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Stocks that profit from pampered pets
The $36 billion Americans will spend on Fido and Fluffy this year should make investors sit up and take notice. Companies like Petco and PetSmart are likely to shine.
By Michael Brush
The gifts are as quirky as they are extravagant.
- Gucci goat-hair dog beds. Price: $2,195.
- Louis Vuitton pet carrier: $1,470.
- Petapotty (a doormat-size container of real grass for dogs to use): $279.99.
They're part of what the pet industry is calling the humanization of pets. And that odd trend is one result of young professionals substituting cats and dogs for kids and empty nesters replacing their grown-up offspring.
As pets become more significant extended family members in many households, people are giving them a more important role in their lives, says Bob Vetere, managing director of the American Pet Products Manufacturers Association (APPMA). They are regarding them in human terms. And since human rewards cost more than dirty tennis balls, they end of spending more on their pets.
And it's not just well-heeled pet owners on a spending spree. Many new items are cheaper, if no less bizarre: Nail Pawlish for dogs from OPI Products (in green, blue, pink, purple and silver for $9.95), dog colognes at less than $10 a bottle, and a DVD for cats called Kitty Goes Hunting, featuring mouth-watering footage of mice and chirping birds.
Related news and commentary on MSN Money
The APPMA estimates close to 154 million pet owners in America will spend $35.9 billion on their pets this year, about twice what they spent in 1994. Thats more than U.S. families spend on toys for their children.
Pet owners will shell out $14.5 billion for food, $8.8 billion for supplies and medication, and $8.6 billion for veterinarian care. Last year, households spent an average of $1,571 on their canine companions alone. Over 80% of dog owners buy at least one gift for their dog (average cost: $13 per gift).
Petrol's role in pet-shop profits
Experts like Vetere believe spending on Fido and Fluffy will continue to grow at 5% to 6% a year for the next several years -- a respectable rate for a subset of the retail sector.
Fortunately for investors who might want to profit from profligate pet spending, the stocks of the two main publicly traded pet-care retailers suffered some damage after reporting two weak quarters in a row. The companies blame the weakness on high gas prices. In other words, their core businesses are fine, and profits will pick up again if gas prices continue to fall.
We saw people consolidating trips, says Rodney Carter, the finance chief at Petco Animal Supplies (PETC, news, msgs). Instead of buying a 20-pound bag of dog food, they bought a 40-pound bag. So we had fewer opportunities to sell that impulse item. This led to weaker sales growth and then markdowns, which hurt margins. Competitor PetSmart (PETM, news, msgs) noticed a similar cutback in the number of trips to the pet store.
Both stocks fell 25% to 30% from their highs of the summer as Wall Street analysts cut ratings and estimates. But Morningstar analyst John Owens thinks thats just shortsighted. He cites three factors that will help these stocks recover in the medium term, which well get to in a moment.
The stocks have rebounded a bit already, thanks to falling gas prices. The sector seems to be recovering very nicely, says Vetere. I am hearing about a lot very positive Christmas sales numbers. Carter, the finance chief at Petco said last week that he was "comfortable now with what we see in the fourth quarter."
Here are the three reasons Morningstar thinks these stocks should continue to get a lift, at least in the medium term.
Pet lovers will continue to spend. After all, people arent going to stop loving their pets overnight. Before the second quarter, Petco had delivered an enviable record of 49 consecutive quarters of 4.6% or greater comparable-revenue growth, says Owens. He thinks regular growth like that will come back. We dont think we should write off their long-term track record just because theyve had a couple of bad quarters, he says.
PetSmart and Petco are consolidating the sector. Though both are sizable chains -- with nearly 760 stores each -- they still control only 15% of the market. That leaves plenty of room to expand and grab share from smaller operators.
PetSmart, which has bigger stores located near malls, plans to double in size to 1,400 stores -- including 100 new stores this year. Petco, which has smaller stores usually in strip mall shopping centers, plans to grow by 10% a year for many years. It will add about 70 stores this year.
Pet services are growing. Each chain offers its own assortment of pet services, ranging from clipping and grooming to doggie day camps and boarding. PetSmart has veterinarians in more than half of its stores.
These services draw pet owners who buy more stuff while dropping off their dogs. The services also create customer bonds with the stores. Services have a healthy 20% annual revenue growth. But services are still a small piece of the business -- about 5% to 7% of overall sales.
Of these two pet-store chains, Owens favors PetSmart because it has a stronger balance sheet and more sales per square foot -- in part because PetSmart's stores carry more items. Its also more focused on the rapidly-growing services component of this business.
Blame Wal-Mart, again
It wouldn't be retail if Wal-Mart Stores (WMT, news, msgs) wasn't a threat, but the pet stores do have some defenses against the Bentonville, Ark., behemoth. The service component is one. Wal-Mart is unlikely to start letting pets in stores for grooming and care. The pet stores also offer a huge variety of pet products. PetSmart superstores stock more than 12,900 items, something Wal-Mart wont try to replicate.
In dog chow, Wal-Mart will likely focus on high-volume discount fare, leaving the premium niche brands like Science Diet, Nature's Recipe and Eukanuba alone. Clearly if we were just in the commodity business, trying to compete with an engine as powerful as Wal-Mart would be pretty tough, says Petcos Carter.
He also thinks customer service will give his chain an edge, as pet owners prefer to deal with sales associates who know more about pet needs. There is a degree of empathy and expertise that cannot be replicated, says Carter.
Sick puppies
Pet owners are dialing up spending on sophisticated medical treatments for pets. Chemotherapy, cosmetic dentistry and back surgery are becoming commonplace, and the procedures can cost anywhere from $1,000 to $2,500.
But the real growth in pet health care is in routine care and basic testing, says Tomas Fuller, finance chief at VCA Antech (WOOF, news, msgs), a company that runs 365 veterinary hospitals and 30 diagnostic labs around the country. We use early detection for preventative medicine in humans, and that is transferring over to pets, too, he says.
VCA Antech gets about two-thirds of its revenue from its hospitals. But the labs bring in half the operating income, since they have higher margins. The company is growing through a combination of more tests being ordered up by vets, higher prices and its acquisition of hospitals.
Morningstar analyst Debbie Wang likes the underlying trends at VCA Antech and IDEXX Laboratories (IDXX, news, msgs), another player in the pet-diagnostics arena.
But their stocks havent suffered the damage sustained by the pet store chains this year. So unlike many of the gifts pet lovers will be buying in the next few weeks, these stocks are a little too pricey to touch for now, she says.
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