WOOF - Petco Health and Wellness Company: I Still Think The Near Term Is Going To Be Weak

2024-01-04 04:48:10 ET

Summary

• Petco Health and Wellness Company's business performance outlook is weak, with declining revenue and gross margin.
• The growth and margin outlook for the company is not attractive, and there is no strong catalyst for growth in the near future.
• The company's value strategy may face stiff competition from major retailers like Walmart, and the macro conditions are not favorable for discretionary spending.

Summary

Readers may find my previous coverage via this link . My previous rating was a hold, as I believed Petco Health and Wellness Company ( WOOF ) was going to see negative near-term performance. I also expected the possibility of WOOF missing guidance if management cut prices more aggressively than expected. I am reiterating my hold rating as I still think the WOOF business performance outlook is weak. The value strategy might turn out well, but I am very concerned about the competitive factor. Also, the macro conditions are not exactly in favor of a discretionary spending turnaround yet.

Financials / Valuation

WOOF's performance for 3Q23 was not as great as expected. Net revenue declined by 0.5% y/y to $1.45 billion, failing to meet consensus estimate of $1.51 billion. Comparable sales deteriorated on a sequential and annual basis as well, declining from 3.2% in 2Q23 and 4.1% in 3Q22 to 0% in 3Q23. Gross margin also decreased by 300 bps to 36.8%, again missing consensus estimate of 38.3%. The same miss against consensus was also seen in the adj. EBIT margin of 1.4% vs. 3.1%.

Based on my view of the business, WOOF is not an attractive investment at this point. The growth outlook remains weak, as does the margin outlook. For FY23, I am adjusting my growth estimates to 1%, reflecting the low-end of management's low-single-digit guided range. For FY24, I don’t see any strong catalyst for growth to accelerate. In fact, based on 3Q23 performance (comparable sales growth of 0%), I think there is a good chance for 1H24 to continue seeing weakness, especially with consumers staying conservative for the near term until they start to spend more on discretionary products again. I am also using management’s FY23 EBITDA guidance for my model and expect the same margin for FY24. Unlike my previous post, where I valued WOOF at 8x forward EBITDA, I believe the situation is much worse than before, and as such, it deserves to trade at a lower multiple, which the market has already incorporated (the WOOF multiple went down from 8x to 5.9x).

While my model points to an upside of 10% for the risk profile (potential missing guidance and weak performance outlook), I think a 10% upside is not attractive at all. Hence, I am reiterating my hold rating.

Comments

I believe the results were evident that WOOF is still in very bad shape, one that I do not expect to recover anytime soon. Take the comparable sales performance, for instance. It was the first time comparable sales dropped to a near-negative region since 2019. The weakness was driven by continued discretionary demand headwinds and increased value-seeking behavior from consumers. Some bullish investors might argue that this is a one-quarter thing. However, if we look at this from a 2/3/4-year stack, comparable sales growth has been declining for the past 2 quarters already. The impact of weak comparable sales had further implications. The underlying softer discretionary demand also led to gross margin compression. For context, pre-covid, more than 40% of WOOF sales came from pet supplies and companion animals. In FY23, this category only makes up about 1/3 of revenue. This decline has huge implications for margins, as discretionary goods have higher gross margins.

Looking ahead, I take management guidance as a clear sign that WOOF is not going to see any turnaround in the near term. Specifically, management lowered their FY23 adj EBITDA and adj EPS guidance but maintained their prior sales guidance. What this implies for 4Q23 is that sales growth will come in the low-single-digit range.

My opinion is that the low-single-digit range 4Q23 growth guide might be tough to achieve as well, given that the management guide is based on current trends. Two things come to mind:

1. The macro situation clearly has not recovered to such an extent that consumers are flipping on their discretionary spending mode.
2. The management value strategy might not work out as well as it seems.

On the macro situation, I think it is positive that the Fed is signaling to cut rates, but this does not mean that the worst is over. I expect consumers to stay conservative in the near term in terms of discretionary spending. On the value strategy, I will start with the bull-case narrative. The positive side of things is that even though the company's decision to boost their value brand mix will probably cut into their profit margins, WOOF could attract more customers who are focused on value. If this happens, they could spend more money on grooming and vet services as new and returning customers combine their trips. In addition, 50% of WOOF's service users don't buy food from WOOF right now, but with a better value proposition, WOOF can win over more of these customers and grow their business. Although a more extensive product line might attract more customers, it would also put WOOF in direct rivalry with supermarkets and mass grocery retailers, many of which are located near consumers. The most prominent player that comes to mind immediately is Walmart. Given that these customers are value customers, they are more price-sensitive than brand-sensitive. Also, given that these valued customers have been going to the same place (e.g., Walmart) to get their pet products, WOOF would need to invest a lot in marketing to attract traffic, which could further hurt its gross margin if more promotions are required. I understand this is an obvious point, but I like to highlight that more than 90% of the US population resides within 10 miles of a Walmart store, and Walmart has ~3x more Walmart stores than WOOF. Note that I am only talking about Walmart because it is the most prominent player; if we include all the other players like Kroger, Costco, and others, the competition is huge.

Risk & conclusion

The risk to my hold rating is that I could be entirely wrong about how successful WOOF is in its value strategy. They could be a huge bunch of customers that are unhappy with products from the typical supermarkets and are willing to try a new brand for a similar price. WOOF could also benefit from the initial launch of this strategy as customers give WOOF a chance. The macro backdrop could also improve faster than I expected, driving a strong recovery in spending for discretionary goods.

To summarize, my hold rating on WOOF remains unchanged as I anticipate near-term performance to remain weak. I believe management lowered guidance indicates that near-term recovery is unlikely. My two major concerns come from the sustained weak consumer discretionary spending and how successful is WOOF's value-centric strategy which is going to see stiff competition from major retailers like Walmart.

For further details see: