Stockwatch: pet care firm proves retail is not dead

Growing demand for pets is pushing this mid cap stock to an all-time high, and coronavirus social changes could see this trend continue.

Who says retail is a graveyard? An end-March to mid-July update for this £1.6 billion pet-care group Pets at Home (LSE:PETS) has seen its stock jump 20% to an all-time high of around 310p. This beats the previous record of 307p, struck in February before the pandemic materialised. 

Even if a 7.5p dividend is broadly sustained, an implied 2.4% yield does not allow any disruption in the narrative, and if earnings per share stay around 14.5p in the medium term then a price-to-earnings ratio of more than 21x seems rich. We are looking at a group with high quality earnings but which arithmetically deserves a mid-teen multiple at best. 

Pet-care proves durable in difficult times

I suspect there is an element of momentum trading – see how funeral services provider Dignity (LSE:DTY) soared about 60% last week, due to Covid-19 deaths that may be transient now the care home catastrophe seems under control.

But in recent years I have sensed that Pets at Home would distinguish itself as a one-stop-shop for various pet needs – also with scope to create loyalty clubs and subscriptions, hence high-quality earnings. At 155p in August 2018 I suggested it among “Five stocks for a durable ISA for the Brexit years”. 

UK pet care is a market worth £6.5 billion a year, with Pets’ in a strong position. It has physical stores, online capability and veterinary services. Furthermore, it is distinguished in a difficult business environment generally, helping the stock to enjoy a premium for scarcity. 

Grooming and to some extent veterinary services were compromised during lockdown, as were new pet purchases. But I think soaring inflation, for example with puppy prices among breeders, reflects a shift in public behaviour. Perhaps owning and caring for a pet will be part of “the new normal” for quality of life, like working from home instead of commuting. This does not need to affect everyone to be significant, just an element of the population. 

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A prompt rebound, post Covid-19 lockdown

All comparisons made are like-for-like, year-on-year. Pets’ first quarter fiscal update – covering 16 weeks from end-March to mid-July – shows like-for-like group revenue fell 13.5% over the first eight weeks.

It then rebounded 12% for the next eight weeks, so a 0.7% easing overall. 

Retail edged up 0.4%, with strong merchandise sales mitigating revenue lost from closed grooming salons and reduced sale of pets during the first eight weeks. Overall resilience has been helped by ‘essential retailer’ status during lockdown. 

Online and subscription – ‘omnichannel’ – revenue has soared 71% due to investment in capacity and the number of customers nearly doubling. This helped offset a 9.3% fall in vets’ revenue due to lockdown restrictions, and illustrates the business model compensating shortfalls.

For earnings resilience, the number of Pets’ VIP members rose 20.3% to 5.7 million, while those who purchased both products and a service rose 8.5%. The company’s Puppy/Kitten Club members increased by 12%, supporting new veterinary clients.

Around 20% of the UK puppy population is now signed up to the VIP Puppy Club, spending about 23% more than non-members across the group.

Subscription customers rose 18.1%, or more than 906,000, during the quarter, and that for me is the biggest point of this update. 

Pets’ has also not participated in the government’s job retention scheme. It cited strong liquidity, with cash balances and undrawn banking facilities (including an extra £100 million raised in May) totalling £267 million. This is significant in terms of capability and ethics of paying dividends, versus plenty other businesses that have drawn on taxpayers. 

Affirms the chief executive’s near-£250k buy last May 

I have drawn attention to the chief executive raising his stake by a total 121,362 shares at prices around 204p, after a retracement to March lows linked to Covid-19. This fall seemed inefficient of the market, given demand for pet food is what economists call “inelastic”. In other words, it will not change much even in reaction to higher prices.

For the business to suffer one would need to see more competition emerge. Yes, that did manifest online going back a few years, but Pets’ became more competitive and offers a more integrated overall service than many rivals.

The latest update cites “tangible signs of heightened demand for pet ownership, a good proxy for long-term growth as people adopt new attitudes to work and leisure pursuits”. Pets’ is capitalising on this, for instance with £48 million capital investment targeted for a new distribution facility in Stafford. Such are reasons for tucking its stock away like the chief executive has done. 

4.9% of issued equity is currently on loan – i.e. shorted 

Short-sellers occasionally lob allegations against Pets’ which the company refutes. A total of 4.9% disclosed short equity has been fairly constant for nearly a year, having fallen from its 14.3% peak in October 2018.

However, two key positions of more than 0.5% have slightly increased: Foxhaven Asset Management, to 1.7% last April, and Immersion Capital, to 3.2% at the end of June – which does at least represent conviction. 

Last May the stock was briefly hit 13% by Texas-based Bonitas Research alleging use of undisclosed loans in support of profits. 

Pets’ did not issue an Regulatory News Service update, but was reported saying it was an historic issue and had been dealt with.

Bonitas had repeated 2018 claims by Morgan Stanley about operating loans to joint-venture veterinary practices. I recall this was pitched to Morgan’s hedge fund clients, which significantly explained Pets’ becoming one of the most shorted London stocks. 

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Yet events have shown the hedge funds and big US investment banks do not necessarily have better insight than taking a common-sense view on British obsession with pets – hence a good business opportunity for their care.

Secondly, a new-broom chief executive appointed over two years ago has had plenty of time to turn over stones. He has bought substantial equity and is delivering sound progress. Therefore, I note in particular Immersion Capital’s increasing short, though it looks askance. 

Pets’ net cash flow from operations doubled to £215.2 million in its last financial year, versus investment up 7% to £50.3 million, reducing end-March net debt to £86 million. 

Yes, due to FRS16, the new financial reporting standard for leases, Pets’ lease liabilities mean that measure of total net debt is £550 million. Last year’s net interest charge, covered 6.3x by operating profit, would ideally be higher (and should be, going forward, with lower financial debt). But there do not appear to be any red flags as to a culture of misrepresentation, over-stretch or a stressed business.

Pricey, but I suspect will remain so 

It is possible Pets’ shares do consolidate after this rise. The market seems inclined now to overreact to whatever trading updates happen to beat very cautious expectations. There are precious few businesses outperforming a sea of losses and dividend cuts. Pets’ has just managed to tick all such criteria. 

The general assumption is that life will return to something approaching normality once a Covid-19 vaccine appears. Drugs companies and governments are bolstering hopes of this taking months rather than years, as some medics have said. I am sceptical: enough people’s inability to comply with mask-wearing rules will be repeated with any vaccine. 

Lives will substantially alter from previous mass participation events, and domestic pets will play an increasing role – hence Pets at Home being likely to enjoy an exclusive and dominant role, as a stock and business. ‘Hold’. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.