Streetwise for Sunday June 28, 2009

Streetwise

Lauren Rudd

Sunday, June 28, 2009

Believe in Intrinsic Value

Wall Street can be a frustrating place, especially when the intrinsic value of a company’s shares goes unnoticed. Unfortunately, there will be times, actually many times, when regardless of how well a company has performed in the past and how upbeat its future looks going forward, it is still ignored.

So what do you do in such an instance? Relax, because the only cure is time. If a company is a true performer, and if the earnings are there quarter after quarter and year after year, then it is only a matter of time until the shares come into their own. The good news is that the reward is often well worth the wait.

An excellent example of a company with a reasonable intrinsic value that is destined to do well, despite the current economic environment and some negative comments from a couple of analysts, is PetSmart. As a matter of complete disclosure, this company is a particular favorite of mine for reasons other than just investment returns, given an indubitable collection of three dogs, two cats and a horse.

For its first quarter ended May 3, PetSmart reported earnings of $0.37 per share, up 15.6 percent from the same period a year ago. Net income for the quarter was $46.3 million, as compared to $41.2 million a year ago.

At the same time net sales increased 9.5 percent to $1.33 billion, while comparable store sales grew 3.9 percent. Comparable transactions, which are used as a proxy for traffic, were up 0.1 percent. Pet services sales were $142.8 million, up 10.3 percent from a year ago.

In its guidance going forward, the company said that it expects second quarter comparable store sales in the low-single digits and earnings of between $0.26 and $0.30 per share. For fiscal 2009, the company raised its earnings guidance to between $1.42 and $1.52 per share. It also maintained its guidance for comparable store sales of low-single digits.

Capital expenditures for the fiscal year are expected in the range of $115 million to $125 million, resulting in 40 to 42 new stores and about 20 new pet hotels.

PetSmart increased its cash position to $210 million and had zero borrowings on its credit facility at the end of the quarter. During the first quarter, the company repurchased $25 million of own shares and distributed $3.8 million in dividend payments.

The company also recently announced a 233 percent quarterly dividend increase, raising the dividend from $0.03 to $0.10 per share beginning in the second quarter, resulting in an indicated annual rate of $0.40 per share. In addition, the Board authorized a new share repurchase program of $350 million over 2.5 years, expiring January 2012.

One reason for PetSmart’s substantial dividend increase was a slowdown in square-footage growth, enabling PetSmart to minimize cannibalization and give some breathing room to existing assets. It also reduces operating costs and lets management spend more time improving the quality of the business.

The bottom line is that PetSmart continues to perform well, despite the recession, and is generating significant free cash flow. Furthermore, the stability and predictability of the company’s cash flow demonstrates its continued business strength. It is also a testament to the importance of pets to their owners, with many pet owners cutting back on personal expenses to ensure their pets are well cared for.

Meanwhile, PetSmart shares appear undervalued. The intrinsic value, using a discounted earnings approach with an earnings growth rate of 12 percent and a 15 percent discount rate, is $29 per share. The more conservative free cash flow to the firm model produces an intrinsic value of $26 per share.