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PetSmart Inc (NASDAQ:PETM)

Q4 2013 Earnings Conference Call

March 05, 2014 10:00 AM ET

Executives

April Lenhard – Director of IR

David Lenhardt – CEO

Carrie Teffner – SVP and CFO

Joe O'Leary – COO

Analysts

Gary Balter – Credit Suisse

Brian Nagel – Oppenheimer

Chris Horvers – JPMorgan

Scott Ciccarelli – RBC Capital Markets

Matthew Fassler – Goldman Sachs

Daniel Hofkin – William Blair & Company

Michael Lasser – UBS

David Mann – Johnson Rice & Company

Operator

Good afternoon, ladies and gentlemen, and welcome to PetSmart's fourth-quarter 2013 analyst conference call.

(Operator Instructions)

As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Ms. April Lenhard, Director of Investor Relations.

April Lenhard

Good morning, everyone. Joining me on today's call are David Lenhardt, Chief Executive Officer, Carrie Teffner, Senior Vice President and Chief Financial Officer, and Joe O'Leary, President and Chief Operating Officer.

To begin, David will highlight our fourth-quarter business performance. Carrie will review the detailed financial results, as well as our earnings guidance. David will then come back to discuss our strategic priorities for 2014.

At the end of our prepared remarks, we will open it up for questions. Please limit your time to one question and one follow-up question, if necessary.

Before I turn the call over to David, let me remind you that today's call, including the question-and-answer session includes forward-looking statements that are subject to the Safe Harbor statement for forward-looking information you'll find in today's news release. These statements are subject to risks and uncertainties that could cause actual results to differ materially from our expectations and projections.

These risks and uncertainties include, but are not limited to, those factors identified in the release and in our filings with the Securities and Exchange Commission, and we do not undertake any obligation to update our forward-looking statements. Today's presentation also includes certain non-GAAP measures. Reconciliations of these measures are included in our release, and provided on our website at PETM.com. And now, I will turn the call over to David.

David Lenhardt

Thanks, April, and good morning everyone. We are pleased to report our results for FY13.

Consistent with our long-term shareholder value strategy, PetSmart delivered on all elements of the framework. 2013 marks the fourth consecutive year of double-digit earnings per share growth, the fourth consecutive year of gross margin rate improvement, and a record high year for earnings before tax margin.

Combined, this results in an all-time high for return on invested capital. I would like to thank all of our associates for their hard work in caring for our customers and our communities.

During the fourth quarter, we delivered earnings per share growth of 19.6% on an equivalent 13-week basis versus last year, on comparable store sales growth of 1.2%. The fourth quarter was a challenging one.

The macroeconomic environment continues to hold uncertainty, and like many other retailers, we experienced some unique challenges from a weather perspective. During the fourth quarter, we had some of the coldest and snowiest winter weather across the country in years, with storm after storm after storm impacting customers' ability to get out and shop.

Looking at the periods within the fourth quarter, November was our strongest month, with two key milestones. Black Friday was the largest sales day in the Company's history, and Cyber Monday was our largest e-commerce sales day in the Company's history. December and January were much more challenged from a traffic perspective, consistent with overall retail traffic trends in the centers where we are located.

As far as the performance across the business, channel-exclusive foods continue to grow, with strength in naturals and stabilization in science. We continue to be pleased with the growth in our exclusive and proprietary brands, and in the fourth quarter, we set an all-time high record sales penetration, ending the year at 26.5% of our merchandise sales.

Our services sales growth was in line with the core during quarter, with strength in PetsHotels offsetting weakness in grooming, caused by the impact of severe winter weather, interrupting the regular cadence of grooming visits. Our e-commerce sales continued to grow at a rate several multiples higher than the industry growth rate, enabling us to continue to grow share.

We feel good about our ability to consistently deliver financial results, by focusing on those things that are within our control, but we are not satisfied with our comp sales trends. I'm going to turn it over to Carrie to discuss our financial results in more detail, and review our guidance. After that, I will come back to discuss what we are doing to drive up comps in 2014.

Carrie Teffner

Thanks, David, and good morning, everyone. First, I will walk you through some of the highlights of our financial performance for the fourth quarter and FY13, and then I will provide guidance for both the full year and the first quarter of 2014.

As a reminder, the fourth quarter of 2013 was a 13-week quarter, compared to FY12, which was a 14-week quarter on a GAAP basis. Likewise, FY13 was a 52-week year compared to FY12, which was a 53-week year on a GAAP basis.

For financial comparisons on a GAAP basis, I will refer to you the financial statements in our press release issued earlier today. Please note that I will be reviewing our financial results for the fourth quarter and full year on an equivalent 13 and 52-week basis respectively. Before I do, as a reminder, I will break out the impact of the extra week on 2012's results.

The impact on total sales was $126 million, the impact on gross margin was $48 million, and the impact on OG&A was $18 million. Combined, this resulted in a $30 million increase in earnings before tax, and $0.17 in earnings per share.

For the fourth quarter of 2013, total net sales were $1.8 billion, an increase of 3% on equivalent basis. The increase in net sales included an unfavorable impact from foreign currency fluctuations of $7 million. Comparable store sales growth increased 1.2%, with comp transactions at negative 1.8%.

The sales mix for the quarter included consumables, at 54.2%, hard goods at 33.6%, services at 10.3%, live pets at 1.4%, and other revenue at 0.5%. Gross margin for the quarter was 31.4%, representing 30 basis points of improvement versus the prior-year period, driven by services leverage. Operating, general and administrative expenses were 19.4% of sales, representing 80 basis points of improvement from the prior-year period, driven primarily by lower incentive-related compensation and operational efficiencies.

Overall, earnings before tax increased to $204 million, or 11.3% of sales. This represents 14% growth and a 110 basis point improvement. The tax rate for the quarter was 38.5%, and earnings per share growth was 19.6%.

And now, for the FY13 results, which again, I will compare on an equivalent basis. Total net sales for FY13 were $6.9 billion, an increase of 4%. Comparable store sales growth increased 2.7%, with flat comp transaction growth.

Gross margin for the year was 30.6%, representing 25 basis points of improvement. Operating, general and administrative expenses were 20.6% of sales, representing 45 basis points of improvement.

Overall, earnings before tax increased to $642 million, or 9.3% of sales. This represents 13% growth and a 75 basis point improvement. The tax rate for the year was 37.3%, and earnings per share growth was 19%.

Turning to the balance sheet, at the end of the fourth quarter, we had $357 million in cash, cash equivalents, and restricted cash, and zero borrowings on our credit facility. We ended the quarter with average inventory per store of $555,000, up 4.5%, compared to the fourth quarter last year.

From a cash flow perspective, we generated $615 million in cash flows from operating activities during the year, and spent $147 million on capital expenditures. We distributed $54 million in dividends during the year, including $20 million in Q4, which reflects the 18% dividend increase approved by the Board in the third quarter.

We also repurchased $464 million of PetSmart stock during the year, with $230 million repurchased during the fourth quarter. Our weighted average shares outstanding for the year were 104.3 million, reflecting a 4.8% reduction associated with our share repurchases. Depreciation and amortization expense was $235 million for the year.

During the year, we opened 60 new stores and closed 5, which included 19 new store openings and no closings during the fourth quarter. We also opened three new PetsHotels, all in the fourth quarter, bringing our year-end totals to 1,333 stores, and 199 hotels.

Turning now to our guidance for FY14 and for the first quarter. For FY14, we are expecting comparable store sales growth of 2% to 4%, and total sales growth of 4% to 6%. We expect earnings before tax growth between 7% and 10%, with stable to expanding gross margins, and OG&A leverage.

We anticipate the tax rate to be around 39%, 2013 benefited from certain one-time state tax credits, which will not recur in 2014. We expect the equity income from our Banfield investment to grow in the high single digit range. Our guidance also assumes that we will utilize the $418 million remaining on our current share repurchase authorization to deliver earnings per share of $4.42 to $4.54.

Our operating cash flow is expected to be between $625 million and $650 million. Our capital expenditures are expected to be between $150 million and $160 million.

We expect to open 70 net new stores, which includes approximately 50 of our standard prototypes, and 20 micro stores, and three PetsHotels. The remaining capital expenditures will be spent on store remodel-type projects, supply chain, technology, maintenance and other infrastructure improvements.

For the first quarter of 2014, we're expecting comparable store sales growth of low single digits, earnings before tax growth is expected to be in the low to mid single digit range. We're expecting some gross margin deleverage due to the costs associated with opening our Northeast distribution center in Bethel, Pennsylvania in the first quarter. OG&A market rate is expected be stable compared to the prior year, as we make incremental investments in our three customer strategies, which David will speak to later.

The tax rate for the quarter is expected to be around 38%. Earnings per share is expected to be between $0.99 to $1.03.

We remain committed to our long-term guidance, as outlined in our shareholder value strategy at our recent Analyst Day, which includes delivering 7% to 12% earnings before tax growth, and returning our free cash flow to our shareholders. And with that, I would like to turn it back over to David to discuss our 2014 strategic priorities.

David Lenhardt

Thanks, Carrie. As I noted, we are pleased with our ability to continue to deliver within our shareholder value strategy in a challenged environment, but we are not satisfied with our comp sales trends. As the leading pet specialty retailer in North America, we are well-positioned to continue to lead the industry and drive future growth, but in order to do so, we must continue to evolve.

We have made great progress in separating ourselves from mass and grocery over the past four years. However, in a world of increasing choices in the pet specialty market, to drive comp growth, it is critical for us to continue differentiating ourselves with our customers. We are in a position of strength, but we do not take it for granted.

In my first nine months as CEO, I have had the opportunity to look at our business from a different perspective. I am struck by how united our 53,000 associates are, behind the belief that pets make us better people.

Our associates are passionate about it, and our customers connect with it. This belief allows us to play a unique role, centered around creating more moments for people to be inspired by pets. Going forward, I believe we have a real opportunity to elevate how our customers relate to us, in a way that is anchored in creating those moments.

As I outlined at our Analyst Day last October, our strategies are centered around caring for our customers, caring for our associates, and caring for our communities. Our mission of creating more moments for people to be inspired by pets is going to be the filter for those strategies.

As we begin a new fiscal year, today I would like to take you through in more detail our customer and community strategies. In 2014, our customer strategies are focused around three areas:

First, connecting with all of our pet parents in an authentic and personalized way, with an additional focus on personalization. Second, expanding our proprietary and exclusive products and services. And third, growing our most valuable customers.

Our first customer strategy, connecting with pet parents, is all about being relevant to our customers, however and whenever they shop, and leveraging our customer data and analytics to increase personalized connections. To do this, we are going to enhance the customer experience through technology. One of our competitive advantages is our ability to link 90% of our sales to individual customers.

We have the data, and we know that whether it's in our stores, online, or through our customer loyalty program, that personally relevant connections lead to higher levels of customer engagement and spend. We've been investing in new capabilities to help us capture and use customer and pet data, and this year, we will deliver on new methods to use this data to drive growth.

One key method is through our new enhanced promotional system, that for the first time ever, allows customers to enroll in our PetPerks loyalty program through the PIN pads at the register. This new capability significantly increases our ability to capture e-mails, and will help us to accelerate our ability to deliver offers that are personalized, based on a customer's purchases, preferences and unique needs.

We completed the implementation of this technology in the fourth quarter, and are actively using this now with buy one, get one offers, and targeted rewards when certain spend thresholds are reached, and with personalized coupon offers, using predictive models that target relevant offers to customers through point of sale and by e-mail. Finally, we are beginning to deliver personalized content and e-mail communication down to the individual customer, with product recommendations, videos and offers.

Turning now to our omnichannel initiatives, I would like to highlight what we are doing across the three pillars of e-commerce, e-influence, and building new capabilities. Across all of retail, technology is rapidly changing how customers interact with retailers, and we believe that in order to stay relevant with our customers, we are going to need to accelerate our deployment of omnichannel capabilities.

Over the past two years, we have been testing and building a foundation for future growth. I'm excited to announce that in 2014, our customers will experience noticeable changes.

First, there will be a marked improvement in the PetSmart.com shopping experience, when we launch our new website platform this quarter. This platform will deliver the type of web experience that our customers expect, with features like product image zoom, enhanced natural search performance, improved item comparison tools, and better presentation of item-level content like videos, reviews and color swatches.

Second, we are expanding our in-store availability feature online, so that our customers can now view product availability in store across all categories. Last year, we added in store availability for consumables on our website.

This was the most requested feature by our customers on PetSmart.com. We've listened to our customers, and are now accelerating the roll-out to all categories, which will be completed this quarter.

Third, we are launching a redesigned mobile website in the back half of the year. Customer use of mobile devices continues to dramatically increase. Today, about one-third of PetSmart.com visits come via smartphone.

We want to be there for our customers however and whenever they shop, which is why we are excited to launch an enhanced mobile web experience, with expanded shopping tools for our customers, like product comparisons, brand shops, and wish lists, mobile content for services, adoptions, and pet care guides, and mobile optimization of our PetPerks loyalty program and account management. This new mobile site will support e-influence and drive mobile e-commerce conversion.

Fourth, we will accelerate the use of mobile devices by associates in our stores. Over the past several months, we have been testing the use of mobile devices to help customers, with features like the pet food selector, and capabilities like in-aisle ordering when a product is out of stock, or when a product is part of an online-only assortment. We believe that being able to use technology in this way is critical to staying relevant to the customer in the moment, when they are there in the aisle. We plan to have devices in all of our stores by the end of the year.

And finally, we have been testing order online, pick up in store, which is the second-most requested feature by our customers. We will begin rolling this out to all of our stores in 2014.

Next, I would like to discuss the focus of our second customer strategy in 2014, growing our proprietary and exclusive products and services. Today, proprietary and exclusive products and services represent approximately 37% of our sales. This is a key competitive advantage for us.

It differentiates us from the competition, and keeps our customers coming back. On the product side, just over 26% of our merchandise sales are proprietary and exclusive to us. Our intent is to drive double-digit proprietary and exclusive sales growth over the next three to five years. In 2014, this growth will come from all of our merchandising categories, consumables, hard goods and specialty.

The largest growth opportunity for us is in consumables. We are going to build on the tremendous success of our own proprietary brands, Simply Nourish, Authority and Great Choice. In addition, we are working in conjunction with our national brand vendors, to bring in new PetSmart exclusive formulations and sub-brands. We have strong vendor partnerships and our vendors continue to look to us to lead the industry and fuel growth.

In hard goods, our focus is on continuing to grow our existing brands, developing new PetSmart-only unique assortments, and building out our pipeline of innovation for the future. For example, in our fun and fashion categories this year, we will add new assortments in our existing Disney and Toys R Us exclusive product lines, and add a new Puppies R Us exclusive line.

In specialty, we are introducing the National Geographic brand across the aquatics, reptile and smaller animal categories. National Geographic is a brand recognized the world over. It will help drive awareness and provide innovative and differentiated solutions to our specialty business, with products focused on ease of use and care.

Let me now turn to our third customer strategy: Attracting and retaining our most valuable customers. Our most valuable customers buy channel-exclusive foods, use grooming services and are new pet parents of dogs, cats and fish. We know that these customers shop us more frequently and spend more money across the entire store.

We have an opportunity to increase the penetration of these customers, by expanding and innovating in the areas they care about. For our channel-exclusive food customers, we are investing in the most significant differentiation opportunities in the natural food categories, so that we can continue to lead the overall industry.

We will introduce over 900 new items as part of the consumables reset in the first quarter. Within dog, we are significantly expanding the space for natural brands to allow for growth in segments like unique proteins and limited ingredient formulations, as well as wet foods. Within cat, we are introducing over 250 new SKUs, the biggest expansion ever of channel-exclusive foods, primarily in naturals, followed by science.

In litter and treats, we are refreshing and rebranding channel exclusive and proprietary brands, with innovative new assortments. And finally, when it comes to emerging trends, we are expanding our assortment of fresh foods to all stores across the chain, introducing Nature's Variety raw kibble in all stores, and introducing raw frozen foods to approximately 40% of our stores.

For our grooming customers, we are excited to launch our Pet Expressions Creative Grooming Services in all salons across the chain in the first quarter. These add-on services include chalking, stenciling and feathering, with washable, nontoxic ingredients.

This new service is an innovative and creative way for pet parents to personalize special moments with their pets, like birthday parties, holidays, play dates and sporting events. Enabling them to create even more moments with their pets.

For our new pet parent customers, we tie it all together for them with our puppy starter kits. These kits not only provide great savings for our customers, they are also a powerful tool for us to introduce them to our best products and services, driving conversion and increased customer retention.

Now that I've covered our customer strategies, I want to take you through our community efforts, which we believe are a key element in connecting us with our customers, and separating ourselves from the competition. Our customers have told us that they want to affiliate with a Company that stands for more than just dollars and cents, which is why caring for our communities matters.

I believe that we have a tremendous opportunity to differentiate ourselves in the community, and one way we are doing this is through PetSmart Gives Back. By building national partnerships and by supporting the local communities where our associates live and work. Since launching PetSmart Gives Back, we have seen the power of giving back in the tremendous response from our customers, associates and communities.

This is more than just donating dollars. This is about our associates donating their time. I am very proud that last year our associates volunteered more than 8,800 hours to more than 150 local organizations in their communities, to enrich people's lives through the power of pets.

PetSmart Gives Back has also allowed us to build four national partnerships, to help the homeless through PetSmart Promise, in partnership with Family Promise, to help children through PetSmart Paws For Hope, in partnership with Phoenix Children's Hospital and other hospitals throughout the country, to help veterans through PetSmart for Patriots, in partnership with Canine Companions for Independence, and to provide dog parks to communities where there is available land with PetSmart's Pop-Up Parks, the first nationally-branded portable community dog park of its kind in the United States. Caring for our communities is an integral part of our mission, and we will be focused on expanding our efforts in 2014.

Before we open it up for questions, I would like to take the opportunity to thank Joe O'Leary for his leadership and dedication to the Company. Joe has been an integral part of the Company's success over the past eight years, and I wish him the very best going forward.

Joe O'Leary

Thanks, David. The past eight years have been the most successful and enjoyable time of my working life. I've worked with incredible associates, and together we have achieved so much at PetSmart.

With my family, I decided that now is the right time for me to retire, and for all of us to relocate back to San Francisco. In fact, we are even moving back into the same street where we used to live, when we originally moved to the United States, so it feels like going home.

As I leave, what I am most proud of are our talented associates and the business capabilities that we have created together. David and I have had the time to establish a really capable management team.

I continue to believe that PetSmart has a great, sustainable business model, and we have the right vision and strategies for our customers in place to ensure that the Company is successful for many years to come. Thank you. And now I'll hand back over to David.

David Lenhardt

As outlined in our press release in January, I will not be replacing the COO position. Effective April 4, these responsibilities will be realigned among four newly-created Executive Vice President positions. I would like to congratulate Carrie Teffner, Matt McAdam and Bruce Thorn, who are being promoted to Executive Vice President roles, with expanded responsibilities.

An external search is currently under way to fill the newly created EVP of Customer Experience, Strategic Planning and Corporate Development. This new leader will spearhead our accelerated focus on staying relevant to the customer, however and whenever they choose to engage with us.

In closing, we have strong and capable leaders, and I am confident that we have the right leadership team in place to deliver on our customer-focused strategies to drive growth, so that we can continue to lead the industry, and deliver on our commitments to our shareholders. And with that, I would like to open it up for questions. Thank you.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question or comment comes from the line of Gary Balter from Credit Suisse. Your line is open.

Gary Balter – Credit Suisse

Thank you. Thank you, David, for the detailed discussion of the growth that’s going to be going forward and the – just first a very simple numbers question and then a longer question. You mentioned – Carrie, you mentioned the incentive related comp in Q4. Can you discuss how much that was?

Carrie Teffner

I'm sorry, say that again, Gary, you're asking what about the comp in Q4?

Gary Balter – Credit Suisse

You mentioned incentive related comp helped the comparison or the lack of incentive-related comp. Could you discuss how much that was?

Carrie Teffner

Yes. It is the primary driver of the benefit in the OG&A leverage.

Gary Balter – Credit Suisse

Okay.

Carrie Teffner

So it was really tied to the comp performance for the year and obviously you know from our incentive plan that's a big driver for us.

Gary Balter – Credit Suisse

And you know you've had – like you did the dog reset, the hard lines reset in the dog area. Could you talk about what you've seen from that and what does that imply for further resets in the stores? Thanks.

David Lenhardt

Yes, Gary, it's David. We have been very pleased with the results of the dog hard goods reset. We have seen dog hard goods penetration continue to increase since we have done it and looking at the particular categories we would expect to see sales lifts in. We have seen sales lifts, whether it be apparel, whether it be beds, whether it be waste management and the adjacencies that we've built. We did see those lifts. We did see some muting of that in the fourth quarters as we saw the impact of severe weather on those categories.

Gary Balter – Credit Suisse

When you see the severe weather, do you get a sense that customer's switching to an e-commerce purchase because they're not going to let their dog starve I believe – I don't know. I don't have a pet. Does that shift become more permanent like what are your thoughts about what happens? Because your traffic now has been down for a couple quarters in a row and obviously was weakest in December, January based on your commentary.

David Lenhardt

Yes, Gary, again, in December and January we did see much more severe and I would say continual weather. It really kept the customer from coming up for air. And if you think about the categories that affects, we saw an impact in grooming. So if you think about grooming when a customer can't get to a grooming appointment for a period of time they're just going to wait for the next one.

With hard goods, we know that's discretionary. On the consumable side we did see less of an impact.

With respect to online, we've been very pleased with our online business. Fourth quarter was a very good quarter for us. It grew at several multiples of the industry growth rate. But again, we see the customer continuing to shop in our store but then as you said, there is a customer that does shop online as well.

Gary Balter – Credit Suisse

Thank you.

Operator

Thank you. Our next question or comment comes from the line of Brian Nagel from Oppenheimer. Your line is open.

Brian Nagel – Oppenheimer

Hi, good morning. Couple questions on expenses, if the I could.

First off, near term in the quarter included there was some noise so to say with the extra week but nonetheless, you've been digging through that. Your expenses seem to be lower than usual, at least the growth rate was lower.

So I guess the question I have there on the fourth quarter is how much as we look at that and we think about our models – how much of the decline expenses in Q4 should we we as sustainable?

And then second you outlined in the commentary, in the prepared comments about – I guess it sounded to me like an added focus on rolling out online or enhancing online. How should we think about the expense or investment component of that in 2014? Thanks.

Carrie Teffner

Yes. We think specifically around Q4 as I mentioned, again, it is incentive related and we did benefit from that over the course of 2013. But thinking about that going forward you can think about it as essentially we reset the base with performance in 2013, relative to the incentive plan. So Id – you should not plan for that benefit to continue. You should look to see us continue to drive some leverage in the OG&A line and that's factored into our guidance. With respect to the investments and the customer strategies that David outlined, again, that's all woven in. We still expect to deliver OG&A leverage for the year. However, we are a little front loaded in Q1 with those investments, given the fact that we're focused on getting them out and deployed.

Brian Nagel – Oppenheimer

Then maybe just a follow-up. I think somewhat to Gary's question. If you look at the weather including every retailer out there, to some extent we are talking about the weather we've had over the last several weeks, couple months, whatever. Is there a, within your base of stores – is there a control group that you can cite where you saw better trends, maybe where the weather wasn't as unfavorable?

David Lenhardt

Yes, Brian, the way I would frame that for you is as we looked at our store base over the last couple months, we've seen that over 60% of our stores were affected continually by weather during that time and so it had – and that was a much bigger impact that we have seen in previous winters. So it was a very tough period. Most of our stores were affected.

Brian Nagel – Oppenheimer

Thanks.

Operator

Thank you. Our next question or comment comes from the line of Chris Horvers from JPMorgan. Your line is open.

Chris Horvers – JPMorgan

Thanks, good morning, everybody. Dave, can you share more details around the new partnerships with the national brands to provide exclusives to PETM. Any details you have? Will these products not be in PETCO or on Wag? Where will they be positioned in terms of naturals versus premium versus science versus mass and so forth? Are they like some of the mass players would put out a private label product. It’ll be basically a renaming of an existing brand the vendor already offers. So sort of any details you can share in terms of where it's positioned and how many SKUs perhaps and how many categories.

David Lenhardt

Yes, Chris, let me – I'll start and then have Joe follow up. This has been a big focus for us over the last year and it very much is about in the channel exclusive categories, probably much more so on the naturals side, working with our national vendors to develop unique innovations that we can exclusively have at PetSmart. So it absolutely is not the strategy of taking a different size or maybe just a different flavor, renaming it and a having it in our stores. We've really worked with them on uniqueness and exclusivity that would just be in our stores and we are making progress against that and you'll start to see some elements of that moved into our stores this year. Joe, do you want to add on?

Joe O’ Leary

Yes, Chris, it's Joe. This reset was really the one way we were able to align with our vendors two years ago and really plan this forward. That's why we ‘re able to bring so many new SKUs to the market at this point in time and it's one of the subsets there as David said was exclusive products for PetSmart and that's across pretty much all of our national brands. So it new for them and it is new for us but it is a measure of the strength of the partnerships that we had. And obviously as we go into this we're going to see how it plays out, certain categories, certain brands, certain products will be more successful and we would grow into those and other ones maybe not so much. But certainly it's additive to us, it's not just us having proprietary brands and then having channel exclusives, it's working with our key vendors to have products that is exclusive to PetSmart only and therefore differentiate us for our customers and really excited about that and it's been really powerful with our vendors.

Chris Horvers – JPMorgan

So from – I think you said were touching 900 SKUs in this food resets so it's going to be a small number of that and you're going to test and learn and see where you can actually grow into this over the next couple years.

Joe O’ Leary

Yes, we won't go into the detail behind it because it's new but within that you would be in the stores and you stand in front of a set and see not only channel exclusive but product that is very specific to us. And like anything else, we'll measure and test you how it goes, so yes, in summary to your question.

Chris Horvers – JPMorgan

And will it be named – will packaging say exclusive to PetSmart or is that just signage? Will it be of the existing private label brands or will it be hills science exclusive to PetSmart?

Joe O’ Leary

We're working through that. We want to message it to the customer.

Chris Horvers – JPMorgan

Okay. And then as a follow-up, understand you don't break out the margin components but on a 13 to 13 week basis, did you see occupancy leverage? And on the services front, that's really picked up in recent quarters. What's driving the expansion and how structural is the continuance of this benefit?

Carrie Teffner

Let me take a couple of pieces. So specifically related to services, what we're seeing driving that benefit is really more efficient labor management. Sales leverage as you think about hotels, occupancy and then also seen some lower fringe rate benefit that's hit the services category as well. But with that, looking at the other items we have a little bit of deleverage in the quarter in the warehouse and distribution and occupancy relatively small and our merge margin was positive.

Chris Horvers – JPMorgan

Okay. Perfect. Thanks.

Operator

Thank you. Our next question or comment comes from the line of Scot Ciccarelli from RBC Capital. Your line is open.

Scott Ciccarelli – RBC Capital Markets

Wow. It’s Scot Ciccarelli. Hi, guys. Even though your e-commerce channel is very small, by your own mission it's growing rapidly. Could you talk about what you're seeing both on the basket side as well as profitability of sales through that channel especially given how difficult it is to make money to sell pet food with free shipping offers?

David Lenhardt

Yes, Scott. It's David. We are growing our e-commerce business profitably. And what we're seeing is very good basket sizes relative to our store baskets. We’re also seeing that our online customers also shop in our stores so that multichannel customer is an attractive customer for us and it's an area that we're continuing to invest in. And so as we think about 2014, I'm very excited about the new web platform we're going to be introducing this quarter. That's going to bring a lot of features that our customers want. As well as in the back half of the year, we're very focused on improving our mobile web presence. We know that mobile is dramatically increasing in terms of customer adoption. A third of our sales on PetSmart. com come through a mobile device and we are very focused on making sure that we have an improved experience there and that will happen in the second half of the year.

Scott Ciccarelli – RBC Capital Markets

So, David, that's helpful. Is there a certain pressure that we should consider on the margin as e-commerce becomes a bigger portion of the overall pie? I'm presuming it's profitable but still a lower margin channel.

Carrie Teffner

Yes. Let me take that. The – you know it – as we factored in – again, first of all, just the fact that e-commerce is still an extremely small portion business. As we factored in the growth rate again assuming continuing growing significantly above the industry rate. We look at the next year or so, we're not seeing a meaningful impact to our margin rate associate with that.

Scott Ciccarelli – RBC Capital Markets

Got it. All right. Thanks a lot, guys.

David Lenhardt

Thanks, Scott.

Operator

Thank you. Our next question or comment comes from the line of Matthew Fassler from Goldman Sachs. Your line is open.

Matthew Fassler – Goldman Sachs

Thanks a lot and good morning. Dave, you spoke in your discussion about the stabilization in the science category. Could you talk about whatever blip there might have been in that area of food and sort of what's changing as we speak? And then I have a quick follow-up.

David Lenhardt

Matt, let me start and then Joe can jump in. That stabilization is something we've seen for a little while now. I would point to in particular Hills with their relaunch around science diet. We've seen some very, very good traction from that so that's been a key driver of that.

Joe O’ Leary

Matt, as we were growing natural we've soon it in the numbers from those vendors, be it science diet or world come in or you can remember that the science category struggled a little bit a couple years ago relative to the amount of innovation that was going into that category and we partnered with the vendors very strongly, all three, but particularly with Hills to reinvigorate and we're really pleased with the performance and how that's coming through. It was more it came off the pace a little bit in terms of innovation and now it's come back and therefore we're seeing the performance stabilize.

Matthew Fassler – Goldman Sachs

Great. And then my second follow-up question, in the context of the guide that you gave for Q1 which was low singles and then the full year up 2 to 4, what kind of traffic trend is contemplated in that guidance?

Carrie Teffner

Hi, Matt, this is Carrie. So as we look at traffic over the course of the year, obviously in our 2 to 4 comp for the full year we're assuming some traffic and AUR. You think about the quarters within the year, Q1 has started off challenged, not too dissimilar to what we saw in Q4, as we continue to have weather impacting us week after week. So we planned a little bit more conservatively in the first part of the year, ramping through the year as we deliver on the initiatives that David has outlined.

Matthew Fassler – Goldman Sachs

And Carrie, just following up on that very briefly. You talked about the weather and Q1. As you look at weather-impacted markets versus non-weather impacted markets are you seeing a meaningful difference, anything you might be able to quantify?

Carrie Teffner

I would tell you that yes we are seeing meaningful differences but I would not quantify it for you.

Matthew Fassler – Goldman Sachs

Okay. Thank you so much.

David Lenhardt

Thank you, Matt.

Operator

Thank you. Our next question or comment comes from the line of Daniel Hofkin from William Blair & Company. Your line is open.

Daniel Hofkin – William Blair & Company

Good morning. Just a quick question regarding Banfield and then just one follow-up question. In Banfield, could you may be touched on this earlier but what contributed to the larger increase in profitability in the fourth quarter?

Carrie Teffner

You know, Banfield's its own business. While we do own a stake in them, it's really the profitability that came through is really related to their business cycle so I don't really have any more color to share with you on that.

Daniel Hofkin – William Blair & Company

Okay. So there – but no specific true-you up or other adjustment necessarily.

Carrie Teffner

No, no.

Daniel Hofkin – William Blair & Company

Okay. Okay. And then as you look forward and thinking about thus far through the first quarter but also the year, what are the main things that you would expect to drive a little bit better comp for the year as a whole compared to the first quarter guidance?

David Lenhardt

Yes, Dan, it's David. I would point you to as we think about this focus on growing our customers and our three customer strategies. Again, I think it's really critical for us to connect with our customers in an authentic and personalized way and the delivery of capabilities to our customers, whether it be mobile devices in store, order online, pick up in store, the ability for our customers to see the inventory availability in our stores of all of our products, I think that is going to be a driver. We are very focused on growing our proprietary and exclusive products and services. We think that that's a differentiator that keeps customers coming back to us and we intend to continue to grow rate in 2014.

And then finally, our focus on our most valuable customers, specifically customers who purchase channel exclusive foods, grooming and new pet customers. And this year in particular the consumables reset is going to be a big driver around channel exclusive foods and we talked a little about that but we're really continuing to drive innovation in the naturals category in partnership with our vendors. So all of those things combined are going to help us continue to drive growth, which we are very focused on.

Carrie Teffner

And If I could just jump in here for a minute too. David mentioned our enhanced promotional system that we've implemented at the end of last year. That gives us new capabilities around promotional activity. So when I talk about that I'm not talking about more promotions, I'm talking about different and better promotions, as we utilize that to drive activity in the stores. If you were in our store any time this month or the weekend, you would have seen that we have a number of promotional activities going on, buy two, get one free, spend $40, get – come back later, get a $5 discount. There's a number of traffic driving activities that we're actually executing on right now.

Daniel Hofkin – William Blair & Company

Great. Thanks. Best of luck.

Operator

Thank you. Our next question or comment comes from the line of Michael Lasser from UBS. Your line is open.

Michael Lasser – UBS

Good morning. Thanks a lot for taking my question. I'm curious about as you look at your traffic over the last few quarters and the fact that you can tie 90% of your sales to the pet perks card, have you been able to differentiate between those most valuable customers and the stickiness of that traffic versus those that are more marginally attached?

Carrie Teffner

I would say as we look at the actual customer data that we've been tracking and what we've been seeing is a lot of this is related to making sure we're attracting and bringing in new customers into the stores. But even within that, as David – I'm going to take you back to the most valuable customer. We have good retention rates on our most valuable customers. We need to continue to grow that because when we bring in the customer that comes in one time, it doesn't continue to come back, that's not necessarily the most cost effective customer acquisition we could have. So we're really focused on that cost effective customer acquisition which is around the most valuable customer.

Michael Lasser – UBS

Okay. And my follow-up question is on inflation, deflation. Do you experience any in the fourth quarter and what's your outlook for 2014?

Carrie Teffner

Sure. We had about 100 basis points of inflation impact in the fourth quarter, not too dissimilar to what we saw earlier in the year. We are expecting lower impact related to inflation for the full year of 2014. We certainly don't expect any type of deflation but minimal inflation impact.

Michael Lasser – UBS

That's very helpful. Thanks so much and good luck, Joe.

Joe O’ Leary

Thank you.

Operator

Thank you. We have time for one final question. Our final question comes from David Mann from Johnson Rice. Your line is open.

David Mann – Johnson Rice & Company

Thank you. In terms of the inventory levels, can you talk about what caused that extra growth in inventory, what categories and when you expect that to moderate?

Carrie Teffner

That's a great question. So we're up about 4.5% on same store basis, up 9% overall at the end of the year. The increase in the inventory is really driven around in consumables where we've brought in consumables early in P12 to get us set up for this Q1 consumable reset. So it's really all around gearing up for the reset that we've been talking about.

David Mann – Johnson Rice & Company

Okay. Great. And then in terms of the competitive landscape, seeing that PETCO has been lowering prices and talking about that and well historically they've been higher than you guys. I'm just curious what are you seeing in markets where you directly compete with PETCO and do you have any plans to respond to some of their pricing adjustments?

David Lenhardt

Yes, David, we've seen the competitive landscape remain pretty stable. We know that the pet specialty market is an attractive market and there are a number of different choices. We are very focused on continuing to separate ourselves within pet specialty and that's really at the core of our mission of creating more moments for people to be inspired by pets and the three customer strategies I just outlined. So you're going to see us continue to focus very heavily on those three customer strategies as we go forward and in respect to any particular competitor, we react as appropriate but we look at the entire landscape.

David Mann – Johnson Rice & Company

Okay. That's great. If I could sneak one more in. In terms of your community efforts, you didn't mention anything new in the adoption area. I'm just curious what you might be doing there, anything different to try and increase that acquisition of new pet parents.

David Lenhardt

Yes, David. PetSmart Charities and our focus on adoption is a critical piece of our communities and we are continuing to work with charities to grow adoption in our stores. We just had a National Pet Adoption weekend a couple of weeks ago and we saw a nice uptick in adoptions as a result of that and then I think you'll continue to look at ways to communicate more broadly to our customers around our efforts with saving homeless dogs and cats and you've seen us on-air with commercials. You'll see us continue to do that as well as leverage all of our touchpoints, whether it be social media, signage in the stores, to talk about that focus around adoptions again, in conjunction with the other work we're doing through PetSmart gives back.

David Mann – Johnson Rice & Company

Great. Thank you. Good luck in '14.

David Lenhardt

Thank you, David. I think we've come to an end and I want to thank you for joining us today. We look forward to speaking with you again in May. Thank you.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes our conference for today. You may all disconnect. Everyone have a wonderful day.

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Source: PetSmart Inc's CEO Discusses Q4 2013 Results - Earnings Call
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