish short call on PETS). In this scenario, we suspect the branded drug maker will no doubt try to hold pricing as much as it can and generics won't gain 100% share overnight (is a consumer going to stick with a trusted brand such as Frontline, Advantage, and Heartgard for beloved Spot, or immediately move to XYZ imitation drug?). Our guess is that the change is more likely to be gradual for each product, during which PetMed can keep growing the company's customer base as well as revenue from other products, all while passing on savings from generic competition to customers.

Lastly, what about perceived low barriers to entry on the Internet? We argue that barriers to entry are larger than persons appreciate once an Internet franchise successfully carves out a specific niche and has scale - think Amazon (AMZN), Blue Nile (NILE), eBay (EBAY), 1-800-Flowers (FLWS), Youbet.com (UBET). There were and are plenty of me-too participants in the backyards of each player, but the spoils usually go the the number one player in a given market (on- and off-line). And -- a quick aside -- while many knock eBay's e-commerce segment, the reality is that the business generates gobs of free cash flow with excellent margins and isn't going away any time soon.

To summarize: we think PetMed's established brand, market share, and repeat customer base create a meaningful hurdle for potential new entrants, large or small. Further, we believe PetMed's June quarter results (F1Q10) reported today again illustrate the strength of the company's franchise:
  • Growing through recession: Revenue up 13% Y/Y to $77.2 million and EPS up 27% Y/Y to $0.36, better than Wall Street expectations of $76.2 million and $0.31, respectively. Average order size declined 3% Y/Y to $84 as management indicated some customers are purchasing smaller quantities, presumably because of the tough economy.
  • Adding more customers: New customers acquired increased 11% Y/Y to 297K (although new order revenue increased only 5% Y/Y). Cumulative customers (active and inactive) reached 4.95 million, up 20% Y/Y.
  • Loyalty keeps paying: Reorder revenue grew 17% Y/Y to $54.0 million as the convenience of purchasing online keeps customers coming back each year. Habit/frequency is hard to break once established in any business and brand (top of mind) reinforces habit.
  • Carefully managing cost of goods sold: Gross margin of 38.0% versus 37.7% in the year ago quarter, as PetMed used opportunistic inventory purchases during the March quarter and pricing discipline to maintain margins. PetMed is holding the line against competitive threats.
  • Lower advertising expense boosts operating margins: Operating margin of 16.3% versus 14.3% in the year ago period as advertising expense came in lower than management anticipated because, surprisingly, less remnant ad space was available on cable networks (also somewhat impacting new customer additions, per management). Despite less advertising access than desired, management indicated that PetMed "paid less per eyeball", enabling lower expense.
  • Net margins nudge higher: Net margin of 10.4% versus 9.7% in the year ago quarter, boosted by growth/leverage, partially offset by lower interest income and higher taxes.
  • Monster cash flow from operations and free cash flow. The company benefited from a favorable working capital swing as PetMed harvested a large inventory investment in the March quarter. Cash flow from operations was $29.3 million with capex of only $320K for free cash fow of $29 million. However, cash flow should be analyzed on an annual basis to adjust for seasonality: trailing twelve month (TTM) cash flow from operations was $37.6 million with capital expenditures of $3.3 million for free cash flow of approximately $34.3 million. One step further, in this case, we prefer owner free cash flow to eliminate working capital variability: TTM net income of $24.4 million plus depreciation and amortization of approximately one million less normalized capex of one million equals owner free cash flow of $24.4 million.
  • Cash and cash equivalents keep piling up. As a result of large cash generation in F1Q, cash and CE increased to $59.5M at 6/30/09 from $30.1M at 3/31/09. Long-term investments remain unchanged at $14.3 million (illiquid, AAA-rated municipal-based auction rate securities) for total cash/investments of $74 million. The company has no debt.
With the advance in PetMed's share price today and over the past week, we find shares less attractive. In addition, management indicated that PetMed still has approximately $10 million remaining on the company's buyback authorization -- which is the same amount remaining at 3/31/09 -- implying that no shares were repurchased in the quarter. Based on past transactions, we think management prudently prefers to repurchase shares below $15 (at lower multiples).

Still, as noted in our post last week, we can envision PETS trading at 18 to 20 times earnings given the company's consistent, profitable operating model, implying a $20 to $23 fair value. On an owner free cash flow basis, discounted cash flow analysis implies a current fair value in the mid- to high-$20s, more than supporting our P/E based valuation.

On a relative basis, here's how PetMed's pre-results TTM operating metrics and valuation compares to several other online retailers:

PetMed has higher growth and better margins than Amazon and Blue Nile, yet a much lower valuation multiple. ROE metrics are fairly similar, although Blue Nile's 44% bests PetMed's 32% (note: Blue Nile completed a major buyback program over the past year, significantly reducing the company's equity base). We commented on Blue Nile longer ago.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long BRK-B, EBAY, FLWS, PETS, UBET.

© 2009 Jeffrey Walkenhorst
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