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Monday, August 2, 2010

PetMed Express (PETS): Why We Moved to the Sidelines and Prefer Other Ideas Until Proven Otherwise

We mentioned our more cautious stance on PetMed Express (PETS) in our post the other week, More Favorable Earnings Reports, including EBAY; One Exception: PetMed Express (PETS) on Company Specific Risks. Here, we provide more detail.

As it turn out, our timing works well because (1) PetMed Express announced a 25% increase to its dividend today:
AND, (2), The Motley Fool featured PETS as "Today's Buy Opportunity" on Friday 7/30/10.

First, the dividend increase nicely signals management's confidence in their ability to grow the business over time, as well as a willingness to return more capital to shareholders through buybacks and dividends. This commitment is fantastic and exactly what we look for in our companies.

Second, the Fool nicely summarizes the positives: large addressable market opportunity, America's love for pets, healthy historical growth, and healthy free cash flow. The Fool also notes the company's sizable reorder business, incorrectly citing reorders at 75% of sales when - in fact - they were better, at 77% in most recent quarter. From PetMed's earnings release:
  • Net sales for the quarter ended June 30, 2010 were $74.4 million, compared to $77.2 million for the quarter ended June 30, 2009, a decrease of 3.6%. Net income was $7.2 million, or $0.32 diluted per share, for the quarter ended June 30, 2010, compared to net income of $8.1 million, or $0.36 diluted per share, for the quarter ended June 30, 2009, an 11% decrease to EPS. Reorder sales increased by 7%, from $54.0 million to $57.6 million for the quarters ended June 30, 2009 and 2010, respectively.
We have $57.6 million out of $74.4 million = 77% ($57.6 divided by last year's $77.2 = 75%). In any case, the positive story is similar to our original thesis last summer.

NONETHELESS, the company reported disappointing results which, combined with management commentary, brought us to rethink our positive stance. Recall our prior disappointment last October.

Some negative surprises.
Although we expected that a tighter advertising market might negatively impact PetMed Express's access to sufficient remnant advertising space at favorable rates, we still expected Y/Y revenue growth in the quarter (versus a reported Y/Y decrease of 4%). Further, PetMed is having to pay higher prices for product, pressuring its gross margin. This risk factor could be exacerbated by reliance on third party suppliers for products. Another negative surprise was CEO Mendo Akdag citing the economy as a reason for weakness:
  • "I think economy is playing a role. Consumers are giving greater consideration to price, stretching the usual, the preventatives and switching to lower-priced brands. So I think the softer economy has been catching up with us."
To this point, we believe prior management commentary acknowledged the weak economy but pointed to the company's business model as being more resilient, supported by actual results (helped by the previously slack advertising market). It's true that a strapped consumer may be purchasing more selectively, yet heightened competition from Amazon.com (AMZN) and me-too imitators may also be the culprit. Hard to know for sure as they're all somewhat inter-related.

WHAT we do know is that retail pricing for some key medications is intense. Let's quickly review pricing for OTC flea and tick offerings, which along with heartworm preventatives (RX required), make up more than 50% of PetMed Express' sales.
  • Pricing on Frontline Plus from Amazon for a dog 23-44 lbs is listed at $65 (in this case, sold by a third party merchant through Amazon):
  • Another item: Amazon's pricing on Advantix Flea Control for dogs 21-55 lbs, 6 applications is $57.50 (this time, sold and shipped by Amazon):

SO, Amazon is undercutting PetMed Express by a wide margin. That said, this has been the case for some time as we've kept tabs on pricing over the past year. If consumers are continuing to buckle down, which is possible* given the weak employment market and languishing real estate sector, volumes and pricing (and margins) -- as well as repeat business -- will remain under pressure as retailers offer more bargains and consumers hunt for better deals. SO LONG as a buyer is confident that the product is authentic, a "rational" consumer will purchase from the lower-priced outlet. In this sense, customers should be increasingly bargain savvy, even for RX medications which made up 35% of PetMed's revenue in FY2010. While Walmart (WMT), Amazon, and PetsMart (PETM) may not participate in the prescription segment without proper licenses, vets may be steadily more aggressive in an effort to retain the product business that PetMed has been so successful in garnering.

*OF COURSE, deep in the grips of the recession and panic, in late 2008 and early 2009, when the consumer went into hibernation, PetMed Express posted healthy Y/Y growth and new customer acquisitions. We can chalk this up to plenty of remnant advertising space, which admittedly, is crucial for most direct marketing companies, but one could also posit that consumer spending is at least better today than it was during the hibernation period. For those interested, we show absolute retail sales in a prior post, Look at the Bright Side of Retail Sales: STILL UP Y/Y and Don't Forget Recent Commentary from Many Areas.

To summarize: while the economy may finally be a negative factor, we think heightened competition is an equally or more likely culprit (aside from less advertising). As a result, we see risk to both new business AND what we originally considered to be an annuity stream of repeat sales. The company may need to spend more (or give more, discounts, coupons, etc.) on both fronts.

One other risk factor has some investors spooked: the patent expiration for Frontline Top Spot. We asked CFO Bruce Rosenbloom about this and he kindly informed us that the leading flea and tick seller, Frontline Plus, is NOT impacted by the expiration and that the company "will carry any new products that hit the market" (i.e. generics). We've not studied in any significant detail what happens in the traditional pharmaceutical market when generics enter the scene, but common sense suggests lower prices and potentially more competition. YET, it's good news that this is a secondary product and Mr. Rosenbloom also said that there are no other patent expirations on the near-term horizon.

To their credit, management has done a great job building the franchise and is balanced in their commentary. We recommend watching CEO Akdag's presentation at the recent Noble Financial Sixth Annual Equity Conference (captured with Sonic Foundry's Mediasite/SOFO; more conferences should be shared in this format)
Mr. Akdag highlights strengths:

AND also discusses challenges:

Unfortunately, for now, we think concerns outweigh positives until proven otherwise. We still like the company's well-recognized brand, asset-light-high-ROIC business model, iron clad balance sheet, reorder business, excellent free cash flow, and now enhanced 3.1% dividend. However, we must acknowledge that negative Y/Y revenue trends (a new development) and margin pressures bring material risk to our and Street forward estimates, which suggests potential for further multiple compression. At 15 times trailing earnings, we think the company's current valuation leaves little room for incremental disappointment, which could happen should remnant space remain tight (likely, as long as the economy remains stable to better) amidst higher competition (likely). Hence, forward growth and margins are the crux, and are especially critical for valuing the business on a long-term basis (e.g. value of future equity free cash flows to shareholders). The ongoing secular shift to online commerce is a favorable tailwind for PetMed Express and, in addition, we can envision a large strategic buyer making a bid for the company at some point.

Moving to sidelines. For the time being, we are recoiling our positive thesis as the above risk factors raise questions as to whether -- in Charlie Munger style (per our initial post one year ago) -- we can sit back, relax and watch net asset value per share grow. While we take a patient, multi-year perspective and our aim is to never be reactive after an earnings report (always preferable to be proactive prior to positive/negative catalysts, before the crowd), we have higher conviction in our other holdings. For now, we book an approximate 12% total return and will watch from the sidelines. Unfortunately, our prior decision a few months back to let our position ride despite achieving our low $20s fair value range did not pan out. Lesson: always best to maintain target price discipline. Insiders were selling, including a $2.8 million block by Mr. Akdag.

OTHER IDEAS? We have higher conviction in our other "asset-light" holdings, eBay (EBAY), Weight Watchers (WTW), and 1-800-Flowers.com (FLWS), as well as our "asset-heavy" shipping companies, Seaspan (SSW) and Global Ship Lease (GSL), and our aircraft leasing company FLY Leasing (FLY). Recall that we discussed 1-800-Flowers.com, Seaspan, and Weight Watchers in our January video, Which Way from Here, where we also talked about the economy, the market, and psychology. We still like these long ideas and believe they're offered by the market by meaningful discounts to fair value.
  • First, 1-800-Flowers.com is offered at an approximate 20% free cash flow yield to current buyers. Yes, consumer spending remains constrained, but from an owner's standpoint, this is an incredible bargain for an increasingly diversified business that is seeing stabilizing fundamentals and should enable excess cash to consistently build on the balance sheet.
  • Second,we've substantially covered Seaspan and the shipping sector in recent posts. Bottom-line: despite persistent economic fears, global trade is recovering swiftly and Seaspan's real estate like business model is performing as expected. Like PetMed Express, Seaspan also raised it's quarterly dividend by 25% just last week and we see potential for further hikes in the next two years.
  • Finally, Weight Watchers continues to be offered at an approximate 10% earnings yield, far better than paltry bond yields and attractive for a market leading company with fantastic brand awareness and juicy margins.
In addition, over the past six months, we've also committed capital to new ideas, including: snack company Lance Inc. (LNCE) and Central/South American discount club company PriceSmart (PSMT). However, both names have since moved higher and valuations are now more full. If we had more time, we would have previously shared. Apologies for being a bit tardy. We may share more color in future posts.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long SOFO, GSL, SSW, EBAY, FLWS, WTW, FLY, LNCE, PSMT.

© 2010 Jeffrey Walkenhorst
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  1. love the website but would quibble with this:

    cause it really doesn't, right? They've got 1.3b or so in debt that you have to count. i mean, gap, maybe not as stable a business in some people's mind's eye, has 2.5b in net CASH with close to a 15% free cash flow yield. Retail, tech, and a whole host of companies are full of 10% yields based on enterprise value, but nobody much cares right now cause of the all the gloom that you've commented on.

    Agree, WTW is a wonderful business, but adding 1.3b to the market value really brings that yield down to 5 to 5.5% or so, nothing particularly noteworthy, though I realize the debt is being brought down pretty quickly.

  2. Hello Anonymous,

    Fair point that another way to evaluate a business is to look at the total enterprise value of the company (equity + interest bearing debt less cash) and the operating earnings before interest and taxes that the the entire capital base produces. Metrics here are EV/EBITDA or EV/EBIT, or invert these multiples for yields. These figures are relevant to all suppliers of capital to the company, equity owners and lenders. However, with WTW, I am referring to earnings yield to equity shareholders (after debt interest expense and taxes), which currently stands at ~8% on a trailing basis and 9-10% on a forward basis. If an investor buys shares today, this is the implied yield, meaning in 10-11 years the price of one share would be recouped if all earnings were paid out in the form of dividends. If the investor thinks the business can grow the earnings stream over time through share gains, market expansion, pricing power, etc. the implied yield will also increase.

    If we agree that WTW is a wonderful, stable cash generating business that can service/repay debt, then it's safe to evaluate on this basis. While WTW can safely carry a reasonable debt load, my expectation is that WTW will continue to use its $200 million plus annual free cash flow to repay debt (in line with mgmt guidance) and potentially begin increasing dividends to shareholders within the next 2-3 years. Unfortunately, the company levered up to make ill-timed share repurchases at the bequest of its private equity owner Artus/Invus.

    Background on their investment here (but no mention of buyback) http://www.invus.com/case-studies/weightwatchersonline.shtml



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