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PetSmart (NASDAQ:PETM)

Q3 2012 Earnings Call

November 14, 2012 4:30 pm ET

Executives

April Lenhard

Robert F. Moran - Chairman, Chief Executive Officer and Member of Disclosure & Ethics Committee

Lawrence P. Molloy - Chief Financial Officer, Principal Accounting Officer, Executive Vice President and Member of Disclosure & Ethics Committee

David K. Lenhardt - President and Chief Operating Officer

Analysts

Alan M. Rifkin - Barclays Capital, Research Division

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Christopher Horvers - JP Morgan Chase & Co, Research Division

David M. Mann - Johnson Rice & Company, L.L.C., Research Division

Gary Balter - Crédit Suisse AG, Research Division

Kate Wendt - Wells Fargo Securities, LLC, Research Division

Michael Lasser - UBS Investment Bank, Research Division

Peter S. Benedict - Robert W. Baird & Co. Incorporated, Research Division

David Gober - Morgan Stanley, Research Division

Operator

Good afternoon, ladies and gentlemen, and welcome to PetSmart's Third Quarter 2012 Analyst Conference Call. [Operator Instructions] Later we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded.

I would now like to introduce your host for today's conference, Ms. April Lenhard, Head of Investor Relations. Ma'am?

April Lenhard

Good afternoon, and welcome to PetSmart's conference call to announce our results for the third quarter of fiscal 2012. With me on the call today are Chairman and Chief Executive Officer, Bob Moran; President and Chief Operating Officer, David Lenhardt; as well as Chip Molloy, Executive Vice President and Chief Financial Officer. Bob will kick off the call with an overview of our results, and then Chip will take you through the financial review, as well as our earnings guidance. David will review the operations of the business. And finally, we'll take your questions.

Please keep in mind, everything we cover during today's call, including the question-and-answer session, is subject to the Safe Harbor statement for forward-looking information you'll find in today's news release. Thanks.

And I'll now turn the call over to Bob.

Robert F. Moran

Thanks, April, and good afternoon, everyone.

We are pleased to report another quarter of solid earnings growth.

For the third quarter, earnings per share were $0.75, up 50% when compared to $0.50 for the same period last year. Comparable store sales, or sales in stores open at least a year, grew 6.5%. And comp transactions, which we use as a proxy for traffic, were up 2.3%.

Our performance in the third quarter was due to the strength across all 3 merchandising categories: consumables, hard goods and live goods, as well as across services. We are executing well and continue to define the pet specialty customer experience, because we are much more than a store that just sells products.

As North America's leading pet specialty retailer, we provide a full range of services, including professional grooming, training, boarding, day camp and full-service veterinary care, all under one roof. And we are privileged to have the most passionate associates in the industry, who engage with our pet parents to offer solutions. We have also built a culture of innovation and differentiation that sets us apart from the competition. Through our partnership with PetSmart Charities, the largest funder of animal welfare efforts in all of North America, we are proud that nearly 1,100 homeless pets are saved each day in our stores. All these things define the PetSmart brand. It is strong, and it resonates with our customers.

As a side note, we recently signed a product license agreement with E-mart, a leading retailer in South Korea, to sell a limited number of proprietary-branded hard goods products in select pet stores in South Korea. We view this partnership as a low-risk learning exercise to gain a better understanding of how our brand is received in emerging Asian markets without investing significant resources.

Now I would like to take a moment to express our deepest sympathy to those affected by the devastation of Hurricane Sandy. We hope that you and your families are well and safe. I would like to thank our associates, who pulled together during the crisis; and especially to those who so generously contributed to PetSmart's Associate Assistance Foundation to provide financial support to help their fellow associates, who were personally affected by the storm's devastation. Approximately 200 of our stores in the Northeast were closed on Monday, October 29, when Hurricane Sandy made landfall on the greater Northeastern Coast. And we're pleased to report that by November 10, all of our stores were once again open for business.

And now, I would like to shift to a different subject matter before turning the call over to Chip. I am sure most of you saw, as part of our release, our announcement that Chip will be resigning. It is difficult for us professionally, and for me personally, to see Chip leave our company. However, we are fortunate that he has agreed to stay with us through the transition. He will continue as CFO until replacement is in position and has agreed to stay with the company as a Special Advisor until March of 2014. Chip has been an invaluable member of our management team over the past 5 years and has been instrumental in designing a framework and creating a culture within the company that consistently pushes us to always consider our shareholders. It is this foundation of focus and discipline that has contributed to our success over the past 4 years and will remain a key pillar of our strategy well into the future. He has also built a tremendous finance team that is going to serve PetSmart for many years to come.

With that, I will now turn the call over to Chip, who will discuss our financial results for the quarter and our guidance for the remainder of the year.

Lawrence P. Molloy

Thanks, Bob, and good afternoon, everyone.

Before discussing the financials, I wanted to take a brief moment to address my eventual departure from PetSmart. For starters, I want to emphasize, as Bob said, that I will be sticking around for the CFO transition, with the goal of making it seamless for our management team, our associates and our shareholders.

This was not an easy decision for me but the timing seemed appropriate. The company is well positioned in the marketplace. It has an outstanding management team and is executing well by virtually all measures. My eventual departure will allow me to spend more time with my family, who now live back East.

Turning now to the company's financial performance. I will be reviewing our third quarter performance, as well as providing guidance for the fourth quarter and full year.

As Bob mentioned, earnings for the quarter were $0.75 per share, which represents 50% growth when compared to $0.50 for the same period last year. Comparable store sales growth was 6.5% and comp transactions were positive for the 10th consecutive quarter at 2.3%.

Total sales for the quarter were $1.6 billion, up 9%. The increase in total sales included a favorable impact from foreign currency fluctuations of $1 million. Services sales, which are included in total sales, increased 8% to $175 million. Other revenue, which is also included in total sales, was $10 million, representing reimbursements from Banfield for the space they utilize in our stores. The sales mix for the quarter included consumables at 53.9%, hard goods at 33.1%, services at 10.7%, live pets at 1.7% and other revenue at 0.6%.

Gross margins for the third quarter were up 100 basis points to 29.6%. Within the gross margin line, merchandise margins increased 30 basis points. The services contribution to gross margin rate was flat, while store occupancy and supply chain were favorable 60 and 10 basis points, respectively.

Operating, general and administrative expenses were 21.0%, representing 80 basis points of leverage compared to the same period last year. Net interest expense for the quarter totaled $13.4 million.

Overall, earnings before tax increased to $126 million or 7.8% of sales. This represents 45% growth and a 200-basis-point improvement. The tax rate for the quarter was 38.3%.

During the quarter, we opened 24 new stores and closed 4. We also opened one PetsHotel, bringing our total to 1,269 stores and 195 hotels.

We ended the quarter with average inventory per store of $603,000, up 3% compared to the third quarter of last year.

During the quarter, we generated $133 million in operating cash flow, spent $40 million on capital expenditures, distributed $18 million in dividends and repurchased 60 million of PetSmart stock.

Depreciation and amortization expense for the quarter was $60 million. We ended the quarter with $370 million in cash, cash equivalents and restricted cash, and 0 borrowings on our credit facility. We are very pleased that we continue to deliver strong operating results while maintaining a healthy balance sheet.

As we look forward to the remainder of the year, Hurricane Sandy started at the very beginning of the fourth quarter. We are not typically impacted by weather. However, the sheer magnitude of Sandy and the duration of disruption for some areas is estimated to have some negative impact on our results for the quarter. The current estimated financial impact of the storm is embedded in our guidance for the fourth quarter and full year.

As a reminder, 2012 contains a 53rd week. The fourth quarter in annual guidance includes the extra week. However, I will summarize the impact of the extra week on several key measures for both the year and the quarter.

For the year, we anticipate comp store sales growth of 6% to 7% and total sales growth between 10% and 11%. We are raising our earnings per share guidance from a previous range of $3.30 to $3.40 to our current expectations of $3.47 to $3.51.

We now expect our gross margin to improve 95 to 105 basis points, OG&A to grow in dollars approximately 9%, interest expense to be down slightly and EBT margin to expand 140 to 150 basis points.

We anticipate an annual tax rate of approximately 38%. The impact of the extra week on the annual guidance is estimated to be $120 million in sales, almost 20 basis points of the gross margin expansion, $19 million of the incremental OG&A expense, 30 basis points of EBT expansion and $0.16 of EPS.

For the fourth quarter of 2012, we are expecting comparable store sales growth of mid-single digits and earnings per share of $1.16 to $1.20. When compared to the fourth quarter of last year, gross margin is expected to improve 115 to 125 basis points, and EBT margin is expected to improve 130 to 140 basis points. The impact of the extra week is estimated to be approximately 55 basis points of the gross margin expansion and 90 basis points of the EBT margin expansion.

OG&A expenses are expected to grow approximately 16%. The higher increase in cost year-over-year is driven primarily by the $19 million related to the extra week and increased advertising. The tax rate for the fourth quarter is expected to be close to 39%. We are currently in the middle of the planning process for 2013, and it is premature to provide specific guidance for next year. However, we are working diligently to develop a 2013 operating plan that we believe will fall within our stated long-term guidance. We expect to deliver between 7% and 12% earnings before tax growth when compared to 52 weeks for 2012 and repurchase 4% to 5% of our outstanding shares net of long-term incentive plan dilution. The combination of these results would produce EPS growth of between 11% and 17%.

And with that, I'd like to turn it over to David Lenhardt, who will provide an update of our operations.

David K. Lenhardt

Thanks, Chip, and good afternoon, everyone.

As Bob mentioned, our third quarter performance was due to strength across all of our merchandising categories: consumables, hard goods and live goods, as well as services.

Within consumables, over 70% of our consumable sales are channel-exclusive, sold only in pet specialty stores or through vets. In the first quarter of this year, we expanded the space in the super premium category, our largest and fastest growing category, by adding innovative new formulations and expanded grain-free assortments and limited-ingredient assortments in dog and cat. As a result, we continue to see strength in this category and believe that we are well positioned to maintain our competitive advantage of carrying the best assortment across the aisles.

In hard goods, we've added a lot of innovation through resets over the past 2 years, most recently, the Toy Chest reset in the dog toy aisle and the aquatics and small animals resets, both in the second quarter. Resets allow us to stay in the forefront of innovation, so that we can continue to differentiate our brand with the best possible selection for our pet parents. We've also expanded the offerings within our portfolio of exclusive and proprietary brands, including Martha Stewart Pets, KONG, GNC Pets, Toys "R" Us Pets and the Bret Michaels Pets Rock collection, as well as our own proprietary brands, including Top Paw, Great Choice, Top Fin, Authority and Simply Nourish. These highly differentiated brands represent innovation, quality and value and really resonate with our pet parents.

The key customer insights and strong vendor partnerships that we've developed allow us to maximize the potential of our key brands, which we showcase through our fully integrated and compelling marketing campaigns. We've shown our customers how we're different from the competition and how we offer the best choice, but we are not done. This holiday season, we have even more innovation and compelling offerings across all categories to help pet parents celebrate the season with their pets. And we'll continue to invest in integrated marketing campaigns to tell our story of differentiation, exclusivity and value.

Pet services are an integral part of our strategy to further differentiate us from the competition, drive traffic and repeat business to our stores, providing cross-selling opportunities. And they allow us to forge strong relationships with our customers.

We had another strong quarter in services with positive comps across grooming, boarding and training. Our quality of care in grooming continues to drive sales with the Grooming Look Great Guarantee, and we continue to see strength in PetsHotels and pet training as well. We are excited to be able to better serve our customers and improve our operational efficiencies through our PetsHotels call center, which was rolled out nationally to all of our hotels by the end of the third quarter, which is just in time as we enter our peak holiday season.

Delivering authentic customer connections is at the core of our customer experience, and we continue to evolve this experience in our stores through investments in our associates with training and development so they can continue and engage with our pet parents in a genuine and authentic way. Our customer-centric focus is also at the foundation of our Omni-Channel strategy, which includes e-influence or pulling customers through to our stores, as well as e-commerce sales in a better and richer website experience. petsmart.com has been and continues to be the #1 traffic website in the pet supplies category. It is rich with relevant content and a differentiated merchandise assortment, with a growing assortment of Web-only, extended aisle SKUs.

In the third quarter, we launched our Canada site on petsmart.com so our Canadian customers are now able to see assortments available only in Canada as well as Canada-specific pricing. We have also made more than 20 website enhancements this year to improve conversion rates, brand perceptions and e-influence store transactions. Most recently, we launched several new tools on petsmart.com, including the customer feedback tool and dynamic retargeting. We will continue to invest in our Omni-Channel in a relevant way with programs to support the strength across the business.

While we expect the macro economy will continue to hold challenges for the remainder of the year, we believe that the strength of our seasoned management team, coupled with our focus on our strategic and operational priorities, will allow us to continue to navigate through these uncertain economic times.

For the remainder of 2012, we believe we have the opportunity to continue to do all the right things to drive future sustainable growth and long-term shareholder value. And with that, we would like to take your questions. Thank you.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Alan Rifkin with Barclays.

Alan M. Rifkin - Barclays Capital, Research Division

Could you maybe just provide a little bit more color on what you think the benefit from Sandy was, both in Q3 and what you do think that could be in Q4?

Lawrence P. Molloy

Alan, it's Chip. Q3, because it was coming up towards the end of the quarter, it really didn't impact much at all because -- may have been a little bit of pre-buying on the consumables but it wasn't material. Just the sheer fact that the number of stores that were closed in some of those areas just took so long to get back, and some areas still haven't gotten back, it is a -- it's a big enough number that it changes our guidance a little bit but not very much. We're not going to actually break it out. It's still an estimate as we speak, but it's a little bit on the guidance.

Alan M. Rifkin - Barclays Capital, Research Division

Okay. And one follow-up if I may. Obviously, the improvement in the expense ratio is a stepwise improvement over what we've seen out of you guys in prior quarters despite the comp being strong in prior quarters, as well as this quarter. Chip, could you just maybe shed a little bit more color as to what exactly you're seeing there and the sustainability in your opinion of this operating expense ratio leverage?

Lawrence P. Molloy

One, I would say it's -- I know this sounds a little bit like a lame answer, Alan, but it's a little bit of everywhere. It was one of those quarters where virtually every cost center seemed to come in slightly better than we thought it was going to come in. So I'll start there. The second thing is that we have been investing fairly heavily in marketing over multiple quarters, and we're now coming up -- except for the fourth quarter of this year, we're coming through a cycle where we started this a couple of years ago -- probably around the third quarter, a couple of years ago, so it's not as big of an investment. So those other areas where we're saving it aren't getting diluted by huge increase in marketing spend. However, in the fourth quarter, as was mentioned on the call, it's one of those quarters we really haven't made as much investment as we would have liked to historically. And so this quarter, we're expecting a big advertising quarter going forward.

Alan M. Rifkin - Barclays Capital, Research Division

Okay. And one last question if I may. Just playing devil's advocate. If you pull out the benefit from the extra week, which remains at $0.16, that would give you a 13- versus 13-week EPS number of $1 to $1.04, which, in terms of growth rates, would imply a material slowdown versus what you folks have been putting up quarter in, quarter out. What could you possibly attribute that to, Chip?

Lawrence P. Molloy

Well, I don't think it's been unanticipated. So we always thought the back half of the year, especially the fourth quarter, wouldn't be as big as the first parts of the year. One is, top line growth might not be quite as high, primarily as you start to see continued deceleration of inflation. That's number one. And then the biggest thing is that we have some increase in our professional fees. So some of our pro fees and the timing of our projects are hitting the fourth quarter. And then the biggest piece is advertising. So we are investing -- we're growing advertising almost 50% in the fourth quarter year-over-year. We've had a great year. We've had great momentum. We think it's worthwhile to continue to invest there. And we want to keep that momentum going into the first part of next year. And we think that level of advertising is going to keep the momentum going into the first part of next year.

Operator

Our next question comes from the line of Matthew Fassler with Goldman Sachs.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

So I want to press a little harder on 2 points. First of all, expenses. I believe that you had guided to all the leverage in the quarter coming from gross margin, and obviously, expenses beat quite substantially the SG&A ratio down about 80 basis points, and the sales were at the high end of the range but not appreciably better -- so anything in particular because you seemed to be pretty focused that the spending would be higher. Were you just planning conservatively? Or was there anything in particular that came in a little bit better?

Lawrence P. Molloy

No, I think we were planning a little bit higher. We had some things that went our direction. They weren't sort of one-offs but just across the board -- we just had a little bit better across the board. So it was one of those quarters where it just happened to be there. And when you look on an EPS perspective, the last -- the quarter last year in the third quarter wasn't quite as good when it came to the cost side. So it just -- when you look at it year-over-year, it just was -- just a spanking quarter.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Got it. And then secondly, you alluded in your comments a moment ago to inflation, just any amplification on the direction of inflation here and as we move into the fourth quarter of the year?

Lawrence P. Molloy

Yes. It's going to come down. As we said, early in the year, we had -- we were going to peak around 200 basis points in the second quarter of the year. It was going to start to drop pretty materially to basically flat by the end of the year. It is coming down, but it's not coming down quite as fast as -- quite honestly, as I anticipated. The consumables side is coming down as anticipated, but there is a little bit of inflation on some of the other businesses, hard goods, that I didn't quite anticipate. So it's coming down. It's probably going to come down -- it was less than 2 this quarter, and it's probably going to lose -- we might lose -- we might be around 1 for the fourth quarter.

Matthew J. Fassler - Goldman Sachs Group Inc., Research Division

Call it 1.5 in Q3 and 1 in Q4 ballpark.

Lawrence P. Molloy

Yes, that's probably about right.

Operator

Our next question comes from the line of Chris Horvers with JPMorgan.

Christopher Horvers - JP Morgan Chase & Co, Research Division

And so 2 questions. First, can you talk about AURs versus UPTs during the quarter?

Lawrence P. Molloy

Yes. So if you kind of take up the mix of the comps, we had a decent set of traffic or transactions. I would tell you that the units in the basket were just flat to just a hair down. We picked up quite a bit on AUR for 3 reasons. One was, inflation was a piece of that. The second piece is the quality of goods continues to move upscale, especially on the consumables side. And the third piece is that we were less promotional this year in the third quarter and plan to be in the fourth quarter than we were last year. If you remember last year, in the back half of the year, we got pretty promotional, especially on some of our low-end foods in the cans area. And that did have a negative impact slightly to units in the basket this quarter, but it helped both AUR and helped margin.

Christopher Horvers - JP Morgan Chase & Co, Research Division

And then were AURs just sequentially higher in the third quarter versus the second quarter?

Lawrence P. Molloy

The AURs, yes, they were.

Christopher Horvers - JP Morgan Chase & Co, Research Division

Okay. And can you talk about within the food category, the performance among the different good, better, best premium, super premium, bridge and grocery?

Lawrence P. Molloy

Yes. I would call -- what we call natural organic or super premium and Rx foods were both very healthy on the comp side, continue to be healthy both on dog and cat. I would say that the mid-tier, call it, bridge was a push to slightly up. And our low-end foods -- I'm sorry, premium was sort of a push to slightly up. And then on our lower-end foods, bridge and grocery, they were down as predicted.

Christopher Horvers - JP Morgan Chase & Co, Research Division

And then related to that, David, I know you talked about the reset earlier this year in that category. I know a big piece of the growth that sounds like is the super premium side going into treats and into cat, so maybe you could talk qualitatively about the adoption and perhaps, any quantification in terms of SKUs that have been added and if there's more in the come as well?

David K. Lenhardt

Yes, Chris. I think we continue to see customer response to the natural trends going on. And as we talked about earlier, the consumables resets allowed us to devote more space to the natural category, and specifically, to add more SKUs of existing brands. So it's SKUs like limited-ingredient, grain-free, which are extensions of existing natural brands. And we've been -- we've continued to be very happy with those results. And I think you're seeing that be one of the drivers. But I think you're continuing to see the ongoing humanization of pets continue where people are continuing to treat their pets like children more and more. They want the best for their pets. And with the assortment of natural and super premium foods that we have, we're seeing them continue to respond to that assortment in our stores.

Christopher Horvers - JP Morgan Chase & Co, Research Division

Do you worry about as you run over the AUR increases next year, do you worry about your sort of ability to drive the consumables category, given the complexion of the growth amongst the different tiers?

David K. Lenhardt

Not particularly, Chris, I would say. I think I go back to that underlying trend around naturals. And the naturals trend is not just a 1-year trend. This has now been several years that we've seen continued, very attractive growth in that category. And again, I think it goes back to both the humanization of pets and the way customers are feeling about their pets. That's continuing unabated. And I think the innovation that our merch team, combined with our vendors, is continuing to drive that category. And I would expect that it would continue to.

Operator

Our next question comes from David Mann with Johnson Rice.

David M. Mann - Johnson Rice & Company, L.L.C., Research Division

A question and clarification on marketing. Was there some shift in marketing expense from Q3 to Q4? And then also in terms of the guidance you are giving for Q4 comps -- or excuse me, comps and earnings, are you including the hit from the higher -- it looks like you're including the hit from a higher marketing expense in the OG&A but not necessarily the benefit that potentially will come to sales. Can you just elaborate on that?

Lawrence P. Molloy

Yes, David, I will. On the second piece of that, for sure, is that advertising is not as scientific as we make it. And by the way, our marketing team does a great job of trying to understand where we get our biggest bang for the buck. There are still pieces of that, that you really can't -- you can't look at a P&L and say, "Okay. I spent this much money and it happened in that particular quarter." I would say that we've had 10 quarters in a row of ongoing comp traffic growth. And if you can just get a couple of hundred basis points of comp traffic, it makes the rest of the business so much easier. And so we believe with a great year that we've had, continuing to finish out the year. We want to keep this momentum going into next year. And we believe it's the right thing to do to actually accelerate a little bit more in the fourth quarter. It is our lowest quarter from an advertising spend perspective. And we're going to get it back on par with the other 3 quarters by making that investment in Q4. And we think that, that's going to continue to help us going into next year. And we'd like to start '13 with a good year. I apologize, David. On the first part of the question, I've already forgotten what you asked...

David M. Mann - Johnson Rice & Company, L.L.C., Research Division

No worries. Was there some shift in the expenditure from Q3 to Q4 versus your previous plan?

Lawrence P. Molloy

There wasn't actually. We spent what we thought in Q3. It just -- it wasn't as big -- near as big an increase year-over-year, because we got fairly aggressive last year on that quarter.

David M. Mann - Johnson Rice & Company, L.L.C., Research Division

And then in terms of the ongoing shift to more premium upsell of products, can you give a sense based on any of the research you've done, where are we -- or where do you think you are, excuse me, in the process of upscaling the customer, upselling them? How much longer can that continue do you think in terms of that process?

David K. Lenhardt

David, it's David, again. As I was saying, I think we still have room to grow in that area. And again, I think it's 2 of the big drivers of that. I go back to the humanization of pets. We have seen that continue. And I think our ability, our merchandising team, our vendors, to take human trends and bring them into the pet world, we've seen customer response every time we do that. So when you think about things like supplements and GNC, we've been very excited with the response we've gotten to that. Naturals -- again, I think the innovation that our vendors and our merch team are doing give us a lot of runway to test in that area.

Operator

And then our next question comes from the line of Gary Balter with Crédit Suisse.

Gary Balter - Crédit Suisse AG, Research Division

Could you talk -- we've covered a lot of the fourth quarter. Could you kind of shed a little bit of light as you look into next year as to some of the margin and expense initiatives that you have as you -- without saying like, this is earnings number, although you kind of did say what your earnings number is?

Lawrence P. Molloy

Yes. I would say that -- a couple of things. It's still early to tell. But we have several things we're working on. We have some resets coming next year, some fairly major resets that we think are going to be compelling for our customer. And that's going to help drive our business. We're going -- we're continuing down the price optimization route as we work there, which is helping on the margin line. I think that you're continuing to see some trade up, both on the consumables side as well as with a lot of the innovative products that we're bringing. And we have some new and exciting things coming next year, as well, from our merchants that they have not yet advertised or spoken of, and we won't, probably until the next call. So I think between -- once again, some more innovative products and exclusive products, combined with some operational work on the price optimization side, good management on the expense side, I think there is an opportunity to deliver our long-term guidance.

Operator

Our next question comes from the line of Matt Nemer with Wells Fargo.

Kate Wendt - Wells Fargo Securities, LLC, Research Division

David, this is actually Kate Wendt in for Matt Nemer. [indiscernible] with -- on advertising, can you talk about where the 50% increase is coming from in terms of the mix of that spend, whether it's going to be more on TV or print or digital or email? And [indiscernible] versus last year, given that I think you've already tightened your promotional [indiscernible] last year in the fourth quarter.

David K. Lenhardt

Kate, it's David. Let me answer that first question and then I think Chip may answer the second one. In terms of the marketing investment, there were really 3 big areas that we're increasing our investment in, 2 of them are in TV, the other's in search. But you'll see us increase both promotional TV and differentiation, more branded television, as well as search. And from a dollar perspective, about 3/4 of the increase is in TV, the other 25% is in search.

Lawrence P. Molloy

And then on the promotional side, a couple of things. One, I would say, just the -- some of the promotional work we did last year, which was really just sort of a lower-cost piece of the business on some of the lower-end foods, we're not going to be that highly promotional there. However, the rest of the business is going to be as promotional as we've been during the holiday season. In fact, we just walked -- our senior team just walked a store across the street. We've got our holiday set in there. It looks outstanding. I encourage all of you to go out there and look in the stores. We have some great promotional campaigns that are integrated across market and merchandising throughout the quarter. And as you lead in to Christmas, we've got this 12 Days of Christmas marketing campaign that's going on that you're going to be seeing a lot of us on -- you're going to see us on TV a lot. And each day is going to be something different. So I think from that perspective, we're going to be highly promotional as it relates to marketing. But from a just lowering prices to drive velocity, we are not going to be as promotional.

Kate Wendt - Wells Fargo Securities, LLC, Research Division

And then in terms of following up on some of your margin drivers going forward, and I think you mentioned that [indiscernible] categories were up. And where do you think you're starting to see a real recovery in hard goods that maybe is part of what's behind the improvement that you're seeing in merch margins?

David K. Lenhardt

Yes. I would say that hard goods is solid. It's been a solid business now for us for several quarters. If you look at the mix, the comps, though, we had a 6.5 comp. Consumables was still outpacing that. Live was outpacing that as well, and services was slightly outpacing that. Hard goods was not. It was lower than the average, but it was still a good comp. And you can see that through the mix shift year-over-year that it was not as high as consumables. But it's still a solid comp. And as long as it stays solid, and I'm talking a couple of hundred basis points plus of hard goods comp, that's going to help us. And it doesn't become a problem. It's something we can work with and drive some decent results.

Operator

Next question comes from Michael Lasser with UBS.

Michael Lasser - UBS Investment Bank, Research Division

The question I have is on the gross margin in the fourth quarter. You indicated that about 55 basis points of the expansion that you're expecting will be from the extra week. That leaves about 65 basis points at the midpoint of core expansion, and that's coming on a what was a disruptive experience in the fourth quarter last year. So maybe you can talk about why you expect the pace of gross margin gains to slow a bit in the fourth quarter.

Robert F. Moran

A couple of things, Michael, just to sort of bring everybody in. Because I know it's somewhat confusing between 52 and 53. I would say, at the gross margin line, we're going to look at on a 53-week basis or GAAP basis, probably call it 120 basis points of merch -- or of gross margin. About 2/3 of that is going to come from occupancy, and about 1/3 of that is going to come from merch. And then when you go on a 52-week basis, you're looking at something in the 60 to 70 range. About half of that will come at rent and occ and the other half will come from merch. I would tell you that we are -- as you can see from our guidance, it's a slightly lower comp guidance. So you don't get as much leverage on your rents and occupancy line there. We did have a good utilities quarter last year at the rent and occ line. And year-over-year, we're expecting it to be much more normalized this year. As you remember, you guys had a pretty warm winter, I think, last year. And so that's not going to be as accretive year-over-year. And then the merch line is pretty much solid and generally not too different in our expectations in Q4 than it was in Q -- than what materialized in Q3.

Michael Lasser - UBS Investment Bank, Research Division

Okay. A question for Bob. Chip's arrival coincided with a renewed focus on discipline within the organization. Do you expect that to live on as there's a transition in the finance role? And what are you looking for at someone to come in to fill Chip's very, very large shoes?

Robert F. Moran

Well, Michael, I appreciate the words you just said, because I think that's exactly right. I think Chip has made some major contributions and has been a major asset here at PetSmart. I think that big shift in -- this is where the partnership that Chip and I began was we knew that we have an opportunity to drive productivity in our existing stores. And I think we've been very successful over the last 4 years, demonstrating what we can do on a sales per square foot, cost per square foot and driving that discipline into our culture. And when I use the word culture, I don't mean that lightly. This is how we breathe on a day-to-day basis. That culture will continue. The fishbone, the framework of how we drive shareholder value is staying in place. There won't be any deviations from that point of view. And if I had to sort of describe what are we looking for in the future, and I'm not -- I'm a little bit funny but being serious, we want a better Chip.

Operator

Our next question comes from Peter Benedict with Robert W. Baird.

Peter S. Benedict - Robert W. Baird & Co. Incorporated, Research Division

So looking at the store openings, I think they look, at least versus our model, a little light in the quarter. Are we going to make that up in the fourth quarter? Or is there some delay going on in the store openings?

Lawrence P. Molloy

Yes. Hold on, let me get that list out specifically on the store openings. So actually, Q3, we did 24 and we closed 4. So gross was 24, net was 20. And then in the fourth quarter, we're going to do another 11 and close 2. So that will get us for an annual number of 60 gross, less 14 closed, which gets you to 46.

Peter S. Benedict - Robert W. Baird & Co. Incorporated, Research Division

Okay, perfect. And then Chip, maybe can you tell us about how are the smaller-format stores, which are a larger percentage of the business or at least of the openings right now -- I mean, how are they performing versus your expectations and maybe relative to the larger core box?

Lawrence P. Molloy

Yes. I would say -- without too many specifics, I would say they're really good boxes. They are driving more sales per square foot. They are driving more earnings per square foot. A lot of it is, one, those stores are typically going into smaller markets on average and they're markets where we have not existed before. So you don't have the cannibalization. So it's more accretive to the organization as a whole. And then the rent on those stores are less, not just on a gross basis but also on a per-square-foot basis because of where they're typically being located. And it drives a lot more productivity. And the NPVs of those things are literally, we're looking at on average, probably 5x what we were doing just a few years ago with mostly our bigger boxes. So we're very pleased with those. We're going to continue to -- I think, the mix is probably going to continue about 75 or 70/30 going forward. And we're happy with it.

Peter S. Benedict - Robert W. Baird & Co. Incorporated, Research Division

Excellent, that sounds good. Just shifting over to the competitive front, anything new or interesting to call out during the third quarter in terms of pricing, whether from your other retail competitors or online?

David K. Lenhardt

Peter, it's David. It's been very stable across the board. And that's off-line and online retailers. I would say we've seen a kind of continuation of their strategies but nothing significant to report on.

Peter S. Benedict - Robert W. Baird & Co. Incorporated, Research Division

Okay, that's great. And then just lastly back to the inflation front. I mean, we've heard some talk that some of the food manufacturers talking about another round of price increases coming. Have you guys heard that discussion? Is that something that could be imminent for 2013 or even later this year?

Lawrence P. Molloy

That discussion started really right before our last earnings call. So that was starting to filter in with our merchants from the vendors. And I would say that we're still in discussion with that. And as we see -- the longer you drag that in discussion, you see that the commodity prices actually start to move different directions again. I suspect that we will have some inflation next year. It's very hard at this point to quantify about how much that is. If I were a betting person, it's probably going to look similar to this year.

Operator

And we do have time for one final question. Our final question will come from the line of David Gober with Morgan Stanley.

David Gober - Morgan Stanley, Research Division

A couple of questions if I could. I'm just wondering if you could give us an update on proprietary label -- or proprietary-branded products. You obviously had a couple of big launches over the last year, and I'm just wondering where that is today and also if you've had any more success in consumables.

David K. Lenhardt

Yes. David, it's David. We continue to focus significantly on proprietary brands this quarter. That's heading up to be about 23% of our total sales. And that has been a focus -- a big focus of our merchants working with our partners. And specifically, this year, we've had a number of different resets where we've introduced some new proprietary brands, specifically our Toy Chest reset earlier in the year. Toys "R" Us Pets was a big piece of that. We've introduced Bret Michaels this year. That's about 200 SKUs. We've been very excited with both of those as an example. And we've continued to see good growth in brands like Martha Stewart, in brands like GNC, in our own proprietary brands like Simply Nourish, which is our super premium consumable brand. So I do think we've seen it across all of our categories. And it will continue to be a key piece of our strategy going forward.

David Gober - Morgan Stanley, Research Division

Great. And David, another one for you. On the centralization of the call center, I think you mentioned that it just recently launched. Just wondering if you have any early takeaways there. Is that going the way you expected it? And had there been any glitches, given that it is a significant change in process for the company?

David K. Lenhardt

Yes. No, the rollout has gone very well. We just finished that. And that actually started last year, so we followed a very careful test and pilot process before we rolled it out. So we really were able to work out the glitches earlier. What we found is it's continuing to have improvements in a couple of areas in our hotels, where we've rolled it out. One, it helps the customer experience because you can call ahead, register yourself, get things like vaccinations checked ahead of time before you check in, which makes the check-in significantly easier. And we're hearing that from our customers. It also helps with our add-on sales. So there is a sales impact because our customers are getting a consistent dialogue with our call center associates. And then the third thing that it's really helped with is our associates in the hotels, it has now freed up time from them having to answer the phone. They can spend a lot more time on delighting our customers. And that's what we saw in the test. That's what we saw in the pilot. We've continued to see that in the rollout. And I'm excited to be able to be in a place now we're going into the fourth quarter, which is clearly a very big seasonal quarter for the hotels, we've got the call center in place to help our customers.

David Gober - Morgan Stanley, Research Division

Okay. And if I could squeeze one last one in. Bob, just wondered if you could touch a little bit more on the E-mart trial and how you think about international more broadly. Obviously, you mentioned that it's a low-cost kind of test to see how the consumer reacts outside of the U.S. and in that specific market. But just curious where you could see that going, particularly as you're losing your chief steward of capital allocation there.

Robert F. Moran

Well, I think, he also taught us. So don't worry about that. Well, I think we got our MBA in cost management and discipline. So E-mart, it's -- we're dipping a toe in the water. They approached us with the opportunity because they were interested in the pet category. It's a business that builds a lot of stores within a store. And as we looked at other retailers and how they were looking at that business, we felt it was a great low-risk learning exercise for us, so that we could better understand it. I -- we're not thinking about this going broadly at this point in time. It's truly just a learning process for us. And it's immaterial for anything, both resources and any type of investment. So it's an easy way to understand international. I have 16 years of international experience, and I kind of like not having boots on the ground from an investment point of view so you don't have to worry about monetary policies in various countries. So it's a good way to learn. So a lot more in front of us, don't really have anything behind it. We'll just use it as a low-risk learning exercise for us.

Well, I think we have come to another end of an earnings call, and I want to thank you for joining us today. And I'd like to wish you all a happy holiday. And we'll be speaking with you again in March of next year, and Chip will be here.

Operator

Thank you, sir. Ladies and gentlemen, that does conclude today's conference for today. Again, thank you for your participation. You may now all disconnect. Have a wonderful day.

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