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Why PetSmart May Be Dogging It Soon

It has been a category killer so far, but the landscape is shifting


PetSmart (NASDAQ:PETM) has been the Energizer Bunny of retailers because it has kept going and going. At least, until now.

Though its profit in the latest quarter, reported after the bell on Wednesday, rose by double-digit percentages for the eighth period in a row and overall results surpassed Wall Street expectations, investors were spooked by a surprise 20-basis-point drop in PetSmart’s gross margins to 30.4%.

Analysts at Raymond James noted that PetSmart had stronger sales of lower-margin items. Shares of the Arizona retailer, which had surged more than 30% this year, got knocked down in early trading yesterday before scratching back most of the loss, and they’re flat in Friday afternoon trading.

This skittishness represents a change in fortunes for PetSmart, which some on Wall Street had considered to be a sure thing. The retailer has been on a post-Great Recession expansion kick, growing from 1,149 locations in 2010 until 1,232 in 2012. The company has plans to eventually expand to 1,800 locations in North America.

Investors cheered PetSmart’s expansion, boosting the company’s share price by almost 90% over the past five years. But just like people, pets have learned to do more with less. “The $87 billion pet-product market, once deemed recession-proof, is starting to show cracks as owners struggle to make ends meet,” according to Bloomberg News. “Nearly four out of 10 U.S. pet owners in a September Packaged Facts survey said they’re spending less on pet products, up from 27 percent in February 2010.”

PetSmart forecasted 2012 profit of $3.02 to $3.16 a share and 70 cents to 74 cents in the first quarter, ahead of Wall Street forecasts. However, achieving these goals won’t be easy amid heightened competition from larger rivals such as Amazon (NASDAQ:AMZN), Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) which are aggressively discounting pet supplies.

To make matters worse for PetSmart, about 20% of the company’s products are sold at mass merchants at prices that are 3% to 5% cheaper. It’s no wonder that Wall Street expects revenue to rise 3.9% to $6.89 billion in 2014, versus growth of 8.4% in the current fiscal year.

During 2011, PetSmart opened 53 new stores and closed eight. The company also opened 12 pet hotels, including three in the fourth quarter. Finding good locations, though, is getting more difficult as the amount of vacant space has decreased, according to a RBC report issued in November.

Wall Street still has faith in PetSmart. The average one-year price target is $57.88, about 4% ahead of the $55.45 level where it recently traded. PetSmart shares, though, aren’t cheap, trading at a price-earnings ratio of 22.84, near its five-year high, according to Reuters.

Bulls will argue that as consumers become more confident, they’ll lavish more attention on their pets with PetSmart’s Martha Stewart-branded goods and premium pet foods. PetSmart’s services businesses, such as dog grooming, will also do well as the economy rebounds.

While those arguments are true, investors shouldn’t forget that PetSmart faces huge challenges in the months and years ahead. The good news is already priced in the stock, but the potential for future margin pressure is real. This is a stock to be avoided.

— As of this writing, Jonathan Berr was long TGT.

Article printed from InvestorPlace Media,

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