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Executives

Dave Cone – Vice President, IR and Treasury

Bob Moran – President and CEO

Chip Molloy – Senior Vice President and CFO

Analysts

Chris Horvers – JPMorgan

Matthew Fassler – Goldman Sachs

Alan Rifkin – Barclays Capital

Gary Balter – Credit Suisse

David Mann – Johnson Rice

Matt Nemer – Wells Fargo Securities

Mike Baker – Deutsche Bank

Michael Lasser – UBS

Scot Ciccarelli – RBC Capital Markets

Brian Nagel – Oppenheimer

Peter Benedict – Robert Baird

Dan Binder – Jefferies & Company

PetSmart, Inc. (PETM) Q2 2011 Earnings Call August 17, 2011 4:30 PM ET

Operator

Good afternoon, ladies and gentlemen. And welcome to PetSmart’s Second Quarter 2011 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, Mr. Dave Cone, Vice President of Investor Relations and Treasury.

Dave Cone

Good afternoon. And welcome to PetSmart’s conference call to announce our results for the second quarter of fiscal 2011. With me on the call today are Chief Executive Officer and President, Bob Moran; as well as Chip Molloy, Senior Vice President and Chief Financial Officer. Bob will kick off the call with an overview of our second quarter results and then Chip will take you through the financial review of the quarter, as well as our guidance for the remainder of the year. Bob will provide a review of the operations of the business and finally, we’ll take your questions.

Please keep in mind, everything we cover during today’s call, including the question-and-answer session, is subject to the Safe Harbor statement for forward-looking information you’ll find in today’s news release.

Thanks. And I’ll now turn the call over to Bob.

Bob Moran

Thanks, Dave, and hello, everyone. We are pleased to report another quarter of solid earnings growth. For the second quarter earnings per share were $0.54, up 32% when compared to $0.41 for the same period last year. Comparable store sales or sales in stores open at least a year grew 5% and comp transactions which we use as a proxy for traffic were up 2%.

The continued momentum that we experienced during the quarter validates the work that we are doing and continues to propel us forward when our journey to becoming a best-in-class specialty retailer, with a focus on differentiation through exclusive offerings and our unmatched customer experience. We are giving our pet parents even more compelling reasons to shop our stores. While the macro economy still faces a number of challenges, we believe we are well-positioned to continue to execute on our strategic priorities and deliver shareholder value.

In a few moments, I will update you on some of our accomplishments during the second quarter and where we are focused going forward, but before doing so, I will turn the call over to Chip.

Chip Molloy

Thanks, Bob, and good afternoon, everyone. Today, I will be reviewing our second quarter performance, as well as providing guidance for the third quarter and full year. As Bob mentioned, earnings for the quarter were $0.54 per share, which represents 32% growth when compared to $0.41 for the same period last year. Comparable store sales growth was 5% and comp transactions were positive for the fifth consecutive quarter at 2%.

Total sales for the quarter were $1.5 billion up 7%. The increase in total sales included a favorable impact from foreign currency fluctuations of $6 million. Services sales, which are included in total sales increased 7.6% to $178 million. Other revenue, which is also included in total sales was $9 million, representing reimbursements from Banfield for the space they utilized in our stores. The sales mix for the quarter including consumables at 52.2%, hardgoods at 33.6%, services at 12%, live pets at 1.7% and other revenue at 0.6%.

Gross margins for the second quarter improved 90 basis points to 29.4%. Within the gross margin line, merchandise margins increased 70 basis points, driven by the continuation of increase sales of a higher margin mix of products within the key categories, improvements and shrink, and anniversary of the rawhide and live good resets that took place during the second quarter of last year.

Services contributed 10 basis points to gross margin rate, while store occupancy and supply chain were each favorable 5 basis points.

Operating, general and administrative expenses were 22%, representing 10 points of deleverage compared to the same period last year. Year-over-year increases in OG&A expenses were primarily due to store growth, planned incremental advertising spend focused on our differentiated offerings and incentive compensation.

Overall, earnings before tax increased $96 million or 6.5% of sales. This represents 24% growth and a 90 basis point improvement compared to the second quarter of last year. The tax rate for the quarter was 39.2%.

During the quarter we opened eight new stores and closed three. We also opened one PetsHotels, bringing our totals to 1,197 stores and 185 hotels. We ended the quarter with average inventory for store of $533,000 or flat when compared to the second quarter of last year. During the quarter we generated $109 million in operating cash flow, we spend $20 million on capital expenditures, distributed $14 million in dividends and repurchased $63 million of PetSmart stock. Depreciation and amortization expense for the quarter was $60 million.

In June we announced the Board of Directors approval of a new $450 million share repurchase program that begins this quarter and expires in January of 2013. The Board also approved a 12% increase to our quarterly dividend increasing the payout from $0.125 to $0.14 per share per quarter. We ended the quarter with $321 million in cash, cash equivalents and restricted cash and zero borrowings on our credit facility. We are very pleased that we continue to deliver strong operating results, while maintaining a healthy balance sheet.

For the remainder of the year we continue to believe that the macro economy will remain volatile, but we feel that we are managing the business prudently with a good balance of investing in our success, we’re also seeking and developing opportunities to improve our ongoing operations.

For the full year we expect comparable store sales of low to mid single digits and total sales growth in the mid single-digit range. We are raising our earnings per share guidance from a previous range of $2.32 to $2.42 to our current expectations of $2.40 to $2.48, and we now expect to expand our earnings before tax or EBT margin by 70 to 90 basis points for the full year. The tax rate for the full year should still be between 38% and 39%.

For the third quarter we anticipate comparable store sales growth in the 3% to 4% range and earnings per share of $0.41 to $0.45. Earnings before tax rate improvement in Q3 is expected to be 20 to 40 basis points, improvement is expected to come from gross margin accretion driven primarily by the expected continued trade up within the product categories, continued shrink improvements and services leverage.

OG&A expenses are expected to grow approximately 8% when compared to the third quarter of last year. The increase in OG&A is due to slow growth, as well as an increase in overall marketing spend and incentive compensation, interest expense is expected to be flat.

The Q3 tax rate is expected to be between 40% and 41%. As a reminder, Q3 is planned to include a large increase in marketing spend while the Q4 marketing spend is currently expected to be relatively flat when compared to the same period last year.

We remained committed to our long-term goals of delivering EBT growth, yield through share repurchases and paying dividends, all while maintaining cost and capital discipline. With our strong balance sheet and ability to generate free cash flow, we believe our financial position provides us flexibility to deliver on these commitments.

I will now turn it over to Bob who will provide an update of our operations.

Bob Moran

Thanks Chip. During the second quarter the strength of our brand was evidence with another quarter of solid performance. Our focus is on providing our pet parents with the right solutions through our broad assortment and unmatched customer experience all at great value.

Differentiation is that the core of our brand and sets us apart from the competition from our innovative and exclusive merchandise assortment to our suite of services offerings and unique in-store experience with our passion associates now more than ever we have a lot of compelling stories to tell. It’s a best destination for high quality food we provide an unmatched selection at great value.

We have addressed the growing demand for super premium and channel exclusive foods by offering top brands in the category including Blue Buffalo, Royal Canin and Wellness, as well as two new brands that we added in the second quarter Innova and our own super premium proprietary brand Simply Nourish.

Super premium foods are our fastest growing category and by optimizing our assortment we are giving our pet parents another reason to shop our stores for the quality foods that they want at great value.

In hardgoods, we continue to see sustain momentum in our innovative offerings across the key categories and in our exclusive and proprietary brands, within the categories we are focused on optimizing the good, better, best assortment and we are seeing strengths in the best brands, including Bayer, Advantage and Advantix flea and tick, Martha Stewart, KONG and GNC.

We reset our cat hardgoods assortment in the first quarter and have seen improved results in that category post-reset. In next month, we will build on the success of Martha Stewart pets product line for dogs by launching a brand new assortment for cats.

Last week, we announced our partnership with Toys"R"Us to launch a new line of innovative dog toys exclusive to PetSmart available in the spring of 2012. We are excited about this opportunity to work with another leading brand to grow our assortment of exclusively designed dog toys.

Through our customer insights and strong vendor partnerships we can maximize the potential of our key brands through our fully integrated and compelling marketing campaigns. As Chip mentioned, we will continue our planned investment and marketing spend in the third quarter. We have opportunities to tell compelling stories about our differentiation that should further set us apart from the competition. We remain focus on driving transactions and believe our integrated marketing campaigns will strengthen our brand.

We continue to build on our merchandising strength with our differentiated assortments of proprietary brands including Great Choice, Topol and Top Fin, which drive customer loyalty and create sticky behavior. In-store experience for our customers is unique and highly differentiated. Thanks to our passionate and knowledgeable associates, and our suite of services offerings, the customer experience in our stores is not easily duplicated.

Grooming, which is our largest of our services businesses continue to show strength and a response to our grooming Look Great Guarantee has been very positive since we rolled it out in April with our integrated marketing campaign and the first national TV ad campaign for services in 10 years.

The PetsHotel business continues to improve in line with the overall Improvements in the travel industry. We remain committed to our partnership with PetSmart Charities through the in-store and community adoption events and in the second quarter we helped to save the lives more than 90,000 pets.

I’m proud of the results that we have been able to achieve due to hardworking and dedicated associates, and our focus on providing innovative and differentiated solutions at a great value. We expect the macro economy will continue to hold challenges for the remainder of the year as witnessed by the recent market volatility.

That said, we believe that the strength of our seasoned management team, coupled with our focus on our strategic and operational priorities will allow us to continue to navigate through these uncertain economic times. For the remainder of 2011, we believe we have the opportunity to continue to do all the right things to drive future sustainable growth and long-term shareholder value.

And with that, we will like to take your questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And our first question comes from the line of Chris Horvers from JPMorgan. Your question, please.

Chris Horvers – JPMorgan

Thanks, and good morning, guys. So, first, I guess, on the comp guidance for the third quarter, you’d talked about, just under 5 and talked about lot of them in single digits just in the back half and I think the 3 to 4 is something that we’ve received questions about. So, the obvious question is, are you seeing something, does the environment making more nervous and this is, hey, this is just a good time to be a little bit more conservative? How you’re thinking about it?

Chip Molloy

Hey Chris. This is Chip. I would say that it’s not any things that are changing, it’s really just a trend of the business and if you look at it from a two-year comp perspective, even if you triangulate around a three-year comp perspective, it’s a continuation of how we did in the first and second quarters, it’s just anniversary of previous year’s performance.

Chris Horvers – JPMorgan

Okay. Fair enough. And then, perhaps related on that, can you talk about what the inflation experience was in the second quarter, in terms of contributing to ticket and what are your updated thoughts are in terms of inflation, potential lift in the back half of the year?

Chip Molloy

Yeah. I would say, couple of things, one is obviously, just going through the math, the transactions were up. Within that, we also had slightly more units in the basket, we sold more units. AUR was a mild contributor as it relates to inflation. It wasn’t terribly meaningful this quarter. We started to see price increases as we said on the last call. We said it happened in the quarter probably less than 100 basis points of benefit. We’ll see a little bit more as the year progresses and when we look back at the end of the year we think we’ll probably be in 100 to 200-basis point range most likely on the lower side of that.

Chris Horvers – JPMorgan

Meaning, by the time you get to the 4Q, 100 basis?

Chip Molloy

Yeah. By the time, we look back for the full year added benefit would probably be in 100 to 200 basis points for the year, probably closer to the low end of that.

Chris Horvers – JPMorgan

Okay. And then -- and one quick follow-on on the margin side, the occupancy leverage really decelerated in this quarter, understanding that the store openings, the calendar shifted are new. Should we expect higher rate of leverage on 3 to 4 comp, all things equal going forward in the back half? Thank you.

Bob Moran

On the occupancy side, we’ve had several quarters where we’ve really been able to drive some leverage there. A lot of that has been as we’ve although renegotiated leases that are coming up in the near-term or a lot of those were co-tenancy violations where one of the tenants may have gone dark in the space and we have gone to the landlord and we’ve gotten reimbursed.

We’re now in a place where it’s much more stable. You don’t see a lot of that activity taking place any longer and it’s more of a -- it’s probably going to grow from a cost perspective more in line with still – actually more in line with new store openings growth. Okay. Next question.

Chris Horvers – JPMorgan

Yeah.

Operator

Thank you. Our next question comes from the line of Matthew Fassler from Goldman Sachs. Your question, please.

Matthew Fassler – Goldman Sachs

Thanks a lot and good afternoon. I want to follow-up on the inflation theme by just talking about sort of acceptance and success of the price hikes. Where you’ve seen price increases implemented by your vendors, what has been the impact on unit velocity, if any, what you’ve been hearing from your consumers about that dynamic?

Chip Molloy

Hi, Matt. This is Chip. I’ll go through as much as we know. What we know is, it hasn’t been dramatic increases, so it wasn’t like 2008 where there were double-digit increases. It appears that it’s across most of all consumables, all isles of consumables. It appears that the consumer is absorbing it. We’re not seeing a slowdown in velocity, in fact our super premium isles and Rx isle which is our most expensive isle highest quality foods. They’ve actually accelerated.

Matthew Fassler – Goldman Sachs

Got it. And then secondly, as we think about traffic in the second half of the year. I mean, that’s really where your compares get more difficult as we think about low-to-mid single-digit comps. Do we think about ticket growth remaining consistent and a deceleration coming from traffic at this point?

Bob Moran

It’s hard to have a crystal ball and look at it. We are putting quite a bit of effort in our marketing spend in the third quarter to help drive that traffic. It will be little later in the fourth quarter. But, yeah, it will get more difficult on a transaction or traffic comp perspective but we’ll pick up a little bit more on the AUR side as it associated with inflation.

Matthew Fassler – Goldman Sachs

Got it. And then finally, just to revisit the sales guidance. You have always been at least since last quarter low to mid singles for the year and you had been mid singles for the second quarter, so that is what you did. So, I guess, is your forecast for third quarter comps today really any different than it was at the end of Q1?

Chip Molloy

Our forecast for sales in the back half aren’t any different than they were at the end of Q1 and we hit the high-end of our guidance, I would say in Q2. So, that low to mid for the year, I’d say we’re just, slowly but surely creeping our way up into the higher side of that.

Matthew Fassler – Goldman Sachs

Got it. Okay. Thank you so much.

Bob Moran

Welcome.

Operator

Thank you. Our next question comes from the line of Alan Rifkin from Barclays Capital. Your question, please.

Alan Rifkin – Barclays Capital

Thank you very much and congratulation on the nice quarter. Bob, with the recent launch of a relatively well-capitalized e-commerce player in the last month or so. Can you may be just provide some color on like – on your strategy towards e-commerce and your willingness net-net to consider free shipping in an effort to maintain market share? What are your thoughts in that regard?

Bob Moran

Sure, Alan. And let’s face it, when you look at the pet categories, one of the most desirable categories in retail. When you and pick the year it could be anywhere between 3% and 5% growth, and in that world we have -- continually have competition. So, as we look at this well-financed retailer coming into play, this is not the first retailer or large retailer that has entered the pet space and I don’t think it will be the last either.

So, we’re experienced at this, we aggressively monitor our competition and if we really reflect on our actions over the last couple of years, you know that, in our culture we’re never complaint them. And if you couple that with a seasoned management team, we’re experienced in dealing with these types of threats and we will make the appropriate changes if necessary.

But let me talk about e-commerce and specifically Alan asked about that. And PetSmart.com is really the number one visited website for pets in the business and it’s designed both for e-commerce, but also for driving customers inside our stores. And if you think about what we offer, we offer anywhere between 11,000 to 12,000 SKUs to purchase online. So we do have a broad assortment similar to what we have in the stores and actually we even have the 1,000 items that we have online that we don’t have in the stores. So, we do have a good starting point with that.

PetSmart.com is rich in content community, which is really important for our pet parent customers, especially meeting their needs for solutions. And you really think about, our strategy has always been offensive versus being defensive on here and as I said before, we’ll make the necessary changes as we monitor what’s happening in this world.

But what we’d like to do is couple it with not only online but with our differentiated store experience, because we do think we drive a lot of customers inside our store by being in touch with the customer 24x7 and if you think about the in-store experience with that of our stores, the ability of pet parents bringing pets inside the stores, having conversations about solutions building relationships around trust.

And you think about how we built our suite of service offerings, be it grooming, training, hotel, day camp and pet hoteling is really, is in a sense try to compete against the online. And then really you think about the differentiation that we do not only from a product point of view and that’s why we’ve been spending over the last few years is to bring exclusive products be it from a proprietary basis or really from an exclusive partnership basis that will continue.

But we believe that all gets converted on the sales force through our passionate knowledgeable associates and we always say that our most valuable piece of real estate in inside our company is the 3-feet between our customers and our associates to have that type of conversation.

So we believe that online plays a very important role there. (Inaudible) protect our turf. We will do whatever is necessary to compete in this world and which opens up the door for those types of decisions of differentiated offerings and shipping or product line. So as we go forward we’ll be monitoring it.

Alan Rifkin – Barclays Capital

Okay. So, Bob, when you say, you would do whatever is necessary to protect your share. Does that include at least the consideration of free shipping which may ultimately hurt your margins in an effort to preserve the market share that you have today?

Bob Moran

We’re not ready to do that yet. We haven’t really seen a need to do that.

Alan Rifkin – Barclays Capital

Sure.

Bob Moran

And as -- if you look at our performance, not only for Q2 or what we’re projecting for the back half. We’re not really projecting that. We need to really go to that level yet. And as I said, we’ll go keep on monitoring this. We can -- there’s all kinds of metrics we can do to measure various sites to see what we have to do and how do we have to respond to this. But we’re not ready yet to depreciate our margins.

Alan Rifkin – Barclays Capital

Sure. Okay. Very good. And one more follow-up if I may, why the decision now and both Q2, and even more so in Q3 to accelerate the marketing spend. Could you maybe just provide a little color on what’s behind that?

Chip Molloy

Yeah. Alan, it’s Chip. A couple of things, one is, we’ve been on a journey to try and invest in market in the last 18 months I’d say, because, one, we though like we were under invested for years and two, we now have a lot more stories to tell, to try and speak to driving traffic through our differentiated products and our unique offerings.

So we have a lot of things to say and we feel like we can afford to do that while we’re still delivering what we believe are relatively superior earnings results and we want to do that. And it’s a good time to be able to do that and as it relates we’ve gone out, we work with our vendors and the timing of it and what the offerings we’re going to go and partner with our vendors and as it turns out, it’s a pretty heavy quarter in Q2 and pretty heavy quarter again in Q3 and as we get us all set up for the holiday season, so we’re excited about it.

Alan Rifkin – Barclays Capital

Okay. Thank you both very much and congratulations again.

Chip Molloy

Thank you.

Bob Moran

Thanks, Alan.

Operator

Thank you. Our next question comes from the line of Gary Balter from Credit Suisse. Your question, please.

Gary Balter – Credit Suisse

Thank you. Thanks for taking the question. Couple of, just follow ups. On the SG&A, obviously, you mentioned 8% spending like you’re still spending on the marketing. What -- past the marketing spend in Q2 and Q3, what comps do you think you need for leverage?

Chip Molloy

Gary, it’s Chip. Well, on an annual basis and we’ve given long-term guidance since the way we planned it -- we plan the business. So annually assuming we’re going to put 4% -- 3% to 4% more units in the ground, so 40 to 50 more units, 2% to 3% more square footage in the ground every year and we’re driving 2 to 3 comp. We’re trying to grow our cost no more than 4% to 5% a year, so that’s like a 2.5 comp leverage point.

Gary Balter – Credit Suisse

Okay.

Chip Molloy

And then as you go, any quarter, it may not look that way, any given quarter, but over the course of the year, that’s what we plan for. The only wildcard there is if you’re overperforming throughout the year, then you might have more cost because of the variable component of it, so that might drive a little bit driver, as well as incentive comp if you’re overperforming. Outside of that, that’s what we’re driving 4% to 5% a year.

Gary Balter – Credit Suisse

Okay. Great. And then, just different question. Some of the products and you answered, you kind of overviewed them, but could you go into bit more detail on some of the new stuff GNC, Martha Stewart, KONG, et cetera and including there maybe just flea and tick which had been, you are now anniversarying the benefits of that and you’ve been saying you think you continue double-digit if you are able to do that? Thanks.

Bob Moran

Gary, this is Bob. Let me answer, let’s say, probably different type or let me start off with flea and tick. We still look at flea and tick as $1.3 billion industry and our goal is to get to our right full market share at that level and we also said, the first year is going to be a great introduction to the business and then as we entered – we went into the second year we knew that there is going to be a little bit of volatility because of the introduction of the generics and that has taken place, but we feel pretty good about how we are marching towards our rightful share -- market share this year and we feel that as we come to the end of the flea and tick season in a couple of months we are in pretty good shape there.

When you look at Martha Stewart, we’ve been very happy with the results. We have about anywhere between 180 and 200 SKUs on the dog side and we came up to the anniversarying in Q2 and we’re very happy of what the sales, not only ours but what type of customers we’re bringing into the store.

And then in September we’re going to be introducing a cat side of the business and we’re going to start off with about 30 SKUs as we monitor the results especially as we go for the holiday season. So, we’re pretty excited about all the design work and exclusivity we’d been able to drive through Martha Stewart.

GNC, we’re coming up on the anniversary of that business in Q3 and again, there was an introduction of a new category taking a human trend and transferring it to the pet side and we’re very happy with the progression of those sales and lot of the work that has been done mostly has been in dog and we are starting to transfer that type of expertise and science to the cat side. So, again, more to come on that and we’ll be monitoring that. And I’m just trying to think what was the other...

Gary Balter – Credit Suisse

I just mentioned KONG…

Bob Moran

Yeah. Kong…

Gary Balter – Credit Suisse

Yeah. Go ahead.

Bob Moran

Well, KONG, KONG is pretty exciting to us, because not only from the toy side and the durability of the brand, we’ve been able to transfer that to other lines be it beds and shampoos and so forth, and we are continuing with that type of innovation within in that product line, so more to come there and obviously, we really think about how we think about proprietary brands. We’re pretty happy with our progress, again, I can say, in Q2 we were up over 20% of our merchandising sales being proprietary brands.

And again, what we talked about in proprietary brands is not only what we source ourselves, but are exclusive partnerships and we also introduced in Q2 two new brands of foods that also were very helpful, one, proprietary brand Simply Nourish with a super premium and very happy with the results from that. And then we introduced the brand called Innova, which was one of the highly desirable brands on the customer side, especially in the super premium side. And then, last week we just introduced and told the world about our exclusive relationship with Toys"R"Us which we’ll be introducing in spring of 2012.

So, innovation is the part of our culture and it’s a really key component, who we are and what we’re doing is also driving these concept of innovation deeper into the organization. So it’s not just new products anymore, it’s about expanding assortments, it’s about doing resets, it’s about also doing integrated and compelling marketing campaigns, and coupled with that we are also working on a lot of operational improvements, be it from an optimization side of assortment in space, but also process side so that we can actually work on improving the margins on that.

So, we’re pretty happy with where we are and where we came from. Two years ago, we were at 16%, we’re at 20%. We have a stated goal of going to 25% and again, getting to this type of exclusivity and coupling that with our service level dream someday maybe we can get to somewhere between 38% and 40% of our total offerings being exclusive to PetSmart.

Gary Balter – Credit Suisse

Okay. Thank you very much for the response.

Operator

Thank you. Our next question comes from the line of David Mann from Johnson Rice. Your question, please?

David Mann – Johnson Rice

Yeah. Thank you. And let me add my congratulations. If you could hone in a little more on flea and tick, can you talk a little bit about how this anniversary went this quarter in terms of what kind of growth you saw maybe comp contribution? And then also how did the introduction of generics affect that average unit retail and overall profitability?

Chip Molloy

Dave, it’s Chip. I would say on a – let’s talk, flea and tick as it relates to anniversary first. We had a great year last year. It was a great introduction. It really helped the business. I would say, it was almost a game changer for us last year. It is definitely maturing this year, year-over-year as we get into year-over-year performance, we are seeing some growth. It’s not nearly what we had obviously last year. We’re in there – we’re anywhere in the high single digits to low double digits in that category and it’s beginning to mature further.

There has been some disruption in the marketplace associated with some generics. We have our own generic in the box and then there is a generic at some of our competitors, it’s a different generic. I will say the one that competes with FRONTLINE Plus is, there has been a lawsuit that’s very public out there and it is our understanding that most of the products that competes head-to-head with FRONTLINE Plus will start to come off the shelf with a sell-through and it won’t be replaced and that will be the same for the generic that we have, that competes with -- against the Plus, the generic that competes against just FRONTLINE that will still be out there and cause us some disruptions.

But I would say in our box of generics the FRONTLINE and Bayer, both of those have such a branding that the generics haven’t been, selling terribly well and that’s okay with us as it relates to overall sales, AUR and margin. If it did take off, the margin dollars on a per dose basis are about the same. So it really wouldn’t matter from a profitability perspective.

David Mann – Johnson Rice

And then can you just update how the shrink efforts have gone?

Chip Molloy

Yeah. Shrink has been great. If you go in our stores, you’ll see that the product is in what we call keeper boxes. We’ve -- it hasn’t slowed the sales and it has dramatically reduced the shrink and you’re seeing a little bit of that in our overall margin line both this quarter and we’ll see some again next quarter.

David Mann – Johnson Rice

Okay. And then, one follow-up question as it pertains to guidance. In the second quarter, it looks like you beat high end of your guidance by about $0.03, but you raised your full year, the high end of your full year guidance by $0.06. So in terms of the back half, can you just talk about where you potentially see that upside coming from and why you made that move?

Chip Molloy

Yeah. When we see the back half, margins are a little bit better and sales are creeping towards the higher end of what we thought they would be.

David Mann – Johnson Rice

Very good. Good luck. Thank you.

Chip Molloy

Thank you, David.

Operator

Thank you. Our next question comes from the line of Matt Nemer from Wells Fargo Securities. Your question, please?

Matt Nemer – Wells Fargo Securities

Good afternoon. Thanks for taking my question. The first one is, could you just give a little more detail on the merchandise margin and maybe help rank some of the components of the change in terms of mix, proprietary brands, the impact of lower shrink from flea and tick, just want to understand directionally kind of what’s helping the most and what’s helping the least?

Chip Molloy

I would say looking at it is a -- about two-thirds of it is coming from mix within the categories. So, for instance, within the food we’re seeing the margin move up within food because the areas that are growing the quickest in food are the higher end foods with higher ticket and higher margin percent, as well as higher dollars. And then about a third of it is associated with shrink related items.

Matt Nemer – Wells Fargo Securities

Great. And then secondly, on the marketing plans for the rest of the year, what’s the thinking behind keeping Q4 flat, I mean, it’s your biggest profit quarter of the year, is it just that -- it was bigger the year before or just kind of trying to understand that dynamic?

Bob Moran

Hey, Matt. It’s Bob. We felt that Q4 was at the right level last year and we also felt that we missed the both last year in building up more awareness leading into the holiday season. So, that’s why we’re pouring a little bit more money into Q3 and not only we do have a lot more compelling stories, but building awareness as we get into a world where there is ton of noise, because everybody is marching at that point in time. But we feel like we’ve got that right level of marketing for last year and even with the same percent, with the rise in sales it’s still 7% up. So we feel that we’ve got the right marketing campaigns and conversation and communications in play.

Matt Nemer – Wells Fargo Securities

Okay. Makes sense. And then just lastly, can you share any detail on your plans for future resets in the stores?

Chip Molloy

We’ll wait for that Matt as we get closer into the next year. So for this year we’ll just keep doing businesses as we are doing and as we get later into the year we’ll talk more as they come more current.

Matt Nemer – Wells Fargo Securities

Okay. Fair enough. Thanks very much.

Chip Molloy

Thank you.

Operator

Thank you. Our next question comes from the line of Mike Baker from Deutsche Bank. Your question, please.

Mike Baker – Deutsche Bank

Hi. Thanks. Just a couple of follow ups from questions that my colleagues have asked, but trying to be -- hopefully may be little more specific. So, one, to you Chip, you -- Matt also asked, how is your second – how is your comp guidance right now relative to where it would have been at the end of the first quarter and you said your back half guidance is exactly where you would have had it?

I guess trying for a little bit more short-term, what about the third quarter and I guess, the point of question is, what are you seeing in August specifically, we’re trying to gauge how some of the macro concerns, the [C&N] factor, et cetera, with the market volatility impacts your customer? Are you seeing any pullback in the last few weeks? Are you maybe being conservative when thinking that there might be a pullback, just trying to gauge that kind of sensitivity?

Chip Molloy

Michael, I would say that, first, we don’t give inter-quarter information. We try to stay away from that as much as we can. Obviously, there is all kinds of noise in external marketplace and if you think about our guidance and how we’ve laid it out, it really hasn’t changed much on topline and we expect margin to be a little bit better. That would suggest that we feel pretty good about August so far.

Mike Baker – Deutsche Bank

Okay, okay. Good, good. Fair enough. Second one is on the dotcom issue and Bob you said, there is a number of metrics you can track and look at. I guess, one, I’m wondering if you could track this and if so, if you could provide any details in the last month since Wag.com has launched. Have you seen any change in trends in cart abandonment, I guess, it would be the right word on the online business as people get to that point in the transaction where you see the shipping costs. Have you seen any changes in the customer reaction there in the last month?

Bob Moran

Michael, I’ll talk about the last month for the quarter and what has happened is, no, we have not had an abandonment rate drop, if anything, we have had a nice sales increase for a couple of reasons, one is, we have added a lot of more product, we also had a nice campaign going on but we also feel that we’re competing fairly well right now on the online business. So, quite the reverse what anybody was there expecting.

Mike Baker – Deutsche Bank

Yeah. Okay. That is interesting. Good. Thank you. And then, if I could ask one more new question not a follow-up. The EBT guidance for the third quarter is a little bit below, where you were in the first half and I guess what you expect for the year. Is that simply a function of the higher advertising costs or is there something else that I’m missing there?

Chip Molloy

No. It’s primarily the OG&A is up about 8% and that’s driving it. I think we’ve been --- throughout the year we’ve let folks know that Q3 and Q4 from an earnings growth perspective, we’re going to be look very similar. So, I think, it’s just a matter of gauging what we said, I think we’ve been saying that all year.

Mike Baker – Deutsche Bank

Too bad, the analysts don’t listen, I guess?

Chip Molloy

I don’t want to say that.

Mike Baker – Deutsche Bank

I knew what you’re getting at. Thanks.

Operator

Thank you. Our next question comes from the line of Michael Lasser from UBS. Your question, please?

Michael Lasser – UBS

(Inaudible) I think, I guess, I see a few. Good afternoon and thanks a lot for taking my question.

Bob Moran

Okay.

Michael Lasser – UBS

Would you mind digging deeper into your inflation commentary, the nature of the increases in the raw materials were similar to what we saw in 2008. So, do you think that there is just different behavior from the vendors and they are proceeding much more cautiously this time passing along the price increases, such that it could be more of a step function change and you just haven’t seen it yet or have those discussions taking place and your confident you’re not going to see anymore?

Chip Molloy

Michael, it’s Chip, and the idea is if you look back when there was a rapid rise in commodity prices back in ‘08, they didn’t take price through they gave it to the retailers, in our space to get passed on the consumer. There were some velocity challenges and slowdowns in some of the businesses, both on the website and on the high-end foods.

And this time, when there was a massive, I would say, commodity deflation and/or the vendors did not really pass those reductions onto the retailers, what’s happening is they were selectively deciding, how to market and where to market and who to market where, so we actually benefited from that perspective.

And then as commodities came up to their high levels of 2008, they were reluctant to pass through a whole bunch of cost increases because of what happened before on velocity. And so, I think it’s been a lot more moderated. So, we are kind of back to where we were in 2008 and every one is very cautious in the economy to try to avoid raising prices.

Michael Lasser – UBS

Okay. And heading into this year, I think, the expectation was that maybe to get some gross margin length you’re going to need to see that the discretionary product come back and while they’ve improved, the mix is still been tilted towards the supplies category or consumables category.

And so, it seems like there is firmly a new story developing where the trade-up within categories is really benefiting you. How long do you think that that can last and is that being driven by your legacy historic customers, hard with Smart or is it been driven by new folks who are coming into the store -- Smart with hard, sorry?

Bob Moran

Michael, I would say a couple of things, a lot of the strategies that we’ve talked about in the last two years now have been focused around mostly all around assortment and as you remember couple of years ago we took a hard look at ourselves and said we needed to refresh the assortment. We needed to have a good, good, better and best strategy. A lot of the focus we’ve put on has been both in the best categories as well an opening price point, a narrow opening price point categories.

A lot of our proprietary brand efforts have been on the best side. If you think about Martha Stewart, you think about GNC, those are all best products. So, yeah, a lot of the effort has been in that space, as well as bringing them Wellness, our Simply Nourish proprietary brand which is a high end food. We still believe we have a runway there and we’re still working at, where it’s going to stop. We don’t know yet, but we’re going to be working for whatever the next wave of innovations is going to be to try to continue the track record we’ve set up for the last couple of years.

Michael Lasser – UBS

And then the make shift to the hardgoods could still be on the comp hopefully someday?

Bob Moran

Yeah. It could, I mean, with this quarter the consumables was clearly a really good quarter. You can see that through the mix of the business. It outpaced on a comp perspective the average which was a 5, but hardgoods was still comping positive and still within the category was -- I would call it a trade-up, however, we want to put it under best selling. So, it’s still encouraging signs.

And even within our services business, hotels are still double-digit comps, which was great for us. Grooming was still real solid, it was slightly under the average comp. And training, which is a small business for us actually had its first -- first positive comp quarter in a year. So, I don’t remember how many quarters it’s been two and half years or so, since we’ve had a positive comp in training which hopefully is indicative of pet ownership.

Michael Lasser – UBS

Awesome. Thanks for all the great details. Good luck.

Bob Moran

Thanks.

Operator

Thank you. Our next question comes from the line of Scot Ciccarelli from RBC Capital Markets. Your question, please?

Scot Ciccarelli – RBC Capital Markets

Yeah. It’s Scot Ciccarelli. I know that Chip, you said that two-thirds of the gross margin expansion in merchandise was from mix. I guess, you kind of talked around this, but is that due to increase in penetration of private brands or is that more from the trade-up phenomena that you’ve referenced?

Chip Molloy

Well, actually is, after I answered that question, I wanted to add one other piece in there, there is also a piece of anniversarying a reset we did in that space last year. So, we expected margin to be a little bit higher this quarter from an accretion perspective than the rest of the year because of that anniversary.

So, there is a piece associated with that. There is a piece associated with the trade-up and then a piece associated with the shrink. The answer to your question is, it is really within the AUR, it’s just higher quality goods going into basket within both hardgoods, as well as within consumables.

Scot Ciccarelli – RBC Capital Markets

Got it. And then you talked about super premium kind of – super premium food being the fastest growing part of the business. Can you give us an idea of how big of a component that is at this stage?

Chip Molloy

It’s our biggest food right now. It took over premium middle of the third quarter of last year.

Scot Ciccarelli – RBC Capital Markets

Got it. Thanks a lot guys.

Operator

Thank you. Our next question comes from the line of Brian Nagel from Oppenheimer. Your question, please.

Brian Nagel – Oppenheimer

Hi. Good afternoon. First, a quick question and I apologize if you have addressed it, because I jumped in the call late, but you talked about the advertising spend in Q3 and Q4, just to be clear, is that -- are you -- as we get the information today, are you up in that spend now or is this just consistent with what you’ve told us previously in the year?

Bob Moran

Brian, that’s -- it’s consistent with what we’ve been talking about all year.

Brian Nagel – Oppenheimer

Okay. So there is nothing there, okay. Very good.

Bob Moran

No.

Brian Nagel – Oppenheimer

And then the second longer term question, you talked -- I know we’ve talked about this before and you mentioned again today in your comments regarding the push in private label. But if you think about you store and your relationship with your vendors and category altogether, what are the – are the structural limitations and how far you are going to be able to push that private label over time?

Bob Moran

Well, we’ve put, I’ll call it a big goal out there, trying to get to 25%. We don’t know when we’ll get there. We’d like to increase it a little bit every year. We’ve made some progress. We were at 18% just 18 months ago and we are 20% now. So, we made some progress. There will be limitations on the consumable side, that’s a, we have really good relationships with a lot of very big vendors in that space and we want to continue to keep those relationships and continue to make those relationships even better.

So, it’ll be limited on that side. On the hardgoods side in-house, yeah, to the degree that we can grow that, there are a lot of smaller vendors there. We had good relationships with a lot of them and we want to continue those, especially those that really want to innovate with us and those that really want to bring unique products to marketplace with us and we’ll continue to work with them on that, but there will be a limitation, I would say gaining any much above 25% will be very, very difficult.

Brian Nagel – Oppenheimer

Thank you.

Operator

Thank you. Our next question comes from the line of Peter Benedict from Robert Baird. Your question, please.

Peter Benedict – Robert Baird

Hey, guys. Just a couple of quick ones here. Chip, historically your OG&A in 4Q is typically higher than it is in the third quarter in terms of dollars. Do you expect that to be the case this year?

Chip Molloy

I don’t. So it will actually, if -- I think there’s going to be a drop-off from Q3 to Q4 in total dollars.

Peter Benedict – Robert Baird

Okay. And then next on the Inflation, you had said, kind of maybe 1% for the year that basically implies 1.5% to 2% in the back half of the year. Is that fair?

Chip Molloy

Yeah. It’s going to, it was less than a 100 basis points for Q2. I think it’s going to creep up in there somewhere between 1% and 2% for the rest of the year.

Peter Benedict – Robert Baird

Okay. And the on the D&A, I think you might have said, $60 million in the quarter, that’s up about 2.5% year-over-year. What’s driving that? How should we be thinking about D&A over the balance of the year and then beyond 2011?

Chip Molloy

D&A is pretty much at its peak right now and you’ll start to see it come down slightly as far as the balance of the year and it’s going to probably, I would say, you could say, call it, slightly down to -- flat to slightly down for the balance of the year by quarter. There will be some dollar drop off next year. It won’t be terribly meaningful in ‘13, it will be -- our expectations it will drop-off again somewhere in a single-digit range dollars wise and then in ‘14, it will be a double-digit dollar drop-off.

Peter Benedict – Robert Baird

Good. And I don’t know if you’ve answered this, but any comment on what percentage of your sales are online at this point?

Chip Molloy

We’ve talked about. It’s a very small number. It’s is in the – it’s less than -- the whole thing is probably annually $25 million.

Peter Benedict – Robert Baird

Perfect. Thank you.

Operator

Thank you. We have time for one final question. Our final question comes from the line of Dan Binder from Jefferies & Company. Your question, please?

Dan Binder – Jefferies & Company

Hi. It’s Dan Binder. I was just wondering, did you comment or can you comment on the pet adoption trend? I think you said it may have turned positive last quarter. I was curious if that held this quarter?

Bob Moran

Hey, Dan. It’s Bob. After being down 1.5% in 2010, I can say halfway that we have had our second positive quarter of adoption, so slightly positive. So let’s don’t get carried away, but I think we are seeing stabilization and coupling that with Chip’s comment about pet training, I think we’re starting to see the stabilization affect and if we can see some possibly next year in the future years we think we can see growth there.

But we have two big national adoption events coming up in, one in Q3 and one in Q4, and the good news is again we are still monitoring this but we are starting to see a slight improvement in the conversion rates of these options. So, again, if we can continue the growth and keep on going in the positive direction we think this is very good thing for us.

Dan Binder – Jefferies & Company

Great. Just on the ticket, not to beat the dead horse on inflation, but just trying to understand from the back half expectation, I think your ticket has been running up around 2% give or take, in recent quarters, when you talk about inflation of another 1.5% -- let’s call it 1.5% or so in the back half, is that in addition to that 2%, so that we end up with ticket closer to like 3% and 3.5%?

Chip Molloy

I would just state our comp guidance, we’re pretty explicit about that, you can sort of back into that. We are going to expect a little bit less on traffic, most likely and a little bit more on AUR, which is going to drive the comps in the back half.

Dan Binder – Jefferies & Company

Okay. And one final one, if I could. You talked about increased advertising spend this past quarter as well and the transaction growth has slowed a little bit in the last couple of quarters, is there anything about the ad effectiveness that needs to be addressed or going into the back half, is there anything that’s changing there?

Bob Moran

Dan, it’s Bob again. Not really. I mean, we are constantly monitoring that based off returns and obviously, being online it’s starting to be a lot more effective than a lot of other things that we’ve done in the past and we’re constantly monitoring that and we’ll keeping on shifting till we get the right mix. So, we’re pretty nimble and pretty active in that area. So, but we do believe we have a lot more stories to tell them. We think we got some nice awareness to build in Q3 to lead into Q4.

Dan Binder – Jefferies & Company

Okay. Great. Thanks.

Bob Moran

Well, another call comes to an end and I just want to thank everybody for joining us today until we speak with you all again in November. Thank you.

Operator

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

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