PetSmart

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PetSmart Powered By Docstoc
					                Emily Moore, Paul Penland, Mary Semich

                                                         PetSmart is a specialty provider of
                                                         products, services and solutions for
                                                         the lifetime needs of pets in North
                                                         America. PetSmart stores typically
                                                         range in size from 19,000 to 27,000
                                                         square feet, and carry a selection of
                                                         pet supplies at everyday low prices.
                                                         PetSmart complements its product
                                                         assortment with a selection of value-
                                                         added pet services, including
                                                         grooming, pet training, boarding
                                                         and day camp. Virtually all its stores
                                                         offer complete pet training services
Recommendation: Hold                                     and feature pet styling salons that
    Strong financials                                   provide grooming services.
    Positive trends in pet ownership
    Average growth within the company
    Low intrinsic value relative to market value



                                                    PETM at a Glance
                                                    Current Price: $32.76
                                                    Exchange: NASDAQ
                                                    Industry: Specialty Retailer
                                                    Sector: Services
                                                    Headquarters: Minneapolis, MN
                                                    Market Cap: 4.45 B
                                                    Beta: 1.78
                                                    EPS: 1.33
_____________                                       P/E (ttm): 24.71
1
  Reuters                                           P/B (mrq): 4.44
2
  www.ValueClick.com                                P/S (ttm): 1.05
                                                    PEG: .97
                                                    Inside Holders: 1%




                                      1
                                                     Table of Contents
Profile .................................................................................................................................... 3
Products and Services ...................................................................................................... 4
Company History............................................................................................................... 5-6
Recent News ....................................................................................................................... 6
Management ...................................................................................................................... 7
Competitors ........................................................................................................................ 8
Industry Analysis ................................................................................................................ 9
Institutional Ownership and Analysts Recommendations .................................... 9
SWOT .................................................................................................................................... 10-11
Financial Ratio Analysis
     Liquidity .......................................................................................................................... 11-12
     Management Efficiency ............................................................................................. 12
     Profitability ..................................................................................................................... 12-13
     Growth ........................................................................................................................... 13
     Efficiency ........................................................................................................................ 13
DuPont Analysis................................................................................................................. 14
Price Performance ............................................................................................................. 14-15
Multiple Valuations ........................................................................................................... 15-16
Historical and Pro Forma Income Statement............................................................. 16-17
Discounted Cash Flow Analysis
     Most Likely ..................................................................................................................... 18-19
     Optimistic ....................................................................................................................... 20
     Pessimistic....................................................................................................................... 21
Recommendation .............................................................................................................. 22
Income Statement ............................................................................................................. 22
Balance Sheet ..................................................................................................................... 23
Statement of Cash Flows ................................................................................................. 24
Value Line Report .............................................................................................................. 25




                                                                          2
PetSmart Profile1
PetSmart, Inc. is a specialty provider of products, services and solutions for
the lifetime needs of pets in North America. The Company has identified a
group of pet owners the company calls Pet Parents, who are committed to
their pets and consider their pets family members. PetSmart's strategy is to
attract and keep these customers by becoming the preferred provider of
Total Lifetime Care for pets.

PetSmart stores typically range in size from 19,000 to 27,000 square feet,
and carry a selection of pet supplies at everyday low prices. The Company
offers more than 12,800 distinct items. There are approximately 900 stores
                    in North America.

                    PetSmart complements its product assortment with a
                    selection of value-added pet services, including
                    grooming, pet training, boarding and day camp.
                    Virtually all its stores offer complete pet training services
                    and feature pet styling salons that provide grooming
                    services. Through its strategic relationship with Banfield,
The Pet Hospital, and other third-party operators, PetSmart has made full-
service veterinary care available in 525 of its stores as of January 29, 2006.

The Company also reaches customers through its direct marketing
channels, including PetSmart.com, as well as an e-commerce site dedicated
to equine products and an equine catalog. Its PetPerks loyalty campaign
allows the Company to understand the needs of its customers and target
offers directly to them.

Through PetSmart Charities, Inc., an independent 501(c)(3) organization,
the Company supports the activities of animal welfare organizations in
North America. PetSmart Charities creates and supports programs to help
find a lifelong loving home for every pet, by raising awareness of
companion animal welfare issues; funding programs to further individual
animal welfare organizations' missions; and facilitating adoptions through
in-store programs, kiosks and pet transport programs.




1
    Reuters


                                        3
PetSmart’s Products and Services:2
PetSmart emphasizes premium dog and cat foods, many of which are not
available in supermarkets, warehouse clubs or other mass and retail
merchandisers. The Company also offers national brands traditionally
found in supermarkets and pet stores.

The Company's assortment of pet supplies includes collars, leashes, health
and beauty aids, shampoos, medication, toys, pet carriers, pet houses and
equestrian supplies. PetSmart also offers a complete line of supplies for fish,
birds, reptiles and small pets, including aquariums and habitats, filters and
birdcages. In certain stores, the Company has an equine department that
serves trade areas with high rates of horse ownership. The Company's
stores feature fresh-water tropical fish, birds, reptiles and small pets.

PetSmart offers full-service grooming and pet training services in virtually all
its stores. The Company typically allocates an average of 800 square feet
per store for high-quality, full-service grooming, including precision cuts,
baths, toenail trimming and tooth brushing. Depending on their
experience, the Company's pet stylists are educated as part of a 15-week
program that teaches grooming skills using safe and gentle techniques. Pet
training services range from puppy classes to advanced and private
courses.

PetHotel provides boarding for dogs and cats, 24-hour supervision, an on-
call veterinarian, temperature controlled rooms and suites, daily specialty
treats and play time as well as day camp for dogs. As of January 29, 2006,
the Company operated 32 PetHotels within its retail stores in addition to
one stand-alone location. Some include Doggie Day Camps.

The availability of comprehensive                      PetSmart Sales Distribution
veterinary care in its stores further
differentiates the Company, drives sales
in its stores and reflects its overall                 8%
                                                            3%

commitment to pet care. Full-service                                           Pet Food, Treats,
veterinary hospitals in 525 of                                        39%
                                                                               Litter
                                                                               Supplies
PetSmart's stores offer routine
                                                                               Pet Services
examinations and vaccinations, dental
care, a pharmacy and routine and                                               Pets
                                                 50%
complex surgical procedures.

2
    Reuters


                                       4
History of PetSmart3
1986: Become incorporated as Pacific Coast Distributing, Inc.
1989: Open first live fish, bird, and small pet departments; full-service
canine salon. Change name and logo of stores from PetFood Warehouse
to PetSmart.
1990: Contract with veterinarian company to bring mobile clinics to stores
to perform vaccinations and pet physicals. Change corporate name from
Pacific Coast Distributing, Inc. to PetSmart, Inc.
1991: First equine department opens. Open first
distribution center in Texas.
1992: Open permanent adoption centers. Offer
private label brands of pet food. Open and operate
first permanent in-store vet clinic.

1993: PetSmart goes public on the NASDAQ stock exchange.
1994: Begin training pets in all stores. Reach an agreement with Medical
Management International in Portland, Ore., to operate full-service, state-
of-the-art vet clinics in stores.
1996: PetSmart.com debuts. Open first stores outside the U.S. in Ontario,
Canada.
1999: Introduce first baked dog food in the pet food industry under a
private label. Turn PETsMART.com into an e-commerce business. All store
clinics run by Medical Management International, Inc., in exchange for
PetSmart receiving a 36% stake in MMI.
2004: PetPerks program begins in all stores.

2005: Opens third major distribution center in Ottawa, Illinois. Rolls out
PetHotels in selected locations nationally.

2006: Introduces Smart Nutrition Selector online and in stores and New Pet
Center in some stores.




3
    PetSmart.com


                                      5
Recent News:
2/28: PetSmart reported an 8.5% gain in fourth-quarter net profit, helped
by strong sales in its core pet products business and demand for pet
grooming services.4

3/1: PetSmart believes it can continue its investments in growth and start
to see some leverage on its operating expenses. PetSmart will sell its equine
business, State Line Tack. This means the company will exit a business that
is less profitable than its core business, and that space can be reallocated to
more profitable sales. It also allows PetSmart to open additional pet hotels
by converting existing space, so the company doesn't have to build new
space for the equine sales area or a pet hotel in order to expand this
service. This helps improve the investment part of the equation for a
services offering that is already twice as profitable as the core business. 5

3/13: PETA (People for the Ethical Treatment of Animals), an animal rights
organization, is asking PetSmart Inc. board members to urge the pet
products and services retailer to stop selling live animals. A letter dated Feb.
22 details an undercover investigation PETA said it conducted at two
PetSmart stores which found "serious animal care deficiencies". "We hope
that after reviewing our materials, you and other board members will urge
the company to stop selling live animals altogether," the letter said.
PetSmart denies the allegations in PETA's report and has urged customers
to visit stores to see the facts for themselves. The letter-writing campaign is
part of PETA's ongoing effort against PetSmart.6

3/20: A CIBC World Markets analyst said the direct impact of the pet foods
recall on sales should be limited. The recall involves less than 1% of total
sales. The recall “could be an opportunity for PetSmart, which can readily
address pet owners’ concerns with the in-store vet.” 7




4
  Reuters
5
  Motley Fool
6
  Business Journal
7
  AP


                                       6
Management8

                                    -   Francis Phillip
                                    -   Chairman of the Board, CEO since
                                        1998
                                    -   Served as a director since 1989
                                    -   Prior experience includes various
                                        positions at Shaw’s Supermarkets and
                                        management positions in Roundy’s
                                        Inc.

                                    -   Robert Moran
                                    -   President and Chief Operating
                                        Officer since 2001, joined the
                                        company in 1999
                                    -   Prior experience includes President
                                        of Toys R’ Us from 1998-1999, 20
                                        year at Sears Roebuck and Co.
                                    -   Served as President and CEO of
                                        Sears Roebuck in Mexico

                                    -   Timothy E. Kullman
                                    -   Chief Financial Officer and Senior
                                        Vice President since 2002
                                    -   Prior experience includes executive
                                        vice president and COO for
                                        Hagemeyer North America
                                        Holdings and various positions in
                                        Farm Fresh Inc. and Blue Cross
                                        Blue Shield

                                    -   Donald Beaver
                                    -   Senior Vice President and Chief
                                        Information Officer since 2005
                                    -   Prior experience includes Vice
                                        President and CIO of H-E-B and
                                        began working at Eastman Kodak
                                        as a programmer analyst

8
    www.reuters.com; www.petsmart.com



                                         7
Competitors

                                                          Ticker: WMT
                                                          P/E (ttm): 17.7
                                                          Market Cap: $198.97B

Wal-Mart was incorporated in 1969 and with stores located around the
world. The company is divided into three business segments: Wal-Mart
retail stores, SAM’s Club and the international segment. The Wal-Mart
stores are large, offering a variety of goods ranging from discount
merchandise to supermarket foods. SAM’s Club stores are similar in that
they offer a wide range of merchandise including bulk items, food and
electronics. The international segment is similar to the American Wal-Mart
stores, but each are wholly or majority owned subsidiaries. Because of this,
the Wal-Mart stores in each country tend to slightly differ by catering to
local preferences.

                                                          Ticker: TGT
                                                          P/E (ttm): 19.17
                                                          Market Cap: $52.81B

Target Corporation was incorporated in 1902 and headquartered in
Minneapolis, Minnesota. Its stores are large format, general-merchandise
discount stores and located across the United States. SuperTarget stores
include a grocery section in addition to the general merchandise. Target
also sells merchandise under licensed, designer names which provides the
company with more fashionable offerings in addition to everyday
necessities.

                                                          Ticker: COST
                                                          P/E (ttm): 23.77
                                                          Market Cap: $24.68B


Costco Wholesale Corporation consists of membership warehouses with
national and private label goods. Costco purchases its goods directly from
the manufacturing companies and transports them to its warehouses. This
enables the company to keep costs extremely low and sell merchandise in
large quantities. Stores offer a wide range of products including items for
inside and outside the home, furniture, electronics, food, jewelry and
pharmacy products. Costco also has a website featuring items that cannot
be found in all of its



                                     8
Industry Analysis9
Consumer spending is expected to decrease in 2007, and as a result the
specialty store sub-industry will likely be impacted. The caveat however, is
that within this sub-industry, stores range from luxury goods like jewelry to
discretionary items such as office supplies. The degree to which these
stores feel the effect of the slowing economy depends in part on the price
level of their products.

Despite the negative outlook of specialty stores, the pet supply market is
expected to perform very well in 2007. The anticipation of high yearly
gains, strong industry trends, strong share growth and increased spending
per pet all contribute to this belief. Within this category, Pet’s Mart had an
industry leading $3.8 billion in sales in January, 2006.


Institutional Ownership & Analyst Recommendations10

     % of Shares Held by All Insider and
                                               1%
                5% Owners:
     % of Shares Held by Institutional &
                                               82%
           Mutual Fund Owners:
     % of Float Held by Institutional &
                                               82%
          Mutual Fund Owners:
      Number of Institutions Holding
                                               321
                 Shares:



                    Current       Last          Two Months    Three Months
                    Month        Month             Ago            Ago
Strong Buy             7           6                6               6
Buy                    5           5                5               5
Hold                   9           9                8               8
Sell                   0           0                0               0
Strong Sell            0           0                0               0



9
    Standard & Poor’s
10
     www.yahoo/finance.com


                                           9
SWOT Analysis

Strengths
    The leading specialty provider of products, services, and solutions for
      the lifetime needs of pets in North America.
    Large and growing industry
    Unique store format with over 800 stores in 59 of the top 60 markets
      in the United States with a growing presence in Canada
    Strong marketing plan that uses three strategies that is focused on
      three things:
          o Driving traffic
          o Differentiating the brand
          o Increasing what customers spend in stores
    Has positioned its prices to compete with the low prices that the big
      box retailers provide
    PetSmart’s services continue to grow more than 20% each year
    Strong sales growth in recent years has given the company
      exceptional financial flexibility to reach long-term goals
    Strong assortment of products

Weaknesses
   Its competition is constantly fighting for the low price advantage
    which forces PetSmart to attempt to keep up despite the fact that it is
    a specialty retailer.
   This industry is dependent on consumer discretionary spending.
    Factors that affect consumer discretionary spending are the
    economy, consumer confidence, unemployment levels, and other
    things that PetSmart cannot control.
   Because PetSmart thrives off of the specialty image. The company
    has this image because premium pet food suppliers will only sell to
    specialty stores such as PetSmart. Therefore, PetSmart’s business is
    largely dependent on their relationship with these premium pet food
    suppliers.

Opportunities
   The growing market for pet products and services gives PetSmart a
     great amount of opportunities to expand the business.
   PetSmart’s creation of PetHotels and Doggie Day Camp has the
     opportunity to reach a segment of the market that has not been
     captured by any of its competition.




                                     10
Threats
    Large retailers are increasing their supply of pet products as they
      continue to capture more of the market.
    PetSmart is exposed to potential governmental and environmental
      problems. As the company expands and grows, it will be more
      difficult to manage the veterinary and other pet services that can
      affect the company legally.
    PetSmart’s expansion of stores will erode margins as the new stores
      establish themselves in their given market.
    PetSmart has only 10 distribution centers for over 800 stores. If a
      problem arose at one of these distribution centers, the entire
      company would be affected.




Financial Ratio Analysis
Liquidity
Rating: Strong

                 2006    2005     2004    Industry   WMT      TGT     COST
Quick Ratio      0.79    1.22     1.01      0.45     0.14     0.51    0.36
Current Ratio    1.82    2.34     2.02      1.24     0.85     1.29    0.99
LT Debt to
Equity           0.39     0.26     0.2      0.48      0.71    0.77     0.06
Interest                                              48.4            129.3
Coverage         9.98    12.07   11.37      49.14      1      8.86      3

In comparison to its competitors, PETM is in a solid position with regard to
liquidity. PETM generates a large amount of cash, so the Quick and
Current Ratios are quite a bit higher than its peers. The decline in these
ratios over the last three years can be attributed to a stock repurchase
program in conjunction with store expansion. The LT Debt to Equity for
PETM is lower than the industry average, but progressively increasing due
to company growth. Finally, this growth has led to a high interest
expense, placing PETM lower than the industry average for interest
coverage. The company has for the most part been able to internally
finance their growth, but this may change as cash reserves become low.
However, this does not pose an immediate threat to PETM.




                                     11
Management Efficiency
Rating: Strong

                                 PETM     Industry    WMT      TGT      COST
Return on Assets (ttm)            9.21      7.61       7.73    7.21      6.28
Return on Assets - 5 Yr. Avg.     9.12      7.87       8.83    7.18      6.34
Return on Investment (ttm)       24.94     22.98      25.32    26.1     15.56
Return of Investment - 5 Yr.
Avg.                             22.38     21.12      25.21    21.72    15.16
Return on Equity (ttm)           19.18     17.55      20.15    18.39    12.47
Return on Equity - 5 Yr. Avg.    17.86     17.99      21.49     20.1    12.52

PETM outperforms the industry in almost every category of Management
Efficiency. The management team for PETM is strong and very effective
about turning invested capital into revenue. This shows that the recent
growth is well thought out with unnecessary expenditures kept to a
minimum.


Profitability
Rating: Strong

                 2005    2004     2003     Industry     WMT      TGT    COST
Gross Margin     31.30   30.80    30.4      25.35       24.0     33.8   12.3
EBITDA
Margin           11.99   10.86     10.5     8.6875      7.42    11.79    3.55
Operating
Margin           8.30    8.40      8.1       6.525       5.9     9.2      2.7
Net Profit
Margin           4.85    5.09      4.66     3.6275      3.23     4.6     1.83
Effective Tax
Rate             36.9    35.3      38.7     36.275      33.8     37.5    36.9

PETM is also very strong with regard to their margins; outperforming the
industry in every category. High sales and low costs help keep margins
above the average. Their tax rate is right within the ranges of Wal-Mart,
Target and Costco, but could be brought down slightly.




                                     12
              Growth
              Rating: Average

                                                    PETM      Industry          WMT        TGT       COST
              Sales (ttm) vs. 1 Yr. Ago              14.0      11.68             12.0      11.2        9.5
              Sales - 5 Yr. Growth Rate               9.5      10.73             13.3      8.52       11.6
              EPS (ttm) vs. 1 Yr. Ago                 9.5      13.00              8.8      20.4       13.3
              EPS - 5 Yr. Growth Rate               29.53      10.82            15.82     16.06      11.38
              Capital Spending - 5 Yr.
              Growth Rate                           4.94          4.65           4.6        6.6       2.44

              PETM is average to the industry in terms of growth, falling behind both
              Wal-Mart and Costco. EPS is also average, although the 5 year growth rate
              is extremely high, signifying that the company is adding more shareholder
              value than any of the other three in the last 5 years. This is reiterated in
              capital spending, where PETM is second only to Target with the creation of
              new stores.


              Efficiency
              Rating: Average

                            2006         2005          2004          Industry             WMT           TGT           COST

Revenue/Employee        $108,684.94   $111,005.02   $113,060.38    $227,186.27         $175,363.33   $169,005.68   $455,691.11
Net Income/Employee        5274.57     5650.17       5267.92         6947.33            6239.44       7917.61       8357.69
Inventory Turnover           7.0          7.2           7.4              7.33              6.9           4.9          10.5
Asset Turnover              2.02         2.03          2.18              2.27             2.24           1.5          3.33



              PETM is quite a bit lower than its peers with regard to income per
              employee. One explanation for this is that all its competitors sell high end
              products in addition to their pet products. Examples include plasma screen
              televisions and jewelry which skew their sales per employee. The Inventory
              Turnover Rate falls within the industry average. The strong sales
              mentioned above help contribute to this high rate. The Asset Turnover
              Rate also falls within the industry average. PETM’s Asset Turnover has
              been decreasing the last few years as its assets continue to grow. It is
              opening new stores every year which in turn lowers the ratio.




                                                       13
DuPont Analysis

                       Net Profit          Total Asset            Equity
         ROE     =      Margin       x      Turnover       x     Multiplier
2006    19.41%   =      4.85%        x        2.02         x       1.98
2005    17.98%   =      5.09%        x        2.03         x       1.74
2004    16.66%   =      4.66%        x        2.18         x       1.64
WMT     20.73%   =      3.60%        x        2.24         x       2.57
TGT     17.65%   =      4.60%        x        1.50         x       2.56
COST    12.51%   =      1.83%        x        3.33         x       2.05

Once again, PETM is performing right in line with its competitors with
regard to the DuPont Analysis. The Net Profit Margin is above the industry
average, while Asset Turnover is right in the middle. A lower Equity
Multiplier places PETM behind only Wal-Mart in terms of ROE. The high
growth rate has lowered the Shareholder Equity of PETM, resulting in a
comparatively lower ROE. While growth is encouraged at present, it is
important that PETM does not put itself in the position of being too highly
leveraged.




Price Performance
 Time Period     Actual    vs. S&P 500       Rank in Industry (99 is best)
 4 week           3.0%         4.1%                      48
 13 week         12.0%        10.0%                      52
 26 week         17.3%         7.4%                      65
 52 week         16.7%         5.9%                      28
 YTD             13.3%        11.9%                      59

Over the past 52 weeks, PetSmart’s stock price has appreciated by 16.7%,
5.9% higher than the S&P’s return for the same period. PetSmart’s price has
appreciated at least 4.1% higher than the S&P 500 for all time periods
above. Its rank in the industry is average.




                                    14
 Price History         2006         2005        2004        2003         2002
 High Price           $31.38       $35.78      $36.24      $28.80       $21.00
 Low Price            $22.07       $21.13      $22.96       $9.90        $9.35
 High P/E               24           29          32          30           33
 Low P/E                17           17          20          10           15




Valuation

                               Pessimistic       Most Likely        Optimistic
 P/E                             $1.65             $1.67              $1.69
 Pessimistic         15         $24.75            $25.05             $25.35
 Most Likely         20         $32.34            $32.73             $33.12
 Optimistic          33         $54.45            $55.11             $55.77

To find the most likely 2008 price using P/E, we used the forward P/E ratio
as the most likely value, the lowest P/E in the last five years as the
pessimistic value, and the highest P/E in the last five years as the optimistic
value. The EPS pessimistic, most likely, and optimistic values are the analyst
low, average, and high EPS estimates.


                                              Sales/Share
                          Pessimistic         Most Likely      Optimistic
 P/S                               $30.20               $30.48        $34.94
 Pessimistic          0.9          $28.39               $28.65        $32.84
 Most Likely          1.1          $31.71               $32.00        $36.69
 Optimistic           1.2          $35.03               $35.36        $40.53


To find the most likely 2008 price based on P/S, we used the trailing twelve
months P/S ratio as the most likely and added and subtracted 10% for the
optimistic and pessimistic values. For sales/share, we increased revenue by
10%, the mean analyst estimate of sales growth, for the most likely sales
growth. We increased revenue by 9% for pessimistic and 11% for
optimistic.




                                       15
Taking both the P/E and the P/S valuations into account, the most likely
intrinsic value of PetSmart ranges between $32.00 and $32.73. PETM stock
is currently trading within this range, implying that it is fairly valued.


Historical and Pro Forma Income Statement

                                  Value Drivers
               Sales Growth 2007-2008                10.00%
               Sales Growth 2009-2010                12.00%
               Sales Growth 2010-2011                10.00%
               Sales Growth into Perpetuity           5.00%
               Gross Profit Margin 2007-2008         28.00%
               Gross Profit Margin 2009-2010         30.00%
               Gross Profit Margin 2011-2012         27.00%
               Operating Margin 2007-2008             7.00%
               Operating Margin 2009-2010             8.00%
               Operating Margin 2010-2011             7.00%
               EBT Margin 2007-2008                   5.00%
               EBT Margin 2009-2010                   4.00%
               EBT Margin 2011-2012                   3.00%
               Tax Rate                              38.00%



The value drivers for the pro forma income statement are listed above.
Sales have grown around 11.5% over the last five years. In order to take a
conservative approach, we decided to grow sales by 10% as PetSmart
completes the store expansion plan. In 2009, however, we increased that
growth to 12% once PetSmart becomes established in these new markets.
However, in 2010-2011 sales growth will most likely drop as the company
attempts to find new markets for the company to reach. In 2012 we
expect sales growth to increase back to 11% as they establish themselves in
new markets.

Profit margins have been strengths for PetSmart in recent years. Over the
next two years, a gross profit margin of 28%, an operating margin of 7%,
and an EBT margin of 5% are all conservative estimates. They increase in
2009-2010 due to the new store establishments, and then decline again as
they will most likely attempt to enter foreign markets.




                                        16
                                                                                      PetSmart, inc.
                                                                              Pro Forma Income Statement
                                                                               Years Projected 2007-2012
                                                                               All numbers in thousands
                                                   2003      g        2004    g        2005      g        2006     g         2007      2008      2009      2010      2011      2012
Net Sales                                       2,695,180   11.05% 2,993,115 12.37% 3,363,452   11.80% 3,760,499   10.00% 4,136,549 4,550,204 5,096,228 5,707,776 6,278,553 6,906,409
Cost of Goods Sold                              1,907,140    9.75% 2,092,997 11.08% 2,324,865   11.16% 2,584,304   15.25% 2,978,315 3,276,147 3,567,360 3,995,443 4,583,344 5,041,678
Gross Profit                                      788,040   14.22%   900,118 15.38% 1,038,587   13.25% 1,176,195    -1.53%1,158,234 1,274,057 1,528,868 1,712,333 1,695,209 1,864,730
Operating, General, & Administrative expenses    602,990    12.98% 681,270 14.68% 781,248       10.70% 864,815      0.45% 868,675      955,543 1,121,170 1,255,711 1,255,711 1,381,282
Operating Income                                 185,050    18.26% 218,848 17.59% 257,339       21.00% 311,380      -7.01%289,558      318,514 407,698 456,622 439,499 483,449
Interest Expense                                  31,240    -49.13%  15,892 4.05% 16,535        34.09%  22,171     273.15%  82,731      91,004   203,849   228,311   251,142   276,256
Earnings Before Taxes                            153,810    31.95%  202,956 18.65% 240,804      20.10% 289,209     -28.49% 206,827     227,510   203,849   228,311   188,357   207,192
Tax Expense                                       64,960    20.08%    78,005 6.85% 83,351       28.04%   106,719   -26.35%    78,594    86,454    77,463    86,758    71,576    78,733
Net Income                                        88,850             124,951 26.01% 157,453              182,490             128,233   141,056   126,386   141,553   116,781   128,459




                                                                                                                                                                                         17
                                                            40.63%                              15.90%             -29.73%
                                                                             Common Size Income Statement
Net Sales                                        100.00%     0.00% 100.00% 0.00% 100.00%      0.00% 100.00% 0.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%
Cost of Goods Sold                                70.76%    -1.18%  69.93% -1.15% 69.12% -0.58% 68.72%      4.77% 72.00% 72.00% 70.00% 70.00% 73.00% 73.00%
Gross Profit                                      29.24%     2.85%  30.07% 2.68% 30.88% 1.29% 31.28% -10.48% 28.00% 28.00% 30.00% 30.00% 27.00% 27.00%
Operating, General, & Administrative expenses     22.37%     1.74%   22.76%   2.05%    23.23%   -0.99%    23.00% -8.69%       21.00%    21.00%    22.00%    22.00%    20.00%    20.00%
Operating Income                                   6.87%     6.49%    7.31%   4.64%     7.65%   8.22%      8.28% -15.46%       7.00%     7.00%     8.00%     8.00%     7.00%     7.00%
Interest Expense                                   1.16% -54.19%      0.53% -7.41%      0.49%   19.93%     0.59% 239.23%       2.00%     2.00%     4.00%     4.00%     4.00%     4.00%
Earnings Before Taxes                              5.71% 18.82%       6.78% 5.58%       7.16%   7.42%      7.69% -34.99%       5.00%     5.00%     4.00%     4.00%     3.00%     3.00%
Tax Expense                                        2.41%     8.13%    2.61% -4.91%      2.48%   14.52%     2.84% -33.05%       1.90%     1.90%     1.52%     1.52%     1.14%     1.14%
Net Income                                         3.30%    26.63%    4.17% 12.14%      4.68%   3.66%      4.85% -36.12%       3.10%     3.10%     2.48%     2.48%     1.86%     1.86%
                                                     PetSmart, inc.
                                          Discounted Cash Flow Statement
                                             Years Projected 2007-2012

                                      2007             2008            2009          2010          2011          2012
EBIT                               289,558,423      318,514,265     407,698,260   456,622,051   439,498,724   483,448,596
Plus: Stock Based Compensation      43,433,763       47,777,140      61,154,739    68,493,308    65,924,809    72,517,289
Less: Incremental NWC                8,713,120        9,061,645       9,424,111     9,801,075    10,193,118    10,600,843
Less: Incremental Fixed Capital    165,737,000      178,167,275     191,529,821   214,513,399   240,255,007   269,085,608
Less: Income Taxes                  78,594,429       86,453,872      77,462,669    86,758,190    71,575,506    78,733,057

Free Cash Flow to the Firm           79,947,637      92,608,613     190,436,398   214,042,695   183,399,901   197,546,378
Present Value of FCFF                69,372,254      69,728,724     124,420,077   121,344,776    90,219,401    84,323,783



            In order to project the Discounted Cash Flows from 2007 into perpetuity,
            we took the earnings, added in the non-cash expense of stock based
            compensation, and then subtracted the investment in capital along with
            taxes to find the free cash flow to the firm. Following that we found the
            present value of the cash flows.

                                                      Residual Value
                                  EBIT 2012                                   483,448,596
                                  Plus: Stock Based Compensation 2012          72,517,289
                                  WACC                                             15.24%
                                  Residual Value                            3,647,017,171

            Using the Rappaport Model, we were able to determine the Intrinsic Value
            by using the cash inflow from 2012 divided by the weighted average cost
            of capital.

                                                         Intrinsic Value
                                  Cash & Marketable Securities               110,415,000
                                  Intrinsic Value                          4,316,841,187
                                  Total Liabilities at Book Value            922,941,000
                                  Intrinsic Shareholder Value              3,393,900,187
                                  Shares Outstanding                         140,791,000
                                  Intrinsic Value per share                       $24.11
                                  Market Value per share                          $32.40

            The intrinsic value proves that currently PetSmart is actually overvalued by
            34% despite the current growth plan that they are strategically
            implementing.

            Below the value drivers and weighted average cost of capital reveal how
            the model was calculated. Over the last three years, stock based


                                                              18
compensation has been settled at 12%, 18%, and 16% of earnings
respectively. Therefore, 15% of earnings seemed the most likely projection
in the next five years. The tax rate has been steadily around 38% over the
last five years. This is due to the different state taxes they are involved in.
After looking at five year averages and learning about PetSmart’s growth
plans, we determined the incremental net working capital investments and
the incremental fixed capital investments. A steady 4% increase in net
working capital should occur due to the expansion of stores in 2007. A
15% increase in fixed capital should occur due to the increase of stores in
2007, but will most likely drop to 8% after their expansion plan is
completed. We expect an increase to 12% in 2010-2012 due to more
expansion opportunities as they penetrate the international markets.


                                     Value Drivers
                 Stock Based Compensation                 15%
                 Income Tax Rate                          38%
                 Incremental NWC                           4%
                 Incremental Fixed Capital 2007           15%
                 Incremental Fixed Capital 2008-2009       8%
                 Incremental Fixed Capital 2010-2012      12%
                 WACC                                  15.24%



                                       WACC
                 Cost of Debt                           6.50%
                 Weight of Debt                           28%
                 Cost of Equity                        18.65%
                 Weight of Equity                      72.00%
                 WACC                                  15.24%



                                        CAPM
                 Risk-Free Rate                         4.50%
                 Beta                                     1.23
                 Market Premium                            7%
                 Cost of Equity                        18.65%




                                         19
             Optimistic

                                                   PetSmart, inc.
                                        Discounted Cash Flow Statement
                                           Years Projected 2007-2012

                                        2007           2008            2009          2010          2011          2012
EBIT                                 289,558,423    318,514,265     407,698,260   456,622,051   439,498,724   483,448,596
Plus: Stock Based Compensation        43,433,763     47,777,140      61,154,739    68,493,308    65,924,809    72,517,289
Less: Incremental NWC                  8,713,120      9,061,645       9,424,111     9,801,075    10,193,118    10,600,843
Less: Incremental Fixed Capital      165,737,000    178,167,275     191,529,821   214,513,399   240,255,007   269,085,608
Less: Income Taxes                    78,594,429     86,453,872      77,462,669    86,758,190    71,575,506    78,733,057

Free Cash Flow to the Firm            79,947,637      92,608,613    190,436,398   214,042,695   183,399,901   197,546,378
Present Value of FCFF                 69,372,254      69,728,724    124,420,077   121,344,776    90,219,401    84,323,783



                                                     Residual Value
                                  EBIT 2012                                 483,448,596
                                  Plus: Stock Based Compensation
                                  2012                                       72,517,289
                                  WACC                                          13.24%
                                  Residual Value                          4,199,138,109



                                                        Intrinsic Value
                                  Cash & Marketable Securities              110,415,000
                                  Intrinsic Value                         4,868,962,125
                                  Total Liabilities at Book Value           922,941,000
                                  Intrinsic Shareholder Value             3,946,021,125
                                  Shares Outstanding                        140,791,000
                                  Intrinsic Value per share                      $28.03
                                  Market Value per share                         $32.40


             In order to determine an optimistic outlook in the DCF analysis, we
             subtracted 2% from the WACC. Even with the lower discount rate, the
             market value still appears to be overvalued.




                                                             20
             Pessimistic

                                                   PetSmart, inc.
                                        Discounted Cash Flow Statement
                                           Years Projected 2007-2012

                                        2007           2008            2009          2010          2011          2012
EBIT                                 289,558,423    318,514,265     407,698,260   456,622,051   439,498,724   483,448,596
Plus: Stock Based Compensation        43,433,763     47,777,140      61,154,739    68,493,308    65,924,809    72,517,289
Less: Incremental NWC                  8,713,120      9,061,645       9,424,111     9,801,075    10,193,118    10,600,843
Less: Incremental Fixed Capital      165,737,000    178,167,275     191,529,821   214,513,399   240,255,007   269,085,608
Less: Income Taxes                    78,594,429     86,453,872      77,462,669    86,758,190    71,575,506    78,733,057

Free Cash Flow to the Firm            79,947,637      92,608,613    190,436,398   214,042,695   183,399,901   197,546,378
Present Value of FCFF                 69,372,254      69,728,724    124,420,077   121,344,776    90,219,401    84,323,783




                                                      Residual Value
                                  EBIT 2012                                 483,448,596
                                  Plus: Stock Based Compensation
                                  2012                                       72,517,289
                                  WACC                                          17.24%
                                  Residual Value                          3,224,860,126



                                                        Intrinsic Value
                                  Cash & Marketable Securities              110,415,000
                                  Intrinsic Value                         3,894,684,141
                                  Total Liabilities at Book Value           922,941,000
                                  Intrinsic Shareholder Value             2,971,743,141
                                  Shares Outstanding                        140,791,000
                                  Intrinsic Value per share                      $21.11
                                  Market Value per share                         $32.40


             By adding 2% to the WACC, we found the pessimistic intrinsic value to
             come out to approximately $21.11 per share, $10 overvalued by the
             market.




                                                             21
Recommendation

Despite the company’s strong fundamentals and positive outlook in
comparison with the competition, we feel that investing in PetSmart is not
the best use of the Student Managed Fund. The valuations we calculated
cannot justify purchasing shares of this company, however we believe that
PetSmart could be a good acquisition if the price were to become more
favorable to the intrinsic value of the firm.




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