Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message| ()  

Executives

Tawni Adams - Manager of Investor Relations

Robert F. Moran - President and Chief Operating Officer

Philip L. Francis - Chairman and Chief Executive Officer

Chip Molloy - Senior Vice President and Chief Financial Officer

Analysts

Matthew Fassler-Goldman Sachs

Michael Baker-Deutsche Bank Securities

David Schick- Stifel Nicolaus & Company, Inc.

Peter Benedict -Wachovia Securities

Brian Nagle-UBS

David Mann-Johnson Rice & Company

David Cumberland-Robert W. Baird & Co., Inc.

Dan Wewer-Raymond James

Christopher Horvers-Bear Stearns

Charles Grom-J.P. Morgan

Joan Storms-Wedbush Morgan Securities Inc.

Joe Feldman-Telsey Advisory Group

PetSmart, Inc (PETM) Q4 2007 Earnings Call March 5, 2008 4:30 PM ET

Operator

Good day ladies and gentlemen and welcome to the PetSmart fourth quarter 2007 analyst conference call (Operator Instructions) I would now like to introduce your host of today’s conference, Miss Tawni Adams, Director of Investor Relations. Miss Adams, you may begin.

Tawni Adams

Good afternoon and welcome to PetSmart’s conference call to announce our results for the fourth quarter and for all 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 Chip Molloy, Senior Vice President and Chief Financial Officer.

Phil will kick off the call today with an overview of our fourth quarter and full year results. Then Chip will take you through the financial review of the quarter and the year, as well as our earnings guidance for next year and Bob will provide a review of the operations of the business. 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. 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 petm.com.

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

Philip Francis

Thanks Tawni. Our current situation is unlike anything this business has experienced in the past. The last time the consumer cut back to this degree was in the early 2000’s. At that time, PetSmart was coming out of a turn around and we were getting real benefits from our new pet specialty business model. With a more established model, we are experiencing more of an impact from the current economic slow down.

Our top-line performance for the fourth quarter of 2007 was weaker than we expected coming into the quarter. And because we’ve been investing in growth, we’ve built a fixed expense structure that is difficult to leverage with a weaker top line. Those two factors were the drivers of our disappointing bottom-line results.

Our comp store sales growth was 0.8% for the fourth quarter and we delivered earnings per share of $0.59. Excluding the impact of the fourteenth week and the cost to exit the State Line Tack business, earnings per share for the quarter were $0.52 or down 7% compared to the fourth quarter of last year.

For the year we delivered comp store sales growth at 2.4% and earnings per share of $1.95. After two quarters of top-line weakness, it’s hard to argue that the macro economic environment is not impacting our business. Comp store traffic was down 2.6% for the quarter and our customers spent less on hard goods, which tend to be more discretionary. In addition, we are continuing to see some weakness from our decision to exit the State Line Tack business and we believe we still have some work to do to win back some of the sales from the pet food recall. We saw strength in our consumables and services business, but it was not enough to offset weakness in other categories.

Clearly PetSmart has been in a growth cycle for some time: Investing in stores, remodels, PetsHotels, distribution facilities, IT infrastructure and operating initiatives. All that has helped us build a highly competitive business model and deliver impressive top and bottom-line performance for the past seven years. However, as I mentioned earlier, it has also left us with a cost structure that is difficult to leverage with a weaker top line. We recognize if we want to deliver ongoing earnings growth, we have to maximize the performance of our current asset base. This is not a change in our fundamental strategy, but a more balanced approach between investing for the future and maximizing our greatest opportunity to deliver consistent shareholder returns. So let’s take a look at how we expect this more balanced approach to go.

First, we plan to slow our capital spending. In 2007 we spent $294 million or approximately 6.3% of sales: Our capital spend for 2008 is planned at less than 5.6% of sales, we expect to reduce our capital expenditures to around 4.5% of sales in 2009 and around 4% of sales in the out years. To deliver on our capital spending targets, we’ll reduce the number of new stores and PetsHotels we open. Our real estate investments for 2008 have been committed for some time. So, we still expect to open between 100 and 104 net new stores this year. However, we have reduced the number of projected Hotels from 50 to 45. For 2009, we’ll reduce the number of new stores by about 20% while Hotel growth should remain steady at 45 to 50. Beyond 2009, we’ll balance our store growth, our PetsHotel growth and our infrastructure requirements and stay within the confines of our capital expenditure targets. It’s a plan that lets us retain and extend our competitive advantage and at the same time manage our costs. Next we’ll continue to manage expenses by focusing on consistency in execution in our more than 1000 stores. We’re managing the store label line carefully and we’ve introduced a number of new processes and policies aimed at making our operations more efficient; from how we work with vendors at the front end of the supply chain, to how we manage merchandise inside the store. And finally, we’ll keep looking for ways to drive top-line growth and maximize the performance of our current asset base.

In this difficult environment we’re intently focused on driving trips and transactions and on taking great care of the customer.

Our total lifetime care strategy of providing solutions to every pet parent that enters our store remains the touch stone of our business. As I mentioned we have an excellent business model with a number of competitive advantages. We’re the leading player in pet specialty. We have a winning offering of services and merchandise under one roof. Our services business is an important differentiator that lets us develop relationships with customers. Our stores are in great shape to delight our customers. Every store in the chain has been remodeled in the last five years. We’re fully out of the State Line Tack business and focusing our resources on our core strengths. On top of that PetSmart associates are passionate about pets and committed to making this business the best that it can be. And we have all of our senior management positions filled with talented leaders who are focused on driving our business.

With that, I’d like to turn the call over to Chip Molloy to give you more detail on our financial performance for the quarter and the year.

Chip Molloy

Thanks Phil and good afternoon everyone. I’ll start by reviewing our fourth quarter and fiscal year performance and finish up with our guidance going forward.

Earnings for the quarter were $0.59 a share excluding the fourteenth week and the final cost to exit the State Line Tack business, EPS was $0.52 down 7% from the fourth quarter of last year. For the year, earnings totaled $1.95 a share. Excluding the benefits for the extra week, the first quarter MMI transaction and the one time costs associated with the exit of the SLT business, earnings for 2007 were $1.47 or up 10.5% from the prior year.

Revenue for the fourth quarter totaled 1.33 billion, up 13.8% from last years fourth quarter. The impact of the fourteenth week on total sales was approximately 90 million. For the full year, sales were 4.67 billion, a 10.4% increase from the prior year. As Phil mentioned, our comparable store sales for sales in stores open at least a year, grew 0.8% in the fourth quarter, on top of 4.6% growth last year. Comps for the year were 2.4%, on top of 5% growth in 2006.

Operating income for the quarter declined 120 basis points to 9.8% of sales, driven by a reduction in gross margins. Gross margins for the quarter declined 120 basis points. Rent and occupancy costs, which make up approximately 13% of our cost of sales, were unfavorable to gross margins by 90 basis points. Warehouse and distribution costs, which total approximately 7% of our cost of sales, were unfavorable by 30 basis points. We had 30 basis points of margin dilution from the increasing penetration of the services business, while our merchandise margins were down 20 basis points. Those declines were partially off set by a 50 basis point benefit due to the 14th week. Operating, general and administrative expenses were 21.8% for the quarter for a 10 basis point improvement compared to the same period of last year.

The relative weakness on the top line cost some de-leverage in expenses for the quarter, but we were able to off set that by managing costs. The fourteenth week gave us a ten basis point benefit which was off set by a 10 basis point negative impact from the exit of the State Line Tack business.

As a percentage of sales, our fourth quarter net-interest expense, compared to the same period last year, increased 40 basis points. The increase was primarily the result of the funds required to execute accelerated stock repurchase that both reduced investments in short-term securities that provide interest income and increased our debt interest.

The end of the year, with total cash and cash equivalents of 58 million, we generated 333 million or 15% growth in operating cash flow for the year. Most of that growth was driven by an improvement in our inventory. We ended 2007 with average inventory per store of $497,000.00, down 7.4% from $537,000.00 per store at the end of 2006. We spent 294 million or 6.3% of sales in capital for the year, which compares with 241 million or 5.7% of sales for last year. Of the 294 million, we spent approximately 77% for new stores, PetsHotels and store related projects and 23% for supply chain, IT and other infrastructure improvements.

During the fourth quarter, we completed our accelerated stock repurchase program and reduced our outstanding share count by 776,000 shares. During all of 2007, we brought 9.8 million shares, including 7 million, under the ASR. So far, we’ve used 225 million of our current $300 million share repurchase authorization, which is available to us through August of 2009.

As we look forward to 2008, we remain cautious about the economic climate. We expect the first half of the year to be challenging, especially when you compare it to our strong performance in the first half of fiscal 2007. We’re projecting flat to low single-digit comps in the first quarter of 2008 and EPS between 29 and $0.33. For the year, we’re projecting comps in the low single digits and earnings of $1.51 to $1.59 per share.

Our earnings guidance for 2008 is a departure from our previously stated 15 to 20% long- term growth guidance. As we progress through the year and see what the economy holds, we will provide more clarity on the long-term expectations of our business. Our capital expenditures for 2008 are expected to be no more than 285 million. We plan to use approximately 80% of our CapEx for new stores, PetsHotels and other remodels and 20% for supply chain, IT and other infrastructure improvements.

Because new stores are such a significant portion of our capital spends, we believe it is important to provide you with more detailed information relating to our new store performance. Cannibalization is something we’ve always taken into consideration when we look at investing in a new store. But, the new store presentation we’ve traditionally provided showed only the four wall performance of an average new store; so we’ve updated the presentation to reflect the impact of cannibalization. We think it’s clear it ‘s more consistent with how we actually consider the investment and it more accurately reflects the overall company’s net return from an average new store.

You can find the updated information in the investor materials section of our web site at petn.com.

To sum it up, we’ve experienced some top-line weakness, but we still expect to grow operating earnings during a relatively difficult economic period. We are committed to our strategy and believe a more balanced approach of spending for the future, while at the same time delivering ongoing earnings growth, has the potential to drive sustainable share holder returns.

Thanks for your time and I will now turn it over to Bob who will provide insight on the operations of our business.

Robert F Moran

Thanks, Chip, and hello, everyone. Let me start by saying how much I believe in this business model and the power of the 43,000 PetSmart associates who are passionate about what we do. As many of you know, a 0.8 comp is the weakest PetSmart has delivered in a number of years and as you can imagine no one here is comfortable with that. So let's talk about what's happening.

For the quarter comp transactions which we use as a proxy for traffic were down 2.6% and the average ticket was up 3.5%. Why the decline in traffic? Like many retailers we're feeling the pressure of uncertain economy and dramatic drop in consumer confidence in spending. In areas of the country that have been particularly hard hit by the housing slowdown are seeing the greatest weakness. We have experienced macro challenges in the past, traffic has fallen off of it and sales of our hard goods categories have been weaker. That's consistent to what's happening with dog containment and collars and leads among the weakest categories.

In addition to the macro weakness, there's still some lingering impact from our decision to get out of our State Line Tack business which was our smallest, slowest growing and least profitable category. We began to exit the equine product line in our stores in the early part of 2007 and we were completely out of the business at the end of the third quarter. We have re-merchandised the space with higher margin products and we are happy with our progress to date. As we cycle through that change the impact on comps was 1.4% for the quarter and just less than a percent for the full year.

Cannibalization also impacts our comps traffic and sales. For the year are cannibalization was still less than 2% for the business in total. On average approximately 20% of the traffic and sales in the first year of a new store comes from other PetSmart stores

in the chain. We factor cannibalization into our decisions to build new stores, however the acceleration of store growth has a near-term negative impact on comps sales. So while we saw some weakness in traffic we did see some strength in ticket, that in part because commodity prices are up year-over-year driving inflation and consumables across the board. We have passed those increases through to our consumer and because other retailers are doing the same we don't think we have eroded our competitive price position. We are pleased to note that pet parents are not trading down on food in this tough economic time; in fact some of our strongest categories for premium, super-premium and prescription foods. We have seen continue strength in our food categories since we completed our food aisle reset in the middle of 2007. It was the first step in a larger initiative toward space and assortment optimization and we're beginning work on other categories this year.

In spite of the challenges we are facing our services business continue to deliver high growth and high operating margins with steady demand and impressive customer loyalty. Our services business grew 27% for the quarter and 22% for the year. Services sales from the extra week were 8.4 million and accounted for 8.6% of growth for the quarter and 2.2% for the year. Our services associates and our management team as a whole are focused on delivering consistent, exceptional quality and building relationships with our services customer. As a result, we think services like grooming have turned into a real need for many pet parents and during the holiday we continue to see a huge demand for the PetsHotels, in some cases waiting was reached into the hundreds. This exciting and differentiated business continues to draw customers into the stores and helps us deepen the bond between PetSmart and pet parents. We remain committed to the PetsHotels business and its ongoing growth. We finished the year with 97 PetsHotels, we opened 10 new hotels in the fourth quarter and as Phil mentioned, we will open 45 new hotels in 2008. So we continue to feel great about services. It's important to note that as this part of our business is growing to a more substantial size we expect to see the growth moderate a bit. We are targeting 20% services growth in 2008 but it's going to take some work to get there.

So let's talk about new stores. We opened 16 net new stores in the United States and Canada during the quarter to finish the year with 1,008 stores. For 2008 we plan to open up about 115 new stores and close 11 stores. In the first quarter, we will open 35 new PetsHotels. We finished 2007 with 722 stores in the Eagle II format. We plan to refresh 114 stores this year and to finish the chain in 2009. In the face of a tough sales environment, we have to execute on the things we can control, focus on our customers and drive consistency throughout our stores.

I firmly believe that the work we've done in the last year to simplify our business and build vendor collaboration will set us up for solid execution in the future. Getting out of the State Line Tack business has allowed us to focus all of our resources on what we do best and work to renegotiate our operating agreement with Banfield has strengthened that relationship. We believe we're in position to truly leverage the power of having a vet, the most trusted adviser to a pet parent inside a store and drive the success of both businesses. All of our stores are aligned around our DOG strategy of delighting the customer, operating excellence and growing services. And as always we are intently focused on managing the labor line without impacting the customer experience.

We plan to complete the implementation of our new labor management system in our stores by the end of 2008 and we are not stopping there. We're giving our stores tools and processes that standardized non-customer facing tasks and make it easier to run the store. We continue to look carefully at inventory management and we're starting 2008 in a solid inventory position. Our merchants did a nice job of planning the holiday assortment this year and even with lighter traffic our sell through was better and our margins and our holiday products sales were higher than last year. We sold through more products by taking less in markdowns.

During the first quarter we're rolling out detailed standards and procedures that guide how we handle merchandise inside the store. The process covers everything from receiving DC loads to replenishing product. Will continue to gather meaningful data in order to better understand our customers and develop more targeted offers through our PetPerks loyalty program. We have recently launched our new PetSmart PetPerks Visa card. It serves both the loyalty program card and a credit card bringing a new revenue stream to PetSmart. Customers can earn points towards merchandise or donate to help pets in need. The card provides in-store and online discounts and pet parents can personalize their card with a photo of their pet.

Let me conclude by saying that it's certainly never easy to manage through times like this so we plan to focus on the customer and cut unnecessary expenses out of the business so that we can create a strong, solid business today and we will continue looking forward to ways we can grow for tomorrow. Thanks and I'll turn the call back over to Phil.

Philip Francis

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from Matthew Fassler from Goldman Sachs, your question please.

Matthew Fassler-Goldman Sachs

Good afternoon and I appreciate your comments on capital allocation. Two questions, I'd like to ask you first about that, did you talk about the kind of store count you'd be getting two and 2009. And related to that as you pull back CapEx presumably your free cash flow will increase and how would you consider redeploying that?

Philip Francis

Matt? Hey Matt, this is, Phil is going to take the first one and I'll take the second one.

Matthew Fassler-Goldman Sachs

Great.

Philip Francis

A hundred for this year, I believe I said about 20%, 20% of 104 is 21, 104 of 21 is 83 so we're not there yet but the over under for '09 as we sit quite a ways away from it would be 80 or 83 stores would be the new store count for '09.

Robert Moran

Matt on the free cash flow, yes it's obvious as we put constraints around the CapEx we'll have more free cash flow to utilize, if we can't find ways to invest that in the business, which we will limit through our CapEx restrictions, the next natural place for us is to give it back to our shareholders in the form of either share buy backs and/or dividends.

Matthew Fassler-Goldman Sachs

And then this question I'd like to ask relates to sort of elements of the cost structure, particularly the impact that some of the fixed costs, rent and others are having on your gross margin. Given that the comp was actually up and the retailers out there that are comping negatively to a sever degree right now, it kind of feels like the impact, the negative leverage that you're getting on warehouse and on rent is pretty sharp. So are their step-up clauses in your leases that are leading to escalating rents or anything like that that puts kind of an undue burden on you from a cost structure perspective?

Philip Francis

Matt, this is Phil. All of our rents are what I would call very, very mainstream and I'll give you an example. The lease accounting that we do requires us to straight-line whatever rents are, so as an example we might have to sign a 15 year lease and the way the cash really works is we might pay $13 for the first five years, $14 for the second five years and $15 for the third five years. The way the accounting rules work in that example, we have to charge our P&L $14 or the average of the 15 years beginning in year one. But you can here in times past people with really strange leases of five bucks for a while and 30 bucks at the end. Ours are very much kind of one dollar in the second five, one dollar more the third five years but the accounting rules for two or three years have been you straight-line it anyway and so there's nothing weird going on with straight-lines. Our leases the way we account for them actually don't step up, it's year one and for 15 years it's a flat number on rent per foot.

Matthew Fassler-Goldman Sachs

Or especially if you look at SG&A, those numbers were in reasonably good shape it's just kind of these fixed rent costs that seem to be the biggest drag.

Chip Molloy

Matt, this is Chip. If you think about the store growth and you think about our new store presentation, a new store typically does 60% of a mature storage volume in its first year and of which about 20% of those sales are coming from the local market in the form of cannibalization. As we've of accelerated the store growth and you add those new stores in, comp in the core business then it's difficult to leverage your rent and expenses as you add those expenses into the system.

Matthew Fassler-Goldman Sachs

Okay, thank you so much.

Operator

Your next question is from Michael Baker of Deutsche Bank, your question please.

Michael Baker-Deutsche Bank Securities

Hi, thanks guys. For one, I'm just wondering if you could discuss the pace of comps. I think on your preannouncement you said things were getting a little bit better in January. Did that hold through January and into February and if you also talk about the services part if that followed at the same trend? That would be one question, I guess I would ask the second question if I could, it looks like you're opening a lot more stores in the first quarter this year, I think, what did you say, 35 versus on my model at least 20 in the first quarter of last year so what kind of the EPS impact does that have for whatever it's worth, your EPS guidance in the first quarter is a little bit below the street. I'm wondering if that's one of the reasons. Thanks.

Philip Francis

This is Phil and I'll try to do both. In terms of the pace of the comp in the first quarter more stores opening, you are correct. In both cases we knew those things with the guidance that Chip gave. The way last year worked the cons were better in the first two quarters and were weaker in the second and we've got things like the end of the first quarter or last three weeks where we cycle the pet food recall and we basically got kind of a boost last year in the first half from accelerated sellout of the State Line Tack inventory. So lots of moving parts going on but we think the second half of the year is going to be easier for us than the first year in terms of pace of comp. When it comes to first quarter, the new store impact I think it is 35 versus 20 but when the guidance we gave up 29 to 33 included our knowledge of that fact and so we think that's a victim of the guidance we gave you.

Michael Baker-Deutsche Bank Securities

I realize it's baked in but could you -- could you let us know what the costs are, the SG&A cost for new store? Just trying to model what the impact is of the roughly 15 extra stores this year versus last year.

Philip Francis

You know Michael I'm not sure if can help you. The whole model and Chip's maybe going to do some calculation here. We, I think we've indicated in previous times that our new store opening expense is about $100,000 so 15 extra stores just in grand opening expense would be a million five of pretax money would be a year and year change.

Chip Molloy

Which would be a penny.

Michael Baker-Deutsche Bank Securities

I can probably take the math from there then, thanks.

Operator

Your next question is from David Schick of Stifel Nicolaus, your question please.

David Schick-Stifel Nicolaus & Company, Inc.

Hi, thanks. Bob, you mentioned it's going to take harder work to get to the 20 services goal for '08. If you could talk about maybe what that work means, is it talking about price or how is that going to play out?

Robert Moran

I think the opportunities we have in services is about our groomers, our trainers and making sure we have enough in the pipeline. That work is in play already. Obviously opening up 45 PetsHotels also gives us a benefit and we also have been testing seasonal pricing in the PetsHotels and it has been successful. During the fourth quarter will be rolling that out during 2008 more as more benefits but going back to the point, as we keep on building a base, now we're experiencing our eight years of growth of roughly about a 26% cagger. We have a bigger base to come off of and in that way any numbers are going to be harder to get to. But, we still are targeting 20% and we're going to put additional work in place. Our total focus is on operating focus it's about bringing customers into the store, it's about communicating with our customer through PetPerks, to entice them to come in for their groom on a regular basis, but it's a lot more focus on the customer and operating focus inside the stores to get to 20%.

David Schick-Stifel Nicolaus & Company, Inc.

Okay, greats. So I'd be interested in your characterization of what's going on with your competitors, both mass and specialty, given the macro pressures you've discuss.

Philip Francis

Well David, hi this is Phil. Luckily are unluckily we have lots of competitors and I read as well as you do, we end up in competitive stores a lot. When I'm not doing real estate I'm in them a lot we pay attention and humble and respectful and we’re shameless plagiarists whenever we can. We are in a time of most of our focus is in ourselves. We're newly awakened to how important it is for us to focus on our own asset base, the owned current asset base as well as a modest amount of growth going forward, and so I don't-- I haven't seen, big things. I've read the things that you've read. I think the macro environment is a too good for anybody. But our sense rather than paying attention and being respectful, we're focused first and foremost now on growth services and to make the current asset base more productive.

David Schick-Stifel Nicolaus & Company, Inc.

You said basically that inflation, it sounded like you're passing it through on a one-to-one basis roughly, would you say that the marketplace is doing the same?

Philip Francis

Yes I would.

David Schick-Stifel Nicolaus & Company, Inc.

Okay. That's, helpful. Thank you.

Operator

Your next question is from Peter Benedict of Wachovia; your question please.

Peter Benedict-Wachovia Securities

Hey, guys. Thanks for taking the question. Two, first of all the new labor management system I don't look you could talk to many how many you've got that system in today, how many stores? And you said you going to have it rolled out fully for the year. Just can you put a little color, as to how you think that might impact the expense structure as you look out probably passed '08 into '09?

Robert Moran

Peter, how are you doing? This is Bob Moran.

Peter Benedict-Wachovia Securities

Hi, Bob.

Robert Moran

If you think about all the math, it's going to be, it's a tool to help us really manage payroll but it's not the only tool that we have in our arsenal to leverage our expenses. So we intend to be leveraging payroll through the course of the year by focusing on our best practices, really learning and fixing issues as we go through and then obviously as we beef up our reporting to make sure that we're on top of it as we roll out the LMS system to the remaining part of the stores. I believe Chip has a number of stories that we have the LMS rolled out two.

Chip Molloy

Peter, this is Chip. I was going to answer the question as it relates to SG&A line or expenses. Payroll, LMS as well as what Bob is talking about which is just good old-fashioned labor management is going to provide some leverage at payroll line, but the guidance that we are giving as it relates to any sort of margins, we given operating income percentage as guidance which we expect to be relatively flat for the year. We haven't given any guidance on operating general and administrative expense line or the margin line because we are going to have things like labor where we believe we're going to save expenses and it's going to help us. But we're also going to as we continue to invest in the business as other line items such as depreciation and amortization which is going to drive the expense line the other direction. So at the end of the day we're looking operating income percentage for the company to be flat year-over-year.

Peter Benedict-Wachovia Securities

That's fair, Chip. I guess thinking longer-term, I don't know if you have this yet, but in the past you guys have spoken to maybe targeting a 10% operating margin for the business. Is that something that you'll update us on similar to the 15 to 20% EPS growth?

Chip Molloy

Yes, Peter. We will.

Peter Benedict-Wachovia Securities

Okay, great, thanks. Good luck.

Operator

Your next question is from Brian Nagel of UBS; your question please.

Brian Nagle-UBS

Hi, good afternoon. I wanted to ask this dig a little deeper to gross margin trend in the quarter. You highlighted in the press release and your comments 120 basis points down. It sounds like it was mostly a deleveraging of fixed expenses, so I guess my question as we look from Q3 to Q4, where the comp trend decline modestly but there is this trend in deleveraging of fixed expenses seem to go up much further. Was there something that changed in the cost of sales from Q3 to Q4 that facilitated more of a deleveraging?

Chip Molloy

Brian, this is Chip. No, nothing is really changed. We haven't given this much transparency before in the gross margin line and I think we're doing that for a reason so that we can all better understand what's happening within gross margin because we do but so much of our cost of there. And nothing is really changed significantly, it's just now are speaking to it more openly and you can get a flavor for how, as I said earlier, as we've accelerated the growth in our new stores and recognize that new stores are lower than your average volume, it is -- we are going to deleveraging up the gross margin line.

Brian Nagle-UBS

Was that more of a factor than in Q4 that was in the third quarter?

Chip Molloy

I actually don't have it in front of me, Brian, as it relates to Q3 what it was. But my guess is, it's pretty similar.

Philip Francis

Brian, this is Phil, I don't have it either but had we talked about this a year ago we are used to lots of impact with higher sales in Q4 versus Q3 and you ask the quarter on quarter question. We have less different Q4 to Q3 than we've had in times past. And I think that's the year on year difference which is what we reported is as big as it is.

Brian Nagle-UBS

Okay. Thanks. As we look into 2008, how should we think about the gross margins here within the context of the other guidance?

Chip Molloy

Brian, this is Chip again. We haven't given guidance next years guidance at the gross margin line or at the operating general and administrative line but we are giving operating income percentage guidance which is relatively flat for the year. And you'll see some depending on the quarter there will be some of that that will be positive and some will be negative in those two different lines items. But at the end of the year, net we believe we're going to be at the operating income line of flat.

Brian Nagle-UBS

Okay. Thanks a lot.

Operator

Your next question is from David Mann, from Johnson Rice; your question please.

David Mann-Johnson Rice & Company

Thank you. Good afternoon. Can you talk a little bit about your advertising posture going forward in this kind of environment?

Robert Moran

Yes, David. This is Bob. We're looking at our media affect on this in a number of areas, radio and TV and really focusing on hot items that we already have in place but putting more of a sense of urgency and then coupling that with our in-store presentation. Obviously one of the benefits we have is our database that we have in our Pets Perks program so that we can obviously influenced, incense customer behavior both on the product side and also the service side, bring customers in. We're also focusing on the Internet and looking at a sense of urgency from looking at hot items that we are targeted to create demand. But what you're going to see from an actual advertising percent, it's relatively going to be about the same as it was last year quarter by quarter.

David Mann-Johnson Rice & Company

Have you seen less response from customers in your database attempts to reach out to customers?

Robert Moran

Not really. Again, the customers that have signed up for the PetPerks to obviously get the immediate benefits in the stores, they're starting to realize at some of the benefits they are getting from the customized and tailored offerings that we're giving them. And this is a time where offers are important especially where we can customize them to the pet parent themselves or their pets especially with the life cycle event that could be very important to them. So, no, we have not seen any drop off.

David Mann-Johnson Rice & Company

And then if I could ask one follow-up about what you're seeing in terms of new pet formation, new pet household formation. It seems like you have a lot of touch points where you perhaps could see that happening, whether it be adoption, live animal sales, or on the services side. Can you just comment on whether you think your customers out there are just not adopting or buying new pets at the same pace they were in this environment?

Philip Francis

David, this is Phil. I'd temper what I'd say with the data comes in on a delayed basis, so we don't have any real-time data on that. Last year, we rolled out the new pet fixtures into our stores so if you look at things for new pet, we are doing just fine in an environment where we improve the presentation. Our sense of this is consumables are good, services are good, our new pet sales are fine. What's going on with us is replacement hard goods of an existing pet. Meaning it's better collar or a coat it's an annual event to buy one of those because is out of fashion or get to use a phrase dog-eared. And as somebody going 12 months goes in to 16 months as a replacement cycle it's not a share loss but it's a bit of top line pressure for us. And we think were the focus of our modest top line pressure is in replacement hard goods not of the new stuff.

David Mann-Johnson Rice & Company

Okay. And that part of the mix that you think is under pressure can you remind us what percentage of your inventory or sales that represents? And is there any intention to sort of alter the mix away from that given it's weakness?

Robert Moran

David, it's our business that we tend to think about the business by species but to answer the question at the level you'd expect, we've got 10 or 11% for services, low 40s for food and what you're left with is high 40s for hard goods and we're intensely studying this stuff. I think our challenges, have the new item, have to be right on fashion, be right on price point, be right on presentation in store. We're in no way giving up an example of what does it will do for us to get out of State Line Tack we got a bit more space and a bit more focus to simply execute better in hard goods and that's what happened but rather than being discouraged or laying down and quitting I think we try harder on hard goods because it got a bit more space and a bit more management time to spend on it and we intend to operate our way out of whatever weakness it may be natural to be there that's the plan for '08.

David Mann-Johnson Rice & Company

Great. Thank you.

Operator

Your next question is from David Cumberland of Robert Baird; your question please?

David Cumberland-Robert W. Baird & Co., Inc.

Thanks, questions on the recalls. How many of the SKUs returned to the stores through Q4, what's your latest expectation on how many eventually return?

Robert Moran

David, this is Bob Moran. We still have about 70 SKUs that are still outstanding. As a number of things have happened within the recall, customers have traded up as we said, premium, super premium RX Foods are doing extremely well. But we still have that 70 SKUs that will be coming in through probably the first half of 2008. But we feel that we are on top of this. There's about 30 SKUs that will not be coming back, and there's 250 that have been returned.

David Cumberland-Robert W. Baird & Co., Inc.

Thanks. And so you mentioned needing to do some work to win back the sale lost due to the recall. What do you plan there and have your efforts been limited by the fact that some of the SKUs haven't been returned yet?

Robert Moran

Some of the SKUs and some of the behaviors of the wet food and this is again putting wet with dry especially in the dog area. As these SKUs returned obviously we're going to encourage that type of behavior through our PetPerks program so that we can incense our customers and our pet parents to retry that behavior.

David Cumberland-Robert W. Baird & Co., Inc.

On the SLT exit expect that to be a drag on your comps in the first half as you compare to the inventory sales group?

Robert Moran

We basically got out of the State Line Tack business by the end of the third quarter. In the first half we accelerated the sales of the State Line Tack businesses as we were exiting and then as we were -- as we got out of the replenishment side, we could not replenish our sales in the second half. So I would say that you should see a better performance off the State Line Tack in the second half and a better performance in the fourth quarter.

David Cumberland-Robert W. Baird & Co., Inc.

And my last question, how much more of the mix were hard goods in Q4 more than in, say the full year?

Philip Francis

David, this is Phil. I'm not sure that we've talked about that before. It's, I mean my answer would be it's about the same. All sales go up in the fourth quarter look, you sell more haircuts because people are getting ready for parties, you sell more hard goods because it's colder and you sell more food because, sell more hard good because it's colder and you sell more food because it's colder. So we kind of have the fourth quarter everything works for us, but hard goods, it don't particularly change the share of sales in the fourth quarter.

David Cumberland-Robert W. Baird & Co., Inc.

Thank you.

Operator

Our next question is from Dan Wewer of Raymond James, your question please.

Dan Wewer-Raymond James

Yes, thanks; looking at the new store model that you alluded to. On the $600,000 of cannibalization, is that assuming one store is getting hit for 600 grand? Or two stores?

Chip Molloy

Dan, this is Chip. It depends actually, in some places we may be hitting one store for 600,000 and in some instances we may hit three stores and it would be just a little bit at each one of those three stores, but when you average it all out, every new store about 20% of their sales right now are coming from the local market.

Dan Wewer-Raymond James

The profitability on the new stores with this new schedule you provided is substantially lower than what we were talking about at the analyst day, it just looks like just the time needed to recover the capital investments growing to about five years from 3.5 are we looking at that correctly?

Chip Molloy

What's been provided in the past has been just a fore wall, so the things that have changed here is we're showing one, the costs have come down slightly, and because we've just show you the fore wall before, you looked at the return as it relates to what that individual store was producing. But internally, when we think about a new store and we decide whether a new store is going to meet our internal hurdle or cover our lack plus provide some shareholder value, we burdened that investment internally with cannibalization. Our presentation just hasn't shown it that way, and so what we've got here is to help you better understand that indeed, it does take longer to return the capital for the company.

Dan Wewer-Raymond James

And then Phil, the decision to slow the expansion rate 20% or I guess that's about 20 stores in 2009, I guess there was a chance the economy could be recovering by that point. Is this decision perhaps not based so much on a cyclical outlook that you may have at that point but rather we're getting closer to 1,400 or 1,500 potential stores in the US? And this is the appropriate time to be cutting back on the unit growth rate to avoid saturation issues?

Philip Francis

I'd give a slightly different answer. I mean in North America we still think there's 1,800 but we are slowing this pace, and this is just a balancing act that we are playing. We're a big enough company that it's not appropriate to try to sell ourselves as a go-go retailer and we think that particularly in this second -- I mean the real estate is out there, and we could have investments that exceeded the cost of capital. But we are worrying about execution, we are worrying about the productivity of our current asset base, and the slowing down of it is just a way to balance long-term growth versus short-term shareholder returns. We think in the last two quarters, I'm not happy with the mix of that, that we've provided. I don't think we've made long-term mistakes in the last two quarters, but I'm not happy with what we've done for shareholders in the here and now and the slowing of the paces to address that we've described as the fixed-cost basic structure that makes it hard to leverage if there ever is a weaker top-line and we've just given ourselves the, I think a reality check given the size of the business that we want to be long-term successful but we've got to pay some more attention to the here and now that we've managed to do the last two quarters.

Dan Wewer-Raymond James

Right, thanks and good luck.

Operator

Our next question is from Chris Horvers of Bear Stearns, your question please.

Christopher Horvers-Bear Stearns

Thanks and good afternoon. Phil, as you look back to prior times of declining consumer confidence, has there been a change in adoption? Do Americans try to find comfort and increasing adoption? Or is it the added expense that they get worried about? Is there a macro variable like consumer confidence that you are looking at as a potential sign of a rebounding trend?

Philip Francis

At the end of the day, other than what it did for country we thought 9/11 was good for our business and it probably helped our top-line by a percent for about a year. We do sell affordable luxuries, we are in relationships and the degree that people hundred our cocoon or stay at home, we’re in the right side anytime somebody wants to do that. If somebody -- could somebody not take a trip to Europe and get a new dog instead? Of course they could. I think that by price point and by the kind of relationship we have with people, we're not necessarily -- I mean we're probably helped a bit by the kind of business that we're in. So I -- we haven't seen the abandonment of the dog, remember these are family members and not pieces of equipment and there will be a, I'm sure there will be a story somewhere of somebody found a dog that summary walked away from, but that's the exception and not the rule. And on balance, when people hunker down that's good for us not bad.

Christopher Horvers-Bear Stearns

Okay, that's very helpful. Chip looking at the comp, can you parcel out perhaps how much price inflation aided your comp and also to have the data on the price optimization program?

Chip Molloy

We do look at inflation and we have, internally we have a sense but we haven't announced what it is as it relates to how much it's provided in the comp. It is, inflation is accelerated somewhat. We think it's helped us from a sales perspective, a little bit more this year than it did in the prior year in the same period, but we haven't quantified that. And as it relates to price optimization, I'm going to, you okay with, Bob's going to, price optimization, we continue to go down that path, it's very driven towards driving gross margin dollars. Sometimes it accelerates the sales, and sometimes it accelerates the margin rate depending on where we are. We think we're making progress there, we'll be continuing to make progress and we think it's going to help us during fiscal year '08.

Christopher Horvers-Bear Stearns

Alright and then just one final question; how should we think about working capital in relation to free cash this year?

Chip Molloy

Well that's a, I think I can expect our free cash flow is probably going to increase this year and we're going to utilize that. We'll probably see some -- there shouldn't be that much change in working capital, but free cash flow we'd expect would probably go up.

Christopher Horvers-Bear Stearns

Perfect, thanks very much.

Operator

Your next question is from Charles Grom of J.P. Morgan, your question please.

Charles Grom-J.P. Morgan

Thanks, good afternoon; Chip, a question on margins. It's just, at the low single digit same-store sales would drive flat margins this year, and I realize there are some moving parts with labor and then D&A. Just wondering what the basis point sensitivity is for one point swing in the comp front from that one to 3% range you provided?

Chip Molloy

Well, at the operating margin line, to have accretion or expansion of the operating margin line based on our current cost structure and the investments we're making in the business this year it's to actually expand that line, we think we needed three or four comp. As far as creating earnings growth, it's less than that.

Charles Grom-J.P. Morgan

Okay so just set a different way; if you do, do a three to four comp, what is the basis points dump on your operating margin? Is it 10 basis points, is it 20?

Chip Molloy

I haven't quantified that. So it's just, three to four you'll start to get some expansion at the operating margin line.

Charles Grom-J.P. Morgan

Okay and then just one other one just on the input inflation side. What are your exact expectations and your guidance for food and I guess more importantly for the supplies given that we’re hearing that the, you know some of the items coming in from China are going to be coming in pretty heavy. I’m just wondering what you're thinking on that front?

Chip Molloy

That's activity of, as far as we haven't given guidance there, but as far as sourcing from China we're, it’s still, it's still an area that we're looking at, it's something that we're working towards and we have a team in place and we believe that we're going to continue to make some progress in that arena this year.

Philip L. Francis

This is Phil, and I maybe can give a bit of color here. I mean our pricing for Christmas goods is locked in and that's irrespective of what does happen to currency, for example between now and then. I think we understand where you're coming from on the question, might that make a big difference? We're going to have to figure out in '09, absolutely, but hard goods for us has such long lead times, we’ve been doing it a long time, we'd lock things up ahead of time. And our Christmas goods are locked down price-wise for the '08 year as we sit here.

Charles Grom-J.P. Morgan

And then just on the food, the pet food, is that like low singles?

Philip L. Francis

That's, yes low singles and I can't be precise here just because I don't have the data but when you read what's going on with corn and the other grains and fuel and all that stuff, why we'd expect to see some; to date we have been consistent for a long time. We are, we are passing it on in the margin rate and maintenance basis, when it ought to be passed on based upon our inventory. And for people who either treat us as a leader or at least treat us a a reference, we've done consistent behavior and so far the world has stayed in that behavior.

Charles Grom-J.P. Morgan

Fair enough. Thanks very much.

Operator

Our next question is from a Joan Storms of Wedbush Morgan, your question please.

Joan Storms-Wedbush Morgan Securities Inc.

Yes, good afternoon, thank you. I'm trying to just reconcile on the occupancy expense.

I mean your square footage growth has been sort of in a 10, maybe up to 11 even 12 range for the past few years and obviously you've been comping higher in the earlier years, but what are the other fixed components of accelerating your growth? It looks like you have, you know, a lot of the store payroll procedures costs under control. What else can you do to address some of that fixed expenses that you have associated with the new stores?

Philip L. Francis

Well the fixed expenses for us and the ones that have increased, obviously right now I guess we spoke to which hits our margin line. Warehouse and distribution, our supply chain if you want to call it, there’s some fixed expenses there. We did add a DC this year. We’re going to add another DC next year, or this coming year, 2008. There is a fixed component of that that hits warehouse and distribution costs, which lands in gross margin and then the last piece is depreciation amortization, which for us is, it’s in the SG&A line or OG&A line as we claim it.

Joan Storms-Wedbush Morgan Securities Inc.

Okay thank you.

Operator

Our next question is from Joe Feldman of Telsey Advisory; your question please?

Joe Feldman-Telsey Advisory Group

Yes, hi guys. Just as a, I want to follow up on the cash a little bit. You know, can you just discuss a little more what’s going on there, how cash came down so dramatically relative to a year ago? I mean in particular even the short-term investments; you took on a little bit more debt. I mean, I think a lot of us had been expecting you to have higher CapEx relative to the amount of stores and the hotels this year. If you could discuss that.

Philip Francis

It was driven entirely by the ASR transaction, 225 million that we actually queued it against the ASR transaction. We used our cash, we did some borrowings which we’ve since paid down, down to minimal on the balance sheet of $30 million and it was 225 million, so that is solely driven by the ASR transaction.

Joe Feldman-Telsey Advisory Group

Got it and now you know, given, I know you’re tweaking the CapEx going forward, but should we expect some more increased borrowings as you look into ’08?

Philip Francis

We shouldn’t need to borrow anymore funds going into ’08 right now given the CapEx structure that we put out and where we are from a borrowings perspective today. I don’t expect that we’ll need to dive into any more borrowings.

Joe Feldman-Telsey Advisory Group

Got it and then also just to shift gears to the hotels for a minute here. Because I know that you’re rationing it down a little bit by a few stores, but given the expense to open the hotels, I mean at this point is it still, you know, are you still getting the returns that you’d like to see on them? I understand that it adds a fair amount of revenue to the store and it helps the operating margin of the store, but is the actual IRR on the investment one such that it’s worth opening as many as you are as quickly as you are?

Philip Francis

We think that the hotels are still an investment. Every time we’ve update our model we’ve actually, it’s actually gotten slightly better each time we’ve put a new population of hotels in the model, but we have scaled back some. They are going to be diluted in the first year, because they’re not providing any income in the first year, but over time they do provide; they are accretive from an earnings perspective. We believe they’re a differentiator for us. And we continue to, when we talk about our strategy of lifetime care and we talk about our customer relationships, we think it’s a critical element of our strategy and that’s why we’re investing. So, as we balance our CapEx spend, we’re balancing it from a returns of strategic perspective, competitive ends perspective.

Joe Feldman-Telsey Advisory Group

Got it, I mean, just one last follow up on that hotels. I mean, have you found that you’re able to, you know maybe this new generation will be a little less expensive to open some of them this year than in the past couple of years. I mean because it’s close to the cost of a new store, based on your store model right?

Philip L. Francis

Yes, this is Phil and our, you know, I mean that you’re first question, I think, was does a IRR and a hotel investment work? The answer is simply yes, it works and it’s nicely above the cost of capital and improves shareholder value. Remember, in our hotel model, what you see is likely there a blend of two. It a fresh hotel has a CapEx of just over a million dollars, so it’s less; a new hotel is less capital than a retrofit hotel. In a new hotel we get its’ benefit and its’ results, we don’t improve an existing stores performance with it. When we do an investment in a hotel retrofit it takes more capital because we have to deconstruct before we construct, so it’s more expensive to do one of those. At the same time, we also take the existing store and improve its’ profitability, the non-hotel part of the store, by about 400 basis points. So, what we show there is a blend of the two. But, with the model that Chip has put out there, we think we inadvertently created some confusion because we showed such a wide spread between a new store and a hotel and we got the two presentations twined. The new store by itself is better than the hotel with the GAAP that was so wide it has narrowed nicely. And both of them, nice RR, IRRs and exceed the cost of capital.

Joe Feldman-Telsey Advisory Group

Alright, thanks for that explanation.

Operator

Ladies and gentlemen, we have run out of time for any further questions. I would like to turn the conference back over to management for closing remarks.

Robert Moran

Well, thanks everyone for joining us today. We’re wrapped up. Thanks again, we’ll see you probably in about 91 days. Thank you.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: PetSmart, Inc. Q4 2007 Earnings Call Transcript
This Transcript
All Transcripts