Stock Pitch: Is Pets at Home poised for a Tesco-style turnaround?

Photo by Alvan Nee on Unsplash

Welcome back to our Stock Pitch series. This week I’m doubling down on my value instincts and looking at a highly-ranked but unloved FTSE 250 stock – a business I see as the pet equivalent of Tesco.

Read on to find out why Pets at Home (LON:PETS) has caught my interest recently as a potential contrarian buy.

Disclosure: at the time of publication, Roland has no position in PETS.

• Share price at the time of publication: 193p

• Market cap: £860m

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The Pitch

Pets at Home was founded in Chester in 1991 and floated on the London market in 2014.

It’s the UK’s largest pet care retailer and one of the largest veterinary groups, with estimated market shares of approximately 25% and 10%, respectively.

The pandemic pet boom fuelled record profits in 2022, but the company has struggled a little since then as demand has normalised post-Covid. Fewer people having new pets means less spending on new accessories and fewer vet checks for young animals.

Pets has also suffered from cost pressure and admits that some of its ranges – notably in nutrition and accessories – have “lacked innovation” and failed to meet customer needs.

After a valuation overshoot in 2021, the company’s shares have now truly shed their pandemic froth. Pets’ share price has fallen by more than 60% from the all-time high of 505p seen in September 2021 – but its StockRank has been rising recently:

Pets at Home remains a market-leading and profitable business, with a credible turnaround plan and experienced new management. Profits are expected to return to growth this year, too.

On a forward P/E of 12, I think the shares are starting to look undervalued. In my view, this could be an attractive turnaround situation.

The StockRanks agree, with Contrarian styling and high quality and value scores:

The Big Picture

In my view, there are several factors that make this situation attractive right now:

• Sticky business model: the company’s platform business model includes retail, online, product subscriptions, vet care and – shortly – pet insurance. Pets’ loyalty club had 7.6m active members at the last count. This offers rich opportunities to build sticky customer relationships and makes it one of the UK’s largest loyalty schemes, behind giants like Clubcard (24m) and Nectar (18m).

• Retail turnaround strategy: updates to modernise key product ranges are underway, along with changes to improve execution and cost control. Profits are expected to return to growth in the current year. Retail is detail: I estimate that a 1% increase in gross margin could add c.10% to operating profit.

• Tempting valuation: Pets’ trailing 12-month operating profit of £121m gives an EBIT/EV yield (earnings yield) of 10% – comfortably above the 8% level I use as a rule-of-thumb for value. I think the business could be cheap on a steady-state basis, even without a return to growth.

• A turning point for momentum? Pets’ five-year share price decline reminds me of the long-term momentum reversal Ed discussed in October. In “The Hump and the Bowl”, he highlighted how the biggest returns can sometimes come from stocks that have suffered a three-to-five year decline. I think Pets at Home fits this pattern.

Going Deeper

I can see several other reasons to suggest that a turnaround catalyst could be close at hand:

• Experienced new management: new CEO James Bailey was MD at Waitrose from 2020-2025 and was responsible for relaunching Waitrose’s web offering after it moved off the Ocado platform. He should have the skills needed to fix problems and restore growth.

• Vet growth: vet revenue has risen by 15% CAGR since FY20, with pre-tax profit rising by 20% CAGR. This side of the business now generates more than half the group’s profits and is continuing to expand.

• JV vet structure adds alignment: the group’s vet services are run as joint ventures with local management, rather than as wholly-owned branches. My feeling is that this could result in a better alignment of interests between vet staff and the parent company.

• CMA vet sector investigation: recent years have seen the investment prospects for big vet groups overshadowed by a long-running UK competition investigation. This is now over. The CMA’s final report was published in March. Pets at Home says “we continue to expect no adverse impact”.

• Shareholder register: Pets has attracted some interesting active investors to its shareholder register, including legendary US value manager Tweedy Browne, a firm with historic connections to Benjamin Graham and Warren Buffett. Another interesting name is Spanish family office Norbel Inversiones – this vehicle represents the interests of the billionaire López-Belmonte family, who are the controlling shareholders in Spanish pharmaceutical group Laboratorios Farmaceuticos Rovi SA (MCE:ROVI).

What The Brokers Say

Earnings forecasts have trended lower for most of the last 18 months, but now appear to be stabilising:

Brokers are taking a relatively cautious view with a target price of 222p – just 14% above the current level:

However, as I’ve commented before broker estimates are often reactive, simply extrapolating recent conditions. Checking the archives tells me that brokers had a price target of 523p in September 2021 – just 5% above the share price at that time.

I’d be inclined to see the low target price as a potential catalyst for a re-rating. If analysts start to lift their target prices, Pets at Home shares could follow.

The Bear Case

The problem with turnaround investments is that many of them never turn. There are certainly some potential headwinds that could leave Pets at Home trading at a depressed valuation for the foreseeable future.

• Shrinking market: “the UK pet market remains subdued”, according to management. This situation could continue. After all, the combination of post-Covid normalisation and ongoing cost-of-living pressures could mean any uptick in pet ownership and spending remains a long way in the future.

• Kitchen sink risk? Last September’s profit warning and CEO departure is still less than a year old. We haven’t yet heard from the new CEO, who only started on 30 March. There could be another ‘kitchen sink’ profit warning to come if the new boss doesn’t feel confident about current guidance.

• Brand/competition risk: Pets is working to update key product ranges, but there’s no guarantee it will be able to win back customers who’ve already moved away. Without sufficiently differentiated products, Pets at Home could find an increasing part of its retail business commoditised and in competition with online giants such as Amazon, making it difficult to rebuild margins.

The Bottom Line

Pets at Home is a market-leading omnichannel pet retail and vet group. Over the last few years, the company has suffered from a combination of stale product ranging and post-Covid normalisation in demand. However, these are fixable issues that the company’s new CEO should be well-equipped to address.

While profits have come under pressure, the share price has fallen much further. That’s left Pets at Home on a modest forward P/E of 12 with a potential 4% yield, based on recent guidance.

Risks remain – and we haven’t yet heard from new boss James Bailey. It could be worth waiting for his initial statement.

However, I think the shares offer attractive value at current levels and feel this business is well positioned for a possible Tesco-style turnaround.