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PetSmart, Inc. (NASDAQ:PETM)

F4Q08 Earnings Call

March 4, 2009 4:30 pm ET

Executives

Dave Cone – Vice President of Investor Relations & Treasury

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

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

Robert F. Moran – President & Chief Operating Officer

Analysts

Gary Balter - Credit Suisse

Brian Nagel - UBS

Matthew Fassler - Goldman Sachs

Michael Baker - Deutsche Bank Securities

Alan Rifkin - Merrill Lynch

David Mann - Johnson Rice & Company

Matt Nemer - Thomas Weisel Partners

Christoper Horvers - J.P. Morgan

Dan Wewer - Raymond James

Operator

Good day, ladies and gentlemen, and welcome to the PetSmart fourth quarter and fiscal year 2008 investor conference call. (Operator Instructions)

I would now like to introduce your host for today's program, Dave Cone, Vice President of Investor Relations and Treasury. Sir, you may begin.

Dave Cone

Good afternoon and welcome to PetSmart's conference call to announce our results for the fourth quarter and for all of fiscal 2008.

With me on the call today are Chairman and Chief Executive Officer Phil Francis, our President and Chief Executive Officer, Bob Moran, as well as Chip Molloy, Senior Vice President and Chief Financial Officer.

Phil will kick off the call with an overview of our fourth quarter and full year results, then Chip will take you through the financial review of the quarter and the year, as well as our earnings guidance for next year, and Bob will provide a review of the operations of the business and provide insight into our upcoming year. 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 Phil.

Philip L. Francis

Thanks, Dave, and hello, everyone.

As all of you are well aware, 2008 was a very challenging macroeconomic environment, both domestically and globally. News of a widespread economic downturn accelerated in the second half of the year, pushing consumer confidence to record lows and resulted in one of the most challenging holiday seasons for the retail industry in over 40 years.

Despite those macroeconomic pressures, I'm proud to announce that PetSmart was still able to deliver both sales and EPS growth for the quarter when compared to the same period last year. Comparable store sales grew 3%, while earnings per share totaled $0.62 versus $0.59 in the fourth quarter of 2007. As a note, 2007 was a 53-week year and the fourth quarter included approximately a $0.07 benefit for the extra week. We're also proud of the fact that we were able to deliver earnings for all of 2008 totaling $1.52 per share, which was in line with our original guidance provided last March.

Despite our strong performance for the quarter, we are not without our share of challenges. Comp transactions continued to be down a bit and there are fewer items in the customer's basket. The obvious lack of discretionary spending has negatively impacted our higher-margin hard goods business and portions of our services business.

Grooming continues to be relatively strong, while Pet Training has been a bit weaker. Additionally, our Pets Hotel business, which includes boarding and day camp, has also shown some weakness.

2008 was a year when we focused heavily on lowering our cost structure without negatively impacting our relationship with our customers and our commitment to total lifetime care for every pet, every parent, every time. We removed non-customer facing tasks from our stores and drove efficiencies in our supply chain. We created a much more cost-conscious culture as we migrated from a mind-set of how much can we do to how much can we afford to do. We also reduced our capital expenditures from a historical high of $294 million in 2007 to $238 million in 2008.

Our focus on cost reductions helped us mitigate a large portion of the merchandise margin degradation caused by some of the weakness in sales of our higher-margin discretionary products. We're now ready to begin our next step as 2009 begins our journey towards a deeper focus on the customer.

Through extensive customer research and the data available from PetPerks, we better understand our customers needs and wants and are developing targeted strategies to drive incremental sales. We also believe we have a better understanding of how we can acquire new customers.

Under the umbrella of total lifetime care for every pet, we expect to widen the differentiation between ourselves and our competitors. We are focused on providing more innovative products, increasing product speed to market, strengthening our relationship with Banfield, telling compelling stories about our products, and creating excitement in our stores for both customers and our selling associates.

As a result, we believe we can continue to grow our market share and drive more productivity through our current stores, which Bob will speak to in just a few moments.

We are very fortunate here at PetSmart. We are a leader in an industry that services a strong emotional bond between pet parents and their loved ones. Our associates understand that bond and take pride in supporting it.

We're also very healthy financially. We ended the year with $126 million of cash on our balance sheet and zero debt excluding our leases. We have sufficient cash to run our operations without any additional borrowing, and our free cash flow is growing. We plan on reducing our capital expenditures by approximately 50% in 2009. In addition, the actions we have taken to date to reduce costs will continue to benefit us in 2009 and beyond.

Despite the macro economy we expect to look back at this time as one that helped us focus on what is critical to strengthen our market position while solidifying our long-term growth potential. Our management team and associates remain committed to stay the course. We expect to efficiently use our capital, while remaining adaptable to our rapidly changing environment. As a result, we remain confident that our strategy will product long-lasting results and shareholder value.

With that, I'll turn the call over to Chip to give you more detail on our financial performance for the quarter and the year, as well as our outlook for 2009.

Lawrence P. (Chip) Molloy

Thanks, Phil. Good afternoon, everyone. Today I will be reviewing our fourth quarter and fiscal year performance as well as providing our 2009 guidance.

Before I get started I want to emphasize that I will speak in GAAP terms when comparing our performance to last year.

As a reminder, fiscal year 2007 was a 53-week year and also included the one-time benefits from the sale of Banfield stock and the one-time write-offs associated with the exit of the State Line Tack business.

Last year's 53rd week provided approximately $90 million in incremental sales, $8 million of which were for services, and $0.07 in incremental EPS. The Banfield transaction provided $0.48 in incremental EPS. And the one-time costs associated with SLT negatively impacted EPS by $0.07.

As Phil mentioned, earnings for the quarter were $0.62 per share, which was at the high end of our guidance. This compares to $0.59 per share for the same period last year, which included the benefit from the 53rd week.

Total sales for the quarter were $1.36 billion, up 2.3% from the same quarter last year, while services sales, which are included in total sales, increased 6.9% to $131 million for the quarter.

Our comparable store sales or sales in stores open at least a year grew 3% for the quarter. operating income for the quarter was 10.5% of sales, a 65 basis point improvement when compared to 9.8% for the same period last year.

Gross margin for the quarter declined 110 basis points to 30.5% of sales. The loss of the extra week this year negatively impacted margin by approximately 50 basis points.

Merchandise margins were down 100 basis points, primarily due to sales mix, while services provided 30 basis points of benefit.

Store occupancy was unfavorable 55 basis points due to the growth in new stores, while our supply chain costs were favorable 65 basis points due to improve productivity in our distribution centers and the realization of the benefits from the investments we made in the network over the course of the last two years.

Operating, general and administrative expenses were 20.1% of sales for the quarter, a 175 basis point improvement from the same period last year. This is the results of a company wide focus on running the business more efficiently. Improvements in expenses are from our new labor management system, which was rolled out to all U.S. stores in 2008 as well as renegotiated maintenance and service contracts, reduced professional fees, and an everyday focus on areas like supplies.

For the fiscal year, EPS totaled $1.52. Sales totaled $5.07 billion, an increase of 8.4% compared to last year. Services sales totaled $527 million, an increase of 15.8%. And comp stores sales for the year totaled 3.8%.

Fiscal 2008 operating income totaled 7.3%, down 20 basis points when compared to 2007.

Gross margin declined 120 basis points. Within the gross margin line, merchandise margins declined 40 basis points to 41.0% of sales. Services were flat at 2.9% of total sales. Rent and occupancy costs were unfavorable by 70 basis points to 9.9% of sales. And warehouse and distribution costs were flat at 4.7% of sales. We were able to offset the majority of the gross margin decline with approximately 100 basis point improvement in OG&A.

During the fiscal year we opened 112 new stores and closed 8, which included opening 8 stores and closing 3 in Q4. We also opened 45 PetsHotels during the year, including 10 in Q4, brining our year end totals to 1,112 stores and 142 PetsHotels.

During the year we generated $421 million in operating cash flow and spent $238 million in capital expenditures. The total capital spend was $47 million below our original budget and $56 million below our peak of $294 in 2007. This is the result of us tightening our processes for approving capital projects while working to reduce overall spend and minimizing the near-term dilution to our income statement.

During the year we also repurchased $50 million of PetSmart stock and distributed $15 million in dividends, ending the year with total cash and cash equivalents of $126 million and zero outstanding borrowings on our credit facility.

We ended the year with average inventory per store of $525,000, up 5.6% from the end of last year, driven both from inflation and decisions to make select forward buys that provided economic benefits. We are also very pleased with the overall health of our inventory. We sold through essentially all our holiday inventory by fiscal year end and do not have future markdown risk.

Now let's discuss our outlook for 2009. We continue to remain cautious about the economic climate, and for the year we anticipate low single-digit comps, total sales growth in the mid to high single digits, and services growth in the mid to high single digits. We expect earnings per share of $1.40 to $1.50.

We believe that 2009 will continue to be a tough retail environment as consumers hold back on discretionary spending. We anticipate an operating margin decline of 60 to 70 basis points, driven primarily from continued gross margin degradation. Within the gross margin line, the mix shift will continue to pressure merchandise margins while rent and occupancy will also be unfavorable, but at a much-reduced rate. Services are expected to provide some benefit, while benefits from supply chain productivity and lower fuel costs should be relatively significant.

We are expecting OG&A expenses to be relatively flat as a percentage of sales, and we are projecting net interest expense of approximately $60 million for the year as over 98% of our interest expense is related to capital leases.

We expect a reported tax rate between 38.5% and 39.0%. We also expect to report between $4 million and $5 million of equity income from our investment in Banfield.

Our 2009 capital expenditures are expected to be $115 to $125 million, which is a reduction of approximately 50% when compared to 2008. We plan to use 80% of that CapEx to build 40 to 42 net new stores, 20 PetsHotels and other remodel-type products. The remaining 20% will be spent on supply chain, IT and other infrastructure improvements.

During 2009 we plan to maintain at least $125 million of cash and cash equivalents on our balance sheet and zero outstanding borrowings with our $350 million credit facility. Our credit facility does not expire until 2012, and to date we have not had any problems utilizing portions as necessary. However, we believe that given the current turmoil in the banking industry, being self-financing not only mitigates any liquidity risk but also provides a strategic advantage.

We expect to continue to assess the economic environment and market conditions during the year to guide our decisions relating to share repurchases and dividends. Our guidance for the year currently does not assume any share repurchases or changes in our dividend practice of $0.03 per share per quarter. In that scenario we expect our cash to total between $310 and $340 million by fiscal year end.

During the first quarter of 2009 we are expecting comparable store sales of low to mid single digits and earnings per share of $0.27 to $0.31. We anticipate Q1 to be slightly more challenging from a year-over-year operating margin perspective due to the fact that we are opening 65% of our new stores and 50% of our hotels during the first quarter. As the year progresses, the slowing of store and hotel growth will help offset a larger portion of the expected merchandise margin degradation.

Before turning the call over to Bob I want to emphasize how fortunate we believe we are to have the combination of a strong balance sheet and a business model that generates significant cash flow. This will allow us to manage through a challenging economic environment and gain strength along the way.

Now here's Bob to summarize our operational activities for 2008 and discuss more about our increased focus on the customer in 2009.

Robert F. Moran

Thanks, Chip, and hello, everyone.

We feel that our performance for the quarter and fiscal year is a great indication of the strength of our total lifetime care promise. The fourth quarter resulted in a 3% comp; however, it was a rollercoaster ride to get there. Like many retailers, the traditionally busy weeks in December were challenged. Despite a strong start to the quarter, December proved weaker than both November and January. Fortunately, our business rebounded right before the Christmas holiday and continued to gain strength in January.

For the quarter we continued to experience a drop in comp transactions, which we used as a proxy for traffic, and there were slightly fewer items in the customer's basket. The reduced units were offset by inflation and pricing strategies. The fourth quarter inflation impact was less than the third quarter, but still greater than the historic levels of 2% to 2.5%.

We understand that our differentiation and strength comes from knowing our customers and the passion that they have for their pets. For this reason we are beginning our journey towards a deeper focus on the customer and the many ways we can strengthen the relationship and lifetime care we offer to pet parents.

Throughout our organization we are committed to providing more innovative products, increasing product speed to market, strengthening our relationship with Banfield, telling compelling stories about our products, and creating excitement in our stores. This challenging environment helps to clarify the need for some changes in the way we do business. In response, we made some organizational changes to better align our merchandise and supply chain strategies.

Joe O'Leary is now leading both groups to better drive innovative products and increase the speed to market. His focus is clear - to drive profitable sales and margin and to keep inventories in check.

In the midst of new retail challenges, we decided to break our previous paradigm in regards to our approach to the holiday season. We partnered with vendors to offer promotions on certain hard goods and additional in-store offers which proved a success. By challenging how we have always done business, we have been able to increase excitement in the stores and execute with new strategies. In essence, we were actually able to teach an old dog a few new tricks.

Typically, we clearance our holiday merchandise beginning in January. We changed this strategy, too. This year we began to clearance the holiday merchandise before the Christmas holiday. And as Chip mentioned earlier, we were able to sell through virtually all the inventory by fiscal year end, generating positive margin dollars.

Compelling product offerings as well as better in-store execution contributed to increased customer satisfaction throughout the store. Notably, our in-stock levels, as measured by the customer, were the highest we have ever seen as we ensured that customers were not let down when they made a trip to our store. This was a conscious decision on our part, which was a contributor to the slightly higher average store inventory versus last year.

We believe that the right product offering can still drive sales and margin in this tough environment. One example is Pedi Paws, a nail grinding tool for dogs. We knew this would create excitement in our stores, so we focused on speed to market and had these available for our customers in less than three weeks.

However, there are still things we can improve. In some categories we find that we may carry too broad of a selection. We all know and love those lint rollers which help to remove pet hair from clothing or upholstery. We think they're great, too, but discovered that we had far too many lint roller SKUs - 16 to be exact - so we have been working on SKU rationalization and space and assortment optimization in our stores. This will allow us to reduce inventory levels on slower-moving products while creating space for new innovative products.

Our propriety brand offerings provide additional opportunities for us to enhance our margins. Currently, we have several proprietary brands that make up approximately 17% of our merchandising sales. If you add services into the mix, over 27% of our total sales come through our proprietary offerings. Our proprietary brands include well-known brands such as Authority within consumables and Top Fin Aquatic products.

But we can do better here, too. We are currently working to simplify our approach by reducing the number of brands offered to better establish household names while increasing the number of products to successfully gain more market share. We are in the early stages of this transformation, and we'll be sure to update you as the year progresses.

We are also more focused on our drive aisles, using promotions to create cross-selling opportunities. As a leader in pet specialty, we provide our vendors a unique opportunity to market more of their products with an attractive opportunity to increase their overall market share.

Vendors are working closely with us to fund promotions throughout the stores which will contribute to our ability to increase basket size and attract new customers to our stores. Together, we are creating excitement in our stores while giving our associates compelling stories to share with our customers.

Despite some slowing related to the economic environment, our services offerings still remain a very sticky part of our business as pet parents remain loyal to us when they are in need of services. Grooming remains strong, as the Christmas holiday week produced the highest single week of Grooming sales in our history. We also reached another milestone this year as one of our Grooming salons hit $1 million in sales for the year. Our Hotels were slower during the off-peak weeks; however, many still had waiting lists during peak times.

Our partnership with Banfield continues to strengthen as they have a hospital in over 69% of our U.S. stores. Banfield has been successful in recruiting well-qualified veterinarians to keep pace with our store growth. In 2008 Banfield made great strides to change from a protocol model to one focused on customer service. Many of the hospitals now have operating hours that mirror our stores, increasing the consistency of the customer experience.

Our leadership teams and field personnel meet regularly to identify synergies and we have also begun providing joint offerings to our customers. Banfield helps complete the overall customer experience as we can provide pet parent services and solutions under one roof.

Fundamentally we remain in an attractive competitive position against our competitors. But as always, we remain humble yet prepared to retain and grow our market share. Over the past few years we have worked hard to build a foundation, refine our execution, and assure the consistency of our brand in all we do. Our total lifetime care promise stands stronger than ever as we work to continually meet the evolving needs of our customer.

With millions of customers shopping in our stores each week, we have a valuable opportunity to strengthen our relationship with our customers while offering them a uniquely engaged in-store experience. Our marketing plan for 2009 will continue to refine our ability to share our story in a compelling way, offering our customers deeper engagement through in-store events, targeted communications and the web. While our best customers remain extremely loyal, we recognize this year as one that will allow us to share our promise with even more pet parents who have yet to visit our stores. Our loyal customers continue to shop us for the experience, as we offer them a unique retail visit.

With over three-quarters of sales trackable with PetPerks, our PetPerks database has continually allowed us to deepen our understanding of who our customers are, how they shop and what they're looking for. With the use of our extensive database and customer research, we now have the ability to segment our customers while developing targeted strategies to drive incremental behavior. This data is impacting how we invest to reach our customers, while driving many of our everyday business decisions. These efforts will remain at the forefront of our second quarter results focus as we seek to strengthen our customer base and increase the overall value of our brand to our customers.

Despite the uncertainty of the macroeconomic environment, we feel well positioned to deliver returns in 2009. By slowing our store growth in 2009, we believe greater emphasis can be placed on our current store base. Driving incremental sales and margin, as well as operational efficiencies, are expected to be some of our most impactful opportunities. Our increased focus on the customer will allow us to continue to deliver a uniquely engaged customer experience by delivering our goals and gaining market share.

There is no question that 2008 was unlike any other year or that 2009 will be filled with challenges, but we refuse to view these times as a crutch, but rather as an opportunity to capitalize on our strategy. We believe we are creating a cost structure that will allow us to be nimble in this difficult retail environment, and we remain extremely confident in the strength of our balance sheet, liquidity, and operating model to bring us through the headwinds of 2009.

We hope to look back on this challenging time as one that allowed us to realign our priorities and make us stronger. In this environment, we expect the strong to get stronger and plan to emerge stronger than ever before.

Philip L. Francis

Thanks, Bob. And now we'll be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Gary Balter - Credit Suisse.

Gary Balter - Credit Suisse

A number of questions just to fill in some of the holes. Could you mention again why inventory was up as much as it was? You mentioned forward buys. How much of the increase is forward buys and why did you decide to do forward buys this time?

Lawrence P. (Chip) Molloy

A couple hundred basis points are forward buys, but why we do it is in the time environment where we are, we're being offered some discounts that help gross margin if we go ahead and do that. We've been doing it all along the year, helping us along the way. And it's usually consumable products with fast turns, so it doesn't put us in an inventory risk perspective.

Gary Balter - Credit Suisse

Could you talk about inflation, how much you're seeing in inflation?

Lawrence P. (Chip) Molloy

Yes, inflation was not as high as it was in Q3, but still higher than historical levels of 2% to 2.5%. We weren't going to actually quantify the number this quarter.

Gary Balter - Credit Suisse

In your assumption for positive comps for next year, is there an assumption that there is slight inflation?

Lawrence P. (Chip) Molloy

We'll continue to see inflation, especially through the first half of the year, and then that inflation will slow.

Gary Balter - Credit Suisse

And then the last question is just when you look at the guidance and it looks like conservative guidance, why would you not be able to get leverage off expenses with the comp that you're assuming, given that you're slowing the store growth so dramatically?

Lawrence P. (Chip) Molloy

We will, but if you think about the store growth, we're still building, call it 27 stores in Q1, so we're still on a run rate of 100 plus stores in the first part of the year. We'll start to get those benefits on the back half of the year as we really start to monetize that slowing of the growth.

Gary Balter - Credit Suisse

But you gave us no expense leverage for the year.

Lawrence P. (Chip) Molloy

We didn't. We have low single-digit comps as our guidance for the year, so we've come down quite a bit from an expense structure than where we were relative to - we needed a 4plus comp before; we're now in a place where it's a much lower comp.

Gary Balter - Credit Suisse

But they may turn out to be conservative?

Lawrence P. (Chip) Molloy

I won't comment there.

Operator

Your next question comes from Brian Nagel - UBS.

Brian Nagel - UBS

I have a couple of questions. First off, just a follow on Gary's comment on the expenses. If we look at Q4, you guys have done a nice job of controlling expenses really throughout the year, but it seems like in Q4 it was taken to another level with your SG&A dollars down. The first question is related to that. Does any of the SG&A expense in Q4 '07 reflect that extra week or was that only in sales?

Lawrence P. (Chip) Molloy

Primarily in sales. And it's the fixed costs that were up in sales, the rent and occ and the warehouse and distribution. It was de minimis in the expense line.

Brian Nagel - UBS

So as we look at the SG&A expense, then for the fourth quarter and the improvements you've made year-over-year in the fourth quarter, how sustainable should we view that even into the next couple of quarters?

Lawrence P. (Chip) Molloy

Well, you're not going to see the same kind of improvement every single quarter. Right now, just like talked with with Gary just now, we're expecting that we brought our cost structure down to where we're in a place where we can leverage at a much lower comp in the 2% to 2.5% range.

Brian Nagel - UBS

Also, then, on inventories, I saw the growth. The growth in the inventories really seemed - I looked at from Q3 to Q4 - relative to your sales growth, it seems like it accelerated over the past couple of quarters. As we look into 2009, do you expect inventory growth to moderate to be more in line with sales growth?

Lawrence P. (Chip) Molloy

Actually we do. And we have plans in place; we actually think that it will be less than sales growth next year.

Brian Nagel - UBS

Bob talked about the trend of business throughout the quarter. Just to be clear, I think that was from a total sales perspective. Was there a different trend for the service businesses as we went through the quarter?

Lawrence P. (Chip) Molloy

The service business was pretty much in line with the rest of the business. November was strong; December was less than we would have desired, and in the latter part of December it started to pick up. Hotels, of course, it's very seasonal, so the Hotels piece was still very strong in the peak weeks around Christmas.

Brian Nagel - UBS

I guess the follow up to that, as we look at the 2009 guidance, what type of service growth are you assuming in those total sales numbers?

Lawrence P. (Chip) Molloy

I think it's mid to high single digits.

Operator

Your next question comes from Matthew Fassler - Goldman Sachs.

Matthew Fassler - Goldman Sachs

If you could give us a little more color on the impact of the heavier openings in Q1. Is this something that will weigh on SG&A from a pre-opening perspective or does it keep the pressure on gross margin in terms of occupancy?

Lawrence P. (Chip) Molloy

It's a little of both, Matt, so it's pre-opening; it will keep a little bit more of the pressure on gross margin. But as you get through the year, the gross margin will definitely start to see less dilution at the gross margin line with the stores as we've slowed down. On the back half I'm even anticipating that we'll be accretive on gross margin for rent and occ.

Matthew Fassler - Goldman Sachs

Second question, the services breakout, you talked about 6.9% growth. I guess that was 13 weeks versus 14 weeks, so do you have an adjusted number or would we just add essentially 5% or 6% to that to get to a 13% versus 13% or 14% versus 14%, however you want to look at it.

Lawrence P. (Chip) Molloy

Yes, we had $8 million of incremental sales last year associated with services. Just back out the $8 million and do the math from there.

Matthew Fassler - Goldman Sachs

Kind of a mid single digit percentage, adjusted still double digits?

Lawrence P. (Chip) Molloy

Yes.

Matthew Fassler - Goldman Sachs

I know you have a little bit of business in Canada. Canadian currency probably went against you. How material is that to the top line and does that show up in the comp or just in total sales?

Lawrence P. (Chip) Molloy

It shows up really on the expense side of the house as well, but it was not material for Q4.

Matthew Fassler - Goldman Sachs

And then finally, can you talk about consumer behavior among pet food brands? This is obviously a focal point. Are you continuing to see brand loyalty for your core higher end pet food products?

Robert F. Moran

Actually, we haven't seen any trading down. We've seen a lot of brand loyalty to the consumer brands and we're also supporting that with our PetPerks database because our loyal customers, knowing their brand, and also the customized communications we're sending out to them is also helping with that loyalty. So we haven't seen the traditional trading down that everybody's talking about. Our customers continue to be brand loyal.

Operator

Your next question comes from Michael Baker - Deutsche Bank Securities.

Michael Baker - Deutsche Bank Securities

A couple of questions on just some metrics you've given in the past I wonder if you could help us with. Actually quantifying the ticket growth, I think you've given that in the past few quarters. You've also given us a little bit more, I think, specific numbers on the mix.

Then following up on Matt's question, last quarter you had discussed you sort of tier your food brands into five different levels and you were seeing stronger growth at the higher end, the Rx, and less growth on the sort of entry level. I guess, Bob, you just said that there is some brand loyalty, so can we assume that you're still seeing that kind of favorable mix towards the higher end brands?

Philip L. Francis

While Chip looks up some of these, of the five tiers with grocery being the bottom tier and the Rx Food, which is actually a prescription medicine contained in food, being the fifth tier, the top two growers by quite a margin were Tiers 4 and 5, and the bottom grower was Tier 1.

So we continue to see - I read all this stuff about the trading down and at an individual customer level maybe somebody is trading down, but we're getting new customers into the higher tier at a faster rate than anybody's trading down. So the way it looks in a macro sense is there's either good loyalty and/or more growth up than there is deterioration down. I suppose at the individual level there must be some of both, but at a macro level the higher end stuff is growing faster and the lower end stuff is growing, but at a slower rate.

Lawrence P. (Chip) Molloy

On the mix of goods, for Q4 the mix of consumables was 51.6% compared to last year's 49.6%. Hard goods was 36.5% compared to last year's 38.9%. Live goods was 2.3% compared to 2.4% and services was 9.6% compared to 9.2% on the mix side of the house.

Michael Baker - Deutsche Bank Securities

So pretty similar, I think, in terms of the increase in consumables versus previous quarters.

Lawrence P. (Chip) Molloy

That's correct. And then from a growth perspective, transactions for Q4, 39% on transactions, [dollar] per transaction was 61%.

Michael Baker - Deutsche Bank Securities

But I think like last quarter you said, for instance, ticket 6.2%. I think the previous quarter ticket was up 5.6%, etc., 5.2% before that. I'm just trying to fill in the model and get a sense of the trends there. Do you have that metric?

Lawrence P. (Chip) Molloy

What we've given in the past has actually quantified inflation, but we're not quantifying inflation this quarter and just giving you a range of it. It's higher than the 2% and 2.5% and lower than what we said in third quarter.

Operator

Your next question comes from Alan Rifkin - Merrill Lynch.

Alan Rifkin - Merrill Lynch

Chip, I understand your reluctance to not give us an exact inflationary number, but if I recall correctly the benefits in Q3 were 690 basis points. Now you're saying it's somewhere between there and 2.5%. That's a pretty wide range. Would you be able to narrow that down just a little bit? Is it closer to Q3 or is it closer to historical trends?

Lawrence P. (Chip) Molloy

No. No, Alan, we're going to try and - there's so much noise around inflation, and within the inflation there's mix going on as well, so, for instance, within consumables. We're actually seeing on the food side, the food's really solid. And it's really solid in units such as the Super Premium and the Rx and our bridge brands are really solid in units.

Where we're seeing some of the mix challenges even within consumables is things like rawhide and treats, the more discretionary items. And so folks are so wrapped up around inflation and they're not really listening to what's happening in the business, so we are giving you a range. Inflation is definitely impacting our comps, but there's also several things within the line items that are helping the business and some things that are not.

Alan Rifkin - Merrill Lynch

I guess I'm guilty of being one of the ones that are wrapped up on inflation. Colgate just a couple of weeks ago said that they thought the inflationary effects in '09 could be similar to the inflation effects of '08. Is that a statement that, first of all, you're surprised by? And second of all  Phil, I guess this question is for you - do you think that that could be indicative of other food manufacturers in the supply chain?

Philip L. Francis

First, I'm not an insider on all that stuff, as you might imagine. Colgate is one of the ones that did a cost increase to the whole world early in 2009. At this point we don't know of a lot of others stacked up here. I think Colgate might have gone on to say that they feel like they somewhat lagged other people last year and this early 2009 was a return to parity from their point of view, so that'll certainly make some difference because they're an important vendor. But I don't have any reason to know or speculation that everybody else is going to it this year at this time.

Alan Rifkin - Merrill Lynch

Bob, a question for you if you don't mind? You said that there's an effort on your part to decrease the number of brands offered. Keeping everything else constant, what effect on gross merchandise margins do you believe that consolidating some of your brands could have?

Robert F. Moran

I don't think you're going to see a material effect in '09; however, I think the impact is in '10 and '11 and it'll have a positive increase. You think about it, we have 27 different proprietary brands or what you would call private label, and we're going to reduce that down into the low double-digit numbers and put some marketing behind it to really build the brand. And we believe based off also our global sourcing capacities that we're building, that should be a positive increase and should be accretive to gross margins in latter years.

There will be an effect in '09, but it's not material at this point in time.

Alan Rifkin - Merrill Lynch

Phil, it looks like certainly your decision to reduce the number of hotels in '09 was pretty keen foresight on your part given the slowdown in Hotel revenue in Q4 and obviously the macroeconomic environment. As you look at the opportunity for hotels long term and even as we come out on the other end of this macroeconomic malaise that we're in, is your take on that opportunity any different today than it was, let's say, a year ago? Do you still believe net-net long term there's as great an opportunity today as there was back then?

Philip L. Francis

Long term I think the opportunity is still as great as it always was. How we are sorting these out is pretty simple. We've in effect shut off remodels of existing facilities because by not doing them now we don't lose them, and they're also the more hungry on CapEx.

When we do a new store, even in our reduced count of 40, if that's a hotel site where the sales projection passes our ROI and return hurdles, while we're doing new store sites, though the total number of new stores is reduced, if it calls for a hotel we're doing a hotel now because should we not do it when we do the store we lose the chance forever. And remember, they're less capital hungry as new stores than the other ones are anyway. So that's simple decision rules which I think make a lot of sense, both as you tell the story and numerically.

Operator

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

David Mann - Johnson Rice & Company

Chip, in terms of the '09 guidance breakout sort of implied for the back half of the year, the slower comps that are implied, number one, would you still expect comps third, fourth quarter to be positive?

And number two, is the implied slower comp all due to slower inflation?

Lawrence P. (Chip) Molloy

Yes. One, we are not expecting negative comps in the back half of the year.

Two is we are expecting the slower comps to be somewhat driven by the deceleration of inflation and get back to more normal ranges, although that'll have to flush through the whole year.

And third is, as it relates to the business, I think the mix we'll find that, as you start to bottom out on the discretionary items and you start to anniversary that impact that we're having today, the mix may shift slightly to the better for us as we get in the back half, which will help margin a little bit.

David Mann - Johnson Rice & Company

On that issue, can you talk a little more - either you or Bob - about some of these instore promotions that you've been doing and how much more can you be doing over the course of this year? How aggressive can you be to try and take advantage of the traffic you get weekly?

Robert F. Moran

Actually we're building a lot more excitement in our stores by using products to tell compelling stories. Pedi Paws is a great example which I used in the conference call, but there isn't a category or a line or a SKU that's sacred anymore. The customer's looking for value, and using our drive aisle, using our PetPerks and also using any type of form of communication from a marketing point of view, we're really trying to tell product line types of stories.

We had a great promotion at the beginning of the fourth quarter [inaudible] beds, fish and aquariums, the specialty. We're going through right now the month of the cat. So we're going deeper with idea generation and we're also relying off of our eyes and ears of our marketing team to really give us ideas and our merchandising team to really give us ideas that the customer is interested in. So you're going to see a lot more activity there.

You're also going to see a lot more vendor participation there, too, because we're very interested in not only maintaining, but we're trying to bring new customers into the store. So we're pretty excited about this because it's some of the muscles that we haven't exercised in the past and we're exercising them today.

David Mann - Johnson Rice & Company

So when we see some of these promotions, should we expect that they won't necessarily have gross margin impact?

Robert F. Moran

Our focus really has shifted in the past from a gross margin percent to a gross margin dollar. Obviously, we're looking at how to drive velocity off of that. So with the focus of gross margin dollars, we're really looking at a positive impact and obviously trying to make that accretive to the bottom line.

Operator

Your next question comes from Matt Nemer - Thomas Weisel Partners.

Matt Nemer - Thomas Weisel Partners

My first question is can you just comment on the comp trend post-quarter. It sounds like you exited the quarter in a stronger position than perhaps the middle of the quarter.

Lawrence P. (Chip) Molloy

That's in the guidance of low to mid single digits.

Matt Nemer - Thomas Weisel Partners

In terms of the food tiers that others have asked about, is the strength in Rx and Super Premium at all driven by new product introductions? It seems to me like there's a lot of new product on the shelves and I'm just wondering if that's the primary driver or if it really is sort of applestoapples.

Philip L. Francis

It's some of both. We see people converting based upon confidence in the Super Premium to taking care of their children better and better, and with Rx now we actually have two strong brands in that, the two leading brands. We've got full variety of both. Lots of the vet hospitals at which people would shop based on space have limited ranges of either or both of those two, and we're as complete an offer variety wise on both of the key Rx brands as anybody out there. And as it becomes known we've got them and our own vets are willing to prescribe just the right item with confidence, it's growing nicely.

One hears in humans about people cutting pills in half and all that stuff, and we just don't see the behavior as it relates to a pet who needs a prescription.

Matt Nemer - Thomas Weisel Partners

In terms of food pricing, have you seen any changes in the mass channel lately?

Philip L. Francis

No big news. This is something we monitor regularly. And we're paranoid about most of the world, so we watch. There's normal movement here and there, but in terms of big news anywhere we just don't have big news to report.

Matt Nemer - Thomas Weisel Partners

And then for Chip, you guys have done a great job on expenses. I'm just wondering if you can help us with any key milestones by quarter this year. It looks like obviously the fourth quarter has a tough comp because you did a really great job on expenses on an SG&A per store basis, but as we move through the year is there a certain quarter where it just gets a lot tougher for you?

Lawrence P. (Chip) Molloy

I'll give you some direction. Q1 is we're not going to see a big benefit in Q1. Q2 we'll start to see some benefit, Q3 there'll be some benefit, and Q4 will be relatively flat.

Matt Nemer - Thomas Weisel Partners

And then lastly I just want to make sure I heard this right. It sounds like you cleared all of your holiday merchandise during the quarter and perhaps it was before December. Did any holiday clearance get pulled from the first quarter into the fourth or does it still stay within the same quarter?

Robert F. Moran

We started our clearance the early part of December where we normally did it around the holiday period, so we were able to clear it out all this year and not bring anything into 2009 fiscal year.

Matt Nemer - Thomas Weisel Partners

Any sense for how that may have impacted either comps or comp margin dollars in terms of the shift from '09 into '08?

Robert F. Moran

I don't think it was material, Matt.

Lawrence P. (Chip) Molloy

It wasn't material over the quarters, Matt. It would have been material between January and December.

Operator

Your next question comes from Christoper Horvers - J.P. Morgan.

Christoper Horvers - J.P. Morgan

On the inventory side, when you said it was a couple of hundred basis points for the forward buys, was that a per store or a total that you're referring to? And maybe talk about how much inflation was contributing to that level.

James G. Mathews

Well, a couple things on that. First, the inflation, we didn't quantify the inflation but, like we said, between the 2 and 250 and the 690 we said in Q3, so if you add that onto the - you know, take the midpoint of that and add that onto our square footage growth you'll get pretty close to what's remaining there from a forward buy perspective.

Christoper Horvers - J.P. Morgan

So maybe per store and ex inflation, ex the forward buy, maybe you're more like flat on a per store basis?

Lawrence P. (Chip) Molloy

On a per store basis, yes.

Christoper Horvers - J.P. Morgan

And you talked about the acceleration from December to January and what you implied about 1Q comps being better. I'm curious what the drivers are. Is it traffic, anniversarying the big traffic declines? Are you getting hard goods traction from the programs that Bob's talking about? Or is it the mix away to more food and less giftables?

Lawrence P. (Chip) Molloy

The January traffic was better than we had anticipated coming out of December and the mix was a little better as well.

Christoper Horvers - J.P. Morgan

Did you mention if traffic was down in 4Q again?

Lawrence P. (Chip) Molloy

We did say transactions, which we use for traffic, was down in the quarter, but it was better in January than it was in December.

Christoper Horvers - J.P. Morgan

Is that fair to say positive?

Lawrence P. (Chip) Molloy

We didn't quantify that.

Christoper Horvers - J.P. Morgan

And then just following up on the expense side, it's curious. I understand the preopen expense with the square footage concentration, but were there one-time items in the fourth quarter that maybe don't repeat such that the expense levels in 4Q aren't enduring?

Lawrence P. (Chip) Molloy

Q4 was clean from an expense side year-over-year. There were no sort of one-time items on either side.

Christoper Horvers - J.P. Morgan

And you don't really anniversary a lot of the big overhead reductions and the labor management system rollout until the fourth quarter really, right?

Lawrence P. (Chip) Molloy

Correct. Well, and we've been cutting costs all year, Chris, so all year almost every quarter we've been down in costs. That accelerated going into Q3.

Christoper Horvers - J.P. Morgan

And then finally just curious, a follow up on the comp cadence for the year, or I guess maybe asked a different way, do you think that the programs that you've done like the pet bed discounts and the containment discounts on the hard goods side, do you think you can get the hard goods category to begin comping positively?

Lawrence P. (Chip) Molloy

We think that you're going to get to a place where it's no longer going to negative comp strictly from an anniversarying perspective. As you look at the run rate of the business and you just seasonalize it, you understand that you get to a place where you're no longer comping negatively.

On top of that we do believe some of the initiatives we have in place that Bob speaks to and some of the ways we're going to market a little differently could provide some upside on the margin side.

Operator

Your next question comes from Dan Wewer - Raymond James.

Dan Wewer - Raymond James

Chip, I wanted to see if you could help me understand the revenue guidance. So we're looking at about, what, 3.5% store growth rate in 2009. Is that correct?

Lawrence P. (Chip) Molloy

3.5 - you're looking at 42 stores against 1,112. But if you use midyear convention, you're really talking about 70 stores - 104 this year to 42 next year would be 72 stores.

Dan Wewer - Raymond James

That might answer my question because I'm having difficulty seeing how, with a low single digit same-store sales increase and 40 stores, how that could drive total revenue growth of, you know, 7% to 9%. That would imply new store productivity that's quite high.

Lawrence P. (Chip) Molloy

No, it's the midyear convention. Flow through of last year's opening.

Dan Wewer - Raymond James

The second question I have, so the forward buys were benefiting gross margin rate. I understand that. And that contributed to inventories growing faster than revenues. I believe earlier you said that you would expect inventories to grow less than revenues in 2009. Is that assuming that there is a curtailment in this forward buy strategy later next year?

Lawrence P. (Chip) Molloy

There'll be forward buy opportunities this year, too, but we have several initiatives in place and a lot tighter focus as it relates to inventory growth this year, and we believe we'll be in a position that we're going to manage our inventory closer to 4% or 5% growth year-over-year. That's total inventory.

Dan Wewer - Raymond James

Chip, is that also contributing to the lower gross margin forecast in '09, that the incremental benefits from the forward purchases would be less meaningful?

Lawrence P. (Chip) Molloy

No, the margin degradation is really driven by the mix shift and it's going to continue at least for the first half of the year.

Operator

Thank you. Ladies and gentlemen, due to time constraints this does conclude the question-and-answer session. I'd like to turn the program back to management for any further remarks.

Philip L. Francis

Thank you all for joining us today. We'll talk to you in 12 or 13 weeks from today, I suppose. Thanks very much.

Operator

Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day.

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