Pet Valu Holdings: Recession-Resistant Retailer On The Sale Rack

While the S&P 500 Index (SP500) has enjoyed solid returns year-to-date, we've seen bifurcated returns across sectors, and even within sectors. Names like Lululemon Athletica (LULU) evidence this, with that stock sitting at 52-week highs and up 26% year-to-date while other retailers are sitting at 52-week lows with year-to-date returns in deeply negative territory.

One name that's been beaten up significantly more than average is Pet Valu Holdings Ltd. (TSX:PET:CA), a franchisor of pet stores in Canada that's found itself down ~35% year-to-date and ~43% from its all-time highs. The result is that the stock has found itself hovering only marginally above its IPO debut prices and trading at a depressed valuation of less than half of its historical earnings multiple (~14.2x FY2024 annual EPS estimates vs. 30.0x earnings since going public). Let's dig into the company below, and why this selloff is offering a buying opportunity.

All figures are in Canadian Dollars unless otherwise noted. Pet Valu has significant liquidity on the Canadian Market (Toronto Stock Exchange), but there is a significant risk to buying on the OTC Market because of wide bid/ask spreads, low liquidity, and no guarantee of future liquidity. Therefore, the best way to trade the stock is on the Canadian Market.

Business Model

Pet Valu Holdings ("Pet Valu") opened its first store in Toronto in 1976 and has since grown to become Canada's largest pet retailer with 758 stores, with just over 70% of its system being franchised. Not surprisingly (given its scale), it's also the market leader, with 18% market share in Canada, 300 basis points above its second closest competitor with a similar share to Walmart (WMT) and Loblaws (L:CA) combined. Just as importantly, the company's footprint is unique from a convenience standpoint relative to peers, with Pet Valu having nearly 5x as many stores as its closest competitor (PetSmart) and 74% of Canadians within five kilometers of a Pet Valu store, with customers able to drive and even walk with ease to their closest store. Plus, the company has made solid progress growing into areas where it's less saturated with its acquisition of Chico's (Quebec's largest franchisor of pet specialty stores), adding 66 stores in the province of Quebec (bringing its total to 83), with this deal done in cash, providing a solid boost to Pet Valu's annual EPS.

The bulk on Pet Valu's system-wide sales are related to consumable pet-related products (food/treats) with this being non-discretionary and recurring in nature, while less than one-fourth of its sales are tied to hardlines pet-related products such as dog chews, collars, leashes, cages, carriers, toys, etc. In addition, the company also has in-store services which make up ~2% of sales, such as self-serve dog washes and grooming salons. Of note is that not only does Pet Valu benefit from leading market share, but its market share has been growing while others have seen some stagnation, suggesting its unique offering is paying off. Some reasons for this market share growth could include:

• Convenience with a Pet Valu in nearly every community.
• Strong customer service scores and more personal service vs. big box retailers.
• The ability to visit pets up for adoption in the store during visits to pick up food and treats, a bonus highlight to visiting the store for pet lovers.
• A small format (~3,500 square feet) vs. big box retailers which makes getting in and out of the store a breeze for those not interested in browsing.
• Support of animals in the community by supporting Pet Valu, with $23 million raised since 2010 (Companions for Change program) and over 42,000 pets placed in forever homes since the sponsorship program began in 2018.

One concern that some investors might have is that Chewy, Inc. (CHWY) will be the new kid on the block in Canada starting later this quarter, with a planned entry into Canada in Q3 according to the company. The company is certainly a disruptor in the pet space, with ~5% of Americans (20+ million) being active Chewy customers and with FY2022 net sales of ~$10.0 billion.

That said, I don't see as much risk to Pet Valu vs. its peers given that Pet Valu wins on convenience (nearness of locations) relative to its Canadian competitors, making it a less likely substitution for Chewy which also offers convenience. Pet Valu also wins on NPS scores vs. its current peers and its largest competitor PetSmart, with a 20 NPS score, 23 Employee NPS score, and an 80 Customer Satisfaction Score [CSAT] according to Comparably, much higher than PetSmart at 16 for its NPS score, -30 on its ENPS score, 69 (CSAT score), and lower Glassdoor review score. Hence, I would think the loser could be PetSmart (less convenience, lower customer satisfaction).

When it comes to grocery store peers, they lack the breadth of selection that Pet Valu offers, suggesting that Chewy's main area for taking share could be Pet Valu's competitors vs. Pet Valu.

It is also worth noting that Pet Valu's loyalty program has continued to grow at an impressive clip, up 30% to over 2.6 million members from "almost 2.0 million members as of year-end 2021." This is important, because these 2.6 million loyalty members made up 80% of the company's system-wide sales in its Q2 2023 results, and loyalty members have much higher basket sizes than their peers (up from 53% in FY2020). Loyalty program benefits include a free bag of pet food or complimentary dog wash for loyalty members who buy 12 bags of pet food or four dog washes, with other benefits include Discount Days.

As for Chico's and its ~100,000 loyalty members as of year-end 2022, the Chico's Privilege Card holders are awarded two points for every dollar spent pre-tax on qualifying purchases which can be redeemed for subsequent purchases at Chico stores. In addition, Pet Valu recognizes its VIP customers with added benefits, with its VIP customers making up its most loyal clients, as noted in the company's Q1 2023 Conference Call by Pet Valu's CEO, Richard Maltsbarger:

"So for each one of these VIP customers, many of whom have spent almost a decade being a loyal customer to Pet Valu, oftentimes with $10,000 to $20,000 to $30,000 to spend over their lifetime with us, we actually customize a very specific gift box that's tied to the pets that they're purchasing for within our Pet Valu stores. We then, in partnership with our local franchisee or store manager, invite the VIP customer into the store and actually through something only we can do with our true store-based human connection, really say thank you, a deep, personal, heartfelt thank you as we hand over this VIP box completely customized to them. Inside every box is a handwritten note from me thanking them for their business and an opportunity to speak with someone on our executive staff if they just like to give more input into how we could be an even better partner for them in the pet space. This is something that is at the premier level of our existing loyalty program in which we just want to say thank you to our very best customers."

- Q1 2023 Conference Call, Pet Valu CEO, Richard Maltsbarger.

I believe this is a brilliant initiative that makes Pet Valu stand out and while this VIP experience may only be realized by a small cohort of its customers, it ensures that these customers see that they are recognized for their support and likely helps to make them life-long customers of Pet Valu. Hence, between this VIP experience and the strong growth in its loyalty members, I believe that Pet Valu has built something special at its corporate & franchised stores, and I've found this to be true at most stores I've visited, with very knowledgeable (and prompt) pet-focused customer service vs. big-box retailers and many PetSmart locations where this is less the case and or non-existent.

Another point worth noting is that Pet Valu has a very strong management team for a mid-cap company, with its President & CEO Richard Maltsberger spending 14 years at Lowe's (LOW) in positions including President of International (oversaw expansion of RONA), Chief Development Officer, and most recently Chief Operating Officer for the United States. Meanwhile, the company's new CFO Linda Drysdale also has a solid resume, with time spent at Interac Corp. (Canada's leading payment services provider) as CFO and several years at Canadian Tire in positions ranging from VP, Head of Internal Audit, CFO of Canadian Tire Financial Services, and VP, Financial Planning & Analysis for groups including Consumer Brands, IT, Digital/E-Comm, Marketing, Supply Chain, and Real Estate.

In addition, Pet Valu's Senior Vice President, Corporate Store Operations is Gaylyn Craig who has been with Pet Valu for nine years after spending 16 years with Starbucks (SBUX) as Regional Licensed Manager, Field Implementation Manager, District Manager, and Store Manager. Plus, the company's Chief Digital & Marketing Officer Tanbir Grover also spent nearly a decade at Lowe's (most recently VP of E-Commerce & Omnichannel) and its Chief Merchandising Officer (Kendalee MacKay) held multiple positions with grocery juggernaut Loblaws and was most recently VP Merchandising & Business Development at Shoppers Drug Mart (acquired by Loblaws in 2013 for $12.4 billion). To summarize, I would argue that this is a strong team across the board that is highly capable of taking on any competition, making me believe that the Chewy fears are overblown.

Finally, it's worth noting that while we could see competition intensify, the industry itself benefits from a growing numbers of pet owners and multi-pet households, higher overall spend on pets due to humanization of pets (treating pets as a member of the family), a growing Canadian population, and a higher proportion of millennials preferring pets to having children. Hence, with spending on pets being less sensitive to the current slowdown, a larger overall pie due to a higher population, a growing number of households with pets and higher spending per household (humanization of pets), there is more share to go around, suggesting some of the competition worries might be offset by these dynamics.

Now that we've got some background on the company, let's dig into the recent financial results:

Recent Results

Pet Valu released its Q2 results last month, reporting system-wide sales of $343.9 million (+10% year-over-year), same-store sales growth of 6.0% (4.8% increase in average spend, 1.2% transaction growth), and revenue of $256.4 million, up 13% year-over-year. Meanwhile, despite higher net capital expenditures for its supply chain transformation (new distribution centers), the company still generated $13.0 million in free cash flow, a solid performance during a period that was impacted by some softness in hardlines (more discretionary purchases), which the company attributes to some softness in consumer demand and the more difficult macro backdrop. The other headwind outside of a weaker Canadian Dollar was that some consumers have switched to larger food bag sizes for savings which means less frequent visits, reducing the ability for Pet Valu to benefit as much from impulse buys during regular visits.

That said, and as noted earlier, ~80% of sales come from more recurring items like consumables and services. So, the company has still managed to grow revenue and system-wide sales at a double-digit rate despite these short-term headwinds.

As for unit growth, Pet Valu noted that it opened 788 new stores in the stores (ending with 758 stores), and it has maintained its outlook provided at the beginning of 2023 which is for $1.05 to $1.08 billion in annual revenue, 7-10% same-store sales growth, and 40-50 new store openings (implying 6% growth year-over-year at the mid-point). These are very impressive figures that speak to the resilience of the pet industry as a whole and just as importantly, the franchisee development pipeline remains strong despite higher rates, which isn't surprising given that Pet Valu boasts similar unit economics to Domino's Pizza (DPZ), another highly successful retail brand, with an estimated ~4-year payback, annual average unit volumes of ~$2.0 million, and a relatively low investment cost of ~$410,000. And it's also worth noting that 65% of Pet Valu's current franchisees own just one store with 22% owning two stores, suggesting room for organic growth as well as new applicants.

From a development standpoint, the company noted that it completed 18 renovations, expansion or relocation projects year-to-date (of a planned 20-30 in FY2023), and that it signed a lease for a new distribution center in the Metro Vancouver Region that is nearly completed (10 years commencing on January 1st, 2024), with a targeted launch in mid-2024. Pet Valu expects its upgraded distribution centers will serve multiple purposes. The first is that it will double its capacity to support growth and significantly reduce its reliance on third-party logistics. The second is that it will be able to introduce automation (not currently being used) and help improve fill accuracy plus lower costs. Third, it will significantly increase the company's wholesale distribution to its growing Chico franchise base which makes up less than 10% of its total system currently.

Finally, from a product standpoint and convenience, Pet Valu won a Product Innovation Award at the Retail Council of Canada Grand Prix for its Ultra-Freeze Dried Raw Bites as part of its Performatrin, with the company noting in its year-end results that it's seen strong growth in this growth rates in this product. Meanwhile, the company expanded its E-Commerce offering earlier this year with an Autoship subscription service, and the company continues to work on projects related to customer usability and speed improvements for E-Commerce to help it stand out among out from an ease of use standpoint. These investments seem to be paying off with continued traffic growth to its website in Q2 and continued growth in its active loyalty customer count. Finally, the company has begun rolling out its proprietary brand portfolio to Chico locations and has participation from 100% of Chico franchisees, translating to nearly 400 SKUs. This growth in its loyalty program is important as it has unique insights into its members to help with targeted marketing to help offset any recent slowdown.

So, how does the valuation look?

Valuation

Based on 71.5 million shares and a share price of C$25.60, Pet Valu trades at a market cap of ~$1.83 billion and an enterprise value of ~$2.12 billion, with ample liquidity to carry out its planned investments with ~$140 million in liquidity ($130 million available on RCF with an effective interest rate of 7.0% and $9 million in cash). This is a dirt-cheap valuation for a company capable of generating $140 million in free cash flow in FY2025, leaving the stock trading at just ~15.0x FY2025 free cash flow estimates. This is far too low of a multiple for a recession-resistant retailer with a predominantly franchise model (~70% of stores franchised), and especially for a market leader with Pet Valu's solid track record, on track for eight consecutive years of positive same-store sales growth (12% growth on trailing 7-year average basis), with consistent mid-single-digit unit growth.

From an earnings standpoint, the stock is also trading at its most attractive valuation since it went public, sitting at just ~11.9x FY2025 annual EPS estimates ($2.15) vs. its historical earnings multiple of 30.0x. And while I think the stock's earnings multiple since going public is steep, I believe a very conservative for this business is 18.0x earnings, pointing to a fair value of $32.40 using FY2024 annual EPS estimates of $1.80 (1-year target price) and $38.70 (2-year target price) based on FY2025 annual EPS estimates of $2.15. So, if we measure from the current share price of $25.60, this points to ~29% upside on a total return basis (including 1.6% dividend yield) to its 1-year target price and ~53% upside to its 2-year target price even when applying a multiple that's 40% below where it's traded since going public. Hence, this sell-off in Pet Valu looks more than overdone, and I see this as a buying opportunity.

Summary

Pet Valu Holdings Ltd. has enjoyed impressive growth over the past several years (~6% CAGR for unit growth), benefits from robust unit economics (~$2.0 million AUV with 50% cash-on-cash returns) that has helped it maintain a healthy pipeline of prospective franchisees, and outclasses its peers on NPS scores, overall reviews, and convenience. Just as importantly, it's in an industry that has given up ground grudgingly on a spend basis during recessionary environments, and has seen an acceleration in growth from 2016 to 20022 as pet humanization has emerged, with pet owners' priorities being quality, affordability, shopping convenience and brand name. These priorities all support Pet Valu's position as retaining its market leadership and growing share with a wide array of products (including innovative items in private label brands), very affordable prices and industry-leading convenience (70% of Canadians within 5 kilometers of a Pet Valu location).

However, Pet Valu Holdings stock has come under pressure year-to-date, down 35% for the year with worries about a pullback in consumer spending, Chewy's entrance into Canada leading to increased competition, and margin softness/lower free cash flow generation because of a weaker Canadian Dollar, duplicate operating costs for its GTA Distribution Center and increased investments. However, regarding executing on its business model, Pet Valu continues to excel, and the payback on these investments will be meaningful (supply chain transformation with new DCs and benefit of automation) following this investment phase. Plus, the company will steadily see its franchise mix improve as it increases in scale, which should support a higher multiple long-term. Hence, while free cash flow may remain pressured short-term, the company is making the right investments to ensure it maintains its market share leader status, even with increased competition.

To summarize, I see Pet Valu stock as a steal at current levels, with the stock trading at less than 12x FY2025 annual EPS estimates vs. what I believe to be a fair multiple of 18-20x earnings. And with the potential to grow its store count by ~60% long-term to its goal of 1,200 stores, this could easily be a C$75.00 stock long-term and provide nice diversification for a portfolio with a growing dividend with a staples-like tilt, with it being a retailer that's much less discretionary and recession resistant.

Hence, I see this pullback in Pet Valu Holdings Ltd. shares as a gift, and I have recently started a new position in the stock. Plus, it's possible we could see the company begin buying shares as well on this selloff to support the stock, with opportunistic share repurchases discussed as a potential way to return capital to shareholders in its Q4 2022 results and the price certainly being right after this violent correction.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.