Tickers in this Article: PETM, COST, SWY, KR, TSCO,
The specialty retailer announced solid second quarter results August 21. PetSmart's (Nasdaq:PETM) future seems exceptionally bright. Its stock, however, is another story up just 1% over the past 52 weeks. Is now the time to buy? I'll have a look.

Past Performance
Although the past year hasn't been particularly kind to PetSmart's stock; the same can't be said for the past decade. It's achieved an annualized total return over the past 10 years of 13.2%, 600 basis points higher than the S&P 500 and 325 basis points higher than its specialty retail peers. It's currently trading within 5% of its all-time high of $75.15. In every way it's done what you'd want a stock to do over the long haul.

So why has its stock stalled?

I suspect Barron's May 21 article that brought up investor concerns about online competition was enough to spook anyone considering taking a position. It certainly can't be its financial results. In the first and second quarters it beat earnings per share by two and three cents respectively. In terms of revenues, it missed the Q2 consensus estimate of $1.712 billion by $6 million and the Q1 consensus estimate of $1.72 billion by $10 million. Investors chose to ignore the fact PetSmart increased revenue by 5.3% in Q2 year-over-year and by 5% in Q1. Instead they've hung their hat on a combined revenue miss of $16 million in the first two quarters of the fiscal year—less than 1% of $3.43 billion in revenue. That's just silly.

Margins
My wife and I regularly shop at PetSmart for cat litter. We'd buy our food there as well but it sells our favorite brand for C$3.15 per 13-ounce tin. That's highway robbery in my opinion—instead we buy it a Canadian pet food franchise where we pay C$2.50 for the exact same product.

I've never quite understood why a store with such great buying power and size would sell a product for 26% more than its much smaller competitor. Clearly it's not interested in the Costco (Nasdaq:COST) approach to retail, which is to pass on to their customers any cost savings extracted from suppliers rather than sticking the extra profit in their pockets. However, there's method in its madness.

Over the past decade it's consistently delivered 30% gross margins. It takes all the various products and services it provides to customers and figures out how much it needs to charge for every item in the store in order to annually hit that number. As a consequence it charges a king's ransom for some things and a mere pittance for others. It's taken the art of retail pricing and turned it into a science. My guess is it doesn't sell a great deal of our particular brand and so it sets the price higher while the most popular items are more competitive in order to drive traffic. It's frustrating to have to go to more than one store but I understand why it does this.

SEE: Great Company Or Growing Industry?

You Know What You're Getting
Its consistent gross margin is one of the reasons its stock's done so well over the years. No one wants to invest in a specialty retailer whose margins are all over the map. When you buy PetSmart stock you generally know you're going to get 5% revenue growth, 3% same-store sales growth, 20% earnings growth and an annual increase in its dividend. It's not glamorous but it gets the job done.

Bottom Line
If you look at PetSmart's business there are just three pieces: Consumables, Hard Goods and Pet Services. Consumables, which is food, treats and litter, represents slightly more than half of its overall revenue. Hard goods like collars and leashes accounts for another 33% and the remainder consists of pet services like grooming, training, and boarding. It goods you in the door with the food—at least that's the plan—and then sells you the other stuff later on. It's a very simple business model executed extremely well.

When do the good times end?

I don't think they will. We are a pet-obsessed society and there's nothing on the horizon that suggests this is going to change. In many ways PetSmart is a really expensive Safeway (NYSE:SWY) or Kroger (NYSE:KR)—only for pets. Or more precisely it's a pet version of Tractor Supply (Nasdaq:TSCO), providing everything a pet might need all in one place.

If you compare PetSmart to Tractor Supply from a valuation perspective I think you'll come to the conclusion that both are reasonably priced given their niche businesses. The fact that PetSmart's stock's done nothing the past year while Tractor Supply's achieved a total return of 27% tells me it's ready to pop.

Disclosure: At the time of writing, the author did not own shares of any company mentioned in this article.



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