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12/3/2012 8:49:00 PM
The humanization of pets has played into the hands of PetSmart, which sells premium pet food and high-priced toys for the family dog.
Pets are playing an increasingly important role in pet owners' lives. As a result, pet owners are spending larger sums of money on premium pet items that didn't even exist just a few years back.
The pet industry has capitalized on this trend. By catering to animal lovers' demands for fancy toys, premium foods and superior care, sales have skyrocketed. Today, it's an industry with more than $43 billion of annual sales.
PetSmart ( PETM ), the Phoenix-based operator of more than 1,200 specialty pet stores across 47 states, "happens to be in a good segment of an even-better subindustry," said Sean McGowan, an analyst at Needham & Co.
"The specialty retail part of pet supply has been growing faster than the overall pet business. But the overall pet business has been growing very well because of a couple of trends. The most basic trend is the humanization of pets," noted McGowan.
"A hundred years ago, if you had a dog, it was probably a working dog on a farm. That dog migrated from the barn to the back porch to the kitchen floor to the floor in the bedroom to the bottom of the bed," he said. "So the pets have been welcomed as full-fledged members of the family."
Close to two-thirds of all homes in the U.S. have pets, and most of those have more than one pet. Demographically, the two big times of pet acquisition are when newly formed families have young kids and when the kids leave.
"The humanization of pets is an industrywide phenomenon, but it's one that particularly plays well to the specialty store," said McGowan. "The biggest single driver to their business over the last five years has been the emergence of super-premium pet foods."
The higher prices of those super-premium foods have helped drive PetSmart's strong results. Earnings soared 31% to 50% in each of the last three quarters, same-store sales grew at more than 6% and gross margins improved by more than 0.8%.
Consumables make up more than half of PetSmart's business. In-store services, such as training, grooming, boarding and vet care, have also been growing at a faster rate than the overall business.
The company provides boarding and doggie day care via its PetsHotels at 195 of its stores. Vet services are offered via the Banfield pet hospital in about 60% of its locations. It also holds adoptions and other events that attract traffic to its stores.
Since the emergence of online stores, traditional brick-and-mortar retailers such as PetSmart have had to compete mostly on selection of products and services rather than on price.
The company has taken various initiatives to give pet owners a full experience when visiting their store.
Part of that has been a focus on offering exclusive celebrity-endorsed toy collections, super-premium foods, listening to feedback from customers and regularly updating their merchandise mix.
PetSmart carries exclusive product lines such as the Martha Stewart Pets collection, Bret Michaels Pets Rock Collection as well as GNC Pets for vitamins and supplements.
"You have to give a lot of credit to the management team with this unique and inventive merchandising," said Thomas. "It's not only been a benefit to tickets and margins for PetSmart, it's also helped to add another layer of insulation."
But the challenge of competition from the Internet remains as various online merchants offer free shipping and various other discounts to attract shoppers.
"The popular view in the analyst community today is that for the foreseeable future, the next two to four quarters,Amazon ( AMZN ) and the Internet are not going to be a viable threat (to PetSmart)," said Brad Thomas, an analyst at KeyBanc Capital Markets. The reason would be "look at the results that PetSmart has been able to post."
Analysts expect the company to report another round of excellent results in the fourth quarter, while company management raised its earnings guidance.
However, over the long term, Thomas believes competition from online retailers is a serious risk.
"We've done a significant amount of work on Amazon and the threat of Amazon as it relates to brick-and-mortar retailers, and our contention would be that Amazon and the threat of Amazon are only getting bigger and worse. And that the next five years are probably going to be worse than the last five years," Thomas added.
Nevertheless, in the pool of retailers that have suffered from competition of online stores, PetSmart has been an exception and performing well.
A recent pet industry survey performed by RBC Capital Markets states that just 3% of pet owners use the Internet as their primary shopping venue for pet food and pet products.
PetSmart's market share as the primary shopping venue is at 18%, second only to supermarkets and mass merchants. And according to the study, 66% of respondents don't think of the Internet when shopping for pet supplies.
The Street views PetSmart's management team as strong. Even though CFO Chip Molloy will be leaving the company in 2014, he is credited with establishing solid financial discipline. Over the course of his career, he has repositioned the company from a fast land-grabber to a more focused asset manager of its stores.
"He really brought a very thoughtful process to their capital allocation," said Thomas.
"He slowed down their store openings at a time when most retailers didn't do that and were paying far too much to open these stores at high rental rates before the last recession started.
"He gets a great degree of credit for being very thoughtful and disciplined in his spending approach. I think that many of the principles that he's put into place have become ingrained in the company today. While he leaves big shoes to be filled, we see the depth of the management team as very strong right now," Thomas added.