Thursday, August 20, 2009

PetSmart (NASDAQ:PETM): Colour on quarter

PetSmart (NASDAQ:PETM) is getting at least 2 downgrades this morning following weaker than expected results and guidance out last night:

- Credit Suisse is downgrading PETM to Neutral from Outperform as, unlike other industry leaders, PETM is not only seeing sales slow, but is seeing margins decline as its mix deteriorates. Taking away the earnings upside moves PETM down on firm's investment attractiveness scale. Firm is lowering their price target to $21.

Investment case: PetSmart has always been a tween’er that has moved on its own results. It does not offer the cyclicality due to its food sales that investors looking for an economic uplift can find in many of firm's names. Nor does it offer the secular story that CSFB's DIY auto names do. However, the growth of services, lower expense growth and premium food inflation seemed enough to keep this stock beating expectations. That is no longer the case, with PETM losing some of the inflation push from premium, facing some pricing battles in commodity and watching its high margin hard goods comp more negatively. That makes for a less attractive near term story.

Catalysts: The near term catalyst for the downgrade was management’s lowering of second half earnings guidance while leaving sales guidance the same. That points to weaker than expected margins in the key hard goods category for Christmas as well as more competitive pressures than previously projected. CSFB believes that they will have opportunities into next year to revisit this well managed chain.

Lower comps in 2H as expected, but a headwind for stock: As CSFB's shows above, PETM’s quarter over quarter relative stock performance has historically been tied to its same store sales growth. While it has been well documented that comps would be weaker in 2H as PETM anniversaries the significant inflation benefit it got last year and now even less inflation. Therefore, they believe it will be difficult for its stock to outperform as comps get worse, particularly as most other retailers show sequentially better comps against easing comparisons in 2H. PETM management is projecting comps to be flat in Q3 and while that is essentially flat on a 2 year basis with Q2’s trend, headline comps will still be weaker than Q2’s +3.9% as shown below. The difference for PETM is lower inflation and trade downs by consumer.

- Piper Jaffray is lowering PETM to Neutral from Overweight and lowering their target to $21 from $25. While the firm notes they do not like to downgrade stocks on the heels of a negative guidance revision, they see two notable headwinds that will likely mute EPS growth through 2009 and into 2010. In particular, they now believe price deflation on the pet food category is a strong possibility (likely in early 2010), which has negative implications for both comp and gross margin dollars. Also, missteps in the hardgoods business during the first half now removes their confidence that this higher margin category will improve meaningfully in the near future. As a result, Piper is now estimating EPS to decline y/y for the next 4 quarters.

- JP Morgan maintains their Neutral rating but is lowering target to $21 from $25. Firm notes it all really comes down to merchandising and hardgoods sales. PETM reduced its annual guidance due a weaker than forecasted recovery in the highmargin hardgoods business. Food comps (50% of the mix) are driven by price, market growth, and market share. JP Morgan believes that food prices will be flat and the market outside of food is shrinking (perhaps offsetting market share gains; PETM grew share 80 bps LY and expect a similar amount in 2009). Hence, looking over the next twelve months, the ability for PETM to comp is all about driving units per transaction or seeing a recovery in traffic (in other words, hardgood sales). As noted in firm's August 10th downgrade “Back on the Leash”, the secular tailwinds of pet adoption and innovation have (at best) slowed. Thus, sales growth is about PETM being a better merchant, which is also the critical lever to merchandise margin expansion.

Notablecalls: PETM's a tough one here. To get any fills early on one would need to short it down -10%. If you look at PETM's past gap-downs you will see -10% is actually the magic level for the stock. It's loved by many and is likely to bounce.

Yet, the headwinds here look to be for real, so I would expect the stock to drift down a cpl of pts from the $20 level over the next weeks or so.

So, the only way to really play this one is to short the upcoming bounce (if they let you in).


Sandeep Gandhi said...

An unrelated question for NC.

I thought BridgeWater Equity was a good firm focusing on quality research. However, of late, I have been getting spam like emails from them touting small stocks (e.g. HLXW, SGCA etc)
Have they changed?

notablecalls said...

Never heard of these guys. Based on their recs I'd say they are just some penny stock hypers.