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Executives

Philip Francis - Chairman and Chief Executive Officer

Robert Moran - President and Chief Operating Officer

Lawrence (Chip) Molloy - Senior Vice President and Chief Financial Officer.

Analysts

Matt Nemer - Thomas Weisel Partners

Matthew Fassler - Goldman Sachs

David Strasser - Bank of America

David Cumberland - Robert Baird & Co.

Joan Storms – Wedbush Morgan Securities

Brian Nagel - UBS

David Mann - Johnson Rice

Gary Walter - Credit Suisse

Peter Benedict - Wachovia

Mike Baker – Deutsche Bank

PetSmart, Inc. (PETM) F1Q08 Earnings Call May 21, 2008 4:30 PM ET

Operator

Good day, Ladies and gentlemen, and thank you for standing by. Welcome to the PetSmart First Quarter 2008 Investor Conference Call. At this time, all participants are in a listen-only mode. Later, will conduct a question-and-answer session, and instructions will be given at that time. If anyone should require assistance during today’s conference, please press * and then 0 on your touchtone phone for operator assistance. As a reminder, this conference is being recorded. I will now turn the conference over to your host, Ms. Tawni Adams, Director of Investor Relations. Ms. Adams, you may begin.

Tawni Adams

Good afternoon, and welcome to PetSmart’s conference call to announce our results for the first quarter of fiscal 2008. With me on the call today are our 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 first quarter results. Then, Chip will take you through the financial review of the quarter, as well as our earnings guidance, and Bob will provide a review of the operations of the business, and finally, we’ll take your questions.

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

Philip Francis

Thanks Tawni and hello everyone. I’m happy to report that we delivered on our earnings guidance in the first quarter, and we’re on track to achieve our targets for the full year. Our comparable store sales, or sales at stores open at least a year, grew 2.9%, and earnings per share were $0.32 for the quarter. Our top line performance came in a bit higher than we’d expected. That was helped by an increase in inflation which was partially offset by continued weakness in traffic. We expect that these trends may continue throughout the year, so we’re focused on consistent and efficient execution and on outperforming in the areas of the business that differentiate PetSmart from the competition. So, let’s talk about some of what we’re experiencing on the top line.

Comp transactions which we use as a proxy for traffic decreased 2.3%, while average ticket increased 5.2% for the quarter. PetSmart comp sales tend to be driven by changes in comp transactions. We first saw comp transactions fall off last year in the third quarter, with the worse performance in the fourth quarter at -2.6%, but we saw some modest rebound from that low in the first quarter of 2008. Our average ticket generally increases between 3% and 5%, so the increase in the average ticket for the quarter is trending a bit higher than is normal for us; much of that is coming from inflation. So far, we’ve been able to pass that through to the customer.

We saw sales benefit from inflation of about 4.3% in the first quarter, which compares to 1.5% for the same period of last year. Of all our categories, consumables were the most impacted by inflation because of the increased cost of grains. As a result, our sales mix shifted towards consumables. Consumables made up about 45% of our sales in the first quarter, up from 43% at this time last year. This category has always been an important driver and has historically been less discretionary than our hard goods business, and we’re pleased that our channel exclusives, super premium, and prescription foods continue to be some of our strongest categories.

Hard goods were 41% of our sales, down from 44% in the first quarter of last year. The hard goods category includes supplies for dogs, cats, and specialty pets. Specialty includes species like fish, reptiles, and birds, and specialty accounted for the majority of the weakness. We’ve also seen a corresponding weakness in specialty lab good which made up about 3% of our sales for the quarter.

Services continue to be a source of strength. They differentiate us from the competition and attract our most profitable customers. Services made up about 11% of our sales for the quarter, up from the 10% last year. That represents solid growth of 21.6%. Training, which is by far the smallest part of our service business, has experienced a bit of weakness. We continue to see strength in our larger services business—grooming—as well as our highly differentiated PetsHotels day camps. Even in this more challenging economic environment, these services appear to be in need for our customers. At the end of last year, we took a hard look at this business and committed to slowing our capital spending. We remain committed to that strategy. In 2008, it’s about running the business efficiently and driving productivity at our current asset base to continue to grow earnings and drive shareholder returns. We firmly believe in our solid business model and unique offerings of services and merchandise under one roof. Our total lifetime care strategy of providing solutions to every pet parent who enters our store remains the touchstone of our business. That fundamental strength combined with our unique offering of more than 10,000 SKUs and our passionate and knowledgeable associates will enable us to compete and thrive in this environment.

With that, I’d like to turn the call over to Chip who will give you more details on our financial performance for the quarter and our guidance going forward.

Chip Molloy

Thanks, Bill. Good afternoon everyone. As Phil mentioned, we delivered earnings of $0.32 per share, which was in line with our guidance for the quarter. Revenue for the first quarter totaled $1.2 billion, up 9.1% from last year’s first quarter. Our comparable store sales grew 2.9% for the quarter, on top of 4% growth for the same period last year.

Operating income for the quarter was 6.6% of sales, down 30 basis points from the first quarter of last year. We continue to see pressure in gross margins, partially offset by improvements on the expense line. Gross margins for the quarter declined approximately 100 basis points to 29.4% of sales. Rent and occupancy costs were unfavorable to gross margins by 55 basis points. Warehouse and distribution costs were unfavorable by 65 basis points as a result of opening our new replacement Reno distribution center, ramping up our Newnan distribution center that was open last year, and pressure from rising fuel prices. We had 30 basis points of margin dilution from the increasing penetration of the services business, while our merchandise margins were down 30 basis points. We also had a benefit of approximately 10 basis points as we anniversaried obsolescence costs incurred last year from exiting our State Line Tack business and other items. Operating, general, and administrative expenses were 22.8% for the quarter, an improvement of approximately 80 basis points, compared to the same period of last year. Improvements were driven by leveraging store expenses, reductions in professional feeds, fewer costs associated with closing stores during the period, and the anniversary of the cost associated with exiting the State Line Tack business last year. Our first quarter net interest expense, compared to the same period last year, increased 30 basis points as a percentage of sales. The increase was primarily the result of the funds required to execute last year’s accelerated stock repurchase that both reduced investments in short-term securities that provide interest income and increased our debt interest.

During the quarter, we generated $118 million in operating cash flow, spent $60 million for capital projects, and purchased approximately 1.5 million shares for $30 million. We ended the quarter with $56 million of total cash and cash equivalents, $26 million of borrowings on our revolver, and 127.3 million shares outstanding.

We are on track to spend no more than our target of $285 million on capital projects for all of 2008, and we have $45 million remaining of our current $300 million share repurchase authorization.

Looking forward, we now expect comp sales of low to mid single digits for the full year, and we feel confident that we can deliver on our earnings guidance of $1.51 to $1.59 per share. The current trends of the business and the operational activities in place today set us up to take advantage of a weaker back half comparison as we anniversary some softness on the top line.

The second quarter will be the most difficult from a year-over-year comparison perspective. For the second quarter, we expect to deliver earnings per share between $0.26 and $0.30, and we are projecting low single digit comps which are on top of a 4% comp last year. As a reminder, the second quarter of fiscal 2007 included a net benefit in gross margin of approximately $4 million from favorable timing on rent reimbursement from Banfield. We also had a combined benefit of approximately $7 million in expenses from the impact of a reduction in insurance accruals and a reduction in stock-based compensation expenses.

For the back half of 2008, we will anniversary some weakness on the top line. We expect gross margins to continue to be pressured but to a lesser degree, as we begin to leverage our warehouse and distribution network and anniversary the mixture that started towards the end of Q3 last year. On the expense side, we are continuing to focus on managing cost and running the business efficiently to offset the pressure on margins.

So, we delivered on our targets for the first quarter. Our capital spending is on track, and we’re focused on execution, on efficiency, on making the most of our uniquely competitive business model, and on delivering results in 2008. As we look forward to 2009, we remain committed to slowing our unit growth, carefully managing our capital, our productivity, and our expenses. At the same time, we will continue to invest in initiatives that can drive returns over the long haul. We believe a balanced approach can help us deliver ongoing earnings growth and has potential to drive sustainable shareholder returns.

Thanks for your time, and I’d like to turn it over to Bob who is dialing into the call because he is traveling on business today. Bob is going to provide more details on how we plan to deliver on our commitments.

Robert F Moran

We all recognize that we’re living in uncertain times. I want to be clear that the tough environment does not change our two core commitments – achieving our targets for this year and building capabilities for the future. Instead, it focuses us on consistently executing on everything we do. We are intently focused on driving traffic to our stores and increasing the size of the basket by delighting the customer with our in-store experience. We have recently shifted our marketing mix away from circulars to more effective broadcast advertising, and our advertising message is focused on highlighting our promotional offers and solid price position. In addition, with our PetPerks database, we can identify lapsed customers and use direct mail to invite them back into our stores.

Our merchants have continued to work to offer the right assortment and a great value. We’re optimizing pricing on our entire assortment of products and services, and we’re adding SKUs and allocating shelf space to those products that are most popular with our customers, and we recently added educational video displays in our stores for products that solve some of our pet parents’ more nagging problems with very encouraging results. I am happy to report that we’re making strides in driving consistency and efficiency throughout our stores. We recently rolled out a store visit tool that aligns our store and field managers around the keys to creating a superior customer experience and operating a sound, profitable, and efficient store, and we have improved our ability to track customer satisfaction. We know the critical factors that make the difference to our customers, and we’re more frequently measuring our performance against them, and we’re linking people’s incentives to the results.

We remain committed to adding 100 to 104 new stores and 45 PetsHotels this year. We opened 35 net new stores in the United States and Canada to finish the quarter with 1043 stores, and we opened 10 new PetsHotels and finished the quarter with 107. Let's talk about store refreshes. 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. That means all of our stores will have been refreshed in the last 5 years. This investment is very profitable in the long run, but will put pressure on the business this year due to the fact that it takes a new store or a hotel a full year to become profitable. That coupled with some of the current economic challenges makes it challenging to deliver flat operating margins for the year, but we’re focused on getting there. We are likely to see gross margin pressure all year from occupancy costs and rising fuel prices, but we are working to offset some of that pressure by streamlining processes and making our distribution network more efficient.

As Chip mentioned, we started receiving products in our new replacement distribution center in Reno, Nevada. That will contribute to some of the margin pressure in the first half of the year, but once the facility is up and running, it will reduce the amount of miles we drive, which in turn reduces fuel costs. We are smoothing the flow of product throughout our network with real improvement in on-time performance and accuracy. We’re working with our largest vendors to better manage the flow of products coming into our network, and we’re more appropriately aligning our deliveries with our sales flow. All that makes it easier to plan labor and find efficiencies in our DCs.

On the expense side, we will continue to feel some inflationary pressure, but we think we have some opportunity by finding efficiencies and cutting unnecessary costs. Our work to optimize our supply chain helps stores more efficiently process deliveries. In connection with our focus on managing store labor, we’re now stocking shelves early in the morning before customers arrive, which not only frees up time to spend with the customer, it also improves our efficiency. We are on target to complete the implementation of our new labor management system in our stores by the end of 2008, but we are not waiting for the system to move forward on managing labor. We are giving our stores tools and processes that standardize noncustomer-facing tasks to make it easier and more cost efficient to run the store, and from a corporate overhead perspective, we continue to work on cutting costs by regularly reviewing our contracts, doing reverse auctions, taking advantage of economies of scale on our buying of supplies, and managing our professional fees. Everything we are working on today is making PetSmart a stronger business for tomorrow, and it is helping us achieve our targets for this year. We know that those targets are a challenge, but everyone is committed to delivering for this year and for the future.

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

Thank you. (Operator Instructions). Our first question or comment comes from the lines of Matt Nemer with Thomas Weisel Partners. Your line is open.

Matt Nemer - Thomas Weisel Partners

Good afternoon everyone. Thanks for the quantification on the one-time items in the second quarter of ’07. I was just wondering if there were any items like that in the back half of last year that we should be aware of from a modeling standpoint.

Chip Molloy

Hey Matt, it’s Chip. Taking a look at it, I don’t see anything that jumps out. There shouldn’t be any big one-timers. There’s still a little bit of the SLT cost that we quantified last year as went through, but other than that, there are no other one-timers that we’ll be anniversarying beyond Q2.

Matt Nemer - Thomas Weisel Partners

Are there any major offsets to those items? I was looking through the transcript, and it seems like there was maybe higher advertising expense last year, and then you had some one-time expense-related to strategic operatives, I believe.

Chip Molloy

We feel real clean about Q3 and Q4, even from a year-over-year perspective. The other thing I forgot to mention – of course, you got the 53rd week, so beyond the 53rd week and the SLT, there’s really nothing out there that we see that’s going to be big for your modeling. Q2 is sort of rough year over year, but beyond that, we’re good.

Matt Nemer - Thomas Weisel Partners

And you mentioned, in terms of your guidance, that in the second half, you’ll start to anniversary softer comps and I guess a less favorable mix of goods. Does the guidance assume a reversal of those trends or just a stabilization? In other words, do you have comps improving on a 2- and 3-year basis in the back half, and you expecting a shift back from the consumables to hard goods?

Chip Molloy

We are not expecting a shift back right now, and back half is indicative of just the current trends. So current comps, as you go in, you get weaker on the back half. It’s where we are from a current perspective.

Matt Nemer - Thomas Weisel Partners

And then lastly, can you comment on the productivity of re-merchandized StateLine Tack space?

Chip Molloy

With StateLine Tack, there are a couple of things to remember there. First off, from a sales perspective, in the first quarter of last year, we had about $17 million of StateLine Tack sales in the stores. We had about $5 million in our direct business for a total of $22. In the second quarter, we had about $10 million in the stores, and in the third quarter, $2 million. We did get the stores all remerch’d by the end of Q4—towards the end of Q4 by the time we got it all through—and we’re starting to see progress there. We started to see some in Q4, and we’re beginning to see that, but overcoming those lost sales, we still believe we have some ways to go, and that’s good for us for the back half.

Matt Nemer - Thomas Weisel Partners

Got it! Thanks very much.

Operator

Thank you. Our next question or comment is from the line of Matthew Fassler with Goldman Sachs. Your line is open.

Matthew Fassler - Goldman Sachs

Thanks a lot. Good afternoon! I want to start out with a brief question on MMI. I guess you recognized some of the rent this year in the first quarter that you didn’t recognize a year ago if I understand that correctly. Can you help quantify that? Did that help the earnings at all?

Chip Molloy

This year?

Matthew Fassler - Goldman Sachs

Yes.

Chip Molloy

This year, it was not material for Q1. It’s going to be material in Q2 from a negative perspective. Rent reimbursement for the year last year was about $33 million in total, and we recorded about $13 million all in Q2.

Matthew Fassler - Goldman Sachs

Did you have any in Q1 last year?

Chip Molloy

Yes, we actually did. It was almost $5 million in Q1 last year.

Matthew Fassler - Goldman Sachs

And this year?

Chip Molloy

And this year, it is between $7.5 to $8.

Matthew Fassler - Goldman Sachs

So a $2 to $3 million incremental.

Chip Molloy

Correct. That’s every quarter.

Matthew Fassler - Goldman Sachs

Got it! That’s helpful. Secondly, in terms of the sales acceleration that you expect to see, let’s say that the dynamics that are driving the macro environment today continue. Presumably, there’s no improvement in the macro backdrop. Could you make your sales numbers in that environment? Gas prices, for instance, which have been a problem all along seem to be a bigger problem as we speak. Are you presuming that that backdrop normalizes or are you presuming that we are 6 months from now macro-wise where we are today?

Chip Molloy

We’re assuming right now that 6 months from now we are where we are today.

Matthew Fassler - Goldman Sachs

Okay. Inventory growth of 15% and your COGS were up 11%. That’s reasonably close, but still up more than cost of goods. Can you just give us some color on where you stand on the inventory side?

Chip Molloy

Yes, on a couple of things. We do have a new replacement DC, so that’s driving some of it, and that will start to stabilize. The other piece of course is the growth in square footage, and then the third piece is inflation is having an impact. There is one other piece. We have bought a little bit ahead of time for promotional activity. It’s just a timing issue.

Matthew Fassler – Goldman Sachs

Finally, of the EBIT margin drivers that you expect to kick in over the course of the year, the most tangible one seems to be you have these new distribution facilities. They are going to get more throughput as the year progresses and consequently leverage more. How much improvement in the EBIT margin over the course of the year relates to that?

Chip Molloy

It is fairly significant. It starts in Q2 and it is fairly significant going into Q3 and Q4.

Matthew Fassler – Goldman Sachs

Is significant kind of 20 to 25 basis points from beginning to end or 50+?

Chip Molloy

Yes.

Matthew Fassler – Goldman Sachs

Which one?

Chip Molloy

Give me just a second Matt.

Matthew Fassler – Goldman Sachs

Yep.

Chip Molloy

We still believe that it will be dilutive in Q2, and going into the back half probably blended around 30.

Matthew Fassler – Goldman Sachs

For back half and the aggregate?

Chip Molloy

Yes.

Matthew Fassler – Goldman Sachs

Great. And versus how dilutive this quarter. I’m sorry I missed that 20, 30?

Chip Molloy

This quarter it was actually fairly significant. It was 65.

Matthew Fassler – Goldman Sachs

So, is that close to 80 or 90 basis point shift from Q1 to Q4?

Chip Molloy

Yes. And part of that is just anniversarying. Newnan opened in the second and third quarter of last year. All those costs were there, and now we are dealing with the anniversary of Newnan in a quarter we did not have it last year, and we also have Reno in place, so for this quarter, we have got essentially 2 new distributions centers.

Matthew Fassler – Goldman Sachs

Got it. Thanks guys.

Operator

Our next question or comment is from the line of Gary Walter with Credit Suisse. Your line is open.

Gary Walter - Credit Suisse

Thank you. First question. You mentioned that the gross margin on product was up. Can you talk a little bit about the pricing environment right now, what you are seeing?

Philip Francis

Gary, this is Phil. Either Bob or I could that, but I can’t do handle signals with them right here. The pricing environment right now is the big news is that there are cost changes, and I think we have indicated we have historically been people who passed it through and then check very carefully. We are still passing through and checking very carefully, and today, we see that other people are passing through, and so at this point with cost happen, where retails are going through, and what I call a regular and appropriate sort of way and the environments about like it was with some slightly higher retails based on slightly higher cost.

Gary Walter - Credit Suisse

We are also getting the sense that your direct competitor has backed away from some of the aggressive promotions they were doing, maybe, about a year ago at this time or nine months ago at this time. Is that proper market intelligence or are they still playing around?

Philip Francis

There were five or six districts where they did some activity several months ago. We haven’t seen an expansion nor heating up of that activity.

Gary Walter - Credit Suisse

One other thing that we saw from another company yesterday and they reported that they also had a fifty-third weekend and it helped the comparison in terms of this week. You got another weekend to spring versus last year. Did that have any impact on the comps or is the comp an apples to apples in terms of the actual weeks?

Philip Francis

Gary, we’ve been apples to apples, and I don’t know for sure who you are referring to you, but our business is not so much spring. Other than end of the year holidays, we are not necessarily a holiday-centric kind of business. We have been lined up anyway and that is not true with us.

Gary Walter - Credit Suisse

Okay, just checking, and then on new store productivity, could you comment on that? It looks by our math that…

Philip Francis

The fourth quarter was actually slightly better than it has been, so the exact, I don’t have. It was better in Q1.

Gary Walter - Credit Suisse

We will call you off line on that.

Philip Francis

That’ll be good.

Gary Walter - Credit Suisse

Thanks.

Operator

Thank you. Our next question or comment is from the line of Peter Benedict with Wachovia Capital Markets. Your line is open.

Peter Benedict - Wachovia

Hey guys! A question on the inflation impact on sales. I think Chip you said it was 4.3% in the first quarter. Just curious as to what the assumption is for the full year in terms of how inflation went back to top line.

Chip Molloy

Inflation, we believe is here with us for the rest of year. We knew it was with us going into the year. It is a little more than we expected, but we got that baked into our guidance, and we do believe that it is here to stay for most of the year.

Peter Benedict - Wachovia

Okay, and then chipping over to the services business, we did notice you’ve taken some price again in the hotels area recently. Can you just update us on the strategy there? What kind of demand response you’re seeing when you are picking up prices, and it does not look like you moved anything in grooming, so I’m just curious how that experience has gone since the price increase back in October.

Chip Molloy

Peter, Phil is going to answer that one for us.

Philip Francis

Really, no new news continuation Peter. We tested pricing both seasonally and geographically, and what we said last fall was that we tried some in effect holiday pricing, and we were pleasantly surprised by the lack of noise or anecdote or letter or e-mail or anything else. We also regularly do geographic pricing checks on grooming as well as hotels, and anytime we see movement in the market place, we have the capacity to be sort of DMA specific on either hotel or grooming prices, and as there is opportunity, we are not trying to be price leaders in grooming. We are trying to be quality and customer friendliness leaders in grooming, so we would always want to price slightly above the median, though never be highest, and we can look geographically and pretty finite way, and when we get a chance to move, we move.

Peter Benedict - Wachovia

Great! Thanks so much.

Operator

Thank you. Our next question or comment is from the line of Mike Baker with Deutsche Bank. Your line is open.

Mike Baker – Deutsche Bank

Thanks. Just a couple of questions. One, I’m wondering if you can comment on what you are seeing in terms of unit in some of your less discretionary businesses and perhaps the services. We know you pass through the inflation and you are getting some benefit there, but are you seeing units come down, and then I guess related to that, are you seeing any kind of trade down on your food business, in other words, how is your premium versus your regular food?

Chip Molloy

Couple of questions there. I will try to go through as many as I can. First, in terms of trade down, we don’t have data on any trade down. Remember there is a barrier based upon [inaudible] to justice systems if you do that. We specifically call that Super Premium and Rx Foods as among our best growers. We continue to watch that. I understand the kind of thing you’re looking for. We haven’t seen that yet. When you say our share of sales in the hard goods, I think that chip was down from 44 to 41, whereas consumables were up a couple of points and service was up the other point, so we add to 100 on everything. There is some unit slowness in hard goods, and where we think it is you can’t see it in new pet, but in replacement hard goods. My example is if your dog 1740 the first of August and the consumer is feeling a little pressed, they can buy that and turn that into a Christmas present, and that wouldn’t be a share loss for us, but it’s a bit of top line pressure. So I feel good about the fact that we’re well positioned in consumables, because the consumables business has been strong. Grooming business has been strong, and should the economy turn around, I’d look for hard goods to get a bit of help from that. So the fears of services we haven’t seen and we have lost in hard goods as evidenced by the 44 share to the 41.

Matthew Fassler - Goldman Sachs

Okay. That makes sense, and that’s what I figured was happening. One more question –are you seeing any competitive changes out there? We have been PetCo close a handful of stores. I’m wondering if you’ve seen anything along those lines.

Philip Francis

I’m not sure my count is terribly accurate. Since about last November, the closures there would be about 20. Haven’t seen any in recent weeks. Other than that in our environment, we are focusing on our own business.

Matthew Fassler - Goldman Sachs

Great! Thanks a lot.

Operator

Thank you. Our next question or comment is from the line of David Strasser with Bank of America. Your line is open.

David Strasser - Bank of America

Thank you. What are you seeing regionally? If you mentioned it, I missed it and I apologize, but throughout the country from a regional standpoint.

Philip Francis

This is Phil, and I’m probably going to be predictable and boring here. In some of the places you read most about subprime mortgages, there are stores in California that we think are affected and Arizona as well, a bit probably in parts of Florida. I would call that Texas does not seem to us to be noticing that there’s a problem with subprime, but if I were to call that too, I’d say parts of California, part of Arizona, and part of Florida, which matches up pretty well with what we read about the mortgage stuff.

David Strasser - Bank of America

Okay and then predictable (laughs). Looking at Q2, from a modeling standpoint, which part of the P&L gets hit the most in Q2 as far as the weakness. Is it more on the gross margins, is it comp?

Chip Molloy

Well, gross margin is going to take a pretty significant similar hit as it did in Q1, and the pickup that we’re having in Q1 on the expense side, we’re not going to see that kind of leverage in Q2 because of the one-items that are hitting SG&A. So the $4 million and the Banfield that we commented on, that’s up in March, and the other $7 million that we spoke of is all down in SG&A.

David Strasser - Bank of America

Okay, that’s helpful. The last question – I guess the one person who continues to see pretty good strength in this category is Wal-Mart. Are you seeing them doing anything differently? Do you think it’s a mix towards just having more food in the store?

Philip Francis

We watch Wal-Mart closely and are respectful, and we probably read anything Wal-Mart put out as quickly as you do. We think that their mix is more heavily consumables than ours is. So their emphasis on consumables and inflation in consumables would be good to them. We have read of their intent and seen a few stores. They are paying more attention to hard goods. I took it as a good sign when they said they thought that the pet category was relatively recession and economic pressure resistant. We interact with them on about 50% of our sales and only 20% SKUs, and that has been true for ever, and we’ve designed our business model with things like services which they don’t do, and what it comes down to for us is we watch the competition, but as soon as we focus mostly on doing what we do well, that’s when we seem to do best, and we will watch and see what we can learn, but if we focus on quality of execution, we usually do alright.

David Strasser - Bank of America

Thank you very much.

Operator

Thank you. (Instructions). Our next question or comment is from the line of David Cumberland with Robert Baird. Your line is open.

David Cumberland - Robert Baird & Co.

Thank you. On the product margin, how are you able to achieve an increase with the unfavorable mix shift between hard goods and food? As part of that, within your food business, are you seeing a favorable shift towards the super premium and prescription foods?

Philip Francis

This is Phil, David. The first thing I’ll remind you, as a recovered grocer, I can remind everybody that in times of inflation, retailers who can revalue inventory are advantaged on the margin line, as we get cost increases, we’re not for being macho or something waiting 6 weeks before we pass through the cost, and if I was going error, I’d pass it on a week earlier rather than I would a week late, and other than that, it’s just economies of scale, continued new negotiation, more private label, more stuff sources overseas, and a lot of that stuff, but we’ve got groups of people whose whole life is trying to work on the cost of goods irrespective of what’s going on in the macro market place.

David Cumberland - Robert Baird & Co.

And then, Bob mentioned using PetPerks to target lapsed customers. How much progress have you made on the customers that shopped less with you after the recalls last year?

Philip Francis

Bob, you want to take that one?

Robert Moran

Yeah, I’ll take that. David, PetPerks and databases have really become a friend in this time because as we look behavior, and especially the lapsed behaviors, we can incent the customers to come in, and we feel that we’re making a lot of progress there, and it’s in our guidance. The other side too is that we really focus on natural behaviors and shipping behaviors within our various segments to also highly influence our customers to come in. We really are focused on repeat customers and taking care of our best customers. That’s why we switched our marketing spend to broadcast, to also traffic-driving promotions, and also focusing on values. PetPerks is a great way of doing that. Also, when the customer comes in the store, we really focus on the customer experience and the customer engagement, and we talked about it - the execution level inside the store is very important to us, and one of those elements is being in stock, especially at this time when it’s a customer we can get and invite the customer to come in, we want to make sure that we have the product on the shelf. So, it’s a multi-approach, not only utilizing PetPerks to drive customers in, but I think it’s our overall marketing message, and it’s also the in-store environment.

David Cumberland - Robert Baird & Co.

Thank you.

Operator

Thank you. Our next question or comment is from the line of Joan Storms with Wedbush. Your line is open.

Joan Storms – Wedbush Morgan Securities

Hi, good afternoon. Chip, I was wondering if you could just go over the $7 million OG&A comparison from last year – what that’s made up of?

Chip Molloy

As we went through, part of it was on our accruals for insurance, probably about half of that $7 million. That was as we went through with our actuary – we have a third-party actuary who gets us estimates – it provided relief on the accrual, and the other piece of it was stock options, forfeitures, and stock option accruals, and they bolted SG&A.

Joan Storms – Wedbush Morgan Securities

Okay. You revised the guidance for comps for the year to low to mid single, so as you look at the second half and the easier comparisons, we should be looking at more like a 3% or 4% number if you’re getting that contribution from the inflation?

Chip Molloy

Yeah, low to mid however we would define low to mid, but that’s for the year, so considering we added 2.90 in Q1, we’ve given low singles in Q2, obviously we are expecting it to be higher than where it is today for the back half to hit low to mid for the year.

Joan Storms – Wedbush Morgan Securities

Thank you.

Chip Molloy

Okay.

Operator

Thank you. Our next question or comment is from the line of Brian Nagel with UBS. Your line is open.

Brian Nagel - UBS

Thank you. Good afternoon. I just want to hit on the occupancy costs you guys called out again. The question is, first off, when you see the 55 basis points of deleveraging, is that a function of weaker sales or are the occupancy costs actually climbing, and if they are, for what reason. I guess to follow on to that is what level of comps do we need for PetSmart to leverage the occupancy costs going forward?

Chip Molloy

A couple of things Brian on the occupancy costs. It’s a couple of factors. One factor is as we have increased the number of stores over the last couple of years and that’s grown – once again we didn’t give any of those details up until Q4 – so it has been delivered for some time now as we’ve accelerated and grown the stores. We’re growing stores, as you well know, the first year they are at a much smaller volume, and then when you net out cannibalization, it does put a stress on that line item. In addition to that, we have gone into some more expensive areas in the country. Rent and occupancy over the last couple of years in the retail marketplace as the space was more difficult to get into, the rents were higher, and then we are also seeing some accretion, if you will, on real estate taxes, so the states are going after retailers for taxes, so that’s causing some challenges on the rent and occupancy line, and therefore, as we said we’re going to start to moderate the growth of our stores, part of that reasoning is to try and get to a better leverage point. We have not given guidance as it relates to leveraging occupancy costs. What we have said is it takes about a 3 to 4 comp for us in this particular year given the number of stores that we have opening up and the number of hotels. It’s going to take a 3 to 4 comp to have operating margin expansion because we have cost up in margin and we have them down in the expenses as well. We like to think about it from that perspective. That’s where we came into the year. That’s where we think we are. As we go forward, we want to drive that number down, and that’s once again part of the reason for us using a little more balanced approach of spending capital versus earnings growth.

Brian Nagel - UBS

So, if we were to look at occupancy costs – and I know this is difficult from a comp perspective – it sounds like you probably would be leveraging that with a 2.9 comp. Is that correct?

Chip Molloy

We didn’t leverage it this quarter with a 2.9 comp. We’re not going to leverage the occupancy cost with pure loan with the amount of new stores coming in with a 2.9 comp.

Brian Nagel - UBS

If I asked the question, if you take out the impact of the new store openings and look at…

Chip Molloy

Absolutely. If you take out the impact of new stores, we would be leveraging occupancy, yes.

Brian Nagel - UBS

The second question I had is if we could just get an update on where you stand with the remerchandising of the StateLine area in your stores, and any potential benefits there?

Chip Molloy

We have all of our stores remerchandised in the back half of last year. It took us a little time to get that done, and we had most of it completed by the end of Q3 with some trickle into Q4. We started to see some sales start to take place in that space, and we started to see some progress. We continue to see progress, but it’s going to still take us some time before we are at a full run rate as it relates to the sales that we lost for SLT.

Brian Nagel - UBS

So, that’s still a drag on the comps then, so to say?

Chip Molloy

That will definitely have some impact on our comps in a positive way as we move forward.

Brian Nagel - UBS

Great! Thank you.

Operator

Thank you. Our next question or comment is from the line of David Mann with Johnson Rice. Your line is open.

David Mann - Johnson Rice

Yes. Phil, when you talked earlier, you mentioned something about New Pet. Can you just give anymore insights you have in terms of what’s going on in the market in terms of New Pet household formation and any data you have internally on adoptions as it seems like there’s a lot of talk about fewer adoptions out there?

Philip Francis

I don’t think I have great data, but I am glad to give you what we’ve got. We are off shift by two weeks, so it wasn’t perfect on the calendar, but every April or May, we do a very focused three-day adoption event, and the calendar was a slight bit different, so it’s nearly a comp. We ended up with slightly fewer adoptions in 2008 than we had in 2007, not many but fewer, and what I think that’s tied back to is the housing sort of stuff, to the degree that somebody is in an apartment and you have to get a pet when you get to a house and housing is down, that must mean new household and house formation is down, and I think so are adoptions, and therefore some of our New Pet would be tied in a secondary way to that. When it picks up, I think that it would be expected to pick back up, but we are still the person of choice for adoption, we’re still the person of choice for new pet, but I do think there’s a secondary impact on some housing on new pets with household formation.

David Mann - Johnson Rice

And then, if I could ask another question for Bob, in terms of what’s going on in the hard goods piece of your business, I think on the last call, you talked about potentially rolling out some new items or price points. Can you just give an overview of what you’re doing there – whether you are changing any pricing or product SKUs or it’s just one of these things you have to ride out with the environment?

Robert Moran

I think there are a couple of things there. One is we’re constantly testing through our pricing optimization the inflection point of where we can start moving goods, and obviously using PetPerks as a means to getting that message out and obviously the in-store look and presentation is very important to us. I think a lot of that is, as Phil mentioned before, there’s a little bit of delaying going on and deferral, and I think we are influencing customers, we are changing presentations that are influencing sales, we are changing prices that is helping us go through a number of those subcategories in line; however, I think there’s still a bigger element out there that we have to ride out the storm.

David Mann - Johnson Rice

And when you’re talking about price optimization, are you moving more towards offering better value or is it more raising prices?

Robert Moran

It’s better value. Again, what’s great about price optimization is that always half the prices can go up and half the prices go down, and obviously the pricing that can go down, you can really drive with great value message, which we have put in the stores and we have put into our promotional advertising.

David Mann - Johnson Rice

Great! Thank you.

Operator

Ladies and gentlemen, we have reached the allotted limit of our time for today’s conference. We do again thank you for your participation. You may all disconnect at this time.

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Source: PetSmart, Inc. F1Q08 (Qtr End 05/04/08) Earnings Call Transcript
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