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Pet ownership in America grows at about twice the rate of the human demographic. This basic approximation has driven the growth of pet retailing. This growing marketplace is very compelling because of its growth and its relatively unconsolidated nature. The largest participant in the industry is PETsMART (NASDAQ:PETM) holding about 11% market share followed closely by PETCO (PETC) with about 6% market share.

The industry has come under increased scrutiny lately as value pricing on some SKU’s by PETCO resulted in some Wall Street downgrades of PETsMart stock.

A recent Motley Fool post seems to have promulgated further concern.Since year-end, PETM is actually up about 4.3% (total return) versus a decline of about 9.6% for PETC, but the recent downgrades of PETM have diminished PETM’s lead.

In my view, PETM stands out from its superstore competition with the broadest offering of services that is available in the industry. PetsHotels, pet grooming, Doggie Day Care, dog training and access to full veterinary care provides a much broader experience than any other retailer can. Translate broader experience into greater selling opportunities. Its loyalty program, PetsPerks was modelled after the loyalty program of Harrah’s (HET) generally believed to be one of the most successful loyalty programs known in marketing. The program is designed to increase the average spend by each customer without sacrificing gross margins.

PetsMart is in the midst of a remodelling program which should bring greater focus on its service offerings. Remodelled stores have demonstrated much improved same store sales comparisons. The remodelling costs are minor at between $50K and $100K per store. So far, 170 of over 800 stores have been remodelled.

A recent Citigroup report highlights the strong impact that the service side of this business can provide. The service business has grown by over 25% CAGR in the last five years. The services side represents only about 8% of sales at this point but I believe this will grow substantially over the next five years to some 15%. There is a leveraged benefit to these services. According to Citigroup, PetHotels have provided a 25% lift to same store sales at maturity as well as significant improvement in store operating margins of some 430 basis points.

The impact to profitability at the margin can be substantial. Taking your dog in for a grooming, often results in additional sales of grooming accessories, toys, and shampoos. According to the Citigroup report, incremental revenues of 25% arise from a PetHotel, but of greater importance, pre-tax margins lift from 8.1% to 12.4%. Pre-tax income per square foot lifts a very impressive 94%. The rollout of hotels is accelerating. Starting with only 7 stores in 2004, to a year-end 2005 total of 32, PETM should have a count of over 60 hotels by year end 2006.

The economics of PETM don’t really require much improvement. The essential story is one of free cash flow generation which is a better model, in my view, than that of PETC.

PETC vs. PETM 1-yr chart:


Source: PETsMART and Petco Duke it Out For Fido's Attention (PETM, PETC)