A Dog of a Stock?

Blog Hog, Jonathan V. Last, e-mailed me a thesis. Once you work through the home-buying frustration, with which I sympathize fully, you get to today's stock analysis inspiration:

Economic circumstances in most of urban America are such that one of two things must happen:

1) The housing market will collapse in a significant and catastrophic way, or

2) Over the next 20 years there will be a major downward revision in the standards of American middle-class living.

The cost of real estate has become such that a normal, middle-class couple just starting out cannot purchase a single-family home in most major metro areas in America. To do even this requires two incomes. Where a single-income family was the norm two generations ago, and was increasingly rare in our generation, it will become all but non-existent in the metropolitan middle class if current trends continue.

So if the housing market is not a bubble--if it does not collapse--we're going to see the middle-class family standard changing to mean condominium instead of single-family home; 90 minute commute instead of 30 minute commute as the standard; and fewer children with the total extinction of stay-at-home moms.

What does this mean for the Pig? Look for stocks that fit with the new standards of middle class. One of those is pets, since I suspect that pets will take the place of children, since middle class families will no longer be able to afford children. I'd be very high on pet stocks.

JVL was thinking about 1-800-PetMeds, or PETS, when he sent me these thoughts. I have no idea if the housing market is a bursting bubble, or if we've established a higher price floor for urban housing. But I can evaulate some stocks. I will regale you, the reader, with the fruits of my research.

PETS is trading at about $13.40, with a 52-week range of $5.25-$14.00. The company description from MarketWatch:

Petmed Express, Inc.. The Group's principal activity is to market prescription and non- prescription pet medications, health and nutritional supplements and accessories at discounted prices through the Pet Med Express catalog, customer service representatives and on the Internet. The Group offers broad variety of products for dogs and cats.

PETS the stock has done quite well this year, up 75% during 2005 and up 125% over the last 52 weeks. However, I found mixed opinions from various analysts.
Jim Cramer disagrees with JVL's thesis. From the recap of Mad Money from 9/7/05:

PetMed Express (PETS:Nasdaq - news - research - Cramer's Take): "This pet market has been not so hot. ... I am not a fan. If you need to be in the pet business somehow, go buy a dog."

Another analyst has a positive outlook on PETS. At least it was positive a month ago, when Ladenburg Thalmann issued this press release. Since then, PETS has hit the $14 price target, then pulled back slightly.

NEW YORK, Oct 13, 2005 /PRNewswire via COMTEX/ -- Ladenburg Thalmann announced today that it has initiated coverage of PetMed Express, Inc. (PETS) with an initial Buy rating and a price target of $14 over the next 12-15 months. For a full text of the report please call (212) 409-2028.

PetMed Express ("PetMed"), the largest pet pharmacy in the U.S., sells well-known prescription and non-prescription medications and health care products for dogs, cats and horses through its internet website, catalogs and 1-800 call center.

The analyst, Ethel V. Hill, believes that PetMed is the market leader in the profitable pet pharmacy segment of the growing pet supply industry. Favorable trends of increasing pet ownership and increased spending per pet, which drove 5.9% growth in 2004 in the $34 billion supply industry, are expected to continue.

"PetMed Express holds a major share of the internet/catalog pet pharmacy segment and is the only public company in the space," said Hill. "We believe PetMed can leverage its market leadership and successful business model to double its current size in four or five years -- primarily through organic growth."

According to MarketWatch.com on November 7, 2005, Sidoti and Company set a higher price target of $15, but cut PETS to a lower rating of Neutral. (You must check out their embarassingly amateurish website.)

Here are excerpts from a cutesy stock spotlight piece on PETS from SmartMoney.com:

The company's customer base is approaching two million. Its trailing 12-month sales total $117 million — mere Kibbles n' Bits next to PetSmart's $3.6 billion and Petco's $1.9 billion. But its operating margin of more than 12% handily tops PetSmart's 9% and Petco's 8%. Operating margin has been on the rise recently for PetMed, as its larger size has created more scale over its administrative and marketing spending.

Fiscal second-quarter results for the company showed sales increasing 34% year-over-year as earnings jumped 50%. Earnings per share of 11 cents topped Wall Street estimates by a penny. Customer acquisition costs — always a concern for young, less-known companies as they pay up to bring in business — fell for the fourth straight quarter, to $34 from $37 a year ago. Analysts say word-of-mouth marketing is likely helping. Gross margin declined to 38.4% from a year-earlier 40.4% on an increased contribution from wholesale business, higher freight costs and more aggressive pricing. But operating margin expanded to 10.3% from 9.9%.

"This price strategy is obviously driving faster than expected adoption of this disruptive online model — don't change a thing!" gushed Avondale Partners analyst Frank Gristina in a Tuesday research note. He thinks shares could fetch $15 a share within a year, or about 30 times his next-12-months earnings estimate of 53 cents. Gristina notes that the company has plenty of potential for organic growth and margin expansion, citing its anticipated roll-out of private-label merchandise as one example. He also points out that PetMed's products are more necessary than many of those sold at other pet stores (faux mink coats for cats come to mind), making them less responsive to rising gas prices, and that they're cheaper than those sold by veterinarians. (Gristina doesn't own shares of PetMed; Avondale Partners doesn't have an investment-banking relationship with the company.)

For such a fast-growing company, PetMed's valuation strikes us as modest, and then some. The stock trades at 25 times forecasted earnings for fiscal 2006 (ends March 31). And analysts figure the company will boost its earnings by 35% annually over the next five years. That gives the stock a price/earnings-to-growth, or PEG, ratio of just 0.7, vs. 1.0 for PetSmart, 0.8 for Petco and 1.5 for the broader market. The whole group looks fairly cheap right now, come to think of it, but PetMed might be the most promising pick of the litter.

Now it's time for some numbers. Numbers alone tell us very little, unless we throw in the competition's numbers. Data is from SmartMoney.com and Morningstar.com.

Name - Ticker - ROE - ROA - ROIC - PEG - FCF
PetMed Express - PETS - 41.8% - 35.00% - 41.80% - na -
('00-'05 + TTM) (.9), (1.3), (.1), .2, .4, 8.2, 14.4
PetCo - PETC - 56.80% - 12.50% - 23.82% - .87 -
('02 - '05 + TTM) 23.5, 77.3, 61.1, 52.8, 40.8
PETsMART - PETM - 19.20% - 10.80% - 15.18% - 1.15 -
('01 - '05 + TTM) 65.8, 84.9, 59.1, 74.2, 139.5, 171.4

PETS is a small-cap growth stock, and it shows in its gaudy ROA and ROIC. It's also apparent in the turnaround in free cash flow, from small negatives to substantial positive gains, as a percentage.

PETC has an attractive PEG below 1, and its ROIC is better than PETM's. PETC has declining free cash flow over the past four years. YTD, the stock is down 46%.

PETM has the weakest return numbers of the three, but has very attractive free cash flow growth. YTD, PETM is down 30%.

Do we just listen to Cramer and buy a dog? Or if we invest in one of these three stocks, will we still by buying a dog?

The price of PETS has run up nicely based on strong numbers and investor interest. PETC and PETM as stocks have performed terribly this year, but now could be considered cheap. The value investor in me would favor PETM and its steadily increasing free cash flow.

These three stocks are going into the doghouse, where we can keep an eye on them.