How PetSmart’s plan to go upscale paid off

Go Upscale in a Recession? Sounds Crazy But This Unlikely Retailer Made it Work

The rich don’t feel economic recessions the way everyone else does, and that’s one reason investors in companies like Coach (COH) and Nordstrom (JWN) made out like bandits in this muddling recovery while WalMart Stores (WMT) investors got merely good returns, despite its increased store traffic. But PetSmart (PETM), the big box pet store, has done a brilliant job of having it both ways.

Back in 2009, PetSmart bet that people would pamper their pets even while they cut spending elsewhere. Rather than trying to sell more discount dog foods and cheap litter boxes, the company made room for all sorts of products and services former generations of pet owners would have scorned – like pet teeth cleaning, organic rabbit food and orthopedic dog beds. Recently, it teamed up with Martha Stewart Living Omnimedia (MSO) for a line of food bowls, pet furniture (Fido’s toy box, for example) and the like. It was counterintuitive thinking that’s paid off big for its investors, especially when dividends are considered in the returns.

The higher end products dramatically boosted profits. PetSmart operating margins, which used to be in line with Target (TGT), are significantly higher now. Profit margins are so hard to fatten in a downturn. PetSmart has beaten the revenue growth of most big competitors (mainly, discount or grocery stores) while earning more for every sale at the same time.

With 1,250 stores and a $7.6 billion market cap, PetSmart is now the go-to place for all things household animal. Its second quarter earnings released recently included a newly-raised forecast calling for a 9% to 10% rise in overall sales this year and gross margin expansion of 90 to 100 basis points. The company estimates its annual earnings now at $3.19 to $3.31 per share, which is a minimum 25% gain over a year ago. The company boosted its dividend 18% in June and authorized $525 million in share repurchases. The dividend yield, paltry now, should grow as PetSmart has shown it regularly lifts its payout.

For investors, the problem with PetSmart is that pictures of yorkies in designer boots or installed in Coach handbags are no longer surprising or amusing. Everyone knows that baby boomers pamper their pets and that PetSmart has grown cash heavy from this, so there’s little hope of grabbing some untapped value in their shares now. PetSmart shares, which used to lean toward Target-level valuations, now trend closer, in PE ratio, to those of diamond and Prada sellers.

That’s quite the turnoff for investment analysts, despite the respect they have for the pet business. The vast majority like holding PetSmart shares but not buying them at these levels. YCharts Pro feels the same way, giving the company strong marks for fundamentals but marking its shares as considerably overvalued.

But perhaps long-term investors shouldn’t write off PetSmart just yet. PetSmart’s recent growth is pretty good evidence that the company can sell superfluous doggie items even when much of the country is scrimping on groceries. Imagine what it might achieve in a real recovery.