Uwe Krejci
In the summer of this year, I concluded that shares of Petco Health and Wellness Company (NASDAQ:WOOF) were approaching value territory. This came as the company continued to see solid operating momentum, as it seemed as if the quality of the business and management has improved versus the years before. This distinguishing feature was hard to read into (or isolate for that matter) given that the pandemic still had an impact on the business, yet overall valuations had come down a lot already, almost enough to get involved.
Some Background
Petco was founded in the 1960s already, having grown to deliver a range of products and services to animals. Examples to think of include merchandise, pet care, digital expertise, all driven by a comprehensive humanization of animals trend, certainly during the pandemic with discretionary spending on these categories on the rise, and more people taking a pet.
The potential is huge as some 70 million US households have a pet, translating into a huge $100 billion market opportunity, comprised out of food, care, insurance and other services. The company has seen a tough past with zero or even negative organic growth reported in 2016, 2017 and 2018, despite the secular growth trends and ahead of the pandemic of course.
The pandemic and the resulting boom in valuations made that its private equity owners decided to float the business early in 2021, with shares offered to the public at $18 per share, after having acquired the business in 2015.
Ahead of the pandemic, the company generated $4.4 billion in sales in 2019 on which a mere $129 million in operating profits were reported, translating into tiny margins. With sales up 9% in the first three quarters of 2020, operating earnings doubled to $128 million, as the extent of the improvement felt a bit soft, with the company having to service a lot of expensive debt as well. As it turned out, 2020 sales rose to $4.9 billion as adjusted EBITDA improved to $484 million, with adjusted earnings only reported at $0.28 per share.
2021 sales were originally seen at $5.3 billion, with EBITDA expected at around $525 million and adjusted earnings seen at $0.65 per share. Earlier this year, the company did post a $5.8 billion revenue number for 2021, on which adjusted EBITDA of $591 million was reported, with adjusted earnings posted at $0.91 per share as stock-based compensation of $0.19 per share was excluded in this number, for otherwise a $0.72 per share number. Net debt fell to $1.45 billion, for a 2.5 times leverage ratio.
More good news was seen in 2022 with sales seen up to $6.2 billion, EBITDA seen rising to $637 million, as adjusted earnings were seen at around $1 per share. In May, the company posted a mere 4% increase in first quarter sales, with adjusted earnings per share coming in flat, creating some risks to the guidance, yet the company maintained the guidance nonetheless.
Trading at $13 per share in July, the realistic earnings multiple came in at 19 times earnings, with leverage looking quite reasonable. While the valuation was reasonable, I was mindful of the risks to the 2022 guidance and the long-term concern related to the health of the business, with secular growth and pandemic related trends all impacting the business.
An Update
After becoming gradually more constructive at $13 in July, shares have traded around the $15 mark this summer, having sold off to the $10 mark in recent times, to now trade at $11 per share.
In August, Petco posted second quarter results which revealed that comparable sales growth slowed down to 3.8%. On the back of slower growth and a decline in earnings per share, the company cut the full year sales guidance to around $6.0 billion, with EBITDA now seen at a midpoint of $587 million with adjusted earnings now seen around $0.79 per share. This is down quite a bit from the roughly $1 earnings per share number guided before, all while net debt remained pretty stable around the $1.5 billion mark.
Late in November, Petco posted a 4.1% increase in comparable sales for the third quarter. With adjusted earnings again down on an annual basis, the only comforting factor is that the company reiterated the full year guidance on the sales and EBITDA front, with the midpoint of the earnings guidance cut by two pennies to $0.77 per share. With stock-based compensation trending at $0.20 per share here, realistic earnings are only seen around $0.60 per share, or even a bit lower. As net leverage is stable around $1.5 billion, leverage increases to 2.6 times EBITDA here, mostly on the back of lack of deleverage and lower EBITDA.
What Now?
Fast forwarding between July and today, we have seen two recent quarterly numbers which confirm my suspicion of a slower operating performance. This is seen in the full year guidance which was cut in a major way alongside the second quarter earnings report. This makes the situation quite tricky, although that leverage is not a major issue (yet).
The reality is that the operating performance has been softer than anticipated, perhaps driven by a reversal of pandemic related trends and general softer performance from still not a superior business, if you ask me, with cash flow conversion held back by relative larger capital spending requirements and aggressive adjustments made to the earnings numbers. These earnings are hurt by slower growth, but more so by supply chain issues and inflationary trends, with Petco not being able to fully transfer this onto its customers.
With shares down from levels seen this summer, trading near their lows, I am still constructive but remain reserved on the shares here as the quality of the business remains a concern of mine. This is the case even as the overall valuations keep falling, as the equity value is down to just $3 billion here, at a market multiple in relation to the realistic earnings power around $0.60 per share.
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