So what’s going to happen now that gas prices are hovering around $3 and threatening to go higher? Will it be bad news again for the two big-box retailers—and, by extension, for the rest of pet retailing? Probably not, say several stock analysts, but much depends on how far over $3 gas prices rise.

“The high gas prices last year pinched discretionary income, and consumers kept their cars parked at home,” said John Owens, who follows PetSmart and Petco for Morningstar Inc. (Chicago). “Anyone who thought pet supplies were recession-proof had their argument weakened considerably.”

Why does this matter to the thousands of other retailers in the country? Because, said analyst David Cumberland, who follows pet retailing for Robert Baird & Co. (Milwaukee), his company’s research shows there is a relationship between the big-box pet retailers and the rest of the industry. “What’s bad news for the chains is also bad news for the smaller retailers,” he said.

So what’s going to happen now, given that earnings for both PetSmart and Petco fell by half between the first and second quarters of 2005, and didn’t really recover until the first quarter of 2006? And given that same-store sales in 2005 fell for both chains—especially for Petco, which also is forecasting flat same-store sales for the first quarter of 2006? And given that PetSmart’s stock price remained 18 percent off its 52-week high and Petco’s stayed 36 percent lower (through the middle of April)?

“We think the stocks are still undervalued,” said Cumberland, who sees PetSmart as a better bet than Petco, based on the former’s improved sales, better margins, growth in service revenue and new store openings. His estimate: PetSmart’s stock is probably worth $33 a share ($27.50 in mid-April), and he sees sales growing 12 percent to 14 percent over the next three years, with earnings per share up 17 percent to 19 percent. His numbers for Petco: a stock price of $24 ($23 in mid-April), with sales up 10 percent to 12 percent and earnings per share up 16 percent to 18 percent over the next several years. Petco’s sales, said Cumberland, have been hampered by too many older stores, higher costs for distribution and a less profitable inventory mix that’s too heavy on supplies.

Owens is more bullish on Petco (a $31 stock target), and said the company seems to have many of the aforementioned problems under control. In fact, neither analyst is surprised that both chains are in the middle of stock buyback programs, given that each company sees that its stock is apparently so undervalued. Cumberland said not to read too much into the stock buyback, since half of the companies he covers are doing the same thing. Still, he expects Petco to add one penny a share for each $12 million to $15 million of stock the company buys (it has allotted $100 million for the purpose).

Which brings the discussion back to $3-per-gallon gas.

“What you saw last year were basic trends—gas prices, the war in Iraq—that impacted all retailers,” said Tawni Doyle, PetSmart’s manager, investor relations. “Consumers were leaving the car in the garage. But we’re back to normal trends now.” In fact, she emphasized that the company sees itself as a growth stock that Wall Street will appreciate.

The analysts share that assessment. Owens said he sees last year’s hurricane-related price spikes as just that, and gas prices will stabilize over the long term. He also noted each company’s stock price has increased by almost one-third since bottoming out last fall. But if prices do spike again, he said, “It can negatively impact customer’s confidence. … So we’d become more concerned if we felt that a run-up in gas prices would stick for the long-term.”

Over the long term, Owens said the chains’ biggest threat may not be from the cost of gas, but from its competition—Wal-Mart and Target on the one end, and independent specialty retailers on the other. He hasn’t seen any numbers that show either has happened yet, though he is very impressed with Target’s efforts to come up with what he called “cheap chic” and its emphasis on private labels. And, ironically, any pressure from specialty retailers may well be because the independents improved their efforts in response to PetSmart and Petco.

“There are a lot of excellent specialty retailers out there,” said Owens. “And they’re going to appeal to certain segments that Petco and PetSmart don’t.”

Assuming the price of gas doesn’t get in the way. [June 2006 PET AGE]