PetMed Express: Still Hope After A Concerning Quarter

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About: PetMed Express, Inc. (PETS)
by: Vince Martin
Summary

The bear case for PETS is that Chewy is going to take its margins (at least) away, and that case seemed to be confirmed by disappointing fiscal Q3 results.

But the story here isn't quite over - PETS continues to drive strong growth from existing customers, and has some potential to improve on the new customer front.

This increasingly looks like a binary play; while I was too early in timing the bottom, I'm not ready to toss the story quite yet.

PetMed Express (PETS) has been one of the most-shorted stocks in the past decade, with a short float usually over 20% and now at a peak 44%+. And there's been no shortage of catalysts for the bear thesis here.

The company's "gray market" business model, in which it acquires products through third parties rather than directly from manufacturers, long has been seen as a key risk. More recently (starting in fiscal 2015) PETS earnings growth accelerated thanks to steady advertising cuts - a move whose benefits by definition were going to fade. Gross margins then expanded, apparently due to "new generation" flea & tick medicines - but that benefit, too, seemed potentially transitory. Now, PetSmart's Chewy.com appears to be targeting the online pharmacy space aggressively - adding a new and potentially dangerous competitor for PetMed Express.

As PETS pulled back on those competitive worries last year, I turned bullish - and admittedly too early. PETS trades near a 21-month low after a disappointing Q3 earnings report last month. The stock has been halved just since late June - and the bear case seems to be gaining momentum (and the short trade gaining adherents).

But I do wonder whether it's too early to write PetMed Express off completely. Q3 numbers were concerning. Chewy is a formidable competitor. But the online space remains a growing market (figures cited by PetIQ (PETQ) suggest double-digit annual growth of late) and it's possible PetMed Express has some room for improvement on the execution front. With the stock at ~10x free cash flow, there's room for a huge bounce if and when PetMed Express can silence the doubters - and admittedly more downside ahead if it can't.

The New Customer Problem

One of the issues with valuing PETS is that to some extent investors are flying blind. Chewy seems like the biggest competitive threat at the moment (though it's hardly the only one), but as a private company its financials aren't available. PETS' own disclosure, in both filings and conference calls, is somewhat limited, which CEO Mendo Akdag historically has attributed to a desire to keep information out of the hands of competitors.

So it's not guaranteed that Chewy's launch of its pharmacy offering in July is what drove the disappointing Q3 results. But that's certainly the message investors are taking away from the Q3 release - and there is a notably concerning trend on the top line that seems to support that interpretation:

PETS stock quote source: author from PETS press releases and filings

New order sales (the yellow line) here have collapsed. It was the strength in those sales in past quarters that led PETS to gain so significantly, since new order sales were growing at the same time margins were expanding. Just as concerning (if not moreso), the number of new customers has fallen off:

PetMed Express New Customer Acquisition

Quarter New Customers % Change y/y
Q4 FY17 126,000 +8.6%
Q1 FY18 169,000 +7.0%
Q2 FY18 134,000 +2.3%
Q3 FY18 106,000 +7.1%
Q4 FY18 113,000 -10.3%
Q1 FY19 169,000 flat
Q2 FY19 117,000 -12.7%
Q3 FY19 81,000 -23.6%

source: author from PETS earnings call transcripts

In fact, the Q3 FY19 figure of 81,000 new customers is the company's lowest in at least the last eleven years. Seasonality is a factor (Q3 is the smallest quarter from a sales standpoint, as winter depresses demand for flea & tick), but as seen in the table above even the y/y trend is turning south quickly. Even Q1's flat performance is colored by the fact that Q4 FY18 results took a hit from a longer winter, which no doubt shifted some flea & tick sales (and new customer acquisitions) into the following quarter.

That erosion of new customers means PetMed Express is returning to a long-troublesome trend:

PETS stock quote source: author from PETS earnings call transcripts

After new customer acquisition had shown some signs of life, the direction again is turning negative. And it certainly seems possible - if not likely - that Chewy's launch, which occurred at the beginning of PETS' Q1 FY19, is responsible for that reversal, and the accelerating declines in the last two quarters.

Margin Concerns

That said, we know that PetMed Express' financials can hold up with declining new order sales - because that's what happened for most of the first half of this decade. EPS and operating income were choppy, but relatively stable, over that stretch. Lower new customers isn't optimal, certainly, and smaller cohorts affect reorder revenues down the line. Still, new order sales are just ~17% of the trailing twelve-month total, and reorder sales remain positive (including a 4.7% increase in Q3).

The worry at the moment, however, is that continued pressure on new order sales probably leaves the consolidated top line flattish (as was the case in Q3) - while margins start to erode. Gross margin fell a stunning 420 basis points year-over-year in the quarter. The 10-Q attributes the pressure to both higher product costs and "increases in discounts given to customers to stimulate sales in response to increased online competition".

Again, this seems like a Chewy problem, as that site has been aggressive in discounting for customers to switch to that platform. (As a Chewy customer, I've received several offers myself.) And PetMed Express' pricing clearly was down sharply: the average order value fell 2.3% year-over-year, which Akdag on the Q3 call attributed solely to reduced prices.

Even with lower advertising spend (down 12.3% year-over-year, an 80 bps boost to operating margins) and cost control at the G&A line, EBIT margins still compressed 330 bps year-over-year. Gross profit dollars alone dropped 11.7% on basically flat sales. And this aspect of the story is relatively new: gross and operating margins were flat year-over-year in the first half of the year (and actually expanded modestly in fiscal Q2).

And so the fundamental bear/short case here starts to reappear. Advertising spend is going to rise, as Akdag himself pointed out on the Q3 call. That will reverse the benefit PETS earnings received earlier this decade (advertising leveraged 450 bps as a percentage of revenue between FY14 and FY17). Gross margins are coming down. If Chewy keeps taking potential new customers, revenue flattens out.

A trailing twelve-month EBIT margin of 18.3% starts compressing toward the low teens rather quickly. EPS drops from a current ~$2 to something like $1.25-$1.35. Slap on a 10-12x multiple, even adding back $4+ in cash per share, and PETS is at $18 or so, about 20% downside. If Chewy starts taking existing customers, or margins get even worse, PETS drops even further.

The Case For Patience (Some Patience, Anyway)

Those risks do seem real at the moment. And combined with the Q3 report, they are real enough that an investor can't argue that PETS at $23 is too cheap simply because it trades at ~10x earnings (backing out net cash and interest income), ~7x EBITDA, and with a 4.7% dividend yield. Fellow contributor Almeida Investment Management last week made a case that PETS is a value trap, and that's the biggest risk to the case here. Operating income declined 18% y/y in Q3, and PetMed Express is lapping the benefit of a lower tax rate in Q4. 10x EPS and 7x EBITDA are not necessarily 'cheap' if this is a business in long-term decline.

The question is whether Q3 supports the argument that this is a business in long-term decline. Certainly, new order sales are a concern. It appears probable that EBIT margins are going to have come down, and that PetMed Express may face a "new normal" where those margins simply can't hold at 18%+.

A step-down in earnings, however, isn't the same thing as a long-term decline. And there are reasons to believe that PetMed Express isn't being shoved out of the market to the point where earnings are headed for a multi-year decline.

First, reorder revenues remained positive - against a difficult 13.4% comparison the year before. PetMed Express still has a large built-in base of customers driving 80%+ of total sales. There's an obvious debate over what stickiness/switching costs might be in the industry, but as an owner of too many pets myself I remain skeptical customers are going to aggressively move elsewhere for modest savings in irregular purchases. And even with a generally negative customer acquisition trend, PETS' reorder revenue has grown steadily over the decade (about a 3.6% CAGR over the past eight years).

For PETS earnings to collapse over a multi-year period from the current ~$2 to something below $1, those reorder sales have to start declining. In other words, Chewy and other competitors like Drs. Foster & Smith have to start poaching existing clients, not just winning the battle for new customers.

And it's important to remember too that there are likely more online customers available - and a market that will continue to grow. (See slide 4 of this PETQ presentation for industry data on the pet prescription space.) Chewy's growth isn't coming just from PetMed Express; it's coming from Petco and PetSmart and likely veterinarians as well. And Chewy's aggressive advertising and customer acquisition efforts (not to mention the wide reach of its pet food business) themselves likely are helping to grow the market, and shift prescription sales online.

I'm simply not quite ready to start modeling in steady revenue declines for PETS. Even with the worst quarter ever in terms of new customer acquisition, overall revenue declined 0.1% - against a 13.7% comparison. Market share and competition are real concerns, but those factors don't necessarily imply that PetMed Express sales have peaked.

On the margin front, Q3 was disappointing. But PetMed Express is responding - and it also looks like the company had a poor quarter from an execution standpoint. The decline in advertising spend doesn't appear planned: Akdag cited "a lower-than-expected response to our online advertising" in the quarter, perhaps one reason PetMed Express is going to add in TV and offline efforts.

This not to say that PetMed Express can turn back on the advertising spend spigot and ricochet back to new customer growth. But it does seem like the ad strategy missed in the quarter. Per the Q2 call, the company already was looking to add offline spend, and more successful efforts there for flea and tick season should at least improve results from Q2/Q3 levels.

More broadly, I'm not quite ready to write PetMed Express off as a viable competitor in the space. It's easy to assume that Chewy and - Amazon (AMZN), should it move in - will simply muscle PetMed Express out. But PETS has been at this for 20 years. It benefited in recent years from the newer flea & tick medicines; that benefit may be fading, and Chewy may be a tough rival. That's not the same as saying that PetMed Express is headed for extinction - or that its management team can't pull some levers to try and improve on the disappointing Q3 numbers.

Buy The Dip?

The question here is whether PETS is cheap enough, and its competitive position strong enough, to justify an entry at $23. Again, I argued for the stock last year, unfortunately. PETS is cheaper - but Q3 can't be written off, either.

The case for PETS at the moment is that even lower earnings probably are good enough if they stabilize. Cut EBIT margins from 18.9% to 14% and EPS drops to ~$1.50. A no-growth ~12x multiple plus nearly $5 per share in cash pretty much supports the current price.

There are some near-term worries, however. The narrative toward PETS quite clearly has changed, even if the stock has stabilized in recent months (even recovering rather quickly after falling after the Q3 report). In that context, the next few quarters (particularly Q4 and Q1, given stronger seasonality) are key. And PetMed Express is facing some very difficult comparisons:

PETS Two-Year Stacks, Q4FY19-Q3FY20

Quarter 2-Yr Revenue Stack 2-Year Reorder Rev. Stack
Q4 FY19 21.5% 23.8%
Q1 FY20 20.6% 20.9%
Q2 FY20 17.4% 21.8%
Q3 FY20 13.6% 18.8%

Any revenue weakness is going to be taken as further evidence of eroding market share. And given that Akdag guided for higher advertising spend and more discounting, margin compression has to be modeled as well. Even if the bull case is that PetMed Express a) can adapt to some extent and b) is cheap once margin stabilize, bulls are going to be fighting aggressive short interest and likely year-over-year declines in earnings in coming quarters.

To be honest, at this point, little would surprise me. I certainly didn't expect PETS to clear $50 - or to hit $21 less than a year later. The large short position and the oddly high interest in the name (3-month average daily volume is about 4% of the market cap) are going to create volatility.

From a long-term standpoint, I still believe the sell-off here is overdone. But the near-term problem is that PetMed Express, between margin-diluting strategy changes and tough comparisons, is going to have a tough time changing the narrative in the next couple of quarters. This will remain a battleground stock - as it's been for years now - and bulls might have to wait out the storm before charging too aggressively.

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.