Jana's Locked in on PetSmart, But What About This Drugstore Chain?

Activist investor Jana Partners, with some $10 billion in assets under management and whose strategy is reportedly to invest in value opportunities with catalysts for unlocking greater shareholder value, has identified PetSmart as its latest opportunity. Shares have underperformed the S&P 500 index over the past year, falling 10% before Jana took a stake and the share price soared by nearly 13%. 

PetSmart Annual Report

PetSmart shares are trading at a 15.5 forward P/E ratio compared to a trailing P/E of closer to 17. Yet analysts are predicting earnings-per-share of $4.32 for fiscal 2014, representing growth of about 7.5% from $4.02 per share (before tax) in fiscal 2013. Hence the value. 

PetSmart's Diluted EPS History
Fiscal 2013Fiscal 2012 Fiscal 2011 Fiscal 2010 Fiscal 2009
$4.02 $3.55$2.55$2.01$1.59

The catalyst lies in PetSmart's proven ability to of deliver on the fundamentals, with the exception of the most recently reported quarter and subsequently lowered guidance when the company succumbed to online competition and a lack of customer loyalty in the period. Still Jana sees the potential in the $37 billion pet industry, where according to Barron's sales of pet food alone are growing as much as 5% each year.

Greater shareholder value
Jana, according to its filing with the U.S. Securities and Exchange Commission, is pushing for a sale of PetSmart, and company executives maintain that they too would like to "enhance shareholder value," according to a statement. 

It didn't have to come to this for PetSmart. Last year the company had $615 million in operating cash flow; the board lifted the quarterly dividend by 18% to $0.195 per share and approved a $535 million stock buyback plan. Comparable-store sales have been positive, but the 2.7% increase in fiscal 2013 paled in comparison to a 6.3% jump in the prior year. It just hasn't been enough to keep shareholders happy, and when PetSmart missed consensus sales estimates in the most recent quarter and guided for flat same-store sales, the bottom fell out. 

Jana seems to have little faith in management's ability to turn things around (and rightly so considering the stock's underperformance over the past year), evidenced by the fact that it has taken a different tack with another one of its holdings.

Indeed, Jana Partners' largest holding is in retail drugstore Walgreen , in which the activist investor raised its stake earlier this year. Walgreen shares are up close to 30% year to date.  Similarly compelling is the fact that Jana has been satisfied on the sidelines, not pushing for a company sale or management or board shakeup as long as Walgreen management continues to push for value creation.

Could Walgreen scoop up PetSmart?
One could argue that Walgreen is already consumed on the acquisition front, with the company considering a takeover of U.K.-based Alliance Boots, which the U.S. based drugstore retailer already has a 45% ownership stake in. But Walgreen, with 8,582 locations, hasn't pulled the trigger on that yet, suggesting that other options could still be on the table.

PetSmart, with 1,333 locations and $6.9 billion in net sales in fiscal 2013, trades at an enterprise value-to-revenue multiple of about 1, which isn't that expensive. In fiscal 2013, Walgreen generated $4.3 billion in operational cash flow and had $3.1 billion in free cash flow. And while it also been whittling away at its billions in long-term debt, $3.7 billion to be exact, which has piled up as the drugstore chain has invested in Alliance Boots, Walgreen probably doesn't want to add to its excessive debt load to fund an acquisition with debt rating agency Moody's watching its every move. PetSmart, meanwhile, has about half a million dollars' worth of debt. Perhaps the two companies could explore the store-within-a store concept. 

Indeed, a deal with any buyer isn't a foregone conclusion. Oppenheimer analyst Brian Nagel doubts a sale because of competition, which incidentally has left PetSmart grappling for market share in its own niche market. He said in a report cited in Bloomberg Businessweek: 

[PetSmart] possesses the characteristics of a retail takeout candidate, [but] we view a sale of the chain at this juncture as unlikely.

If a suitor for PetSmart fails to surface, Jana said in the filing it is pursuing a host of improvements in the "capital structure including providing for a significant return of capital to shareholders" and the "management and board composition." 

So while change is afoot at PetSmart, the way that change will actually unfold is unclear. But investors should look to Jana's track record, not only with Walgreen but its other holdings. Take a look at Jana's top five holdings as of March 31:

Jana's Top 5 Holdings: Year to Date Returns
Walgreen+ 28.8%
Oil States International+10.7%
Equinix +20%
Cameron International+15.4$

Foolish conclusion
So there you have it. PetSmart is in good hands, as is Walgreen. The key difference here is that Jana has enough confidence in Walgreen management to watch from the sidelines. PetSmart is a different story, and while a Walgreen/PetSmart combination may not be in the cards, Jana is sure to have some ideas about unlocking value -- whether it be larger share buybacks, higher dividends, or a strategic change in direction -- in the weeks and months to come.

Warren Buffett: This new technology is a "real threat"
At the recent Berkshire Hathaway annual meeting, Warren Buffett admitted this emerging technology is threatening his biggest cash-cow. While Buffett shakes in his billionaire-boots, only a few investors are embracing this new market which experts say will be worth over $2 trillion. Find out how you can cash in on this technology before the crowd catches on, by jumping onto one company that could get you the biggest piece of the action. Click here to access a FREE investor alert on the company we're calling the "brains behind" the technology.


The article Jana's Locked in on PetSmart, But What About This Drugstore Chain? originally appeared on Fool.com.

Gerelyn Terzo has no position in any stocks mentioned. The Motley Fool recommends PetSmart. 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.

Copyright © 1995 - 2014 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

Read Full Story