SINGULAR DILIGENCE NOTES. PetSmart (NASDAQ:PETM)

Transcription

1 SINGULAR DILIGENCE NOTES PetSmart (NASDAQ:PETM)

2 Overview PetSmart: Does a Cheaper Price Suggest a Narrowing Moat? 10 years growth 169% 106% 32% Sales Earnings Enterprise Value Enterprise value didn t increase much despite 169% earnings growth - Supermarkets once dominated the pet food market o 95% market share i o Specialty players failed to break the dominance of supermarkets Including Petco - Supermarket s dominance started to weaken in the mid-1980s o Part of the cause for the change was the emergence of warehouse discount stores and superstores - Jim and Janice Dougherty opened the first store of their new company o The Pet Food Warehouse o In 1987 o The store was 25,000 square feet o In Phoenix, Arizona o It was the first high volume, low-priced pet store in the U.S. o The Pet Food Warehouse was incorporated in August 1986 ii Using $1 million start-up investment From Phillips-Van Heusen Corporation, and Other investors Opened 2 stores in 1987

3 Received more money from venture capitalists after the first 2 stores Opened 5 stores in 1988, in o Arizona o Colorado, and o Texas The 7 stores performed well $16 million sales But didn t make money o Lost $1.8 million in 1989 o => The board of investors removed the Doughertys - Samuel Parker was hired as chairman of the company o In 1989 o He was a 19-year veteran of the Jewel supermarket chain Also had served as president of Frame-N-Lens Optical GEMCO division of Lucky Stores - Samuel Parker refined the Doughertys concept iii o Transformed the money-losing Pet Food Warehouse into PETsMART More hospitable environment for customers Cement floors were replaced with tile floors Aisles were widened In-store lighting was brightened Add more pet accessories and supplies Beat competition by A far greater selection of products iv o 7,000 pet-related products o Supermarkets carried 800 items o Warehouse clubs carried 20 items o A mass merchandise store carried 500 items o A traditional pet store carried 1,000 items At substantially lower prices o 10-30% below competitors Added services Grooming Veterinary centers Adoption service called Luv-a-Pet

4 - PETsMART started to expand o Had in total 1989: 12 stores 1990: 29 stores 1991: 48 stores o From 1989 to 1993 Annual sales growth was 85% 1989: $15.9 million 1990: $29.3 million 1991: $58.2 million 1992: $106.6 million 1993: $188 million o $2.4 million net income Became the largest operator in the industry o During this time, Petco started to transform its stores into superstores 12,000 to 15,000 square feet - PETsMART went public in 1993 o Yielded $125 million o Allowed PETsMART to further expand - PETsMART complemented organic growth with some acquisitions o Pet Food & Supply In 1993 Based in Phoenix 5 stores o Petzazz 1994 $50 million sales Gave PETsMART entry into the Chicago market PETsMART paid $81.3 million stock swap o Petstuff Based in Atlanta PETsMART s closest rival With 56 stores o Pet City A U.K. chain 50 superstores $214 million in a stock swap

5 o PETsMART later exit the U.K. business At a loss of $46 million - PETsMART ended 2000 with 533 stores - PETsMART works hard to differentiate from competitors o Changed the format in 2000 v Stores have a warmer environment Bright colors to distinguish various sections More visual emphasis on services Reduced shelf inventory => more open and visually appealing layout Added more distribution centers to replenish stores more often o Added day care and hotels vi ,500 square feet A hotel has vii 75 to 90 regular guest room 5 to 8 suites Two to three play rooms to support the Day Camp business Other features, amenities, and services Change the name from PETsMART to PetSmart viii MART get PetSmart to the commodity of the world Smart get into the total lifetime care o Invested total $1.2 billion in advertising since 2000 o Services revenue grew 18% annually since : $76 million 2013: $766 million o A PetSmart store today 12,000 18,000 square feet In power centers Draw customers within 5-miles radius An additional 1,500 square feet for a Banfield hospital Carries a wide selection of pet food and supplies 11,000 items Carries from widely distributed brands to channel-exclusive brands o Example of dog food brands

6 o Widely distributed brands Pedigree About $0.5 per pound Beneful About $0.8 per pound Purina One About $1 per pound o Channel exclusive brands Purina Pro, Hills Science Diet About $1.2 per pound Eukabana About $1.5 per pound Nutro Ultra, Innova, Nature s Recipe About $1.8 per pound Hills Ideal Balance About $2 per pound Blue Buffalo, Wellness, Royal Canin About $2.5 per pound Pet supplies has a lot of human brands like o Martha Stewards o GNC o Disney o Etc. o PetSmart get exclusive license for these brands Pet adoption services Found homes for approximately 440,000 pets in 2013 Found homes for over 5 million pets since 1994 Grooming About 900 square feet Grooming is done with dogs on raised tables The grooming section has glass around instead of wall => people can see Hotel 4,000 to 7,500 square feet - PetSmart is the price leader o Follows everyday low price strategy o PetSmart price is

7 5-7% above mass retailers ix 8-10% below specialty competitors and groceries o PetSmart is the original pricer x xi Set price reference for others - Big scale allows PetSmart get over 40% return on capital o Gross margin is about the same as other people 30% o But earn 10% profit margin Specialty stores average 3.6% profit margin o Asset turns over is about 4.4 o => 44% return on capital - PetSmart has been gaining market share o In food & supplies 2006: 12% 2013: 17% o In services: 2006: 9% 2013: 16% - PetSmart can continue gaining share o Sell services to merchandise customers o Services help get new customers to the stores - The pet industry has great future prospect o Expects to grow at or slightly above GDP growth rate - Over the last 10 years o PetSmart grew sales 8.3% annually Operating profit grew 11.7% annually Thanks to margin expansion Service sales has higher margin o But EV increased by only 30% $4,249 million in 2004 $5,622 million today At $58 per share - The two top concerns are o Competition from supermarkets and mass retailers o Online competition - Are these concerns legitimate?

8 i Petco had been operating as a retailer of pet food and supplies for nearly 30 years before the company launched its bid to become the dominant national player in its industry. Founded in 1965, the company competed during its first decades as one of the hundreds of regional pet merchandisers scattered across the country who found it difficult to operate under the shadow of the all-powerful supermarkets. In the battle to lure pet owners into their stores, the supermarkets prevailed comfortably, accounting for 95 percent of all the pet food sold in the country. Their dominance came at the expense of specialized retailers like Petco, but beginning in the mid-1980s the stifling grip maintained by the supermarkets started to weaken. The cause for the change was part of a pervasive transformation of the retail industry as whole in which massive "warehouse" discount stores and "superstores" secured a substantial foothold in the retail sector. Along with the growing prominence of these new retail formats, the diversity of pet products- -particularly food--increased, providing a lucrative niche for the specialized retailers to exploit. Supermarkets had held sway by stocking their shelves with popular brands such as Alpo, Kal Kan, and Purina, but beginning in the mid-1980s new premium brands of pet food were introduced into the market. Premium brands such as IAMS, Science Diet, and Nutro that offered higher levels of nutrition than the supermarket brands became increasingly popular among pet owners, and specialized pet products stores were the only retailers to carry such brands. The changing dynamics of the pet products industry led to the decreasing strength of the supermarkets and the growing prominence of retailers such as Petco. Between the mid-1980s and the mid-1990s, the percentage of pet food sold in supermarkets slipped from 95 percent to 50 percent, with specialized pet products retailers, warehouse clubs, and mass merchandisers accounting for the change. The conditions were prime for Petco's growth and expansion into a national chain. In the reshaping of the pet products industry, the nearly 30-year-old regional retailer played a leading role. Petco s history, ii In 1987, a new concept in retailing pet food was born when Jim and Janice Dougherty opened the first store of their new company, The Pet Food Warehouse. As its corporate title suggested, The Pet Food Warehouse sold huge bags of pet food in a large, sparsely decorated, cement-floored store, giving consumers the opportunity to purchase food for their pets in bulk at discount prices. The warehouse retail concept was not new at the time, but it was the first time the high-volume, low-priced approach of retailing products to consumers had carried over to the pet industry, a roughly $7 billion-a-year industry during the mid-1980s that was dominated by supermarkets and mass merchandisers, with myriad small pet stores

9 snatching what little was left. The Doughertys, however, were intent on adding a new type of competitor to the industry, one that could take advantage of a burgeoning trend among consumers during the 1980s and fuel the growth of their fledgling enterprise. Jim and Janice Dougherty incorporated their company in August 1986, using $1 million in start-up investment from Phillips-Van Heusen Corporation and other investors to open their first two stores in Phoenix, Arizona, the following year. Venture capitalists continued to fund the company's expansion after the first two stores were established, providing the financial support to establish five additional stores by 1988 in Arizona, Colorado, and Texas, as The Pet Food Warehouse began to take on the qualities of a retail chain. Although there was evidence that The Pet Food Warehouse was performing well--seven stores had been established in less than two years, and annual sales had risen to nearly $16 million--there was one important financial statistic that tinctured its success, particularly in the minds of the company's all-important investors: the regional chain was losing money. In 1989, The Pet Food Warehouse lost $1.8 million, prompting the group of investors supporting the company to make a dramatic change. That year, the board of investors voted for the removal of the Doughertys, retaining the two founders as consultants but excluding them from direct control over the company they had started less than two years earlier. PetSmart s history, iii Although the Doughertys were gone, the concept of selling pet supplies in a large retail store at discount prices remained alive, at least in the hearts of the investors who still hoped The Pet Food Warehouse approach could yield a return on their investments. To replace the Doughertys, the company's financial supporters wanted someone with more retail management experience, and in Samuel J. Parker they gained a leader with considerable experience. A 19-year veteran of the Jewel supermarket chain, Parker also had served as president of Frame-N-Lens Optical and the GEMCO division of Lucky Stores, accruing sufficient executive management experience to attract the attention of The Pet Food Warehouse's anxious controlling investors. Parker was hired as chairman of the company shortly after the removal of the Doughertys in 1989, and he immediately began to exert his managerial control over the seven-unit chain. Although the Doughertys had originated the warehouse retail concept in the pet supply industry, Parker's refinement of the concept would produce the results for which antsy investors hoped, and he soon transformed the money-losing Pet Food Warehouse into

10 PETsMART, Inc., one of the fastest growing companies of any kind in the United States during the early 1990s. Once Parker was brought on board, sweeping changes were made: cement floors were replaced with tile floors, aisles were widened, and in-store lighting was brightened, creating a more hospitable environment for customers. Instead of merely selling pet food, Parker stocked the company's stores with a full array of pet accessories and supplies, attempting to beat the competition by offering a far greater selection of products at substantially reduced prices. What emerged early under Parker's reign was a hybrid version of the concept first developed by the Doughertys, a retail approach that incorporated the design of a warehouse store with the more conventional trappings of a retail store. In the rear of a PETsMART store, pet food was sold in austere surroundings; pet accessories were displayed on retail racking in the front, giving the customers who frequented each location the benefits of both worlds. In addition, Parker established grooming and veterinary centers at PETsMART stores and then set up a pet adoption service called 'Luv-a-Pet,' creating a one-stop pet store that offered services and supplies even the largest mass merchandiser or supermarket could not match. PetSmart s history, iv Prices at the company's 25,000 square-foot units are "typically 10 to 30 percent below those of traditional pet food and pet supply outlets," he reports. Product selection is extensive, with items carried ranging from collars, leashes, and health aids, to toys, animal carriers, and equestrian supplies. In fact, a Petsmart unit offers 7,000 pet-related products, as compared to "an average of 800 such items in a typical supermarket, 20 in a typical warehouse club, 500 in a typical mass merchandise store, and 1,000 in a traditional pet store," says a spokesperson. Smart Moves at PETsMART, Discount Merchandiser, September 1993 v The retailer is happy so far with results from its reformatted stores, which group products by how pet owners shop. Spokeswoman Lynn Adams said, the existing formats are arranged by product type rather than pet type; for example, dog and cat food in the same section rather than adjacent to other dog and cat merchandise. In the new format, pet owners can purchase every kind of product for their pet in one area. Stores in markets such as Chicago, which won't be fully converted until next year, have already begun an incremental migration to the new format, according to one manager.

11 The new stores have a warmer environment, with bright colors to distinguish various sections and more visual emphasis on services, Adams said. No longer treated as an adjunct to the core business, pet training classes will be moved from the sidelines to their own centrally located, cordoned-off space in the store where they can clearly be seen by shoppers. Another significant change already underway is a decline in shelf inventory; steel shelving will eventually be eliminated throughout the stores. PetsMart has added four forward distribution centers to the two that had been supplying stores throughout the United States, helping to cut shelf inventory for a more open, visually appealing layout, Adams said. "We'll supply our stores more often with products that move quickly and are most in demand," she added. PETsMART Spruces Up Sales with New Services, Improved Store Format, Katherine Hutchison, DNS Retailing Today, 18 June 2011 vi Today, the inside of the store looks a lot homier, with a little blue shingled area inside with brick and siding that houses the hotel and day care area. Inside the hotel section, visitors are greeted to slate tiles and wooden reception desk. In the dog area, owners can choose between regular boarding, where dogs congregate in a big room and then sleep alone in kennels, or private suites with raised platform beds and televisions airing the Animal Planet cable network and other pet programming. Since the stores are in strip malls, the company developed a porous pebble floor where the dogs could urinate. There's also a "bone phone" that allows owners to call in and talk to their pets. Cats have quarters with separate air filtration systems so their smell doesn't drive the dogs crazy. The cats also get to watch a live fish tank. Francis says he can add a pet hotel to an existing location for less than half the cost of building a similar standalone location. Plus, the hotel shares the cost of the heating and air conditioning system, parking lot, employee break area, armor car pickups, and other overhead. Overnight stays start at $21 a night, $31 for a suite. Day care starts at $14 a day. After five years the hotels can help boost a store's sales by 29% and double its profitability, both because the hotels are a high-margin business and because customers come more frequently and buy other things when they do. A typical PetSmart store with a hotel earns $879,000 on sales of $7.1 million.

12 Even with numbers such as those, Francis says he's rolling out the hotel concepts slowly. They're in just 62 of the stores today, although Francis says they could ultimately be in 435 stores, or 40% of the chain, by He's taking it slow because "people get angrier about bad service than a bad product. It's more personal. We have to make sure we get it right." The Battle to Be Top Dog, Christopher Palmeri, Business Week, 05 August 2007 vii The Hotel's impact on the store four walls profitability remains consistent and compelling. We now believe that the Hotel adds 29% to the total revenues of the store and boosts pretax income by 99%, and drives 440 additional basis points of pretax margins. Every Hotel has a Day Camp business folded in and we have seven stores operating Day Camps without a Hotel attached. We have looked at these two types of businesses and it's clear while the Day Camp is a good business on its own, it's much more interesting when it's attached to a full PetsHotel. So we're pursuing a high grade concept that gives our customers the best of both worlds and fulfills Day Camp's customers' demand for Hotel services. This new concept is between 5,000 and 5,500 square feet versus the 7,200 square feet that we have in our traditional hotel. It has between 75 to 90 regular guest rooms and five to eight suites. In addition, it has two to three playrooms to support the Day Camp businesses. While the lobby is scaled-down, it offers all the same services, features and amenities as a full PetsHotel. We're testing this hybrid model in one store in Dallas and we plan to extend this test to an additional store this year. While it's early in the test, we'll have the benefit of operating Hotels and Day Camps. We have had the benefit of operating Hotels and Day Camps for four years. So we feel quite confident in the potential of the new and slightly condensed version of the PetsHotel. While overall revenues are lower in the smaller facility, investment costs are also less. So the profitability of a 5,500 square foot PetsHotel is comparable to a regular PetsHotel. And because the smaller version requires substantially less square footage, we can put it into more potential store sites and more markets. Because this hybrid model is so compelling, we think it can effectively replace the stand-alone in-store Day Camps that we have planned, with better revenues and increased profitability. So as we open more Hotels and better understand the market potential, we now believe that the total buildout is 435 Hotels, well up from our original projection of 300. Of those, about 65% will be in new or relocated stores, with the remainder in existing stores. Robert Moran, former COO, John Rice 2006 Conference viii On the new advertising campaign, we've done extensive focus groups to look at, in a sense, the differentiation of the brand, who we are and how we stick out in the pet specialty world and we came out very strong from the point of view of

13 moving and emphasizing the SMART. The MART really gets us into the commodity of the world. The SMART really gets us into the total lifetime care. We have used our ad agency, Leo Burnett, to really help with us that, and they have a great track record, especially in retailing with this type of creative effort. So we are really looking forward to kicking this off on September 7. Bob Moran, former COO, 2005 Q2 Earnings Call Transcript ix store. Overall, on average, PetSmart is 8% to 10% less than the other pet specialty retailers as well as grocery and we are within 5% to 7% of max prices. Joe O Leary, head of merchandising, 2011 Investor Day x We, too, have heard some manufacturers talking about price increases on the food side of the business. We think we are the price leaders for some, and we're a price reference, at least, for several others. We are ones who do our own original pricing off our own original algorithms and what we understand about our own elasticities. That means in, I guess, more simple terms that we price product off what it costs. So when stuff costs more we do keep an eye on competitors and are vigilant in that regard, but the base case here is that we price product based upon its cost and what we understand about our own elasticities. When we had price increases, I guess it was about two years ago, and now, the behavior then was we priced our, we essentially pass through the prices and after a short amount of time, the rest of the world, broadly speaking, passed through as well, and competitive positions in that time were pretty much maintained at slightly higher price points. I can't speculate what this time will happen, but we'll price our product off the cost you pay for it then be vigilant as we look at the competitive environment. Phil Francis, former CEO, 2005 Q3 Earnings Call Transcript xi What Tim said, yes. And remember, we're what I would call original pricers. We don't go after name 'em minus some or somebody else plus some, we're one who has our own price elasticity by subcategory, by competitor. The goal is to optimize cash gross margin in the subcategory, and it just turns out that when people do studies we're about 3 to 5 less expensive, or 10 to to 5 more expensive than some and 10 to 17 less expensive than others. But as we do our price optimization studies, if that told us the customer had moved and we should move, those numbers would change. But we get there out of our own numbers, not because we look at somebody else and use a calculator to do either a fraction or a 1 point something or other calculation. We do original pricing. I'm not

14 sure there's many of us left. Phil Francis, former CEO, 2005 Q4 Earnings Call Transcript

15 Moat PetSmart: The Biggest Fish in a Big Ocean 3% 11% 23% 17% 46% PetSmart Mass Retailers Grocery Online All Other PetSmart hold 17% market share of the $33 billion pet product market - Market share o Product market According to Nielsen 2012 Homescan Customer Panel data PetSmart: 17% Mass retailers: 46% Grocery: 23% Online: 3% All others: 11% According to America Pet Products Association ( APPA ) The pet product market is $33.71 billion o Food and treat: $21.57 billion o Pet supplies and medicine: $13.14 billion PetSmart merchandise sales excluding pets: $6 billion o => 17.3% market share o Service market: According to America Pet Products Association ( APPA ) The service market excluding veterinary care is $4.41 billion PetSmart s services sales was $766 million

16 o 17.4% market share According to PetSmart s 2013 investor day presentation PetSmart s services hold 16% market share o Excludes training Compete mainly with tiny private competitors o Vet care market According to America Pet Products Association ( APPA ) Vet care market was $14.37 billion in 2013 Banfield sales was $1 billion => 7% market share o PetSmart dominates the specialty market According to IBIS World March 2014 Pet specialty market was $16.5 billion o PetSmart: 40.3% market share o Petco: 19.5% market share Share within the pet specialty market by category o Pet food: 52% $16.5 * 0.52 = $8.58 billion o Pet supplies: 29% $16.5 * 0.29 = $4.785 billion o Pet services: 13% $16.5 * 0.13 = $2.145 billion o Live animal: 6% 16.5 * 0.06 = $0.99 billion There are 13,156 players o 59.1% of players are nonemployers Stores without paid employees o 83% of players have fewer than 5 employees o Only 7.8% of total operators have more than 20 employees - PetSmart and Petco have advantages over independent stores o Scale Independent stores buy from distributors Can t get product at as low price as PetSmart and Petco Advertising PetSmart spent about $140 million in 2013 o Only 2% of sales

17 o In 2001 $80 million 3.2% of sales 83% of specialty competitors have fewer than 5 employees o They can t do much advertising o PetSmart s profit margin is almost 3 times higher than industry average According to IBIS World March 2014, pet specialty s average profit margin is 3.6% PetSmart s 2013 EBIT margin is 10% o As a result, independent stores focus on ultra-premium foods Sells brands that are not available in big boxes Like Orijen dog food - PetSmart has some difference with Petco o PetSmart has bigger stores PetSmart s traditional store is 20,000 square feet Today PetSmart s store ranges between 12,000 and 18,000 square feet o 12,000-square-foot stores are for new locations i Average square feet per store o 2005: 26,211 square feet o 2013: 22,270 square feet Petco store is between 12,000-15,000 square feet Average square feet per store o 2005: 14,449 square feet o PetSmart is in power centers ii Petco in neighborhood strip mall Petco started as neighborhood stores o 3,500 square feet o Only started building big 12,000-15,000 square-foot stores in early 1990s iii 1992 Small stores: 161 Superstores: Small stores: 132 Superstores:

18 Small stores: 107 Superstores: : Small stores: 79 Super stores: : Small stores: 58 Super stores: 278 Petco is strong in the Northeast and California iv PetSmart tends to have better locations than Petco v vi o PetSmart focuses more on services vii Petco focuses more on supplies In 2005: o 30% of Petco s sales was from dog and cat food o 67.5% of Petco s sales was from pet supplies and small animals o 53% of PetSmart s sales was from pet supplies and small animals From 1995 to 2005, Petco s gross margin increased steadily o 1995: 23.8% o 2005: 33.4% The improvement in gross margin was thanks to Petco's focus on selling more pet supplies viii Petco stores have limited vet services at a number of stores ix Routine vaccinations Petco stores don t have hotels Petco purchased Pooch hotels o Has 10 hotels o PetSmart has similar number of stores like Petco, but double sales and the number of employees Number of employees PetSmart: 53,000 employees o 26,000 full-time employees Petco: 23,000 Sales PetSmart: $6,917 million

19 Petco: $3,227 million - PetSmart well differentiates from supermarkets & Wal-Mart o Focuses on different customers x These customers give a special trip to buy pet products PetSmart is actually close to Target/Wal-Mart or other big box o Differentiation Food Little overlap xi o Less than 17% of sales overlap o Less than 10% of SKU overlap 75% of sales are channel-exclusive xii o But these products are available online xiii Services Knowledgeable staffs Customers can walk in with pets o 25% of customers walk with pets o Pet-centric atmosphere xiv Services o Grooming o Training o Kennels o Etc. - PetSmart is the price leader o Follows everyday low price strategy o PetSmart price is 5-7% above mass retailers xv 8-10% below specialty competitors and groceries xvi xvii o PetSmart is the original pricer Set price reference for others - The supply side is well organized o Top pet food companies by revenue in 2011 are Mars Petcare: $16,162 million Cesar, Whiskas, Pedigree, Nutro, Royal Canin Nestle Purina Petcare: $10,403 million Alpo, Dog Chow, Puppy Chow, Beneful, Purina One, Purina Pro Plan Hill s Pet Nutrition: $2,175 million

20 Hill Science brand P&G Petcare: $1,802 million Iams, Eukanuba Del Monte Foods: $1,784 million Kibles n Bits, Meow Mix, Canine Carry Outs, Nature s Recipe Mars Petcare acquired P&G Petcare in 2014 The biggest pet food companies are big consumer product companies These companies has strong distribution capability with the mass channel They have a lot of brands for the mass channels They also have premium brands in the specialty channels o Royal Canin o Nutro o Hill Science o Nature s recipe o Eukanuba o Purina Pro Plan Price is lowest among premium foods Purina One is available at Wal-Mart o Smaller manufacturers Blue Buffalo WellPet Wellness brand o New manufacturers don t have distribution capability with the mass channel => Sell through independent stores Sell through distributors Consolidation of distributors make it harder for new manufacturers today xviii o 3 companies control 40% of the pet distribution facilities in the U.S. Animal Supply Co. Philips Pet Food & Supplies Central Pet Distribution Position as ultra-premium food producers

21 o These companies are loyal to each channel If a ultra-premium brand moves from independent stores to mass stores, it will be dropped immediately by independent stores xix Foods are differentiated by channels People equate good/premium with o High price o Smaller package o Specialty outlet o Small manufacturer o More natural xx xxi o Changes happen only when a premium brand is acquired o But that would only benefit PetSmart Ultra-premium brand can go to PetSmart Premium brands wouldn t go from PetSmart to the mass Only Iams went to the mass o That happened when P&G acquired a pet food company o P&G has distribution strength with the mass P&G wanted to get exposure to the mass Result: xxii Get wide distribution Lower margin Assortments reduced Today, big consumer products companies already have exposure to both mass and specialty channels - PetSmart has strength in services o PetSmart gained share in service market 2006: 13.9% According to APPA o 2006 pet market was $38.5 billion o Services were 7% $2.695 billion PetSmart services sales was $374 million in 2006 => 13.9% According to another source, PetSmart s market share was 9% in 2006 xxiii

22 2013: 17% o PetSmart has advantage in advertising over local competitors o PetSmart has advantage in getting new pet owners to use services People go there to buy food and see there are grooming, hotel services o Grooming Labor intensive May not enjoy scale advantage But PetSmart can have high volume to keep groomers busy PetSmart provides a decent cut for half the price at local professional groomers xxiv o Hotel Competes with small competitors xxv Best Friends is an East Coast oriented chain o Freestanding hotels o hotels Most competitors are mom-and-pop o Has one or two hotels Enjoys great scale advantage ½ CapEx of freestanding hotel Share costs of xxvi o Heating and air conditioning system o Bathroom o Parking lot o Employee break area o Armor car pickups o Other overhead - Customer habit is attractive o Smart with Heart customers 13% of customers 51% of sales Average 17.8 transactions per year Average annual spend: $657 => Average spend per transaction: $37 o Smart customers 48% of customers

23 41% of sales Average 4.1 transactions per year Average annual spend: 150 => Average spend per transaction: $36.6 o Mart customers 39% of customers 8% of sales Average 1 transaction per year Average annual spend: $34 o Purchase frequency is not high enough for a budget item o Price is not high enough to shop around - PetSmart was able to gain share overtime o PetSmart gained share within specialty market According to IBIS World March 2014 PetSmart market share o 2008: 37% o 2013: 40.3% o Specialty market gained share from mass channel Mass market share xxvii 2011: 47% 2013: 46% Grocery market share 2011: 25% 2013: 23% Supermarket lost share overtime From mid-1980s to mid-1990s, supermarket market share reduced from 95% to 50% xxviii o 23% in 2013 Mass brands like Purina, Alpo, Friskies and Kalkan lost share overtime 1996: 75% of U.S. pet food sales 2000: 67% of U.S. pet food sales 2005: 62.1% of U.S. pet food sales o The best chance to gain share is to Cross-sell services to existing customers Get people to stores for services Then cross-sell foods

24 Get new pet parents Partner with PetSmart Charities o Assist in saving the life of homeless pets Provide in-store adoption program o Found homes for approximately 440,000 pets in 2013 o Found homes for over 5 million pets since 1994 Get 2X for market share when a pet is adopted at PetSmart xxix Vendors sponsor adoption events xxx o A vendor sponsor 20,000 pets Hope the pets stay with their foods => $100 million life time value New pet owners may go to PetSmart because o They want to buy premium food or use services Humanization of pets continues o The brand is strong Younger generations are more likely to shop at big boxes xxxi - If there s any threat to PetSmart, it s online competition (see Durability) i UNIDENTIFIED AUDIENCE MEMBER: Could you guys talk a little bit about when you're deciding where to put your new stores, can you talk about the dynamics of the market that you look at? I know that you're looking at some smaller store formats, and can you just talk about population, square footage, product assortment, that type of thing? DAVID LENHARDT, PETSMART CEO: Yes, sure. So, beginning last year our mix of stores was about 65% of our stores were a smaller concept or smaller box, roughly 12,000 to 13,000 feet, probably an extra 1,500 feet if it has a Banfield in it. And this year, 65% of our stores will be that format versus our more traditional 20K format. What that allows us to do is that allows us to, one, keep the customer proposition. So, it still has grooming, it still has all the same SKUs that we have in our more traditional box, and there are fewer facings, but it still looks and feels like a PetSmart store, very little difference. So, we can go to market as a PetSmart, and it allows us to go to markets where you really couldn't make a 20 work from a rent perspective. So, it's lower rents both on a rate perspective as well as lower rent in totality because of the sheer smaller square footage. I would tell you that

25 from a pro forma perspective, as we reviewed those, that the returns on those are there to four times what we were doing with our vintages in '07, '08 vintages, and maybe some in '09. The best way I can describe it is those stores are going into markets that are what I would characterize as tractor supply-like markets, so it's in smaller fringe of the suburbs, smaller populations. We do have them in some small towns, Grand Isle, Nebraska, Hot Springs, Arkansas, Beckley, West Virginia. So, those are pretty small markets and we're pretty excited about those just from a returns perspective. And now we're into our first fully year, we're looking at the ramps and they seem to be holding everything we thought they were going to do. Bank of America Merrill Lynch 2012 Conference ii Petco's stores tend to be smaller and more ubiquitous, almost replacing the neighborhood pet store. They're located in strip malls. PetSmart stores are bigger and tend to be in the larger "power centers," alongside other discount chains. According to a recent analysis from JPMorgan (JPM) retail analyst Nancy Hoch, PetSmart's prices were on average 8% higher than those of Wal-Mart Stores (WMT), but 11% below Petco's. The Battle to Be Top Dog, Christopher Palmeri, Business Week, 05 August 2007 iii Petco K iv This is a part of the country where I think PetSmart is more on the defensive. We have the better locations, but there are more PetCo stores. We have to fight harder for our piece of the dedicated pet store shopping trip. A PetSmart s regional manager in the Northeast, Blueshift Research v In the specialty channel, things get interesting. We have about as many stores in this metro area as PetCo; only, ours are better clustered around the city center, the big shopping districts. The PetCo locations are out anchoring various suburbs and are more of a hard destination shopping sort of weekend trip. A PetSmart s regional manager in the mid-atlantic, Blueshift Research vi Locally we have PetCo but as a junior competitor. We were here before them and had our pick of locations. Then we have Pet Supermarket tiptoeing around our southern border and Pet Valu hugging their mid-atlantic stronghold to the north. - A PetSmart s regional manager in the Southeast, Blueshift Research vii GROSS-OUT PETS. Petco has a different approach. The $2.2 billion company still does two-thirds of its business in dog and cat products, but Petco features a broader selection of goods for other animals, everything from

26 hamsters to tarantulas. The company recently featured a "Reptile Rendezvous" at 200 stores. The events included "in the terrarium" photo contests and demonstrations for products such as a new clay that reptile owners can mold into small hills and caves. Snakes, iguanas, and turtles remain very popular with teenage boys, says Petco's CEO James Myers: "Anything that grosses your parents out." Petco has not embraced the services strategy quite as aggressively as PetSmart. Its stores do prominently feature grooming services, and the company provides doggie day care at some locations. But Petco stores, at about 14,000 sq. ft., aren't as large as PetSmart and for now Myers is holding back on overnight pet-sitting. "I'm not sure that plays everywhere in America," he says. The Battle to Be Top Dog, Christopher Palmeri, Business Week, 05 August 2007 viii Gross profit as a percentage of net sales increased to 33.2% for fiscal 2003 from 31.2% in the prior year period. The increase was driven partly by the continuing change in mix from lower-margin premium pet food sales to higher-margin categories such as pet accessories, supplies and services, which accounted for an increase in gross profit of 0.9% of net sales. Petco K ix We offer obedience training in most of our stores, grooming in the majority of our stores and limited veterinary services, such as routine vaccinations, at a number of stores. Petco K x DAVE LENHARDT, CEO: I would say the overall environment continues to be pretty stable, I think. Let me start with mass and the grocers. Over the last five, six years, we have seen, from a market share perspective, continued share shift away from the mass and the grocers into the pet specialty channel,and I think that is continuing. I think that increasingly our overlap with the mass is decreasing. I think our customer overlap, it's a very different customer base. I think the mass guys may be competing against each other, but increasingly they are less relevant from that perspective to us. I think on the pet specialty perspective, as you mentioned, our largest direct competitor remains private. They are opening stores at a healthy pace, they are investing in marketing, and we think they are doing okay. This is an attractive sector, and again it has been pretty stable in the dynamics. PetSmart 2013 Q2 Earnings Call Transcript

27 xi But another really important reason is exclusive for us. So, the PetSmart shopper who buys a proprietary brand at very sticky behavior comes back to our store and is very loyal to us. In terms of our assortment again emphasizing the point around differentiation between our channel-exclusive offerings and our proprietary brands if you look at the chart on the left hand side, we do not, I want to emphasize, we do not overlap with more than 90% of our SKUs. So, 90% of our SKUs do not overlap with mass and if you move to the right hand side on the sales basis, 83% of our sales do not overlap with mass retailers, so our assortment not only very broad is very differentiated from mass retailers. Joe O Leary, Head of Merchandising, PetSmart 2011 Investor Day xii DAVID LENHARDT: It's the biggest portion of our food today and I'll talk about us, 75% of the food that we sell is channel exclusive to us. Within that category of food, organic and naturals is the biggest and it's the fastest growing. And we see a lot of runway ahead of us there both again in dog as we continue to bring in innovation and also in cat. We really start to focus on cat in a way that we did in dog a couple of years ago RBC Capital Market Conference xiii Unknown Attendee: On your food category, you guys talked about 75% of that being sort of exclusive to the pet specialty. Did I just hear you right that you've said that a lot of that is available online, of that 75% that's exclusive to pet specialty? David K. Lenhardt - President and Chief Operating Officer: I think if you look online, you will find in -- not all of our vendors are supplying the online players directly but through diverters and just other distributors. I think if you look online today, you'll see a fair amount of our assortment online absolutely Bank of America Merrill Lynch Conference xiv When I went to PetSmart I would say more than 25% of all shoppers had a dog on a leash with them. The grooming place was packed. There were 2 receptionists at the animal hospital. They were doing cat adoption. And they were selling pets like lizards, snakes, etc. Overall, I would say PetSmart was by far the most lively and interesting. It was absolutely full of animals. I was very impressed with the service parts of PetSmart. They make them very visible. I think customers who visit will keep in mind that they also have grooming and a vet. It adds a lot to the pet centric atmosphere of the place. A lot of both the dogs and employees are there for the services. Where I went the grooming is all done with dogs on raised tables and with the entire grooming section having glass around it instead of walls. So the animals are on display. Anyway, it was totally different than any pet supply store I've ever been to. The atmosphere in PetSmart was unique. But it was a

28 weekend and I didn't compare it to Petco. So that might be an overly optimistic assessment of PetSmart's uniqueness. Geoff s description of his visit to PetSmart xv Overall, on average, PetSmart is 8% to 10% less than the other pet specialty retailers as well as grocery and we are within 5% to 7% of max prices. Joe O Leary, head of merchandising, 2011 Investor Day xvi We, too, have heard some manufacturers talking about price increases on the food side of the business. We think we are the price leaders for some, and we're a price reference, at least, for several others. We are ones who do our own original pricing off our own original algorithms and what we understand about our own elasticities. That means in, I guess, more simple terms that we price product off what it costs. So when stuff costs more we do keep an eye on competitors and are vigilant in that regard, but the base case here is that we price product based upon its cost and what we understand about our own elasticities. When we had price increases, I guess it was about two years ago, and now, the behavior then was we priced our, we essentially pass through the prices and after a short amount of time, the rest of the world, broadly speaking, passed through as well, and competitive positions in that time were pretty much maintained at slightly higher price points. I can't speculate what this time will happen, but we'll price our product off the cost you pay for it then be vigilant as we look at the competitive environment. Phil Francis, former CEO, 2005 Q3 Earnings Call Transcript xvii What Tim said, yes. And remember, we're what I would call original pricers. We don't go after name 'em minus some or somebody else plus some, we're one who has our own price elasticity by subcategory, by competitor. The goal is to optimize cash gross margin in the subcategory, and it just turns out that when people do studies we're about 3 to 5 less expensive, or 10 to to 5 more expensive than some and 10 to 17 less expensive than others. But as we do our price optimization studies, if that told us the customer had moved and we should move, those numbers would change. But we get there out of our own numbers, not because we look at somebody else and use a calculator to do either a fraction or a 1 point something or other calculation. We do original pricing. I'm not sure there's many of us left. Phil Francis, former CEO, 2005 Q4 Earnings Call Transcript

29 xviii Still, some retailers and manufacturers remain concerned about how they will fit in an expanding distributor s business model. Drasner says that SKU rationalization among larger distributors can hurt not only small pet stores, but also small manufacturers. If you can t do multi-million-dollar business with these guys, they don t want to allocate the space or sales resources to your products. In some cases, million-dollar lines are being delisted, he says, conceding that the problem in those cases is often slower-moving SKUs within the line. Who would have ever thought that if you are doing a million dollars worth of business with [a distributor], they just wouldn t have the room for you? A Narrowing Pipeline, Mark Kalaygian, Pet Business Magazine, August 2013 xix I view independents as a stepping-off point to launch you into PetCo and PetSmart eventually, if that is where you want to go, and then you need to support that with a huge marketing budget to grow even a new following, because you are going to lose a good percentage of your sales from the independents once you go into the big-box stores. Products like ours, you will never see in grocery stores. If you put your product in a grocery stores, independents will drop you like flies. From a managing partner at a premium pet food manufacturer, Blueshift Research xx Manufacturers always are likely to sell through mass channels. Manufacturers start small, produce quality, and build a following with brand recognition and then they sell out. And the people that buy them out, like Procter & Gamble and Mars, reduce quality. from owner of a holistic-focused pet food manufacturing company, Blueshift Research xxi We do not sell our high-end premium products at PetSmart. We do sell our products indirectly to PetSmart on a third-party contract basis. But that is not the core of our business. When it comes to Pet Smart and PetCo, we try to stay out of the way of the Purinas and Proctor & Gambles. And we do just fine without them, selling a couple of hundred million dollars a year through the pet specialty channel. I m talking about the independent, boutiques and small chains with 10 or so stores. Very few of the true premium-brand pet food manufacturers attempt to sell in the mass-market channel. If a premium brand becomes popular within the specialty/boutique pet store segment, it does not then necessarily transition into PetSmart. What typically happens is that one of the larger consumer product manufacturers acquires the premium pet food brand and takes them into the chains. From a Vice president of a premium pet food manufacturer, Blueshift Research

30 xxii Peter J. Keith - Piper Jaffray Companies, Research Division: Okay, fair enough. And then the follow-on question to that is just with the proliferation of some of these channel-exclusive brands, what is the risk that some of these more popular brands might actually look to go more to the mass or grocery channel just as they're looking to grow their business as any company would, if you're just talking about maybe a Nutro or a Wellness. Does that come up in your discussions with these companies as a potential risk? David K. Lenhardt - Chief Executive Officer: Yes. Yes, it does come up quite a bit. We talk about it all the time and we have very strong, terrific relationships with the channel-exclusive vendors. We spend a lot of time working with them, making sure they understand our strategy, what we need to accomplish. We spend a lot of time understanding what they need to accomplish, what type of pressure they may be and to do these type of things. And I can confidently tell you at this point that every channel-exclusive vendor we work with today is very committed to PetSmart and pet specialty and continue to grow because they see that there's still a nice run rate of growth there. And I would tell you that the innovational pipeline and the new products that they are working on to come in to help us and the channel, I'm very confident that in the -- for the foreseeable future, I don't think it's a big risk. And I would just add to that, we're very focused on partnering with our customers to grow both of our businesses. And we've been very successful at that in the past. The other thing I would mention is there's been a -- there's only been one brand ever that has gone channel exclusive to mass, which was IAMS and Procter & Gamble. And the other vendors have looked and watched and seen the results of that. And when you go mass, you get certain things. You get wide distribution, you generally see margin compression, you also see your assortment dramatically reduce. So I think there's a lesson out there that's instructed to the vendors we work with. And again, and our focus is on continuing to grow with them and grow both of our businesses. We've been successful at that and, again, I share Matt's confidence that we continue to build a really good innovation pipeline with them. PetSmart 2013 Investor Day xxiii PetSmart, with 12% of the pet food and supplies segment, is battling its traditional rival, No. 2 Petco Animal Supplies (PETC), plus general big-box retailers like Wal-Mart Stores (WMT) and Target (TGT). Hoping to stay ahead of the pack, PetSmart aims to boost its 9% share of the highly lucrative pet-services segment, which includes grooming and veterinarians, by adding animal hotels -- aimed primarily at dogs -- to many of its 850 stores. It also plans to increase its roster of stores by 100 annually over the