Petco Stock: Value Territory (NASDAQ:WOOF)

In the summer of last year, I noted that it was slowly getting interesting to have a look at Petco Health and Wellness (NASDAQ:WOOF) as the business has seen a strong performance since the company went public earlier that year. While appeal was increasing, I believed that this should not be confused with appeal seen at the time.

Former Take

Founded in 1965, Petco has grown to deliver a wide range of products and services related to animals. This includes merchandise, pet care, digital expertise and subscription models, all driven by the humanization of pets trend which was already seen ahead of the pandemic, with even more people taking a pet during the pandemic.

The pet industry is huge in the US as some 70 million households have a pet, resulting in a $100 billion industry which is among others comprised out of food, care, insurance and related services, with solid growth seen ahead.

I did believe that the business had a challenged past with no or negative growth seen in the years 2016, 2017, 2018, despite the secular growth trends, as a new management team managed to rejuvenate the business to post growth ahead of the pandemic.

The company went public at $18 per share early in 2021 as the company had some debt on its books as well after private equity parties bought the business back in 2015. Ahead of the pandemic, the company posted adjusted operating profits of $129 million on $4.4 billion in sales, being very tiny margins.

Revenues were up 9% in the first nine months of the pandemic, with operating earnings doubling to $128 million, yet it felt like an underperformance, certainly in relation to other players, among others Chewy (CHWY). Even if operating earnings came in at $200 million for the year, much of that money would go into serving the debt load, leaving very minimal earnings, making me very cautious.

Operating in a different market mantra, shares rose to $28 on the first day of trading, but shares fell towards the $19 mark by the summer of last year. In March 2021, the company posted an 11% increase in full year 2020 sales to $4.9 billion, with EBITDA up to $484 million, as adjusted earnings came in at $0.28 per share for the year, in line with the modeling at the time of the IPO.

The company guided for 2021 sales at $5.3 billion, with EBITDA set to rise modestly to $525 million, with adjusted earnings seen at $0.65 per share. Net debt of $1.5 billion post the initial offering looked reasonable, with leverage coming down rapidly. Following solid first quarter results, the company hiked the sales guidance to $5.5 billion, with EBITDA seen at $555 million, and earnings seen at $0.75 per share.

With 265 million shares trading at $19, the resulting $6.5 billion enterprise value (including $1.5 billion in net debt) made that valuation starting to look more compelling last year, although I was not happy with the aggressiveness in terms of adjustments made to the adjusted earnings, notably with stock-based compensation expenses being excluded for.

What Happened?

After trading at $19 in July of last year, shares of the company rose to the $25 mark in November, with the market seeing solid momentum, but this all changed as high valued firms and technology names kept dropping, with shares now down to a fresh low of $13 per share.

In March of this year, Petco posted its 2021 results with revenues up 18% to $5.8 billion, comfortably ahead of the initial guidance. Adjusted EBITDA improved to $591 million with adjusted earnings posted at $241 million, or $0.91 per share, all ahead of the initial guidance. GAAP earnings came in at $0.62 per share and excluding a $0.19 per share pre-tax equity compensation expense, realistic earnings likely came in around $0.75 per share. Net debt came in at $1.45 billion at the end of the year, as leverage ratios came down to 2.5 times, getting healthier.

The company guided for 2022 sales to rise to a midpoint of $6.2 billion, adjusted EBITDA around $637 million and adjusted earnings seen a few pennies short to a dollar, marking modest growth.

In May, Petco posted first quarter sales of $1.48 billion, just 4% ahead of last year as adjusted earnings were flat year-over-year at $0.17 per share. While the company maintained the guidance, it is clear that there are some risks to the growth guidance now given the underwhelming performance in the first quarter, and certainly inflationary and spending headwinds materializing in the second quarter.

Needless to say, even if realistic earnings are flat this year at around $0.75 per share, valuations have been de-risked quite a bit here at $13 per share, for a 19 times earnings multiple as leverage ratios come in around 2.5 times. This looks a lot better than was the case at the time of the IPO, but I am mindful of these numbers and the outlook here as the company is essentially a mixture between a secular growth play and a boom induced by the pandemic.

While the new management team has certainly delivered on some promises, this all happened largely in a period in which the pandemic has mixed up a lot of trends, making it hard to read into the true organic performance of the business. That being said, these levels mark territories where appeal is rising because of the solid growth displayed upon and the lagging, or actually falling share price, creating a better set-up from a valuation multiple and leverage point of view.