We think that WOOF should be bought on today’s selloff. Despite coming in 10% ahead of consensus, there was a ‘freak-out’ factor associated with the Gross Margin line, and a transitory pressure due to mix and freight pressure. The operative word there is transitory. The company is seeing an impact from strong sales in consumables due to the pet life cycle going from Year 1 (heavy supplies, little food) to Year 2 (low supplies, lots of food). Also keep in mind that as it scales its vet clinics the services personnel costs are booked in COGS as opposed to store labor, which is booked in SG&A. People are wigging out over GM weakness, but not giving the company credit for the 240bp of SG&A leverage due to the mix shift despite the industrywide labor shortage that is pressuring wages. Operating margins, where it all nets out, came in ahead of last year – which is what matters, and is something we think will accelerate into next year and beyond.
The reality is that this story is 100% on track. The vet hospital initiative continues to plow forward, as WOOF added 17 new pet hospitals taking the total number to 172 pet hospitals and by the end of the year should be at ~200, which gets the company to about 22% of its planned rollout of vet hospitals. Importantly, the company also now has 1,100 clinics, up from 800 at the beginning of the year, which acts as a feeder system of vets for the pet hospital business. Clinics are the simple shot/vaccination and perscription filling parts of a store as opposed to the vet hospital which is the full kit and caboodle of surgery, lab work, diagnostics as well as shots and scripts. The 4-Wall EBITDA Margin of the stores with hospitals is ~20% and has an MSD store comp lift relative to the rest of the fleet. Vet hospitals are a critical component of the ecosystem that Petco is building whereby a consumer takes their dog to the vet at Petco, the Vet writes a script for the pet which can be fulfilled either in Petco or online, all the while controlling the consumer at every touchpoint to get them to purchase food or toys from either of Petco's channels.
Ultimately, we think this company sustains 7-8% top line growth – which is roughly in line with the category and if anything is a conservative assumption given the clinic/hospital rollout – and more than doubles EBIT margin from 4% last year to 8.8% over a TAIL duration. Then tack on the impact of financially deleveraging the model (was 7.4x levered pre-IPO, now down to 2.6x, and headed to ~0x as EBITDA doubles and debt gets almost completely wiped out over 3-5 years) and we build to $2 per share in earnings. That compares to the consensus at $1.30. Simply put, the Street is grossly underestimating the key drivers of this operating and financial model. We’d pay 13-15x EBITDA for this story (each EBITDA multiple turn is about $2.30 in the stock, or ~10%), which equates to a $13bn-$15bn EV with no net debt over a TAIL duration. That’s about $50-$55 per share in TAIL value, or about $35 in 12-18 months – roughly 50-60% upside from current levels. Best Idea Long.
