Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

PetSmart, Inc. (NASDAQ:PETM)

Q2 2014 Earnings Conference Call

August 20, 2014 10:00 AM ET

Executives

April Lenhard - Director of IR

David Lenhardt - President and CEO

Carrie Teffner - EVP and CFO

Analysts

Seth Sigman - Credit Suisse

Simeon Gutman - Morgan Stanley

Brian Nagel - Oppenheimer

Michael Lasser - UBS

Christopher Horvers - JPMorgan

Matthew Fassler - Goldman Sachs

Peter Benedict - Robert W. Baird

Peter Keith - Piper Jaffray

Alan Rifkin - Barclays

Omair Asif - Wells Fargo

Scot Ciccarelli - RBC Capital Markets

Operator

Good morning ladies and gentlemen, and welcome to PetSmart’s Second Quarter 2014 Analyst Conference Call.

At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will be given at that time. (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, President and Chief Executive Officer; and Carrie Teffner, Executive Vice President and Chief Financial Officer.

To begin, David will highlight our second quarter business performance and discuss our strategic priorities. Carrie will then review the detailed financial results, as well as our earnings guidance. At the end of our prepared remarks we will open the call 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.

And now, I will turn the call over to David.

David Lenhardt

Thank you April and good morning everyone. Before I get started I would like first to take a moment to comment on our announcement yesterday that based on thorough business review undertaken by the board began in the spring, the company will explore strategic alternatives for the company to maximize value for shareholders, including the possible sale of the company.

As noted the board has been working with JPMorgan and the Wachtell, Lipton, Rosen & Katz law firm to assist in the process. Notwithstanding this announcement we have committed a 100% to growing our business, improving performance and serving our customers and their pets. I notice this news may cause a lot of questions but I want to be very clear that we won’t be commenting on or speculating about the timetable or potential outcome.

Our board remains consistent in its view that despite recent headwinds affecting us and indeed most retailers PetSmart has a great future. It is up to us and our 53,000 or so associates to continue to deliver the outstanding products and services that our customers and their pets expect.

As you have seen from our press release, we’re also delighted to have announced the definitive agreement to acquire Pet360. Pet360’s family of e-commerce websites, which includes PetFoodDirect and Only Natural Pet, their innovative digital media programs and content sites like petMD, are an ideal complement to our existing web platform PetSmart.com. This transaction is a smart and efficient way to immediately position PetSmart as a leading online pet specialty retailer of food and supply.

In addition to bringing key talent to our online and leadership teams, providing cost savings opportunities, increasing our merchandise assortment and providing additional web platform and fulfillment capabilities. As we have said before, while online sales represent only a small part of pet industry sales now that is changing. And this acquisition positions us well to capture what is expected to be more relevant revenue growth in the future. The transaction is expected to close in September.

Before I turn it over to Carrie to go into detail on our financials, I’d like to say a few words about the quarter and the improvement initiatives we outlined in the release. Clearly, as we told you last quarter the environment for most retailers is challenging we have not been immune to that. Comparable store sales decrease 0.5% driven by comp transactions of negative 2.6%. We are pleased within the challenging retail environment with increased promotional activity, earnings per share increased 10% and the earnings before tax margin grew 25 basis points.

That said, we believe we can do better and we are very much focused on implementing a broad range of initiatives to drive store growth, reinforce our customer relationships and deliver value to shareholders.

Before I talk about the initiatives I do want to take a moment to recognize and welcome two new members of our Senior Leadership team who will join us in June, Phil Bowman our new Executive Vice President of Customer Experience and Mike Goodwin our new Senior Vice President and CIO.

Phil joined us from TD Ameritrade, where he most recently served as the Chief Marketing Officer for the online retail brokerage firm. Prior to servicing as CMO, Phil held senior roles across branding, planning and data analytics with TD Bank Group. Phil is a proven leader in brand building, digital marketing, e-commerce and customer data analytics, as well as in the creation of an integrated customer experience.

Mike Goodwin joined us from Hallmark, where he was recently served as a Chief Information Officer of Technology and Business Enablement. He brings over 20 years of Information Technology experience and a proven track record of creating and leading Agile Organization that leverages Technology to explore and develop innovative concepts quickly. They are important additions to the company and complete my senior team. We are extremely pleased to have them on board and know they will make strong contributions to PetSmart.

I’d like to turn now to our performance initiatives, which has been a key focus of our management team and board which began a detailed review of our business in the spring. Following that review, we have embarked on a broad cost reduction program that will fundamentally restructure the cost base of the company.

The program will target all areas of the business including in order of magnitude cost of goods sold, logistics, sourcing, store operating costs and overhead. We expect to realize these savings before the end of fiscal 2015 and will provide additional details about the program and targets next quarter.

At the same time, we are steadfastly focused on ensuring that PetSmart is well positioned for the long-term. As I said a moment ago, driving customer traffic is central to our success. Let me update you on our efforts to drive traffic and performance overall. As most of you know, we completed our consumables reset in April. We have been carefully monitoring and analyzing the results and what we have seen is that our customers who buy grocery and mass brands were impacted more than we expected. These customers are important to us because they represent over 70% of the consumables market and we have a proven ability to trade up these customers to channel exclusive foods over time.

In response, we have taken actions in the stores. In June, we added more sales space to high-volume SKUs, such as Iams and Purina ONE. And this month we are adding incremental pallets of these and other grocery store and mass brands to the top 800 stores carrying this popular brand, which will be completed next week. We will continue to make adjustments if needed to make sure we continue attracting these customers. Additionally we have invested and we will continue to invest in marketing with a more focused message on our broader assortment and price position ranging from grocery stores and mass brands to natural food brands.

We are leveraging the insight from our customer database to adjust the media mix with specific emphasis on targeted digital display, page search and organic search to better segment and target specific key customer groups for instance identifying new customers versus last customers. With respect to proprietary and exclusive products sales and services sales, I believe we have made good progress in both areas which reflects the key competitive advantage for us. In the second quarter, proprietary and exclusive products sales grew 10% to 27.7% of merchandize sales, up 250 basis points from the second quarter last year with improvements across all three division consumables, hard goods, and specialty.

This growth was driven by our own natural proprietary brand simply nourished our markets towards re-launch and our new national geographic partnership. Based on our strong year-to-date performance and pipeline of innovation, we remain confident in our ability to deliver double digits sales growth in proprietary and exclusive products sales over the next three to five years. On the services side, sales continue to outpace the core with growth of 4.7% driven by grooming and PetsHotels. Services had both positive transactions and sales per transaction growth driven by successful initiatives to drive sales and differentiated offerings in both the salon and hotels.

Our services customers are some of our most loyal and valuable customers. More than a third of the customers who come in for services, at the same time, by our merchandize when they are in the stores. They also shop more frequently and stand almost twice as much as the average customer, customer. In the online space as our acquisition of Pet360 reflects a more robust e-commerce platform is important to our long-term growth, we’re taking a customer driven approach to our e-commerce strategy, monitoring customer behavior by channel and investing consist with customer preferences.

In Q2, our e-commerce sales increased 25%, mostly driven by consumables. With recent improvements to our site, we’re seeing conversion increase 33% and mobile traffic grow 35%. Multichannel customers are some of the most valuable customers we have. Shopping both in the stores and online and we’re competing for them aggressively. We are also continuing to invest in new omni-channel capabilities. We just completed the rollout of mobile devices to all of our stores, which improves the customer experience by enabling our associates to order for us online that are not available in the store.

Additionally, Buy Online Pick-Up in Store is currently available in 322 stores increasing customer convenience. Our system wide rollout is on track to be completed before this coming holiday season. Finding ways to create deeper more personalized connections with our customers is a way of life at PetSmart. Of the 35 million active customers that we track, 19 million are enrolled in our PetPerks loyalty program. Since April, we have increased PetPerks membership by 9% and more than 5 million members are now enrolled in our Deal Alert program to receive email notifications when their favorite products go on sale. This helps drive valuable traffic and aids in customer retention.

As you can tell, we’re working aggressively to build the customers legacy of being the premier definition for pet parents and their pets. We are leveraging the scale of our 1352 stores including 13 new stores opened during the quarter and our distribution capabilities to be where our customers are and to deliver what they want and expect from us. There is no question the PetSmart has the platform, strategy and resources to maintain and grow its competitive advantage. And to deliver meaningful value going forward. Our team is excited about the future.

With that, I will turn it over to Carrie for more financial detail and then we’ll take your questions. Carrie?

Carrie Teffner

Thanks David and good morning everyone. I will take you through our financial performance for the second quarter and then I will discuss guidance for the third quarter and full year.

Total net sales for the second quarter were $1.7 billion, representing an increase of 1.4% over the same period last year. As David mentioned, comparable store sales decreased 0.5% with comp transactions of negative 2.6%. Foreign currency fluctuations negatively impacted comp sales by approximately 25 basis points, and inflation was 120 basis point headwind, declining sales in our specialty business, as a result of ongoing slowing industry trend negatively impacted our comps sales by approximately 75 basis points.

As you may recall, we saw our specialty business start to decline in the second quarter last year and this business has continued to decline consistent with the secular specialty industry trend. We continue to focus on differentiating our offering with exclusive products with our new national geographic assortment and an effort to bring customers back to the category.

With respect to sales mix, we’ve heard from you, your desire for more information in an effort to provide more transparency on our merchandized category performance, I will be breaking out sales penetration a little differently than in the past in order to isolate the specialty business from consumables and hard goods. You’ll find both sales mix breakdown on our investor website at petm.com.

As a reminder in the sales mix breakdown we have use historically, live pets represents the specialty pets that we sell in our stores. The consumables and hard goods categories have included the products associated with this specialty pet. In this breakdown, the specialty category is defined as the live pets, as well as the consumables and hard goods products associated with this specialty pets.

So with that as a background during the second quarter of 2014, the sales mix included consumables at 49.0%, hard goods at 26.6%, specialty at 11.3%, services at 12.4% and other revenue at 0.6%. For comparison, I will also provide the sales mix during the second quarter of 2013 which was consumables at 48.4%, hard goods at 26.8%, specialty at 12.3%, services at 12.0% and other revenue at 0.5%.

If you can see more clearly from this breakdown consumables penetration is up 60 basis points versus Q2 last year, hard goods is down 20 basis points, specialty is down 100 basis points and services is up 40 basis points. Hopefully, this breakdown will provide with more clarity and transparency to help you understand the category performance.

With respect to those margins, there are number of moving part this year, especially with the opening of our new distribution center. So I will provide some additional colors to help you better understand the puts and takes. Gross margin for the quarter was 29.8% representing a 40 basis points deleverage compare to the second quarter last year. Within the gross margin line, services added 45 basis points to the overall rate driven by improved safety claims as a result of safety program the company has been focused on over the last couple of years, as well as benefit associated with optimizing full on capacity and add on packages to drive ticket.

Merchandize margins were down 45 basis points due to a combination of mix and rate at approximately one third and two third respectively. We ran various promotional offers including spend/gets and BOGOs during the quarter. Warehouse and distribution cost were 35 basis points unfavorable, which included the 25 basis points impact from cost associated with the new Bethel distribution center, with the remainder due to sales deleverage.

Rent and occupancy costs were 5 basis points unfavorable due to sales deleverage. Operating general and administrative expenses were 20.4% of sales representing 65 basis points of improvement compared to the prior year period. This was primarily driven by lower reset of expenses as we lapse the dog hard good merchandise reset in the second quarter of last year, lower incentive compensation expense and ongoing expense management.

Overall, earnings before tax increased to $150.1 million or 8.7% sales this represents 4% growth and a 25 basis points improvement over the prior year period. The tax rate for the quarter was 38.7% and earnings per share growth was 10%.

Turning to the balance sheet, at the end of the second quarter we had $323 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 $587,000 down 1% compared to the second quarter last year.

From a cash flow perspective, we generated $92 million in cash flows from operating activities during the quarter. Depreciation and amortization expense for the quarter was $60 million. We spent $36 million on capital expenditures during the second quarter and year-to-date through the second quarter approximately 60% of our CapEx had been for store both opening new stores and maintaining a store base with remaining 40% for investments and technology and infrastructure.

During the quarter, we opened 13 new stores including one and twelve microstores and closed one store bringing our total stores count to 1352 stores. We did not open any PetHotels during the quarter, of the 12 and their format stores opened during quarter 9 were 12K format stores. These stores give us greater access to attractive markets that we can’t access with the larger format store and the 12K format stores produced higher sales and four-wall cash flow per square foot on average from the larger 18K format stores.

With regard to our 6000 to 7500 square foot microstores format as you recall, we opened 12 in small markets in the first half of last year and we opened our first urban in-fill micro-store in Q2 in the Greater Toronto area. While still early day, we’re pleased with the overall performance of our microstores and the ability they give us to extend our runway to both small markets and in-fill markets. We are currently planning to open approximately 20 microstores in the second half of this year. During the quarter, we distributed $19 million in dividend and we did not purchase any PetSmart stock during the second quarter.

And now turning to our guidance for fiscal year 2014 and the third quarter, we are expecting comparable stores sales growth to be relatively flat and total sales growth in the low single digits. We expect earnings before tax growth in the mid-single digits reflecting gross margin deleverage and OG&A leverage. We anticipate the tax rate to be around 38% and earnings per share to be between $4.29 and $4.39. Please note that our guidance assumes no additional repurchases during the year. Our operating cash flow is expected to be between $600 million and $625 million.

For the third quarter of 2014, we are expecting comparable store sales to be flat to slightly down. Earnings before tax growth is expected to be in the mid-single digit range driven by gross margin deleverage offset by OG&A leverage. The tax rate for the third quarter is expected to be around 38% and earnings per share is expected to be between $0.93 and $0.97.

Please note that our third quarter and full year guidance excludes the impact of the Pet360 acquisition. You also heard David discuss the expensive cost base reset we are undertaking. Our guidance does not include any of the potential impact of the cost reduction efforts which are underway now and expect to be realized before the end of next fiscal year.

As data assessed, we are not satisfied with the overall results but we believe that the initiatives outlined earlier combined with our proven track record of managing operating expenses to invest in the business are the right course of action to drive shareholder value.

That concludes our prepared remarks. I would like to open the call for questions. Thank you.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) First question is from the Seth Sigman of Credit Suisse. Your line is open.

Seth Sigman - Credit Suisse

David, you outlined a number of steps to improve the positioning and one of those focused on your assortment in the store and specially broadening out your assortment of mass in grocery brands and just trying to understand how the assortment is positioned long term and maybe specifically you can discuss the evolution away from mass in grocery over the last few years and the opportunity now to shift back where do you see some opportunity to acquire new customers? And then I’ll have a follow-up.

David Lenhardt

Yes, Seth. It’s David. We think we have an opportunity as we mentioned to continue to strengthen our leading position as the definition for food in this industry and that really includes having a broad assortment of both widely distributed the grocery and mass brand and the natural brand. We continue to think that all of those brands are important. We have seen over the last couple of years as we saw the gross in natural continue to increase that we have dedicated more space but also the way we message to the customers has been more focused on natural.

We do think it’s important to have more of a balance and as we did just do the consumables reset and we’ve looked at the results of that we do feel like we have an opportunity to rebalance towards some more mass and grocery brands. But again, we think it’s about having the full assortment, we think that those grocery and mass brands are very important for us to have because they are really the pipeline of our future natural brand customers. Today, 70% of the consumables market is those widely distributed brands and we know we can trade those customers up to channel exclusive overtime. So it’s a key piece of our strategy but we are very focused on having kind of that breadth of assortment.

Seth Sigman - Credit Suisse

What are the near-term ticket and maybe margin implications from that mix shifting to mass in grocery because clearly over the last few years with that trade up, that’s helped your ticket has also helped margins a bit, how do you think about that?

Carrie Teffner

Yes, hi, this is Carrie. Certainly as we look at the overall gross margin level where we’re looking at that with the widely distributed customers, they do attach other categories when they come into the stores. So while the consumable margin is lower. With the attach rate that they have they bring the overall margin of that transaction up, so you know within consumables we will see that weight into the consumable margin itself but in the overall merch margin line, we do see that as positive.

Operator

Thanks. Your next question is from Simeon Gutman of Morgan Stanley. Your line is open.

Simeon Gutman - Morgan Stanley

Thanks. Good morning and thanks for the sales and margin color. David, I know you may not talk a lot about some of the cost savings a little early but can you just mention directionally, it sounds like based on the commentary that the savings were more than offset whatever investment that you’re making, meaning there’ll be some growth to the bottom line. Is that a correct interpretation?

Carrie Teffner

Yes. This is Carrie, I’ll take that question. Yes, what we’ve outline is a broad cost reduction program you heard us and the call is going to target a number of areas including cost of goods sold, logistics, sourcing, et cetera. We’ve certainly look to deliver savings associated with that, but to invest in the businesses as well as the drop to the bottom line.

Simeon Gutman - Morgan Stanley

And then on those buckets, can you just talk about where the business is, with a most inefficient or what are the some of the biggest buckets within those, I mean a little bit more specific than some of the broad categories?

Carrie Teffner

No. I think what I leave with you is, as we outline on the call and we kind of size it by order of magnitude I think I would rely on that.

David Lenhardt

And again, I think we’ll have a much better sense on the next earnings call for you there.

Simeon Gutman - Morgan Stanley

Okay. And then my follow-up, just on Pet360. Can you just talk about what you found more compelling or most compelling with this platform versus some of the other one’s out there, any other color on that? Thanks.

David Lenhardt

Yes. We’re very excited about Pet360. We think that this allows us to continue to grow our omni-channel capabilities. This, we’re excited because Pet360 is more than just pure e-commerce. This bring us capability and talent also in the omni-channel and from a personalization perspective, very specifically they operate about 10 websites including the number one pet health website petMD, we’re very excited about this diverse and rich content sources. They also bring an established prescription pharmacy operation to us and in house digital media team as well as significant online and technology experience. The other piece to Pet360 is they also have a variety of different products used in premiere natural brands that they also offer, so we think it’s a very complementary business for us and will allow us to significantly advance our omni-channel strategy.

Simeon Gutman - Morgan Stanley

And just to clarify it will operate in exclusive of PetSmart online platform that goes through on GSI or does it come in and then I guess does it help you internalize this process or we -- set the stage for internalizing this process our omni-channel overtime?

David Lenhardt

Yes. At this point we absolutely are planning on running it as a standalone business and we will run PetSmart.com separately as well. Having said that, again some of the content capabilities they bring the personalization capabilities overtime, I would expect you will see a start through incorporated to PetSmart.com.

Operator

Thank you. Our next question is from Brian Nagel of Oppenheimer. Your line is open.

Brian Nagel - Oppenheimer

So maybe a follow-up to Simeon’s question on Pet360 but with the purchase, does the company come with distribution or would you be distributing, will you increasingly distribute purchases made on the website of Pet360 through the PetSmart distribution infrastructure?

David Lenhardt

No. It’s a fully comprehensive business. So both from the web hosting which uses a standard platform, they also have their own fulfillment and we would continue to use that.

Brian Nagel - Oppenheimer

And then from an integration standpoint, again I know it's early because the acquisition was just made but it sounds like what you said before, it’s going to largely be a separate division but overtime will there be a systems integration and how complementary are the current PetSmart systems to those Pet360?

David Lenhardt

Yes. As of today we are intending to keep them separate I think, but that’s something we will continue to evaluate the CEO of Pet360 upon closing will become and SVP and our Chief Digital Officer reporting to Phil Bowman. So I think that will be something that we continue to evaluate as we look at the various capabilities we can bring from Pet360 into PetSmart.com and into our business overall.

Brian Nagel - Oppenheimer

Just one final question and I know, again it’s early and this too because and you’re going to talking about more about this, if you look towards this new cost-cutting effort, I know which you described throughout the whole organization, maybe just talk a little more about how much in addition to your normal cost control efforts which I think you guys have done a very good job overtime, but if you, how much more aggressive is this and is there other any even broad parameters we could look at in terms of magnitude overtime, what we should be thinking about, the type of cost you could take out of system?

Carrie Teffner

Hey, Brian this is Carrie. So with respect to the cost program that David outlined today, we’ve been focused on cost for a while, we’ve increased that focus this year and certainly and more recently accelerating standard that focus based on the boards evaluation, but what I would tell you right now is it early days and we expect to be back to you by our next call with more specifics.

Operator

Thank you. And our next question is from Michael Lasser of UBS. Your line is open.

Michael Lasser - UBS

I was hoping you could provide more detail on what you thought -- what you think the reason is the behind the sequential deceleration in traffic from the first to the second quarter, it seems like weather got a little better in the second quarter but on a one, two, three years back basis the traffic got a little worse, do you think that’s a competitive issue?

David Lenhardt

Mike, a couple of things we continue to believe that the macro in consumer environment remain challenged. Overall retail traffic as we’ve looked at in centers continues to be down year-over-year and as a retailer we’re not immune to those factors. In addition as we’ve said we all are operating in a more competitive market, our customers have more choices for their pet specialty need and within that backup we’re very focused on what we can control and we very much believe that the initiatives that we’ve talked about. And that we’ve outlined today again focused on the, depth of becoming, strengthening our position as the leading destination for food, continuing to grow our proprietary products and services, growing our omni-channel capabilities as well as building a personalized customer experience. We think that those are the right strategy in conjunction as we’ve talked about with focused effort on cost reduction to help fund those initiatives. We think that that is the right path going forward and we’re confident in that but we also recognized with these initiatives will take time to take hold.

Michael Lasser - UBS

Should we expect the traffic continues to decelerate or stay at this level and gradually gets better?

Carrie Teffner

What I would do is refer you to the Q3 guidance where we guided comps to be flat slightly down and then obviously on the full year being relatively flat we’re obviously assuming things would be improving in the latter part of the year.

Michael Lasser - UBS

Okay my follow-up question is on the vendor community and the decision to skew a little heavier (Ph) into the mass and grocery brand will that -- who is that going to take shelf base away from and what is the response being from the vendors who might move a little shelf space in that process? Thank you so much.

David Lenhardt

Thanks Mike. One thing I would point out is we fully expect the channel exclusive natural food will continue to be the fastest growing part of our food business, so it continues to be a very critical piece of our business. We noticed those customers come into our stores more frequently and we’re very focused on continuing to grow that business. Again we feel to having broader food offering allows us to tap into a broader pipeline to trade up. In terms of the space allocation is that something that our merchants look at. And we’ve got the right tools and methodology to look at where do we have the appropriate product activities and we look at that and use that to make the decision.

Operator

Thank you. Next question is from Christopher Horvers of JPMorgan. Your line is open.

Christopher Horvers - JPMorgan

Can you talk about the trends within the specialty category, is it aquatics, is it reptile, is it small animal and what do you think is driving the decline just I am curious to see if are these type of pets that are bridge pets for twenty-some things who were things were on their way is to dogs and cats as they buy a home and that’s driving it or do you think it’s something else?

David Lenhardt

Yes, thanks Chris. Again within specialty, we’ve seen this broader market decline since the beginning of 2013. As we looked at it, we’ve seen the decline, the largest decline has been in the aquatics but we’re seen in the birds and small animals. Reptile has been probably the most resilient but all of the species within specialty are down. As we looked at household data in terms of ownership rate of household when you look at the ownership rate of household around those fish and small pets and birds, what we’ve seen a big decline in those ownership rates again over the last 18 months and we think that’s the biggest driver here.

Christopher Horvers - JPMorgan

And I guess historically do you just intuitively think this was - it could have been a bridge pet onto a dog to a cat curious if this is something that is it household formation related or millennials related that this is a segway to something that could happen in the dog and cat category?

David Lenhardt

Yes to some degree I think there are a bit separate now having said that, we do know that a fairly large percentage of our specialty customers also have dogs and cats but in terms of being kind of entry level, I think for customer it is -- I am not sure we have that exact kind of insight actually Chris, I don’t necessarily see it playing out that way.

Christopher Horvers - JPMorgan

And then just some questions on Pet360 I am not sure what you can disclose at this point, but how do you think about funding this acquisition is it something that you would consider using debt to do as we think it has potential buyback the impact of the buyback in the back half and at this point could you share revenue and profitability sort of guardrail as we think about what the integration might look like?

Carrie Teffner

Okay so I’ll take the first part. We’re funding this acquisition from cash on the balance sheet so as you know the purchase is $130 million with potential 30 million burnout over the next couple of years. So that will come from cash in the balance sheet relative to the fundamentals of the business right now, estimated sales for the business were approximately $100 million. It is not currently profitable but continuing to improve and we clearly see a path of profitability here. So hopefully that gives you a little bit more color.

Operator

Next question is from Matthew Fassler of Goldman Sachs. Your line is open.

Matthew Fassler - Goldman Sachs

Thanks a lot and good morning to you. Two question, first of all I’m trying to reconcile sort of strategically additional simultaneously buying a business and looking into the exploration of strategic alternatives, I understand they might have developed on independent pets, but just trying to reconcile both of those kind of coming out on the same day, is the view that the acquisition essentially enhances the value of the business to a potential buyer, just anything could you do to help us, think about those two announcements coming out simultaneously?

David Lenhardt

Sure, Matt. Everything we’re doing as a management team and as a board is being done is by value for our shareholders, the Board of Directors have been engage and still overview of all of our operations since the spring and many of the performance improvement initiatives that we’re pursuing now were already been developed well before. Pet360 relative to growing our omni-channel capability absolutely makes sense, relative to that focus. That said, the board is also been engaged with listening to many major shareholders who believe that in addition to pursuing our initiatives that we should seriously explore other ways to maximize value including our potential sale if it in the best interest of our shareholders. We certainly step up the pace of our efforts all around in response to shareholders feedback which is what the board and management believes is the right thing to do.

Matthew Fassler - Goldman Sachs

That’s very helpful I appreciate that. And then secondly, to the extent that the gross profit trend has been under some pressure and you’re engaging in a cost-cutting effort is there room within that effort to continue to invest in the business, it seems like the time where it might be tough financially in the short run but perhaps the business could stand some investment, I know those two are not mutually exclusive but if you could just talk about the room you have to invest in and where you think those investment dollar would best go in the context of your better plans?

Carrie Teffner

Matt this is Carrie. The interesting thing about our gross margin especially in the back half of the year, this is early days in the process towards relative to the cost reduction program, but we are expecting some continued leverage within the gross margin lines that invites high gross margin as we continue to work this right traffic in the stores. So we’re going to clearly continue with that in the initiative that David outlined here and I think either that clearly outlines where we think the focus needs to be in. And then we absolutely believe we can find that through the programs that we are currently underway and that we are in the process of developing.

Operator

Next question is from Peter Benedict of Robert Baird. Your line is open.

Peter Benedict - Robert W. Baird

First, just on the expense, while you distributed good offerings, remind us how do you historically price these item versus the mass and grocery competitors. Is there any change as you think going forward on that front? Are there any brand beyond items (Ph) and one that you’re looking at back and then how do the, how good attachment rates for these customers compared to those for higher-end natural foods, I know they do attach but just trying to understand the new answer there?

David Lenhardt

Yes. Peter a couple of thoughts there, in terms of the brands that we are adding back, in addition to O&E (Ph) and iams we’re also adding back Pedigree, Friskies as well as some of our proprietary mass brands and so we will continue to do that. As we look at the, actually from a pricing perspective again no change and how we’re thinking about that we typically will price these products higher than the mass that we would expect we will continue slightly higher we’ll continue to do so. On attachment perspective as Carrie said earlier, we have seen that these customers do attach rather in our stores at very similar rates to other customers and so when you look at the basket of this customer in addition to just buying the food they are buying hard good and other product in our stores and we think there are valuable customers that we want to continue to attract.

Peter Benedict - Robert W. Baird

That’s all. Thank you, David. Switching over to e-commerce 25% growth I think is what you guys said mostly consumable. How does the hard good attachment rate look online compared to what you see in the store? I assume it’s slower but just trying to get any metric orders of magnitude, so we can help understand that?

Carrie Teffner

Yes. I think this is, it’s a dynamic situation online, especially we opened up and done three shipping at certain price points on consumables so that attach rate online continues to change, certainly as we increase the consumable piece the attachment of hard good is not as high but I think we got to get to a level of that situation because we could really call out what the attach rate is.

Peter Benedict - Robert W. Baird

Okay. Thanks. That’s fair Carrie. Last question just on the buyback obviously buying it here, it does looks like you’re planning to [indiscernible] you don’t buy more than to, I mean is there reason why you’re not in the market what would we need to see if you guide to step back in, is our buying stock again. Thank you.

Carrie Teffner

No it’s a great question but really come down to it the Board has been evaluating strategic alternatives and last listened to our shareholders and gotten feedback from our shareholder, we really felt like the one we decide to hold off on any share buyback this year considering alternatives you know one of the items that we had been considering was a leverage recap, so we decided it wasn’t appropriate to be in the market at that time while we considering those alternatives, so basically as we go through this process the decisions are made that we will suspend our share repurchases program.

Peter Benedict - Robert W. Baird

Okay and so the leverage recap option is now off the table or is that so far one option?

Carrie Teffner

As I said, we’re exploring all the strategic alternatives available to us that certainly one of the options available.

Operator

Next question is from Peter Keith of Piper Jaffray. Your line is open.

Peter Keith - Piper Jaffray

A couple of quick questions, Carrie, I think you had said that inflation was about a negative 100 basis point impact. I want to get confirmation on that. And then if it’s correct what the key drivers were because that somewhat unusual for you guys given sort of you’ve seen a benefit form inflation?

Carrie Teffner

Yes, so maybe let me help clarify that little bit. We had about 25 basis points impact, positive impact associated with inflation that’s 120 basis points essentially less than last year. So last year Q2 inflation was about 140 basis points and this quarter it’s about 20 to 25 basis points I hope that clarifies that.

Peter Keith - Piper Jaffray

Okay so there is still modest inflation.

Carrie Teffner

Yes.

Peter Keith - Piper Jaffray

Okay that’s helpful. Thank you. And then David I have a question for you. You had last quarter talked about new ad campaign. We have seen some of the commercials I guess I didn’t hear any commentary on that in the prepared remarks and I am wondering do you have any early thoughts on how that campaign is performing and still continuing.

David Lenhardt

Yes, its early days but you have noticed the difference in our advertising. We’re much more focused again on highlighting our assortment our unbeatable price guarantee. With Phil Bowman now coming on board I think you will see us continue to both improve the quality of our marketing and also for the media mix you’re going to see us continue to optimize that media mix to utilize more efficient methods with special emphasis on targeted digital displaying, paid search and organic search.

In addition to leveraging our 19 million PetPerks customers and increasing the frequency with which we’re communicating with them via email and that’s up in that we have also begun to do. So I am pleased with kind of the early impact we talked customer panels on their reactions to the commercials. These commercials are among the better one we’ve ever had but accepting that we’re going to continue to evolve and very excited that Phil is here to lead that.

Peter Keith - Piper Jaffray

Helpful thank you. And one last question on the buy online pickup in store initiative, so that sounds like it’s ramping quickly, I was wondering now that you’re at 322 stores if there is any metrics you could provide maybe a comp lift from attachment sales or you’re seeing from acceleration with the overall online sales growth?

David Lenhardt

I think it’s too early to see kind of that full impact you’re seeing that percentage of it is playing out in our 25% total e-commerce sales. That’s where it rolls up but again its early days but we’ve had very good feedback from our customers about it and as we have been turning on the capability in the stores, we see an immediate impact in terms of that customer demand. And we know again we’ve taken a very customer driven approach to building out our omni-channel capabilities. Order online pickup in store was the second most desired capability after the ability to look up online and see whether we were in stock physically in the store. This was the second capability and we’re seeing the customers’ respond to it.

Carrie Teffner

And to your point we’re ramping quickly, so 322 we’ve got to get some time under our belt with (inaudible).

Operator

Next person is from Alan Rifkin of Barclays. Your line is open.

Alan Rifkin - Barclays

Thank you, a couple of questions if I may. If you could just speak to the overall availability of both super premium as well as prescription online where do you see that category going on line?

David Lenhardt

Alan, its David. I think if you look at the kind of the marketplace today, you can find other than the prescription food let me talk to with prescription food you very much do need a prescription from a vet and you need a pharmacy operation to be able to offer that online that’s one of things we’re excited about relatively to Pet360. They have their own in-house pharmacy operation. But in terms of the other foods, you can find those all online today. Now the amount you can find online and where you find it differs where those sites are procuring it from differs but again as a customer you can find food online today.

Alan Rifkin - Barclays

Okay and second question if I may it’s a follow-up to Matt’s earlier question. So year-to-date you’ve grown just offline maybe 1% your comps are marginally negative although if you took out deflation it probably be flattish to slightly up. Your net income has grown 6%, you’ve laid out a very elaborate plan here although you haven’t quantified it of how you’re going to improve the business that you and the Board working since last spring. I guess simple question, I don’t understand what’s prompted the exploration of selling the company. Would you be able to add any color at all?

David Lenhardt

Yes. As I said earlier, first the Board of Directors has been engaged in the thorough review. And as you’ve heard us talk about the performance initiative, we absolutely believe those are the right ones to grow the business going forward we’ve outperformed as a company for a long time, we absolutely believe we can again, in the future. At the same time the board has also been engaged within listening to many major shareholders to believe that in addition to pursuing the initiatives that we talked about that we should seriously explore other way to maximize value including the potential sale as within the best interest of shareholders. And so again, everything we’re doing as a management team and as a board is being done to drive shareholder value.

Alan Rifkin - Barclays

Okay. I guess I could say because it is somewhat appropriate, but it seems like the tail is wagging the dog in some respects no?

David Lenhardt

Yes. Again, I mean I just pointed back to what I just said.

Operator

Thank you. Our next question is from Matt Nemer of Wells Fargo. Your line is open.

Omair Asif - Wells Fargo

Good morning, this is Omair Asif on for Matt. My first question is, at the last analyst day the messaging was pretty loud and clear that you were partnering with eBay to provide some of the digital innovation in omni-channel capabilities and the acquisition of Pet360 seems like a pretty significant change and thinking just curious what’s changed since then?

David Lenhardt

Yes. Again, we view as I said earlier Pet360 is a very complementary addition to our business, we think it’s going to help accelerate our omni-channel capabilities. We are going to operate it from a standalone basis and as we look at today, we don’t see the acquisition having any immediate impact on our relationship with eBay and this acquisition doesn’t change our current omni-channel strategy. What it does do is give us even more capabilities and a solid foundation for future innovation in growth.

Omair Asif - Wells Fargo

Thank you. And just a separate question here and now that you’re are [hard good] and consumable reset have been in stores for a few quarters and you added back it sounds like some other mass and grocery brands that maybe will reduce too much but not completely yet. What is in the customer response, do you believe this changes help traffic in the quarter despite the overall decline. And then, has there been any changes to how you view future resets either in terms of size or the frequency? Thank you.

David Lenhardt

Yes, Matt. We’ve been making the changes throughout the quarters so I think it’s a little bit early to really be able to quantify the impact of bringing back the space. The other element to it is the marketing support that has come along, so I think we will continue to evaluate that. I think relatively to broader reset, resets will continue to be a part of, the way in which our merchants, deliver new assortment into the stores. And I think, as I said, we very carefully evaluate the results of our resets and adjust appropriately and I think we’ll continue to do that, but I would expect resets will continue to be part of our future as we bring new innovation and new assortments into the store.

Operator

Thank you. We have time for one final question our final question comes from Scot Ciccarelli with RBC Capital Markets. Your line is open.

Scot Ciccarelli - RBC Capital Markets

Hey, guys Scot Ciccarelli. Can you give us an update on a percentage of your food business today that channel is exclusive. I think the last update you provide suggest it was about 75% of the food mix is that still a relevant figure?

Carrie Teffner

Yes. That’s a relevant figure; we’ll roll over 75%.

Scot Ciccarelli - RBC Capital Markets

Okay. And did they still generate gross margins roughly 2x the grocery brands?

Carrie Teffner

Yes, on average.

Scot Ciccarelli - RBC Capital Markets

And so when you look at the merchandize margin trends that you’ve seen over the last, really two quarter I guess, is it coming more from the channel exclusive food side or is it coming in a hard goods space, can you just help us understand where the merchandize margin pressure is coming from? Thanks.

Carrie Teffner

Sure, it’s a couple of different things, one of the reason why it took the time to breakout the specialty element of the business a little bit more and that is some of the highest, well, that is the highest margin category we have in the store and as you notice when I gave the numbers the penetration is down a 100 basis points in that category from Q2 last year. That’s definitely creating a drag on the overall margin. And so the other element of course is the penetration of consumables has gone up, so that’s a headwind that we talk about consistently in that category. So really, you can’t point to one specific thing, there’s a couple of different variables in there, but that’s fundamentally what we’re focused on as we look at specialty, when we look at consumables, as we look hard good is driving table to expanding gross margins in each of those businesses.

Scot Ciccarelli - RBC Capital Markets

Okay. Maybe I wrote it down wrong, but I thought you said one third of the gross margin pressure merchandize mix pressure was mix and two thirds was rate, so I would assume the rate is just within particular category, so maybe I am misunderstanding that?

Carrie Teffner

No the rate would also be associated with the promotional activity that we executed as well.

April Lenhard

Thank you. While with that I think we’ve come to an end and I want to thank you for joining us today. And we look forward to speaking with you again in November. Thanks very much.

Operator

Thank you ladies and gentlemen. That does conclude the conference for today. Again, thank you for your participation. You may all disconnect, have a good day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: PetSmart, Inc. (PETM) CEO David Lenhardt on Q2 2014 Results - Earnings Call Transcript
This Transcript
All Transcripts