The Money in Creature Comforts

Not only do dogs, cats, and pythons have to eat, but they're pampered even in hard times. That makes PETsMART and Petco cheap growth bets

As one who wisely drew the line on house pets at two cats from the pound, I was in for a shock the other day as I stepped into a PETsMART (PETM ). Yes, years ago I had heard of health insurance for Fido, an insane idea in a nation with 39 million uninsured humans. But just how indisputably pets now enjoy the upper hand, I had no clue.

I spied more toys, shampoos, beds, pillows, holistic foods, and treats than Noah could ever have foreseen. Half an aisle was given to scoops and bags for you-know-what. Also, doggy diapers. A vet clinic held down one corner, with an adoption agency and a grooming salon nearby. There were magazines (Ferrets--The Ultimate Guide for Today's Ferret Owner) and a $9.99 package of puppy oral hygiene items including enzyme chews, dental bones, toothbrush and paste, mint-flavored rinse, and sugar-free breath lozenges. I confess to having skirted the reptile aisle. But for kitty, I found Play Gym Condo, the Taj Mahal of scratching posts, for just $319.99.

Here's the scary part: PETsMART's 570 stores are only the half of it. There's also Petco Animal Supplies' 585 stores. Between PETsMART and Petco, they rang up $4 billion in sales of small pets (not including dogs and cats) and supplies over the last 12 months. With same-store sales gains running 8% to 11%, profits are surging and the stocks are hot, particularly PETsMART's (chart). It's up 80% this year, while Petco (PETC ) shares, which came public in February at $19, are holding their own amid the bear market.

Such popularity on Wall Street usually prejudices me against most any stock. And these two could fall out of fashion as more familiar growth vehicles, such as technology stocks, come back into vogue. Yet for investors looking for companies that promise years of continuing growth, these two retailers still have reasonable valuations.

Demographics are driving demand for pet supplies and, increasingly, such services as grooming and training. Aging baby boomers are filling their empty nests with pets, while the number of households with children from 5 to 15--the core pet market--keeps climbing. PETsMART CEO Philip Francis calls pets "an affordable luxury," sales of which have yet to be dented by weakening consumer confidence. "I'm glad to be selling dog beds rather than 80-foot luxury yachts" in the current economy, Francis told me.

Both chains figure they're less than halfway to the number of outlets the market can support. So, for example, Petco this year expects to add 37 new stores, while PETsMART aims to add 25 in 2002 and another 60 next year. Both chains also have been remodeling the interiors of older locations. Petco's chief financial officer, James Myers, said its new layout moves the animals it sells from the store's periphery to the center. "Customers get a closer, 360-degree look," he told me.

While similar in their strategies for growth, the companies differ financially. Petco, with sales over the past year of not quite $1.4 billion, has an edge in operating efficiency. Its stores are smaller on average but inventory turns over a bit faster and yields a wider gross margin. Yet PETsMART is clearly stronger, with no long-term obligations beyond leases. And its revenue base is a lot bigger: Sales in the past four quarters came to $2.6 billion.

Both retailers are enjoying outsize gains in earnings as recent investments in distribution and inventory management pay off. Petco expects a profit of at least 87 cents a share this year, up from 52 cents in 2001. For 2003, estimates are running around $1.08 a share, which would be a 24% gain. PETsMART sees this year's earnings doubling, to around 71 cents from 35 cents, and the Street expects another 25% gain next year, which CEO Francis suggests is a reasonable forecast.

If these estimates pan out, then Petco at $19 trades under 18 times next year's earnings. PETsMART at $18 would be going for 20 times 2003 earnings. Both, in other words, sell for price-earnings multiples below their growth rates. For such growth-stock valuations, we can thank one animal that makes a lousy pet--the bear.

By Robert Barker

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