PetMed Express Yields Just Under 5%, But We Will Be Taking A Pass

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About: PetMed Express, Inc. (PETS)
by: Vanaheimr Capital
Summary

After analyzing PETS' finances it is clear that the company is financially strong and has been conservative in their use of debt.

The market for pets is a very interesting secular growth area.

After seeing so many positive characteristics we decided to avoid the stock because of their unsustainable customer acquisition cost.

Investment Thesis

PetMed Express Inc (PETS) is undoubtedly a value stock with low financial leverage, a low PE ratio, and a small price to book ratio. However, even with numerous pros, we think one con is enough to give investors pause. The customer acquisition cost is extremely high relative to their average sale amount and has grown year over year. We think the stock should be avoided as the growth in cost is likely to worsen in the future. We would not be short the stock, but longer-term oriented investors should think twice before investing in PETS.

An Internet 1.0 Darling

PetMed Express Inc. was one of the high flyers during the internet bubble of the 1990s, rocketing up from $1.70 in 1997 to over $8 per share in 1999 before cratering to $.021 per share in 2001. In this time virtually every company with a website skyrocketed to unsustainable highs before plummeting to lows that were equally insane. While the inexperienced and weak hands were shaken out, the smart money began to move in and pick up values amongst the rubble. There doesn't seem to be many bubbles of similar magnitude in the market today although a similar mania will take hold again like the crypto-currency craze of late 2017. Since we like to focus on the value that is overlooked, we are asking ourselves to essential questions. Is PETS a value stock? Is their business sustainable or will it lead to a value trap?

Source: YCHARTS

Is PETS a value stock?

PetMed Express traded just under $48 per share in February of 2018 and traded at $22.48 as of Friday, February 8th. PETs is down almost 50% over the past year and is trading well below historical metrics on ratios such as price to earnings and the highest return on equity ratio for the company in a decade at 35.6% for 2018. PETS' PE ratio is at the lowest it has been in the past ten years, 11.28 as of Friday's close, and has been as high as 40 over the past decade but has never dipped below 11. We think it is not very likely for the PE to get much lower however that does not mean it has to go up via multiple expansion or price appreciations.

Source: YCHARTS

PetMed Express achieved an incredibly high return on equity of 35.6% for 2018 while having virtually zero debt. As students of finance know the higher the level of debt a company has the easier it is to inflate financial metrics such as return on equity however with only $24 million in debt, there's very little leverage to inflate the ROE. Lastly, PETS has paid a consistent dividend which they raised to $0.27 in August of 2018. PETS now yields 4.72% as of Friday, February 8th. These metrics are often associated with a company that has declining revenue or similar challenges however what is so interesting is that PETS has grown revenue consistently since 2015 and shows no indications of a major dropoff anytime soon. So now that we know PETS is financially strong, is the business any good?

Source:YCHARTS

PETS Is A Challenged Business

PetMed Express is essentially a direct-to-consumer online pharmacy for pet owners, specifically owners of dogs and cats. The most important nuance to this business is that many pet owners will get prescriptions filled by a veterinarian or at the pharmacy within an animal hospital. This is why of all pet medications, about 55 to 60 percent is fulfilled by an in house pharmacy 6% is fulfilled by PetMed. This still makes PETS the largest pet pharmacy, but their connection to the consumer is often made after the pet owner goes to a veterinarian or animal hospital. Making the sale or connection to the consumer is often difficult, which, in our view, is why their customer acquisition cost grew from $34 in 2017 to $37 in 2018. What makes their customer acquisition cost so shocking to us is their average customer order value of $83 in 2017 and $87 in 2018. This means that on average 43% of PETS revenue is for marketing expenses. In other words, before paying any of the other expenses, including shipping and the costs of the medicine, $0.43 goes out the window toward marketing expenses for every $1 of sales revenue.

Conclusion

PETS is trading at the lowest PE ratio in a decade, which could point toward a trading opportunity for those expecting a reversion to the mean or a positive catalyst. We think a strong case for an upside move could be made by a savvy trader however that is not our expertise. In our view as longer-term investors, we think the business is not sustainable given their degree of separation from the consumer who has options to purchase medicine at the veterinarian, and PetMed Express's incredibly high cost of acquiring new customers. These two factors make PETS ripe for disruption by competitors like an Amazon or even by Vets who create their own automatic prescription refills or online ordering. In addition, we think PETS will be incredibly dependent on marketing costs not rising over the long term. If they were to rise, it could easily wipe out their profit. Management has built a financially strong company, but we will be taking a pass on this name.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.