Description

I recommend shorting Pets at Home, as its core business is structurally challenged.

Business description:

Pets at Home is the largest specialist retailer of pet food, pet products and pet-related services in the UK. It’s a brick and mortar retailer in the UK, with 450 stores that are placed in out of town retail parks. Within brick & mortar, they’re a clear leader in the UK with ~3x the footprint of the closest pure-play B&M competitor. They also sell products on their petsAtHome.com website, but that’s a tiny part of their business. PETS operates two segments Merchandizing (pet food and accessories) and Services (vet clinics and grooming). Merchandising accounts for 86% of sales and 70-75% of EBITDA. 55% of PETS stores contain a vet surgery franchise and grooming salon.  

Bull thesis:

The thesis is that the UK pet industry is growing at 4-5%, and that PETS should grow in line with the industry growth through its continued store roll-out program, while maintaining or growing margins over next 3-5 years. During this timeframe, an investor would expect EPS to grow in MSD to HSD range, while clipping a 4% dividend. In the meantime PETS would mix more into the Services business which should improve earnings quality, thereby potentially improving the exit multiple (vs. ~14x NTM consensus EPS multiple today). Assuming couple of turns of multiple expansion, MSD EPS growth, and 4% dividend yield, this investment could generate >25% IRR over next couple of years. Given the potential upside opportunity, this business is very attractively valued at 14x NTM EPS and ~7% NTM FCF yield.   

Short thesis:

Although the share price has been under pressure over last 12 months, I believe there’s another 35-40% downside over next two years. I expect PETS top line and gross margins to erode due to online competition, while costs will continue to increase. As such, I expect EPS to decline to 10.5p per share in FY2020, which assuming 10x NTM multiple implies a 105p share price, a 45% downside potential from current share price (which will be offset by 4% dividend).

There’s a chance that I’m misjudging the timing of headwinds for PETS, which means that the thesis might play out over longer period of time. Having said that, there’s no doubt that the online headwinds will intensify over time and become more obvious, so at the very least this is a reasonable funding short as the multiple will be under increasing pressure.

Valuation:

Consensus has top line growing at 4.5%, EBITDA slightly declining (-1%) and EPS flattish over next 3 years. On consensus figures, PETS is expected to generate £953M, £127M and £15p of fiscal year (3/31) 2020 sales, EBITDA and EPS, respectively. This implies that PETS is trading at 8.8x and 13x FY2020 EBITDA and EPS. Also, on NTM numbers it trades at 14x NTM EPS, which screens as cheap if you believe consensus earnings and resilience of it going forward, which I don’t.

I have top line growing at LSD, EBITDA declining at HSD and EPS declining at low DD CAGR over next 3 years. As such, I expect EBITDA and EPS to decline to £104M and £10.6p by FY2020, implying an 18% and 27% discount to consensus, respectively. This implies that PETS is trading at 10.7x and 18x fiscal year 2020 EBITDA and EPS. I should add that current net leverage is at 1.2x and it’s going to stay in this range, as FCF will be used to fund unit growth and the dividend. Note that unit growth is financed through leases (all stores are leased).

My numbers vs. Consensus:

I don’t have a differentiating view on the Services segment, but do believe that Merchandize business will become a melting ice cube. The Street expects the merchandize business to comp at 1-2% SSS going forward, while I expect the SSS to turn negative starting in FY2019. Furthermore, I expect merchandize gross margins to start compressing while street expects GMs to remain flat. Lastly, the SG&A is a largely fixed cost bucket that will continue to rise due to continued roll-out of new stores as well as National Living Wage initiatives – this is consistent with consensus assumptions. So shorts have few things working for them: (i) Merchandize revenues will start to decline (LFLs are somewhat offset by store unit growth), (ii) gross margins will start to compress, and (iii) SG&A will continue to grow.

To hit my numbers, I’m assuming that merchandize revenue starts declining in in FY2019 and FY2020 driven by -1% SSS which is largely offset by unit growth, gross margins start compressing by 100bps a year starting in FY2019, and that SG&A grows in the 3-4% range to support the unit growth (and due to NLW). These are the key components that bridge my numbers to consensus.

To put my numbers in perspective, SSS trends have been steadily decelerating over last few years from ~4% in FY2015 down to below 1% in FY2017. Meanwhile, the SSS trends have been helped by the continued “maturation” of stores that are within the SSS cohort but that have not fully matured. Obviously, this “maturation” benefit will decrease as store base increases and as newer stores fully mature. On gross margin front, merchandizing business has actually slightly expanded its margins over the same period (FY2015-FY2017), but given competitive pressure and PETS recent decision to lower pricing of its products, I don’t see it holding up for much longer. Lastly, I have SG&A growing in the 3-4% range, while historically it’s grown at HSD range. On the SG&A per store basis, my assumptions are in line with historical growth.  

Also, PETS continues to grow its units, so once the Merchandizing business starts slowing down then they should re-calibrate their unit growth goals. To be clear, I’m not assuming any slowdown in the unit growth, but since Merchandizing funds the growth of Services business and new units, I’m hoping to see even more downside.

Why I’m different vs. Street:

I think the brick & mortar pet food and accessories business is structurally challenged. PETS talks about how their Merchandising segment is insulated from online disruption due to their online presence, private label penetration, advance nutrition mix, VIP program, food vs. accessories mix, etc. To be sure, they have online presence but it’s tinny and their pricing is at premium to other pure-play online players, frequently at 15-25% premium! Also, PETS’ online market share significantly trails their B&M market share. Other reasons, such as PL, VIP and advance nutrition, are areas that other pure-plays are tackling themselves as well – I don’t see a reason why they shouldn’t be able to offer similar offerings.

We’re seeing rapid growth of the online channel within the pet food sector supported by couple of key tailwinds: (i) price and (ii) convenience. Online players are selling products typically at 15-25% discount to brick and mortar! Also, it’s much more convenient to order a bulky bag of pet food (>15kgs) online and have it delivered to your front door, than having to go to store to buy it / carry the heavy package to car / home. Some estimate that online penetration of UK’s pet food market is at ~4% today, and some estimate that it’s much bigger (~11%). While it might be small today, it’s growing much faster than physical retail channel. Across the entire Europe it’s estimated that the online pet food penetration has increased from 4% to 8% over last five years. I haven’t seen any reliable data on how quickly UK online pet food channel is growing, but by looking into some larger pure-play companies I think it’s growing at least at ~20% range. That’s pretty impressive growth when you put it next to PETS’ decelerating LFL trends. So it’s not a matter of “if”, it’s a matter of “when” online will start cannibalizing brick and mortar.

PETS management used to say that “engaged” pet owners don’t care about the price, or that price is not the most important factor in their purchasing decisions. This just doesn’t add up with data I’m seeing. Zooplus is the biggest pure-play pet food online player in Europe with ~50% market share, and they provide quite a bit of information on their business. Zooplus has been growing top line at ~30% CAGR over last 5 years! In the UK alone, they grew by 25% in 2016 and ended the year with €84M in sales (~11% of PETS Merchandising revenue). A quick glance at their GM profile over last 6 years shows that they’ve invested heavily into price to capture market share. During these 5 years they’ve seen their GMs compress by 10% to 25%. What’s interesting is that the recent pricing pressure is not being driven down by Amazon and Zooplus, though they do stay ahead of competition, but by small regional players on back of the Chewy.com take out precedent. So if you follow the data you’ll conclude that price matters a lot! This is incredibly competitive space at the moment – check out Zooplus, Amazon, Ocado / Fetch, MedicAnimal, PetPlanet, etc. In fact, PETS was forced to lower pricing on its products in 2017 which speaks to importance of pricing.

Zooplus data shows that once customers shift to online, they tend to shop online for duration of pets lives. As such, the Zooplus’ sales retention has improved every year over last 5 years. Also, we also know that the average ticket size at PETS is less than half of that at Zooplus. Thus the convenience factor of shopping online is pretty evident in these numbers.

More importantly, the gross margin differential between PETS’ Merchandising segment (57%) and Zooplus (25%) is large. When I spoke with Zooplus management, they explained that 15-20% of the 33% difference is due to lower pricing and the remainder is due to PET’s higher mix of private label, advance nutrition and accessories. The other headwind that PETS is facing is that Zooplus’ purchasing power will just increase over time, which in turn will be reflected in lower pricing. Just to clarify, Zooplus orders products regionally and thus doesn’t have the purchasing power of PETS in the UK, but that’ll obviously change over time.  

So in light of these market dynamics, I think my assumptions are reasonable. I think I’m more likely to miss on timing of some of these impacts rather than severity of financial impact once it happens. PETS has a good set-up from here on: slowing down top line + compressing GMs + growing Opex. And once the core business slows down, I suspect the unit growth story will be recalibrated as well.

Near-term catalysts:

Unfortunately, I don’t have a hard catalyst. But I do expect to start seeing a deceleration in sales and pressure on gross margins over next 18 months. PETS will either have to give up on gross margins in a big way to maintain its sales growth, or try to protect their margins in which case I expect accelerated shift to online sales / slowdown in PETS top line. As I noted earlier, it’s not a matter of “if”, it’s a matter of “when” online will start cannibalizing brick and mortar in a noticeable way.

Risks / downside / things to get comfortable with:

More resilient business than I give it credit for. PETS have created some Private Label brands that they claim have strong brand value and following. They also claim that they’re insulated from online due to their Advance Nutrition mix, VIP membership, etc. Personally, I don’t buy their story as I expect online players to pursue all of these initiatives as they scale, but I might be wrong. There’s still 50-70% of pet food market share held by conventional grocers, so in the near-term PETS might show better resiliency than conventional grocers.  

Services business will provide a bottom to valuation / it’s not going to 0. Unlike some other retail concepts, I don’t expect PETS to go to 0. They have Services business, which accounts for ~15% of sales today, that’s outgrowing rest of PETS business. Services segment largely consists of Vet clinics and grooming. I like the Vet business because it’ll continue to ride nice tailwinds (pets getting older, humanization of pets, not prone to online disruption, etc.). Similarly, the grooming business is insulated from online, but not from other competition. So I believe there’s a bottom to the share price, supported by the value of Services businesses. But this doesn’t take away from my thesis that focuses on degradation in profitability of Merchandizing business, which funds future growth of Services business.   

High short interest and low liquidity. Short interest is at 18.5% and the stock trades thinly (2M a day), so susceptible to short squeeze. But it’s not too pricey, can borrow for 2-2.5%.   

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Catalyst

Near-term catalysts:

Unfortunately, I don’t have a hard catalyst. But I do expect to start seeing a deceleration in sales and pressure on gross margins over next 18 months. PETS will either have to give up on gross margins in a big way to maintain its sales growth, or try to protect their margins in which case I expect accelerated shift to online sales / slowdown in PETS top line. As I noted earlier, it’s not a matter of “if”, it’s a matter of “when” online will start cannibalizing brick and mortar in a noticeable way.