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PetSmart Inc. (NASDAQ:PETM)

Q3 2008 Earnings Call

November 19, 2008 5:30 pm ET

Executives

[David Cohen] – Vice President of Investor Relations & Treasury

Philip L. Francis – Chairman of the Board & Chief Executive Officer

Robert F. Moran – President & Chief Operating Officer

Lawrence P. (Chip) Molloy – Chief Financial Officer & Senior Vice President

Analysts

Matthew Fassler – Goldman Sachs & Co.

Alan Rifken – Merrill Lynch

Gary Balter – Credit Suisse

David Mann – Johnson Rice & Company

Matt Nemer – Thomas Weisel Partners

Peter Benedict – Wachovia Capital Markets, LLC

Michael Baker – Deutsche Bank North America

Christopher Horvers – JP Morgan

David Cumberland – Robert W. Baird & Co., Inc.

Dan Wewer – Raymond James & Associates

Brian Nagel –UBS

[Joe Feldman] – [LZ Advisors]

Operator

(Operator Instructions). I would now like to introduce your host for today’s conference, Mr. [David Cohen], Vice President of Investor Relations & Treasury. Mr. [Cohen] you may begin.

[David Cohen]

Good afternoon and welcome to PetSmart’s conference call to announce our results for the third quarter of Fiscal 2008. With me on the call today are Chairman & Chief Executive Officer, Phil Francis, our President & Chief Operating Officer, Bob Moran, as well as Chip Molloy, Senior Vice President & Chief Financial Officer.

Phil will kick off the call with and overview of our third quarter results, then Chip will take you through the financial review of the quarter, as well as our earnings guidance, and Bob will provide a review of 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 & 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 Phil.

Philip Francis

Thank you, [Dave] and hello everyone. The world has gone through striking changes since we spoke about our second quarter results, but our commitment to delivering on our targets and building a business model that can deliver ongoing and sustainable returns for our shareholders has not changed.

Our performance for the quarter was in line with our guidance. Earnings per share were $0.28, up 21.7% when compared to the same period last year. And comparable store sales or sales in stores open at least a year grew at 5.4%. The unique blend of staples and discretionary items inherent to our business model has allowed s to manage through this challenging environment and deliver on our guidance for the quarter.

But we’re not without our share of challenges. We continue to see top line strength coming from our ability to pass inflation through to the customer. Our average ticket was up 6.2% in the third quarter, including a 690 basis point inflation benefit to comp sales. Last year our average ticket was up 3.5% and included a 225 basis point inflation benefit. Comp transactions which were used as a proxy for traffic decreased 0.9%, slightly better than the 1.7% decline we saw in the second quarter.

We continue to experience weakness in our higher margin, more discretionary hard goods business. And our services sales growth had dropped to 152% for the quarter from 20.4% in the second quarter. For the first time, we’re seeing some weakness across all three of our services businesses, Grooming, Training, and the PetsHotel.

Like many other retailers, we believe the weakening economy is impacting the discretionary spending of pet parents a bit. But these challenges don’t require that we change our commitment to our shareholders or our customers. In fact, our management team and our associates are more focused than ever on efficiently using our capital and emerging from this challenging time as a stronger player.

We have a number of things working in our favor that make us confident we can deliver. The pet industry continues to be one of the most attractive in retail. Pet parents continue to show that their emotional bond is powerful enough to keep pet spending in the budget. While it was the worst retail sales month in a number of years, PetSmart delivered 4.1% comp sales growth in October.

Clearly when you’re fortunate enough to be operating in this kind of an industry, you have to be prepared to defend your position. We believe the PetSmart business model is well-positioned to do just that.

Our total lifetime care strategy was built to flourish in boom times and to withstand the challenging times. Our less discretionary consumables business makes up over 50% of our sales and continues to be an important traffic driver.

Our knowledgeable associates and our services offerings help us differentiate from our competition and position us as a source for solutions to pet parenting challenges. Our newly mature customer relationship marketing program based on our PetPerks database helps us with customer recapture and driving trips for more casual customers.

Both efforts are difficult for our competition to counter. And years of experience offering solutions for pet parents gives our brand credibility. So it all comes down to our ability to execute and drive this business to deliver what it is capable of producing.

We recognized a year ago that our expense structure precluded us from delivering the leverage necessary to continue to grow earnings with a weakening top line. So we’ve had a year to begin tightening up on our day-to-day expenses and addressing our fixed cost structure.

We’re pleased with our initial progress and expense management and as a result of the evolving competitive landscape economic outlook, we’re going to pull back even further on our capital spending in 2009. We now expect to spend between $115 and $125 million in capital in 2009.

That will include the opening of 42 net new stores, all of which have a signed lease agreement and many of which are currently under construction. We also expect to build approximately 20 new PetsHotels next year, most of which will be in new store locations. The reduction in new investments will further reduce the near-term burden on our earnings, and will allow us to generate additional free cash flow.

We have a healthy balance sheet today. The generation of additional cash further increases our flexibility and allows us to be well-positioned to deliver in uncertain economic times. Our business model has recently shown some resilience, though we’re not immune to the pressures of the slowing economy.

The magnitude of the recent downturn may prove to be greater than we can fully mitigate with smart expense management and slowing our capital spending. We’ll continue to do everything in our power to deliver ongoing growth to our shareholders, but we do expect the next year to be challenging.

With that I’ll turn the call over to Chip to give you more detail on our financial performance for the quarter and our outlook for the remainder of the year.

Lawrence P. (Chip) Molloy

Thanks, Phil. Good afternoon everyone, as Phil mentioned, we delivered earnings of $0.28 per share, which was 21.7% higher than the same period last year and in line with our guidance for the quarter.

Revenue for the quarter totaled $1.3 billion, up 12.1% from last year’s third quarter. Our comparable store for sales grew 5.4% on top of 1.4% at comp growth for the same period last year.

We opened 32 net new stores during the quarter, to finish with 1,107 stores. We also opened 11 new PetsHotels and finished the quarter with 132. Operating income for the quarter was 5.8% of sales, an improvement of approximately 50 basis points compared to the same period of last year.

Gross margin for the quarter declined 110 basis points to 28.6% of sales. Merchandise margins were down 60 basis points from the sales mix shift and services margins were down 10 basis points. Store occupancy was unfavorable by 50 basis points due to the growth in new stores, while our supply chain costs were favorable by 10 basis points as we anniversaried the start up of our new distribution center in Noonan and began to realize the benefit from transportation efficiencies.

The leverage of our supply chain was in spite of an increase in fuel rate costs that averaged 35% higher than the same period last year. Operating general and administrative expenses were 22.8% for the quarter, or down 155 basis points when compared to the same period of last year. Positive impacts to expenses included cost savings initiatives, such as new store labor management processes, reduced professional fees, re-negotiated maintenance contracts, and a reduction in supplies.

During the quarter, we generated $46 million in operating cash flow and spent $68 million for capital projects. We ended the quarter with $54 million of total cash and cash equivalents and $50 million of debt on the balance sheet. We’re on track to spend no more than our target of $285 million on capital projects for all of 2008.

We ended the quarter with average inventory per store of $553,000, up 3.6% from the same period of last year, driven primarily by inflation. We’re managing the pressure from inflation by bringing down inventory levels to match customer demand. We ended the quarter with 127.1 million shares outstanding and we have 25 million remaining of our current $300 million share purchase authorization.

As we look forward to the fourth quarter, we expect to deliver earnings per share between $0.59 and $0.62 and comparable store sales in the low to mid single digits. Through the first two weeks of the quarter, comparable store sales have been 3.7%. We anticipate the inflation benefit in sales to continue through the fourth quarter, along with product margin pressure and ongoing leverage expense.

For fiscal 2009, we’re planning for a very difficult economic environment. We expect to have some continued top line benefit from inflation at least through the first part of the year, but margins will still be pressured from continued weakness in hard goods and slowing services growth.

We believe we can mitigate a portion of that pressure through capital and expense management. And as Phil mentioned, we’re reducing our capital spend from $285 million this year to between $115 and $125 million next year. We also expect improvements to leverage from improvements in our distribution network, and will continue to work on other non-customer facing expense management.

Given the uncertainty in the financial markets, we believe it is critical to create an even stronger balance sheet than we have today. We currently have a $350 million credit facility that expires in August of 2012, through a syndicate of institutions that includes Bank of America, Wells Fargo, General Electric Capital Corporation and Wachovia.

Over the last year we’ve kept our cash position to a minimum and distributed excess cash to our shareholders in the form of dividends and share re-purchases. That required us to periodically utilize our credit facility to run daily operations.

Going forward we plan to build our cash position to a minimum $125 million and be essentially self-financing prior to any additional share re-purchases. Given our healthy operating cash flow and reduced capital expenditures, we expect to be self-financing by the middle of next year.

Over the last year we’ve attempted to stay ahead of the economic downturn and make adjustments accordingly. We’ll continue to be flexible. Our goal over the next several quarters is to deliver consistent financial performance and positively position ourselves to take advantage of longer term improvements in the economy.

Now I’ll turn it over to Bob to provide more details on how we plan to deliver on our commitments.

Bob Moran

Thanks, Chip, and hello everyone. We’re building on our strong basic model with the addition of financial discipline and operational consistency. We think it’s a powerful combination that positions us to deliver returns through good times and bad.

So let’s talk about what we have seen on the top line. As Phil mentioned, our ability to pass inflation through to the customer is helping us to mitigate some weakness in traffic. Consumables made up about 52% of our business in the third quarter, up from 49% during the third quarter of last year.

And we continue to see growth in our channel exclusive categories. Our customer data tells us that we’re not seeing an increase in the rate of food trade down or deflection. In fact, it appears that we’re attracting more new customers than we’re losing.

Instead we believe our customers are pulling back on spending as they try to digest what the recent developments in the economy means for them. Our services growth rate dropped to 15.2% for the quarter, and now makes up 10% of our sales.

We have seen a decline in the frequency of trips in grooming. The PetsHotel has started to slow consistent with trends in the human travel industry. And training continues to struggle as new pet acquisition trends soften.

We also continue to see weakness in our hard goods business. For the quarter, hard goods penetration was 35%, down from 38% last year, and our live goods business has remained unchanged compared to last year at 3% of the business.

To offset some of the weakness in discretionary spending, we’re continuing our work to manage expenses and differentiate ourselves from the competition. I’m happy to report that we have completed the labor management system rollout in all of our U.S. stores and efficiencies in our supply chain are helping us to reduce cost.

We recognize that execution is not only important in managing cost, but it is also important in differentiating ourselves from the competition. We believe that our in store experience is an important differentiator and therefore, consistency across the chain makes a difference.

There aren’t many stores that allow you to shop with your pet and there aren’t many companies that understand the pet parent that wants their pets to choose their own toys. Here at PetSmart we have years of experience understanding that passion and we’re working to capture that spirit in everything we do.

We know that differentiation comes from knowing your customer and our PetPerks database allows us to understand how our customer shops and what they are looking for. This allows us to target our efforts and focus on what will drive the greatest returns.

During this holiday season we know that value is important. So our merchandising team is focused on the right mix of holiday themed and best selling products at the right value that should sell well during and after the holiday season.

Our assortment makes PetSmart a destination for customers looking for solutions to their pet parenting challenges. So our merchants have continued to improve our good, better, best strategy providing solutions at affordable prices. And of course a cornerstone of PetSmart differentiation is our ability to gain credibility with our customers through our services offerings.

We don't just have a place to leave your pet when you travel; we have a PetsHotel where pets can join happy hour and get a belly-rub and a bedtime story. At PetSmart its more than just providing a service; it's earning the trust of the pet parent by taking great care of their pet each time they visit us. So we have grooming and training academies for our service associates to instill and reinforce the skills that are necessary to provide only the highest quality of care.

It's clear that we're in a solid industry and that PetSmart is well positioned and we believe that we have the right strategy in place to emerge from this challenging time the unquestionable leader in our space. But we know that times will be tough and that we have to deliver time and time again to continue to grow this business and drive returns for our shareholders.

With that I will turn the call back over to Phil.

Philip L. Francis

Before we finish today, I'd like to think Tawni Adams for her outstanding work in our investor relations area. Over the next few months she'll be moving to a key role within our finance organization and will transition IR responsibilities to [Dave Cohen].

Now let's open up the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Matthew Fassler – Goldman Sachs.

Matthew Fassler – Goldman Sachs & Co.

I want to focus if we could first of all on the expense line; you had very impressive cost control including relative to the first half of the year. If you could talk about precisely where you were able to cut and also whether that was essentially a moving target through the quarter as you saw sales growth begin to moderate.

Lawrence P. (Chip) Molloy

That was really a function of things that we started at the beginning of the year and they're starting to materialize so things like headcount management, things like trimming professional fees, our insurance costs are coming down. We renegotiated all of our contracts, our store maintenance contracts. We continue to trim on expenses on supplies, so it's been an ongoing effort for probably the last nine months. Fortunately for us we continue to push those along and they're starting to materialize and something that we've been expecting for – ever since probably the beginning of the year.

Matthew Fassler – Goldman Sachs & Co.

I guess secondly, we've all seen commodity costs start to rollover. How do you think about pass through to pet food pricing as the increases abate? I would take it you don't expect to see pricing cuts, but how does that work both for street price and also for your margin as you move into next year?

Philip L. Francis

The history in pet food certainly and I think grocery as well is that when frontline prices go up and then commodity prices abate a bit they almost never, in fact I'd say, almost never, never come down. What we think is going to happen are beginning to see early signs of this. People who are on futures prices know that they're going to abate and going to come down. I think people are going go leave frontline prices alone, frontline costs. I think their promotional spend as they try to grow their business will be the way they'll go rather than a frontline based cost kind of cut.

We've been pretty religious about maintaining margin rates rather than just dollar for dollar as we've gone through and other people have followed that pattern as well. And in the last couple of weeks we've had a couple people who, based upon a story which is delayed reaction to oil up and so forth, we actually are going to have a couple of pet food price increases we know about in January of '09.

Operator

Your next question comes from Alan Rifken – Merrill Lynch.

Alan Rifken – Merrill Lynch

A couple of questions, we certainly applaud your proactiveness in continuing to take down your CapEx and your store count but, Phil, could you maybe just provide some empirical evidence that will tell us that its really more of a function of the current environment as opposed to your belief that maybe your approaching saturation sooner than what you thought? Then I have a follow-up please.

Philip L. Francis

Your hypothesis or your suggestion I concur with. Speaking for myself, I have been accused of being an optimist and a Pollyanna more than I have been considered conservative and I think the consumer – this time I'm not a Pollyanna as I look at the next 12 or 18 months I think the consumer is in trouble this time and so based upon that and over the last six or nine months, and with Chip's voice added to the mix, we've got a very realistic conservative view that today may be the new normal for 18 or 24 months.

We’re not a business that has been CapEx starved so we're in decent shape anyway, and so we have got ourselves down to either customer facing or differentiation initiatives. The other stuff we pushed off. We have been able to push out real estate. I mean our '10 real estate is going to be our '09 and '10 real estate mostly. The '09 real estate's going to be done in '09 and '10 basically because projects in some cases are delayed because developers couldn’t fill up their co-tenancy requirements.

But at the rate of 50 for a year we think the questions about saturation actually are off the table. We've got a long way to go and at 50 or so per year this is a matter of our pivoting 30 or 40% in our view of the macroeconomic world, and being a company that hasn't been starved for capital. So, we're going to hunker down but take care of the customer and take care of differentiation and should, if and when there's a glimmer, we're going to be prepared to rock and roll again.

Alan Rifken – Merrill Lynch

One follow-up if I may? As you continue to reduce CapEx and as your cash flow generation continues to increase, what's the order of your priorities with respect to plowing back that incremental cash flow that is generated?

Lawrence P. (Chip) Molloy

Priority one for us is to build the cash position to $125 million so we don't dip into our revolver any longer. We go in and out of it regularly so we don't see it as a problem, but given some of the financial crises that have gone on of late we just think it's prudent for us to build our cash position to where we don't have to dip into that, so that's priority one.

Priority two is to not change our dividend policy down so we don't plan on reducing our dividend policy, and then from that point I'm not certain yet. We’re going to get our cash position where we want it probably Q2 of next year and then we're going to start talking about a mix of share repurchases and dividends and what's the appropriate amount and then there'll be more news to come on that.

Alan Rifken – Merrill Lynch

One last question if I may, there's been a lot of talk about Wal-Mart really going after this area going forward. What are you seeing out of them from the competitive standpoint?

Philip L. Francis

Well as you can image there's no upside for me to say anything about Wal-Mart and talk about us. When Wal-Mart moves food to the center of the store I think they gain some traffic and I think they'll sell some more food. Our median, the numbers dipped in '06. Two people gained share it was Wal-Mart and PetSmart and in '07 there was two people who gained share, the same two.

In '08 the year's over enough but we know there's two people who are going to gain share; it's the same two. We’re confident that we're going to gain share next year. As they apparently target and shoot at us they may gain share.

Our job is to duck and let them hit somebody else. With the changes they've made we're the ones now who have the theater of live pets. We're the ones who have the theater of the sale of live pets and we're the ones who have the credibility of people thinking they know and can give advice on live pets because we're the ones who sell them.

So Wal-Mart targeting us is an honor I guess we could have passed upon but we've been working for ten years to differentiate ourselves and our answer is not to play their game but it's to differentiate, take care of the customer and be the solution for pet parents. The evidence so far is that we're doing well on that path.

Operator

Your next question comes from Gary Balter – Credit Suisse.

Gary Balter – Credit Suisse

First of all congratulations because you guys have what looks like the best numbers out there right now in retailing; hopefully your stock at one point reflects that. Questions for you, one is just as we look out to next year we haven't seen any guidance from you. It sounds like past the first half of the year where you have the inflation benefit that actually second half there's no reason to think that we're not going to be into negative comps. What stops the comps from going negative in this environment?

Lawrence P. (Chip) Molloy

The first half of the year, let me put it this way, we do think we'll have some comp benefits from inflation for the first half of the year. Where it's going to go in the second half of the year, I think what we're planning for is part of the reason for our reduction in CapEx and part of the reason for additional management of expenses is to manage through a year that could have some negative comps as we flow into the latter part of next year.

We're going to continue to do selling efforts. We have initiatives in place all around selling. We're going to continue to work to differentiate ourselves. We're going to continue to leverage our database of customers. We are working very diligently with our vendors on co-marketing programs, so we think that at the end of the day we'll continue to drive sales and we hope – we're not planning for big comps next year but at the same time we continue to work to try and drive that.

Gary Balter – Credit Suisse

That leads into the second part of the question which is as we look at SG&A as I think Matt mentioned before you've done a great job on the expense lines. You deserve a lot of credit for that. As we think about where you are in that equation, obviously get the benefit of not opening as many stores next year which will help. What are the other big things that we should be thinking about?

Lawrence P. (Chip) Molloy

Well, some of it we haven't capitalized on the investments that we've made into our services network, I mean in our W&D network or distribution network. We're going to start to see benefits. We'll see some, what I believe is some very decent benefits from our supply chain network in Q4 and that's going to flow in all through next year. It’s a much better network. It’s a healthier network. It's less transportation costs. That's going to be one area.

We still have benefits associated with store labor. We still think that there are activities in the stores that can be simplified. We have a list of those that – we'll not take out customer facing labor but we'll take out tasks which will then therefore help us on the labor lines. Those are just two of the examples and there's still areas that we have, I don't want to call it quite low hanging fruit anymore but there's still areas for us to manage our expenses and get better and we're only half way through this journey. So that along with a combination of a lower CapEx is going to benefit us and we should start seeing some higher benefits even in the latter part of net year.

Gary Balter – Credit Suisse

So what would be the comp number that we need to get expense leverage next year?

Lawrence P. (Chip) Molloy

Well, the biggest point there is really about the softness in discretionary items. At this point, Gary, we’re driving a cost structure originally to get us to a 2.5 comp to leverage which we expect it to be in that path by they second half of next year, but that was assuming that we wouldn’t have product margin degradation. The fact that we're now in a place where the mix shift is overcoming the rate changes that comp number is we're going to have to trim more on our expenses which is what we're doing, but our target is to be in that two range.

Gary Balter – Credit Suisse

So we could be lower or you could be lower and still be kind of flattish on expense percentage.

Lawrence P. (Chip) Molloy

Sure.

Gary Balter – Credit Suisse

Lastly, as you look at PetsHotel, one of the worries we get from clients is the worry about how is that going to do in the slower environment. People won't be taking as many vacations. They may not use it as much, etc. What are your thoughts on that? Obviously you're slowing you growth a lot.

Philip L. Francis

The reasons you said it’s a matter of degree I suppose, when human travel slows a bit why PetsHotel slows and that's why we did what we did next year. What we've essentially done by going to 20 is the hotels we had planned for new stores, which we've dialed back, if we had a hotel planned at any of those 42 stores that was new we're doing it. But in all of the stores that might have been remodeled or retrofit stores we're not doing those we're delaying those. There's a couple benefits.

Remember the CapEx is lower for a hotel in a new store than in existing because we don't have to deconstruct anything, so the 20 hotels we're going to put up are going to have a lower average CapEx cost next year that wouldn’t be the norm, and we don't lose anything; no something falling out of our deck of cards because we don't do a remodel. We can merely do the remodel two or three years later when the travel picks back up. So, we believe it’s a good business.

We've got lots of stores full for Christmas. Now the difference is instead of being full six weeks, nine weeks ahead of time they're full seven weeks ahead of time, but there is a little bit of affect there. I don't think you could stay at a PetsHotel anywhere if you tried to get a reservation on the 10th of December. I mean they're going to be full and they're going to be sold out. So we're not just doing the new ones which are low CapEx than the ones we have to do or lose, we're merely saving the more expensive ones in an existing store for a more advantageous time.

Operator

Your next question comes from David Mann – Johnson Rice & Company.

David Mann – Johnson Rice & Company

When you're looking at the mix shift that's going on and going into the fourth quarter when you have a higher discretionary spend typically, how are you approaching that in terms of what your expectations are and are you changing you marketing at all to try and offset that degradation?

Lawrence P. (Chip) Molloy

I’ll talk to the first part and then I’ll let Bob talk to the second part. How are we thinking about it? We do think it’s going to be a week in the fourth quarter we think that at the gross margin line that we’re going to have a bigger impact, negative impact to gross margin in Q4 than we did in Q3 related to that mix shift and we’re planning for that.

On the flip side there are some opportunities in Q4 that will help stabilize the gross margin. We think once again at W&D that we’re going to get a fair amount of leverage, more than we did this quarter in Q4. One, because of transportation network's improving plus fuel costs have come down tremendously. We’ll also not see as much degradation on the occupancy line as we saw in Q3 either.

So we are planning for gross margins all in to be down. They won’t be as bad as they were in Q3 from a year-over-year perspective. They will be worse at the product line but there are other areas to make that up.

Robert Moran

I’ll take over the marketing side. We’re doing a number of things. Obviously we’ve got a lot of foot traffic during the holiday time and we also know that we are creating traffic through our consumable side. So what we want to do is really ride on the coattails. One is on the in store environment we have a great opportunity while the customer is in looking for either the consumable or looking for gifts to really enhance the in store environment. We’re looking at that from category special 20% off on certain lines. We’re looking at emphasizing our PetPerks program and database to really emphasize the hard goods.

And then obviously we’re investing and continuing to invest in marketing. Especially in not only December but in January which is one of our biggest months of the year. So a lot of business is normal but a little bit more focus on hard goods so that we can mitigate the mix shift.

David Mann – Johnson Rice & Company

And the amount you're spending versus last year, relatively?

Robert Moran

About the same percent of sales.

Operator

Your next question comes from Matt Nemer – Thomas Weisel.

Matt Nemer – Thomas Weisel Partners

So my first question was just on the comps that you’ve seen over the last few weeks, what would be the sequential impact from inflation? So I guess what’s the – can you give us a sense of what the core business ex-inflation has done recently?

Lawrence P. (Chip) Molloy

So we gave the number in the script there it was 600 and what was the total?

Unidentified Corporate Participant

90

Lawrence P. (Chip) Molloy

690 basis points. Our expectation is that number is probably going to look very similar in Q4 maybe slightly less and all in comps we’ve guided to low to mid single digits. We’ve had a 37 for the first two weeks of the year, I mean first two weeks of the quarter, and we’re expecting something similar throughout the quarter.

Matt Nemer – Thomas Weisel Partners

Okay and then my second question was you spoke to the fact that channel exclusive foods, your share I guess in channel exclusive pet foods seems to be holding up pretty well. What about at the lower end in terms of grocery have you seen any share erosion in those SKUs?

Philip L. Francis

This is Phil and I am, I mean like you and everybody else I’ve probably read and extreme amount of noise about mix shifts and trade down and I – if we had the tread down story to tell we would tell you. I mean we would point out that we told you what had happened in services and we have no data to support a trade down or a defection, sort of story through yesterday.

I tried to figure something that might make the point [inaudible], from low to high on price we talk grocery bridge premium, super premium, and RX which is the basically medicine food that requires a prescription that 700 or so of our stores sell.

And that’s the highest price point stuff we sell. I mean this is $3.50 for a one pound can. This is $14 for a five pound bag because it's medicine and I looked up on comp, cat and dog sales, Q3 year-on-year, our RX business was up 40%. We’ve heard about humans splitting pills and skipping prescriptions. In the case of pet the highest price point stuff we sell was 40% year-on-year comp.

If we have that, I mean I understand if pet food's $3 million a pound something is probably going to happen and should we have the store to tell we would tell it, but today the defection or the down grade story is not evident in the data that we have.

Operator

Your next question comes from Peter Benedict – Wachovia.

Peter Benedict – Wachovia Capital Markets, LLC

Hey, guys thanks, most of mine have been answered but a couple of things. First on the services business you saw the slow down to 15% growth. How do you – what were you trending as you exited the third quarter and what’s kind of your sense of what you’ll see here in the fourth quarter?

Lawrence P. (Chip) Molloy

We weren’t going to – we gave comps for the first two weeks but we are not prepared to break out the mix of the comps for the first two weeks of the year and just inline with we had a five plus comp in the quarter all in for Q3 we had a four one in October so generally in the services business fell inline with the rest of the business on the drop off.

Peter Benedict – Wachovia Capital Markets, LLC

On the – what's the additional cutback in CapEx when we think about the timing of the store openings, the 42 new net next year. Are virtually all those going to happen in the first half? Could we have basically no openings in the back half?

Philip L. Francis

This is Phil it’s not quite – it’s heavily weighted to the first half. It’s not exclusively and probably 75% I the first half and more than half of those in Q1.

Operator

Your next question is from Mike Baker – Deutsche Bank.

Michael Baker – Deutsche Bank North America

Thanks, one just a follow up from a previous point so Phil, what were the comps in the super premium, premium, etc? Do you see those types of high products also costing better than average?

Philip L. Francis

I am unwilling to be as specific about that. I can tell you the lowest grade growth rate we had was in grocery but it was double digit and the RX was 40%. Generally the higher end was the better than lower end. Our lowest one was grocery though it was double digit. I am unwilling to give a particularly number quarter-by-quarter on category by category.

Michael Baker – Deutsche Bank North America

And then sticking on the consumables, so you told us the mix so we know then, we can figure out that the total consumable growth is about 19% year-over-year. If we assume 6% or 8% of that was from average new store growth, kind of the new store productivity number, then your consumable comp was maybe in the 10% to 12% range 7% from inflation. So does that – am I correct to say that the other 3% was from unit growth or maybe a bigger basket or something along those lines in the consumables?

Lawrence P. (Chip) Molloy

Hold on just a second Mike.

Philip L. Francis

While Chip looks that up if you've got another, I mean that’s a fairly specific question there that we didn’t have at our fingertips. If you’ve got another question while Chip looks that up we’ll come back to it.

Michael Baker – Deutsche Bank North America

Sure last one then, accounts payable to inventory was down again this quarter. It’s been down I think two or three quarters in a row by about 5% is that, why is that down and then should we consider that to continue to be down?

Philip L. Francis

Staff here just sayings it’s timing differences.

Michael Baker – Deutsche Bank North America

Three quarters in a row it’s been timing differences?

Philip L. Francis

Could be sure.

Michael Baker – Deutsche Bank North America

Does that catch up then at some point?

Philip L. Francis

Yes.

Michael Baker – Deutsche Bank North America

Okay.

Lawrence P. (Chip) Molloy

So Michael give me – you talked about 10% to 12% –

Michael Baker – Deutsche Bank North America

It’s the comp in consumables seems to be higher than the seven or the 690 basis point inflation I think. So what’s the rest of the comp consumable? I guess I would assume it’s unit growth in consumables?

Lawrence P. (Chip) Molloy

Unit, comp units are actually slightly down.

Michael Baker – Deutsche Bank North America

Okay then I guess the size of the basket must be up then?

Lawrence P. (Chip) Molloy

That’s correct.

Operator

Your next question is from Christopher Horvers – JP Morgan.

Christopher Horvers – JP Morgan

As you think about the Wal-Mart concern is going to stick there until I think it’s disproven and particularly in the food side. Maybe you could talk about what the prospects are for price reductions in light of what inflation was in the high end food brands versus the grocery brands?

Philip L. Francis

I would say on a percentage basis the increases are very similar. My experience I can’t differentiate between they weren’t to the – within a range of a couple of percent why they were similar across the board.

Christopher Horvers – JP Morgan

And what has been I guess the commentary from the P&Gs and the Colgates and the big food vendors as they’ve been thinking about price going into next year?

Philip L. Francis

Well I believe I said earlier we’re, I mean our hypothesis has been this inflation was going to flow through the first quarter and a half or something. We have had two of the big vendors describe to us price increases are going to be coming in January so that’s new news. I don’t know if they will be their or not under the implication that is. Probably at a lower level than in ’08 but we’re going to have some inflation benefit continuing in the back half of next year, first half, okay?

Lawrence P. (Chip) Molloy

Back out there.

Philip L. Francis

Yes.

Christopher Horvers – JP Morgan

And then as a follow on to Chip, a comment that you made earlier, you talked about a potential – this is a consumer shift and the potential for negative comps in the back half of the year. If you still get some inflation occurring in the back half does that, are you suggesting that maybe you expect traffic to deteriorate further?

Lawrence P. (Chip) Molloy

This would be for everyone on the call. We don't have a plan in place for next year. We're talking about – we haven't done it by period or by quarter yet. We're running it based on where we've seen the cost increases. We're still building our FY09 plan and the first part of that is we're expecting next year to be difficult because we're expecting it to be difficult we're managing our CapEx and we're managing our expenses.

We don’t have clarity yet as to what the comps are going to be by period or by quarter, but you can expect inflation to hit us, to benefit us at least through the first half of the year and at that point going forward it's uncertain for us right now because we haven't planned each of our periods.

Christopher Horvers – JP Morgan

Then finally as you think about L&S and saving payroll at the store level, could you possibly breakout how much that helps in that 155 basis and maybe give us the old baseball innings analogy where do you think you are on that side?

Philip L. Francis

I'll let Chip do the basis points if he wants to. In terms of timing we, the last two districts out of about 70 were done two weeks ago. We had a schedule disrupted by a hurricane that we had some stores to put back together and those two districts were delayed and so the flow through to next year of year-on-year benefit it kind of ratably through the year over the first three quarters of the year we ought to be giving year-on-year help ratably through the first three quarters on the payroll line as we cycle that.

Lawrence P. (Chip) Molloy

Yes, [per some] it was north of 20 basis points in store payroll and I expect that will get slightly larger as we go forward.

Operator

Your next question comes from David Cumberland – Robert Baird.

David Cumberland – Robert W. Baird and Co.

Bob, you mentioned carrying holiday-themes products that could sell well after the season. Is your markdown risk less as a result of this approach on the holiday assortment and about how much of your Q4 mix is holiday related?

Robert Moran

We really haven't disclosed the mix from a holiday point of view, but we put a lot into it and also how we're going to promote our way out of it, we feel that we're going to be in a pretty decent position by Christmas Day. And then obviously as I said, going into the last week of December and into the month of January, January's still very strong for us so that helps us mitigate some of this inventory.

Our inventory's in pretty decent shape right now. And actually some of the timing issues of looking at the inventory at the end of the third quarter, without bringing Christmas in earlier, and if you look at where we are today in inventory we're at a rate of increase of inventory that's under our sales increase. So we're in pretty decent shape for the inventory. We're not really anticipating really large markdowns, but we'll do whatever is necessary to make sure we're in a decent inventory position by the end of Q4.

David Cumberland – Robert W. Baird and Co.

And my other questions are on the Eagle Two refreshes, where do you stand on those and I know those aren't capital intensive, but does your lower CapEx plan for next year affect that program?

Lawrence P. (Chip) Molloy

Yes it does and a good question here. And this is an example, I think, of what businesses that haven't been capital starved can do. We would have had, I think the number's plus or minus a couple of 159 stores left to do on Eagle Two next year. We're not going to do that. We're going to be working with much of our class of '09 on Eagle Three.

We're going to have several initiatives in place with the Q resets, but mostly the new stores and what we think the next generation's going to be. Whatever part of that we validate during '09 we'll then take those 169 stores that were not going to be the last tranche of Eagle Two; make them the first tranche of Eagle Three in '10. We'll essentially collapse Eagle Two and Eagle Three into one effort and in the short term we can save the money.

These are stores that were Eagle Oned and they're not bad looking. Most of Eagle Two is adoptions and training which are softened a bit just now and so we're saving the money. We're going to take care of the shareholders and the very tail end of Eagle Two will be collapsed into Eagle Three in 2010.

Male

So can you talk a little about what changes are going to take place with Eagle Three?

Philip L. Francis

Well, with a smile on my face I say I could but I'm not going to. We, I bet we've got a dozen initiatives that we're going to have in various tests around the place. Surely some of them will fail. And I'll just bet you four work and four will be modified and work and four of them are going to be lousy ideas, but we're going to figure out the eight by the year from now and that'll be the class of ten that will be the last 169 stores in Eagle One that we'll do in 2010 and we're going to keep this thing fresh and going.

Operator

Your next question is from Dan Wewer – Raymond James.

Dan Wewer – Raymond James & Associates

Chip, when you were working on the last two new distribution centers, the company was anticipating a faster rate of unit growth than what's currently planned. Will you be able to get the leverage on these distribution facilities that you had originally anticipated given the density of stores is going to be less?

Lawrence P. (Chip) Molloy

We will. The primary reason is that at that point we actually thought we needed three and so we had one planned, I think it was planned for 11; we were going to spend the capital in '10, and we've actually pushed that out. We needed the capacity that we now currently have and we have enough capacity now, we believe to get through probably with the stores that we expect, probably through '12 into '13.

But we needed three and we've spared that. We've pared that down to two and have extended the time for the third one so we're in good shape there.

Dan Wewer – Raymond James & Associates

And then the drop in diesel fuel prices, as you alluded to, will benefit your freight expense going forward. But at the same time I guess it offsets some of the benefits of shortening your stem links. So when you're looking at the leverage in transportation, will the benefits be somewhat less given where diesel is currently running?

Lawrence P. (Chip) Molloy

No, actually I think that we'll continue to – we'll see some pretty significant benefits from the reduced line and the capacity that we have. I think we'll see in Q4 that the benefits are going to be higher than they were in Q3 and I think next year you're going to see some pretty significant benefits on it.

Philip L. Francis

Dan, this is Phil. It'll be less leverage than might have been at $150 a barrel oil, but it's still going to be leverage compared to what we put in the pro forma when we needed the CapEx to bill it to begin with.

Dan Wewer – Raymond James & Associates

And as I recall your freight costs are capitalized in inventory?

Lawrence P. (Chip) Molloy

That would be true.

Dan Wewer – Raymond James & Associates

Do we'll really begin to see the benefits of the drop in diesel fuel prices probably in the second quarter of next year?

Lawrence P. (Chip) Molloy

We will but bear in mind that our entire cost to run, the cost of fuel for us runs about $19 million so all in it's a very small piece of our entire cost structure.

Operator

Your next question comes from Brian Nagel – UBS.

Brian Nagel – UBS

So the first question that I have, with respect to – and I'm looking the fourth quarter comp guidance and it does suggest somewhat moderating from trends in Q3. As you think about the business as we go into Q4, how much more discretionary do sales become from Q3?

Philip L. Francis

A couple things go different directions. I think the hard goods business goes up in Q4, but what underlies all of Q4 for us is cold weather, Brian. Pets eat more food when it's cold out. You sell heated bowls in Q4 because it's cold, not because it's Christmas. You sell a new bed because it's cold, not because it's Christmas. You sell a sweater because it's cold, not because it's Christmas.

And so when Bob says things like January is a good month, first it's true, but it's because it's cold and our Q4 is good because it's Christmas and it's cold and I mean our, oftentimes our third quarter is the softest because it's hot. And pets tend to get a bath or even if the frequency is reduced, everybody's going to get a groom in the two and a half weeks before Christmas, and we're still going to sell a lot of training classes in January with three holidays in six weeks kind of takes a pause in December but it does very well in January as well because of new pets.

So the hard goods is discretionary but some of it is just cold weather-related and that's still – that's not going to be impacted.

Brian Nagel – UBS

And then the second question that I had, with respect to the PetsHotel and the boarding, to what extent have you experimented with different pricing schedules, given the weaker macro environment?

Philip L. Francis

We have experimented and we have raised some prices. We've also sent, I mean, it costs more to stay in the PetsHotel the 15th of January to the 7th of December than it does the rest of the year and that wasn't always true. And we've now done some more localized pricing based upon competitive checks and some tests that we've done, and so our price points have risen in '08 from what they would have been in '06 or '07.

We haven't raised many in the last 90 or 120 days because we think that the sensitivity is probably raised, but in terms of the structuring kinds of things people were talking to us about 18 months ago; do you charge more here than there and do you charge more at holiday times, we put that in place before this holiday season so our prices have been pretty stable for 90 days.

Brian Nagel – UBS

Okay, and then one final quick question. I looked. Your inventory at the end of the quarter was up about 15% year-over-year. It tracked a little bit above your sales growth. I think you commented before that inventory's in good shape. Is that basically in line with your plan or is there any reason for the variance there with sales?

Lawrence P. (Chip) Molloy

Part of that is the timing of the store growth so we have about 11.5% more stores this quarter than we had last quarter. Part of it's inflation, so 600 plus basis points of inflation adds to that. However, this was part of our plan. We expected to be in this position and we expect, based on where we're going and where we are even today that those inventory levels will be in line with our plan and from a year-over-year perspective, by the end of the year we're expecting about a 12 to 13% growth top.

Operator

Your next question is from [Joe Feldman] – [LZ Advisors].

[Joe Feldman] – [LZ Advisors]

Follow-up on services, I noticed during your commentary on margins you had mentioned that the gross margin was down a little bit, maybe 10 basis points or so and because of services? And I was just curious if you could just explain what happened there? Is it maybe a shift between the services, or?

Lawrence P. (Chip) Molloy

It just – we had less sales than we anticipated and the timing of the labor within – we put all of our labor up in our services line against the gross margin, both the labor and the hotels as well as the labor for grooming. And the fact that we saw a little bit of slippage there made the all in gross margin for those two businesses a little less than historically they've been. But we're ahead of it now. We understand where we're going from a Q4 perspective and we plan the labor accordingly.

[Joe Feldman] – [LZ Advisors]

Then one other quick question, I know Canada's not a huge part of the operation but just given the way currencies have been, was there any kind of currency impact to note in the quarter or maybe going forward that you guys are expecting?

Lawrence P. (Chip) Molloy

There was a currency impact. We didn't quantify it but we have 60 stores total in Canada so it did have an impact on us. The business in Canada actually on a Canadian dollar perspective is in great shape. It's doing really well but it has impacted us and we just haven't quantified it and we've planned it in our guidance going forward.

Operator

Your next question is from Peter Benedict – Wachovia.

Peter Benedict – Wachovia

A couple of follow-ups, thanks. First, can you remind us, what was the inflation impact on the business in the fourth quarter of last year?

Lawrence P. (Chip) Molloy

225.

Peter Benedict – Wachovia

So that was similar to the third quarter. I think that's what you said it was for the third quarter, right?

Lawrence P. (Chip) Molloy

Yes, third quarter --

Philip L. Francis

No, I think we did year-on-year, Peter.

Peter Benedict – Wachovia

All right. You said 225.

Philip L. Francis

We didn't give it to you.

Lawrence P. (Chip) Molloy

We gave you year-on-year not quarter-ob-quarter in the numbers you had.

Peter Benedict – Wachovia

Right.

Philip L. Francis

Last quarter we did give you the number, though.

Peter Benedict – Wachovia

Right. Do you have what the impact was for the fourth quarter of '07, the inflation impact?

Philip L. Francis

We'll look it up. What's your other question?

Peter Benedict – Wachovia

And then the other question, just to clarify on the mix shift, or – that occurs in the fourth quarter, are my numbers right in that the food business becomes about 25 to 30% of sales in the fourth quarter?

Lawrence P. (Chip) Molloy

I'd say your numbers are wrong. We have a slight shift of food going down because hard goods and services go up more, but I mean, food isn't going to go from 50 to 25%, no.

Philip L. Francis

Chip's got the other one here.

Lawrence P. (Chip) Molloy

So in Q3 inflation last year was 225 basis points and this year it's 690, like we said on the script, and then in Q2 it was 220 basis points last year and it was 450 basis points this year.

Philip L. Francis

How about Q4 last year?

Lawrence P. (Chip) Molloy

And you asked Q4 of last year, Peter?

Peter Benedict – Wachovia

Right.

Lawrence P. (Chip) Molloy

Q4 of last year was 260.

Peter Benedict – Wachovia

260, great. Thanks, Chip.

Operator

Your final question comes from Mike Baker –Deutsche Bank.

Mike Baker – Deutsche Bank

I just wanted to clarify, I don't know, on the inflation. So when you talk about it being 690 basis points here, is that the positive impact to the total company comp or just to the food business?

Lawrence P. (Chip) Molloy

Michael, after you got off I realized your question was a slightly different – that was total company. So as you think about it inflation for consumable was actually higher than that because that's where most of the inflation's been coming from.

Mike Baker – Deutsche Bank

I see, so in fact if you just wanted to do a simple analysis we could say if inflation was zero, in other words you would have comped down 1.5%.

Lawrence P. (Chip) Molloy

That would be true.

Operator

And this concludes our Q&A session for today's conference. At this time we're out of time for any further questions. I'd like to turn it back to management for any closing remarks.

Philip L. Francis

Thank you all for joining us today. I hope you have a great holiday season and I hope '09 turns out better than all the pundits predict. Thank you.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program.

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Source: PetSmart Inc. Q3 2008 Earnings Call Transcript
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