Let’s start with the company’s past returns.
PetMed Express Inc. - Historical Returns, 2003 - 1Q 2012
Here we see that the company’s returns have been historically above 20%, and that the recession had very little effect on the business until the most recent full year. There are a few things to note about this. First, the declining returns are to be expected, given the growth in the company’s equity over the last nine years. While equity has experienced a compound annual growth rate of 37%, earnings have experienced “just” 23% CAGR, causing the declines witnessed here. As the business matures, these returns will approach a more normal level, subject to the potential disruption of competition discussed below. As mentioned above, the company has recently begun using its free cash flows to return capital to investors.
Second, given the company’s massive (and growing) cash hoard, the Return on Invested Capital (ROIC) figures present a better explanation of the company’s performance with its operating assets (ROIC = NOPAT / Invested Capital, where NOPAT = EBIT * (1-tax) and Invested Capital = Book Value of Equity + Book Value of Debt – Cash). ROIC looks through the growing cash balances to assess the company’s performance, whereas the other metrics do not. Looking at the company’s historical ROIC, we see that its returns have never been below 60%!
Let’s turn to the company’s revenues and margins.
PetMed Express Inc. - Historical Returns, 2003 - 1Q 2012
Though the company’s revenues have grown quite dramatically, this too is to be expected given the company’s relative youth. The more interesting point to note is that the company’s gross margins have come down quite dramatically over its short life (declining 642bp) , and that until recently, the company had been able to compensate for gross margin compression by growing its operating margin, likely due to the economies of scale present in its web based operations. Unfortunately, masking gross margin compression with expense optimization only works to a point, and is reliant on continued high revenues. A reduction in revenues for a company with this strategy has a compounding effect as economies of scale move in the wrong direction.
The company noted in a recent conference call that it will expand its nascent private label and generic branded products in the future. This should improve gross margins and may serve to expand the company’s customer base. Currently, these products account for a “single digits” percentage of the company’s sales, so there should be significant growth potential here.
It is also worth mentioning that the company only recently entered the pet accessories market. These products sell through PETS’ various sales channels but do not hit PETS inventory as they are drop shipped from third party sellers. This allows PETS to leverage its brand and customer base, earning a commission on each sale, which should improve margins and free cash flow, as these sales are highly profitable and require essentially no capital investment to generate.
Let’s look at the company’s cash conversion cycle.
PetMed Express Inc - Cash Conversion Cycle, 2003 - 1Q 2012
From this chart, we see a worrying trend in the growth of the company’s inventories, from just 40 days worth when the company went public to nearly 55 days at the end of the last year. Keep in mind that the Days of Inventory figure adjusts for the increase in sales, so this is an apples to apples comparison. This likely has to do with the company’s efforts to speed up deliveries, which includes minimizing the likelihood of delay-causing stockouts. The company notes the importance of speedy delivery and touts the fact that nearly 80% of all orders are shipped within 24 hours of ordering. Since this is a strategic decision, I see no reason to worry about this growth in inventory (an inexplicable and persistent rise in inventory may be a concern in some situations. Read Financial Shenanigans or my in-depth review to learn more).
Let’s look at free cash flows.
PetMed Express Inc - Free Cash Flow, 2003 - 1Q 2012
I like pretty much everything about this chart. As you can see by comparing this chart to the revenue growth chart above, the company has growth free cash flows largely in line with revenues. Additionally, by the only slight difference between free cash flow and cash flow from operations, we see that the company has relatively low capital demands. This is a great quality to look for in a business as future revenue growth translates into free cash flow that can be used for the benefit of shareholders, such as repurchasing shares, paying dividends or reducing debt. Speaking of debt, let’s take a quick look at the company’s capital structure.
PetMed Express Inc. - Capital Structure, 2003 - 1Q 2012
Look ma! No Debt!
Not only does the company not have any debt, it also has a boat load of cash and investments equal to about $3.03 per share or approximately 1/3 of its its current share price. Not bad! One more thing before we get to valuation: the company has been actively repurchasing shares, with four different $20 million share repurchase plans over the last five years (the most recent occurred subsequent to the last 10-Q, so you will find it in Note 9: Subsequent Events). Up to this last quarter, the company repurchased $55.9 million, with an additional $3.8 million subsequent to the quarter ending, leaving the company with $20.3 million remaining authorization, or another 10% of its current market cap. Given the recent collapse in the company’s share price, I hope they are taking full advantage of their authorization.
The company appears to have done everything a shareholder could ask for. It has improved its performance dramatically while behaving in a shareholder friendly manner and returning the bulk of its free cash flow back to shareholders. So why is the market ignoring all of this?
One possible reason is that the company is suffering increased competition. The increasingly competitive industry has been mentioned in several recent conference calls, and the effects are visible in the company’s gross margins. Moreover, the internet retail giant Amazon.com (AMZN) appears to be gearing up in this market. Though AMZN has been active in pet-related products since its failed investment in dot-com bubble poster child, Pets.com (of hand puppet fame), the company recently showed renewed interest in the market with the introduction of Wag.com. More than 70% of PETS’ total sales are generated through its websites, so AMZN’s entrance is definitely cause for concern. PETS has a slight advantage in that it can sell prescription pet medication directly (it is a licensed pharmacist in every state), whereas AMZN acts only as a conduit for other pharmacists. Though in the OTC market, all bets are off. I would suggest that PETS really does not have a competitive advantage, though at the right price I can get past this.
Given the company’s lack of a competitive advantage and the increasingly competitive market, I expect margins to continue to contract. I took this into account in all of my scenarios for the company’s future (despite the opportunities discussed above in terms of generics, private label products and third party commissions). I also reduced the company’s revenue growth, and in my bearish scenarios I assumed fairly dramatic revenue declines. The result? Even in my most bearish scenarios, the company appeared to be fairly valued at worst. Using less dramatic assumptions shows the company to be significantly undervalued, especially if the company uses the bulk of its repurchase authorization at current low share prices.
I like PETS, but I am interested in hearing your thoughts. Leave them in the comments below!
Author Disclosure: No position, but may purchase within 72 hours.