How to be a Heroic StockPicker
Instrumental in making any call during earnings season is a whole bunch of dot-connecting. If Company A blows the doors off consensus sales estimates, it's highly probable that Company B, a close competitor, had a softer than expected quarter. Sure, there are the typical nuances surrounding actually communicating the call to short the stock of Company B into its report or to develop a fancy options strategy, chief among them being if that share gain by Company A is priced into the valuation of Company B. Then, there are those instances as a stock picker where you are feeling your oats so to speak and decide to “get cute” with a near-term call. I am having one of those moments (all calls documented on our site www.decodingwallst.com) as earnings season draws to a conclusion, with retail representing the final leg.
Oftentimes when I have gotten cute with a stock recommendation it has been rooted in something seen in a small or mid-cap company that either makes me excited or concerned for a large-cap. For this latest cute moment, I have used animal hospital operator VCA Antech (WOOF), which posted a dog of a quarter, to predict the potential for disappointment in the earnings from pet retailer PetSmart (PSMT). Now, PetSmart has been performing just fine and dandy, posting respectable margin expansion in 1Q12, an impressive earnings beat, and a full year earnings guidance lift. The problem is that the stock is priced for a continuation of near perfection that I believe is at risk if small-cap WOOF's results were any “tell.” Here is where I am coming from…
The Only Things I Cared About in WOOF's Earnings Call
•The drop in sequential growth was mostly a function of volumes.
Tell: Although not the cheapest animal hospital operator in the space, fewer visits by pet owners signal a financial inability to address pet needs; and (2) fewer people are owning pets as a result of financial considerations.
•Management blamed the lackluster sales on a “systemic issue.”
Tell: Eh, partially an excuse for a lousy quarter but enough of a bold statement to get me wondering further on the underlying dynamics in the overall pet industry (which includes pet product retailers).
•Sales were weak in April, May, and June.
•60%-65% of the store base had negative same-store sales volume growth.
Tell: Widespread nature of the pressured sales supports the systemic problem statement.
How All of this Applies to PetSmart
•Market is not anticipating any slowdown in the financial results of PetSmart in 3Q12 and 4Q12 (stock is chilling near its 52-week high). This is also a function of management's guidance, in particular expectations for 2H12 merchandise margin “strength.”
•Store occupancy leverage has been a larger driver of PetSmart's gross margins; leverage is derived from strong same-store sales primarily (and new unit growth). The way I am thinking about it is that should same-store sales moderate, as areas in WOOF's business imply could happen, there goes a good chunk of PetSmart's cost leverage. In addition, merchandise margin wouldn't be strong as management guided to as more promotional efforts are taken to bring in traffic. Two gross margin headwinds would exist, basically.
I have conveyed to clients to enter into a small speculative short position in PetSmart into earnings. Risks to this call include: (1) lingering inflation continuing to lead to upside comps; and (2) new product introductions and pricing initiatives actually aid the business while others in the industry struggle.