Chit Chat Stocks - Petco (WOOF) with Paul Cerro

Episode Date: July 28, 2022

Petco focuses on enhancing the lives of pets, pet parents, and its Petco partners. The company offers everything your pet may need from food to services. Petco was founded in 1965 in San Diego, California. Listen as Brett and Ryan ask Paul questions about the company, its business model, and valuation. Enjoy the show! ***************************** This episode is sponsored by Quartr, the new way of doing company research. Access conference calls, presentations, transcripts, and more for FREE on your mobile device. Download Quartr on the App Store here: https://apps.apple.com/us/app/quartr-investor-relations/id1552412128 Download Quartr on the Google Play Store here: https://play.google.com/store/apps/details?id=se.quartr.android ****************************** Access our “Not So Deep Dive” episodes by signing up for CCM+. Sign-up directly through Spotify or Apple Podcasts. If you listen on another podcast player, use this link and create a private RSS feed: https://anchor.fm/chitchatmoney/subscribe Need more information? Check-out our launch newsletter: Here ****************************** Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Interested to see more of Paul's work? Find his Substack here: https://cedargrovecapital.substack.com/ Contact us: [e-mail] Timestamps Petco | (2:55) Growth | (15:54) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's episode is brought to you by our friends at Quarter. Quarter is an all-in-one investor relations app that provides frictionless access to conference calls, investor presentations, transcripts, and more. With Quarter, investors can keep up to date with all their companies while on the move. I personally use it every earning season so that I can keep up with my portfolio companies while I'm on my commute to the office. They also just released a cool new feature that allows users to search across all transcripts. That means you can search and see how many companies mention terms like inflation or

cost pressure or recession or even metaverse, you name it. And the best part of all, the app's 100% free and it's on both iOS and Android. So go find it on your app store by searching quarter. That's Q-U-A-R-T-R, no E. That's quarter, Q-U-A-R-T-R. Welcome to Chit Chat Money. This is our Thursday deep dive interview where we interview an analyst on a single stock in typically 45 minutes to an hour. And today we're talking with Paul Cero, who is the portfolio manager at Cedar Grove Capital. And we're talking about Petco and really the pet industry at large. His thesis is essentially long Petco, short Chewy. And he gets into the why that is. If you want to read his write-up or anything he's written on the matter,

because he's written it up a few times, you can go to his sub stack. We're going to link it in the description. But did you have any highlights from the interview? Yeah, the two highlights for me were talking about Chewy's margins or lack thereof and how their cost structure is going to make it difficult for them to really generate sustainable profits. Or if they do, it's going to be extremely low. And second, Petco's strategy of going omni-channel with the in-store plus online to give them an advantage over the pure plays like Chewy or even Amazon. All right. Without further ado, let's get to the interview. Welcome to Chit Chat Money. On this show, host Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of

investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or recommendation. Now, please enjoy this episode. Welcome in. Today, we are joined by Paul Serro, now two-time guest. First time we had you on, we talked exponential fitness. So if you want to hear more of Paul after this interview, go ahead and go check that one out. But Paul is a investor slash portfolio manager at Cedar Grove Capital. Today, we are talking about the world of pets. So the pet industry at large,

but more specifically Petco as well as Chewy. So why don't we kind of start there? Do you want to talk about the pet industry overall? Who are some of the major players? And then how has the industry changed over the years? Yeah, of course. So when it comes to pets, there's a few chains that people really know about, right? We probably grew up with either the pet smarts of the world the petcos of the world um like uh pet supplies plus which is a franchise um central garden petco there's a bunch of bigger names that operate in it but at the same time depending on where you are especially in urban environments it can be highly fragmented meaning like there's a lot of independent owners that have a pet store who whether it's just like

food etc or they actually have training services grooming services uh maybe all three um then there's the the veterinary care right to care for your for your animal um it really i mean it's an over 100 billion dollar industry and that's inclusive that's that's of like everything in the united states so um there are oh there was an up-and-coming company which people know about as chewy uh that basically decided hey why don't we just be the pet retailer of the online world and they i want to say rewrote the book on uh the pet industry for how they get to the consumer but they pretty they pretty much started it on a on a much bigger scale than the dot-com create uh dot-com era this because i guess timing benefited them more um but those are the biggest

players i mean i personally am a um fan of pet petco just because that's just where where i'm at even though i grew up with pet smart um but it's really evolved from being just like your traditional very boring retailer that just sells the food the basic toys accessories whatever to now a full-fledged like business of treating uh your pet which many at this point in time consider um their child like i consider my dog my child a lot of people other consider their dog as a child. And the spend on them has just only been going up. And I don't mean in the sense of because they're getting more sick, I would not. It's like people are even spending more on their pet, more premium this, more premium that, myself included. And these retailers have really

been capitalizing on it and taking advantage. Yeah. And it's been a multi-decade. This isn't just recently, right? It's maybe even been like a 50-year kind of secular tailwind, if I'm not wrong. Yeah. I mean, it's really funny because Petco actually has been around for a really long time. They were actually first founded like in the sixties under a different name, but they actually became Petco. And I think the early 1980s or the late 1970s, I can't remember exactly which one, but they rebranded as Petco. And then from there, they started off as, you know, like a few dozen stores. Then they kept growing by acquisitions, kept growing, kept growing and growing. they've been uh taken over twice in their lifetime so they've had been they had take privates um

um before 2000 and after 2000 and they recently went public again in 2021 and um uh have really shown for themselves like just how big of a business the pet industry really is and can be and that's why i mean without getting into details i know we'll go further that's kind of why i love it um it's just their track record all right yeah let's move into oh ryan you have to follow yeah you so you mentioned your pet owner i believe i've seen uh the the pup walking around last time uh do you use petco have you tried chewy what uh what do you use yeah i've actually tried all three um when i first got her i see i didn't i haven't had a dog in uh over a decade yeah over a decade and you know i get bombarded by chewy ads like on instagram etc you know i

given i live in new york live in new york city you know you see chewy boxes like in your lobby because people have dog owners and it's like oh chewy done you know like that's that's like their marketing's working right so i actually started off with you i got all my stuff from chewy i got my food from chewy my both wet and dry i got my toys beds cages my you know like medicine from chewy and then it was only after um the apartment that i eventually moved into uh was next to a petco that i'm like oh wait if i need if i need something quick i can just walk a few blocks go to petco and pick it up and then from there i really started to see live just how good petco was in comparison to chewy and i'm like why am i still with chewy and that's that's

I strictly moved my dog to Petco. I still do. And I looked at the company more when they were going public. When they filed their S1 in 2020, they went public in Jan of 2021. And after initial pullback, I was like, oh, I'm in. It's good. All right. That leads right into it then. People, I think, understand vaguely what Petco's business model is, but any more important history, things that investors should know about and just what are the basics of its business model yeah so um i gotta stop saying i remember i re i re-listened to my last podcast with you guys and i always say this so yeah thing all the time so damn it said it again sorry so when it comes to their history they actually were a part of the internet craze

of pet food like in 2001 they actually launched petco.com this was in comparison to all the other companies that wanted to you know take anything and everything online like pets.com was you know the other one with the super bowl commercial they like spent millions of dollars but only generated like a few hundred thousand dollars in revenue it was hilarious um so petco was a part of that they were online retailer they tried to be at least but with you know the 2001 unfortunate uh 9-11 incident and then like the dot-com crash happening they suffered pretty bad compared to everybody else right now because everybody else is cratered um and i think that really left a bad taste in management's mouth that you know what maybe online is not the thing to do so they

actually um while they saw a presence they they really did not put pedals in the metal there they're like you know what it can exist but we're going to be focusing on our in-store footprints we're going to be uh making sure we can optimize our stores through the current offerings that they had, which might not be garnered highly from Wall Street. But hey, if you're producing a bunch of cash flow, but you're not getting the recognition for it, take it private. That's exactly what happened. I think it was in 2002 or 2003. It was taken private by TPG. And they just sat on it. They were just milking it for all the equity that they can get. And it was only recently, in the last few years that, you know, alongside Chewy being the online retailer, that they kind

of woke up and were like, you know what, we kind of need to really beef up our online presence if we're expecting to survive and compete. So over the last four or five years, they've really started to expand their online presence to compete. PetSparts are doing the same thing. It's not an isolated incidents incident and what's amazing um and i'll pause in a bit to give you guys a chance here but um they've completely changed the way um a traditional specialty retailer has handled its real estate because before there was the whole notion of you know in-store retail is dead everything's going to be online if you own stores you know you're a loser you're going to go under. You're going to be suffering the consequences. But what many people didn't realize

is that these stores didn't need to be considered liabilities. They could actually be very valuable assets if used properly. Because what ended up happening, and this is with everybody, when you're a retailer and you move to online, what most of them ended up doing in the beginning was they created these fulfillment centers to service the online business. There was the retail storefront where you, me, your mom, your family, whatever, would walk into and buy from. But then there were these separate warehouses, like how Amazon was doing it or is doing it, where that only fed the online business. That was what I thought was a liability because you're kind of having two businesses when you can really just have one. And what eventually ended up happening, which they have been doing and executing phenomenally on, is instead of opting in for just fulfillment centers.

to their, for the online push, they're actually just using their stores to fulfill it. So it's like, why would you have to buy double inventory? Why would you have to buy double this, double that when your stores, you know, those quote unquote liabilities are now assets because they themselves are fulfillment centers. And not only do you get to save money on the cost of like, the real estate, the operating leases, et cetera, but now you cut down almost across the board everywhere, right? You cut down on the labor, you cut down on the time to deliver, you cut down on the um the cost to deliver right because if you're if you're setting something from state to state but now you're sending it from you know like town to town much cheaper you know it's that's where

they really decided like hey our stores are not liabilities or assets and we're going to build a model around that which they have all right uh do you want to go to the next one ryan well it sounds like can you talk about some of the different omni-channel strategies that they have because i know that they uh obviously they have like e-commerce and in-store but they've been doing some interesting stuff uh otherwise as well right yeah because if you're a pet owner the the number one number one thing but one of the biggest things that you want to do is be able to get the best uh items for your for your pet uh and hopefully you can get the best items for your pet in one place right you don't want to have to go to this store to get this to that store to get that

blah, blah, blah, blah, blah, blah. You don't want to do that. Right. So what PetSmart and Petco have been doing, and this is something that Chewy can't do, like literally they can't do it because they're not an in-store retailer. They're only an online store retailer. Is if I can walk into a Petco or a PetSmart, I can get literally everything done for my pet in one go. I can get my food from there. I can get my toys from there. I can get my training from there. I can get my grooming from there. I can get my veterinary care from them. And depending on where you go, you can get rewards for doing so. They offer incentives for being able to go into the store rather than getting shipped, which is something that I highlighted in our research twice already.

Petco has this phenomenal plan called buy online, pick up in store. And they run it very often. It's not like a rare thing where I can literally go on to Petco, buy whatever I need for my pup, and I can actually save, I can get like 10% or 15% off if I just physically just go to the store and pick it up. And it's so simple, right? And it's instant savings because I don't mind going to the store. I only live a few blocks away. You know, if someone has a car and I'm only a five-minute drive to save 15%, you know,

especially in an economy like this, absolutely. Like, no problem. So they incentivize people to go into the store, which anybody who covers retail-related stocks or companies, when you can get someone in the store, more often than not, they actually end up spending more. And I can attest to this myself. They've convinced me to go into the store to save 10% to 15%. And while I'm there, oh, you know what? I forgot to buy something. I'll buy another tennis ball for my dog, or I'll buy a little bone because I see it's like attractively there you know so now my now my average basket size has been going up and

up and up because of how they got me in there they save i mean they granted they're getting a 15 haircut on the msrp but the thing is they're saving on shipping they're saving on the cost of the labor to then do fulfillment they're saving on a bunch of stuff and then to further compete with chewy because again you can't do that right it's online only um they have been um doing same day delivery they partnered with door dash so now even if i don't want to go pick it up i can get it in a few hours because of door dash so we can't do that should we choose time frames anywhere from like one to two business days at best but i can get the same day from pet smart and get the same day from petco and when you keep like stacking up all these points um between like being able to

order online picking up the store or just straight up ordering online getting it delivered when whatever they've been able to leverage so many different channels on how to attract any kind of pet owner with any kind of circumstances that they might have. And it's been paying off. If you're listening to this ad right now, we know you're already a listener to our show. But for our avid listeners, we've also started a paid membership service called Chitchat Money Plus that extends beyond just our podcast. Every Tuesday, subscribers get access to one not-so-deep-dive research episode that covers

everything you need to know about a company. You also get an email newsletter with our written show notes, important charts, a transcript of each show, and access to our Chit Chat Money research files. Chit Chat Money Plus costs $5 a month. You can subscribe directly through Spotify or Apple Podcasts, or if you listen on another platform, click the link in the show notes to go through the simple steps of signing up. If you're a regular listener to the show, we think the membership will provide tons of additional value. On top of the stock research episodes, members will get one Arch Capital Fund episode a month where we outline why we bought, sold,

or continue to hold a stock in the Arch Capital Investment Fund, along with shows on our broader investment strategy. Sign up and become a Chit Chat Money Plus subscriber today. We can't wait for you to join our community. You mentioned some of the services they have beyond traditional pet retail, you know, just selling food and toys. Which of these do you see driving the most growth going forward? And maybe on top of that, who are they competing with in these things like grooming and uh what was it uh maybe i don't know if they're doing insurance but all that other stuff veterinary yeah they actually are i mean insurance so insurance is a big business uh because you know dogs and animals get sick all the time right um you can collect some pretty hefty premiums on that

because you know you're you're paying for god forbid anything happens right more often than not things really don't happen but when they do it's very costly um i speak to that but if you're talking about like the biggest area of growth most of the pet industry is staple related goods right so it's the food it's the wet food it's the dry food like yes you can pay up for the quality of it you know you can get some premium fresh dog food from you know just food for dogs or um what's the what's the other company farmer's dog which is you know super super fresh food um but if you talk about like growth i was i was highlighting that i think the veterinary business is the biggest um growth factor of the company uh if you're already generating you know uh billions

of dollars in sales based off of your stapled goods there's not going to be much growth in that unless there's going to be another covid where the influx of dog adoptions happens but like how do you how do you really boost the level of you know uh like earnings that you can generate from the business and that's by offering super high margin um like pet insurance and uh veterinary care because at the same time everyone's got to get their dogs annually annual checkups right their vaccines um they're revaccine like a bunch of things that even if your dog is or your animal is not sick you still got to go in to get it done right like we all we have to get sometimes we have to get updates and checks for ourselves which it's that's recurring revenue it's it's really

simple to do. And when you're talking about millions and millions of dogs in the country or animals or just whatever, I keep going to dog. Sorry. Cause I have one. It's, it's a really attractive business. And I actually built out a visual like chart in our research to kind of show you what that build-out looks like. And, you know, just to kind of like highlight, you know, the numbers here in the next about like five, six years, the vet build-outs that they're doing, the animal hospitals, will add over $1.3 billion to the top line and about $36 million in EBITDA. And that's me being conservative. That's literally me being conservative because I wanted to be comfortable with it.

It's pretty wild how much people are willing to spend on pets because they're your child. You don't want to see them get sick. If you want to see them get sick, you'll pay whatever you need to pay to get them better and fast. uh i was just gonna you mentioned some of the numbers there can you provide any more financials just for like context for listeners who haven't looked at it before what do they kind of generate in revenue what do margins look like um sort of the can you go through the economics yeah there's um so i actually put on i don't want to find because i want to misquote it um i put a chart on my twitter i think it's my twitter maybe it's my the funds twitter where i was comparing on the

columns it was comparing um uh echo pet smart and shui because there's there's a big misconception on how three are really compared are compared to and they listed out all the offerings that they did and they listed out um between because pet smart's not public uh the financials between Petco and Shoei so that people could face value. Even if they didn't want to take the time to dive into it, they could just visually take a look at it and learn about the businesses super quickly. So if we look at what the values of the companies are, Shoei by size is a much, much bigger business. I think it's generating over $10 billion. Oh, no. I think it's over $10 billion in sales. Sorry, let me pull it up right here.

Yeah, I'm looking at it right now. It's 9.1 over the last 12 months. Yeah. And here's the thing though, because everybody gets hung up on that number. So yes, it is a massive business. Chewy is. But the problem is when you have that massive business, if you look at their adjusted EBITDA, you look at their free cashflow, it's not there they're they're they're so focused on driving that top line that they're actually not producing anything um which is where i have an issue with that because i think if you're going to be a company driving that that big of um i guess financials but an issue where you're supposed to be making money and you aren't making money that's a that's like that's a problem um

So when you look at it from a Petco's perspective, like when I made the chart, I mean, they were being valued at about $7 billion in enterprise value. They were generating almost $6 billion in sales. But when you look at how much earnings they're actually making, like, yes, they actually have positive EBITDA margins. They have positive free cash flow margins. They're actually generating something that is real. And I was giving them more credit for that, right? I'm like, how are you going to say that, you know, a company that's doing, yes, a company that's doing about two times more in sales is being valued almost two times more in value, despite them not being profitable. Like that just didn't make sense to me.

So like Peko is a big company. And like, unfortunately, especially since I posted that the company has been going down just from like further multiple contraction, retailer collateral damage, et cetera. But it is not a small company. So when you're talking about what the veterinary build-out adds, if we're talking about $6 billion in revenue right now within five years, a little over a billion dollars just from veterinary care, that's massive. That's literally a massive number. And the key is that veterinary care has higher margins, right? Yeah, because you're paying, especially if it's in-house, right? If you control everything, you're just paying for the vets, like the actual vets that are there.

You pay for the supplies, which you're going to get a good deal from anyway, because you're a massive company, you can get economies of scale, you own the operations, et cetera. So, I mean, I was factoring in 12% margins, like 12% veterinary margins on each little veterinary care clinic. Realistically, you're probably going to look at close to 20%, not 12%. So that's why I'm being very conservative with my bottom line figures, because obviously there's going to be a ramp up time to reach those levels. um but those those those margins are great you're talking about um average unit volumes i think i think i'm rejecting like over two million dollars in like four years or something like that which is great per clinic which is great um and the more you have the better and there's always going to be people having pets sometimes people get more than one pet you know etc etc so it really

just keeps compounding on its own especially the control of all okay and now let's move into comparing more Chewy and Petco. Is the key here, the omni-channel capabilities? And can you explain maybe, I guess you talked about Chewy's model, but can you explain why they're not profitable? Is it that marketing spend? Is it the big discounts they're giving? Or is it really just they don't have the physical stores that give them that double advantage, kind of like Petco? Yeah. So it's a combination of a lot of things. Chewy really changed the game because they showed that a consumer wants a DTC pet company. That's why they went public and Ryan Cohen made a bunch of money. Then he's out here buying Bed Bath & Beyond and GameStop and whatnot. But the cost

associated with doing business with freight, which I'm sure you guys have noticed with a lot other companies, it's expensive. And it's only going to keep getting expensive. So when you talk about a business that only relies on online retail, like, yeah, I can get it to you super fast, but it's still going to cost me. So shipping a 30-pound dog of dog food is not cheap. And here's the thing. At this day and age, you really got to offer free shipping, right? You can incorporate some type of minimum to the price, which is fine, right? You're going to hit that when you order dog food, but their minimum price, I believe is $49 and you get free shipping. If I'm ordering, you know, a 60 pound dog or $60, um, you know, 30 pound dog, 30 pound food for my dog. Um,

I cannot imagine them making too much money on that because now they don't have to pay for shipping and the margins on that are, are decent in and of itself. But once you, once you factor and the freight costs and the labor and everything like that, I would be surprised if you're making any money on that. And that's kind of why they incorporate... This is every pet store business at this point. That's why they incorporate those subscribe and save options, which is, you know what? Hey, if you're going to order dog food, which we all order, if you just keep it on a regular cadence, A, you never have to worry about ordering it again. But B, it will give you 5% off every single time you order it, just so they can drive recurring

revenue. They don't have to work from your... They don't have to execute more on marketing dollars to get me again, because I've already signed up for it. It's very similar to Amazon subscribe and save. The more things you add onto it, the more you save, whatnot, whatnot. But that's where the problem is. It's really the freight is the problem. So now when you look at a business like Petco, you really don't have to worry about that anymore. Because if I live a few blocks away from Petco and I can either A, buy online and pick up in store, so I physically go and get it. Yes, they take a hit on the margin for the discount that they offer, but they're not spending nearly the amount that they would to ship it. So they're actually net, net, they're

winning. Then you have the option of, okay, well, I can order it online and have it delivered same day. I don't get the discount, but I get the speed. And they don't have to worry about the cost associated with that either, right? Because they have a contract with DoorDash and the DoorDash people are the ones that fit the bill for the gas that they use to ship it. They're not doing the labor. The labor is already baked into it. So they save money on that front as well. And then additionally, they have another option where I can just go buy it and I can just pull up. I'm going to have to enter the store and they'll have an associate come out, load it into my trunk, and I'm on my way. So when you're talking about what they can cut to boost margins,

they're doing it um and they're and that's why i'm saying they're giving me so many different options for people who like imagine being an 80 year old grandmother with a dog like they may not be able to go to the store and if they go to the store they can't take a 30 pound bag of dog food no so they have an option for someone to come out and give it to them or they can ship it to you they can have somebody else um ride a bike or a car depending on where you are and deliver it to you from doordash like they have so many different things where the option to cut out very costly expenses that the consumer-facing side doesn't see is happening. And that's why they have leverage with their rewards where they, yeah, you can do the 5% off, or they have like the vital care

offering, which I'm a big fan of, where it's almost like a no-brainer to sign up for because you save so much money as a consumer if you just do everything in-house with Petco. That's something that just Chewy can't offer because they just don't have the capabilities for those product offerings and they also just um they don't have the leverage that the other stores have and i mean other stores i mean petco and pet smart as petco talked about competing with amazon does this the the comprehensive offering and the in-store stuff that you just talked about do you think that gives them just way better capabilities to i don't know blunt any consumers going over to amazon subscribe and save because when i see amazon versus chewy i think this is

the same exact product it is no it is it's the exact same thing if you want to talk about a real competitor like yes the pure play is chewy that's because it's it's black and white what they sell overlaps you know um but if you're talking about like a true true comparison like that's just online right you're talking about like online and in-store you're looking at the other stores like Walmart, like Target, like other specialty retailers or grocers that do offer dog pet food and pet products might pay a little bit more from them because that's not their bread and butter. But if someone's going to be like, yeah, I'll go to Walmart to buy all my groceries and whatnot, and I'll pick up a bag of dog food on the way while I'm there. Okay. That's like real

competition. When it comes to Amazon, no, I mean, when I shorted Chewy, that's actually part of my reason why I shorted Chewy. And if you're talking about a pure play online retailer, Amazon's going eat its lunch and um that's what's been happening uh so it's really more that's who their real competitors are but if you're looking at a public facing side what you see in the market you see in the news chewy is the one that gets advertised heavily um and sorry i forgot one point too what um petco also has as leverage which i know petsmart does i just haven't really dove into it it's private label if you want to expand margins private label is the way to go and they have i I think 10 brands that are private label and exclusive to just Petco.

So when you talk about expanding margins, they, they're, they're, they're offering things where like, if you want blue Buffalo shit, get a, get a Petco brand, pay a little bit less, but they make more money on the side. So that's, that's what else they got going for them. The other thing I saw, I was looking at, I was looking at Chewy this week. I can't really remember why, but they, They talked about on the conference call how auto ship helps save them costs logistically and through shipping because it's easier to automate auto ship orders.

There's higher average order value typically, and it just generally saves them money. But they have 70, I think it's 72% of their customers or sales come from auto ship and they still can't generate cash. I can't imagine that that probably has to be close to its ceiling in terms of percentage of sales coming from Autoship. So at what point do they generate cash? It just seems difficult or it seems like supply costs would have to come down. I couldn't even tell you. I couldn't even tell you because I think it's the best comparison is what Jim Shano said about DoorDash. if you can't even make money at the peak performance of what the market is

giving you, then you're just never going to make money. And that's exactly how like DoorDash was not making money really at peak performance during COVID when everybody couldn't leave their home. Chewy was, I think they were like profitable for like two quarters and they, they just can't, they can't sustain that because of just like how their business is built. And you see, I mean, you see the chart, they're down from their all-time high of what, like 75% down, I think at this point,

because they just, the auto ship thing, and this is what investors really have to be wary about. Unless you dive in, that auto ship number looks fantastic. It keeps going up. The average order value keeps going up, but you have to look at what constitutes an auto ship. And I think they base it off of someone who has had a shipment to them while on auto ship in a month period of time. So that number just looks massive because you're having such a wide, a super wide time range of what counts as that. And the other thing too, they don't tell you is what actually is a part of that auto ship. I can get a $5 bag of dog treats sent to me once every six months that counts as auto ship. I can get a 30 pound bag of dog food every two months

and that counts as it but everybody gets fixated on the latter than the former that they don't realize that it's actually a very big blend between the two like getting tennis balls getting toys like bark box for instance you get a new you get a new box of toys every you know like um month two months three months six months etc like it's it's something that you really have to dive into because if you take it at face value it's gonna burn you right yeah i don't know i i'm surprised uh you don't have bark box on the short trade but maybe that's a whole different i was long on it, man. And boy, was I wrong on that one. All right. Let's move into the numbers. Let's get some more context here. How are you valuing Petco? Maybe some numbers behind that.

And how does it compare to Chewy's? I know you mentioned the revenue numbers, but just, I guess Chewy doesn't generate consistent profits, but maybe that's the key here. yeah so what my issue was um is that um the market was not giving petco the credit it deserves like it totally revamped its business because of like its focus on retail and how it's focused on online and how it's leveraging retail to cater to the online world um initially when it went public it's like 20 i think it like peaked at like 28 a share it's touched that again but that was kind of like a meme squeeze um back in 2021 but the the biggest thing that i had with it was you have a specialty retailer who has been

consistently beating consensus estimates on the business like since it's been public every single time it's beat on top and bottom it's complete it's uh consistently uh you know slammed down any notion of nah the consumers are not going to pay for this anymore like it was all pulled forward, this and that. No, it actually wasn't. They've been doing well. They've been taking share. So I was saying, one, the market is not giving it the correct multiple that it should be given. It's actually been suppressed. I mean, I'm not even on a sales basis. And I wanted to focus on the cash flow basis and the earnings basis because it actually generates that. So if you're talking about a comparison, I can't even compare to Chewy because it doesn't make anything.

um so when you're looking at one it's expanding margins by doing all the things that i listed previously with you know the shipping costs the you know one-stop shop for all your pet needs etc a basket increase basket sizing subscribing like all that kind of stuff they're increasing margin while growing top lines like top lines growing at like 78 but you're you're growing even the margin you're going even sorry not even the margins at like um 10 or 11 that that's going to create margin, right? Like one's growing faster than the other one. And it was at the time when I wrote my, my research, it was showing, I think like 12 times, uh, 12 times EBITDA forward EBITDA, um, which was like a joke, um, considering it was, it was generating, um, over $500 million

in cashflow, hypothetical cashflow. So I was saying, you know what, if you're looking at other retailers that have been under the same kind of transformation where they were written off as an in-store retailer that will never be anything but, but they've revamped themselves, then they should be valued at the same, because they are doing the exact same thing. It's in a different industry. So I was looking at other specialty retailers like Home Depot, like Tractor and Supply & Co, where they took what seemed to be an only in-store business and turned it online. Home Depot is one of the biggest online retailers in the country, literally. I don't think many people don't realize that. And what they were trading at. So you look at what they were trading

at, and I was being conservative with what they were trading at, which is at like 14 and a half times forward estimates. So I'm like, even if you factor in two and a half turns more of a forward multiple on their EBITDA, but you're getting additional EBITDA margin going forward, this thing should be trading um over 25 bucks a share i think i think i posted at 26 bucks a share when realistically it should be at like probably 30 if it gets the recognition it deserves so that's why i was like you know what yeah i'm i'm long this stock because i think it's getting seriously mispriced i think with all the damage that has been done with consumer related stocks this year with retail related stocks this year if you actually look at the chart for anyone listening

in on this would like to see kind of a drop off what happened peco for most of the year was killing it they were actually not doing bad at all and then you can see a very precipitous drop in may i think it was and that's when target like when walmart walmart did it walmart announced hey we're gonna get reduced margins we're screwed the stock didn't even move it actually went up on the walmart news and the next day when target came out with theirs targets like oh we're screwed then you see a massive drop that Petco had because they're like, oh, you know what? Petco is a little bit more of an affluent customer base, which aligns better with target demographics. And they cratered. And I'm talking with my other hedge fund buddy who was short the stock. And I'm like, this doesn't

make any sense to me, dude. And he's sitting over here like, I see the credit card data. I see this, I see that. I'm like, I don't see any of this because I'm actually going to the store. I'm talking to people. This place is popping. They released earnings, I think a couple of weeks a week or two after that, and it rebounded 15%. And I'm like, this is what I mean. This is why the market's so stupid, because they just punish people on the pretenses of what's happening to other people. And the same thing recently happened, too.

It was recently trading back up again at $17 a share, and now it's down at like $13 for no other reason than other retailers are just doing utterly crap. It would have been the Walmart news that they just announced that they were guiding down, I think. I didn't read the details on that, but they said more margin, right? That's one of that. And it's like, but the thing is, that's been the growing story for the last nine months. But again, time and time again, Petco on their earnings reports, on their transcripts, they

all keep saying, we are not seeing any slowdown. Digital is still going up double digits. We're seeing it, you know, like margin, like we might take a hit on price, but the thing is like, we're also raising price. It's, they keep defying the odds, but no one's is giving them the recognition. And if you do a side-by-side of Chewy share price and Petco share price, Chewy's has flown since the bottom of June compared to Petco. And I'm like, why? Petco is literally a better overall business, but Chewy is so internet focused that my buddy told me, he's like, buy the dream, sell the execution. And I'm like, I really hate you for saying that, but that's such a valid point when you're comparing the two right now, because Petco is executing amazingly, and Chewy is the dream. Chewy is the tech side of things.

Like, yields go up, yields go down. It affects Chewy more than it does Petco, but this is getting punished. Do you think that's the only reason why Chewy gets the multiple premium? A thousand percent. A thousand percent. They have the, yeah. What if things go right at Chewy? And this kind of leads into our last question, which is like the pre-mortem. So I'll just double the question then. So how could you be wrong on the investment, sort of the long, peck, go short Chewy thesis? And then what kind of margins do you think Chewy could have, profit margins, if things go right? uh okay so if we talk about like margins of what should we go right um i don't think they're going

to be much at all right because if if they're not even adjusted ebitda profitable and again mind you adjusted ebitda is complete crap to begin with but they have a lot of depreciation right if i'm not mistaken oh you mean the spc yeah and that's yeah yeah yeah i mean if you're not even profitable in that sense even with adding back all those things that's i don't know how you get i really don't know how you get there um and it's uh if if we're talking about like realistically let's just hypothetically say they actually do get there i think at best they could probably match up with like a grocery store right you're talking like four to six percent margins um which for a grocery store makes sense you're buying produce you may be talking about the margins on

pet products it should be more than that you know um that's that's best case scenario i don't think it ever gets there um other other guys i've spoken with too also don't think it'll get there again you're buying a dream of it getting there um if we're talking about uh petco and i forget sorry would you say is what could go wrong yeah how could how could your thesis of uh or how could the investment long, Petco, short, chewy, go wrong? Yeah. Well, I mean, again, if you're looking at the business itself, Petco has a solid business. If you have any experience being an operator, Petco has hit the mark on anything and everything that the consumer could want. Could they make it a little bit better? Yeah, of course. But they're making it literally the

one-stop shop place for any pet owner for not only the everyday needs, but also the health and wellness side of things. So it's all encompassing and it's making it so that I save money, like the vital care offering, which I highly recommend people read on my sub stack because it breaks down the unit economics. As a consumer, I save so much money, but Petco takes more share. So it's hard for me to realize what could go wrong because they seem to be doing everything right. They're just getting a golf clap, not even a golf clap. But what could go wrong is like for instance like if if someone just there's a big big recession and people just decide to scrap all their pets and you know i just can't afford them anymore which again i don't see

that happening because i would i would literally go and switch to rice and beans for my life if it meant i still keep my dog right getting rid of my dog is not an option um uh that could that could happen there's no there's no real interest interest rate risk because the debt that they have is actually at a very attractable rate like they have they got like 1.7 billion dollars in debt, but the interest rate that they're paying right now is at like 4%. That's not bad. That's totally manageable. It is floating, but it's very attractive floating rates. It's like LIBOR plus 0.75 or LIBOR plus one. It's not tough. And they generate the free cash flow to pay for it. So they're not hemorrhaging anything. So there's no interest rate risk. There's no real consumer risk

because they keep they keep blowing that up if anything it's a market risk and that's shown this year by you know it it holding up so well until that target news and then that target news is kind of sent it spiraling so can it go lower yeah i just broke it's 52 week low today um but i'm thinking in the long term there's nothing that says to me at this current point in time granted, I'm biased, but I've been right on the other one as well, that this thing should not be trading above $25 a share when the times are back to being good again, when the market's not crazy with volatility. I just don't see it. I mean, at this current point in time, you've got a market cap of $3.8 billion, but they're generating $600 million of EBITDA this year. I mean,

do the math on that. And they're growing it at 10%. That's ridiculous. That's just so cheap. um so can i get hit yeah 100 which i have been already but i don't know this this thing is a winner i just don't see how it can go wrong unless the management just decides to complete 180 like a blockbuster-esque type strategy but that's not going to happen right there's always management risk um i think one more follow-up i had that maybe people would be interested in is do they have the capacity to repurchase shares because if we're going to get this huge discount um i don't know it's always nice and it can help you know get back the fair value if you can be really aggressive with it so i mean do they have the ability to yes does it make sense to do it

now if you look at the share price you you'd say like yeah obviously it's like so depressed but at the same time i think because of all the capital um like the capital allocation that they're using it for to build out these these their retail distribution arm and which like takes a lot of like spend to boost up the technology to facilitate it all you know etc etc etc i think having that cash to prove to investors hey if shit does hit the fan you know we're not going to dilute ourselves by doing some type of equity raise we're not going to have to like get unattractive uh rates on debt because you know we need to you know media for working capital etc um i think them keeping the cash that they have in the bank and them generating the free cash

what they do helps mitigate any type of worry that oh crap you know they might need to do another raise or something um if it comes to the point where yeah you know what this thing's like trading like close to or below ten dollars which i really hope it doesn't i i would actually like talk to like to see like ron or like brian and be like hey man like you this is just dumb you know it's um just go ahead and start buying stuff back because this is ridiculous right yeah so only if you get super cheap but with their conservative strategy maybe that's kind of a two year two or three years down the line they'd start returning capital to shareholders uh yeah i can see that because i mean you're talking about if you're talking about the whole revamp that they're doing

switching to online isn't cheap they got great momentum right now why try to focus on something else just to appease shareholders in the short term would i love more would i love more you know um, you know, like earnings per my shares, like, yeah, but I also know what they're trying to achieve and do it to achieve it. You gotta have to keep that strategy going and how to fund it properly. All right. I think that is all the questions that we have, uh, for any listeners that are hearing you for the first time, once again, go ahead and check out the exponential fitness episode, another sort of interesting, uh, retail, I guess you'd call it retail gym, uh, business as well, but, uh, where can they find you? Where can they, where can they keep

up with you yeah you can just follow my um twitter at paul sarah um it also has my the funds twitter on that as well on my bio and then if you actually want to check out the actual the work that you know i post um it's a cedar grove capital sub stack you'll find it's the first thing that pops up um and subscribe it's free right and we should link we'll probably link the petco write-up in the show notes because i know you referenced it a few times so yeah i mean even if you're looking at it right now if you're interested in a two-bagger At minimum. Go ahead. Take a look at it. Yeah.

All right. Well, that's going to do it. We want to remind our listeners that Brett and I are not financial advisors. Anything we say or discuss here on Chit Chat Money is not formal advice or recommendation. We are, however, general partners at Arch Capital, so clients may have positions in the securities discussed in this podcast. Thank you all for listening. Thanks, Paul, for coming on the show again. We'll see you next time. do you wish you could just hit skip on the worst parts of your life you know the same way you can skip an ad i get it i'm siaya and i live in ice cove i've made some questionable decisions that didn't end up the way i planned and today i'm still figuring it out somehow things usually

get worse before they get better apparently that's how i roll so bundle up and come along for the bumpy ride. Stream a new episode of North of North Tuesdays on CBC Gem.