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PetSmart, Inc. (NASDAQ:PETM)

Q4 2011 Earnings Conference Call

February 29, 2012 4:30 PM ET

Executives

Dave Cone – Vice President of Financial Planning and Analysis

Bob Moran – Chairman and Chief Executive Officer

David Lenhardt – President and Chief Operating Officer

Chip Molloy – Executive Vice President and Chief Financial Officer

Analysts

Matthew Fassler – Goldman Sachs

Chris Horvers – JP Morgan

David Mann – Johnson Rice

Helen Pan – Barclays Capital

Seth [ph] – Credit Suisse

Kate Wen [ph] – Wells Fargo

Michael Baker – Deutsche Bank

Michael Lasser – UBS

Peter Benedict – Robert W. Baird

Brian Nagel – Oppenheimer

Daniel Binder – Jefferies & Company

Operator

Good afternoon, ladies and gentlemen, and welcome to PetSmart’s Fourth Quarter and Full Year 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) And 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 Financial Planning and Analysis.

Dave Cone

Good afternoon and welcome to PetSmart’s conference call to announce our results for the fourth quarter and for all of fiscal 2011. With me on the call today are Chairman and Chief Executive Officer, Bob Moran, our President and Chief Operating Officer, David Lenhardt; as well as Chip Molloy, Executive Vice President and Chief Financial Officer. Bob will kick off the call with an overview of our results, and then Chip will take you through the financial review as well as our earnings guidance. David will review the operations of the business, and provide insights into our upcoming year, 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 fourth quarter, earnings per share were $0.91, up 18% when compared to $0.77 for the same period last year. Comparable store sales or sales in stores opened at least a year grew 5.5% and comp transactions, which we use as a proxy for traffic, were up 2.9%.

Our results for the fourth quarter reflect our most successful holiday season yet. We built on the success of last year by focusing on our key differentiators with compelling holiday stories, and even stronger integrated marketing campaigns behind the events this year, and by having the right assortment at the right price, we were able to offer pet parents thousands of gift ideas at great value, with a sell through rate of over 90% for holiday merchandise.

But that is not all; we also saw double-digit growth in our services business as more pet parents became loyal users of our services. 2011 was a great year overall with even more stories of innovation and differentiation in our stores. We expanded our assortment of super-premium foods, our fastest growing category of food, with the addition of the Innova, and our own super-premium proprietary brand Simply Nourish in the second quarter.

In the third quarter, we built on the successful Martha Stewart pets products by extending the lines to include cat products, and we are very pleased with the results. We are not done. We have built a culture of innovation and differentiation within merchandising, so that we can continue to bring the best new brands and extended assortments to our pet parents, and with our customer insights and strong vendor partnerships, we will continue to maximize the potential of our key brands through our fully integrated and compelling marketing campaigns.

Our pet parents are showing us that they value our commitment to saving the lives of homeless pets through their support of our partnership with PetSmart Charities in our stores. With over $40 million in contribution income on an annual basis, PetSmart Charities is the largest funder of animal welfare efforts in North America. We are proud to be able to partner with PetSmart Charities, and adopt approximately 1100 pets per day in our stores, including more than 107,000 in the fourth quarter.

Over the past 17 years, the lives of nearly 5 million pets have been saved, and that really has made an impact. All these things define the PetSmart brand. It is a strong brand and resonates well with the consumer. Our performance continues to validate the work that we are doing to even further strengthen our brand, as we continue on our journey of becoming a best in class retailer. By focusing on solutions for our pet parents, we provide the broadest assortment with an unmatched customer experience, all at great value. Our differentiation ties it all together, and sets us apart from the competition making us the leading pet specialty retailer.

Our results are really a testament to the strength of our management team. Our seasoned management team is strategically aligned across the company, and I am confident in their ability to execute on our strategic priorities. We recently announced that David Lenhardt was appointed President and Chief Operating Officer. David has made many important contributions to PetSmart since joining the company 11 years ago.

Under David's leadership our services business one of our key differentiators has grown from $92 million in 2000 to $675 million in 2011. During that time, he has also evolved our customer experience and transformed our operational consistency making our stores easier and more efficient to run. As President and COO, David, will focus on the entire enterprise looking at ways we can strengthen integration and the overall customer experience, and assure that we can sustain our trajectory and continuing the path to becoming a best in class retailer. We will have the opportunity to hear from David today following Chip's financial review, and I look forward to David's contribution in his new role.

And now I would like to turn the call over to Chip.

Chip Molloy

Thanks, Bob, and good afternoon everyone. Today I will be reviewing our fourth quarter and full year results for full year 2011, and providing 2012 guidance for both the full year and fourth quarter.

As Bob mentioned, earnings for the quarter were $0.91 per share, which represents 18% growth when compared to $0.77 for the same period last year. Comparable store sales growth was 5.5% and comp transactions were positive for the seventh consecutive quarter at 2.9%.

Total sales for the quarter were $1.6 billion, up 8%. The increase in total sales included an unfavorable impact from foreign currency fluctuations of $1 million. Services sales, which are included in total sales, increased 11% to $168 million. Other revenue, which is also included in total sales was $9 million, representing reimbursements from Banfield for the space they utilize in our stores. The sales mix for the quarter included consumables at 52.8%, hard goods at 34.8%, services at 10.3%, live pets at 1.6%, and other revenue at 0.6%.

Gross margins for the fourth quarter were down 20 basis points to 30.4%. Within the gross margin line, merchandise margins decreased 70 basis points, while services added 10 basis points to the overall rate. Store occupancy was favorable 40 basis points, and supply chain was flat. Operating, general and administrative expenses were 20%, representing 70 basis points of leverage compared to the same period last year.

Overall, earnings before tax increased to $156 million or 9.5% of sales. This represents 15% growth and a 60-basis-point improvement compared to the fourth quarter of last year. The tax rate for the quarter was 36.3%.

For the full year, earnings per share were $2.55, up 27% compared to $2.01 last year. Total sales were $6.1 billion, up 7%, including a favorable impact from foreign currency fluctuations of $11 million. Comparable store sales growth was 5.4% and comp transactions were up 2.5%.

Gross margins for the year improved 40 basis points to 29.5%. Within the gross margin line, merchandise margins were 39.7% of total sales, services margins were 3.1% of sales, rent and occupancy costs totaled 9.3% and our warehouse and distribution costs were 3.9% of sales.

OG&A expense for the full year was 21.3%, representing 20 basis points of improvement. For the year earnings before tax increased to $446 million or 7.3% of sales. This represents 21% growth and an 80 basis point improvement compared to last year. The tax rate for the year was 37.4%.

During the year, we opened 53 new stores and closed 8, which included 25 new store openings and 3 closing during the fourth quarter. We also opened 12 pets hotels, including 3 in the fourth quarter, bringing our year-end totals to 1,232 stores and 192 hotels. We ended the quarter with average inventory per store of $523,000, or flat compared to the end of last year.

During the year, we generated $575 million in operating cash flow, and spent $121 million on capital expenditures. In addition, we distributed $60 million in dividends, with $16 million paid in the fourth quarter. We also repurchased $337 million of PetSmart stock during 2011, with $101 million repurchased during the fourth quarter. Our weighted average share count for the year was 114 million, which was 4.5% lower than 2010. Depreciation and amortization expense was $237 million for the year.

We ended the year with $413 million in cash, cash equivalents and restricted cash, and zero borrowings on our credit facility. Although the macroeconomic environment still holds some uncertainty, we remain cautiously optimistic about the outlook for 2012, and are confident in our ability to influence those things within our control to continue to deliver on our commitment of driving strong operating results, while maintaining a healthy balance sheet.

Based on our fiscal year calendar, 2012 will contain a 53rd week. The annual guidance will be for 53 weeks. However, I will summarize at the end, the impact of the extra week on several key measures. For the year, we anticipate comp store sales growth in the 3% to 4% range, total sales growth in the 7.5% to 8.5% range, and earnings per share from $3.02 to $3.16. We expect gross margin to improve 30 basis points to 40 basis points, OG&A to grow in dollars by approximately 7%, interest expense to be essentially flat in dollars, and EBT margin to expand 50 basis points to 70 basis points.

We anticipate the tax rate to be 38% to 39%, and expect the equity income from our Banfield investment to grow approximately 15% to 20%. The guidance also assumes that we utilize the $279 million remaining on our current share repurchase authorization, which would reduce our weighted average share count to approximately 110 million shares for the year.

The impact of the extra week is currently estimated to be 120 million in sales, 20 basis points of the overall gross margin expansion, $19 million of incremental OG&A expense, 30 basis points of the EBT expansion, and $0.16 of EPS. Our 2012 capital expenditures are expected to be between $130 million and $140 million. We plan to use approximately 25% of that CapEx to open 25 net new stores and few new pets hotels. The remaining 75% will be spent on story model type projects, supply chain, IT, maintenance and other infrastructure improvements.

We continue to fund our needs with our cash flows from operations, and currently have no plans to borrow against our revolving credit facility. Our free cash flow, defined as our operating cash flow, less our capital lease obligations and capital expenditures is expected to be between $400 million and $420 million for 2012. Operating cash flow is expected to be between $590 million and $610 million, and capital lease obligations are estimated to be approximately $60 million.

For the first quarter of 2012, we are anticipating comparable store sales of low to mid single digits, and earnings per share of $0.70 to $0.74. EBT margin is expected to improve 20 to 30 basis points, when compared to the first quarter of last year. The majority of that improvement should come from gross margin expansion and slight leverage of OG&A and non-interest expense.

We remain committed to our long-term guidance, and believe we have an operating plan that can deliver on those goals. Before I turn it over to David Lenhardt, I would like to take this opportunity to thank Dave Cone, for his outstanding work as vice president of investor relations and treasury over the last 3.5 years. Dave is moving to a new role within finance, as the vice president of financial planning and analysis to further his career development. And I know he will be very successful in his new role.

The IR responsibilities are being transitioned to April Lenhard, no relation to David Lenhardt. April has worked with Dave Cone in IR for the past two years.

And with that, I would like to turn it over to David Lenhardt, who will highlight our 2011 operational activities and provide insights into our 2012 priorities.

David Lenhardt

Thanks, Chip, and good afternoon everyone. As Bob mentioned the PetSmart brand is strong, it is recognizable and it connects with the consumer. In 2011, we celebrated that authentic connection with our customers through our Happiness In Store campaign, where thousands of pet parents shared their stories about local PetSmart associates, who deliver an unmatched customer experience.

These stories really drive home how our associates are making the lives of pets and their pet-parents even better. Our associates are the foundation of our differentiated in-store experience with a focus on providing solutions to our pet parents to help them help their pets live long, healthy, and happy lives. And how do we do this, by providing the broadest assortment with an unmatched customer experience all at a great value.

Within merchandising, our assortment continues to evolve with well-known national brands, exclusive brands and our own proprietary brands. We've established ourselves as the best destination for high quality food with our assortment of channel exclusive foods, including key brands like Blue Buffalo, Royal Canin, Wellness and our own super-premium proprietary brand Simply Nourish. These innovative brands are a key point of differentiation and give our pet parents a compelling reason to shop our stores for the quality food that they want at a great value.

In order to maintain our leadership position, we must continually evolve with our customers desires. We are currently in the process of a consumable reset in our stores and expect to finish this quarter. This reset allows us to expand the space dedicated to super-premium foods in both dog and cat, and focus on innovative brands and unique formulations to optimize the assortment for our pet parents. We've added new Nature's Recipe cat food, as well as some exciting new formulations including expanded grain free assortments across the aisles.

This reset has been going well, because it was planned and executed in order to cause minimal store disruption, and it will allow us to stay on the forefront of innovation so that we have the best possible selection for our pet parents. In hardgoods, our merchants have been working hard this year to create new assortments and product lines that will be ready to launch in 2012.

In the spring we will be introducing a new line of proprietary dog toys under the Toys 'R' Us Pets brand name. Our exclusive partnership with Toys 'R' Us will bring our pet parents high quality, unique products for their dogs from two brands that they trust, allowing us to expand our leadership position as the pet specialty retailer with the largest assortment of dog toys. Coming up this summer, we are excited to launch the exclusive Bret Michaels Pets Rock collection from the legendary rocker and dedicated pet owner.

Our pet parents have told us that they want unique high-quality products for their pets that are also fun and reflective of their personalities. Bret has designed a line that promises to be fun and cool, allowing us to tap into a new demographic and expand our customer reach.

This year, we will also be expanding our already successful Martha Stewart pets assortment with new product lines and fresh designs, and you'll see innovative new assortments under the KONG label as well. And we also just announced that through an exclusive partnership, we will debut a unique line of limited edition Marvel Super Hero inspired pet toys, apparel and accessories in March. In addition to our exclusive partnerships, we have a team of merchants focused on our proprietary brands assortment, including our Grreat Choice, Top Paw and Top Fin brands.

We worked hard to establish a culture and pipeline of innovation and merchandising that will take us well into the future, and we'll continue to tell our story of differentiation by investing in compelling marketing campaigns that match the exclusivity of our key brands and highlight our position. Our unique in store experience would not be the same without our highly differentiated services offerings.

As Bob mentioned, we saw double digit growth in our services business in the fourth quarter with all of our services posting positive comps. We spent a lot of time over the last year really focusing on driving awareness and driving trial and services, particularly in grooming, which is the largest of our services businesses.

And as a result, we've seen new customer growth, increased retention rates and an overall increase in customer satisfaction. PetsHotels have also been improving nicely for us, with solid top line growth and they’ve turned the corner to profitability, which is a trend we project to continue. In 2012, we will be deploying a call center to serve all of our hotels across the country, and we are excited with what this will do to better serve the customer and improve our operational efficiencies.

So when you put together our entire offering, everything from products to grooming to pet training to PetsHotel, vets, to live pets and pet adoptions, and you add the most passionate associates in the industry that are engaging with our customers each and every day, you end up with an overall customer experience that is very difficult for our competitors to duplicate. And when you add to that the strength of the alignment across all areas of our business for merchandising, marketing, supply chain to store operations; we have a powerful competitive advantage.

And that differentiation makes our brand strong, and sets us apart as the leader for products, services and solutions for the lifetime needs of pets. From here, we will continue to build on the solid performance of 2011 by focusing on the proven strategies that have made PetSmart successful, and continuing to challenge ourselves to improve on those strategies, we will continue to deliver strong shareholder returns in 2012 and beyond. We have an unwavering focus on our strategic priorities, and we are intent on executing them at every level of the business.

And with that, we'd like to take your questions. Thank you.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Our first question comes from Matthew Fassler with Goldman Sachs. Your line is open.

Matthew Fassler - Goldman Sachs

Thanks a lot. Good afternoon. I like to start out by asking about your gross margin trend, specifically the 70 bps of merch [ph] margin decline, a bigger number I think than we have seen in a while, and I am sure you anticipated a question on this theme, can you talk about what the underlying drivers were, did it relate to mix, did it relate to pricing, any color you can give us on that would be great?

Bob Moran

(inaudible) cat foods as well as litter. In addition to that something we didn't anticipate we had a really good quarter within the hardgoods on the flea and tick side much better than we anticipated, which is a lower margin hardgood item. And then on the short side, we didn't have near as good a quarter as we would have liked on the apparel side. We went pretty long in apparel. It was solid, but wasn't near what we expected. So the sell-through wasn't quite as high, and we also marked it down as we got through the end of the quarter to be cleaned going into the spring season.

Matthew Fassler - Goldman Sachs

Not to bring weather into it, but just as winter apparel sold poorly for some humans I guess, same thing on the pet front or was it unrelated to that?

Bob Moran

We like to not talk about weather as an excuse in this case. The good side of the weather for us was flea and tick was really solid. That's a great business in warmer weather and much better, but the apparel was not as good, especially the seasonal apparel.

Matthew Fassler - Goldman Sachs

So as you think about that gross margin comment on the year would you expect within that context for merch margins to be flattish in '12 or up a little bit?

Bob Moran

Yes, as we look to '12, our expectation is going to be slightly up on the merch side for the year. The first quarter will be down a little bit. We have some reset activity taking place in the first part of the year, first half of the year and most of the activity around that that is dilutive happens in the first quarter. We will claw [ph] most of that back in the remaining three quarters, and by year's end we hope to be and expect to be slightly accretive on the merch margin side for the year.

Matthew Fassler - Goldman Sachs

Got it, and then my follow-up question, just as we think about where in the P&L the extra week shows up, I guess perhaps you lever occupancy with no incremental rents for that extra week, but as we look out to Q4, and I guess this has some impact on the composition of the year as well, where does the incremental margin, the higher incremental margin for the extra week show up?

Bob Moran

Yes, so, well first on the sales side as we said on the script about $120 million in sales, and then if you go dig into the merch margin or on the margin side, gross margin side, occupancy is very minor. It is really just utilities costs because you don’t have rents and then on the supply chain side it is small as well.

So it is basically just transportation – it is transportation and some payroll costs. I would say occupancy is going to be about $2 million in that period, and W&D or warehouse and distribution will be between $3 million and $4 million, and then you got about $19 million in OG&A costs, and you don't have any extra interest expense.

Matthew Fassler - Goldman Sachs

And just to go by virtue of contrast that $5 million for rent and utility contrast to what kind of number for the average?

Bob Moran

Well, I would have to take – do the math real quick. I'll let you do the math on that one Matt.

Matthew Fassler - Goldman Sachs

Fair enough. So $19 million of incremental expense, which is probably below the 7% increment for sales and the rest comes from gross. Okay, thanks so much.

Operator

Thank you. The next question comes from Chris Horvers with JP Morgan. Your line is open.

Chris Horvers - JP Morgan

Thanks and good evening. Can you talk about first in terms of the store openings in '12, and how that with the cadence around that should be for the year?

Bob Moran

Yes, hold on just a second Chris. We are looking at, let's see for '12, we are looking at 14 opens and 4 closes in Q1, 13 opens and 4 closes in Q2, 34 opens and 4 closes in Q3, and 1 open and 2 closes in Q4, right now for 62 opens and 14 closes, a little bit of that will move around. Net-net, we will end up with probably 45.

Chris Horvers - JP Morgan

And then how – are occupancy dollars basically growing at the rate of footage growth?

Bob Moran

On an annualized basis, I would say it is probably at footage growth, it is maybe just a hair more.

Chris Horvers - JP Morgan

And then how does it play out in terms of the cadence year-to-year on the store openings, do you – because it is a little more back-end weighted in ’11. Do you see more pressure in the first part of the year and then normalizes out?

Bob Moran

Hold on a second. If you are looking at a growth perspective, hold on, you are looking at in the first quarter probably about $7 million in growth year-over-year. It is up $7 million, about $5 million, close to $10 million and close to $10 million on a 52-week.

Chris Horvers - JP Morgan

I got you. And I know you don’t like taking about the weather, but do you think that you saw any benefit here with the warm December flea and tick is the big ticket item as you talked about, and then obviously January was pretty snowing here on the East Coast a year ago. So is it fair to say that maybe the comps accelerated throughout the quarter, or how would you think about the lift perhaps?

Bob Moran

No. I mean the comps were pretty solid throughout the quarter. So we didn't see a lot of big weather changes as it relates to overall sales. There, obviously you have some good days and some bad days, but for us we don’t have a lot of – it doesn’t kill the business or dramatically benefit the business. However, the mix was a little different. We haven’t been in the flea and tick business, only been in it for a couple of years now and that is a warmer weather product, and apparel for us is a colder weather product.

Chris Horvers - JP Morgan

And then, and the last question, Bob, was there a difference in terms of the marketing plan in the fourth quarter this year versus last year? Obviously the traffic in the services growth were very strong. So I was curious, was there a difference in dollars and was the – how the marketing got done, was it more brand, maybe more services oriented, and that drove the traffic to the services side or was it more price impression? Thank you.

Bob Moran

Hi, Chris. Bob. When we talked about it in Q3, we said that, we are going to spend more marketing dollars in Q3 to get ready for Q4, and we felt like we had the right marketing campaign going on for Q4. So, we didn’t really deviate from that. We had a series of events that we lever off of from the previous year, and we build off of by obviously working up our proprietary brands and also products.

And we did say, we were going to be a little more promotional discreetly on fast moving products, and the reason why we do that too is that, we do feel that by bringing in new customers into Q4, we also lever up Q1 and beyond and into '12. So that’s very important to us, but it was more towards products versus service.

And obviously, when you are trying to figure out the campaigns too you are picking product lines, where you would think that you would have a natural weather pattern, but – at the same time as we talk about the mix, we did not have any marketing going on for flea and tick. It just naturally happened for us, but we learnt a lot from 2010, Q4 in 2010, and we just levered off of that and made that even stronger.

Operator

Thank you. The next question comes from David Mann with Johnson Rice. Your line is open.

David Mann - Johnson Rice

Yes. Thank you. Good afternoon. Nice year guys. My first question was on the services side of the business, I think I thought you had mentioned in the past there might have been some opportunity to further lever some labor in the fourth quarter, yet the services margin improvement was relatively modest. So maybe you could dive a little bit into that, and then also talk a little bit about the opportunity in '12 both for the top line and bottom line for services?

David Lenhardt

Hi, David. It is David. In terms of the overall margin for the quarter, if you think about our services business, and grooming is the biggest piece of it, and historically the fourth quarter is a very strong quarter for us from a grooming perspective, particularly around the holidays. That is a commission based business.

So from a leverage perspective there it is relatively consistent. It is not something that we see a ton of operating leverage again because it is commissioned based. The hotel, we will see some leverage on it. Again the hotels also had a very, very strong fourth quarter, double-digit comps, and so we did see some leverage there, which combined with grooming gets you that net positive margin you just talked about.

In terms of this coming year, we've got our services is embedded in our overall comp guidance, but I would anticipate we're going to continue to see strong growth in all three of our services businesses.

David Mann - Johnson Rice

Should we expect it to be close to double-digit growth on the top line in '12?

Bob Moran

David I wouldn't expect double-digit growth. I think within the hotels we're probably going to be close to double-digit growth, but even though we are having – grooming is doing really well, and it is actually outpacing the comp, it is still not double-digit and it is a huge piece of the business. So my expectation is it is going to be probably slightly higher than the core comp of the company.

David Mann - Johnson Rice

Okay. And then in terms of your promotional activities in the back half, I know you are more aggressive, you know, on some pricing on the consumable side to try and drive traffic, what's your stance on that going into 2012?

Chip Molloy

Dave, it is Chip. I would say that, you know, we learned a lot and we're analyzing the work that we did trying to understand the basket. As it stands right now, we are probably not going to be as promotional in some of the areas that we were for the third quarter, and the first two thirds of the fourth quarter, but we are going to play it out as the year goes on see what we've learned. We are doing an analysis now, and my expectation is it is within our guidance right now. We are expecting overall merch margin to be up slightly for next year.

David Mann - Johnson Rice

Okay. And then lastly, on flea and tick, can you give us a sense on what kind of growth rate you saw in it for last year, and were there any other drivers from a product side that helped, you think helped in the fourth quarter, and anything you see in terms of 2012 on the product side that could help drive further growth?

Chip Molloy

Yes, David. I would say one as it relates to flea and tick growth, it was double digit growth, I will just leave it at that. The fourth quarter was significantly higher. It was really a nice quarter for us. As it relates to things that were really working well all year and in the fourth quarter, our highest end foods are continuing to outpace both on the (inaudible) side, as well as the super-premium or what we internally are now calling natural side, they are well outpacing it.

Some of the other areas, anything around cat has been a pretty good year and a good fourth quarter. And then an area that’s really been nice of late, last half of the year, is our specialty business. So, we think externally about live being less than 2% of sales, but if you take that whole section of the store, in specialty it is about 13% of sales in totality so that be aquatic, small animal, reptiles et cetera that’s about 13% of sales, take off the 2 for live, and you split the other two in half, half consumables, half hardgoods, and those are high margin consumables. That whole section of the store has been growing quite nicely, well outpaced the core comp of the company, and we expect that to continue into next year.

David Mann - Johnson Rice

Great. Good luck in ’12. Thank you.

Chip Molloy

Thank you.

Operator

Thank you. Our next question comes from Alan Rifkin of Barclays Capital. Your line is open.

Helen Pan - Barclays Capital

Hi, this is actually Helen Pan filling in for Alan. Thanks for taking my question. We wanted to dig a little deeper into what happened during the holiday, do you think that you had your most successful holiday period due to customers being responsive to the advertising, or do you think that customers felt more confident and you saw that benefit come through?

David Lenhardt

Hi. It is David. I would say really a combination of a number of different things. I think the marketing and really we think the marketing, and really the integrated marketing campaigns that we had certainly helped. At the same time, I think we also had a great assortment of products in the store, a unique assortment with the right value. We had a number of different three-day events that were very, very successful.

I think when you combine that all we just saw some really nice traffic trends, and when they were in the store our customers were buying.

Helen Pan - Barclays Capital

Okay. Thank you.

Bob Moran

I received an e-mail from one of you guys that my answer on merch margins didn’t go through all the way, so I will just repeat the answer there. What it was in the quarter for merch margin, one, we had anticipated the merch margin would be slightly down coming into the quarter, and we spoke to that on Q3 call, and that was with some of the promotional activity in some of our higher traffic driving items, specifically low-end foods, cat low-end foods and litter.

That we anticipated. It was slightly worse overall than anticipated because within the hardgoods space, flea and tick accelerated, which we didn’t expect and that’s a lower margin hardgood item, whereas apparel was not as good as expected. We went long on apparel from an inventory perspective. We thought it was going to be a bigger quarter than it was, and then we aggressively got out of the apparel, the seasonal apparel specifically, as we got towards the end of the quarter, so that put some pressure on the merch margin. Net-net we were down 70 bps. So I hope that answers your question, if you didn’t hear.

Next question.

Operator

Thank you. The next question is from Gary Balter with Credit Suisse. Your line is open.

Seth - Credit Suisse

Hi, this is Seth [ph]. Congratulations on a great year. First question, I was wondering if you could discuss the traffic versus ticket assumptions built into the 3% to 4% comps guidance you have for the year, and what some of the moving pieces maybe, and then a follow up.

Chip Molloy

Yes, Seth. It is Chip. I would say that as we think about the year, you got 3 to 4 comp, and you will get a little bit on the positive traffic side, and a little bit on AUR, not really much of that would be inflation, there will be probably a tiny bit of inflation in the first half of the year. Right now, we are not anticipating much as you go into the midway through the second quarter and the back half. And the AUR is going to be driven by within the categories, some higher-end products, primarily on the food side of the house as people purchasing natural or super-premium foods.

Helen Pan - Barclays Capital

Okay, got it. And then a question on the hardgoods category, you have seen some improvement over the last few quarters, you know, how do you think about the opportunity in this business for 2012, and how do you think about the potential for hardgoods as a category to kind of get back to historic levels, you know, over the next couple of years?

Chip Molloy

I would say for 2012, we're anticipating positive comps in hardgoods again for the year. Although we do anticipate that consumables because it is just been such a great business for us, it is going to outpace hardgoods. We do have a consumables reset that took place this first quarter. It is giving some more space to our super-premium natural foods, which are growing quite nicely, and because of that we don't believe that you'll see hardgoods as a mix outpace consumables this coming year.

As it relates to getting back to historical levels, I'm doubtful that we will ever get back to the historical levels, one because consumables is such a stable and steady business, and two, because services is now such a bigger mix of our business than it was four or five years ago when hardgoods was a bigger mix. I do hope – we all hope that if the economy ever does get some sort of a massive swing that you will – and you start to see housing start to improve as people enter new homes, and they acquire pets then that's the time where you might get a reverse, and you actually get some hardgoods acceleration beyond consumables. It is not something that we have on our radar screen for this upcoming year, but something we always keep our fingers crossed, and hope that will occur at some point.

Helen Pan - Barclays Capital

All right, great. Thanks, good luck.

Operator

Thank you. The next question comes from Matt Nemer with Wells Fargo. Your line is open.

Kate Wen - Wells Fargo

This is Kate Wen [ph] in for Nemer. Just a couple of questions, first, I know that in the past you have talked about how gas prices have modestly impacted the behavior of your customers, I am just wondering if you are starting to see any impact early this year, as gas prices have gone up in terms of either consumers consolidating trips that might more for visits or reducing their spend on some of the more discretionary products?

Bob Moran

Yes, Kate, it is, as we think about gas prices, the impact is two ways, one, obviously it cost us more in fuel from a supply chain perspective. That is not that material, about $5 a barrel; it is about $1 million to our P&L. We can manage through that. It is more on the consumer side when gas prices start to rapidly increase. Now, we are feeling pretty good about our first quarter. We have given guidance today, and we are feeling solid about the guidance. So I would say based on our guidance so far we are feeling pretty good.

Kate Wen - Wells Fargo

Okay, great. And I just had a follow-up, we actually noticed that you launched a new pet boutique online, and features some deals for the holidays, and we were just wondering how that product set is performing given that the price points skew a little bit higher than your average, and whether these items are drop shipped, or whether they are actually stocked in your DCs.

Bob Moran

Hi, Kate. This is Bob. Yes, we've been putting a lot of emphasis on our online business, also because the e-influence of bringing customers into our stores, and we've been working on expanding our assortment, and right now we have about 14,000 skews online, of which about 3,000 are exclusive, and part of that was the launching of the PetSmart boutique.

Obviously the customers – our customers were really looking for some unique products, and to answer your question on the fulfillment side, it can be a combination depending on the products that could either be drop shipped or to be stocked in our DCs. So we were very happy with the results especially in Q4, from our online business, and also the acceptance of the PetSmart boutique business.

So, and again as we keep on focusing on this business, we are looking at our fulfillment cost. We are also investing in our website to really increase and improve our experience with the customer. So a lot more work to come there, but that’s more of a sign or a trend of what type of work we are putting into our website.

Kate Wen - Wells Fargo

Great. That is helpful. And just as a final housekeeping follow-up, could you guys provide how much inflation benefited the comp in Q4?

Bob Moran

We don’t give specific numbers anymore, but if you remember back on the Q3 call, we thought it would be between 150 basis points and 200 basis points, and pretty much came in right in the middle of that.

Kate Wen - Wells Fargo

Okay, great. Thank you so much.

Operator

Thank you. The next question is from Michael Baker with Deutsche Bank. Your line is open.

Michael Baker - Deutsche Bank

Thanks. So, a couple of follow-ups, one just on the flea and tick, you guys talk about how much, you think that may have helped your comps, and what’s your expectation for that going forward? I think you probably have some – I’m not sure how the comparisons were or how that did last year with the weather, so is that something that you think will continue to help you in early 2012?

Bob Moran

Michael, it was – we wouldn’t talk specifically on the growth numbers for flea and tick. I would say that it was an unusual quarter because the fourth quarter last year was not a very big number for us, because you don’t sell a lot of that in the winter time. This year obviously it was much better for the warmer weather reasons.

The nice part about it is it is now something that counters another side of our business that does have some sort of weather or seasonality to it associated with apparel. So they counterbalance each other out. Next year, if we have a cold winter I’m guessing flea and tick won’t be near as good in the fourth quarter, but apparel will make up for the difference that would be my anticipation.

Michael Baker - Deutsche Bank

Got it. Interesting, okay. I guess different margin rates, so one more question if I could, just competitively, do you see anything different from either Petco or some online competitors, anyone a little bit sharper in price, and I guess what's that related to is your decision, you are a little bit sharper in price on some traffic driving items this fourth quarter, but it sounds like you are backing off on that. I am wondering if you just didn’t see the lift you expected from that?

Bob Moran

Hi, Michael. It is Bob. No, I would say that from a competitive point of view, it is still a lot of (inaudible). I mean it is not that there are different campaigns or different events that we don’t be competitive on, but the point is this is relatively the same as this year versus last year. So – and we say that we are not going to be as promotional as we were in Q4, because we are really trying to drive comp transactions.

But we are going to be selective, and again the acceptance from the customer point of view, those selections it could steer the mix, but we are going after comp transactions and we are going after frequency. So, we are driving our marketing behind that.

Michael Baker - Deutsche Bank

So, it seems to work I guess in that your transactions were as strong as they have been all year, if you back off of it all year, if you back off of it a little bit, would it be reasonable to assume that transaction growth might be little bit lower than it was in the fourth quarter?

Bob Moran

I would say, we are always testing, so it is hard to say – you could argue that yes, you might get a fewer less transactions, but you might get margin dollars, because you are not being as promotional. So, it is always a balance. As we look to next year or throughout the whole year we are expecting to have positive transactions throughout the year.

Michael Baker - Deutsche Bank

Okay, perfect. It is very helpful. Thank you.

Operator

Thank you. The next question comes from Michael Lasser with UBS. Your line is open.

Michael Lasser - UBS

Good evening, and thanks a lot for taking my question. And Dave, good luck on your new role. First question is, and I hate to belabor this point, but if you back out the impact from flea and tick and apparel, was the hardgood result in the fourth quarter in line with the trend over the last couple of quarters?

Bob Moran

The hardgoods were positive comps. They were slightly below the core comp. So it was a solid, very solid quarter generally in line with how it is been tracking, maybe even a little bit better. Just the mix within the hardgoods was different than we anticipated coming in the quarter.

Michael Lasser - UBS

Okay. So that's overall speaking not necessarily breaking it down further?

David Lenhardt

No.

Michael Lasser - UBS

Okay. Second question is on the resets, do you anticipate that there will be any potential margin impact once those resets are done either to the positive or to the negative side?

David Lenhardt

Yes. This is David. I think we've baked into our guidance for the year the impact of the consumables reset, and overall, as we said before, the reset entails us basically allocating more space to our super-premium natural foods, and those are clearly have been our fastest growing foods.

We're introducing some new assortments, limited ingredient, grain free that we know have a lot of traction with the customer. Within our consumables mix, those foods do have a higher gross margin rate. So to the degree we're driving more sales through that it is going to have a positive impact on margin, and that's reflected in our guidance.

Michael Lasser - UBS

And is that what's driving up the merchandise margin for the year?

Bob Moran

There's couple of things driving up for the year, one is high-end foods, so high-end foods are driving it. That's somewhat a result as David just mentioned on the reset and just demand on the high-end foods. We're also seeing our specialty business has been really solid, will continue to be solid in the upcoming year, we anticipate, which is higher margin businesses, and we're starting to get some leverage out of our pricing optimization tool, which is helping the margin.

And then going against us a little bit is going to be overall mix, because we still believe consumables all in is going to be a faster paced comps than hardgoods.

Michael Lasser - UBS

Okay. Good luck in this upcoming year.

Bob Moran

Thank you.

Operator

Thank you. The next question in queue comes from Peter Benedict with Robert W. Baird. Your line is open.

Peter Benedict - Robert W. Baird

Yes, hi guys. Just also on the resets, can you give us a sense, are there any new brands that you are bringing in, or is it just kind of additional product within the current brands that you’ve got and how are communicating the change to consumers?

David Lenhardt

Yes, Peter it is David. Nature’s Miracle or Nature’s Recipe is the one new brand that we are adding in. The rest of it is increased assortments, particularly within our Naturals brands. And again, I talked about the limited ingredient. I talked about the grain free, which are both again very fast-growing customer segments that our vendors have now been innovating around.

So you are going to see brands like Blue Buffalo, Wellness, our own proprietary Simply Nourish brand getting more space with different assortments, and we are very excited about that. Also, the other resets we are doing, which are primarily in the second quarter, but some of the negative impacts in the first quarter, our toys [ph] reset, our products reset and our small animal reset. Things like the toys reset – we are calling it our toy chest reset that’s where we are going to be introducing Toys ‘R’ Us. Within there, there will be a subset of Bret Michaels’ toys, and we are going to launch some marketing campaigns around those resets.

Peter Benedict - Robert W. Baird

All right. And then Chip, just to revisit kind of D&A cascade, kind of your latest thinking as we look out ’12 and ’13, how you see that line item moving?

Chip Molloy

I don’t see anything material for this year or next, meaning ’12 and ’13. It becomes somewhat material in ’14. Hopefully a double-digit decline in dollars in '14. Between now and then it is fairly immaterial.

Peter Benedict - Robert W. Baird

All right, terrific. Thank you.

Operator

Thank you. The next question in queue comes from Brian Nagel with Oppenheimer. Your line is open.

Brian Nagel - Oppenheimer

Hi, good afternoon. The first question I had just I want to look at the guidance, the comp guidance you guys gave for 2012. So 3% to 4%, how should we think about that it is lower than or slightly lower than the comp guidance we had in Q4, even which you articulated for Q1? So just to have the parameters run, how should we think about maybe a tall gap [ph], and the slight slowdown in comps for the year?

Bob Moran

Brian, I would say that it is a long year ahead for starters. We’ve had incredibly strong comps of recent. In fact, the last two quarters have been some of the highest two year comps for several years, and as the year rolls through, we don’t have as much inflation in the back half.

It is a little bit in the first half of the year, but outside of that I would just say it is a long year as we need to work our way and earn our way through the year. For now, we are very comfortable around a 3 to 4 comp guidance, and building our plan around that.

Brian Nagel - Oppenheimer

Fair enough, and second question, somewhat of a housekeeping question, the tax rate in Q4 was lower than I think then we were modeling, I think lower than the tax rate guidance would imply what you give for the full year or so, maybe just help understand that and how should we think about the tax rates as we start going…

Bob Moran

Yes, I would say that I think about the tax rate as we are a 38%, 39% tax rate company typically. That’s federal and state and local. We don’t have anything really international outside of Canada. Any given quarter there maybe some tax credits or tax audits at the state or local level that will give us a credit that will require us to pay something extra, and they are hard to anticipate.

We are always working those. This particular quarter we had some wins in a couple of states in some localities on some tax credits, and that helped benefit this individual quarter. They are really hard to anticipate timing, so I just like to think of us as a 38 to 39 and it can vary from that, maybe a 100 basis points in any given quarter based on that type of activity.

Brian Nagel - Oppenheimer

Then final question, and a follow-up I think to previous question, just on gas prices. Chip, you and I have talked about in the past that you do see a somewhat of a relationship between gas prices and sales in your business. We've obviously had gas prices begin to move up here again, you commented that you are pleased with, obviously pleased with fourth quarter sales, pleased with sales here in Q1, but as you look over the next several months, I mean, is there – do you sort of say, keep those same type of concerns as we are seeing gas prices climbs as you historically would have?

Chip Molloy

I would say that, you know, the number one thing that I look at every day on CNBC is oil prices. So yes, it does concern us as a company just like it should all of retail. And I don’t think we are any more immune or any more at risk than retail on average.

And it sounds like from listening to all of our peers out there as they have released that everyone is a little cautious about it, but so far no one has really seen an impact, and that’s the same story as it is for us. It will make us nervous as the year progresses, but we are just going to have to wait and see. I think the indicators, there is going to be several other indicators before us that it is starting to impact the consumer.

Brian Nagel - Oppenheimer

Thank you.

Operator

Thank you. The next question in queue is from Dan Binder with Jefferies & Company.

Daniel Binder - Jefferies & Company

Hi, good afternoon. I just had a question regarding the traffic driving initiatives that you had planned for Q4, I was curious, is the margin decline related to those initiatives similar to what we saw in Q3 or was it greater?

David Lenhardt

It was similar.

Daniel Binder - Jefferies & Company

Okay, and then on the resets that you have planned for Q1 that will result in a slight decline in merchandise margin, is there anything unusual about them that just from the standpoint that you've done resets in the past and we haven't had as much of an impact, is it just the sheer size of it?

David Lenhardt

Actually what we're expecting in Q1 is less than some of the delusion we've had in the past on some of our resets. So, we are expecting to be down year-over-year slightly in Q1, but it won't be near as much as it was this past quarter. At least that’s our expectation. And we do have a number of fairly large resets taking place all in the first quarter or by the fifth month of the year, and most of that activity takes place in the first quarter.

Daniel Binder - Jefferies & Company

Okay, and then two final ones, anything on pet adoptions year-over-year, and any big changes for online in the coming year in terms of what your expansion of consumables or is that sort of status quo?

Bob Moran

Hi, Dan. It is Bob. Actually Q4 was our best quarter in probably about three years for pet adoptions. We're up close to 2% up for the year. Just basically it was flat on the positive side, but some good signs. It is about 107,000 adoptions during the year and we've been doing a lot of work also in the conversion side, and we've been making a lot of progress there, but more to come on that, and we're going to continue doing National Adoption weeks.

For example, in February we just did one, and we saved more than 16,000 lives over a weekend. So lot of good work there, but obviously from the charity side we want adoption to happen, but also we want the conversion side to the commercial side. And try to sustain and keep these customers within our shop.

So some positive signs, but three months doesn’t make a trend. So obviously what we want to do is keep on evaluating this as we go further on. On the web, you know, we are putting focus our there, as I said before. We haven’t been impacted by any of the online players. However what we are doing is expanding our assortment as I said before, and we are going to continue working on that.

We are looking at our costs, especially on the fulfillment side, we are looking at drop shipped, and whatever else we can do to look at our cost. We are also – we also know that our customers are looking for a 24x7 experience on the web, so that they can get solutions. So we are investing in our website to improve our customer experience there, and we talked a little bit earlier about the PetSmart boutique, where we started to put some thinking behind how do we bring some really unique products. You'll see more and more of that coming during the course of the year, so more to come there.

Daniel Binder - Jefferies & Company

Okay, great. Thank you.

Operator

Thank you. And at this point, I would like to turn the program back to our presenters for any concluding remarks.

Bob Moran

This is Bob Moran. I just – I think we've finally come to an end of another earnings call, but I wanted to thank everybody for joining us today and we look forward to speaking with you again in May. Thank you.

Operator

Ladies and gentlemen, thank you for joining us on today's conference. This does conclude the program and you may now disconnect. Everyone have a good day.

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