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PetSmart, Inc. (NASDAQ:PETM)

Q3 2007 Earnings Call

November 14, 2007 4:30 pm ET

Executives

Tawni Adams - IR

Phil Francis - CEO

Bob Moran - COO

Chip Molloy - CFO

Analysts

Matthew Fassler - Goldman Sachs

Michael Baker - Deutsche Bank

David Mann - Johnson Rice

Peter Benedict - Wachovia

Brian Nagel - UBS

Mitch Kaiser - Piper Jaffray

David Cumberland - Robert W. Baird

Chris Horvers - Bear Stearns

Jonathan Kramer - Cowen

Operator

Good day, ladies and gentlemen, and welcome to the PetSmartthird quarter 2007 earnings conference call. (Operator Instructions) I wouldnow like to introduce your host for today's conference, Ms. Tawni Adams,Director of Investor Relations. Ma'am, you may begin.

Tawni Adams

Good afternoon and welcome to PetSmart's conference call toannounce our results for the third quarter of fiscal 2007. With me on the calltoday are Chairman and Chief Executive Officer, Phil Francis; our President andChief Operating Officer, Bob Moran; as well as Chip Molloy, Senior VicePresident and Chief Financial Officer.

Phil will kick off the call today with an overview of ourthird quarter results. Then, Chip will take you through the financial review ofthe quarter and our earnings guidance for the remainder of the year. Bob willprovide a preview of the fourth quarter and an update on our ongoing work todrive meaningful shareholder returns. Finally, we'll take your questions.

Please keep in mind that everything we cover during today'scall including the question-and-answer session is subject to the Safe Harbor statement forforward-looking information you'll find in today's news release. We'll post areconciliation of the non-GAAP financial measures we discuss on the call to themost directly comparable GAAP measure in the investor relations section atwww.PETM.com.

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

Phil Francis

Thanks, Tawni. Hello,everyone and thanks for joining us. During the third quarter, we weathered thetop line impacts of a tough consumer environment and our decision to exit ourState Line Tack business and we did a nice job of managing inventory andexpenses. That allowed us to deliver earnings of $0.23 per share. That's betterthan our recent guidance of $0.17 to $0.20 and we're on target to deliver solidearnings growth for the year.

Total sales grew 7.8%, driven by the addition of 106 net newstores since the third quarter of 2006, and comparable store sales or sales instores open at least one year grew 1.4%.

The exit of the State Line Tack business cost usapproximately 1.2% of comp for the quarter. We came into the quarter expectingsome impact as we cleared out product from our State Line Tack business andremerchandised the space. We accelerated the remerchandising and I'm happy toreport that at the end of the quarter we were fully reset with fast-moving andtop-selling products in all of our stores. We think the worst of that impact isbehind us. We are seeing sales in these 180 stores ramp back up and we believewe're in a good position heading into the holiday season.

The pet food recall had some lingering effects on the top linefor the quarter; however, we're making progress. At the end of the quarter, wehad 108 SKUs of the total 305 recalled back on our shelves. We expect vendor toadd back an additional 163 SKUs by the early part of next year. The remaining SKUs,about 34, will not be returning to our shelves, because the vendor has chosento rebrand, reformulate or discontinue the product.

We believe the unseasonably warm weather impacted certaincategories of our business. As you can imagine, dog skiwear tends to sellbetter when the weather cools off, but beyond that beds, apparel, outdoorcontainment, heating accessories and consumables typically ramp up as theweather turns cooler. In the early part of the fourth quarter, we were seeingpromising trends from cold weather categories and expect this momentum tocontinue through the holiday season.

The fires on the West Coast had a minimal impact on thebusiness for the quarter. Only two of our stores were briefly closed while 34stores were impacted indirectly as a result of evacuations, road closures andwarnings about people and pets staying inside because of the smoke. Of coursefor us, the loss of sales is secondary to keeping pets safe. So we evacuatedpets in affected stores to safe locations. This work was especially importantfor our birds who are sensitive to air quality issues. I'm pleased to reportthat we kept everyone safe.

At the same time, we dispatched two emergency trailers tothe fires and provided much needed supplies and care for evacuated pets. Ourcustomers donated generously during the fires and saw PetSmart as the placebest positioned to help pets during a crisis. As a result, we raised more than$300,000 for disaster relief.

The experience of the fire demonstrates again the uniqueconnection people have with pets and with our brand. We think that connectionand the emotional nature of our category, will continue to benefit us. In anenvironment where macroeconomic issues and the resultant slowdown in consumerspending have impacted many retailers, we believe there may be an impact on ourbusiness; however, to a much lesser degree. We're not seeing customers tradedown in food or give up their pet. Instead, we're seeing continued growth inour ultra premium, natural and organic foods and we've seen services continueto grow.

In fact, service sales grew 23%, demonstrating that in goodtimes and bad, our services customers are extremely loyal and see our servicesas a need, not a discretionary expense. Services growth has ramped nicelythroughout the year. Our year-to-date growth through the third quarter was20.3%, and we're on pace to achieve our 20% growth target for all of 2007.

So during a time of uncertainty in the environment, the bestwe can do is run our business well. We will continue to use all the data at ourdisposal to understand emerging situations and react quickly and appropriatelyand continue to drive top line growth. We're allocates our marketing mix to whatwe know drives traffic, emphasizing our competitive pricing and our uniquevalue proposition. We are focusing on making our stores easier to run whichmakes us much more efficient and helps us to control costs. For the thirdquarter, we are pleased with where our expenses came in on a 1.4% comp and planto keep that level of expense intensity going forward.

As we head into the holiday season we're well prepared todelight our pet parents. Our merchants have delivered our best holiday offeringyet, with more than 1,300 exclusive SKUs at attractive price points as low as$2.99. Our stores are in a consistent format that is designed around ourcustomer, with service offerings to prepare each pet with the high stylegrooming and party etiquette to attend even the most high-class holidaygatherings. If the pet is somehow not on the guest list, our hotels are readyto deliver five-star accommodations. Our stores are staffed with associates whoare passionate about pets and ready to delight the pet parent.

We've done a nice job of managing inventory through thethird quarter, and are headed into the holiday season with the right amount ofinventory and the right products in stock and ready for the customer. We werepleased with our Halloween product sell-through and we believe we're on targetto have similar success with our holiday products.

So we're committed to gaining share, delivering consistentfinancial results and generating long-term value for our shareholders. While wedon't know how long any consumer weakness will last, we have a good businessmodel and a solid plan to execute and emerge stronger.

With that, I'll turn it over to Chip Molloy, our CFO whowill take you through the financial review of the quarter.

Chip Molloy

Thanks, Phil and hello, everyone. It's great to be here. I'mgoing to discuss our financial performance for the third quarter, provideguidance for the remainder of the year and discuss briefly my observationssince joining PetSmart a month-and-a-half ago. Our consolidated net income was $29.5million or $0.23 per share for the third quarter of 2007. That includes anegative impact of $4.7 million pretax related to the exit of the State LineTack business. This net expense includes accelerated depreciation of assets,severance, and cost to remerchandise the former equine sections of our stores.

By controlling the costs to remerchandise this space andtaking fewer markdowns to sell through the remaining inventory, we managedexpenses to below the $7 million we previously estimated. Also included in ourthird quarter results was a $5.5 million pre-tax benefit for the recognition ofgift card breakage. Our program is relatively new, and we now have sufficienthistorical redemption information necessary to recognize breakage. The benefitin the third quarter was for our portfolio of gift card balances from thebeginning of the program until now. On a go forward basis, we will continue torecognize gift card breakage but the annual impact is unlikely to be material.

At $1.12 billion, our total sales increased 7.8% from thesame period last year. As Phil mentioned, our comparable store sales or salesin stores open at least a year grew 1.4% for the quarter. That's on top of the6.8% comp growth in the third quarter of last year, which was our highest compquarter for 2006. Our total sales growth was also fueled by 106 net new storesopen since the third quarter of last year, which was a 12% increase. Our totalsquare footage increased from 20.3 million to 22.5 million or 11%.

In addition, we opened 30 new Pets Hotels since the thirdquarter of last year which is a 53% increase year over year. We expect to openan additional 16 net new stores and ten Pets Hotels in the fourth quarter.

Gross margins declined 11 basis points to 29.7% for thequarter. Merchandise margins improved in all three of our primary categories,dog, cat and specialty. Merchandise margins continue to benefit from our workto optimize prices and negotiate favorable terms with our suppliers. We aresourcing our products smarter and making assortment decisions that benefit boththe customer and our margin. Those benefits are offset by increased occupancycosts associated with new stores and dilution from increasing penetration ofour services businesses. For the year, we expect gross margins to increase 25to 30 basis points. That includes the cost to exit the State Line Tack businessand a benefit from the 53rd week.

Operating, general and administrative expenses were 24.4% orflat compared to the third quarter of last year. That includes the 39 basispoints increase for the exit of the State Line Tack business and a benefit of49 basis points from the gift card breakage. For the year, we expect operating,general and administrative expenses as percentage of sales to decrease 20 to 25basis points. That also includes the cost to exit the SLT business and abenefit from the 53rd week.

Our net interest expense increased 47 basis points comparedto the third quarter of 2006; the increase was primarily the result of theaccelerated share repurchase and increase in capital leases. The funds requiredfor the stock repurchase both reduced our investments in short-term securitiesthat provide interest income and increased our debt interest. In addition, ournew store growth increased not only our operating leases but also our capitalleases resulting in an increase in interest expense.

Cash provided by operating activities was $29 million in thethird quarter, and capital expenditures were $75 million. We're anticipatingspending between $280 million and $290 million in capital for the year.

We ended the quarter with total cash, cash equivalents andshort-term securities of $57 million. Average inventory per store decreased$40,000 or 7% to end the quarter at $534,000 per store.

We've done a good job of mitigating excess inventory despitethe fact that our inventory balances per store generally rise in the thirdquarter as we prepare for the holiday season. We have established processesthroughout our supply chain to efficiently manage inventory. In addition, wecontinue to get better at planning for promotions, such as Halloween, and haveseen a higher sell-through on promotional product.

As was mentioned during second quarter call, our boardapproved a $300 million stock purchase authorization, which will be availablethrough August 2009. We used $225 million of the $300 million authorization toinitiate an accelerated share repurchase program. As a result, our outstandingshare count was reduced approximately 6.2 million shares during the quarter. Weexpect our outstanding shares to be further reduced by approximately 775,000shares before the program expires in January of 2008.

We initially funded the program with $125 million of cashand $100 million from our $350 million revolver. We paid down $20 million ofthe debt outstanding at the end of the quarter with cash flow generated throughoperations.

We have the tools in place for a strong finish to the year.Our business is well prepared, but we remain cautious due to macroeconomicuncertainty surrounding this year's holiday season. We project comp salesgrowth in the low single-digits and earnings per share of $0.70 to $0.74 forthe fourth quarter. For all of 2007, we're projecting comps in the low to midsingle-digits and earnings per share of $2.05 to $2.09.

Before I turn it over to Bob, I want to take thisopportunity to give you my thoughts on why I joined the company and what I haveobserved in my first month-and-a-half on the job. When I did my due diligence,I liked that the business operates in a growing marketplace, has a solid andprofitable model and generates a lot of cash. I also liked the idea thatPetSmart has established itself as #1 in the pet specialty space and created adifferentiated customer experience enabled by a strong services model.

I saw future potential for new store growth and profitableand scalable Pets Hotel business. At the end of the day, I love the fact that petparents are not allowed to bring the pets into many competitors' stores.

Now that I'm here, I've seen firsthand the passion of theassociates. I've also observed that this management team is pretty special.There's quite a bit of intellectual capital around the table and the commontheme of humility throughout, which I believe is a somewhat unique combination.That combination can breed collaboration and enables innovation. I'm excited tobe part of the team. After learning more about the business every day and itsopportunities, I believe I can bring some value to this company.

With that, I'll turn you over to Bob to walk through ourstrategy as we head into the fourth quarter.

Bob Moran

Thanks, Chip. When wespoke to you at analyst day, we told you we're committed to consistentlydeepening our relationship with the customer, to executing on the basics and togrowing our successful differentiated Pet Services business. We believe thosestrategies can create shareholder value over the long term, and they put us inthe position to weather the current economic softness and emerge stronger andeven more capable of generating solid profitable growth.

Deepening our relationship with pet parents is all aboutdelighting the customer each time they interact with us. We know pet parentshave a choice where they shop and during a slowdown, we want to be the placethey turn to because they can count on us to have what they need at the rightvalue. So we're focusing our assortment around what the pet parent wants andneeds right now, and we're capturing new and innovative trends so that we cangive customers a reason to shop.

We will attract customers to our stores with increasedoffers that are aimed at driving traffic, raising awareness of our offering andour value proposition. We will use our Pet Perks card to reach out tooccasional shoppers and give them new reasons to visit our stores.

We are continuing to build out our new stores, ending thequarter with 993 stores and 87 hotels. We believe these ongoing investments arecritical to bring us closer to our customers and extend our offering and ourbrand. Operating excellence is the foundation of our business and of ourability to delight the customer. We remain extremely focused on consistentexecution of the basics, which frees our associates to do what they do best,take care of the customer.

Having the right products in the store when they come in toshop us is our most basic commitment to our customer. We have done a great dealof process work in the last year, building a plan the entire business couldexecute on from our buyers to our DC's to our stores. The result of that workis that even with soft sales in the third quarter, we're heading into the holidayseason with the right products and the right amount of inventory.

All of our former State Line Tack departments are remodeledand our Eagle II refreshes for this year are complete, giving us a goodfoundation to provide a consistent customer experience. We will close the yearwith about 70% of our stores in the Eagle II format and complete the remainingrefreshes next year.

We're continuing to focus on simplifying processes so thatwe can manage expenses more closely during leaner times and become a moreefficient business for the long haul. We believe this is the right time tocontinue to differentiate our brand by expanding our lead in the highlydifferentiated services business. Not only is this a part of our business notimpacted by the consumer weakness, but it's difficult to replicate and it'shighly profitable.

Once customers discover our pet services, they're extremelyloyal; spending more in our stores and become a great source of word of mouthmarketing which we believe continues to be the biggest driver of this important,highly profitable piece of the business. We now have the scale to market thePets Hotel using TV advertising to a broad national audience. The ad helps usto drive traffic to both the hotel and the stores, but perhaps more important,it introduces the concept to many people who have not yet heard of the Pets Hotel.

In the short-term, we believe we have put ourselves in thebest possible position to capture market share during the holiday season. Thefourth quarter brings initial trial of our business from pet parents acquiringnew pets or buying presents for their existing pets, which makes this time ofyear that delighting the customer is the most important thing we can do.

Our merchants have refined their buying for the holiday season,buying the right amount of inventory, focusing on products we know will sell,and offering an assortment that gives customers the right selection and theright value. With 1,300 exclusive products, we have positioned ourselves as thedestination for pet parents during the holidays. We continue to be happy withour price position versus the competition, and think we have a strong valueproposition in our offering. We have solid in-stocks across the chain and our holidaysets are in the stores and ready for shoppers.

Our merchandising and marketing departments work to give ourstores a holiday set that was easy and efficient to put in place and it looksgreat. We are pleased with our online holiday shop. We have a full assortmentof gifts, and for all of you looking for that last-minute gift for your pet,make sure you consider an e-gift certificate.

Our grooming, training, boarding, and day camp services givecustomers another reason to try PetSmart. We know the increased level of trialwe experience during the holiday season gives us a chance to impress thecustomers and make pet services something they can't live without.

We're ready for this holiday season and we are tackling thischallenging macroenvironment head-on. With solid performance in the fourthquarter, we hope to continue to attract those new customers to our stores andgive ourselves a head start on 2008.

Thanks and I'll turn the call back over to Phil.

Phil Francis

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

Question-and-AnswerSession

Operator

Our first question comes from Matthew Fassler - GoldmanSachs.

Matthew Fassler - Goldman Sachs

Could you talk about your sales trends in October? Onlybecause it seems like the business probably ended up a bit better at the end ofthe quarter than it seemed like you were alluding to at your analyst meeting.

My second question, just to get it out there, relates to theimpact of the 53rd week. You mentioned the impact to gross margin, if you couldbreak out how you see it impacting gross margin and the SG&A, that would bevery helpful.

Phil Francis

Matt, this is Phil,I'll try the first one. At the timing of the analyst call, the quarter was astough as the quarter got; we had stabilized very soon after that when westarted to get some cold weather. I think implied in your question were instinctsthat the end of the query was a bit better than we were feeling at analyst dayand that is true. Things did stabilize alittle bit and cold weather helped a little bit and your instincts on that oneare correct.

Matthew Fassler - Goldman Sachs

In terms of thethinking about the 53rd week and you how it impacts; obviously it drives salesto some degree. Do you get leverage on cost of goods from that reported cost ofgoods from that?

Chip Molloy

The 53rd week, wewill get some benefit in both margin and expenses. On the expense side, it's inthe 5 to 10 range and on the marginside it is 15 to 20.

Matthew Fassler - Goldman Sachs

Finally, can you just give us a precise share count? I knowthat in the release you alluded to some carryover impact from the deal, but itwould be helpful just to note that's a reduction from your fully dilutednumber, fully diluted average number reported in the quarter or whether it'sreduction from the quarter ended share count that would help you.

Chip Molloy

The share count,we're at almost 131 million at the end of the quarter. We're expecting at theend of the fourth quarter to be around 129.2 million.

Operator

Your next question comes from Michael Baker - Deutsche Bank.

Michael Baker - Deutsche Bank

The fourth quarter outlook, $0.70 to $0.74, just trying togo through some of the math on some of the changes in State Line Tack and theMMI Holdings, et cetera. Can you just tell me, is the fourth quarter guidancedifferent than you would have expected the fourth quarter to come in when youdid your second quarter call? In other words, have you gotten a little bit morecautious? My math is maybe a $0.015 more cautious but I wanted to run that byyou.

Chip Molloy

When we gave the guidance, it was $2.02 to $2.07 for theyear, we didn't give a fourth quarter. But in the third quarter, we saved someexpenses on the SLT piece, and we picked up the gift card breakage. The giftcard breakage, we actually expected to receive that in the second half of theyear but we were relying on our third-party vendor that manages our gift cardsto give us the information so we can actually do the analysis. We were actuallyexpecting that later in the year, so it came in early. Basically, for thefourth quarter, we're feeling better than we did at the analyst call.

Michael Baker - Deutsche Bank

So the key there, is in October, when you said $2.02 to$2.07 in early October, you were anticipating $0.25 from the gift card breakage?

Chip Molloy

We weren't exactlysure on the exact magnitude either. We knew it was going to be a benefit, weassumed it was going to be a couple pennies, we just weren't certain on thetiming of it either and we were conservative as it relates to the timing.

Michael Baker - Deutsche Bank

But then again, as you just said, the bottom line isrelative to what you were thinking in October, you actually feel better aboutthe fourth quarter because as Phil said, things have gotten a little better.

On the pricing environment, I understand you're happy withthe price differential, but we've done some pricing studies and I know othershave as well. It does look like Petco's gone a little more sharper orpromotional in the last couple of months. Do you agree with that? How do youreact to that?

Phil Francis

Our focus is on the customer and taking care of our ownbusiness here. We watch pricing, we price against the whole market, not justanybody. We are aware, we have positioned ourselves where we have on purpose.We think we're still positioned where we have been versus the market. Our valueproposition includes services, it includes variety in the customer experienceand pricing.

We watch and respect all competitors, but we don't thinkthere's been a material change in our overall position in the marketplace. Ourmodel is price plus other things, and we think our model is intact as it hasbeen for several years.

Operator

Your next question comes from David Mann - Johnson Rice.

David Mann - Johnson Rice

My question is about the growth you're seeing in servicesacceleration this quarter and in general. Can you elaborate a little more onthe absolute growth you saw in grooming versus hotels, and perhaps let us knowin some level of magnitude what the same-store growth in services might havebeen?

Phil Francis

I don't think we've typically done that. My recollection ofthe year, we really called that out as an echo of what we did in our firstquarter call. We called out that unusually wet weather had hurt our groomingbusiness in Q1. That led to concerns that, gee, is this growth story over? Youdidn't do 20, are you going to miss your promise and so on and so forth. Withgood execution and that problem behind us, we've clawed back in Q2 and Q3 all ofthat Q1 shortfall, mostly in grooming because of wet weather in the shave downand clip season. We believe that with new stores and new hotels coming, we'recertainly expecting to achieve the 20% growth on the year. But we haven'tcalled those out. I think at analyst day we had differentiated growth ratesonce a year, but we've never done it on a quarter and I think we're going tocontinue that policy.

David Mann - Johnson Rice

I have a question on the food side of the business with therecalled product. As you put some of these SKUs back on the shelves, can youjust tell me a little bit on what the customer behavior has been? Do they comeback to those SKUs entirely or has their behavior changed by the recall?

Phil Francis

This is Phil. Myanswer is in good faith, but imprecise. It's some of all of that. A lot ofpeople are glad to see it back and just resume the behavior they had. We'vetalked a lot with our vendors and we share the same desire to repeat thebehavior and repeat the sales we all enjoyed. They are spending through us toachieve that with the people we can talk to with cards. It's a bit early totell just now. If you'll ask that again in 90 days from now, we'll have moredata and we'll try to let you know how much was substitution and how much wasreturn to the original product.

David Mann - Johnson Rice

I think as we go into the holiday season every year you talkabout the exclusive product that you have. Can you just give us some sense? Inprevious years how important this exclusive product has been, and then relativeto last couple of years how much more exclusively product do you have and howmuch more sales do you expect that to drive?

Bob Moran

I think if you talk to our store managers, they'll probablysay this is the best holiday assortment we have had in our history. Obviously,we're learning off of prior years, both from a price point and also from aselection point of view, so a lot more fashionable, a lot more exclusive. Rightinventories, right pricing, and the right presentation inside our stores.

David Mann - Johnson Rice

Thank you very much, good luck with the holiday.

Operator

Your next question comes from Peter Benedict - Wachovia.

Peter Benedict - Wachovia

Can you talk about how the customers, at least initially,have responded to the tests you guys are doing in pricing on the services sideof the business?

I just wanted to talk about some of the expense controlplans as we think out to '08, I know you're not giving guidance there yet butgiving us a sense of maybe what level of same-store sales may be required toleverage SG&A as we look out into 2008? Thanks.

Phil Francis

Pricing on services, the tests are continuing. We haveraised some prices. We are seeing no negative customer impact from that. The advantagewe have is we can do it geographically; in the case of grooming, we can do itby breed. In the terms of any competitor of ours figuring that out, it would bea terrific migraine headache to try to sort out what it is.

As we have opened new hotels, we've tried different pricing,if it's a ways away from an existing hotel. All of those we'll be measuringthrough the holiday. Whatever we learn, we will incorporate into the rest ofthe business for next year. We'll be able to be more definitive and we'll bakethat into the guidance we talk about on our fourth quarter call.

Bob Moran

Talking about expenses and expense leverage, as we looktowards 2008 I think you're going to see a continuing extension of our focus oncosts and cost take-outs. We've talked in the past about our labor managementsystem that we'll be rolling out next year. We've been doing a ton of processreengineering, especially in the merchandise movement through our supply chain,which not only affects task and also labor hours in the store but it's muchmore efficient from a point of view of building towards the customer experiencewe want to have inside our stores.

Then there's every single line expense, especially on thecontrollable side, putting a lot of focus on, be it supplies, be it travel, beit insurance, be whatever. We're looking at every single element and thenbringing state of the art type of work in. For example, we're looking atreverse auctions and bidding out a lot more in a number of areas so that we cantake a tremendous amount of savings.

A great example of that is the cost for our bandanas that wehave in the salons, we've been able to take a significant amount of cost out bydoing a little bit more global sourcing. Nothing is sacred and everything isbeing looked at to continue our focus on expense leverage going forward.

Operator

Your next question comes from Brian Nagel - UBS.

Brian Nagel - UBS

First, a point of clarification. As you look at the impactof the State Line Tack that you said in the press release was $4.7 million,which I figure is about $0.02. October 10 you said $0.04. Did something changethere?

Chip Molloy

We thought it was going to be about $7 million, which roundsup to about $0.04 in our pre-tax basis earlier in the year. A couple things.When we remerchandised space, we went at it, we tried to do it more efficientlywith those costs and manage that. As we sold through the product, we were ableto sell through the product without taking as many markdowns as we hadpreviously estimated. So at the end of the day, we felt like we managed throughthat exercise much better than we originally estimated. We saved a couplemillion dollars in the process from what we expected.

Brian Nagel - UBS

On the breakage charge in the quarter, I assume that $5.5million is some type of catch-up?

Chip Molloy

That's a catch-up. Since the inception of the gift cardprogram, those balances build over time, it's a catch-up for our currentliability of gift cards. That's a one-timer. As I said in the comments, wewon't see that kind of impact going forward.

Brian Nagel - UBS

Did you make any changes to the way you reserve for thatgoing forward?

Chip Molloy

No changes going forward at all. We're required to recognizegift card breakage. You can't do it when you first start selling gift cards atall, you have to create a history of redemption. Once you have a couple years'worth of history, then you can go back with your auditors and they evaluate it,you look at all the data, analyze it, estimate it, approximately how much willnot be redeemed.

Once you do that, it's a catch-up. A lot of retailers havebeen doing it in the last couple years. Our program is newer than many of theother retailers, once we had the data we were able to do it. Going forward it'sgoing to be a small amount each year.

Brian Nagel - UBS

Going back again to the announcement you made on October 10,at that time you tempered your guidance upon weather and general consumerconcerns. The weather now has turned more favorable and you're seeing yourbusiness improve, could you better dissect the impacts on your business betweenwarmer than expected weather and the general consumer weakness?

Phil Francis

The simple answer is no we can't. With the passage of moretime, we might be able to look back, but right now you've got recall andweather and State Line Tack going at the same time and the only variable isstore sales, it is those three. But our sense continues to be that there'sprobably some macro out there but we think it's less for us than it is forother people. If we can sort anything out, try this again in 90 days, and afterthe holidays should we be able to develop any more clarity, we would certainlyshare it with you.

Operator

Your next question comes from Mitch Kaiser - Piper Jaffray.

Mitch Kaiser - Piper Jaffray

Thanks guys, goodafternoon. I was hoping you'd comment, you saw an acceleration in servicessequentially despite the weak comp. Was there anything that you didpromotion-wise there? I'm surprised it accelerated given the weak comp.

Bob Moran

Actually when you look at services, the customersparticipate in that don't really probably worry much about the macroeconomicissues. They really spend through their loyalty to the brand. So if you thinkabout what Phil mentioned about Q1 andQ2 where we were impacted mostly in Q1, a little bit in Q2 by cold weather,we've been able to obviously accelerate that.

You do not ever use promotions in services. It's aboutquality. It's not about promotion at that point in time. So we just basicallywent back to the basics, talked to our customers. This is one of our businesseswhere we do have relationships, we do have conversations with the customer, webuild off of that and obviously we remind them about appointments. It workedvery well to the tune of 23% for the quarter. So I feel good that we're over20% for year-to-date.

Mitch Kaiser - Piper Jaffray

Just to clarify, was the gift card breakage or the buybackin the guidance that you gave at analyst day?

Chip Molloy

It was not. The amount was not included in our guidance forthe third quarter.

Operator

Your next question comes from David Cumberland - Robert W.Baird.

David Cumberland - Robert W. Baird

First a question on the State Line Tack space. For the storesthat were converted earliest, how has that part of the store been performing sofar?

Phil Francis

This is Phil. Ourexpectation when we did this that we'd ramp the sales up over a year. The veryearliest ones are about halfway into the year and the limited data so far, butthe data we have would say that we're on the path as expected. Please remember,we did the worst stores first and we did the best stores last. So it hasn'tmade much impact yet because the very best stores have been reset for two-and-a-halfweeks. But in the early days, on the worst selling State Line Tack stores,recovery has been on the path we projected.

David Cumberland - Robert W. Baird

It looks like the CapEx plan went up by $10 million; is thatright? What's the reason for that?

Chip Molloy

It went up slightly, we have some projects that wereoriginally planned in Q1 and we're just seeing some of our projects are aheadof schedule and we're starting to work those through and it's increased ourCapEx for the fourth quarter.

David Cumberland - Robert W. Baird

Chip, you mentioned the impact of the State Line Tack costson your operating expenses. Were any of those costs in your cost of sales andif so, what was the size of that impact?

Chip Molloy

It's immaterial. It'sa couple basis points but it's immaterial.

David Cumberland - Robert W. Baird

Last question in case I missed it, the contribution fromtraffic and ticket to your sales growth?

Chip Molloy

For Q3, thetransactions were 64%; those are total transactions. Dollars per transaction,36%.

Operator

Our next questioncomes from Chris Horvers - Bear Stearns.

Chris Horvers - Bear Stearns

As the comps recovered, did you see the mix recover? Hardgoods sales also picked up?

Phil Francis

I would not in the quarter validate what's implied in yourquestion here. Our consumables business is strong and the hard goods are moreimpacted by lack of cold weather than the consumables are. We would expect somenormalization in Q4 time period, as we look backwards here, the food businessconsumables is strong. When you have seasonal weakness related to cold weather,that's around the business but is more important in hard goods, I would not sayin Q3 they recovered proportionately. I would anticipate they would move awayfrom that trend in Q4. That's a good question to ask us 90 days from now.

Chris Horvers - Bear Stearns

It sounds like it's continued to pick up the first coupleweeks here in November. Is that fair?

Phil Francis

Well, early days.We're not in the habit of given monthly or daily or weekly kind of comps here.That's a policy we'd like to continue. We have seen some cold weather. We'reready for the holidays. The State Line Tack is behind us and the recall effectsare mitigating away and we're trying to run the business and take care of thecustomers very well.

Chris Horvers - Bear Stearns

The $2.02 to $2.07 that you put out at the investorconference, did that include the roughly $0.02 or did it not include the roughly$0.02 for the gift card breakage?

Chip Molloy

It did include forthe year, it just was the timing was off.

Chris Horvers - Bear Stearns

So it was in 4Q, so essentially 4Q is up by $0.02?

Phil Francis

Yes.

Operator

Your next question comes from Jonathan Kramer - Cowen.

Jonathan Kramer - Cowen

You guys made niceprogress on your inventory reduction. Just wanted to get the key drivers behindthat and also your thoughts on a sustainable rate?

Phil Francis

Jonathan, I'd love to talk about inventories because I thinkthat's been a focus not only this year but last year. It started last year bycustomers telling us that probably the best promise we could make to them isabout being in stock and we started experimenting with different levels ofstock to really focus, what is the optimal level? As we got back learning, we've been buildingthat into the system.

Simultaneously, we started really working on ourdiscontinued inactive inventories and obviously working on the State Line Tackinventory has really brought a lot more and better inventory productivity intothe system. We feel that focus and learnings will be applicable, not only forQ4 but into the future. We feel that we're moving in the right direction.

Operator

At this time, we are out of time for further questions. I'dlike to turn it back to management for closing remarks.

Phil Francis

Thanks very much. From all of us to all of you, we hope youand all of retail have a great holiday season. We'll talk to you in about 13weeks or so. Thank you.

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Source: PetSmart Q3 2007 Earnings Call Transcript
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