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PetSmart, Inc. (NASDAQ:PETM)

F2Q09 Earnings Call

August 19, 2009 4:30 pm ET

Executives

Dave Cone - Investor Relations

Robert F. Moran - President, Chief Executive Officer, Director

Lawrence P. Molloy - Chief Financial Officer, Senior Vice President

Philip L. Francis - Executive Chairman of the Board

Analysts

Christopher Horvers - JP Morgan

Matthew Fassler - Goldman Sachs

Alan Rifkin - Banc of America Securities Merrill Lynch

Michael Lasser - Barclays Capital

Gary Balter - Credit Suisse North America

Michael Baker - Deutsche Bank North America

David Mann - Johnson Rice & Company

Brian Nagel - Analyst

Peter Benedict - Robert W. Baird & Co.

Operator

Good day, ladies and gentlemen, and thank you for standing by and welcome to the PetSmart second quarter fiscal year 2009 analyst conference call. (Operator Instructions) Now I would like to turn the program over to our speaker, Mr. Dave Cone. Sir, please go ahead.

Dave Cone

Good afternoon and welcome to PetSmart's conference call to announce our results for the second quarter of fiscal 2009. With me on the call today are Executive Chairman Phil Francis; our Chief Executive Officer and President, Bob Moran, as well as Chip Molloy, Senior Vice President and Chief Financial Officer.

Bob will kick off the call with an overview of our second quarter results, then Chip will take you through the financial review of the quarter as well as our earnings guidance. 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-and-answer session, is subject to the safe harbor statement for forward-looking information you'll find in today's news release.

Thanks, and I'll now turn the call over to Bob.

Robert F. Moran

Thanks, Dave. First I would like to take a moment to thank Phil Francis for his tremendous work at PetSmart as our Chief Executive Officer over the past 10 years. Phil has been a great leader, mentor, and a personal friend. His efforts have produced significant value to our shareholders. I am now honored to have this same opportunity.

So let’s move on to the business -- all of us have seen glimmers of hope in the macro environment; however, reports of recent weakness in retail industry sales, especially in more discretionary areas, and volatility in consumer confidence have challenged the idea that the retail customer is ready to return to levels at or near previous spending habits. Despite the weak retail environment, I am pleased to report that we’ve delivered second quarter earnings per share of $0.31 compared to $0.30 in the same period last year. Comparable store sales, or sales in stores open at least a year were slightly less than expected with growth of 0.8%. Our traffic was down only slightly for the quarter, as evidenced by comp transactions of a negative 0.5%.

The large benefit that we have experienced from food inflation over the last several quarters have slowed significantly. However, we are finally beginning to see that an overall deceleration in the decline of comp units and with that, I will turn it over to Chip.

Lawrence P. Molloy

Thanks, Bob and good afternoon, everyone. Today I will be reviewing our second quarter performance, as well as providing guidance for the third quarter and full year. As Bob mentioned, earnings for the quarter were $0.31 per share. This compares to $0.30 per share for the second quarter of last year. Total sales for the quarter were $1.31 billion, up 5.4% from the same quarter last year. The increase in net sales was partially impacted by $8.6 million in unfavorable foreign currency fluctuations.

Services sales, which are included in total sales, increased 10.2%. Our comparable store sales, or sales in stores open at least a year, grew 0.8% for the quarter. Operating income was 5.6% of sales, a 50 basis point decline compared to 6.1% for the same period last year.

Gross margin declined 130 basis points to 28.2%. Within the gross margin line, merchandise margins were down 165 basis points, with mix representing 50% and rate representing 50% of the decline.

Services provided 15 basis points of improvement, primarily due to continued strength in grooming, our largest services business. Our Pet’s Hotels and training businesses remain soft.

Store occupancy was unfavorable 45 basis points, driven by top line weakness in the second quarter. We continue to see some success in lower rents in line with market conditions, as well as obtaining rent abatements by exercising our site specific tenant rights in a number of retail centers.

Despite the top line weakness, our supply chain performance was favorable 65 basis points from the benefit of lower fuel costs, improved productivity, and transportation efficiencies in our network.

Operating, general and administrative expenses were 22.6% of sales for the quarter, an 85 basis point improvement from the second quarter of last year. Overall advertising dollar spend was flat for the same period last year, which is helping to drive a portion of the leverage. As expected, we have seen declining advertising rates providing us with increased efficiencies in our spend.

We are also starting to see the benefits of moderating store openings, resulting in lower pre-opening expenses, and we continue to benefit from a cost conscious culture, as travel and supply costs are also down.

Our effective tax rate was 36.4% for the quarter compared to 40.4% in the same period last year. This change was primarily driven by reductions in certain tax, state tax liabilities and tax exempt gains from our deferred compensation plan, which we do not expect to continue in the back half of the year.

During the quarter, we opened 10 new stores and closed two, and also opened four Pets Hotels.

During the quarter, we generated $80 million in operating cash flow. We spent $23 million on capital expenditure projects, which was 65% lower than the second quarter of last year.

In June, we announced the Board of Directors approval of a $350 million stock purchase plan that expires in January of 2012, as well as an increase in our dividend from $0.03 to $0.10 per share per quarter beginning in the second quarter.

During the second quarter, we repurchased $25 million of PetSmart stock and distributed $3.8 million in dividends, ending the quarter with total cash, cash equivalents, and restricted cash of $236 million and zero outstanding borrowings on our credit facility.

Going forward, we expect third quarter earnings per share between $0.20 and $0.24, and comparable store sales to be essentially flat. For the year, we are expecting earnings per share between $1.37 and $1.45 and comparable store sales of low-single-digits.

We anticipate continued gross margin pressure throughout the back half of the year. Product margin dilution should lessen slowly as we progress due to the anniversary of significant unit declines in higher margin discretionary goods, as well as reduced promotional activity going forward.

We also believe the merchandising activities Bob will address later in the call will help to drive some benefits this fiscal year.

Supply chain should continue to provide year-over-year benefits through the third quarter, while rent and occupancy should no longer be dilutive in a low-single-digit comp scenario, as we begin to see the benefits of slowing store growth.

On the OG&A side, incremental benefit will continue -- will become increasingly more difficult. We are beginning to anniversary many of the big cost reduction efforts made during 2008.

In addition, at the beginning of the year, we made an investment decision to change a portion of our incentive system in the field, which shifted some incentive dollars away from pure financial metrics towards customer satisfaction metrics and as a result, the improvement in our customer satisfaction scores will most likely require more incentive to be accrued in the back half of this year relative to both ’07 and [’08].

As Bob mentioned, our traffic is holding steady at relatively flat to slightly down. We are seeing encouraging trends in comp units; however, the units are not coming back as quickly as anticipated.

Our customers continue to shop us and we believe we are still getting the same share of their wallet; however, the impact of inflation on consumables which had been benefiting the top line has forced the consumer to use discretionary dollars to pay for consumable staples, thus reducing the spend available for higher margin hard goods.

We remain committed to a strong balance sheet and we will continue to fund our business through cash flow from operations. We expect cash to total between $245 million and $270 million by fiscal year-end, exclusive of any additional share repurchases we may make in the third and fourth quarter.

Now, here’s Bob again to provide you an update of our operations and how we are progressing in regards to our increased focus on the customer.

Robert F. Moran

Thanks, Chip. We continue to believe that we are well-positioned to lead the pet specialty market, given our core business strengths, commitment to fiscal discipline, and our solid leadership team. Our ability to provide pet parents with a uniquely engaged in-store experience, a differentiated assortment of products, services, and solutions, and knowledgeable associates create an unmatched customer experience. The difficult macro environment has driven us to take a fresh look at our business. In recent years, our focus was primarily centered on store growth. In some ways, we functioned like a construction company first and a retailer second.

After recognizing this last year, we decided to focus our efforts on becoming a more cost conscious operating company. As we slowed store growth, reduced capital spend, and created a culture of expense control and now, we are continuing our journey as we focus on becoming a better merchandising company.

Our business continues to be impacted by changes in consumer spending. Significant price increases during the last year forced many pet parents to spend more on dog food, limiting their spend available for more discretionary purchases, such as wet food, treats, toys and beds. For the first time, customers were forced to make choices based upon what they could afford versus what they wanted.

In addition, we have seen a decline in new pet acquisitions, which we have been able to partially offset thus far with successful national in-store adoption events. These challenging times have taken its toll on us, driving our gross margin down about 280 basis points in two years, primarily due to a decline in hard goods penetration of 315 basis points.

As a result of continued mix shift pressure, our second quarter product margin decline was disappointing but not unexpected. We continue to experience a mix shift away from higher margin goods to consumables, which is driving a lower product margin. Within our consumable business, we continue to maximize our traffic driving opportunities as we strive to remain the destination for food.

We are still experiencing an overall net trade-up and significant strength in dry super premium and RX food; however, we have seen a slight volume decline in a few of our premium brands due to price increases over the last year. With challenges come new opportunities. We were making investments in our key hard good categories, all while attempting to balance near-term results with long-term growth opportunities.

Last quarter we shared with you some of our initial efforts in improving our merchandising capabilities, including the resets of several hard good categories, representing over 50% of hard good sales and we are consciously investing in the category of collars and leads, containment, toys, and waste management, with the expectation of overall category margin enhancement, improved product innovation, better solutions for pet parents, and ease of customer shop-ability.

After not substantially refreshing some of these categories for a number of years, we are confident in the data and research that initiated many of the category resets, as well as the improved product quality and sourcing, margin enhancement, and in-store operational efficiencies that will result going forward.

During the quarter, we completed our category reset and waste management, which has allowed us to provide both a better quality product and better retention to opening price points. After the completion of the category reset, initial data has provided encouraging signs of improved sales, margin, and increased market share across the category. Despite challenges in margin impacts in the early stages of our reset efforts, all other category resets continue to show promising signs of margin and market share expansion. We plan to complete these resets by the end of Q3 and will look to reset some additional categories during 2010.

As a result of an increased category focus and key merchandising strategies, we are beginning to see several hard good categories rebound, resulting in positive comp units. While many categories still remain in negative territory, we believe the investments we are making will provide increasing up-side slowly as we move towards the back half of the year with continued improvement into 2010. In the back half, we will continue to use promotions as an effective means of driving incremental units profitably. We took away some great learnings from promotions in the first half which we will apply to our strategy going forward. Oftentimes, we found only a few products drove the success of a particular category promotion. In response, we will reduce the number of full category promotions for discretionary goods and place more emphasis on promoting key products within the categories to drive margin dollars.

Another area we continue to focus on is our proprietary brands portfolio. Within our consumables category, we will be relaunching our authority premium brand of dog food and treats by September of this year. In an effort to increase current brand awareness and market share. We are happy to introduced a reformulated and repackaged advanced nutrition offering within our stores.

This is a big win for our pet parents and us, as we can provide a lower priced alternative in a premium offering with a higher margin return. We plan to have extensive marketing of this launch and are optimistic of the potential incremental margin and market share gains.

We will also be introducing several new designs and brands in hard goods, with incremental sales and margin opportunities, which we will be sure to share with you as the year progresses.

In addition, we continue to see improvements in our international sourcing capabilities with significant opportunities for 2010 already in the works. As we focus on resetting key categories, driving more impactful promotions, growing our proprietary offerings, and further expanding our international sourcing opportunities, we are poised to return to expanding product margins. We are becoming better merchants, our own expectations are high and we plan to deliver.

We continue to believe in the value of our differentiated services model which strengthens our connection with pet parents. Grooming, which is by far the largest of our services sales, continues to do well despite the macro environment. We have been successful in driving innovative add-on packages, value offerings, and improved customer communication.

Grooming has emerged as a non-discretionary service for our pet parents. They recognize the value in regular grooming as it contributes to a happy and healthy pet.

Similar to the human travel industry, our pet hotel business continues to be challenged. However, we remain committed to this business model. During peak holiday weekends, our hotels are at full capacity with many customers on waiting list. As the economy recovers, we anticipate improved performance in our hotels. For now, we continue to focus reengineering costs to build and operate our hotels to maximize profitability. However, our doggie day camp business has seen significant strength as pet parents choose us when they are in need of daycare during the day. Our day camp business saw positive comp numbers during the quarter and is a testament to the amount of trust and loyalty our services customers have for our stores and associates. The back half of 2009 has challenges both from headwinds of the macro environment and a few challenges unique to us as we work to improve our merchandising categories and processes.

Despite the challenges, we remain confident in the strength of our business model and are working towards taking action to further solidify our position as the pet specialty leader. We will continue our journey towards becoming a better merchandising company, preparing for the return of the consumer to hard goods. In the meantime, we refuse to remain idle and will continue to maximize our opportunities and drive shareholder returns.

Thank you and now we’ll take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Christopher Horvers. Sir, go ahead.

Christopher Horvers - JP Morgan

Thanks. Good afternoon. Maybe you could talk about -- really two questions. First is rank the difference in how you are looking at the back half this year, back half of the year now versus maybe a quarter ago between sales, the rebound in hard goods, gross margin versus SG&A. And then bigger picture, do you expect deflation and/or would you be able to pass further price increases on, should inflation start to pick up over the next six to 12 months?

Robert F. Moran

-- versus earlier in the year or how we thought about it -- well, first off I would say that the lack of inflation is as expected, so it’s slowing. It’s actually slowing probably a little bit quicker than we anticipated and the units are coming back but they are not coming back quite as quick, so the combination of those two is driving a little bit weaker back half than we expected as we started the fiscal year.

And then as far as we think about deflation, we don’t believe we will have inflation for the back half benefits. Like I said, it’s coming down quite a bit. I think on the deflation side, we don’t -- we think net net, we’ll probably be flat from an inflation perspective. There will be some areas and some vendors that will lower prices, but in other cases prices are still going to flow through so generally flat on an inflation/deflation impact is what we are expecting for the back half.

Christopher Horvers - JP Morgan

And so as we think about let’s say beyond 3Q, because maybe there’s a little more coming through here and thinking about fourth quarter and 2010, is it really -- you know, if traffic stabilizes here and not expecting further inflation, is it -- does it really come down to how the hard goods come?

Lawrence P. Molloy

The hard goods is the primary driver of the business so for us, it’s -- and as Bob spoke to, several of the things we are doing in merchandising, for us driving the hard goods is the most critical thing that we can do because one, obviously 2X the margin, it really helps the margin rate and we want to get the margin rate stable -- stable to expanding again and it really comes down to driving the hard goods business. The consumables business is always a staple -- it’s driving traffic, it’s bread and butter but driving the hard goods business and improving that is going to drive margin expansion and drive leverage and provide earnings growth.

Christopher Horvers - JP Morgan

And then just one quick follow-up and then I’ll jump off -- how should we think about the merchandise margin pressure maybe in the third and fourth quarter as you cycle out some of the category management efforts and some of the clearance activities abate? Thank you.

Lawrence P. Molloy

I think the dilution is going to be -- it’s going to become less, both in Q3 and then even further less in Q4. Probably to the tune -- it’s probably less dilutive, call it 20 to 40 basis points in Q3 and maybe as much as 60 or 70 in Q4. The counter to that is we will still get the benefits from the WD improvements through the third quarter but that starts to anniversary in Q4, so that doesn’t become as much of a benefit in Q4.

Christopher Horvers - JP Morgan

Thank you.

Operator

We’ll take our next question from Matt Fassler. Please go ahead.

Matthew Fassler - Goldman Sachs

Thanks a lot and good morning -- good afternoon, excuse me. If I could just kind of clarify directly, as you look at the reduction in your guidance and obviously none of it came from your second quarter performance, does it relate to sales projections or does it relate to -- and the deleverage associated with that or does it relate to gross margin reduction?

Lawrence P. Molloy

I would say it’s generally a piece of both, so our guidance on the street was about $1.42 to $1.52 previous, so we obviously have brought it down somewhat. But it’s totally driven by the fact that AUR, benefits from AUR increases are coming down a little quicker and the units, even though getting the hard good units are -- declines are decelerating. They are not decelerating quick enough to help us get there by the end of the year.

Matthew Fassler - Goldman Sachs

So you addressed rate, or rather mix, and we understand that as hard goods are coming back a little more slowly. What about the rate issue? I know that last quarter you were clearing the decks in some of the hard goods categories for your remerchandising process. Is that process continuing or do you find that you are cutting price for competitive reasons or to stimulate consumer demand in the face of soft underlying demand?

Lawrence P. Molloy

It’s not cutting price for consumer demand. It’s really a fair amount of the non-mix is -- I would call it self-inflicted from just resetting the business. So we’ve reset several big categories of our business. So for instance, collars and leads, huge reset for us, disruption at the category level and caused some issues for us to get through it. That activity was in Q1 and Q2 and some of it is even in this quarter up until about Labor Day. We’ll be through that by Labor Day, those major resets and that disruption will start to dissipate and it will also -- therefore the rate less dilution as we move forward, by the time we get to Q4, most of the dilution will be mix related.

Matthew Fassler - Goldman Sachs

And one final one -- you know, Hills or Colgate on their conference call talked about their experience with Hills over the course of the past several months and it sounds like they had backed away from -- they had backed away from some of their price increases, which I know that they -- that stood out a bit for them earlier in the year. Did you find, broadly speaking, consumers pushing back in that regard and was that particular brand kind of a culprit in thinking about the price volume equation?

Robert F. Moran

Actually, we have had a lot of pressure on the premium category of consumables because we had a couple of vendors that raised prices and in a sense, unless they are positioned between super premium and bridge brands, and both of these vendors are looking at both pricing and reducing prices and doing temporary price reductions or promotions to increase units.

We are not losing any customers through this process. They are trading up and they are trading down but with a net trade up, so we feel good about that and we feel that the work that we are doing with these vendors, we’ll get the premium category back well-positioned and get the units up.

In the short-term, we think there will be some pressure on the top line and margin dollars but the margin rate will hold but we think in the long-term, we anticipate to sell more units.

Matthew Fassler - Goldman Sachs

Got it. Thank you so much.

Operator

Thank you. Our next question comes from Alan Rifkin.

Alan Rifkin - Banc of America Securities Merrill Lynch

Thank you very much. It’s a question for Bob -- Bob, we’ve heard both retailers and manufacturers for quite some time talk about the vitality and the health in this space. Do you think that the underlying demands for the product categories in this space are enough to lend a little bit support on the inflation front longer term, or is it more so a function of changes in commodity costs that will more so influence inflation or deflation?

Robert F. Moran

It’s a good question. I think in the short-term, I think there’s other elements that are affecting us. I think the concept of pet acquisition is down. There’s a high correlation to the new homes, housing starts, which is impacting us. Then when you throw in the concept of commodity pricing, which is leading to some form of deflation, we do believe that eventually the customers will come back and there will be normalized inflation going forward.

Alan Rifkin - Banc of America Securities Merrill Lynch

Okay. Thank you very much.

Operator

We’ll take our next question from Michael Lasser.

Michael Lasser - Barclays Capital

Good afternoon. Thanks a lot for taking my questions. When you look at your customer data, do you have a sense for how much the hard good sales are being driven from consumers of those specialty brands, such that if there is a net trade up, some of those dollars are being crowded out, or some of those potential dollars that might be spent on hard goods are being crowded out by that trade-up effect?

Lawrence P. Molloy

Actually, I think there’s two things going on there. I think the wallet of the pet parent is still being spent on -- they are still spending the same amount and we quite honestly believe they still spending the same amount in our stores. The challenge has been that either one, if they do choose to trade up, then they are making a conscious decision within those wallet dollars to trade up, which in some cases if they are going -- for us, if it’s just within the food aisles and they are trading up, that’s a good answer because that produces more gross margin dollars for us. In the case of if their wallet is such that they are having to spend it on food, and the food prices have been continuing to increase, they are still spending the same amount of dollars but unfortunately they are not spending those extra dollars on the toy, or on the bed, which is a lot higher margin for us, so that -- I think that is the dynamic that is going on. So there could theoretically, although I am not ready to commit to it -- that if prices do come down, that hopefully that pet parent will then have a little bit more discretionary dollars of their pet spend dollars to spend back on the hard goods business.

Michael Lasser - Barclays Capital

Okay, thanks and one quick follow-up -- maybe you can describe some of the early success that you have seen in remerchandising from the hard goods and how you think the connection has been between the changes you’ve made and the early improvement you’ve seen?

Robert F. Moran

We have seen some encouraging signs with some of the resets that we have completed and again, a lot of the work has been looking at that assortment optimization but also good, better, best categorization and the customer is recognizing that. They are in the stores for the consumable side and they are noticing the resets -- we have a lot more work to do and it’s still early and as I said, we’ll finish most of the resets by the end of Q3 but we see some encouraging signs, especially as we lead in the fourth quarter. We -- customers are more prone to look at hard goods in the fourth quarter, especially for the holidays, so that’s exactly why we got this position, to really take advantage of the Q4.

So more to report as we go further into it.

Michael Lasser - Barclays Capital

Okay, thanks a lot. Best of luck.

Operator

We’ll take our next question from Gary Balter.

Gary Balter - Credit Suisse North America

This is Gary and Seth. Can we just step back and Matt asked it but I wasn’t clear on the answer, but can you just kind of walk us through what is pulling down from the previous guidance to this guidance in terms of between comps and margin?

Lawrence P. Molloy

The answer is that it’s a little of both. Comps are probably not going to be as high in the back half of the year as we expected, as we came into the year. Part of that is driven by a decelerating AUR sort of inflationary impact. It’s not as big as we thought it would be as we get through the year. And the second piece is on the margin side, we were hoping as we got through this year, we start to anniversary the big declines in comp units and the hard goods business, that that would start to anniversary both on a two-year and a three-year performance and we’d start to see it come back much quicker. It is coming back but right now it’s early to tell but it appears to be slower than we expected. So that’s not taking away that margin dilution as much as we thought it would by the end of the year.

Gary Balter - Credit Suisse North America

And why is it so focused on Q4, because that’s the big hard goods quarter?

Lawrence P. Molloy

It’s the biggest -- yes, it is the biggest hard goods quarter of the year.

Gary Balter - Credit Suisse North America

Thank you.

Lawrence P. Molloy

All right, thanks, Gary.

Operator

We’ll take our next question from Michael Baker.

Michael Baker - Deutsche Bank North America

A couple of questions -- can you talk about the trend throughout the quarter? The trend through the quarter and the other question is on hard goods -- you talked about units. How about pricing in the hard goods? Have you taken down your pricing there at all, to drive some of the demand and is there anything going on noteworthy competitively from Walmart or maybe Petco, along those lines, that might be impacting your hard goods pricing? Thanks.

Lawrence P. Molloy

I caught the first part of the question but there’s a lot of background noise from where you are calling. I don’t know -- it was hard to catch the second part.

Michael Baker - Deutsche Bank North America

Sitting in an airport.

Lawrence P. Molloy

Okay, so from the first part of the question, as far as talking about the performance through the quarter, you know, we traditionally -- we only do that once in a while so I mean, it’s generally the quarter as -- I think we started the quarter saying the business was slightly weaker and it sort of continued throughout the quarter. And our guidance on the table today for the third quarter is in line with our current performance.

As far as -- I couldn’t catch the rest of your question.

Michael Baker - Deutsche Bank North America

The second question on hard goods pricing -- you talked about units but what about pricing and/or dollars in the hard goods? Is that -- has the pricing come down at all in hard goods and is there anything noteworthy competitively in terms of promotions or anything like that?

Robert F. Moran

Well, as I said in the speech leading into the questions, we did a lot of work on promotions and we looked at a lot of category promotions to see if we could drive units, unit sales and we found that there were some key SKUs that were really -- really drove the customer in, so we picked up a lot of learning on that. So from a promotional side, we will be doing a lot more SKU or high awareness items.

From a pricing point of view, we are not really changing much. We are still within tolerance of where we are with Walmart. We’re not responding to Walmart in any way, shape or form but we will -- we have been doing a lot of work on the good, better, best in the entry point of good so that we can trade up to the better and best item and as I said, a lot of these resets and a lot of work we are doing has really been keyed on to focus on Q4.

Michael Baker - Deutsche Bank North America

So is it fair to say, just to put it all together, that trends in dollars on the hard goods are below trends in units in the hard goods?

Lawrence P. Molloy

It’s probably in line.

Michael Baker - Deutsche Bank North America

Okay. Okay, thanks a lot.

Operator

We’ll take our next question from David Mann.

David Mann - Johnson Rice & Company

Yes, thank you. Good afternoon. My question is relating to the deflation forecast that is sort of implicit in your guidance. Can you just give us a sense on what you would expect to happen if deflation is worse than you expect, let’s say into the fourth quarter?

Robert F. Moran

Well, if deflation gets worse, it can be one of two outcomes -- either it’s just totally soft on the top line and becomes even a bigger challenge, or deflation becomes a place where folks, especially during the holiday season, look at that as a bargain and say hey, I’ve now got extra dollars to spend on something else within the four walls of the store.

So either way, it’s -- one way is not as good and the other way could be a big win.

David Mann - Johnson Rice & Company

And are you seeing any evidence in your customer database where you have lowered prices, where you have seen the customer is spending more within the store, more units?

Lawrence P. Molloy

Well, one area I’ll point out was we got -- we went pretty promotional on rawhide, which rawhide is counted as consumables but rawhide, that whole aisle is about 2X the margin of the average consumable. We got promotional there. We drove a lot of units in rawhide.

Unfortunately the whole category as far as gross margin dollars, we didn’t look at that as a win but we looked at it as a learning point because there were some specific SKUs, as Bob sort of alluded to the learnings, there were some specific SKUs within there that really drove a lot of units. So what we are learning there is to be much more SKU specific and a lot less category, total category on some of the promotional activity to really drive the units and we think we can be able to do that. We’ve had some other areas where it’s been kind of a win.

David Mann - Johnson Rice & Company

And one last question -- on a regional basis, are you -- is there anything to call out in terms of some of the regional trends from some of your weaker markets or are some of the overall trend more consistent now across the chain?

Robert F. Moran

In the past, we’ve talked about California, Florida, and Arizona. One is we see some improvement in California, especially in Southern Cal. Florida and Arizona have basically stayed the same, they are not big contributors right now but there’s two other areas of the country to be added to the list -- one was Texas, which finally has caught up to the rest of the country and the northwest. Again, because of a high unemployment, we think we are being impacted up there, so we are looking at five regions of the country right now as being slower performers and others with one improving in California.

David Mann - Johnson Rice & Company

Great. Thank you.

Operator

Our next question comes from Brian Nagel. Your question, please.

Brian Nagel - Analyst

First off, I wanted to just maybe -- somebody had asked previously about competition. I want to expand a little bit on that. I know there’s been chatter within the channel for a while that greater competition with other -- either with the discounters or even in some of your specialty competitors. So as you look at the back half and the more subdued outlook you have now, is the prospects for increased competition at all a factor in that or is it much more the macro environment?

Robert F. Moran

We believe it is totally the macro. We believe the whole market is down. We actually are gaining market share and we’ve got a lot of information from our vendors that have obviously to deal within the grocery area, the mass area, and we are doing extremely well but the whole market is down, the whole industry is down.

We believe the model is strong -- the customer is not strong.

Brian Nagel - Analyst

Okay, and then the second question I have with respect to expense controls, and you’ve done a great job controlling expenses over the last several quarters and I think the controls actually got better Q1 to Q2 -- so as you take a more say dampened look at the business near-term, is there an opportunity to sort of say further sharpen the pencil and cut expenses to further offset weaker sales?

Robert F. Moran

We are and we are continuing to work that -- it is getting more difficult and the challenge for us as we get further is -- it’s about customer experience, so you start to get to a place where you have to make those really hard choices around sacrificing the customer experience, customer facing labor, and we believe we are in a time when it’s really important to be differentiated from some of our competition, so we are set up for success as the consumers -- you know, with a weakened consumer but more importantly is the consumer starts to come back. So that’s a tough choice for us.

So I would say we are going to -- we are continuing to sharpen our pencils. We are going to continue to look under every rock, every place we can find it, but to really start to make a big dent going further, it would probably require us to sacrifice the customer experience.

Brian Nagel - Analyst

Understood. And then someone may have asked this before but I will ask it again -- are you going to comment on sales trends thus far in Q3?

Robert F. Moran

In Q3, it’s in line with our current guidance for the quarter.

Brian Nagel - Analyst

Okay. Thanks a lot.

Operator

Thank you, Brian. And ladies and gentlemen, due to time constraints, we have time for one final question. Our final question comes from Peter Benedict. Sir, your question, please.

Peter Benedict - Robert W. Baird & Co.

Bob, can you talk a little bit about your view of the long-term store growth plans or potential for PetSmart, you know, next year and beyond?

Robert F. Moran

We still think next year we are probably going to be in the 40 to 60 range. We haven’t solidified it but it will probably be closer to 40, as we look at where we are. We feel that we are probably similar to what Home Depot talked about the other day. We think the back half of 2010 is obviously where we are going to start seeing some movement and a recovery, so we will reevaluate that as we go into 2010.

Peter Benedict - Robert W. Baird & Co.

Okay, and then Chip, just a couple of questions -- first on your fourth quarter outlook, does that at this point assume an outright decline in comps?

Lawrence P. Molloy

It doesn’t right now. It assumes -- you know, it kind of depends on where you are looking at it, from a two-year or a three-year stack perspective but right now, it’s hard to say but I am kind of leaning towards it’s slightly positive.

Peter Benedict - Robert W. Baird & Co.

Okay, great. And then Chip, the inflation benefit last year in the second quarter was maybe 450 basis points. I know it was somewhat positive this quarter -- can you give us a little color as to maybe how positive it was this quarter?

Lawrence P. Molloy

It’s come down a lot. How’s that?

Peter Benedict - Robert W. Baird & Co.

That’s fine. I’ll ask one more, since I’m the last guy in here -- kind of tailing off of Brian’s question, on the OG&A, I mean, 2% to 4% dollar growth in the first half of the year, you mentioned that’s unsustainable. When you think about the second half, is there something that we should be thinking mid-single-digit growth, could it be even more than that? What type of expenses were you looking at?

Lawrence P. Molloy

I would look at -- because of the top line, I don’t know where you guys are going to end up on it from a top line perspective in line with our guidance or you make your choice but from a dollars perspective, I would just look at the Q2 dollars spend on the OG&A line and expect the Q3 and Q4 will be in line, if not just up a little bit versus Q2.

Peter Benedict - Robert W. Baird & Co.

Great. Okay, thanks so much.

Lawrence P. Molloy

Thank you.

Dave Cone

Thanks, everybody.

Operator

Thank you. Ladies and gentlemen, thank you for your participation. This does conclude today’s program. You may now all disconnect. Have a wonderful day.

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Source: PetSmart F2Q09 (Qtr End 8/2/09) Earnings Call Transcript
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