Interactive Investor

Stockwatch: time to buy the drop at this mid-cap share?

26th April 2022 09:56

Edmond Jackson from interactive investor

After slumping over 40% in seven months, this once popular business has a more reasonable valuation and attractive dividend yield. This stock is now essentially a timing challenge. 

In common with various growth stocks, mid cap pet care group Pets at Home Group (LSE:PETS) began falling from an all-time high at around 520p late last September, and tested 400p in the New Year. I think the concern has moved on from rising interest rates – which are bad for growth sector ratings – to discretionary consumer spending, as a current share price of under 300p marks a 42% drop from September’s all-time high. 

The slump comes despite a period in which the company’s news flow involved upgrading guidance on 26 January for its financial year to 25 March. Helped by continued momentum in the final quarter, underlying pre-tax profit will be at least £140 million.  

The UK pet care market was described as “robust, with strong continued growth in new pet ownership and prevailing themes of long-term pet ownership…creating a sustainable tailwind for growth across our business.” 

What are the prospects now consumer spending is being hit? 

Amid outcry about soaring home energy costs and a national crisis in fuel poverty, keeping a dog can cost upwards of £2,000 annually, with some estimates putting the total cost of a dog at circa £33,000 over its lifetime. 

The argument in favour of pet-related businesses is, “they all have to eat and be cared for”. But an economist would consider marginal change in demand for products and services. 

While that could simply mean cutting back on pricey treats or dinners or not adding yet another dog coat to the collection, more dramatically pet charities say the rate of intake of abandoned dogs is around twice pre-pandemic levels. From Wales: “Many owners are in a desperate situation, we get 20 to 30 calls a day with many owners saying their financial circumstances have changed, they cannot afford vet bills…they can no longer provide for them”. 

It is starting to look a different consumer environment for taking on a new pet – compared with the recent years’ halcyon period when Covid lockdowns triggered a boom in pet ownership, especially dogs.  

A de-rating to 14x earnings and a 4% yield 

I suspect Covid contributed to momentum buying of Pets’ equity, such that at the 520p high – and assuming recent consensus for £111 million net profit in respect of this latest year, then £115 million in 2023 – a growth multiple of 24x easing to 23x is applied. 

Yet that was not so stretched like tech valuations of about 40x earnings, and Pets’ drop to 300p now implies a price/earnings (PE) ratio of around 14x and prospective yield near 4%.  

It implies investors have turned sceptical that Pets can, in the medium term, sustain a classic “growth” PE of around 20x.  

When the growth halo slips, market price can over-shoot on the downside as aggressive growth investors bail out; yet potential buyers fear a “falling knife” and income investors want to see a material yield. 

Arguably, 4% income is starting to look material unless a negative earnings surprise hits prospective cover around 2x. 

Pets at Home Group - financial summary
Year-end 25 Mar2015201620172018201920202021
Revenue (£ million)7297938348999611,0591,143
Operating margin (%)13.312.2129.35.59.811.8
Operating profit (£m)96.897.199.983.953.1104135.0
Net profit (£m)72.272.875.462.830.567.499.0
Reported EPS (p)14.414.515.
Normalised EPS (p)13.515.415.113.514.014.713.3
Operating cashflow/share (p)18.322.122.021.421.442.238.1
Capital expenditure/share (p)
Free cashflow/share (p)12.214.813.913.114.034.531.2
Dividend/share (p)
Earnings cover (x)
Return on equity (%)
Cash (£m)13340.056.359.860.579.1101
Net debt (£m)188161155138119548407
Net asset value (£m)797844883906903931994
Net asset value/share (p)159169177181181186199
Source: historic Company REFS and company accounts

Jupiter appeared to halve its stake at end-March 

A 29 March “Holding” RNS is ambiguous, citing “Jupiter Fund Management” as the person subject to notifying obligation, then citing Northern Trust, Citigroup and BNP Paribas as shareholders.  

But whether or not Jupiter was the manager involved, one or several decisions were made on 25 March to cut from nearly 10% to 4.7%. This was a pertinent move versus a prevailing price of around 390p, as if demonstrating a firm resolve to sell the rebound from 347p earlier that month.  

On the “buy” side in early March, Blackrock raised its stake from 7.0% to 7.44% which looked astute by the month-end, but since then the stock has plunged 22% from 390p. 

Recent director share trading has similarly been mixed. Early last December, the CEO exercised 19,116 options at 94p and kept those shares; whereas the CFO exercised the same and sold his, raising £18,000. Yet there has been no unloading of shareholdings by insiders that would suggest any doubt about Pets’ prospects or valuation. 

Has equilibrium between buyers and sellers been reached? 

I therefore regard Pets’ 42% share price drop as mean reversion, initially due to the prospect of tighter monetary policy cooling a hot-house environment for growth stocks, then the biggest hike in cost of living for decades. This is starting to temper a rather artificial last two years when spending was boosted by people not going out but instead discovering pets for company. 

More positively, pet-related retail is likely to remain very significant in a UK context – supposedly a circa £6.5 billion annual market. Core interest rates seem unlikely to rise much over 2% if high inflation tempers the demand side of the economy; hence, Pets’ de-rating may broadly be complete. 

Another scenario, however, could be interest rates staying higher versus stubborn inflation, if enough wage increases and producer price inflation become ingrained. 

Not surprisingly, stocks like Pets have fallen back as enough holders bail and potential buyers sit on their hands. 

Big emphasis on the next outlook statement in May 

Fresh money is understandably nervous – lest the 25 May preliminary results statement and/or guidance to analysts in any way softens the tenor expressed on 25 January. 

Even if valuation looks fair, heading into a possible slowdown there is little chance a stock like this can resume its uptrend if underlying business prospects get downgraded. Even if management continues to sound resilient, if the economic context is weakening then some investors also will not buy. 

I would be surprised if Pets’ can buck a slowing trend given even the big food retailers cite revenues easing. Yes, pet ownership is very important to many Brits, yet it would appear to have a greater element of discretionary spend than food retail. Pets live for maybe four to 14 years versus around 80 years for humans.     

Strong market position means buyers will return 

This stock is now essentially a timing challenge. 

Pets enjoys a strong position, straddling stores, online sales and veterinary services. Its online customer reviews vary from “Excellent” 4.3 out of 5 out of 14,336 reviews on Trustpilot, to 1.9 out of 5 based on 429 reviews on Facebook. That is a very good rating overall: any big business will experience slip-ups and online reviews are a lightning bolt for customer frustration. Broadband provision is a solid business, yet providers have net-lousy reviews. 

Some investors may start to think that averaging-in is already justified given the stock market has sold off lately and a more cautious narrative from Pets is already priced in. 

If the stock continues to drift or stabilises at around 300p, and the prelim results outlook statement is not as bad as feared, then the price can rise. 

Significantly, you take your pick according to risk appetite. 

Mind, there is also uncertainty about how the CEO of 11 years is stepping down this summer, and also the chief operating officer of the vets side by spring 2023. Successors will need to gain investors’ confidence, for what looks set to be a more challenging environment. 

I conclude with a “hold” stance because the risks a UK recession are rising now that a high-inflation genie is out the bottle, and the Bank of England’s response is too late and modest to be effective. The “buy” point in Pets will, however, only become clear in hindsight. 

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

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