Description

Executive Summary

I recommend a short position in PETS. PetMed Express operates under a stale and tarnished brand, 1800PetMeds (how I’ll refer to the company going forward). Its active customer base has been shrinking for almost a decade. Recent, significant changes to the distribution policies of pet medication manufacturers have removed a critical barrier to entry that historically supported 1800PetMeds’ business. In the wake of that change, new, well-capitalized, technologically savvy and aggressive competitors have entered – and are continuing to enter – the pet medication retailing space. The flood of new entrants is likely to further exacerbate 1800PetMeds’ customer acquisition challenges and compress its profit margins to levels more in line with what one might expect for a middling third-party ecommerce retailer. 

When it comes to earnings misses, it is often the case that “there is never just one cockroach.” 1800PetMeds missed revenue and earnings expectations for its most recently reported quarter. Alternative data suggest the trend in its business has deteriorated further thus far in the calendar second quarter, its highest volume quarter of the year. Against the backdrop of recent, positive results and comments on industry demand trends from major pet medication manufacturers, such as Zoetis and Elanco, it seems competitive pressures may be behind the weakness 1800PetMeds has been experiencing. Any competition-driven weakness in 1800PetMeds’ results should prove persistent.  

The pandemic provided 1800PetMeds a shot in the arm and obfuscated its declining long-term trajectory. As the company laps those pandemic-juiced results, the market should come to better appreciate the competitive challenges 1800PetMeds faces and value it accordingly.  Applying an 11.0x price-to-earnings multiple to my estimate for the current fiscal year ($1.18) and adding balance sheet cash ($5.85) gets me to an ~$18 price target, 41% below the current stock price.  

Background

PetMed Express, Inc. does business as 1800PetMeds. It is a direct-to-consumer specialty retailer of prescription and over-the-counter pet medications, health products and supplies for dogs, cats and horses. Prescription pet medications account for around 80% of the business, with flea/tick/heartworm preventatives representing approximately 50% of the business. The company sells through three channels: its website (1800petmeds.com), a toll-free phone number (1-800-PetMeds) and direct mail. Sales through its website accounted for 84% of sales in FY20. 1800PetMeds uses online (SEO, SEM, display, video, affiliates, social, etc.), television, direct mail/print and email advertising to acquire customers and drive sales. The company runs a very lean organization with just 214 employees: 116 in customer care and marketing; 30 in fulfillment and purchasing; 54 in our pharmacy; just 6 in information technology; 3 in administrative positions; and 5 in management.

For the year ended March 31, 2020, 1800PetMeds had 2.3 million active customers (defined as those that made a purchase in the preceding two years). Over the past five years, customer churn seems to have averaged about 20% of the active customer base per year, implying the average customer sticks around for about 5 years. In its most recently completed year, the average order value was $89 and the average active customer placed 1.47 orders. 1800PetMeds reported a 29.1% gross margin in its most recent fiscal year and an average customer acquisition cost of $48.85. Putting all these numbers together, 1800PetMeds has an average customer lifetime value of around $150 assuming a 10% discount rate. That implies an average LTV / CAC of about 3.0x. 

Historically, most major manufacturers of prescription animal health medications had formal policies of only distributing products through the veterinary channel. Manufacturers are reliant on vets to prescribe their products. Restricting distribution to the vet channel allowed vets to charge high markups - often 100% or more - on prescription medications. The high markups vets could earn on prescription medications exclusive to the vet channel created an incentive to prescribe those medications.

Founded in 1996, 1800PetMed’s business model was built around circumventing the exclusivity vets enjoyed on most pet medications. 1800PetMeds would purchase pet medications from secondary sources, such as veterinarians or animal health distributors. Although selling to 1800PetMeds was technically prohibited by the manufacturers, it would still occur under the table. For example, a vet might place a larger-than-planned order with its distributor in order to take advantage of a volume rebate and then turn around and sell the excess product to 1800PetMeds at a modest markup. Alternatively, a vet might offload prescription medication that was approaching its expiration date to 1800PetMeds. Distributors would deal with 1800PetMeds in a similar fashion. Although purchasing through secondary sources left 1800PetMeds with somewhat higher product costs than vets who were buying through official channels, the eye-watering markups that vets charged allowed 1800PetMeds room to offer consumers a discounted price (e.g. 25% lower than what vets would charge) and still earn healthy profits. Ensuring adequate supply of pet medications at acceptable costs often required 1800PetMeds to discretely deal with more than 500 sources of supply. While doing so was operationally complex and required developing relationships over time, those obstacles served as meaningful barriers to entry for would be competitors.   

In 2010, the exclusivity that vets enjoyed on pet medications began to show the first signs of cracking. In February of that year, Bayer’s Animal Health Division announced that it would begin two of its top-selling flea and tick products, Advantage and K9 Advantix, to pet specialty retailers and pet specialty internet sites. 

In 2019, the floodgates completely opened. Essentially all major pet medication manufacturers opened up direct distribution of pet medications to non-veterinary sources. The change was in large part precipitated by Chewy’s entry into the animal health category. Chewy launched its online pharmacy, Chewy Pharmacy, in July 2018. It initially sourced product primarily through secondary sources, just as 1800PetMeds did. Chewy used a highly aggressive and disruptive pricing strategy to make a splash and acquire customers, frequently selling products for less than what even vets could buy them for through official channels. While the pet medication manufacturers loved the incremental demand Chewy was driving, they didn’t love its destabilizing approach to pricing and the complaints that approach was creating among vets. The major pet medication manufacturers struck a compromise to address the situation. They would open up direct distribution relationships with Chewy and others outside the veterinary channel in exchange for compliance with minimum advertised pricing policies. By late 2019, Chewy, 1800PetMeds and others who had historically been sourcing pet medications through secondary sources had in most cases established direct sourcing relationships.

Industry

Key Points

1800PetMeds has a stale and tarnished brand, something that will prove challenging to fix. 

• 1-800 numbers have become an anachronism 

• Even the company itself has essentially admitted that its brand is stale. Inspired by “consumer feedback,” 1800PetMeds recently updated its logo for the first time in 25 years. 

• For a long time, veterinarians worked to raise doubts among their clients about the safety and legitimacy of non-veterinary sources of pet medications that were technically unauthorized sellers (see here and here, for example). Those efforts have left 1800PetMeds with a brand that may be irreparably tarnished in the eyes of many pet owners. Type “is 1800petmeds” into google and here is what you get:

• 1800PetMeds also bears some of the blame for the tarnished reputation it may have. The company has had numerous run-ins with regulators – mostly in the early to mid-noughties – over its practices with respect to prescription drugs. The company’s Wikipedia page does a good job of highlighting them. 

• The company’s stale and tarnished brand weighs on its ability to remain competitive.

The recent decision by most pet medication manufacturers to expand formal distribution beyond the veterinary channel has removed a critical barrier to entry that protected 1800PetMeds’ business. Several aggressive, well-capitalized competitors have entered the pet medication retailing space recently. More may be on the way.

• Chewy launched its pet pharmacy in July 2018. 

• About a year after Chewy entered the market, most pet medication manufacturers abandoned their long-standing official policy of exclusively distributing their prescription pet medication products through the veterinary channel while simultaneously adopting minimum advertised pricing policies. The change was partly in response to changes in consumer shopping preferences and partly in response to the aggressive and destabilizing pricing tactics Chewy was using to acquire customers (which MAP policies reigned in). 

• In May 2019, Walmart not only launched WalmartPetRx.com, its online pet pharmacy, but also announced that it would now stock the 30 most requested pet medications in the pharmacies at its retail stores. 

• Petco struck a partnership with Express Scripts to launch an online pharmacy fulfilled by Express Scripts. 

• Discussions with industry executives suggest other well-capitalized companies, such as CVS and Walgreens, may enter the space in the foreseeable future.

• The deluge of entries into the pet medication retailing space by aggressive, well-capitalized competitors should put pressure on 1800petmeds in a variety of ways (e.g. new customer additions, CAC, churn and customer experience-related operating expenses) for the foreseeable future.

Vets are increasingly setting up their own online retail capabilities and lowering in-clinic prices for pet medications to remain competitive.

• Most vets partner with companies such as Covetrus, VetSource or MyVetStoreOnline (owned by Midwest Veterinary Supply) to set up a white-label online storefront. These storefronts are arguably superior to what 1800PetMeds offers in a variety of ways. Here is an example.  

• These types of online stores offer pricing that is at least competitive with – if not lower than – online alternatives after considering manufacturer-provided instant rebates that are often exclusive to the veterinary channel.

• The strong relationships veterinarians have with their clients and the perception of veterinarians as small, local businesses worthy of support provide vet-branded online stores with important advantages over non-veterinary sellers of pet mediations.

• Vets are also adjusting their pricing on pet medications offered in-clinic to remain competitive now that they no longer have a degree of exclusivity on selling those products.

• Any increased focus that vets put on diverting their clients from shopping at third party ecommerce sites to shopping at veterinarian-affiliated online stores or in-clinic at more competitive prices could put further pressure on 1800PetMeds’ business

Despite favorable industry tailwinds, 1800PetMeds’ active customer base has been shrinking for nearly a decade. It appears poised to shrink further. 

• 1800Petmeds’ active customer base – defined as customers who have made a purchase in the last two years – peaked at 2.7 million in 2013 and has declined to 2.3 million as of March 31, 2020.

• The company’s shrinking active customer base is mainly due to its struggles to acquire a sufficient number of new customers to offset those that churn.

• Since 2005, the median annual customer churn as a percent of the beginning active customer base has been 23.8% (IQR: 22.3% - 25.8%). In more recent years, it has been below that median, ranging from 18.3% to 20.3% for fiscal years 2018 – 2020. It may be the case that new customers churn at a higher rate than seasoned customers, in which case the churn ratio would decline as new customer additions slow all else being equal.

• For the quarter ended March 31, 2021, 18000PetMeds acquired 88,000 new customers, 12% fewer customers than it acquired in the comparable period in 2019. For 2014 through 2019, customer additions in the March quarter represented a median of 24.1% (IQR: 22.9% - 24.2%) of customer additions in the following four quarters. Applying that ratio to the company’s customer additions for the quarter ended March 31, 2021 suggests new customer additions are on track to be around 365,000 for the next four quarters (fiscal 2022). 

• Recent data from Google Trends suggests the trend in 1800PetMeds new customer additions may be deteriorating from even the level it achieved in its most recently reported quarter. There is a statistically significant relationship between interest in search terms relevant to 1800PetMeds and the company’s new customer additions. The two-year trend (to adjust for the impact of the pandemic) in interest in search terms relevant to 1800PetMeds has been deteriorating pretty sharply recently. 

• Although 1800PetMeds’ average LTV/CAC is a respectable 3.0x, its steadily declining new customer additions suggest that its marginal LTV/CAC is uneconomic at current levels of acquisition and that the number of customers it can acquire economically has been falling over time. 

• With annual new customer additions of 365,000 or fewer, 1800PetMeds’ active customer base should continue to fall over the coming years. 

1800PetMeds will struggle to maintain its current level of revenues with a shrinking active customer base.

• 1800PetMeds’ average order value has grown at a CAGR of 1.2% from FY2004 to FY2021. It is unclear precisely how changes in pricing, product mix and units per transaction have affected that figure, but most of the increase has likely been due to manufacturer-driven increases in ASPs. It seems reasonable to expect AOV to continue to grow at roughly its historical rate going forward.

• 1800PetMed has also seen its average orders per active customer increase over time. This is likely due to the seasoning of its active customer base. Less engaged customers probably have a higher propensity to churn. As growth slows – or reverses – the company is left with fewer, but more engaged customers. At some point, this effect should hit a limit, but it is unclear when that will be.

• Although increases in AOV and average orders per active customer may mitigate the impact of a declining customer base on 1800PetMeds’ revenue, it seems unlikely that 1800PetMeds will be able to maintain its current level of revenue over time if its customer base shrinks by more than 3% per year

Competition from new entrants should put pressure on 1800PetMeds’ operating margin over time. 

• For the fiscal year ended March 31, 2018 – the last full fiscal year before the recent flood of new entrants and fundamental change to manufacturer distribution policies - 1800PetMeds achieved a 19.0% operating margin.

• 1800PetMeds’ operating margin has already compressed substantially in the wake of the recent, adverse developments in the competitive landscape, mainly as the company aligned its selling prices with the MAP prices set by manufacturers. For the fiscal year ended March 31, 2021, the company reported an operating margin of 12.2%.

• Despite the substantial decline in 1800PetMeds’ profitability over the past few years, its margins likely have further to fall. Third-party ecommerce retail is generally a tough, low margin business. Well-run ecommerce retailers with strong brands and preeminent scale in their categories aspire to ultimately achieve Adjusted EBITDA margins in the 8-12% range. With a questionable brand and middling scale, 1800PetMeds will likely struggle to maintain margins at even the low end of that range over time. 

• While MAP policies implemented by pet medication manufacturers in conjunction with shift to unrestricted distribution of pet medications will limit the degree to which retail selling prices and retailer gross margins come under further pressure, the increased competitive intensity in the industry will manifest itself in other ways, such as higher customer acquisition costs, higher churn and greater levels of customer experience-oriented operating expenses (e.g. technology, customer service, shipping, etc.)

Pandemic-induced changes in consumer shopping behaviors gave 1800PetMeds’s business a shot in the arm that obfuscated the business’s poor underlying health and outlook. The poor state of 1800PetMeds’ business will become more readily apparent as the company laps pandemic-juiced results.  

• 1800PetMeds’ revenue and operating income grew 8.8% and 21.3%, respectively, for the year ended March 31, 2021, a dramatic improvement from the 0.2% revenue growth and 32.9% decline in operating income the company reported in the preceding year.

• 1800PetMeds will almost certainly show declines in revenue and operating income this year as a result of comparing against pandemic-juiced numbers. It will likely continue to show declining operating income and possibly also declining revenue thereafter unless trends in customer acquisition materially change. 

• Sell-side estimates currently show revenue and earnings for FY22 and FY23 above what the company achieved in FY21. 1800PetMeds is unlikely to meet those estimates, in my view. 

1800PetMeds missed consensus estimates for revenue and earnings for its most recently reported quarter. Certain alternative data suggest that the company’s revenue trends have continued to be weak. The company may be poised for another disappointing earnings report for the current quarter.

• Using alternative data, I have constructed an index that aims to estimate 1800PetMeds transaction volumes. 

• To state the obvious, there could be issues with the data series used to construct this index and/or how I’ve constructed the index that cause it to paint an inaccurate picture of how 1800PetMeds is doing. You cannot take this index to the bank. That said, it has been a helpful guide in the past. 

• The index suggests the current quarter is off to a very weak start based on data for April. The second calendar quarter of the year is the highest volume one for 1800PetMeds because it is beginning of flea & tick season. 1800PetMeds’ revenue typically increases an average of 30% from the first calendar quarter to the second. While we are only 1 month into the current quarter, April appears to have been much weaker than it should have been based on seasonal patterns, up only 13% over the first calendar quarter.   

• Google Trends data for the terms “Nexgard” and “Bravecto”, two leading flea & tick medications, illustrate the seasonality for those types of products. Demand for preventatives should be near its seasonal peak right now. 

• Another source of alternative data also suggests there is some demand weakness in the parts of the industry. VetSuccess publishes a weekly industry tracker that is based on PIMS data from 2,900 veterinary practices in the U.S. VetSuccess included the following commentary in one of its recent weekly updates:

“Flea/tick and heartworm protection dispensed and revenue from products and services all experienced YoY growth again this past week, although considerably less than the week prior. If we compare 2021 numbers to 2019 for April 18-24, we see heartworm growth at 9%, flea/tick growth at -2.3%, services revenue growth at 24.5%, and products revenue growth at 13.3%—this certainly raises some questions about flea/tick protection dispensed, especially as we're well into spring now.” (original emphasis)

• Elanco and Zoetis recently reported strong 1Q21 results, raised guidance and struck optimistic tones about industry demand. That runs counter to comments by 1800PetMeds management on its recent earnings call that aimed to explain its lower-than-expected results for the first calendar quarter. It may be the case that the data pointing to weakness are channel / company specific and reflect shifting market share. 

• Bottom line, the alternative data I look at leads me to believe there is a good chance 1800PetMeds will report disappointing results for the current quarter (calendar 2Q21). 

1800PetMeds pays out nearly all of its earnings as a dividend. If its business follows the trajectory I expect, it may choose to cut its dividend within the next two years. 

• 1800PetMeds earned $0.34 per share in its most recent quarter and declared a $0.30 dividend, implying a run-rate payout ratio of around 89%. 

• I expect 1800PetMeds’ quarterly earnings to fall below the level of its most recent dividend at some point over the next four quarters.

• The board may choose to cut the dividend if the payout ratio exceeds 100% for several quarters running

• If the board is willing to continue to pay the dividend using cash on the balance sheet, 1800PetMeds can continue to support its current dividend for a longer period of time though. 

Valuation & Returns

I expect 1800PetMeds to earn $1.18 for its current fiscal year and $1.04 for the fiscal year that ends on March 31, 2023, both well below the corresponding consensus estimates. As the market comes to view 1800PetMeds as challenged business facing new and serious competitive pressures that is shedding customers and market share, its P/E multiple should contract. Applying an 11.0x price-to-earnings multiple to my estimate for the current fiscal year ($1.18) and adding balance sheet cash ($5.85) gets me to an ~$18 price target, 41% below the current stock price. 

Risks

• A rising tide lifts all boats. Favorable industry trends may support 1800PetMeds’ business for longer than I expect.

• The company is working on new ways to acquire customers. If it is successful, that could fundamentally alter the downward trajectory the business is currently on.

• 1800PetMeds’ dividend may support the stock to a greater degree than I expect over the intermediate term. 

• Short interest accounts for around 30% of the float. The stock tends to trade like a heavily shorted stock (e.g. trades up during periods of real or perceived de-grossing by hedge funds).

Catalyst

• Worse than expected results for the current quarter and beyond

• Announcements of new entrants (e.g. CVS, Walgreens) into the pet medication retailing space

• Potential dividend cut in the future