Quick, those of you who own dogs, give me a "Woof!" Okay, now tell me where do you take your dogs for groomings and shop for treats?

Exactly, PetSmart (NasdaqNM: PETM). This, my dear fellow readers, is called economic moat. According to Investopedia's definition, economic moat refers to the competitive advantage a company has over its competitors. I like Morningstar's explanation better:

... think of it as the strength and [sustainability] of a firm's competitive advantage ...

The word to focus on is sustainability. But enough with the investionary. Let's try to listen to what our pets have to say. That's right. Pets can talk. Call me the Fish Whisperer.

Why I Like PetSmart?
PetSmart is everywhere and it has everything your pet needs. I have stepped into Petco once and have never been back. The many Petco (NasdaqNM: PETC) stores that I have passed by usually have quiet parking lots. As a consumer, I prefer to shop at places that are crowded although I don't necessarily like the long queue at the cashiers. Crowded retail stores tell me the stores are probably doing something right. As an investor, I look for crowded stores because it's a sign the stores are doing well.

I love going to PetSmart because I can always find what I need there. Sure, there is the cheaper stuff at Wal-Mart. But the sight of floating dead fish in the Wal-Mart fish tanks is not very attractive. I have to admit I'm a fish magnet. Whenever I walk into a pet store, I find myself walking towards the many tanks of colorful fish lining the walls of the store. The fish looks happy. Once in a while, I hear them say, "Pick me. Picke me. At the very least buy PetSmart stock."

The Reckoning
There are a few companies that I have admired all along. These are stores I go to frequently to shop. Then one day, I stumbled upon this gem written by Peter Lynch that prompted me to look closer to home for good stocks. I have always known about how Peter Lynch found some of the best investments in his career simply by looking at where his family shops. But I have never put that knowledge into practice.

The past few weeks, I have been paying special attention to one of the places I shop at, PetSmart. The stock has fallen more than 23% in the past 52 weeks. The past couple of days it has breached the 52-week low. What is going on?

When I find a popular brand name share price dropping as quickly as Martha Stewart gets out of jail, I get very excited. But there are two possible reasons for the drop: 1) the company is deteriorating 2) the market is overreacting. Value investors look for reason #2. Based on my limited experience, the market reaction can sometimes be very predictable. When a company misses the analyst estimates despite improved earnings, the market will react accordingly by punishing the stock sometimes creating excellent buy opportunities. On August 26, 2005, PetCo reported second-quarter profit below analyst estimates and lowered full-year earnings forecast. Accordingly, the market beat the share down 15% to $21.76 share. PetSmart also lowered its forecast for the third quarter due to lack of customers in stores in July and August. Apparently, this news overpowered the reported 23% gain in second quarter net income and the stock fell 13.5%.

Lowered earnings forecast is not always a bad thing, especially if it's just a quarter of earnings. This is what I consider a temporary woe. Especially in PetSmart's case where if you looked carefully at the previous quarters, you would realize that PetSmart has consistently met if not beaten analyst estimates. However, this consistency may have been due to the consistent lowering of earnings estimates.

At the beginning of this year, the stock was trading close to 52-week high at $35.84 a share. In January, PetSmart lowered 2004 earnings forecast and the stock began its now 9-month long descend. The following quarters were littered with bad news from lowered earnings forecast to earnings restatement due to new regulatory accounting for leases.

Despite all the bad news, if you looked closely enough you will find that PetSmart is not all that. Same store sales have been increasing consistently. Earnings have been increasing. Gross margin has increased consistently for the past 16 quarters. The company is buying back $270 million worth of shares.

The management team has been performing very well so far. Back in 1997, PetSmart was growing so fast so that it outgrew its infrastructure. The company began its spiral downward losing half its market share. When a stock is so overvalued that it's trading at 72 times its earnings, you can only expect the stock to tumble sooner or later.

Then in 1998, PetSmart brought in Philip Francis to give PetSmart a new leash on life. Philip knew what he was doing and curtailed the expansion. Instead he focused on introducing in-store services for pets such as grooming, training and just plain old advice. It is these services that sets PetSmart apart from its competitors and other big-box retailers such as Wal-Mart (NYSE: WMT) and Target (NYSE: TGT). And these services are also the most profitable segment for the company. Pet services sales have consistently grew on an average of 20 percent over the previous quarters.

PetCo, the nation's #2 pet specialty retailer has some pretty impressive numbers too. However, with the aforementioned competitive advantage that PetSmart has over PetCo, plus a slew class action lawsuits filed against PetCo and a threat of delisting from Nasdaq due to late filing of its quarterly report ended April 30, 2005 I would rather take my chances with the top dog, PetSmart.

PetSmart is currently trading at $22.66 a share with a P/E of 17.68 and an annual growth of 18%. It's almost a buy. However, I imagine the price will fall further following its third quarter earnings report coming October which it projected will be disappointing. I'm hoping the price will drop to the teens. At $17/share, the stock will be a screaming buy. Until then, I'll stay tuned to my fish.

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