As the bull market continues, I am becoming more defensive. In the "Intelligent Investor," Benjamin Graham said, “The defensive investor must confine himself to the shares of important companies with a long record of profitable operations and in strong financial condition.” I used GuruFocus’ All-In-One Guru Screener to find a defensive stock in order to add a more defensive position.
Business Predictability: Minimum of 5 out of 5 stars
Financial Strength: Minimum of 7 out of 10
Warnings Signs: Maximum of 0
P/E: Maximum of 17
Beta: Maximum of 1.0
Dividend Yield: Minimum of 0.10%
High business predictability indicates that the company has a strong history of producing operating profits. These companies have not had an operating profit loss in the past 10 years. 5-star stocks have had an annual average return of 12.1 percent over the past 10 years. Only 3 percent have had a loss if held for 10 years. The criteria for warnings signs can be related to both the financial statements and issues with the characteristics of the stock.
The strong financial and predictability criteria resulted in 29 stocks. I wanted to narrow down the results because the screen did not include valuation. The stock’s price can be disconnected from the company even if it is strong financially. I chose to screen for a P/E of 17 or less in order to find stocks that were not trading with higher valuations than the S&P 500. The beta of 1 is to find stocks that were less volatile than the S&P 500. The dividend yield is to help provide support for the stock if the overall markets are in a downturn. When running the screen, PetSmart (PETM) was the last stock standing. Let’s see what makes it the best defensive stock.
PetSmart’s strategy is to become the preferred provider for the lifetime needs of pets. They provide a broad range of competitively priced pet products and in-store services including pet adoption, boarding, grooming, and training. Expert veterinarian care is available in more than 60 percent of the stores where Banfield Pet Hospital operates full service pet hospitals. PetSmart holds a 20.5 percent equity interest in Medical Management International Inc., the operator of Banfield Pet Hospital. At the end of 2013 PetSmart had 1,333 stores in the U.S., Puerto Rico and Canada.
Their most valuable customers buy channel-exclusive foods, use grooming services, and are new pet parents of dogs, cats and fish. In my own experience their strategy has mostly worked. They are a very convenient one-stop shop for everything. As a new pet owner, they made everything very easy. The puppy training was great for my goldendoodle, and the trainers were great at recommending the appropriate food and treats. Banfield offered a wellness plan that covered a majority of the costs of checkups, shots, and neutering. It offers a large savings for the first year, but I am still deciding whether it is cost effective to keep the insurance after the first year. I am not the perfect valued customer since I do not use their grooming services or boarding, but they have achieved the emotional connection to the store. It became one of my dog’s favorite places to go, even when taking him to the vet. Unless I move far away from a PetSmart store, I’ll be a lifetime customer since it is a destination for my pet and their food is priced in line with the prices available at Amazon.com. As far as their direct competitors, Petco and Pet Supplies Plus do not provide the full suite of services that help reinforce the connection to the store.
| Sales Penetration | |||||
| Â | 2009 | 2010 | 2011 | 2012 | 2013 |
| Merchandise | 89.2% | 88.5% | 88.4% | 88.5% | 88.1% |
| Service | 10.8% | 10.9% | 11.0% | 11.0% | 11.4% |
| MMI | 0.0% | 0.6% | 0.6% | 0.6% | 0.6% |
Even if I do not use their other services, their strategy has worked since 54 percent of their sales come from pet food. They have been able to keep their food competitively priced while increasing their margins every year for the past four years. Services only account for about 11.5 percent of their revenue. It seems to be a way to create the overall experience to keep the customer coming back to buy more merchandise.
When looking at the company’s financial statements, it’s as steady as it gets. Its revenue chart is almost a straight line growing over 12 percent per year.
PETM data by GuruFocus.com
PetSmart’s consistent revenue and earnings growth helps give it our highest ranking of five stars for business predictability. The company also receives a score of 9/10 for profitability and growth. Its earnings have been growing at a rate of 14.8 percent over the past 10 years and grew 13.2 percent over the past 12 months.
When it comes to financial strength, PetSmart scores an 8/10. The company has $286 million in cash compared with $452 million long-term debt. The debt-to-equity level of 0.47 is better than its industry average of 0.6. The company’s debt is very manageable with enough operating earnings to cover its interest payments 13.4 times. It also has a high current ratio of 1.7 compared to the industry average of 1.1. The company has also been buying back shares every year for at least the past ten years, and the buybacks have helped increase their return on equity (ROE). The number of outstanding shares has been reduced by about 40 percent over the 10-year period, about 4 percent per year on average. The current ROE is at a high level of 38.35 percent.
PetSmart is held by 9 gurus we follow, including Ken Fisher, Steven Cohen, and Joel Greenblatt. Joel Greenblatt (Trades, Portfolio) is known for his magic formula investing based on return on capital and earnings yield. The return on capital for PetSmart is 55.11 percent and earnings yield is 10 percent based on Greenblatt’s version of EBIT / Enterprise Value.
The company also has an F-Score of 8 out of 9. The scoring system is based on the categories of profitability, funding, and efficiency. Joseph D. Piotroski developed the system. He earned a Ph.D. in accounting from the University of Michigan and is currently an associate professor of accounting at the Stanford University Graduate School of Business. The system was back-tested over the 20-year period of 1976-1996. He found that stocks with an F-Score of 8 or 9 led to an average out-performance of the market of 13.4 percent. Also interesting is that a strategy of shorting stocks with a score of 0 or 1 led to an average annual return of 23 percent, outperforming the S&P 500’s average annual return of 15.83 percent over the same 10-year period. PetSmart is in an exclusive club of only 9 companies that have an F-Score of 8 or 9 and a business predictability of 5.
The valuation of PetSmart is based on earnings. The company’s earnings have been consistently growing at rates of 14.80 percent over the past 10 years, 27.40 percent over the past 5 years, and 13.20 percent over the past year. The company is still growing and opened 55 new stores and had same-store sales growth of 2.7 percent for 2013. The company is projecting earnings growth of about 11.5 percent for 2014. It is currently trading at a P/E of 16.80. The industry average P/E for specialty retailers is 17.1. With its high predictability and earnings growth along with its strong financial condition, PetSmart should be trading at a premium to its industry. Its median P/E for the past ten years has been 19.7, and is a fair P/E for the company. The stock is undervalued and should revert back to its median P/E giving it a value of $79.30 per share. It is currently trading about 16 percent below its fair value. In the event of a market downturn, its strong revenue stream, consistent earnings, and low volatility will help support the stock price. The main risk is if people stop feeding their pets which is not likely going to happen.
Go to the PetSmart (PETM, Financial) page at GuruFocus to get full details on the stock including guru trades, 10-year financials, and an interactive chart.
