U.S. spending on pets surpassed $53 billion in 2012, up from just $17 billion in 1994, according to the American Pet Products Association. Most of the businesses that cater to pets — especially at the higher end — are growing at a steady mid-to-high single-digit pace.
The industry’s steady past returns and favorable growth prospects makes a pull-back in a pet-related company’s stock price an opportunity to get in at a discount. Not long ago, PetSmart, Inc. (NASDAQ:PETM) announced disappointing guidance for 2013 due to weaker same-store sales increases than the street had anticipated, and a sell-off of its stock ensued.
However, PetSmart, Inc. (NASDAQ:PETM) appears to be oversold — providing an attractive entry point for investors.
Good to be in the pet business
Lots of stores sell pet food, but only PetSmart, Inc. (NASDAQ:PETM) and its main rival, PETCO, sell a wide variety of high-end pet food and supplies. PetSmart, Inc. (NASDAQ:PETM) is like the Whole Foods of pet food — pet owners who care what their pets eat would not dare buy the off-brand processed food sold by Wal-Mart Stores, Inc. (NYSE:WMT).
But pet supplies companies are not the only pet-related businesses benefiting from the boom in pet spending. VCA Antech Inc (NASDAQ:WOOF) and IDEXX Laboratories, Inc. (NASDAQ:IDXX) also benefit.
VCA Antech Inc (NASDAQ:WOOF) and Idexx compete in diagnostic lab tests for animals. VCA Antech Inc (NASDAQ:WOOF) also owns animal hospitals. It frequently acquires independent animal hospitals in a roll-up format designed to produce cost advantages over local competitors by way of economies of scale. The lab business is much better than the animal hospital business, though integrating the two makes the animal hospital side more attractive than it otherwise would be due to synergies.
The key for both VCA Antech Inc (NASDAQ:WOOF) and PetSmart is that they are large companies operating in a fragmented market. Most animal hospitals are independent — or are part of a two- or three-hospital chain. Likewise, most of PetSmart, Inc. (NASDAQ:PETM)’s non-PETCO competition comes from mom-and-pop stores.
As a result of economies of scale, these companies typically earn relatively high and stable margins. However, VCA Antech Inc (NASDAQ:WOOF)’s margin has fallen precipitously over the last couple of years due to an increased emphasis on the lower-margin animal hospital side of the business.
One thing to note is that there were no substantial drop-offs in margins during the recession. Pet spending is becoming more of a non-discretionary expense for many pet-owners as the humanization of pets takes hold in America. This should enable all pet-related businesses to outperform the general economy during another downturn.
Getting in at an attractive price
Quality limits your downside, but price determines your return. So your goal should be to pay a low price for a high-quality business.
VCA Antech Inc (NASDAQ:WOOF)’s animal hospital is not nearly as good as its labs — and unfortunately it seems content to continue moving away from its lab business. So VCA is the least attractive of the three on the quality scale and should be put aside from further consideration.
Idexx’s lab business has high and stable margins. It earned $164 million in free cash flow in 2012 and will likely earn between $160 and $175 million in 2013. $175 million divided by the company’s current market cap, $5.06 billion, suggests a 3.5% initial free cash flow yield. But Idexx is still growing, so the actual return on investment will probably be closer to double the initial yield, or 7%.
Luckily, PetSmart, Inc. (NASDAQ:PETM) is both high-quality and selling at a low price. The stock sells at just 11x pre-tax earnings — a bargain when you consider that it is growing at a high-single-digit rate. Investors keen on entering the pet business may have just found their entry point.
The article Take Advantage of the Stable and Growing Pet Products Industry originally appeared on Fool.com is written by Ted Cooper.
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