PETS - PetMed Express: Short Puts Make Much More Sense

Summary

• I think results this quarter were less bad than they were in Q2, but the company is still struggling. The dividend is well covered, though.
• I would want to see the shares trading at a pretty steep discount given what's going on, and the shares are priced richly in my view.
• Thankfully, the options market is offering a decent way to make what I consider to be very acceptable risk adjusted returns here.

It's been about 5 ½ months since I wrote my "avoid the stock but sell the put" article on PetMed Express, Inc. ( PETS ) stock, and in that time the shares have returned a loss of 8.3% against a loss of 2.4% for the S&P 500. The company has just reported financials, and market seems to disapprove, given that the stock is down 5.2% this morning. I want to review these financials because a stock since, and I want to review those. Additionally, a stock trading at $19.40 is, by definition, a less risky investment than one that's trading at $21.40. I'll decide whether or not to buy the stock by looking at these financial results and comparing them to the valuation here. Also, the puts that I recommended in that article have just expired worthless, which was gratifying enough, but it means that I need to do some more work and try to understand whether or not it makes sense to finally buy the stock, write more puts, or stay on the sidelines.

Welcome to the ubiquitous "thesis statement" portion of the article, dear readers. It's here where I give you the highlights of my thinking so that you won't need to read all 1,900 words unless you really want to do that to yourself. You're welcome. Although I'm hopeful for the future, the financial results have been mediocre in my view. They're not as bad as they were in the 2nd quarter in my view, but they were troubled. As a result, the valuation is even more stretched, and the dividend yield is even lower. For that reason, I'll remain on the sidelines. That written, I will be selling puts on this name today as the premia on offer is quite good for deep out of the money puts in my view. This trade worked out well in the past. I earned $.75 selling puts, and I prefer that outcome to what could have been a $2 per share loss. Today I'll be selling the same strike for about $.80.

Financial Snapshot

I'd say the most recent financial results were not great. Compared to the same period in 2021, the first nine months of 2022 have been rather soft. Revenue was down by about 6.25%, and gross profit was down by about 8.6%. Results were lower when compared to the same period in 2019, with revenue and gross profit in 2022 off by 7.33%, and 9.95%, respectively. That's bad, but it really gets bad when you compare net income during the most recent period to the same time in 2021. In spite of a slowdown in revenue, the company boosted G&A expenses by $7.9 million, or 35.4%. That was a significant driver in the $9.7 million decline in net income from last year to this. The same picture emerges when we compare the most recent results to the pre-pandemic era. Net income in 2022 was about 72% lower than it was in 2019.

At the same time, the capital structure has deteriorated somewhat. I'm less concerned about this, because it is still very strong, but I am in the mood to note it, so I will note it. Total liabilities have crept up by $4 million, or 14.5%. Admittedly, the company still has cash on the balance sheet that represents over 3.25 times total liabilities, but the trend has not been great in my estimation.

Given the enormous cash hoard, I have not changed the view expressed in my earlier article that the dividend is well covered here. It has grown nicely over the past 12 ½ years, and, given the cash hoard, I don't think there's risk of a cut here anytime soon. Additionally, the company does compete in a colossus of a market, so I think there is opportunity for them to start to grow again. I think is especially the case given the recently announced acquisition of PetCareRx. Given the above, I'd be very happy to buy at the right price.

The Stock

If you read my stuff regularly you know what time it is. It's the time where I turn into a bit of a financial "mall cop," where I remind everyone that a company is distinct from its stock. The company sells Pet medications at a profit. The stock, on the other hand, is a piece of paper that gets traded around in a public market and is influenced by a great many factors, many of which are only peripherally related to the underlying business. While the stock price has been very negatively impacted by yesterday's financial results, it's also impacted by the crowd's ever-changing views about the company's future financial performance. Someone may fret, for instance, about the possibility of a slowing dividend, which may impact the price of the stock quite significantly. The stock price also is potentially impacted by the crowd's ever-changing perspectives on the relative merits of "stocks" as an asset class. To use PetMed as an example, some portion of the loss seen since I last reviewed the name may be a function of the fact that the S&P 500 itself is down since. Admittedly, this is a counterfactual argument, but I think a reasonable case could be made to suggest that when the market turns sour on stocks, people throw out financial babies with the indices bathwater. While this is tiresome, it's potentially profitable. If we can spot the discrepancies between the crowd's take on a given business, and the assumptions embedded in the price, we can earn a profit.

Finally, I should point out that I've found that cheaper stocks offer a higher risk-adjusted return, so I like to buy shares when I consider them to be cheap and eschew them when they get expensive. If you're one of my regular readers you know that I measure the cheapness (or not) of a stock in a few ways, ranging from the simple to the more complex. On the simple side, I look at the ratio of price to some measure of economic value like sales, earnings, free cash flow, and the like. Ideally, I want to see a stock trading at a discount to both its own history and the overall market. In my previous missive on PetMed, I characterized my take on their valuation onomatopoeically as "meh." For example, the shares were trading at a price to earnings ratio of about 22, and the dividend yield was 5.65% at the time. The shares are now about 15% more expensive as a result of the drop in price, and the dividend yield is about 19.5% lower, per the following:

I must tell you, dear readers, that I don't adore the idea of paying more and getting less.

My regulars know that I think ratios can be instructive, but I also want to try to work out what the market is "thinking" about a given investment. If you read my stuff regularly, you know that the way I do this is by turning to the work of Professor Stephen Penman and his book "Accounting for Value." In this book, Penman walks investors through how they can apply some pretty basic math to a standard finance formula in order to work out what the market is "thinking" about a given company's future growth. This involves isolating the "g" (growth) variable in this formula. In case you find Penman's writing a bit opaque, you might want to try "Expectations Investing" by Mauboussin and Rappaport. These two have also introduced the idea of using the stock price itself as a source of information, and we can infer what the market is currently "expecting" about the future. Applying this approach to PetMed at the moment suggests the market is assuming that this company will grow earnings at a rate of ~8% in perpetuity. I consider that to be a very optimistic forecast for any company, even one with a recent growth profile like this.

Given all of the above, I'm going to continue to avoid this name. The shares are cheaper in price now, but the fact is that the company seems to have some challenges growing. I want to see some evidence of ongoing profitability before buying aggressively.

Options As Alternative

In my previous missive on this name, I recommend eschewing the shares just like I am today, but I was comfortable owning the stock at the right price. Specifically, I was, and am, comfortable owning this stock at $15 per share, so I sold 10 of the January 2023 puts with a strike of $15 for $.75 each. I like this sort of trade because it is a "win-win" in my estimation. If the shares crashed below $15 from $22, I'd be the proud owner of a reasonably good company at a very good price. Since the shares remained above $15, I simply collected the premia which also was not a hardship.

I like to try to repeat success when I can, and for that reason, I'll be selling puts again this morning. Specifically, I like the September PetMed puts with a strike of $15, which are currently bid at $.80. So, one of two things can happen over the next eight months. Either the shares will be "put" to me at a net price of $14.20, or I'll collect even more options premia. Note that holding all else constant, if the shares are put to me, that would represent a very well covered dividend yield of 8.45%. So, I'll either earn another $.80 per share, or I'll lock in a very nice dividend yield. This is why I consider this trade to be a "win-win."

It's time, once again, to write about risk. It's all well and good for a stranger on the internet to write about "win-win" trades, but if you're going to trade these, you need to be made aware of the fact that this investment, like all investments, comes with risk. I consider the risks associated with these instruments to fall into two broad categories: the economic and the emotional.

Starting with the economic risks, I'd say that the short puts I advocate are a small subset of the total number of put options out there. I'm only ever willing to sell puts on companies I'd be willing to buy, and at prices I'd be willing to pay. So, I would never advocate that people simply sell puts either "willy" or "nilly" with the highest premia. In my view, that strategy would lead to disastrous results. So my first bit of advice is to only ever sell puts on companies you want to own at (strike) prices you'd be willing to pay. Take my word on this one, as it's informed by painful history.

The two other risks associated with my short puts strategy are both emotional in nature. The first involves the emotional pain some people feel from missing out on upside. To use this trade as an example, let's assume that PetMed stock price goes parabolic and hits $50 per share between now and the third Friday of September. Obviously my puts will expire worthless, which is a great outcome in some ways. I will not catch any of the upside in the stock price, though. So, short put returns are capped by the premium received. This may be emotionally painful, but my attitude is that if the shares are a bit rich at $19, they'd likely be destined for a fall at $50, so no harm, no foul.

Secondly, it can be emotionally painful when the shares crash below your strike price. So far, whenever this has happened to me, things have worked out well over the long term, because I insist on only ever writing puts at "screaming buy" strike prices. That said, it has been emotionally stressful in the short term on occasion. If you're going to sell puts, please be aware of this phenomenon.

If you understand these risks, and can tolerate them, I would recommend that you sell puts. For my part, I'm going to replace the puts that expired last month with this new crop of $15 strike prices. If you're comfortable with selling puts, I think they offer the best risk adjusted returns at this point.

For further details see: