This is one of those situations that can stir up a hornets’ nest. It pits M&A and private equity against activist investing and creates a negative value investing scenario. What’s not to like about that — or hate?
Merrill Lynch even said there is “no doggone way PetSmart gets taken out.” The firm went back to a formal Underperform rating after having previously dropped it from coverage. The new PetSmart stock price target is down all the way at $55.00.
What should stand out here is that PetSmart’s 52-week low is also $55.00, and the $72 or so share price on Friday compares to a 52-week high of $77.00.
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Friday’s report signals that fundamentals and new initiatives laid out by management are negative. These include cost reductions and broadening of mass food and omnichannel expansion, and the analysts feel the efforts are insufficient to turn around the business. Another view is that the sheer number of initiatives being simultaneously pursued only will increase the execution risks as it faces a number of structural and self-inflicted headwinds that helped to create three quarters of negative traffic.
As far as how that negative three-quarter period sounds, just imagine that this was after 14 consecutive quarters of traffic growth. The Merrill Lynch $55 target is based on 12 times the firm’s own 2015 projected earnings per share number. The team said:
Two months ago (July 3rd), Jana Partners took a 9.9% stake in company and sent a letter to the board seeking a potential sale of the company, improved operating performance and capital allocation and better disclosure to shareholders. Since then, shares have risen 21% and the company is now trading at a 15.6x P/E multiple and 7.4x EV/EBITDA from 13.8x and 6.1x prior to Jana’s disclosure. PetSmart management also preannounced second quarter results and stated it is pursuing strategic initiatives including a possible sale of the company and a slew of initiatives aimed at improving results (to which Jana has yet to respond). Given that a potential acquirer has yet to emerge, the possibility of a deal appears to be diminishing. We also believe PetSmart’s current valuation and challenged fundamentals would not make a deal attractive.
PetSmart shares were trading at $71.96 late Friday afternoon. If Merrill Lynch is correct in its assessment, then PetSmart shares are currently more than 23% overvalued. This $55 price target sounds atrocious, but the consensus analyst price target for the stock at Thomson Reuters is still just shy of $64. The absolute highest price target is only up at $75.
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Several other words of caution were made regarding the fundamentals in this report. The Merrill Lynch team issued the following cautious points under its investment thesis for such a negative outlook:
- Multiple headwinds to comparable store sales and valuation
- Market share losses
- Slowing in-store adoptions
- Sentiment overhang from online competition
- Limited benefit to hardgood categories from new household formation
- The potential entry of natural pet food into mass and grocery could be very damaging
One word of caution: this assessment is a standalone valuation. The risk is that any private equity firm or other company may take a different view. PetSmart is worth more than $7.1 billion in market cap as it stands today. That is not small for an acquisition size by any means, but it is also not outside of the realm of possibilities.
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