I came across PETS while scanning the magic formula screen (www.magicformulainvesting.com) for the Top 30 magic formula stocks with a market cap greater than $50 million. PETS had been in the magic formula screen for quite some time, but I always figured it was fairly to slightly undervalued. As you can see from the price chart below, PETS has slowly drifted lower and has lost roughly half of its value year to date. Now that it is near its 52-week low, I felt it was time to do a bit more research as I consider it to be a simple business.
Current Price $9.34
Market Capitalization: 189.96 million
Like other consumer-driven businesses, PETS faced a challenging year in fiscal 2011 and thus the decline in share price and company performance. Among the challenges the company experienced was the first sales decline and a decrease in gross margins as the company implemented a strategy which lowered prices to compete with online and generic competition.
In my opinion, the recent company troubles are short-term hiccups as the company operates in a very niche business and is taking the necessary steps in marketing their products at the proper price. At the same time, they are spending money on customer acquisitions by obtaining more traffic to their website and working on improving their conversion rates. It costs the company $2 to obtain a new customer (up from $34, and thus the lower margins) but the average customer spends approximately $80. Nevertheless, despite the recent slowdown in operating results, PETS has some amazing numbers. These numbers are achieved despite heavy online competition (it's a fragmented market) and competition from brick and mortars like Walmart.
Why is PETS holding its ground? For one, most individuals continue to get pet medications from the veterinarian. The other major factor is ordering online from the PETS website is more convenient. And individuals are spending money on their pets and the trend will likely continue as PETS points out that the American Pet Products Manufacturers Association, spending on pets in the U.S. increased by 6.2% and reached $48.3 billion in 2010, and the pet medication market that we participate in is estimated to be approximately $3.8billion, with expectations that pet spending will continue to grow.
- PETS faces several risks to its business. For one, online competition will continue but should not pose a significant risk as the market is tough but very fragmented. The major competitor(s) are veterinarians who control roughly 67% of the Pet Medication market.
- PETS's main operations are located in Pompana Beach, Fla. (south Florida), an area that gets hit by hurricanes. Keep in mind that PETS's operations are very concentrated (sales, order processing, inventory from one location), and thus they are very susceptible to large power, facility, inventory, etc. interruptions that could really hamper its business, not only now but in the future.
- The company relies heavily on its web properties as it generates about 70% of its sales from its web properties. While it currently is ranked No. 1 in Google for key words “Pet Medications,” any decrease in rank (Google is known for penalizing businesses for bad practices) could have an adverse effect on revenues.
PETS Operating Results
Despite the bad fiscal year, PETS continues to be a very good business. In just about every type of ratio PETS is healthy across the board with no major fluctuations (see numbers below), the green numbers represent an increase while the red indicate a decrease from the previous year.
As you can see, PETS has virtually no long-term debt that threatens the firms solvency. The company has no reported off-balance sheet obligations. It’s a simple business as sales and deliveries are made out of its Pompana Beach, Fla., where inventory is stored and orders are processed and then delivered via UPS, USPS and FedEx. Thus, about 100% of the orders are processed instantly.
Profitability Ratios & Valuation Multiples
As you can see, PETS is trading at low ratios when compared to previous years. This is mainly due to a tough 2011. Keep in mind this is a company that prior to this year had a five-year sales CAGR of 11% and five-year EPS CAGR of 13%. Yet, despite the down year, PETS was able to produce $19.6 million in cash from operations. In the previous year, which could be considered a more normal year, PETS produced $30 million, 99% of its considered free cash flow since it doesn’t spend much money on capital expenditures. Will the company return to a more normal period? In my opinion yes. The company is trying to increase its position as the number one pet pharmacy and is investing in its brand. It’s also moving into the generic arena to compete against online competition who only wants to compete on price and not in brand recognition and customer service. PETS also has room to grow in prescription sales, which the company has focused on in the past couple of years.
I’m not a big fan of discounted cash flows. Rather, I focus on the assumptions of a stock and rely on earnings yield as defined in Joel Greenblatt’s "The Little Book That Beats The Market." In addition, I’m a big fan of using a a cash flow yield.
“Invert, always invert”- Charlie Munger
As of today’s price (see image below), the market is implying the company will decrease FCF by 5% per year. This scenario is highly unlikely and the market is implying unrealistic expectations.
PETS also offers a nice 5% dividend yield and has $70 million in cash, or roughly $3.
Earnings Yield: 19.3%
FCF Yield: 9.2%
EV/EBITDA (TM): 5.3
Finally, management does have a share repurchase program which it initiated in 2006, in which it was authorized to purchase $20.6 million in stock. That plan was further extended in 2008 and 2010 to repurchase an additional $40 million ($20 million in each year). During fiscal 2011 the company repurchased approximately 791,000 shares of its outstanding common stock for approximately $12.2 million, averaging approximately $15.47 per share. In March 31, 2011, the company repurchased approximately 695,000 of its own shares for approximately $9.0 million, bringing its cost basis to $13.56 per share. The company is still authorized to purchase $8.7 million worth of shares and I highly recommend the company do so at these levels.
Disclosure: None; I do not plan to purchase PETS in the next 72 hrs.