Description

Note that PETS’ fiscal year ends in March. Also, be forewarned that most web data is notoriously imprecise, so use numbers as directional indicators rather than exact readings. Apologies, the bulk of this work was done last month, but could not be posted until now for a few reasons. Instead of undertaking an update of the whole document, which we found oppressive due to the length, we have made a few notations instead where things have changed. In terms of changes, the share price has moved down since the work originally done, and the web data is obviously fast changing and fluid. Happy to discuss new developments in the messages section. Also of note, our work suggests the recent Tramadol accusations are speculative at best (and probably wrong), even though that would be good for the short case.

Summary

PETS operates 1800petmeds.com, billed as the largest pet pharmacy in America. They are an internet-based pet meds retailer with some legacy telephone/catalog business that is churning off. They sell both OTC products as well as prescription meds.

We’ve been following the PETS situation for almost two years now and believe it is finally time to initiate a short position. While many of the prior short accusations levied against the company around industry structure are perfectly valid — adversarial relationship with manufacturers, grey market sourcing risk, vet pushback, no moat, price-based competition — we believe the only thing that matters is credible web-based competition, which has for the first time arrived in the form of PetSmart.

• PetSmart flipped the switch on their redesigned website on June 30th. The new website prominently displayed a revolving banner ad for their pharma offering and now has a navigation bar in which pharmacy is a new category (and entirely new section of their website).

• The website change itself is not a big deal, except that PetSmart also blitzed a sophisticated web marketing campaign starting around the end of July that we believe will devastate PETS traffic and conversion.

• PetSmart’s pharmacy push is sophisticated and likely to capture a large share of the high ROI sales PETS has been exploiting. As a primarily search-driven enterprise, PETS will have the choice of either seeing their growth slow/reverse or adjusting their discounting with resultant margin impacts. Marketing cost efficiency will also worsen over time and pressure their margins.

Driven by temporary earnings beats and aided by technical factors, the stock market has credited PETS with a valuation that implies high double digit growth with fat margins into a wide-open eCommerce market. Oddly, Street expectations imply 5% revenue CAGR and 10% EPS CAGR for a company trading at ~30x P/E and 3-4x sales. While these numbers on the surface appear achievable, even beatable, in a modeled upside case, such forecasts don’t come close to justifying the valuation. Once it becomes clear (again) that PETS is at best a single-digit growth company with no pricing power, we see 50% - 75% downside inside of one year. PETS’ market is just a profit pool that is too ripe for the picking, and the major competitors, of which there are many, will absolutely not let PETS own this space alone.

How Did PETS Beat Earnings?

PETS crushed revenue and earnings expectations the past two quarters after years of mediocre performance, sending the stock into the stratosphere: ~30x 2019 P/E and ~3-4x 2019 EV/sales. Investors can’t get enough of pets and eCommerce. Like crack, this combination is impossible to resist even when Wall Street has been unwilling to pin large growth numbers on their forecasts.

As we checked into recent performance drivers, it became clear that the ASP leap and the margin shift from ~30% GM to ~35% are primarily due to a few key prescription flea & tick products, which are both higher ASP and higher margin. The CEO said as much on the recent conference calls, calling out “next generation” medicine as the key drivers of top line.

Comparing prices on new meds, particularly prescription meds, to old meds (many of which are OTC) on equivalent treatment regimes, it is immediately obvious that they are far more profitable, costing 50+% more than the prior generation treatment for the same regime. Incremental efficacy seems to be debated in the community, but the convenience factor of chewables vs. topicals, for example, is not in doubt. Not surprisingly, animal health is a HSD/LDD revenue growth driver for Zoetis, Merck and friends, and management commentary confirms growth in many of the products we will discuss below.

First off, for PETS to do well, not only do vets need to prescribe these new products (which they are doing in droves, because, why not, when it generates fatter margins?), but a growing % of consumers also need to shaft their vets by asking for a prescription and going online to buy their drug supply. Search traffic trends bear out that this is happening (2 year data below). These terms were selected for being prescription with low SEM competition and high PETS paid search placement, but there are others.

Relatively, Bravecto, Nexgard and Apoquel far outpace other medicines in terms of search frequency and growth. This is also true when comparing search trends vs. OTC. Thus, it is no surprise that in May, Bravecto and Nexgard ranked in the top five organic and/or paid keyword search traffic drivers to PETS’ website. May (flea season) and August data both shown below, source: Similarweb.com.

Per Similarweb, search dominates PETS web traffic sources at 65% vs. 18% direct (ie. typing in their website URL). Social media, referrals and other web traffic represent the rest of web traffic at 17%, and so search should be a decent proxy for marketing effectiveness. Notably, PETS usually shows up as the #1 spot paid search advertiser in any Google search for the key prescription products, as well as numerous other keywords related to pet medications. It also fills most of the top picture ad spots. Curiously, it also showed up as the #1 organic web result at one time for Bravecto and Nexgard (no longer, but still top 3).

Note PETS highlights in SEC filings that ~17% of sales come from non-internet sources. While it is hard to track other sales channels (telephone, catalog, apps, etc.), management is clear there is no spending on telephone/catalog and these customers are churning off slowly. The company is 100% transparent that all of its advertising dollars are being spent on the internet, the majority in search, after having cut all TV spend in 2015. Although impossible to quantify precisely, we believe the search percentage is higher than Similarweb suggests, or at least has higher relevance, based on discussions with company.

Why Is Prescription Important to PETS?

If you search for any non-prescription pets meds online, you will find an incredible assortment of companies offering these products. Depending on product, they may include Amazon, Chewy.com, PetCo, PetSmart, 1800petmeds and numerous others. This doesn’t mean this category is not profitable for PETS, as their paid advertising on several popular products indicates they have found good ROI, but it does mean that brand name retailer competition is fierce and margins are lower. These OTC products can also be found at your local pet store, and often general goods retailers such as supermarkets as well. PETS does not disclose profitability or mix of prescription vs. OTC, but the industry structure, not to mention management confirmation of a GM differential, makes it clear supernormal margins are to be found where competition is light, which is prescriptions for the reasons described in the next section.

Are Prescription Competitors Sleeping?

Maybe. Active web competitors include Petco (which offers pharma through drsfostersmith.com, whom they bought last year) and less well known players like PetCareRx, Valleyvet and Allivet. They all pretty much carry equivalent product, often at discounts to PETS. At one point, we understand Canadian pharmacies were very popular, but that trend seems to have died down. Note that thanks to big pharma always looking out for the little guy, pet owners cannot walk into their local brick & mortar shop to get prescriptions filled. It’s either the vet or online.

For a long time, PetSmart had negligible pet meds presence despite recently buying out Chewy.com (the dominant eCommerce pet supply store), buying Pet360.com (small online pet pharmacy) previously and having a vet center located within many of its physical stores. That all changed on June 30th. See screen capture on June 29th vs. today. The key changes are 1.) “pharmacy” is now a navigation bar category of its own, and 2.) one of the 4 giant revolving banner ads is now an advert for the same. [Note the banner ads rotate, and one of the 4 may not be highlighting the pharmacy as of any given time. It was gone for a while, but just came back when we looked today.]

Arrival of PetSmart

We came across PetSmart because we’ve been tracking PETS’ keyword search data monthly. Organic and paid results were boring for months, until our last check. Suddenly, PetSmart surfaced everywhere. Literally, PetSmart went from back page or no online presence in the prescription meds category to front page results overnight. We believe the switch on the campaign was flipped toward the end of July. See some examples below of how they show up.

PetSmart’s targeting and placement has been very clever, often taking the 4th paid ad spot on desktop searches, meaning they pay less on average than other advertisers but still show up just above the organic results at the top of the page. This is the earmark of a dynamic keyword bid program meant to target a specific position. Also, searching for terms like “bravecto” on your phone instead of your PC browser will highlight they use differential placement strategies for each platform. In general, searching for product on mobile devices shows much higher PetSmart placement vs. desktop, sometimes above PETS, indicating they are likely allocating more click dollars to winning mobile and the above captures may under-represent the extent of PetSmart’s advertising blitzkreig. There are some additional considerations related to how auction pricing works and why more relevant advertisers have greater advantages, but we believe the thesis is strong enough without getting into the weeds. Overall, the campaign is sophisticated according to SEO experts we had review the situation.

Their organic search placement isn’t terrific … yet. It was non-existent on the first results page since we started tracking and now shows up frequently in top 4-10, which means we may see further gains simply as time passes. For those not familiar, organic search placement doesn’t just happen naturally. When there is money to be made, it is a battle to the death between search optimization geeks.

Also, the PetSmart app displays a banner on page 1 telling you all about their pharmacy offering, and we have encountered retargeting ads and facebook ads from PetSmart on specific meds.

A couple of notes on data that will suggest things aren’t so bad:

1.)  Adwords’ cost per click estimates haven’t changed. This is apparently due to the algorithms used to generate suggested CPC bids, which are always based on opaque historical data and not current data. For simplicity’s sake, paid search is a second price auction per click, meaning that, even if PETS stays in the top paid position rank, PetSmart may be driving up their cost per click when they show up just beneath PETS. So PetSmart will have two impacts: 1.) culling revenue by soaking up web traffic and 2.) raising COGS and thus hurting GM.

2.) PetSmart’s paid keyword overlap with PETS has decreased from 7,819 in July vs. 4,258 in August (August graphic below). We believe that PetSmart overhauled their ad budget as part of their pharma launch, as total keywords went from 74,430 to 42,547. We believe PetSmart didn’t cut back on their efforts, but instead they sharpened their focus on high-return keywords.

There are likely further refinements to PetSmart’s SEM strategy as they pull down click-through data and measure conversion rates. Their targeting and price strategy will only get smarter from here.

[Note that paid search placement ranks for different keywords move around, so on any given day (and different times of day), testing results will be different for various quirky reasons. As of posting, PetSmart has fallen to bottom of page paid results in some tracked desktop keywords (5th rank or more), while staying high on phone and tablet. It is hard to discern whether competitors increased their bids to climb ranks, PetSmart is reallocating to mobile where more traffic resides, or PetSmart pulled back bids in some categories (due to organic results improving (which they have, by a lot), the passing of flea & tick season, ROI analysis, or laziness). If one of the first two, CPCs will probably have gone up further for PETS. Also, we've noted price changes on the PetSmart site, but not on PETS, suggesting PetSmart is dynamically testing price sensitivity in the style of Amazon.]

But Pet Meds Competition Isn’t New, Right?

True, but consider for a second that web bargain seekers previously were confronted with the choice of the PETS offering with:

• Top of page and top of mind placement

• “America’s largest pet pharmacy” label

• Sometimes lots of colorful ratings stars (which is a product rating, not a PETS seller rating..)

• A very compelling 15% off offer and free shipping. If you’re really cheap, other coupons can be found online offering up to a 20% discount instead

• Very competitive, but not always the lowest, prices in the paid picture ads

• Oh, and they show up high in organic search too so they must be legitimate

Or a choice of various no-name, possibly sketchy, companies you’ve never heard of (but may actually be a reputable firm, quite possibly a subsidiary of a nationwide brand owned by a PE firm that is overpaying their operational team to take naps).

Now, however, pet owners seeking to stiff their animal care professional have a superior choice in PetSmart:

• The #1/#2 most recognized name in pet supplies nationwide

• Headline pricing of 3-9% less than PETS for the majority of prescription medications [Note, the discount has gotten bigger on several products we surveyed as of this post.]

• In addition to lower headline pricing, lower all-in pricing via 20% off your order with free shipping. When said cheapskates visit the actual website, they will find an additional 20% off their first reorder, plus 5% off if signing up for auto-reorders

• Active app, social media, and retargeting presence, where PETS is less present

It is hard to see how PETS competes with a huge national brand that has almost certainly better sourcing economies of scale and a gargantuan advertising budget, who has replicated (arguably improved) their marketing strategy and who is discounting to take market share.

PETS is a one-trick pony for which search marketing is its only source of growth. They need to constantly add new customers to replace their churned customers. Whereas PETS’ competitors seemed previously to be content to skirmish for small share wins and coexist together in a growing market, we believe PetSmart just put the market in disequilibrium. [Note that PetSmart has a distribution center and previously sold pet meds through its pets360.com acquisition, but traffic was anemic.]

Financial Scenarios

While the PETS numbers are deliberately opaque (sensibly so, given what the CEO will tell you is a completely no-moat business), we can use their disclosed metrics to understand performance drivers.

It is clear that three levers matter: 1.) their ability to generate new order volume, 2.) the cost of generating such new order volume, and 3.) their ability to generate reorders from their existing customer list. Other matters such as uptake of drugs with high ASPs do matter, but we are assuming to be stable for our 1 year forecast, based on our review of new product launches.

Upside Case:

In our steady state of the world (assuming PetSmart didn’t just enter), which is our upside case, customer retention holds at the historical ~90% level (ie. 10% churn every cycle; churn could be understated if we are picking up larger $/order for newer orders in our calculations) and we more or less straightline metrics, adjusted for seasonality and assuming the recent double digit flea & tick season new order bumps are a one-time phenomenon. While one could argue these results are beatable next flea & tick season, using this model, we get a result not too far from Wall Street estimates.

Base Case:

More realistically, we expect PetSmart (and others) to begin peeling away customers, resulting in higher churn, as well as a slowing pace of new customer acquisitions and higher customer acquisition cost as illustrated in the base case. This case does not illustrate any discounting by PETS to hold the line on market share.

Downside Case:

Finally, in a downside case, we envision a scenario in which customer acquisition costs really escalate, new order growth declines as a result of pullback in spend, and customer attrition picks up. Deep discounting becomes necessary to combat attrition as all the online players fight a price war (note this is modeled incorrectly as a decline in GM, not as a decline in top line, for simplicity.) In prior cycles, PETS resorted to discounting to defend their market share and their margins bled. We don’t know if CPCs have already risen, but believe they will. While seemingly draconian vs. Street, a 10% escalation in keyword bidding price for example is a tiny change and it is not unreasonable that price and convenience sensitive customers migrate wholesale to a well-known brand where they likely already shop.

Valuation

At the end of the day, eCommerce financial forecasts are only directionally useful, and one can nitpick many of the inputs and nonsensical outputs. Let’s just consider the scenarios illustrative for purposes of understanding the business drivers. In general, we expect that PETS will see a small impact in this upcoming quarter, shielded somewhat by reorders, the newness of PetSmart’s campaign (2 months), and the passing of peak flea & tick season. Results should only worsen from here as customers continue to discover PetSmart.

In addition to normal seasonality, results are very wonky quarter to quarter for reasons such as variable flea & tick populations, weather, other competitor actions, etc. Management provides no guidance, and analysts are game to play along with the narrative. Due to these quirks, it could even take until next tick & flea season (when prescription medicine sales will be most apparent) for things to really get bad, but we think declines will start to show up earlier, so long as investors are paying attention.

We don’t think the Street numbers are crazy here. But, what is clear to us is that the valuation implies a high-moat company that is primed to dominate a high growth eCommerce category, while the impending reality is exactly the opposite. Investors will realize this within the next year. Most of PETS’ parabolic move has come from multiple expansion. The stock has more than doubled on a ~30% FY2019 EPS step-up from analysts. When the narrative reverts, PETS should swing all the way back and then some, even if we do not see major EPS revisions. We peg PETS at 17x P/E in the upside case, or $26. Our base case at 15x yields $20. Our downside case at 10x yields $10.

Our hesitation to be short previously was always 1.) the adoption curve for the next generation medicines powering PETS’ growth and 2.) the slow distribution shift from prescriptions filled by vets at high margin to prescriptions filled at retail at low(er) margin. There are lots of reasons why more expensive pet medicines will only grow wallet share and why prescription meds will increasingly be filled offsite. When PETS was the only game in town that seemed to be taking things seriously, that was a scary short due to the squeeze risk. But, now that we see a capable competitor mobilizing aggressively into this space at what we think will be PETS’ peak multiple, we see the blowout risk as capped. Any time PETS finds a new profit niche or marketing edge, PetSmart should be there to box them in. SEM is ultimately a 100% competitive, transparent and real time arms race.

It is still early days, but the beauty of this trade is that we can monitor PetSmart’s (and maybe others’) escalation, as well as PETS’ competitive response, in real time. SEM is an ROI game, and placement + pricing reveals exactly what’s working and what’s not. At the end of the day, we are betting 1.) in the short term that PetSmart will find the PETS milkshake very tasty, sharpening/upping their ad spend over time to take more share, and 2.) in the long term that others (PetCo especially) will show up to further drink that tasty milkshake. https://www.youtube.com/watch?v=s_hFTR6qyEo

Catalysts

As we’ve spent too many pages discussing the catalyst and financial analysis, which we think are the crux of the investment, we are deliberately skipping over the industry structure, capital structure and shareholder issues. Importantly, we believe the setup of their business creates additional risks, such as supplier risk. Happy to debate in Q&A and also always keen on others’ input.

• Deterioration in key financial metrics over next year causes investors to re-rate

• Change in sector narrative, even if Wall Street numbers do not move substantially

• PetCo gets their act together after realizing PetSmart just found a free lunch and unifies drsfostersmith’s offerings under its brand instead of sending shoppers to the sister site with a crummy link.

Risks

• Earnings – Expectations on paper into shoulder season are not high and company could beat for any number of reasons. Short interest is still high, algos are in this and a squeeze could happen at any time, for any reason

• Cost or growth levers – Not really clear what’s left that is transformative after all the previous cost cutting and customer retention efforts.

• Acquisition – PetSmart and Petco already own online pharmacies with identical offerings. Who are the buyers? Also, Chewy.com was acquired for ~3.7x revenue, about where PETS trades now

• Vet to Retail Shift – Even management does not have a handle on this, however, it is clear that the shift away from vets is happening. Per PetIQ S-1: “We believe the market for pet medication and health and wellness products in the retail channel is likely to outpace growth in the broader pet industry. This migration away from the veterinary channel has already begun as the estimated mass market share of the U.S. pet medication industry increased from 12% in 2011 to 21% in 2015 while the estimated veterinarian share declined from 63% in 2011 to 59% in 2015. We believe that migration will continue in the future as more consumers become aware of the significant cost savings that retail channels can deliver and our product penetration at retail increases.” We believe the online winners will be the large branded retailers.

• Fairness to Pet Owners Act of 2017 – This legislation proposes to make it law that vets must tell patients they can fill prescriptions elsewhere, clearly a huge boost to PETS should it pass. It returns from the dead every 1 – 2 years, but appears to be DOA every time it shows up in the House. The sponsors and co-sponsors list changes every year, and this looks appears to be a perennial APAWS (nonprofit) boondoggle.

• “Next generation” pet meds – Animal health units of the major pharma companies are demonstrating HSD to LDD growth and the Zoetis’ of the world spend their days coming up with new ways to gouge help pet owners and fight off generic + OTC competition. However, our review of their pipelines shows there isn’t a big new product for PETS in the immediate horizon. Some of the promising newer products such as injectables cannot be sold online for obvious reasons, and many other innovations have been non-prescription. Regardless, if there does come a new savior, we should see it on PETS’ website long before it shows up in earnings.

Catalyst

• Deterioration in key financial metrics over next year causes investors to re-rate

• Change in sector narrative, even if Wall Street numbers do not move substantially

• Additional competition enters