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Monday, October 19, 2009

PetMed Pulls Up Short -- Express Becomes Local Train

In yesterday's post, we pointed to several potential sell signals for PetMed Express (PETS, $19.66): insider selling, still large short interest, and bearish moves in option activity (per another source), as well as a fair valuation indicated by our own model (aside from DCF valuation). We also mentioned that the company's history of beating expectations could prove perilous in the event of a disappointment.

Well, in this case, the warning signs were correct as PetMed's F2Q10 results came up short: revenue of $62.4 million (+5% Y/Y) was below a consensus estimate of $66.0 million (+11% Y/Y) with in-line earnings of $0.28 per share (+12% Y/Y, not good enough given expectations for beat). Further, on the conference call, management explained that the company was unable to purchase as much remnant TV advertising space (left over TV commercial slots in "scatter" market) as prices that make sense for PetMed. Apparently, "general advertisers" that would normally be buying slots "in advance" are buying remnant space this year because of economic uncertainty.

If this is the case, we're surprised we didn't see or hear of this last quarter, although we understand the advertising market can swing around quickly. Perhaps certain advertisers are now being more aggressive given signs of economic stabilization and possible improvement. Management expects the advertising market could be more "orderly" in calendar 2010 with more advance purchasing. Yet, such forecasting is near impossible -- only time will tell. One thing is for sure: access to remnant space is critical for growth in a direct marketing business model such as PetMed's. Investors will now question the company's growth potential into 2010, which may keep shares range bound.

By purchasing less advertising, PetMed added only 233,000 new customers (down 3% Y/Y) which, coupled with a lower average order size of $78 versus $81 in the year ago quarter, led to the revenue miss. However, less spending on advertising (down 11% Y/Y) helped offset a lower gross margin (mix, possible competition) to yield operating income of $9.8 million (+15% Y/Y) with an operating margin of 15.7% versus 14.4% in the year ago quarter. The company ended the quarter with $69 million in cash/investments, compared to $74 million at 6/30/09, and no debt. Notably, PetMed paid the company's first ever quarterly dividend of $0.10 per share during the quarter, resulting in a cash outflow of $2.2 million.

As previously described, we like the company's business model, especially a growing stream of repeat business (73% of F2Q10 revenue, +11% Y/Y). However, the stock will be under pressure today. As with any company, we strive to purchase with a significant margin of safety to our estimate of fair value. Based on most valuation metrics, such a margin did not exist last week. We may soon have another opportunity.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long PETS.

© 2009 Jeffrey Walkenhorst
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