As some readers may recall, I'm a conservative investor, which means I don’t like to pay for future growth.
No matter how promising a company’s prospects may be, if its current financials don’t reflect its potential, it’s not for me.
Hence, I’m going to go out on a limb and assume the company I'm going to tell you about today will maintain its current earnings into the future, without the benefit of any growth.
Even with this constraint, it's still a fantastic investment according to my analysis.
Here's the main reason why… on a normalized basis, if I estimate that the firm can generate about $520 million of free cash flow annually into perpetuity, its value works out to roughly $80 per share (compare that to its current price of $58).
In other words, if the retailer just maintains its current rate of earnings and does nothing else (such as opening new stores -- which is unlikely), the stock is worth $80. Combined with its 1.3% dividend yield, this implies total return upside of almost 40% from current levels.
Not bad for a company with strong cash flows, high returns on capital, shareholder-friendly capital return policies, manageable debt levels and, most important, low market expectations.
In fact, based on my calculations, the market seems to be expecting a secular decline for the company, which seems way too pessimistic given the positives I see in the business model.
That opens up a fantastic opportunity for investors…
An Industry On Fire
There’s no doubt about it: Americans love pets. And this love is growing.
According to a 2013-2014 survey from the American Pet Products Association, 82.5 million U.S. households (68% of the total) owned a pet versus 72.9 million in the previous survey.
Importantly, spending on pet products continues to grow every year, with $58.5 billion estimated for 2014 versus $55.7 billion in 2013.
As shown in the chart below, this growth has been steady throughout economic cycles, reflecting the fact that more and more people consider their pets to be members of the family for whom spending is a necessity, not an option.
The most compelling play I've found to take advantage of these favorable industry dynamics is PetSmart, Inc. (NASDAQ: PETM). PetSmart is the largest retailer of pet products and services, operating 1,289 stores in the U.S., Canada and Puerto Rico as well as an e-commerce website, www.petsmart.com.
Although many have talked about the demise of brick and mortar retailing due to online competition, PetSmart has some unique offerings that give the firm what Warren Buffett would call a wide moat, including pet adoption, boarding, grooming, training and veterinarian care.
These services only make up about 12% of total revenue, but they drive product sales, as customers are likely to shop for merchandise when they bring in their pets to get serviced. The company also sells premium pet foods that are not available at many of its competitors’ stores.
So why is the market down on this company right now?
About a month ago, PetSmart reported disappointing earnings for the fiscal first quarter of 2014 and lowered its outlook for the rest of the year, including comparable store sales growth that was flat versus previous guidance of 2-4% growth.
The stock immediately dropped from $65 to $56 within days, but has bottomed out from there. On a NTM (next 12 months) basis, it trades at an EV / EBITDA multiple of 6.5X and a P/E ratio of 14.3X. For reference, the S&P 500 trades at EV / EBITDA and P/E multiples of 10.3X and 16.4X, respectively.
Although I’m not a big fan of applying such multiples to value a stock, I do think they can serve as signs of whether a particular security is attractive or not; in this case, the signals are flashing the 'buy' signal.
Risks to Consider: Risks related to PETM include further deterioration in consumer spending and confidence, more aggressive competition from both online and brick and mortar retailers, and a high short interest equal to 17.5% of its total float.
Action to Take --> That said, at current prices of $58-59, I recommend purchase of PetSmart for a potential total return upside of 39%. My conservative analysis shows that this short-term pullback provides a solid entry point
