The One Small Cap I’m Buying Today
Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
If you’ve followed me in building the “No Drip, No Mess” Portfolio you’ll know that I just can’t seem to get over writing puts on dividend paying stocks. This time however, instead of writing puts to get a boring slow grower, I’m writing puts on a much more volatile small cap. PetMed Express (NASDAQ: PETS) is a nationwide pet pharmacy that markets both prescription and non-prescription products direct to the consumer through their namesake 1-800-PET-MEDS toll free number and website. While slowing sales and the rising cost of sales have hurt earnings the past two years, they are generating ample cash flow to pay shareholders a very friendly 5% dividend.
Why PetMed Express?
Management doesn’t sugarcoat their recent struggles as they welcome shareholders to their investor relations page with the following, “Fiscal 2011 was a challenging year, which can be attributed to increased customer acquisition costs, decreased new order sales due to increased competition, and a softer demand for some of the product categories we offer.” To address their struggles management has implemented an aggressive pricing strategy combined with an increased marketing spend. It’s their pricing that is key to the success of the company as consumers need to be able to save money compared to their vet’s prices.
If you are taking fluffy or fido to your local VCA Antech (NASDAQ: WOOF) vet whom you have a trusted relationship with, it’s a no brainer for you to then buy your pet’s medication from that vet if pricing was comparable. Why not give the business to someone you know and trust instead of ordering over the phone or the internet. This is why their aggressive pricing and marketing will be the key to driving future revenue and growth. They need to prove to their value to the consumer in order to grow their marketshare.
Despite their recent struggles, the fundamentals of their industry are exceptional giving PetMed Express plenty of room to run. The $11+ billion dollar pet supply and medicine industry is growing by about 5% per year. At just under a quarter billion dollars in sales and a debt free balance sheet with $50 million in cash the company certainly has the flexibility and the runway to grow. The pet medications market alone is estimated at $3.8 billion with vets claiming 67% of the market and retailers another 22% so if PetMed Express can differentiate more on price, then they have room to run as they grow their current 6% of the market. In the meantime the dividend is excellent and very bankable. We plan on picking up shares to enjoy that dividend as we wait for management’s strategy to play out.
Why Write Puts?
Usually when I write puts it is a strategy to acquire shares of a company a bit cheaper. In the case of PetMed Express we’re writing slightly in the money puts in an effort to bank some nice option premium on a fairly volatile small cap stock. For the portfolio we’ll be writing two September $12.50 puts for around $175 dollars total. This will give us a 2.5% allocation to the company and given its market cap I’m unlikely to allocate any more of the portfolio to the company. The fundamentals of the pet industry when combined with management’s shareholder friendly dividend policy are just too good to pass up.
Risks and why sell?
If the increased ad spend doesn’t produce corresponding sales increases then it might be time to put this one in the dog house. They’ll need to really concentrate on internet ad spend to drive traffic to their website, with more consumers turning to the internet for their purchases, PetMed Express needs to win in that channel to be successful. What would be most concerning is if a competitor such as VCA Antech’s VetStreet.com can really gain traction and begin to steal their customers. If that began to happen then investors should head for the exit.
A second and equally concerning risk is if one of the retailing behemoths decides to really make a push into their market. Either Wal-Mart (NYSE: WMT) going directly to the consumer or Amazon (NASDAQ: AMZN) via the World Wide Web could decide to make a major push into this profitable niche. Wal-Mart already sells pet supplies and is known for their ability to beat on price. They’re also not one to shy away from competing with pharmacies or over the internet. However, of the two, I’d be more concerned by Amazon because if they decide they wanted to get their paws on PetMed Express’s customers, they could easily outspend them online. Threats from competition on all fronts are but one of the many reasons that small caps can be so volatile.
Conversely and while we never bank on a buyout, PetMed Express would fit in as a nice brand extension at PetSmart (NASDAQ: PETM). With over $350 million in the bank they could pick up the company and still have a hundred million dollars left over. If traders started bidding up shares on a rumored buyout we’d be happy to hand over our shares. What we’re looking for is a nice steady grower paying a healthy and growing dividend to reinvest elsewhere.
The Bottom Line
While the threats are very real, PetMed Express does have a very good niche business that generates a lot of cash. Management has taken a very shareholder friendly approach to their uses of that cash, buying back shares and paying a generous dividend. While this company certainly has plenty of room to grow, we’ll be content to enjoy the dividend. Over time the dividend and the upside from management’s repositioning plan should lead to some very nice returns.
latimerburned has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com. Motley Fool newsletter services recommend Amazon.com, PetSmart, and VCA Antech. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.