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PetSmart, Inc. (NASDAQ:PETM)

F1Q12 Earnings Call

May 22, 2012 4:30 pm ET

Executives

April Lenhard – Head of Investor Relations

Robert F. Moran – Chairman of the Board & Chief Executive Officer

David K. Lenhardt – President & Chief Operating Officer

Lawrence P. Molloy – Chief Financial Officer & Executive Vice President

Analyst

Matthew J. Fassler – Goldman Sachs

Alan Rifkin – Barclays

Christopher Horvers – JP Morgan

David Mann – Johnson Rice & Company

Gary Balter – Credit Suisse

Matt Nemer – Wells Fargo Securities, LLC

Michael Baker – Deutsche Bank Securities

Michael Lasser – UBS

Daniel Binder – Jefferies & Co.

Daniel Hofkin – William Blair & Company

Peter Keith – Piper Jaffray

Scot Ciccarelli – RBC Capital Markets

Operator

Welcome to PetSmart’s first quarter 2012 analyst conference call. At this time all participants are in a listen only mode. Later we will conduct a question and answer session and instructions will be given at that time. (Operator Instructions) As a reminder, this conference call is being recorded.

I would now like to introduce your host for today’s conference Ms. April Lenhard, Head of Investor Relations.

April Lenhard

Welcome to PetSmart’s conference call to announce our results for the first quarter of fiscal 2012. With me on the call today are Chairman and Chief Executive Officer Bob Moran, our President and Chief Operating Officer David Lenhardt, as well as Chip Molloy, Executive Vice President and Chief Financial Officer. Bob will kick off the call with an overview of our results and then Chip will take you through the financial review as well as our earnings guidance. David will review the operations of the business and provide insight to the remainder of the year and finally, we’ll take your questions.

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

Robert F. Moran

We are pleased to report another quarter of solid earnings growth. For the first quarter earnings per share were $0.85 up 39% when compared to $0.61 for the same period last year. Comparable store sales for sales in stores open at least a year grew 7.4% and comp transactions which we use as a proxy for traffic were up 3.3%. Our performance in the first quarter was due to the strength across all three merchandising categories: consumables; hard goods; and live goods as well as across services.

The PetSmart brand is strong, it is recognizable and it resonates with our customers. By focusing on solutions we provide the broadest assortment with unmatched customer experience all at great value helping our pet parents help their pets living long, healthy, and happy lives. And through our partnership with PetSmart Charities approximately 1,100 pets are adopted each day in our stores. We are proud to be able to partner with PetSmart Charities, the largest funder of animal welfare efforts in all of North America that help save lives of homeless pets and ensure that pets stay in happy homes which is why we proud offerings like the new adoption kits and puppy starter kits with valuable coupons for products and services.

Our knowledgeable associates are always available to answer any pet parent’s questions. I am proud of the success we have been able to achieve due to our hardworking and dedicated associates and our focus on providing innovative and differentiated solutions at great value further solidifying our position as the leading pet specialty retailer.

Now, I would like to turn the call over to Chip.

Lawrence P. Molloy

Today I will be reviewing our first quarter performance as well as providing guidance for the second quarter and full year. As Bob mentioned, earnings for the quarter were $0.85 per share which represents 39% growth when compared to $0.61 for the same period last year. Comparable store sales growth was 7.4% and comp transactions were positive for the eighth consecutive quarter at 3.3%.

Total sales for the quarter were $1.6 billion up 9.4%. The increase in total sales included an unfavorable impact from foreign currency fluctuations of $2 million. Services sales, which are included in total sales increased 8.3% to $181 million. Other revenue, which is also included in total sales was $9 million representing reimbursements from Banfield for the space they utilize in our stores. The sales mix for the quarter included consumables at 53.1%; hard goods at 33.4%; services at 11.1%; live pets at 1.8%; and other revenue at 0.6%.

Gross margins for the first quarter were up 90 basis points to 30.5%. Within the gross margin line, merchandise margins increased 15 basis points while services added 10 basis points to the overall rate. Store occupancy and supply chain were favorable 55 and 10 basis points respectively.

Operating, general and administrative expenses were 21% representing 40 basis points of leverage compared to the same period last year. Overall, earnings before tax increased to $140 million or 8.6% of sales. This represents 31% growth and 140 basis point improvement. The tax rate for the quarter is 34.4%. We expected a relatively low rate of between 35% and 36% coming into the quarter due to the impact the Banfield dividend has on the overall rate and some expected favorable settlements with states and municipalities. Both of those were slightly better than expected resulting in an additional 100 basis points of favorability.

During the quarter we opened 14 new stores and closed five. We also opened three PetHotels and closed one bringing out totals to 1,241 stores and 194 hotels. We ended the quarter with average inventory per store of $550,000, an increase of 3.2% compared to the first quarter last year.

During Q1 we generated $150 million in operating cash flow. Included in our operating cash flow was our second annual dividend from our investment in Banfield. This year’s dividend totaled $14 million. We are currently forecasting next year’s dividend from Banfield to between $8 and $10 million.

During the quarter we spent $36 million on capital expenditures, distributed $15 million in dividends and repurchased $175 million of PetSmart stock. Depreciation and amortization expense for the quarter was $60 million. We ended the quarter with $340 million in cash, cash equivalents and restricted cash and zero borrowings on our credit facility.

Although the macroeconomic environment still holds some uncertainty we remain cautiously optimistic about the outlook for 2012 and are confident in our ability to influence those things within our control to continue to deliver on our commitment on driving strong operating results while maintaining a healthy balance sheet.

As a reminder, 2012 contains a 53rd week. The annual guidance is for 53 weeks however, I again will summarize at the end the impact of the extra week on several key measures. For the year, we anticipate comp store sales growth in the mid single digit range and total sales growth between 9% and 10%. We are raising our earnings per share guidance from our previous range of $3.02 to $3.16 to our current expectations of $3.19 to $3.31.

We now expect our gross margin to improve 65 to 75 basis points. OG&A to grow in dollars 8% to 9%, interest expenses to be down slightly and EBT margin to expand 90 to 110 basis points. We anticipate an annual tax rate of approximately 38%. The impact of the extra week is expected to be $120 million in sales, almost 20 basis points of the gross margin expansion, $19 million of incremental OG&A expense, 30 basis points of the EBT expansion, and $0.16 of EPS.

For the second quarter of 2012 we are expecting comparable store sales growth of mid single digits and earnings per share of $0.61 to $0.65. EBT margin is expected to improve 30 to 50 basis points when compared to the second quarter of last year. All of the EBT margin expansion is expected to come from gross margin.

OG& expenses are now expected to grow 7% to 8% and could produce some slight deleverage. The higher increase in cost year-over-year is driven primarily by the two major resets taking place in our stores this quarter. The tax rate for the second quarter is expected to be close to 40%. We remain committed to our long term guidance and believe we have an operating plan that can deliver on those goals.

With that, I would like to turn it over to David Lenhardt who will highlight our first quarter activities and provide insights into the remainder of 2012.

David K. Lenhardt

As Bob mentioned, we continue to see strength across all of our merchandising categories: consumables; hard goods; and live goods as well as services. With the integration and alignment across our merchandising, marketing, supply chain, and store operations teams we successfully executed a full consumables reset across the entire chain during the first quarter.

With our strong vender partnerships and focus on innovation we expanded the space dedicated to super premium channel exclusive foods, our fastest growing category, added innovative new formulations, and expanded grain free assortments of both dog and cat. We are pleased with the early results of the reset and believe that we are well positioned to maintain our competitive advantage by carrying our pet parent’s favorite food brands.

Going forward we have a number of other resets planned this year. As the pet specialty retailer with the largest selection of dog toys we are excited to be able to refresh and rebrand our toy isle in the second quarter with a new PetSmart toy chest look and feel. This compelling reset will include some exciting changes including new items like the exclusive line of bright fun new toys under the ToysRUs Pet’s brand name.

We will also be launching the Brett Michael’s Pets Rock collection in the second quarter through our exclusive partnership with the legendary rocker and dedicated pet owner. Brett has designed a line that promises to be edgy, fun, and cool allowing us to offer newness to our existing customer and tap into a new demographic as well.

This summer we will also be resetting our aquatics and small animal categories within our live business that will create an improved shopping experience in the aisles and continue to support the strong growth in these categories. We’ve worked hard to establish a culture and pipeline of innovation with strong vendor partnerships that will allow us to continue to differentiate our brand well into the future.

Services had another strong quarter with positive comps across the board. Our quality of care and grooming and messaging around the look great guarantee continued to drive sales and we’re seeing strength in the PetsHotel and pet training businesses as well. We are excited to be able to better serve the customer and improve our operational efficiencies through our PetsHotel call center which is in the process of being rolled out nationally to all our hotels by the end of the fiscal year.

We remain focused on telling our story of differentiation through compelling marketing campaigns that message the exclusivity of our key brands and highlight our value proposition. Our customer satisfaction scores continue to reach all time highs reflecting our unique in store shopping experience and authentic engagement from our passionate associates. Our focus on customer engagements includes new programs like our puppy starter kits that we rolled out in the first quarter.

These kits enable our associates to engage with new pet parents in a meaningful way with helpful resources and valuable coupon savings for products and services that enable a new pet parent to start their puppy off right. As Bob mentioned, the PetSmart brand is strong and it resonates with the customer. The highly differentiated experience in our store backed by the strength of the alignment across all areas of our business is a powerful competitive advantage and not easily duplicated and that is what sets us apart as the leader for products, services, and solutions for the lifetime needs of pets.

With the strength of our differentiation and pipeline of innovation we will continue to execute on our strategic priorities at every level of the business to deliver strong shareholder returns through 2012 and beyond.

With that, we would like to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Matthew J. Fassler – Goldman Sachs.

Matthew J. Fassler – Goldman Sachs

First of all, as I do the math on traffic and ticket to the extent that I think comp traffic was up in the low threes, suggested ticket that was up in excess of 4% which would be a real turnabout from where you were in Q4 and the strongest ticket growth you would have had in over three years. So if I got those numbers right, if you could please talk to what’s producing that strength?

Lawrence P. Molloy

A couple of things one, you’re right traffic is just north of 3%. We are getting more units in the basket so from a units per ticket we’re getting slightly more units in the basket. That’s been steadily improving. Then there’s a little bit of AUR in there, primarily on the inflation front but that’s where we predicted it would be, call it 200 basis points, but net/net that drives ticket.

Matthew J. Fassler – Goldman Sachs

My second question relates to the online business. I noted in your proxy that some members of your senior management are actually now getting compensated in part on growth in your Internet business. I know historically this was not a major focus for you, presumably you or the board see some importance to it. It’s been a very controversial category so is there a new line of thinking about what the online channel can do for you and how you’re going to come at that segment?

David K. Lenhardt

I actually think it’s an extension of the thinking that we’ve had. We very much view what we would call the omni channel opportunity as something that we need to focus on. We think that increasingly customers are looking to interact with us wherever, whenever, and however they want and we think we’ve got an opportunity given that to really work on extending our in store customer experience online and really creating a seamless integration between our online and offline channels.

A piece of that is clearly our eCommerce business which we continue to be happy with but the other piece of that is all around again, how do we offer that seamless experience with a customer. As we talk to our board about that I think we collectively felt like a piece of our bonus being tied to eCommerce makes sense. I would point out though that it’s 10% of our bonus and that the other 90% is on sales and profit. So I think we have it appropriately scoped out given that.

Matthew J. Fassler – Goldman Sachs

Do you have any evolution in the kind of fulfillment options that you’re making available to consumers who choose to order online?

David K. Lenhardt

That’s something that we’re continuing to evaluate. I don’t have anything to report on that now but absolutely when you think about fulfillment that’s the single biggest cost item from an eCommerce perspective so I think we’re continuing to look at ways to reduce that cost and different ways to serve that customer.

Operator

Your next question comes from Alan Rifkin – Barclays.

Alan Rifkin – Barclays

With the unseasonably warm weather in Q1 can you maybe quantify Chip, the impact if any, from flea and tick on both comps as well as gross margins? Then, I have a follow up.

Lawrence P. Molloy

Weather is not a big driver of our business. The two categories it can impact is flea and tick which is a better business in warmer weather and apparel which is a better business in colder weather. Just like in Q4 we did have in Q1 a very, very robust flea and tick business relative to last year. Apparel was not as good as we would have liked coming into the quarter but it was okay. It really didn’t impact overall both on the sales side – there was probably some margin impact in there but we overcame that through other things that happened from within the business that actually made the merch margin better than we expected coming into the quarter.

Alan Rifkin – Barclays

One follow up if I May? Could you may just shed some color on what you’re seeing with respect to adoptions? I know that’s been a very good leading indicator in the past. What are you seeing at the store level with respect to any increases in that category, if at all? And, what that may mean for the remainder of this year?

Robert F. Moran

Let’s talk about adoptions from a point of view that we really started to see an increase in Q4 of ’11 and we’ve continued to see that type of increase going into Q1 so it’s encouraging. But, I don’t think we have enough data points to say if it’s a trend at this point in time. Obviously, what we stay focused on is our relationship and partnership with PetSmart Charities so that we can build national programs, especially with our vendor partners, to continue to save lives in that way. I think there’s more to talk about in subsequent quarters at this point in time so we can talk about a trend line but the same types of trends that we saw in Q4 have continued into Q1.

Operator

Your next question comes from Christopher Horvers – JP Morgan.

Christopher Horvers – JP Morgan

Just a follow up a little bit on not necessarily the weather but perhaps intra quarter trends, most retailers even those not necessarily weather sensitive saw a bit of a slowdown in April and you’re guiding mid single digits for the second quarter so I’m just curious if that’s just being conservative because the comparison is the same or is that because of something that you’re actually seeing in the business?

Lawrence P. Molloy

I would say a couple of things. One, as I said earlier, there’s a little bit of direct impact on our business from weather in those particular categories. Fortunately for us, they are kind of counter to each other. I would say that we probably did benefit indirectly with this a really strong consumer in the first quarter as they were out and about shopping throughout all of retail. But as we go into Q2 we feel really solid about Q2. I think our guidance for mid single digits, we are going to start to comp some of the inflation impact that started to hit in Q2 of last year so we’re starting to comp against that but generally we feel pretty good about the business right now going into the quarter. We feel very solid.

Christopher Horvers – JP Morgan

Then could you just talk about how you think about inflation into the balance of the year?

Lawrence P. Molloy

Yes, so it’s peaking right about towards the end of Q1. We had some cost increases last year. I would say about 30% of our business last year had on average a 6% increase and that was in the middle of Q2 so that’s kind of peaked now. We’re looking at close to 200 basis points for Q1 and then we’ll start to lap that going into the next quarter. There aren’t really a lot of cost increases that we know about as we sit here today for the balance of the year so we’ll lose a little bit of the inflation impact as we filter through the remainder of the year.

Christopher Horvers – JP Morgan

So maybe it goes down to 100 basis points in the back half or something like that?

Lawrence P. Molloy

Yes, it could be probably 100 or even less.

Christopher Horvers – JP Morgan

Final question, it looks like your occupancy per store was actually lower year-over-year were there any unusual items in there? Were there [inaudible] or abatements and how do you think about occupancy dollar growth going forward?

Lawrence P. Molloy

The one thing I’d say was utilities were light. It was good weather for us so that was the piece there. I think you’re still going to see some leverage in Q3, a little bit less in Q4 as we anniversary some good utility costs in Q4.

Operator

Your next question comes from David Mann – Johnson Rice & Company.

David Mann – Johnson Rice & Company

The numbers you gave in terms of the consumables and hard goods percentage it looks like the mix shift is amongst the smallest change year-over-year that we’ve seen in years. Can you just elaborate a little more on what you’re seeing there and maybe might we actually see that mix shift not necessarily happen – what do you think might happen in upcoming quarters?

Lawrence P. Molloy

A couple of things, one is I would say you are correct, not as much mix shift. Our consumables business still did outpace the overall core so if you go in sort of order of events here, consumables was our strongest. Live was actually our second strongest although a smaller piece of the business. Services was pretty much in line with the average and hard goods was under slightly but still a very strong quarter for hard goods.

Because the consumables business is just doing so well, we just did another consumables reset and naturals are growing and our treats, and our rawhide business is going well it’s hard to predict when the hard goods would actually take over the consumables from a growth perspective but if we could continue to comp this way with this kind of mix we’d still be pretty satisfied.

David Mann – Johnson Rice & Company

Then the merchandise margin kind of guidance that is implied within what you’ve talked about on gross margin, how do you expect that for the rest of the year?

Lawrence P. Molloy

For second quarter I think most of our overall EBT margin is going to come from up above in gross margin. You’re going to see probably, right now, we’re thinking close to 10 basis points on the merch side. We are anniversarying a pretty nice pick up last year in Q2 on the merch size so we get about 10 basis points there. We’ll probably get close to 40 on the rent and occupancy line and I would call services and supply chain pretty much a push. Then as we move forward through the balance of the year I think we’re going to get a little bit more on the merch side and probably a little less on the rent and occupancy side as we go in, all in, on a 52 week basis I think the gross margin pick up in the back half of the year should look similar to Q2.

Operator

Your next question comes from Gary Balter – Credit Suisse.

Gary Balter – Credit Suisse

Could you talk about our private label percent and where – assuming it grew given what’s going on with all the programs you have going on, but what impact that had on your sales and margins?

David K. Lenhardt

Our proprietary brands are running at about 22% which is pretty much in line with where they’ve been the last couple of quarters. That continues to be obviously a very big focus for us, not only the proprietary side but the exclusive brands and I think you’ll continue to see us focus on that. We’ve got a number of new offerings that are just hitting the stores now. We have ToysRUs Pet, that’s part of our toy chest reset that we just finished and we’ve got some others coming out in terms of Brett Michaels going forward.

Lawrence P. Molloy

I would add to that that strategy really has never been about margin, it’s been much more about exclusivity. There is some margin pick up there generally but it’s really around the exclusive nature and a lot of that work has been done – in the good, better, best range a lot of that work has been done in the best so that does help overall not just the AUR but also the margin rate a little bit. But it’s not the traditional proprietary brands where you’re picking up 1,000 basis points.

Gary Balter – Credit Suisse

The overall results are so strong that it begs to question are there changes that you’ve done in either your advertising approach or some of the presentation that are helping this? Like it’s not just all of a sudden all the pets decided to go shop at your stores, I assume so can you discuss some of the strategic changes that you made?

David K. Lenhardt

I would suggest that it’s a continuation of the focus that we’ve had and in particular I don’t think it’s any one thing, it’s a number of different small things working and in particular, I think the integration that we now have from our merchants to our supply chain, to our marketing team, to execution in the stores I think is leading to the results and so whether it be a consumables reset, whether it be the launch of our toy chest, to our new puppy kits, what you’re seeing is we’re taking an innovative approach to all of those pieces started with merchants making sure we have the right product in the right store from the supply chain perspective.

We are messaging from an integrative perspective using all of our channels and marketing whether it be online, whether it be CRM, whether it be direct mail, whether it be television, whether it be education of our associates. And finally, we’re executing in the stores. I think when you put that all together over time consistently you start to see the momentum that we have.

Gary Balter – Credit Suisse

Finally, David and Chip when you were in town, I guess it was a year ago, the worry you remember is Wag was about to start and it was going to destroy you guys and you won’t be in business and whatever. Obviously, that hasn’t happened your stock is up $20 or $25 higher. When you look at how you’re doing versus the Internet, could you talk about are there areas that are having impacts there where you’ve had to change your pricing?

David K. Lenhardt

We haven’t had to take any actions. We continue to see no impact from any online competition to either our own eCommerce business or our bricks and mortar business. We do think it’s important, as I said, to really focus on an omni channel strategy and again, really improve the integration between our online and offline worlds and so you’re going to see us continue to focus on our eCommerce and our website from that perspective.

So specifically, we’re focused on continuing to improve the website experience. If you go to PetSmart.com today over the last probably month I’d say, you will have noticed some changes from the way we looked three months ago. We’ve got enhanced content around our product. We’ve also made it easier to find our product and I think you’ll notice if you just go to our landing page on PetSmart.com. So we’re continuing to focus on that.

We’re continuing to focus on extending the aisle and adding on new SKUs online that we don’t have in stores. We’ve added about 1,500 of those in the last several months and as I said earlier, we’re continuing to focus on evaluating different fulfillment options. But we’re doing that all in the context of an omni channel world where our physical stores and our online presence interact with each other to help differentiate ourselves.

Operator

Your next question comes from Matt Nemer – Wells Fargo Securities, LLC.

Matt Nemer – Wells Fargo Securities, LLC

I wanted to talk a little bit more about operating expenses. You were up a little over 7%, clearly on a great sales performance, you had more store openings year-over-year, you had the consumables reset, are there any other expense buckets within OG&A that stand out for you that are driving that number higher or perhaps lower?

Lawrence P. Molloy

I would say just one or two things, one is advertising is up so we are deleveraging at the advertising line which we had intensions of doing that coming in and then on some of the benefit costs are a little bit higher so that’s growing a little bit higher with a little bit of deleverage there. Those are the only two. There really weren’t a lot of reset costs in Q1, there are some in Q2 so in Q1 we got through the product we wanted to get out of the space, now we’re actually executing both the toy chest reset as well as our specialty reset this quarters so there’s a little bit of charges in there for Q2 to get that completed. But outside of that nothing extraordinary.

Matt Nemer – Wells Fargo Securities, LLC

Secondly, we’ve been reading that you’re testing in store pick ups in certain locations. I realize it probably hasn’t been up and running for that long but can you just talk to the response and how does that work within stores? Is there an area where you have enough rooms to keep bags of food, are you able to carry it out to someone’s car? Just talk about the multichannel opportunity around in store pick up.

David K. Lenhardt

At this point we are not testing in store pick up in any of our stores. As we think about an omni channel world and different fulfillment options something like order online pick up in store could be something that we might do but at this point we’re not testing it in any of our stores.

Matt Nemer – Wells Fargo Securities, LLC

Lastly, Chip you mentioned that the Banfield divided is expected to decline quite a bit next year versus this year. Can you just explain that?

Lawrence P. Molloy

We’re kind of counting on $8 to $10 million a year. It was a little bit more this year. Remember first, it just started last year so you got a pretty big dividend because they were essentially resetting their balance sheet so it was a pretty big number last year. We were expecting $8 to $10 million a year, it was a little bit extra so we got $14 million this year. I think a lot of it is around how much they choose to invest in their business. So every year they review their own capital need and their own investment needs and actually David and Bob sit on their board so they’re part of that equation. So as we sit here right now I like to think about it as an ongoing $8 to $10 million number and then there may be some years that there could be some upside to that depending on the needs of their business.

Operator

Your next question comes from Michael Baker – Deutsche Bank Securities.

Michael Baker – Deutsche Bank Securities

Hopefully this is right, I guess you’re not testing in store pick up but I think you tested free shipping online at some point in the quarter? First of all, is that right and secondly, what did you learn from that test?

David K. Lenhardt

As part of everything we’re doing with omni channel you’re going to see us testing a number of different things. We have been offering free shipping, we’re offering it right now online with a $49 purchase. Now, that does exclude food and liter where we have a lot more extended aisle SKUs that aren’t available in store. Clearly, if we get a more attractive basket that helps the economics of fulfillment. We’ve also been engaging our vendors a lot more on that front so that’s something I think again, we’re trying to test and learn as we go through that. Clearly, as we talked about before, free shipping is a challenge from an economic perspective. We want to be profitable online and so we’ll continue to test and learn as we go through the year.

Michael Baker – Deutsche Bank Securities

Can you discuss what you might be seeing in terms of a customer response to that?

David K. Lenhardt

No, we’re not going to discuss that.

Michael Baker – Deutsche Bank Securities

One more if I could, I say this in the context of it was obviously a strong quarter but your services growth up close to 9%, a very good number. But, as I count back here, the slowly growth in 20 or so quarters so what in particular slowed there? I don’t think it’s a reason to be concerned but just curious where you did see the slowdown?

Lawrence P. Molloy

One, I would say is if you think about that business the grooming business is a fairly mature business so that kind of grows in line with the overall core. So number one, that’s been that way for a while. For a while there the growth was being driven a lot by the building of new hotels and then that slowed, and then the hotel business picked up. So we’ve been seeing double digit comps now for several quarters in the hotels businesses.

We did see a double digit comp this past quarter, although it was low double digits, it’s still growing nicely and I think you’re going to see that business continue to kind of mature because we’re not building a lot of new hotels so that’s not going to drive it. It’s going to be much more in line with overall comp but we’re very happy with the performance.

Operator

Your next question comes from Michael Lasser – UBS.

Michael Lasser – UBS

On the traffic side, do you think you gained share during the period?

Lawrence P. Molloy

It’s hard to tell at this point because we’re beyond that. Our business, as most folks are well aware, is very difficult to get really good share data. But with that kind of comp, and that kind of traffic, we love to think we’re gaining share.

Michael Lasser – UBS

Then coming into the quarter you had expected some modest amount of merch margin erosion from the reset, the consumable reset, did that happen? And if it did, what was strong enough to offset that?

Lawrence P. Molloy

The erosion we were expecting to come into the quarter was less around the consumer reset. That doesn’t cost us a lot, it’s very easy to do and we don’t have to flush out a product typically. When we start to do hard good type resets or other areas of the store you have to make room – in many case you’re getting rid of the SKUs or you’re doing some SKU optimization. You have to get through that, if there’s some markdown activity that goes on to get through that product.

So in Q1 we were expecting that to happen for both the toy chest reset as well as the specialty products or live goods area reset. We got out of that products, or the products we were going to at a better rate than we expected so that was a very nice story for us. Then on top of that, as someone pointed out earlier, our difference between consumables and hard goods, the delta was very small from a comp perspective so we didn’t have that draining against us. Then within the categories, natural foods are still growing, natural and super premium are still growing super nicely. Our treats and our rawhide business, high margin business within consumables growing very nicely, and our consumables around the live pets area growing very nicely and those are high margin consumables. So all in it was a nice quarter for us relative to what we thought coming into the quarter on a merch margin perspective.

Michael Lasser – UBS

Are you already starting to see some benefit from the consumables reset?

Lawrence P. Molloy

Well, we’re hopeful and it’s embedded in our guidance so we’re hoping it’s going to be there.

Michael Lasser – UBS

Last one for Bob, with the puppy adoption kit it seems like a really smart strategy. I know in the past you’ve talked about if someone gets their initial supplies at PetSmart they tend to be [inaudible], I forget the highest quality customer so what does that suggest about a) have you seen success with it and what does it suggest about the future potential that you could see from this strategy?

Robert F. Moran

Well, we’ve always been a puppy business and obviously we took a couple of steps back because of the high correlation between housing and pet acquisition. As we said, we’re seeing encouraging trends in adoption which is kind of a proxy but you have to keep in mind that adoptions are only about 25% of the pet acquisition world. But, good companies make themselves stronger as they see opportunities in the future and we see a nice opportunity in the future with the puppy kit.

It’s directed towards customers who already had pets and are bringing new pets in and/or new entry customers coming in. But the whole desire of this is to really drive the customers to the Smart or Smart with Heart side and both of those sides we’re seeing nice improvements in customer increase. So that’s the intent and obviously the kit is designed to help a pet owner to become a pet parent and in that world we get the opportunity to tell our stories and then we can match that up with our nice marketing, integrated marketing programs/campaigns and events. I think we match pretty well up with the stories that we can tell to our pet parent customers.

Operator

Your next question comes from Daniel Binder – Jefferies & Co.

Daniel Binder – Jefferies & Co.

Two questions, first on the rest costs going forward, I’m just curious if you can give us a little bit of quantification of what that looks like in Q2 and any color on the balance of the year in terms of the reset costs year-over-year how that’s impacting earnings? Then the second question is related to the web business, online you’re offering food now I’m curious – in some situations it looks like you offer delivery and in others it’s in store pick up. I’m just kind of curious what determines how the customer ends up getting the product?

David K. Lenhardt

I can answer the first question, the later question and then Chip will jump in. In terms of food online again, we’re not offering in store pick up of anything online but we do offer food. You’ll see that we tend to be tilted towards the more premium foods that have higher margins versus the grocery foods.

Lawrence P. Molloy

On the guidance there in the script for OG&A we’re expecting OG&A to grow in the second quarter in totality 7% to 8%. Embedded in that are some of those reset costs. Going forward I think in Q3 and probably the latter half of the year it will be a little bit less growth but not much. So there are other things moving different directions but we’ll have a little less growth overall the back half of the year on OG&A.

Daniel Binder – Jefferies & Co.

So resets overall is it similar in terms of drag on expenses year-over-year? In other words, you had reset costs last year, right?

Lawrence P. Molloy

It was a little more last year.

Operator

Your next question comes from Daniel Hofkin – William Blair & Company.

Daniel Hofkin – William Blair & Company

A question a little bit within the merchandise categories can you talk about what drove – was there greater incremental contribution than in recent quarters for example from premium and super premium food? Then I’d ask the same question within hard goods, what are you seeing from some of the newer brands, recognizing that Martha Stewart is about two years old now, but how is that brand performing and anything you can share there in terms of what’s driving the strongest performance?

Lawrence P. Molloy

I would say I would take consumables first and a couple of things driving that. One is naturals is continuing to grow at a pretty nice clip and has really not slowed down. You are seeing on the cat side actually the cat was behind dog I would say from that growth perspective so we’re seeing some nice growth on the cat side on higher end foods which is really nice. Part of the reset is helping that as well.

I would say that both our treats business and our rawhides business are very solid. Those are high margin businesses for us. The premium food which had not been doing very well is stabilizing more so we’re in a better place there and the lower end foods are not doing that well so grocery is probably the weakest area, especially on the dog side, but both in dog and cat.

Now, on the hard good sides really good, really solid year-over-year across the board. Not the same kind of growth as you’re seeing in consumables on average but really nice. We’re seeing some improvements in toys, it is literally across the board it’s a little bit everywhere. The only weak spots we’ve seen is on lower end things like grocery foods are lower. Then on everything associated with that specialty space, so all of – and you think of small animal, bird, aquatics, reptile, that entire section of the store makes up about 13% of sales. We only talk about the live and break that out for you which is about 1.8% but the other 11% is about 50% consumables 50% hard goods and that whole space is doing very well for us right now and it’s very encouraging.

As you see folks get into small animals or they get into aquatics, it’s an entry level place for a lot of our customers to become pet parents so we’re very encouraged. A lot of that we think is the work that’s been done over the last two years in that space with some more work to come this quarter.

Daniel Hofkin – William Blair & Company

Do you attribute that – I mean, it sounds like that particular development is more recent in terms of the live including the animals as well as the good, that pick up is more recent. Do you attribute that to your own initiatives or anything else you would point to?

Lawrence P. Molloy

I would say that’s actually been going on now for probably about four quarters or so. We did do a reset last year and we put in some better signage and we gave some more space to reptile which is our fastest growing. But I do think, and we don’t like to attribute everything to ourselves, but that’s one area of the store that I can tell you the innovation and what are merchants have been able to do in that space has really been exciting.

I think you’re going to see some very exciting things in that area in the later part of this quarter after we finish the reset from an adjacency perspective, from an education to the customer perspective with signage that says, “Hey, if you’re going to get into this type of pet these are the things that you need.” So from a basket perspective I think you’re going to really like what you see and our merchants have done just a heck of a job in that space.

Daniel Hofkin – William Blair & Company

Just real quickly back to your comment about grocery, the lower end grocery food brands it seems as though – has that softened or is it just that’s weakest on a relative basis?

Lawrence P. Molloy

It’s weakest on a relative basis but it’s been weak for a while.

Daniel Hofkin – William Blair & Company

So not really a change?

Lawrence P. Molloy

No.

Operator

Your next question comes from Peter Keith – Piper Jaffray.

Peter Keith – Piper Jaffray

Back at your analyst day you had talked about testing some localized assortment and pricing here in 2012. I’m just curious if you’ve started to kick that off and if you’ve had any near term observations?

Lawrence P. Molloy

Actually, we were just doing more of a national level, I would say less localized level for this year. We’re doing price optimization on a national level. We have a tool that we’re using and we’re trying to play around with that and we are getting some benefits there. We are also getting some benefits on the markdown optimization piece of that tool which are taking place this year and a little into next year.

The more localized – the complexities associated with that are exponential and it’s going to take us some years to get there. It is on our plate of things to do and we have sort of an approach to get there but it’s probably going to be well into next year or the year after before you start to see any benefits from that work.

Peter Keith – Piper Jaffray

So it sounds like the price optimization already is playing into merch margin a little bit?

Lawrence P. Molloy

It is, it is.

Peter Keith – Piper Jaffray

Separately, your share repurchases at $175 was quite high. It looks like you have already done over 60% of kind of the guided share repurchase amount for the year. Are you still thinking that $279 million or potentially we could see that come up and maybe be a little bit higher than your standard 4% to 5% share repurchase yield?

Lawrence P. Molloy

No, I don’t think we’re going to go any higher than the 4% to 5%. We have $103 million left on our current authorization. We’ll utilize that going into the rest of the year. We do look at our capital structure, we talk about distributions both on the dividend side and the share repurchase side in the summer with our board. Like the last couple of years, we’ll have that discussion and figure out where we’re going to go from there.

Operator

Your last question comes from Scot Ciccarelli – RBC Capital Markets.

Scot Ciccarelli – RBC Capital Markets

I guess the first question is you guys have continued to reset various parts of the store and we’ve obviously seen some of the mix shifts that have occurred between consumables and hard goods. Has there been much reallocation of space in the stores between categories?

Lawrence P. Molloy

There has not as of yet. That may come at a later time but for now, when you think about consumables our store is sort of set up consumables both dog and cat, hard goods, and then the specialty side is sort of set up by species. But you haven’t seen reallocation across the big categories. Within the categories you have so for instance, the food reset we’ve given more to the higher end foods that are seeing much higher velocity, they have earned their space and we’ve taken away from some of the other food sections of the store. At some point in the future we may, but right now the space by the big categories has stayed pretty consistent.

Scot Ciccarelli – RBC Capital Markets

Just a question about the pet adoption commentary earlier, have you actually seen some improvements in the housing sector in certain geographic areas and given the correlation we’ve historically seen between home ownership and pet adoption I’m just curious if you can draw any conclusions regarding the increase in pet adoptions you’re starting to see and some of the changes we’ve started to witness in some of the housing markets?

David K. Lenhardt

It’s too early to tell on that front. I think if we’ve had some housing indicators they’ve been very recent and I think we’ll have to see some broader trends but you absolutely are right that housing starts more broadly is very highly correlated to pet ownership and I think that will be the big driver that if and when that gains acceleration you’ll see movement on the pet ownership side.

Robert F. Moran

I think we’ve come to the end and I just wanted to thank everybody for joining us today and we look forward to speaking with you again in August.

Operator

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

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