PetMed Express: Caught In The Crossfire And Cracks Showing – Sell – PetMed Express, Inc. (NASDAQ:PETS)

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PetMed Express (PETS) is a retailer of pet medication, food and supplies that sells its products online and via a call center. In my prior post on Chewy (CHWY) on Seeking Alpha (Chewy: Improving Fundamentals And A Large Total Addressable Market Already Priced In), I performed a deep dive on the industry of selling pet food and supplies online and, also, discussed why Pets.com went into liquidation within a year of going public. However, the purpose of this article is to make one simple point: Sell PetMed Express as it is stuck in the middle between Chewy (CHWY), Amazon (AMZN), and Walmart (WMT) driving profitability lower and cracks are showing in the operations.

Trading at 1.4X revenue and 11.5X EBITDA, PetMed Express is trading at a discount to its closest pure-play competitor Chewy; in the discussion that follows, I believe that PetMed Express will have challenges to grow its revenue next year and maintain its EBITDA margin. My current target is $19/share which represents 1X NTM revenue and 8X NTM EBITDA.

Overview

PetMed Express (d/b/a 1-800-PetMeds) markets prescription and non-prescription pet medications and, also sells pet food and supplies in the United States. These products can be purchased through its website or via the phone. Its fiscal year ends on March 31st and the company generated ~84% of its revenue from its website.

The company’s revenue is seasonal and its strongest quarter ends June 30th (1Q), its weakest quarter is December (Q3) and typically comprises 15% of revenue. Below is a chart of its historical seasonality over the past two years. The driver behind 1Q being the strongest quarter is that pet owners are buying flea and tick products for their pets prior to the start of summer.

https://static.seekingalpha.com/uploads/2020/1/21/3439-15796533554830453.png

Source: Company reports & TWG estimates

As of 2Q’20 (ending September 30th), the company has $95M in cash and no debt. With no leverage, PetMed Express enjoys Returns on Equity (ROE) in excess of 20% and Return on Invested Capital (ROIC) in excess of 40%! ROIC is higher than ROE, given that PetMed Express has zero debt and ~$100M in cash and, as a result, this company requires little capital to operate.

Deconstructing PetMed Express’ revenue stream between New order & Re-order, one can see that through FY’19 ending in March 2019, revenue is steadily growing and grew at a Compound Annual Growth Rate of 4% over the time period. Moreover, as the competitive intensity in the industry increased, PetMed Express’ Re-order revenue continued to grow, especially from FY’17 to FY’19.

https://static.seekingalpha.com/uploads/2020/1/21/3439-1579653355536225.png

Source: Company reports & TWG estimates

As revenue grew, earnings per share grew as well and over the same time period, the CAGR for EPS was 15%. Please note that in FY’18 (FY ending in March 2018), EPS grew to $1.82/share due to operating margins expanding ~400bps to 19% and, partially, driven by tax cuts enacted since its FY ends in March. However, in FY’19, operating margins contracted by ~300bps and PetMed Express generated 1% EPS growth due to the tax cuts enacted as its effective tax rate declined from 31% in F’18 to 23% in FY’19. In other words, the 1% YoY growth in EPS in FY’19 is entirely driven by the tax cuts since the competitive intensity of this industry increased, driving PetMed Express down by ~300bps YoY.

https://static.seekingalpha.com/uploads/2020/1/21/3439-15796533555456052.png

Source: Company reports & TWG estimates

Sell PetMed Express

This thesis is based upon:

  • Prescription Medication is a high-margin/high-return business and it has been attracting competition
  • PetMed Express is not going to be able to grow earnings via Subscriber Acquisition since newer subscribers are purchasing lower margin products and services
  • Operational cracks are showing in FY’20

Prescription Medication is a high-margin business and it has been attracting competition

With PetMed Express’ margin and return profile, the company is doing something different (either targeting a different segment or operational excellence). The driver behind PetMed Express’ high margins is the sale of Prescription medications (see table below).

https://static.seekingalpha.com/uploads/2020/1/21/3439-1579653355939389.png

From the table above, one can clearly see that PetMed Express enjoyed a stable gross margin (%) of 39-40% as Prescription medications grew. Once prescription medication started to decline in FY’10, Gross margin (%) fell over 700bps to 32% in FY’17 even though the company was able to keep its total revenue flat (via selling Non-prescription medication and other) – in essence, PetMed Express replaced lost high-margin Prescription revenue with low(er) margin other revenue. Zooplus (OTC:ZLPSF), also, confirmed that the sale of consumables such as pet food is a low margin product.

Your margin is my opportunity

Jeff Bezos

With high margin Pet Medication revenue in decline since FY’10, the pet pharmacy business has attracted additional competition as Chewy entered in 2018 (Chewy.com expands into pet medications sales with Chewy Pharmacy – South Florida Business Journal) and Walmart in 2019 (Walmart Now Delivers Pet Meds Straight to Your (Doggie) Door and More Paw-sitive News).

When price-shopping on PetMet Express, Chewy and Walmart for various flea and tick products for dogs online, pricing across vendors is virtually identical; except in the case of autoship where both Chewy and Walmart offered identical discounts for autoship products and the price of these autoship products was lower than PetMed Express’ prices (For the products I evaluated, PetMed Express did not offer an autoship discount). While my sample size is small, it doesn’t appear that pricing pressure is eroding PetMed Express’ revenue – it is competitive behavior, i.e. more entrants.

While not directly comparable, since the launch of Chewy’s Pet Pharmacy in July 2018, Chewy has generated more revenue attributable to its Other revenue segment than PetMed Express generated in Pharmacy revenue (as of FY’14). For full disclosure, Chewy’s Other Revenue includes: Chewy’s pharmacy business and royalties from Petsmart pharmacy and may include other things as well.

https://static.seekingalpha.com/uploads/2020/1/21/3439-15796533561209383.png

Source: Chewy

PetMed Express is not going to be able to grow via Subscriber Acquisition

As the competitive intensity in the industry heated up, the management team announced during the 2Q’20 conference call that PetMed Express has direct relationships with all the major manufacturers. The benefits of this relationship enable PetMed Express to have lower costs and minimum advertised pricing policies, which will assist with price competition. However, these operational improvements will not cure the issue regarding industry structure where PetMed Express is competing against two players (Chewy and Amazon) that are 10X the size of it and, moreover, another large retailer (Walmart) entering the pet pharmacy business. For market share information for Chewy and Amazon, please refer back to my report on Chewy on Seeking Alpha. https://static.seekingalpha.com/uploads/2020/1/21/3439-15796533559922132.png

Source: Company reports & TWG estimates.

In all four quarters, total revenue for PetMed Express declined on a YoY basis (see later for an analysis of 3Q’20 results). The two drivers for declining YoY revenue are:

  • Declining Re-order revenue (except in its two most recent quarter); and
  • Declining New customer revenue

PetMed Express stock price surged and continues to grow to ~$27/share currently and the catalyst for this growth was its 2Q’20 performance where revenue was flat YoY and re-order revenue grew YoY. https://static.seekingalpha.com/uploads/2020/1/21/3439-15796533558319376.png

Source: Company reports & TWG estimates.

Should re-order revenue continue to fall, revenue from new customers may not offset the decline in re-order revenue for two reasons:

  • New revenue/customer is declining; and
  • The number of new customers PetMed Express adds is declining

Operational Cracks Showing in the Business

The management of PetMed Express publicly discloses numerous metrics to help an investor understand the business; however, the management does not publicly disclose the number of customers it has at the end of the quarter. However, since the management discloses revenue and average revenue/order, one can track the number of orders that are placed each quarter.

https://static.seekingalpha.com/uploads/2020/1/21/3439-15796533559134605.png

Focusing on the YoY (%) change in orders, one can see continued deceleration (and even decline) in the number of orders the company processes in a quarter and this decelerating/declining trend has occurred for the past two years. Assuming order value stays stable going forward, PetMed Express needs to grow its order volume in order to drive revenue growth.

Analysis of 3Q’20 Results

On Tuesday, PetMed Express reported its earnings (see table below). Results are shown based upon Year-over-Year (Y-o-Y) comparisons and versus sell-side analyst consensus estimates from Unhedged. Results are presented in this format as the business is highly seasonal and, as a result, one cannot see improvement (or dis-improvement) in results based upon a sequential or quarter-over-quarter view.

https://static.seekingalpha.com/uploads/2020/1/21/3439-15796533559819133.png

Overall, revenue declined by only $0.2M and EPS declined by $0.04 per share (EPS beat consensus by $.04) and based upon those results, one would not expect a ~5% decline in the stock price.

That is not the case since the revenue decline was driven by lower new customer revenue and total revenue missed consensus estimates by $1.4M. During the quarter, PetMed Express’ advertising expenses declined by $0.5M, which resulted in signing up 5k fewer customers. In order for the company to grow its top-line revenue consistently, it is important for PetMed Express to increase the number of new customers each quarter; however, this is a double-edged sword since any growth in its customer base via new customers will come at the expense of its “war chest” of ~$92M in cash. While not directly linked on the call, PetMed Express delayed $5M in spending on modernizing its website to deliver a better customer experience – perhaps once the website is modernized, advertising expense will increase in order to grow its new customers.

As noted above, PetMed Express’ re-order revenue declined on a Y-o-Y basis in two of the three quarters. The good news is that Re-order revenue grew $0.5M on a Y-o-Y basis to $53.8M and the growth in Re-order revenue represents the second consecutive Quarter of re-order revenue growth.

Gross profit declined by $1.7M YoY, driven by a decline in gross margin (%) of 273bps. In my prior note, I emphasized that it is my belief that the sale of Pet Medications is a high margin business; however, this business has declined from FY’10 to FY’14 (until the company stopped reporting this metric). In my note, I stressed that the company is replacing the revenue loss from its high-margin Pet Medication business with other lower-margin products. As a result, PetMed Express is able to generate relatively flat revenue, but with lower margins.

The decline in Gross Profit dropped to Operating Income and Operating Income declined $1.5M YoY and beat consensus by $0.3M. Operating margins contracted 243bps YoY, driven by the 273bps contraction in Gross margin (%). These declines resulted in the $.04 decline in EPS to $0.34.

In 3Q, the company reported 76k new customers at a Customer Acquisition Cost (CAC) of $42 and these new customers generated $89 / customer of new revenue. CAC improved YoY by $3.

The Subscriber Growth Paradox – Acquire New Subscribers and Burn Cash or Continue BAU and Lose Profitability

PetMed Express reported flat revenue YoY and grew its re-order revenue by +0.5M YoY; however, even though the company has direct relationships with major suppliers, PetMed Express’ Gross margin (%) declined 273bps YoY. In order for the company to offset the margin dilution from the loss of Pet Medication revenue, PetMed Express needed to sign up an additional 64k customers and spend an additional $2.7M in advertising.

https://static.seekingalpha.com/uploads/2020/1/21/3439-15796533558408644.png

Sell PetMed Express – Target Price: $19 / Share

Trading at 1.4X revenue and 11.5X EBITDA, PetMed Express is trading at a discount to its closest pure-play competitor Chewy; however, based on the information above, I believe that PetMed Express will have challenges to grow its revenue next year and maintain its EBITDA margin. My current target is $19/share which represents 1X NTM revenue and 8X NTM EBITDA.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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