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PetSmart, Inc. (NASDAQ:PETM)

Q2 2007 Earnings Call

August 15, 2007, 4:30 PM ET

Executives

Tawni Adams - Director of IR and Corporate Communications

Philip L. Francis - Chairman and CEO

Raymond L. Storck - VP of Finance, Chief Accounting Officer, Controller and Acting CFO

Robert F. Moran - President and COO

Analysts

David Schick - Stifel Nicolaus

Matthew Fassler - Goldman Sachs

Gary Balter - Credit Suisse

Matt Nemer - Thomas Weisel Partners

Peter Benedict - Wachovia

Michael Baker - Deutsche Bank

David Mann - Johnson Rice

David Cumberland - Robert Baird

William Sims - Citigroup

Joseph Feldman - Telsey Advisory Group

Christopher Horvers - Bear Stearns

Presentation

Operator

Good afternoon. My name is Thia, and I will be the conference operator today. At this time, I would like to welcome everyone to the Quarter Two 2007 Analyst Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions]

Thank you. I will now turn the conference over to Ms. Tawni Adams. Please go ahead, ma'am.

Tawni Adams - Director of Investor Relations and Corporate Communications

Good afternoon and welcome to PetSmart's conference call to announce our results for the second quarter of fiscal 2007. With me on the call today are Chairman and Chief Executive Officer, Phil Francis; our President and Chief Operating Officer, Bob Moran; as well as Ray Storck, Vice President of Finance, Chief Accounting Officer and Acting Chief Financial Officer.

Phil will kick off the call today with an overview of our second quarter results. Then Ray will take you through the financial details for the quarter and Bob will update you on our strategic growth initiatives and our ongoing work to drive meaningful shareholder returns. And finally, we'll take your questions.

Please keep in mind that 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. And we'll post a reconciliation of the non-GAAP financial measures we discuss on the call to the most directly comparable GAAP measure in the Investor Relations section at www.petm.com.

Thanks. And I'll now turn the call over to Phil.

Philip L. Francis - Chairman and Chief Executive Officer

Thanks, Tawni. Hello, everyone, and thanks for joining us for a review of our second quarter. I am happy to report that in the wake of a large pet food recall, our business has yet again demonstrated its resilience, our associates have continued to execute on our initiatives and the pet parent consumer is showing strength.

We delivered earnings of $0.35 a share, exceeding both our guidance and the Street's expectations. Comparable store sales or sales in store open at least a year grew at 4% despite the impact of lost sales from both recall products that have not yet returned to do the shelf and our strategic decision to exit our State Line Tack equine business. In fact, once we exclude the State Line Tack business, our core pet business delivered comparable store sales of 5%, and without the impact of the recall, our comps would have been even better.

Our topline growth continues to be among the best in specialty retail at 9%. Increased traffic accounted for 77% of that growth, which we believe is a direct result of our ability to execute effectively on our initiatives and attract new customers and mitigate some of the impact of the recall.

Coming into the quarter we knew we were dealing with a consumer who was weary from the recall, concerned about food safety, and feeling a bit of pressure from increasing fuel prices. Despite those challenges, all signs still point to a healthy pet parent consumer. Our own research indicates that our customers still experiencing some lingering effects of the recall, we didn't see any heightened impact from fuel.

In fact, Americans continue to pamper their pets. They spend twice as much on their pets today as they did a decade ago. That is, we spend more on movies -- we spend more on our pets than we spend on movies, playing video movies and listening to recorded music combined. Clearly, the trend toward the humanization of pets is alive and well, though circumstances gave us a unique opportunity to reintroduce pet parents to PetSmart's unique offering and value proposition.

During the second quarter, we worked closely with our vendors to fully capitalize on that opportunity using their customer research and our PetPerks database to get the most out of the advertising effort. We believe that effort helped us regain the confidence of our existing customer base and begin to attract new customers.

As a result, we're in a strong position to attract more than our fair share of sales from the 7 million dogs and cats whose parents enter the market place each year. We did experience some hit to the topline due to the fact that only 42 of the 305 recalled SKUs have returned to do our shelves.

Both the new pet fixture and the pet food aisle reset initiatives helped us mitigate some of the impacts from the recall and deliver solid topline performance for the quarter. Recalled SKUs will continue to trickle back into our stores through the spring of next year, and we expect that will continue to make our core business stronger.

Our associates outperformed our expectations in taking care of customers during the recall, but the footsteps we lost had some impact on our fast-growing services business. During the second quarter we refocused our store associates on educating new customers about the benefits of services.

At 19.5% growth, our services business increased nicely over Q1. Throughout the second quarter we saw the growth ramp up and our momentum continues. We remain confident that we can grow our grooming, training and hotel businesses at 20% for all of 2007.

While our strategic growth driving initiatives continue to position us to make the most of the favorable consumer trends in our industry, we remain focused on simplifying the work list, building on our core strengths and targeting our resources where they can drive the most compelling returns.

Our management team remains focused on driving expense management without compromising our growth or the customers' experience. That's a cultural shift for us, but we're excited about our progress.

Our exit from our State Line Tack equine business is going well. During the first quarter we told you we had sold the assets related to our Internet and catalog equine business. As part of that transaction, we sold some of the inventory that we had originally plan to sell through our stores. So we sold out of inventory in our stores a bit faster than we originally planned.

That hurt the topline a bit in the second quarter, and because we're now beginning to exit our best performing State Line Tack departments, the transition will put some pressure on comps in the coming quarter. The topline impact is offset by the fact that due to the quick sale of the inventory we took less in inventory write-downs than we had originally estimated. And we have been managing other costs related to the project well. So we now anticipate, in addition to the topline impact we just discussed, we'll incur net costs to exit the business of only $0.08 compared to our previous estimate of $0.11.

We're also executing well which allows us to accelerate store resets. During the second quarter, we completed the reset of 76 State Line Tack departments in our stores, and now plan to have all the remerchandising complete by the end of this quarter, ensuring our stores are ready for a strong holiday season.

So with our solid business model and the initiatives we have in place, we remain confident in our future prospects and our ability to generate long-term shareholder value, and we're committed to enhancing our value in the near term.

Consistent with that, we purchased 1.9 million shares of our stock during the second quarter using the remainder of our stock purchase program. And our Board has authorized a new program that lets us buyback $300 million in stock over the next two years. And today we entered into a plan with Lehman Brothers to purchase $225 million of that stock on an accelerated basis.

We will fund the accelerated plan with cash and borrowing from our new credit facility. We will use the remaining $75 million of the stock purchase program to buy shares opportunistically. The new credit facility will take the Company revolver from $125 million to $350 million.

Now let's talk about guidance for the rest of the year. We'll have a lingering effect of the recall on the exit of the State Line Tack business, will cause a bit of topline pressure. We still feel very good about our core business, our ability to manage expenses, and our solid position going into the holidays. And we feel good about the health of the pet parent customer.

So we're projecting comp sales in the low to mid single digits for the year. We expect comps to be at the low end of that range for the third quarter as we continue to recover from the recall and experienced our largest sales impact from exit of the State Line Tack business. For the fourth quarter, we expect to see some recovery and deliver mid single digit comps.

Both our Eagle 2 and State Line Tack remodels will be complete, and we'll have more recalled product on the shelf. We expect the benefits of our strong marketing initiatives and the work we're doing to build trusting relationships with our customer to continue to build and take hold. And the stores we bought in Kansas will be remodeled and ready for customers.

That comp guidance translates to earnings per share of $2.08 to $2.10 for the year, which is an increase from our previous guidance. As I mentioned, it's costing us less to get out of the State Line Tack business than we previously estimated. We also expect some benefit from the ASR.

In addition, most of our out performance in the second quarter will carry through for the year, although we will see a bit of it reverse in the back half as it relates to a new contract with MMI that changes how we recognize rent from Banfield throughout the year. Finally, we true-up our estimates on the change to the equity method of accounting for the MMI investment.

So our guidance for all of 2007 now includes an expected loss to exit the State Line Tack business of $0.08. Also included is $0.47 of benefit from the sale of shares of MMI in the first quarter, and the benefit of about a penny for the change to the equity method of accounting for the MMI investment. We also expect an $0.08 gain for the 53rd week of sales and a benefit of about a penny from ASR.

For the third quarter, we estimate earnings of $0.21 to $0.23 per share, which includes $0.04 per share in expense to exit the State Line Tack business. In addition to the topline pressure inherent in Q3, we'll increase our advertising spend and feel the impact from the timing of how we recognize rent from Banfield.

Finally, we're continuing our CFO search with the commitment to finding the right person for the business and its future. Our competent financial associates here at PetSmart have made it possible for us to take that time. We'll make an announcement as soon as we can.

With that, I will turn the call over to Ray who is our Acting CFO to take you through the financial review of the second quarter.

Raymond L. Storck - Vice President of Finance, Chief Accounting Officer, Controller and Acting Chief Financial Officer

Thanks, Phil, and hello, everyone.

Our consolidated net income was $47.1 million or about $0.35 a share for the second quarter of 2007. That includes about a penny in net loss related to our exit from the State Line Tack business. The net loss includes accelerated depreciation on assets and costs to remerchandise the equine sections in our stores. Without those items, our second quarter earnings were $0.36 a share.

We exceeded guidance due to a benefit related to the renegotiation of a contract with MMI Holdings, Inc. which resulted in a change in the timing of Banfield rent recognition. Some of this impact will reverse in the third and fourth quarters, but it will be a net positive for the year. In addition, we have some favorable results in insurance expense based on updated actuarial estimates due to recent positive trends in claim activity.

In the second quarter of 2006 we earned $0.27 per share, excluding $2.9 million or a penny per share of expenses related to a potential acquisition, $1.8 million or about another penny per share in costs to re-rack a distribution center, and adjustment to cost of sales related to a change in accounting practice from early pay discounts and a tax benefit. At $1.1 billion, our total sales were up 9.4% in the second quarter compared with $1 billion in the same period last year.

And as Phil mentioned, our comparable store sales or sales in stores open at least a year grew 4% for the quarter. That's on top of 4.9% growth in the second quarter of last year. Comparable store sales in our core business, excluding the State Line Tack business we're exiting, grew at 5% for the quarter.

We continue to grow square footage during the quarter, and we opened 38 net new stores in the quarter, including the acquisition of stores in Canada. Gross margins were 31% for the quarter, with no material impact from the exit of the State Line Tack business. That's a 53 basis point improvement compared to pro forma gross margins of 30.4% for the second quarter of last year.

Part of that margin expansion is due to the timing of how we recognize rent payments under the newly renegotiated contract with MMI. Keep in mind that some of that benefit will reverse in the back half of the year.

Gross margins continue to benefit from our work to optimized prices and negotiate favorable terms with our suppliers. We're sourcing our products smarter, making assortment decisions that benefit both the customer and our margin. And we saw some expansion from product mix for the quarter. Those improvements were offset by dilution from increasing penetration of services and strong redemption from our PetPerks program.

In addition, we experienced increased costs year-on-year in our supply chain for line haul rates and fuel surcharges. We also incurred some costs to ensure the successful startup of our Atlanta-based distribution center which started shipping this quarter.

With the changes in the MMI contract and trends in merchandising margin, we anticipate gross margin expansion for the year to be 25 to 30 basis points compared to the prior year, which is up from our previous targets of flat to 20 basis points of expansion. That does not include the impact of the exit of our State Line Tack business or the benefit of the 53rd week.

Operating, general and administrative expenses were 23.4% of revenue in the second quarter. Excluding the costs associated with exiting the State Line Tack business, operating, general and administrative expenses were 23.1% for the quarter, and that compares to pro forma operating, general administrative expenses of 23.5% in the second quarter of 2006.

We had some favorable results in insurance expense that I mentioned earlier. Those results were partially offset by higher advertising expenses compared to the prior year. We continue to feel good about our goal of 20 to 25 basis points of expense leverage for the year, and that does not include the impact of our exit of our State Line Tack business or the benefit of the 53rd week.

We successfully sold through the excess inventory we had at the end of the fiscal year, and we did it without marking down the product. We have managed our inventory well through the leasing start-up of our Atlanta-based distribution center and through a change in the way we source one of our largest vendors' products by bringing it into our distribution network.

We ended the second quarter with an average of $488,000 in inventory per store, up just slightly from $482,000 per store in the same period last year. As always, our inventory balances will rise in the third quarter to prepare for our holiday selling season. Capital expenditures were $82 million in the second quarter, while depreciation and amortization was about $50 million. We're on track to have between $270 million and $280 million in capital expenditures for the year.

Cash provided by operating activities was $51 million in the second quarter, and we ended the quarter with total cash, cash equivalents and short-term investments of $245 million. Our ability to generate cash means we can invest in the business and at the same time provide shareholders with tangible returns in the form of share purchases and dividends.

We used the remainder of our $250 million share purchase authorization and bought back 1.9 million shares in the quarter at an average price of $33.97 per share. As Phil mentioned, our Board has approved an additional $300 million stock purchase authorization, which will be available over the next two years. We will use $225 million of that authorization to execute an accelerated share repurchase program.

On August 10th, we paid a quarterly dividend of $0.03 a share to shareholders of record as of July 27th, 2007. So we delivered a solid performance in the second quarter and are on track to deliver a solid performance for the year. Thanks.

And now, Bob will give you a review of our operating initiatives.

Robert F. Moran - President and Chief Operating Officer

Thanks, Ray. We came into this year with a commitment to simplify our work list, focus our resources and build on our core strengths. While the recall was not on our list, it tested who we are and gave us a chance to show what we were made of.

I told you at the end of the last quarter about how well we performed in the weeks initially following the recall performed in the weeks initially following the recall, but it was our flexibility as a business and our outstanding associates that allowed us to deliver what we did in the second quarter.

We executed consistently on each of our initiatives, and at the same time, made strides to bring an uncertain consumer back into our stores. Each initiative played an important role in attracting the customer, delighting them once they were in our stores and continuing to grow our business.

The first order of business was to take a hard look at how we could drive footsteps back in the store after the recall. Our marketing and merchandising groups worked closely with our vendor community to identify the biggest opportunities. We started with a large mailing, inviting customers back into our stores.

We gave our vendors the chance to reach out to our shared customers and together we shouldered the burden of winning back customer confidence that was shaken from the recall. We then went after helping our districts that were recovering the slowest from the recall by reaching out to potential new customers. Our response rates were better than we expected from both of those efforts.

Because of the consistently impressive performance from everyone in our business, our brand was in a strong position to reach out to the customers after the recall. But it is our people that made our brand what it is and created the in-store experience that drove our performance for the quarter.

Our associates made the dog and cat aisle resets along with the new pet fixtures come alive. They listened to customers and they talked about their pet parenting needs, and they provided solutions by educating them on the benefits of advanced nutrition food, our extensive product offerings and our services.

Services continued to differentiate PetSmart from the competition and to be an important driver of our overall profitability. Our services businesses are high-touch, and we are clear that the recall was a distraction in the early part of the year. I am pleased to note that we're back on track and remain on target to grow the business north of 20% for the year. And that will be seven years of growth at or above this level.

Thanks to the passion that pet parents feel for their pet, we can't seem to open enough PetsHotels during the year. For the quarter, we opened four new PetsHotels, and we still feel good about our target of 35 new PetsHotels for the year. We also know that our strong assortment and our sharp pricing contributes to our superior in-store experience.

While we have experienced price increases throughout the year due to commodity cost increases, our pricing environment remains stable, and we did not see a notable change with any of our competition during the quarter. As you know, we are executing a long-term plan to keep our infrastructure just ahead of our store growth. This ensures a consistent in-store experience for our customer by continuing to improve service levels to our stores.

During the quarter, we began shipping from our new larger replacement Atlanta-based distribution center. This facility is the second of our new combo distribution centers that allow us to provide enhanced services to our stores with better delivery schedules and better reliability. We implemented our new warehouse management system in this facility and did it all without any disruptions to our stores. The Atlanta-based distribution center will be fully operational in time for our holiday shipping season.

And we're pleased with our progress on exiting our State Line Tack business and remerchandising 180 State Line Tack departments in our stores. Every aspect of the project has been executed well. And as Phil mentioned, we've accelerated the remerchandising and now expect to be out of all 180 of our in-store State Line Tack departments by the end of the third quarter. That puts us in great position to delight the customer for the holiday season.

The State Line Tack remerchandising is part of our existing plan to refresh our stores with our newest Eagle 2 format in 2007. We will complete the Eagle 2 remodels for the entire chain by the end of 2008. We will be converting five in-store State Line Tack department to say PetsHotels as part of the 35 we plan to open this year.

New stores will continue to play an important role in our growth plan. At the close of the quarter, we had 966 stores, and we will open about 100 net new stores this year, and we expect to end the year with more than 1,000 stores. Our build-out for the year includes the stores we purchased in Canada.

And during the second quarter we began the work to transition the stores to the PetSmart format and have been working to ensure that we have the right people in place to help us operate effectively in the Canadian market. That work is going quite well, and by the end of August we expect to have all stores converted. We plan a re-grand opening later in the year, which will be establish us as a strong presence in the Canadian market.

At the end of the first quarter, I told you about our work to focus our resources and build on our core strengths in our pet internet business by outsourcing the technology, logistics, and customer care solution. That work continues, and we expect to complete the transition during this quarter.

We are retaining total control over product assortment, content and total control over product assortment, content and community. And these are changes that will give us the ability to ship the way pet parents use our e-commerce business and make that business a nice extension of our brand.

Finally, we continue to be committed to expense leverage. We have identified key areas of expense control that could result in significant savings for the year. We're focusing on and finding savings by managing supply lines, simplifying processes, and efficiently managing store labor.

We found savings more of a $1 million in our salons alone by changing how we buy shampoo and towels and implementing best practices across all our salons on shampoo usage. That is just one example of the great work our people are doing on this initiative.

We are also implementing a labor management system in our stores that is set to be complete by the end of the third quarter. We're excited about the opportunities ahead of us and think we've just begun to scratch the surface on expense management.

Thanks, and I will turn the call back over to Phil.

Philip L. Francis - Chairman and Chief Executive Officer

Thanks, Bob. And let's open the call for your questions.

Question and Answer Session

Operator

[Operator Instructions]

The first question is from David Schick with Stifel Nicolaus.

David Schick - Stifel Nicolaus

Good afternoon. Ray, first a question for you, and I had one for Phil. If you talk about the guidance for and I had one for Phil. If you talk about the guidance for the year and with the ASR and the net effect to net interest expense, I was just hoping you could walk us through how that impacts -- it is $0.04 to $0.05 without the net interest expense. If you could just tell us where or guide us to net interest expense for the back half, that would be helpful.

Raymond L. Storck - Vice President of Finance, Chief Accounting Officer, Controller and Acting Chief Financial Officer

Overall for the ASR we're expecting a pickup of about a penny for the year netting out the impact of the interest expense with the ability to retire the shares.

David Schick - Stifel Nicolaus

Okay. Okay. It is three to four offset of the four to five. Okay. Phil, obviously I don't think Wal-Mart is… it is a major… it is everybody's major competitor but may not be your primary competitor for consumers day-to-day, but, A, they're talking about taking down margins.

And, B, I guess today or yesterday it looked like they may have cut out menu foods that the Canadian guys off the recall. Are they repositioning? What do you think or know about what's going on in the competitive landscape where people are positioning themselves relative to you?

Philip L. Francis - Chairman and Chief Executive Officer

David, we watch and we're respectful, especially of Wal-Mart and several others for that matter. I don't have data yet on menu foods, so ask us in two weeks or the next call and we'll have more data on that. I can tell you that six months ago before the recall happened there was a very, very high percentage of manufacturing capacity for private label pet food that was controlled by menu foods.

I know of a vendor who and no need to say who, has reached an arrangement with sort of the number two to use a lot of their capacity, and my belief is of the number two to use a lot of their capacity, and my belief is that in the short run there is simply no capacity.

In the short run other than menu foods capacity and what we're doing and what most people are doing is letting them demonstrate to us as some of the branded manufacturers for whom they co-pack they tightened up the quality control in the ingredient supply chain which after all was the issue here.

As for Wal-Mart's repositioning, they've said they're going to get out of some fish departments. We don't know where all of those are yet. I expect we'll know more in 90 days. They have historically been pretty happy with their pet businesses.

And as I read about them and as you and others do as well, they seem to them and as you and others do as well, they seem to be focusing hard on recapturing some sales momentum and worrying a lot about their apparel business, and in both of those cases we're not necessarily on a prime target of theirs, I don't think.

David Schick - Stifel Nicolaus

Okay. Great. Thank you.

Operator

Your next question is from Matt Fassler with Goldman Sachs.

Matthew Fassler - Goldman Sachs

Thanks a lot and good afternoon and congratulations on a good quarter. I would like to dig a little deeper just into a couple of the line items that you discussed just standing out in Q2 and Q3. If you could quantify the MMI impact on an anticipated impact on both the favorable impact and in the second quarter and the unfavorable impact in Q3.

And then, also, if you could quantify the insurance benefit and also talk about whether that sort of relates to prior adjustments for prior periods as well or whether it is something that we should really only think about for the third quarter?

Philip L. Francis - Chairman and Chief Executive Officer

Okay. Matt, this is Phil. I will try the MMI thing, and I think Ray will take a shot maybe at the insurance stuff here. The MMI contract we updated was done in the late 90s, and it was done in the context of a time when they were a very, very small startup business who acquired businesses from us, and by today's standards that was a contract which was kind of the big person being helpful and supportive of the little person.

Fast forward eight years, and they're a substantial business, over 600 stores, and are well able to stand on their own two feet. In that time the way the rent used to flow is lots of things were done on a percentage of sales basis, so later in the year there was more rent recognize in Q4 then it was less rent recognize.

Basis, so later in the year there was more rent recognize. In Q4 there was less rent recognized in Q1. The change in this contract means that we're in effect passing through the rent they earn, and they're paying rent to us on the same time we as a master lessor of the space pay rent to our landlords, so they are going to pay more rent in Q1 and Q2 and Q3 and a lot less rent than they used to pay in Q4, and all that's going on here is we're not getting less rent.

This year one time we're getting it earlier in the year. It is forever going to go ratably just the way we pay for the space, but during this year we're go to have some quarter on quarter fluctuations, and what we had in Q2 was true up of Q1 and Q2 because we did the contract in Q2, retroactive to the beginning of the year.

So we had two quarters of this catch-up in Q3 and Q4, we pretty much ratably in Q3 what it was going to be but the year before we collected on at lot of rent on a percentage basis will be back to normalized time willing.

And I hope that's a simple enough explanation. It is a more mature relationship with a more robust partner. We used to… they used to in effect grade payment terms on rent, and they now have better payment and typical payment terms, and that's what's going on.

Matthew Fassler - Goldman Sachs

So, Phil, does the annual amount change or simply the timing within the week?

Philip L. Francis - Chairman and Chief Executive Officer

It is the timing on a constant store basis, it is by in large pretty flattish. It is timing with a slight increase in total.

Raymond L. Storck - Vice President of Finance, Chief Accounting Officer, Controller and Acting Chief Financial Officer

Slight increase in rents.

Matthew Fassler - Goldman Sachs

And how big was the catch-up if you will, the catch-up piece of it that's more than you typically see earning this quarter?

Philip L. Francis - Chairman and Chief Executive Officer

We're not going to be quantifying that one, Matt.

Matthew Fassler - Goldman Sachs

Okay.

Raymond L. Storck - Vice President of Finance, Chief Accounting Officer, Controller and Acting Chief Financial Officer

And Matt, this is Ray. On your question on insurance, we do have ups and downs in insurance. We did have a positive this quarter, the first quarter was a little bit negative. We've been working very hard on safety both in the stores and in our DCs.

And we believe that that's contributing to the positive trends that helped us this quarter, and we hope that will be a trend going forward that we'll be able to report to you.

Matthew Fassler - Goldman Sachs

And the only reason I asked this question is because you beat the consensus number pretty substantially in Q2. You guided below the con census number for Q3, so I am just trying to true it up to the original expectations, if these line items are that exceptional.

Philip L. Francis - Chairman and Chief Executive Officer

I think they are, Matt.

Matthew Fassler - Goldman Sachs

Okay. So it sounds like the year and the aggregate is a little better, even considering all the items. Just one quick follow-up question. Can you talk about how the hotels are faring from a revenue perspective?

Over the past quarter or two, and where they've been, and I know there has been some fluctuation in service revenues. Is that primarily grooming or the hotels also moving around in there?

Philip L. Francis - Chairman and Chief Executive Officer

Good question. I mean, the hotels are doing just fine across the board in doing well. We think the focus we had as a result of the food recall probably impacted mostly on grooming and less on hotels.

Matthew Fassler - Goldman Sachs

Got you. Thank you very much.

Operator

Our next question is from Gary Balter with Credit Suisse.

Gary Balter - Credit Suisse

Thank you. This is Gary. I… just following up first on Matt's question. When you say using your wording that the second quarter was benefited from these two items and otherwise would have been in line, you beat by $0.06. And we should assume that the companies insurance and the rent changes are $0.06. Is that the easiest way to think about it?

Philip L. Francis - Chairman and Chief Executive Officer

Yes. That's the easiest way to think about it.

Gary Balter - Credit Suisse

Okay. And then also following up on Matt's question is on the -- just on the grooming side of it, or on the services side, it was up 19.5. You sound pretty confident something over 20 for the year. Does that mean reason to that is you're trending up as you get further away from the recall. Is that what we should read, Phil?

Philip L. Francis - Chairman and Chief Executive Officer

Yes, Gary. I think quarter one, I think was 18.5, and this quarter was 19.5. The net of the two is 19.1, and to be over 20 for the year we're going to have to average 19.1 up, so it takes about 21 or more to get to 20 and off the pace through the quarter and recent trends we're confident we'll be over 20 by the end of the year. That does imply 21 at least for the second half of the year, yes.

Gary Balter - Credit Suisse

And how much of that is driven by additional hotels versus the other factors that go in?

Philip L. Francis - Chairman and Chief Executive Officer

Don't have that number at my finger tips. We are opening more, but remember at this point grooming is still such a high percentage of the business, the success of the sales by and large turns on the success of the groom shops, and the hotels are becoming more material, and when we update that as we do in the fall of every year while we'll be able to do that, but its a help. It's a big deal in the services business and today certainly is still the groom shops.

Gary Balter - Credit Suisse

Phil, you commented on this. This is my only question. You commented on this in the presentation, but it doesn't sound competitively like there is anything really going on. You should good gross margin again?

Philip L. Francis - Chairman and Chief Executive Officer

Gary, we are respectful of everybody every day. We characterize the competitive environment as rational with no big changes of direction or intensity noted from any one material.

Gary Balter - Credit Suisse

Okay. Thank you, and nice quarter and keep it up.

Operator

Your next question is from Matt Nemer with Thomas Weisel Partners.

Matt Nemer - Thomas Weisel Partners

Good afternoon. My first question is can you give us an update on the use of the remerchandised State Line Tack base? What are you planning on doing with that? Thanks.

Raymond L. Storck - Vice President of Finance, Chief Accounting Officer, Controller and Acting Chief Financial Officer

I think we've indicated previously that we're going to use a criteria, which was gross margin dollars per foot and taking store by store the very best performing categories and gross margin dollars per foot, which of course, brings together item velocity and margin rate into one metric, and we're expanding those departments typically in four-foot increments.

So you know, I'll just pick a category here as an example. In a store that used to have a State Line Tack, let's say that the Cat Litter Department used to be 24 feet, and that's a good performing department in that store as a result of the relay, the space in that category might be 32 feet, up from 24 feet.

And I think we also gave some indications that the State Line Tack on a sales per foot basis was the lowest performing species we had, so in a sense, and I know this is a bit of a play on words, it's a low hurdle rate with the new space to improve, because we're getting rid of the least productive inventory we had in the store and merely giving more space to our very best store by store.

Matt Nemer - Thomas Weisel Partners

Okay. And then secondly, could you talk about with regards to your SG&A guidance, 20 to 25 basis points, I think is the full year target. Does that include the labor management system? Can you give us a sense of what's baked into that and what might not be baked in?

Raymond L. Storck - Vice President of Finance, Chief Accounting Officer, Controller and Acting Chief Financial Officer

Yes, it does include the impact of the labor management system.

Matt Nemer - Thomas Weisel Partners

Okay. And then lastly, just wondering, looking at the competitive environment, if you have any information from your real estate teams in terms of changes from some of your peers. Are they pulling out of leases, are they slowing down growth? What can you tell us from that side of the equation? Thanks.

Philip L. Francis - Chairman and Chief Executive Officer

This is Phil, not a lot of information. I mean, that I expect there will be more clarity in that in 90 days, if somebody's interested, but the store opening program of our competitor who went private this year is largely been the flow-through of leases that would have been signed before the going private transaction. I certainly heard nothing about an aggressive spade of lease signings, and I would have to size it and might slow down a bit, but I will have better data in the 90 days if you ask again.

Matt Nemer - Thomas Weisel Partners

Thanks so much.

Operator

The next question is from Peter Benedict with Wachovia.

Peter Benedict - Wachovia

Hi, guys. Thanks for taking my questions. First, Phil, can you talk about any plans you've got for testing price optimization in services? Is that something we could see at some point in the second half of the year?

Robert F. Moran - President and Chief Operating Officer

Peter, this is Bob Moran. Definitely in the second half and more to come in 2008, and we're doing a lot of testing, and as we are a Company of tests and pilot and rollout, you'll see some of those elements coming in the second half and into 2008.

Peter Benedict - Wachovia

Great. Just one more follow-up. The recall restocking, I think, Phil, you said 42 of I think 305 SKUs are back in. Is the restocking taking longer than you had expected, maybe a couple months ago? How do you feel about the pace of getting back in stock on those items?

Philip L. Francis - Chairman and Chief Executive Officer

Well, it's surely no faster than we thought, and it's much slower than we hoped. I mean, we know of a couple people who are not talking about being back in March. On the other hand, we don't need to have a repeat of this. And it's not the matter we can't get restocked. It's that the manufacturers can't get assurance themselves and us of quality to the degree that we're pushing.

I mean, if you think about the self abusive for us to take one back, unless we are completely confident it was going to be okay, because we may think -- we think we've gotten quite a bit of forgiveness for one. I don't want to ask for forgiveness for letting this happen twice. And so 42 are back. They're going to be coming ratably.

As soon as we get them, we're getting on them on the shelf pretty fast because our stores are practically meeting the truck and ripping it apart to go get the stuff so we can offer it for sale again, but it is going to be ratably between I think by the 1st April at the latest they'll all be back, but as they come back, while we'd expect that that's a little bit of a boost that they will get ratable over the next six months.

Peter Benedict - Wachovia

Great, makes sense. Thanks so much.

Operator

Your next question is from Mike Baker with Deutsche Bank.

Michael Baker - Deutsche Bank

Hi. Thanks, guys. So just on the comps, so I think, you know, good quarter here, but the full year guidance is now low to mid single-digits. It was mid single-digits. Is that simply due to what we talked about the timing on getting back in stock and the recall is different than you thought it was three months ago, or are you seeing anything from your customers as it relates to general economic softness, subprime, market turmoil, anything along those lines leading to what's just a slightly lower full year outlook?

Robert F. Moran - President and Chief Operating Officer

Michael, this is Bob Moran. One is I think we're going to see it second quarter is we're somewhat resilient and some of the resiliency is coming back. And looking forward in the second half and really two events that are really affecting our comps, one is the recall, which we said about the products trickling back in.

And the second one is the SLT especially in the third quarter we'll be ramping out of that business through Q3 and then obviously we will be able to use the remerchandise business going into Q4. So really everything that we're talking about from a comp point of view is really things, one, event that happened without us, which is recall, an event that we made a decision on, which is State Line Tack.

So nothing else would be impacting us.

Michael Baker - Deutsche Bank

You're going to say that State Line Tack was something you were thinking about three months ago?

Robert F. Moran - President and Chief Operating Officer

Yeah. We made a decision to get out of State Line Tack in the beginning of the year, so…

Michael Baker - Deutsche Bank

And if I could ask one more, just on -- I understand you're not going to give the quantification of how much the Banfield rent helped or insurance helped, but would gross margins still have been up without the rent and I guess conversely would SG&A still have been levered without the help from insurance and was one bigger than the other?

Robert F. Moran - President and Chief Operating Officer

Well, we're not going to quantify, but on the gross margins, we still would have been up without the Banfield agreement, and expenses, we might have had just a little bit of de-leverage, but remember we also said that we had higher advertising expenses during the quarter.

Michael Baker - Deutsche Bank

Right. Okay. Thank you. That's very helpful.

Operator

The next question is from David Mann with Johnson Rice.

David Mann - Johnson Rice

Yes. Thank you, good afternoon. Just to follow-up on that last question, in terms of the State Line impact, can you first quantify the performance of the stores that were exiting State Line in terms of comps versus the rest of the base?

Philip L. Francis - Chairman and Chief Executive Officer

David, this is Phil. Sample size and stores and week is too small to be meaningful yet. A lot of the ones we know there are few weeks, and I expect that's a question that we'll get to 90 days from now, and I expect we'll have some data for you in 90 days.

David Mann - Johnson Rice

And the faster sell-through is the issue that's going to hurt you in Q3 comps?

Philip L. Francis - Chairman and Chief Executive Officer

Yes. We had to estimate when we -- we sold the business about like we thought we would sell it. We sold it faster than we thought we would sell it, and if, you know, given today's environment, I am darn glad we sold it when we sold. The resets are going well. The sell-through is going well. We've set up a program and getting out of the small volume stores first and the big volume stores late, selling the inventory so fast got us out of the replenishment business early.

And so our biggest volume stores in effect that replenishment shut off early. And so we've been out of merchandise with an inability to perfectly match up resets with their inventory sell down. And that's just the reality we're going to have to live through in the short-term for a few weeks in Q3, and it's baked into our guidance.

David Mann - Johnson Rice

And it sounds like what you're seeing the ability to accelerate the timing of the reset just isn't -- you just don't have that ability…

Philip L. Francis - Chairman and Chief Executive Officer

Well, from what we told you earlier, we accelerated about six weeks, and in terms of capacity is given we're opening so many stores and remodeling and doing so many Eagle 2 remodels, you just order the fixtures, got the hotel rooms reserves, and that's the fastest we could… that's the most we could accelerate it.

David Mann - Johnson Rice

Okay. And then on the last call you talked about a number of initiatives that had led you to feel like comps would accelerate in the second half and axing out these two items, recall and the State Line Tack issue, are you still feeling good about the ability of those initiatives to drive comps?

Philip L. Francis - Chairman and Chief Executive Officer

Yeah. And we talked about the new pet fixture, and now we feel with the more time under our belt, we feel even better about the new pet fixture. I think 7 million new cats and dogs have parents every year in America. We see almost all of those at least once and the new pet fixture gives us a chance for a better conversation, better service and better retention of those customers.

The food aisle resets turned out to be well-timed given the recall because classifying the product the way we did made substitution easier to talk about. Our CRM sophistication gets better, and the Canada is going to be refreshed, ready to go, and in effect doing a grand opening in the Greater Ontario part of Canada.

David Mann - Johnson Rice

Okay. And then one other question on the customer behavior, are you still seeing unusual food buying or habits with the customer that you saw in the first quarter with size of bags and…

Philip L. Francis - Chairman and Chief Executive Officer

I think the size of bag phenomena has return to do a more typical, meaning larger size bag, and if the other part of your question…

David Mann - Johnson Rice

Are they in terms of the type of product they're buying, are they buying more premium and a mix of food relative to the rest?

Philip L. Francis - Chairman and Chief Executive Officer

The mix is advantageous on balance. It is up the latter because there seems to be more confidence, up the ladder, so we have seen a favorable internal mix shift on the quality of food people are buying, yes.

David Mann - Johnson Rice

Very good. Thank you.

Operator

The next question is from David Cumberland with Robert Baird.

David Cumberland - Robert Baird

Thanks. First, can you confirm that comps guidance for Q3, did you say low end of low to mid single digits?

Philip L. Francis - Chairman and Chief Executive Officer

Yes. That's what we said.

David Cumberland - Robert Baird

Thanks. And the CapEx guidance sounds like that increased by 20 million. If so, why was that the case?

Philip L. Francis - Chairman and Chief Executive Officer

We're up a bit in CapEx from the Canadian acquisition and the cost to fixture those stores and get them into the right format and also from our SLT remerchandising efforts.

David Cumberland - Robert Baird

And then, you talked about the slow return of the recalled SKUs hurting your topline. Can you elaborate on why that is the case when presumably you and your customers have found substitutes for those recalled item science.

Philip L. Francis - Chairman and Chief Executive Officer

Good question, question, David, and the most obvious example comes on think about wet food. Most of the recalled items were wet food. Typical behavior for a cat is wet food, dry is still under developed relative to dog, and in dog very typical behavior has been dry food with a bit of wet substituted on the top for appetite stimulation and pal stability reason the.

When there was a problem with the wet food people were buying, they simply quit putting the wet food on top of the dry food. And our expectation is when the wet food, and that's what most of the recalled items are, the SKUs come back. It’s going to be with advertising from the vendors about quality, confidence, and so forth.

And we're going to be participating with our PetPerks database and then getting those back and we think we can recreate the behavior that's been suspended, and wet food being Fed in total to a dog or as a supplement on top of dry is enough to make up the difference we're talking about.

David Cumberland - Robert Baird

That’s helps. And one last question how many stores in the Eagle 2 format at the end of Q2?

Philip L. Francis - Chairman and Chief Executive Officer

If you take 960, we have about 230 to do next year that would get you to 730. We have the third quarter remodels, and 700, 675.

David Cumberland - Robert Baird

Thank you.

Operator

Your next question is from Bill Sims with Citigroup.

William Sims - Citigroup

Thank you. Good afternoon. I realize there have been a number of moving parts in your guidance than many of the previous calls have addressed, but just to be clear is your outlook for the remainder of the year a little better or a little worse? Your guidance would imply a little worse, but I just want to be clear on that.

Philip L. Francis - Chairman and Chief Executive Officer

I would say it’s very similar to what we have given the things that we have talked about. I mean, on balance, you know, in over simple terms we're up $0.05 from the guidance we had over performance in the first half was $0.06.

However, you've got state line tax impact and MMI rent timing to consider as well, and my comment would be that broad terms allowing that I am not smart enough to be precise to the penny, we're pretty much carrying through our over performance in the first half and therefore raising the early guidance a bit.

William Sims - Citigroup

Okay. And my second question is recording your advertising plan for the third quarter. Did I hear you correctly that you said you are increasing your advertising budget for the third quarter? I know you did it in the second quarter. But if so, what led you to -- is it a decision to want to drive more traffic or what led you to increase the advertising budget?

Raymond L. Storck - Vice President of Finance, Chief Accounting Officer, Controller and Acting Chief Financial Officer

If I could go back through the whole year, we actually planned to have less advertising spending in Q1 and then allocate increased advertising spend in Q2 and Q3 and Q4 normal. This was already originally planned that way, and it wasn't a result of anything else going on.

On top of that, we have had vendor contributions coming in, obviously because as they trickle back in their SKUs from the recall, we're trying to communicate to their customer base saying they're back in business and are also giving the safety and security assurances along with the products coming back into the stores, so a little bit extra marketing from a vendor point of view.

But overall, this was exactly planned this way, and really no changes have really been out of the recall or anything else.

William Sims - Citigroup

So advertising had no impact on your guidance. Is that correct?

Raymond L. Storck - Vice President of Finance, Chief Accounting Officer, Controller and Acting Chief Financial Officer

No.

William Sims - Citigroup

Okay. Thank you. Good luck.

Operator

Your next question is from Joe Feldman with Telsey Advisory Group.

Joseph Feldman - Telsey Advisory Group

Hi, guys. A lot of questions have been answered. But I just had one question about the recall, which is, during the recall -- I think last quarter you said that it was an advantage that a lot of it was expected and actually may have helped you guys, because you're able to take some of the uncertainty out there. But this quarter, you're saying that it actually hurt because of the flow of product.

I guess I am wondering if I have got that trend right. And also, do you feel like -- you know, have you lost customers permanently because of the recall? I mean, are they going somewhere else or do you think they'd just come back once the product is back on the shelf?

Philip L. Francis - Chairman and Chief Executive Officer

Joe, what I believe we said was, in the long-term, this is certainly going to be good for us. Now, long-term isn't one or two quarters. And we're in the second quarter of the recall. We believe we were high performers during a tough time, because our information was better, our associates were better, our website never shut down, our call center never shut down.

And so we're relatively high performers in the short run, which is a quarter or two or three. And as a result of that, we're confident that we could build the long-term strength of the business. I think that's still just what we believe. We're still only weeks after the recall actually stabilizing, and the products aren't back yet. And so when you put that together, we think we'll be mostly, largely back by the fourth quarter.

But the last products won't get back until late in Q1 of next year, so a bit of impact. But in the long-term, we'll be back and reposition ourselves for the long run better than anybody else did during the height of the problem.

Joseph Feldman - Telsey Advisory Group

Okay. Thanks. And one other quick question. What kind of lift -- are you still seeing the same lift from the Eagle 2 remodels as when you first launched it? And I know you still feel good about -- I know the goal is still to complete them, but are you still getting that benefit?

Philip L. Francis - Chairman and Chief Executive Officer

We've never given specific up or guidance on any of our remodels, Eagle 1 or Eagle 2. And the reason is we have so many initiatives going on at once, what we attribute to Eagle 1, 2, what we do to COM [ph], what we do with the new food and all that stuff. So we think we have a pretty aggressive guidance compared to other people in retail, and that impact is baked into that guidance.

Joseph Feldman - Telsey Advisory Group

Thanks. Good luck next quarter.

Operator

The next question is from Chris Horvers with Bear Stearns.

Christopher Horvers - Bear Stearns

Thank you. First a follow-up on the previous question. Can you then talk about how much the recall and state line tack impacted first quarter comps as you did on this quarter?

Philip L. Francis - Chairman and Chief Executive Officer

We said state line tack, I think we said, if you took that at both years as 1%, and the food we never really gave a number to, but it’s in the millions of dollars certainly.

Christopher Horvers - Bear Stearns

Okay. And thinking about the guidance for 20, 25 basis points of SG&A leverage for the year that was the same as it was earlier in the year. Was the insurance benefit contemplated into this guidance or was it kind of a pleasant surprise in the quarter because it did provide a lot of upside?

Raymond L. Storck - Vice President of Finance, Chief Accounting Officer, Controller and Acting Chief Financial Officer

It was something that we obviously contemplated for our yearly guidance. It was an improvement in the second quarter, but in the first quarter insurance expense was a little bit higher, so overall it is a little bit of a benefit, but it is contribute to go the overall 20 to 25 basis points.

Philip L. Francis - Chairman and Chief Executive Officer

Chris, we did take that guidance and leverage up a bit this time.

Christopher Horvers - Bear Stearns

Okay. Thank you.

Operator

Ladies and gentlemen, we reached the end of the allotted time for questions and answers. At this time, I would like to turn the conference back over to Mr. Francis for any closing remarks.

Philip L. Francis - Chairman and Chief Executive Officer

Thank you all for joining us. We're working hard, and we'll see you in 91 days.

Operator

Thank you for participating in today's conference call. You may now disconnect.

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