Pets Market

This stock is catnip for investors

There is a table in Pets at Home‘s (PETS) annual report that sets out just how many board members have pets at home. The majority do, including chief executive Lyssa McGowan. The mini survey reflects well on a company that relies on an animal devotion. Indeed, “gifting and wellness” is now an important driver of sales, according to management, with customers purchasing “special birthday treats” for their furry companions. It’s hard not to feel sceptical, but beneath the fluff there is a strong investment case for the Cheshire-based chain, which is defying the retail gloom and tapping into profitable new markets.

IC TIP:

Buy

Bull points

  • Good long-term prospects
  • Highly cash generative
  • Defensive veterinary division
  • Cross-selling opportunities

Bear points

  • Consumer squeeze
  • Competition from online rivals

It is reasonable to ask why we are looking at Pets at Home now. Consumer spending is clearly under pressure and the pandemic pet boom is old news. Meanwhile, a forward price-to-earnings ratio of 17.5 suggests the group’s shares are more expensive than retail peers like Next (NXT), Marks and Spencer (MKS) and WH Smith (SMWH).

Still, it is important to remember that Pets at Home doesn’t just flog dog treats and collars. About a third of operating profit comes from veterinary services, delivered by the biggest branded vet business in the UK. The group teams up with independent practices via a joint venture partnership model and receives a proportion of a surgery’s revenues in exchange for business support. Practices that are based within Pets at Home stores also pay rent.

This model is proving very profitable. In the 12 months to March, the Vet Group grew sales by 13 per cent and simultaneously widened its margin, meaning underlying profit before tax increased by 18 per cent to £51mn. This more than offset a 2.5 per cent profit decline in the retail division, caused by cost headwinds and lower demand for pet accessories.

More opportunities could emerge as the surgical arm develops. The group is eyeing 24-hour animal hospitals, for example, and wants to expand its range of clinical services. Demand is unlikely to be a problem. Pet ownership is high – almost 60 per cent of UK households now own an animal – and the full benefits of the lockdown pet boom are still to come. Veterinary rivals CVS (CVSG) thinks it will be three to five years before pandemic pet purchases start attracting the biggest bills.

Pets at Home is lining itself up nicely: it is averaging over 24,000 sign-ups to its puppy & kitten club every week, and 42 per cent of pets in its ‘VIP scheme’ are under 3 years old. The average lifespans for cats and dogs are 12 to 18 years and 10 to 12 years, respectively.

Food for thought

While the Vet Group appears to be a nailed-on source of growth, the retail side of Pets at Home is far from ailing. The company has managed to grow its market share from 18 to 25 per cent over the past five years, in large part thanks to sales of its pet food, which has accounted for almost 70 per cent of retail revenue growth since 2019. “Food is the reason why people choose us,” chief financial officer Mike Iddon told investors in May.

Momentum is still building. While customers might be buying fewer party dog ​​birthday bandanas and less posh pooch wine (yes, you that correctly), food sales rose by 11 per cent in 2023. Crucially, management has managed to hold down while maintaining relatively steady margin prices.

The FTSE 250 constituent has an obvious advantage over small independent operators, where average prices have risen by 30 per cent on like-for-like products, according to Jefferies. But Pets at Home is holding its own against bigger rivals, too. Jefferies found its food prices are “virtually unchanged” since January, while online rivals have continued to charge customers more. As such, its pricing position is now within 1 per cent of German peer Zooplus and 10 per cent cheaper than Amazon (US:AMZN).

Quite how big a threat online retailers pose remains a key question for investors, given that Pets at Home is still wedded to its physical premises. Just 16 per cent of purchases are currently made online and, of these, 40 per cent are collected in store.

This is more strategic than it might at first seem. Getting people into shops is crucial, as this is how the company optimizes its cross-selling opportunities and operational gearing. Two thirds of the company’s 457 stores have vets within them, and many also have mezzanines with grooming salons. Once customers are on-site, therefore, there are plenty of ways to encourage them to spend more money at a relatively fixed cost.

The big unknown is whether this way of shopping – particularly for bulky items like pet food – will persist, given the convenience of online deliveries. This issue could become more pressing as Pets at Home targets younger people in urban areas who, according to management, are postponing marriage and getting dogs and cats instead.

The group hasn’t neglected investments in digital, however. It splashed out £37.8mn on data analytics and business systems in 2023 – only slightly less than it spent on a new distribution center and significantly more than it spent on store refurbishments.

Whether or not this investment will pay off remains to be seen. If well deployed, it should allow the group to leverage 10 years’ worth of proprietary pet and customer data collected via its loyalty scheme, and encourage customers to spend more.

“Our average consumer spends £160 a year with us, but our most engaged spend over £900, highlighting our significant growth headroom,” management concluded in its full-year numbers.

Rare breeds

There is still a black mark against Pets at Home, though: its valuation. While its price-to-earnings ratio is roughly in line with its five-year average, it’s not clear what would catalyze a rise in the share price. Earnings growth is robust but not spectacular, consumer-facing sectors are out of favour, and UK pet numbers are expected to remain relatively static.

What shouldn’t be overlooked, however, is the group’s ability to generate cash. Operating cash flow has shot up since the pandemic, as has free cash flow.

This is partly due to strong underlying profit growth and a smaller tax payment in 2023, but it also relates to the make-up of the business. While the Vet Group generated just 9 per cent of sales in 2023, its 53 per cent gross margin meant it accounted for 46 per cent of the group’s free cash flow. As the division matures and grows, cash flow is only expected to increase, creating a “significant value creation opportunity”.

One way or another – either by recycling cash into growth opportunities, issuing dividends, or clearing its modest debt pile – the company should be able to drive future returns. And the virtue of unstable compounding earnings is that what looks expensive today can soon seem like a bargain. Five years ago, Pets’ market capitalization stood at less than £600mn, which is equivalent to less than six times’ current net income. Even if annual earnings growth narrows from 12.5 to 9 per cent over the next five years, a share today will be worth just 10 times EPS by 2028.

The group’s for example profitability and abundance of cash could also attract private equity firms, which have already started to steamroll the veterinary market. Pets at Home was owned by the US buyout fund KKR for four years before it was listed in 2014, and recently featured on our list of UK companies that are most attractive to private equity investors.

This doesn’t mean a takeover will happen, of course. But Pets possesses a powerful market position, an unfurling growth story, a defensive vet business and plenty of cash to play with. If the stock market fails to recognize this, it is reasonable to think that someone else will.

Company Details Name Mkt Cap Price 52-Wk Hi/Lo
Pets At Home (PETS) £1.83bn 379p 400p / 255p
Size/Debt NAV per share* Net Cash / Debt(-) Net Debt / Ebitda Op Cash/ Ebitda
215p -£364mn 1.6x 88%
Valuation Fwd PE (+12mths) Fwd DY (+12mths) FCF yld (+12mths) P/Sales
17 3.4% 5.4% 1.2
Quality/Growth EBIT Margin ROCE 5yr Sales CAGR 5yr EPS CAGR
9.4% 8.5% 9.3% 10.8%
Forecasts/ Momentum Fwd EPS grth NTM Fwd EPS grth STM 3-mth Mom 3-mth Fwd EPS change%
-1% 13% 0.3% 2.9%
Year End March 31 Sales (£bn) Profit before tax (£mn) EPS (p) DPS (p)
2021 1.14 88 13.7 7.9
2022 1.32 145 20.8 11.6
2023 1.40 123 22.5 12.8
f’cst 2024 1.49 137 20.9 12.7
f’cst 2025 1.57 153 23.7 13.8
chg (%) +5 +12 +13 +9
source: FactSet, adjusted PTP and EPS figures
NTM = Next Twelve Months
STM = Second Twelve Months (ie one year from now)
*includes intangibles of £990mn or 208p per share
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