Pampered Pets Convince Their Humans To Keep Contributing to PetSmart’s Profits

December 20th, 2012 by

From kitty litter to spa treatments, PetSmart is making money from the North American tendency to spoil our pets; the company’s focus on managing costs, expenses and cash flow means that those profits are likely to be sustainable.

It is a truth universally acknowledged that Americans like to pamper their pets. They buy designer togs for their dogs (including little booties to protect paws from rain and snow), opt for organic food, are willing to pay well north of $100 for just the right carrier and even fork over for spa treatments. How would your cat feel if her neighbor’s feline got a kitty massage, or your dog react on learning that the pooch next door got a pedicure? That’s the (human) psychology that is helping to drive earnings at PetSmart Inc. (PETM.O) – and those profits look as if they will remain very resilient in the coming months.

PetSmart scores an impressive 97 out of a possible 100 on the StarMine Earnings Quality (EQ) model, indicating that its earnings from providing all those services to pets and their devoted humans are coming from sustainable sources. The reasons for this are myriad, but start with the company’s strong free cash flow levels. The green parts of the bars in the chart below represent the amount by which free cash flow exceeds net income at PetSmart – this serves as an indicator of strong earnings quality. The first of these two charts focuses on the company’s free cash flow levels on a quarterly basis; it shows the extent to which cash flow has improved since 2008. The chart below it shows the dramatic improvement in annual free cash flow levels since 2003, along with the significant improvement in net income since 2010.

Both net income and free cash flow hit 10-year highs of $290 million and $455 million, respectively, in the year ended January 2012.The trend established in the last three quarters of stronger free cash flow and higher net income appears likely to continue as PetSmart opens new retail outlets and – yes – “pet hotels”. During the third quarter, the company opened 24 new stores and closed 4, as well as opening another hotel for pets, bringing the firm wide total to 1,269 stores and 195 hotels according to Chip Molloy, PetSmart’s CFO, during the company’s latest quarterly earnings conference call a month ago. PetSmart has been able to cover those expansion costs by financing the $33 million of capital spending out of its strong cash flows from operations of $133 million in the last quarter.

PetSmart’s efficiency also contributes to its high earnings quality, with this being reflected in the steadily increasing return on its net operating assets. Over the last three years, the company has boosted its trailing four-quarter return on net operating assets from 23.9% to 43.9% — a remarkable gain of 20 percentage points. Furthermore, the company is operating more efficiently than its industry group, which has a median return on net operating asset of 29.2%. While PetSmart has boosted is own operating efficiency in recent years, that for its peer group has remained stable, a sign that this improvement is company specific rather than being due to some industry-wide trend or event.

PetSmartalso has been managing its supply chain more efficiently, reflected in the chart below showing that its accounts payable days are rising, enabling it to keep its cash invested in the business – but not by too much, which would signal that it is struggling to pay its suppliers. In the most recent quarter (the third quarter) the accounts payable days at PetSmart rose to 21.54, the highest level in two years.

The annual revenues of the company also have been rising steadily, from $3.4 billion in January 2005 to $6.1 billion in January 2012. Those positive trends appear likely to remain intact, and analysts appear to be taking notice of this. Of those analysts following PetSmart who changed their estimates after the company’s most recent earnings announcement, every one raised their earnings forecasts for the company’s earnings for the full whole year. That contributes to PetSmart’s high StarMine Analyst Revision Model (ARM) score of 82, which indicates that estimates may be heading even higher.The company’s addition to the S&P 500 index at the beginning of the fourth quarter (where it replaced Sunoco) is another factor that is likely to increase interest in its stock on the part of investors.

The company also is seeing the benefits from strong cost control measures put in place by Molloy, PetSmart’s outgoing CFO. While analysts expect him to step down in June 2013, his departure almost certainly will be part of an orderly transition. Indeed, one of the company’s few sources of concern at present is the fact that, like most bricks and mortar retailers, it must fend off a threat to its sales and profits from online rivals, most notably Amazon.com (AMZN.O) In this case, however, the company has a robust balance sheet, healthy earnings that its high EQ score of 97 indicates are likely to be stable – and the phenomenon of “showrooming” may actually work in its favor. Trying to convince your black Lab to wait until you can order that squeaky toy or rawhide bone more cheaply online and have it delivered may be a tough sale…