2023-04-13 02:28:47 ET
Summary
- CEO share purchase at book value is positive.
- Company's strategy to compete in the sector is favorable.
- Potential for stock to rise if WACC drops despite unpredictable timeline.
Investment Thesis
Overall, we like the company's strategy to compete in the sector. CEO purchased shares at a price close to its book value is also positive. However, we think the stock is likely to stay sideways given the company is unlikely to improve its margin near-term. A potential drop in WACC can trigger the stock but the timeline is unpredictable. Hence, we rate WOOF stock Neutral.
Company Profile
Petco Health and Wellness Company, Inc. "Petco" (WOOF) was founded in 1965. It is an omni-channel provider of holistic pet health and wellness offerings, including premium products, services, and veterinary care. The company had 25 million active customers, more than 1,500 pet care centers in the U.S., Mexico, and Puerto Rico, and operated 247 full-service veterinary hospitals in 2022.
Key Takeaways from Q42022 Earnings:
- In Q4 2022 , its sales increased by 4.2% to $1577 million, from $1514 million, a similar cadence as a 4% increase in Q3 2022.
- In Q4 2022, its gross margin decreased by 210 bps to 39.8%, from 41.9%, driven by lower sales in non-discretionary items.
- In Q4 2022, its SG&A% decreased by 170 bps to 34.8%, from 36.5%, reflecting cost saving efforts.
- As of the end of Q4 2022, its inventories decreased by 3.4% to $652 million, from $675 million. The company provided the 2023 outlook:
- Its revenues will increase by 2.9%.
- Its adjusted EBITDA remains flat.
- Its CAPEX is slightly down to $225 million to $250 million
Some comments from the management in the earnings call :
Now underneath the businesses, we continue to make operational improvements. If you look at our services business, we grew margin year-over-year. If you look at our digital business, we grew margin year-over-year. That includes a rapid scaling of our ad network. So taking all that in, we're taking a somewhat cautious view and we're focused on executing as we navigate through that environment.
We have 50 to 55 vet hospitals, we’re still committed to that for long-term growth. It's one of our number one priorities in terms of long-term strategic growth. We have 10 to 15 of our small town rural build outs on top of the 50 to 55. So in total, when you think about units, you're still about 70 units roughly if you take that the vets combined with the STRs. And so we feel like the guidance we put out with CapEx, the balanced approach to short-term versus long-term investments is the right approach.
When thinking about our guidance, there are a few things to keep in mind: in light of our expectations of the macro evolution and the transitory softness in the discretionary categories, we anticipate adjusted EBITDA to be down in the first-half with Q1 being a low watermark and flat to up in the second-half. As we start to see normalization and discretionary trends, we expect improvement to the revenue and gross margin trajectory that we are currently anticipating for the year and correspondingly an enhanced EBITDA rate. We saw modest improvements in freight costs in the back half of 2022 and we expect to see further improvements to our freight costs in 2023 as the overhang on freight alleviates, which will be increasingly realized as we progress through the year.
We have the following comments:
- The company continued to grow its consumables and service revenue at a nice double-digit rate offset by its supply revenues declining in high-single digits.
- The company continued to demonstrate discipline in cost-cutting and maintained a similar operating margin as last year.
- The outlook suggests an increase in topline but profits continue to be under pressure.
Company Fundamentals
The company continued to open new vet hospitals and close pet care centers in the past couple of years. Their vet hospitals are located inside their pet care centers. This initiative increased the service revenues at high double-digits over the years and at the same time, it also lifted the consumables revenues through cross-selling.
However, this effort was offset by the decline in its consumable sales. Its comp sales grew by 4.5% and 18.9% in 2022 and 2021 while e-commerce sales grew by 10.5% and 21.1% in the same periods. This suggested a decline in pet center comp sales since service revenues grew nicely.
As the result, the company didn't get much leverage from the sales increase. Its operating margins were under pressure and were supported by cost-cutting efforts.
The company continued to face headwinds in non-discretionary item categories as inflation pressures remained. But this pressure was offset by the resilience of consumable and service segments.
Growth drivers
The management was excited about the service market. The vet hospital's average order value increased by 52% through cross-selling from 2017 to 2021. The vet hospital generated a nice 20% adj. EBITDA margin with 1-year breakeven time. The company is expected to hit a $1 billion revenue milestone by 2025.
Also, the company expected the vet and pet services market to grow at a CAGR of 6% and 15% by 2024 and was a $45 billion market in 2022. The segment was fragmented and provided a great growth opportunity for the company.
We learned that Chewy (CHWY), one of its competitors, currently only offers an online-vet service. Through its hospital, Petco enjoys an advantage in the service sector. Petco aggressively launched new veterinary clinics. In 2022, Petco opened 50 hospitals, and it plans to add another 50–55 in 2023. We believe the company's performance was strong and its value offer was compelling.
The management projected a 500 basis point increase in profit, primarily by utilizing its omni-channel edge to reduce shipping costs. 74% of the company's online orders were picked up in stores, according to the company. Although it hasn't yet been seen in its results, we believe the company's strategic strategy is sound.
Industry
Solid growth supported by increase population
According to the company , the TAM grew at 7% in the last couple of years and will continue to grow in the high single digits in the next couple of years due to the increase in the underlying pet population.
The U.S. pet care industry is large and growing, serving millions of households with pets, and represented a total addressable market of approximately $133 billion in 2022. Since 2008, the industry has exhibited steady growth driven by an increase in the underlying pet population coupled with tailwinds associated with trends in pet humanization and a mix-shift towards premiumization. Due to the essential, repeat nature of pet care, the industry has demonstrated resilience and continued growth across economic cycles, as evidenced by the strong industry performance during the Great Recession from 2008 to 2010.
Strong Competitor in The Sector
Chewy , Inc. is a leading online retailer of pet food and supplies and a competitor to the company. Both Petco and Chewy continued to make significant investments in order to grow. Petco's supply business appeared to be losing market share to Chewy even though the industry was still experiencing a tailwind.
Petco had far lower revenue per active client at roughly $250, while Chewy's number was nearly twice as high as Petco's at $495. It suggested Chewy's customers have greater purchasing power. Additionally, in 2022, Chewy's revenue per active customer metric increased by 15% while Petco's stayed unchanged. Compared to Petco, Chewy's customers were more engaged and loyal.
But in 2022, Petco saw a 4% increase in the number of its active customers, while Chewy saw a 1.2% decline. This was most likely attributed to Petco's advantage in vet clinics.
Valuation
Its valuation multiples are not cheap from a profitability standpoint compared to the sector median.
Over time, its P/B ratio dropped from above 3.0x to 1.0x. Given the limited downside, this offers an appealing entry point.
DCF valuation
We make the following assumptions based on the company's financials and current market conditions:
- The TAM increases to $157 billion in 2033
- The company penetrated the 10% market by 2033
- 20% WACC
- 3% terminal growth rate
- Achieved 7% free cash flow margin by 2033
- Net debt 1473 million (Q4 2022)
- Outstanding shares 273 million (Q4 2022)
Applying the DCF method, we can arrive at an equity value of $586 million ($2.1 per share), which implies an 86% decline from the current stock price.
With the sensitivity test below, we can see that the stock is undervalued only if its WACC drops below 10%.
Catalysts
Significant improvement in margins can be a catalyst for the stock.
- However, the company was still in the expanding phase and faced a headwind in the discretionary spending category. Short term, we think the margin benefits from margins traffic lift and cross-selling effort will be offset by the above negative factors.
WACC drop can be the result of (1) a Fed rate cut or (2) a treasury yield drop as a result of a recession.
- In several of our analyses using the discounted cash flow [DCF] model, such as our report on "Warby Parker Progresses At A Consistent Pace", we have found that certain stocks can benefit from economic recessions. In particular, companies that have shown resilience to economic downturns or are in the early stages of growth may experience a boost in their stock prices, as long as they can sustain their operations. This is because a lower WACC means the costs of capital for these companies are lower. If the company can sustain its operation, the market is comfortable to support the company with funding.
- We believe that the pet care service industry could potentially benefit from a recession, as the underlying pet population is still growing and healthcare and consumables categories are relatively cycle-resilient. Hence, recession or rate cuts can be catalysts for the stock.
CEO bought shares
The CEO acquired 61,000 shares, valued at $500k on Mar 29, 2023. This is considered a positive signal for the stock. We think the current valuation of the stock was majorly constrained by its profitability. The management had provided a convincing value proposition to expand the margin through cross-selling from the service category. Given its leadership position in physical presence, we think the company is likely to execute the plan and improve its profitability long term.
The downside of the stock is protected. The company, though facing a headwind, still can generate positive cash flow and pay down debt over the years. Its shareholder equity increased over the years. We think the P/B ratio at 1.0x provides very solid support for the stock.
Risks
Competition risk
Chewy continued to increase its market share. Chewy is more competitive than Petco in terms of scale, client loyalty, and client purchasing power. Petco's growth prospects and margin potential will be impacted if Chewy chooses to enter the services market.
Also, there are other service providers such as Rover (ROVR) and Wag! Group (PET) to compete with the company. Since the industry is still in the growth phase, the competition risk is moderate at the moment. For investors who are interested in this space, we have a detailed analysis of Rover "Rover: Growth Challenges And Leaves Room To Play."
Summary
Overall, we like the company's strategy to compete in the sector. CEO purchased shares at a price close to its book value is also positive. However, we think the stock is likely to stay sideway given the company is unlikely to improve its margin near term. A potential drop in WACC can trigger the stock but the timeline is unpredictable. Hence, we rate the stock Neutral.
For further details see:
Petco: CEO Is Buying, But It Is A Hold