PETS Shouldn't Be in the Doghouse, Despite Correction

Shares of PetMeds Express (PETS) plummeted today on news of a quarterly earnings shortfall. Sales were a better-than-anticipated $31.4 million, with a shift toward greater online sales (63% of revenue vs. 57% last year).

[So I don’t reinvent the wheel from here, feel free to check out my http://retail.seekingalpha.com/article/22742 on PetMeds.]

From a business perspective, I find the increase in online sales to be both good news and bad news. The bad news is simple: the market for online pet pharmaceuticals is fragmented and competitive, making targeted keywords increasingly more expensive and search engine rankings more difficult to build. As more pet pharmacy retail operations try to steal market share, online customer acquisition costs will increase and price competition could further erode margins.

The good news is a bit counterintuitive. Allow me to explain:

What is somewhat striking about the online increase is that the company’s website traffic is down significantly from a year ago. The company has seen website traffic decline noticeably year-over-year, which is disappointing given the more than 50% increase in advertising expenses. My guess is that they are doing one or both of the following things to accomplish a sales increase in light of lower traffic:

1) Targeting their advertising better, leading to higher conversion rates from visitors.

2) Getting visitors to spend more money at the site, whether through upselling, cross-selling, a broader product offering, etc.

3) Getting customers who initially purchased via telephone to place orders on the web instead.

All of these are good things (#1 and #2 for obvious reasons, and #3 due to the lower administrative expense to complete an order on the web vis-à-vis on the phone with a representative). Unfortunately, the aforementioned bad news may largely offset these benefits, and presents some looming challenges in building the PetMeds brand success. But more on that later.

Looking further into the numbers, PetMeds traffic was around 7.4 million visitors for the quarter, based on the Alexa.com statistics. With 130,000 new orders (presumably around 63%*130,000=81,900 from the web), 1.1% of the visitors were new customers. This conversion rate alone is higher than the standard retail website and probably industry averages, and given that a large chunk of traffic probably represents returning customers that need not be “acquired,” the conversion for new visitors was likely substantially higher.

So even while online acquisition costs are increasing, it appears the advertising money is being well spent.

Furthermore, investors shouldn’t lose sight of the PetMeds television marketing campaign. I believe the company is the only of its kind to do this (and maybe the only able to actually afford a national campaign), which gives it an added leg up. So while online marketing costs are increasing and competition stiffens, PetMeds has an extra edge through this media while all must suffer equally under the online sphere.

With greater financial resources, a stronger brand recognition, and successful television ads (including the new Betty White campaign), I still believe that PetMeds will come to dominate the industry and be the trusted, go-to source for pet owners. And now, with the shares having suffered what I would consider a correction, the stock may be at bargain levels (refer to my last post for more info).

PETS 1-yr chart