Sector

ConsumerRetail

Background

Greg Kamstra is the CEO of pet care provider Riverdog and a former private equity investor. We cover how Petco evolved into its current big-box model, how pet care store economics differ from grocery economics, and what impact e-commerce has had on the industry.

Cover

Date

July 21, 2021

Episode Number

18

Petco Business Breakdown and Analysis

Background / Overview

Petco, founded in 1965 as a mail-order veterinary supply business, has transformed into a leading pet care retailer with approximately 1,500 stores across the United States. Initially a niche player, Petco capitalized on the rise of specialty pet products in the 1980s, shifting from a mail-order model to a big-box retail format. The company offers a wide range of products and services, including pet food, supplies, grooming, training, and veterinary care. With around 27,000 full-time equivalents (FTEs), Petco operates in a $120 billion pet care industry, holding a 4-5% market share. Its business model is characterized by a blend of retail and services, with a growing emphasis on veterinary clinics and owned brands to drive customer loyalty and recurring revenue.

Petco’s evolution reflects a strategic response to market dynamics, particularly the shift from grocery-dominated pet food sales to specialty retail. The company has pursued growth through organic store expansion and acquisitions, primarily of smaller retail chains, to build scale. Its current strategy focuses on integrating services like veterinary care into its stores, leveraging its physical footprint to differentiate from e-commerce competitors like Chewy and Amazon.

Ownership / Fundraising / Recent Valuation

Petco has been a frequent target of private equity ownership, reflecting its appeal as a growth asset in a secular bull market. Since the 2000s, it has been owned by various private equity firms, including the Canadian Pension Board. The company went public in 2021, but specific transaction multiples or enterprise values (EVs) from recent deals are not detailed in the transcript. Private equity’s interest stems from Petco’s position in a high-growth industry, offering opportunities for operational improvements and leveraged returns. However, the transcript notes that Petco trades at relatively modest valuations compared to high-growth e-commerce players like Chewy, suggesting a potential discount for investors betting on its pivot to services.

Key Products / Services / Value Proposition

Petco operates as an aggregator in the pet care market, participating in multiple categories:

1. Consumables and Supplies (~$80 billion market): Includes dog food, treats, leashes, and other pet products. This segment represents the core of Petco’s historical business, with a focus on specialty brands like Orijen and Science Diet that command a 30-50% price premium over generic brands like Purina due to higher-quality ingredients.
2. Veterinary Services (~$35 billion market): Petco is expanding its veterinary clinics, currently in 100 of its 1,500 stores, with plans to reach 900 in the coming years. Veterinary care offers recurring revenue and strengthens customer loyalty by addressing a high-frequency need.
3. Non-Veterinary Services (~$5 billion market): Includes grooming and training, which are smaller markets with less frequent customer visits (e.g., grooming every four months). These services enhance the in-store experience but contribute less to revenue than consumables or veterinary care.
4. Owned Brands: Represent 27% of sales, a high proportion compared to peers like Costco (25% Kirkland) or Dick’s Sporting Goods (10-15%). Owned brands drive exclusivity and higher margins, as customers must purchase them through Petco’s channels.

Value Proposition Table

Note: Revenue and EBITDA estimates are derived from total revenue ($5.2B) and EBITDA ($500M) figures, with segment splits based on market size and commentary.

Petco’s value proposition centers on being a one-stop shop for pet care, combining convenience, expertise, and exclusive products/services. Its veterinary expansion and owned brands aim to create a “hierarchy of loyalties,” positioning Petco as a trusted advisor in a market where pet owners face significant information gaps.

Segments and Revenue Model

Petco’s business is segmented into three economically separable units:

1. Retail (Consumables & Supplies): The largest segment, generating ~80% of revenue ($4.2B). Revenue is driven by volume (number of products sold) and price (markups of 50-200% depending on the product). Owned brands (27% of sales) and exclusive brands (e.g., Orijen) enhance margins and customer retention.
2. Services (Veterinary & Non-Veterinary): Contributes ~13% of revenue ($0.7B), with veterinary services growing rapidly. Revenue is driven by service frequency and pricing, with veterinary care offering higher recurrence than grooming or training.
3. E-commerce: Accounts for ~12% of revenue ($0.6B). Revenue mirrors retail but with lower margins due to delivery costs (e.g., DoorDash partnerships) and competition from Chewy and Amazon.

Revenue Model

Petco generates revenue through:

• Product Sales: Markups on pet food, treats, and supplies, with an average initial markup of 50% (e.g., a $37 wholesale bag of Orijen sells for $56, yielding $19 gross margin). High-margin items like treats near checkouts can have 100-200% markups.
• Service Fees: Fixed pricing for grooming, training, and veterinary services, with veterinary care commanding higher prices and recurrence.
• E-commerce Sales: Similar to retail but with additional delivery fees and lower margins due to third-party logistics.

Splits and Mix

Revenue Mix

• Product/Segment Mix: Consumables & Supplies (80%), Services (13%), E-commerce (~12%, overlapping with consumables).
• Channel Mix: In-store (88%), E-commerce (12%).
• Geo Mix: Primarily U.S.-focused, with no significant international presence noted.
• Customer Mix: Targets pet owners, with 85 million U.S. households owning pets (67% penetration). Focus on higher-income pet owners willing to pay premiums for specialty products and services.
• End-Market Mix: Consumables dominate, but services (especially veterinary) are growing in share.

EBITDA Mix (Estimated)

• Consumables & Supplies: ~84% ($420M)
• Veterinary Services: ~15% ($75M)
• Non-Vet Services: ~4% ($20M)
• E-commerce: ~6% ($30M, lower margin due to delivery costs)

Mix Shifts

• Historical: Shift from 95% grocery-dominated pet food sales in the 1980s to 50% specialty retail today, driven by specialty brands.
• Forecasted: Veterinary services expected to grow significantly, potentially reaching 20-30% of revenue by 2030 as clinics expand to 900 stores. E-commerce may remain underpenetrated (12-15%) due to lower margins and competition.

KPIs

• Comparable Store Sales (Comp Sales): The “holy grail” for driving profitability, as incremental revenue significantly boosts margins due to fixed costs (rent, labor).
• Customer Frequency: Critical for comp sales, driven by owned brands, exclusive brands, and services like veterinary care.
• E-commerce Penetration: Currently 12%, underpenetrated compared to retail peers, with a two-year digital comp of 130% during COVID.
• Veterinary Clinic Expansion: From 40 clinics in 2020 to 120 in 2022, targeting 900 by 2030.
• Spend per Pet: $1,000/year in 2022, up from $650 in 2009, projected to reach $2,000 by 2030.

Acceleration/Deceleration

• Acceleration: Veterinary services and owned brands are accelerating, driven by clinic expansion and customer loyalty. COVID pulled forward digital adoption, with 130% two-year digital comps.
• Deceleration: E-commerce growth may slow due to margin challenges and competition. Retail margins face pressure from Chewy and Amazon on commodity products.

Headline Financials

Group-Level Financials

• Revenue: $5.2B (2022)
• EBITDA: $500M (10% margin)
• Free Cash Flow (FCF): Not explicitly stated, but estimated at $300M after maintenance capex (2% of revenue) and working capital needs.
• Revenue CAGR: Not provided, but industry growth from $1B (1965) to $120B (2022) suggests Petco’s revenue grew at a high single-digit CAGR, with recent years likely in the 5-10% range due to store expansion and services.
• Store-Level Revenue: $3.6M/store ($300K/month) across 1,500 stores.

Financials Table

Long-Term Financial Trends

• Revenue: Steady growth driven by store expansion, veterinary services, and owned brands. Industry projected to reach $300B by 2030, implying a 12% CAGR, with Petco likely tracking at 8-10% CAGR.
• EBITDA Margin: Stable at 10%, with potential for expansion to 12-15% if veterinary services scale and owned brands grow, leveraging fixed costs.
• FCF Margin: Likely to remain at 5-7%, constrained by capex for clinic expansion and competitive pressures on retail margins.

Value Chain Position

Petco operates midstream in the pet care value chain, between suppliers (pet food manufacturers, equipment providers) and end customers (pet owners). Its primary activities include:

• Inbound Logistics: Sourcing from branded suppliers (e.g., Orijen, Science Diet) and developing owned brands.
• Operations: Managing 1,500 stores (13,000 sq. ft. average) and 100+ veterinary clinics, plus e-commerce fulfillment.
• Outbound Logistics: In-store sales, buy-online-pickup-in-store (BOPIS), and same-day delivery via DoorDash.
• Marketing & Sales: Promoting owned brands, exclusive brands, and services to build customer loyalty.
• Service: Providing grooming, training, and veterinary care to enhance the customer experience.

Go-to-Market (GTM) Strategy

Petco’s GTM strategy emphasizes:

• Physical Footprint: Leveraging 1,500 stores as distribution centers for omni-channel fulfillment (70-80% of e-commerce orders fulfilled in-store).
• Owned Brands: 27% of sales, driving exclusivity and higher margins.
• Services: Veterinary clinics and grooming to increase customer frequency and loyalty.
• Digital: Underdeveloped mobile app and same-day delivery, with a C-grade digital strategy compared to peers.

Competitive Advantage

Petco’s value-add lies in its physical presence and ability to offer services that e-commerce competitors cannot replicate (e.g., veterinary care, grooming). Owned brands and exclusive partnerships (e.g., Freshpet refrigerated food) create differentiation, while the veterinary expansion aims to capture high-margin, recurring revenue.

Customers and Suppliers

Customers

• Demographics: 85 million U.S. households (67% of total) own pets, up from 40% in 1960. Target higher-income pet owners willing to spend $1,000/pet/year.
• Behavior: Seek convenience, expertise, and premium products. COVID drove 11 million pet adoptions, with millions of new pet-owning households.
• Loyalty: Driven by owned brands, exclusive products, and services. Petco aims to be the “highest trust source” for pet advice.

Suppliers

• Key Suppliers: Branded pet food manufacturers (e.g., Champion Pet Foods for Orijen), equipment providers, and veterinary service partners.
• Dynamics: Petco relies on exclusive partnerships with brands like Orijen and Freshpet, which refuse to sell on Chewy or Amazon to maintain channel differentiation. Owned brands reduce supplier dependency.
• Power: Suppliers have moderate power due to the fragmented market, but Petco’s scale and owned brands give it leverage.

Pricing

Contract Structure

• Retail: Fixed pricing with 50-200% markups. Exclusive brands command 30-50% premiums over generics (e.g., $56 for a $37 wholesale bag of Orijen).
• Services: Fixed fees for grooming, training, and veterinary care, with veterinary services priced higher due to recurrence.
• E-commerce: Competitive pricing to match Chewy/Amazon, but margins eroded by delivery costs.

Pricing Drivers

• Differentiation: Specialty and owned brands justify premiums due to perceived quality and exclusivity.
• Mission-Criticality: Veterinary services and exclusive products are less price-sensitive due to customer loyalty and trust.
• Competition: Commodity products face pressure from Chewy/Amazon, forcing Petco to focus on non-commodity offerings.
• Mix Effect: Shift toward veterinary services and owned brands increases blended margins.

Bottoms-Up Drivers

Revenue Model & Drivers

Revenue Model

• Retail: Price x Volume. Average store generates $3.6M/year ($300K/month), with 50% gross margin ($100K/month). Volume driven by customer frequency and comp sales.
• Services: Fee-based, with veterinary services growing due to higher frequency (annual shots, check-ups) vs. grooming/training (every 4 months).
• E-commerce: Price x Volume, but lower margins (5-7%) due to delivery costs and competition.

Revenue Drivers

• Price:
• Industry Fundamentals: Specialty brands command 30-50% premiums over generics due to quality.
• Branding & Reputation: Owned brands (27% of sales) and exclusives (e.g., Freshpet) drive higher prices.
• Customer Type: Higher-income pet owners are less price-sensitive.
• Mix Effect: Shift to veterinary services and owned brands increases blended ASP.
• Volume:
• End-Market Growth: Pet care market growing at 12% CAGR to $300B by 2030, driven by pet ownership (67% of households) and spend per pet ($1,000 to $2,000).
• Switching Costs: Owned brands and services create stickiness, reducing churn.
• Customer Frequency: Veterinary clinics and exclusive products drive repeat visits.
• Marketing: Promotions and loyalty programs (e.g., Pet Coach app) boost volume.
• Absolute Revenue: $5.2B, with 80% from consumables, 13% from services, and 12% from e-commerce.
• Mix:
• Product Mix: Consumables dominate, but veterinary services growing.
• Geo Mix: U.S.-centric, no significant international exposure.
• Channel Mix: In-store (88%) vs. e-commerce (12%).
• Organic Growth: Driven by comp sales and veterinary expansion. Inorganic growth from store acquisitions.

Cost Structure & Drivers

Cost Structure

• Variable Costs (~50% of revenue):
• COGS: Wholesale costs for pet food/supplies (e.g., $37/bag for Orijen). Bulk purchasing and owned brands reduce COGS.
• Labor: Store-level staff for retail and services.
• Delivery: E-commerce logistics (e.g., DoorDash for same-day delivery).
• Fixed Costs (~40% of revenue):
• Rent: $15K/month/store ($180K/year, ~5% of store revenue).
• Labor: $15K/month/store for management and overhead.
• Utilities & Admin: ~$5-10K/month/store.
• Capex: Maintenance (~2% of revenue, $100M/year) and growth capex for veterinary clinics.

Cost Drivers

• Variable Costs:
• Inflation: Impacts labor and raw materials, though owned brands mitigate exposure.
• Economies of Scale: Bulk purchasing reduces COGS for consumables.
• Contribution Margin: Varies by product (50% for pet food, 70-80% for treats, 60-70% for services).
• Fixed Costs:
• Operating Leverage: Fixed costs (rent, labor) are spread over higher revenue, boosting margins. A 10% increase in comp sales can double store-level EBITDA.
• Economies of Scale: Centralized admin, marketing, and distribution reduce per-store costs.
• Gross Margin: ~33-60% depending on product/service mix (50% average for retail, 60-70% for services).
• EBITDA Margin: 10% ($500M), stable but with potential for expansion to 12-15% as services scale.

Cost Analysis

• % of Revenue:
• COGS: ~50% ($2.6B)
• Rent: ~5% ($260M)
• Labor: ~25% ($1.3B)
• Utilities/Admin: ~10% ($520M)
• % of Total Costs:
• COGS: ~55%
• Rent: ~5%
• Labor: ~28%
• Utilities/Admin: ~12%

FCF Drivers

• Net Income: ~$200M (estimated, assuming 4% net margin after interest and taxes).
• Capex:
• Maintenance Capex: ~$100M (2% of revenue) for store upkeep.
• Growth Capex: ~$50-100M/year for veterinary clinic expansion.
• Capital Intensity: Moderate, with capex at 3-4% of revenue.
• Net Working Capital (NWC):
• Inventory Days: High due to 10,000 SKUs/store, but owned brands reduce inventory costs.
• Receivables Days: Low, as most sales are cash-based.
• Payables Days: Moderate, leveraging supplier terms.
• Cash Conversion Cycle: ~30-40 days, typical for retail.
• FCF: ~$300M (6% margin), driven by EBITDA ($500M) less capex ($150M) and NWC changes ($50M).

Capital Deployment

• M&A: Primarily store acquisitions to build scale, with smaller deals like Pet Coach (app) and investments in Rover. Missed opportunities (e.g., Chewy, Rover) highlight conservative M&A strategy.
• Organic Growth: Veterinary clinic expansion (120 to 900) and owned brand development.
• Buybacks: Not mentioned, likely limited due to capex needs.
• Synergies: Store acquisitions add scale, while veterinary clinics leverage existing footprint for higher margins.

Market, Competitive Landscape, Strategy

Market Size and Growth

• Total Addressable Market (TAM): $120B in 2022, projected to reach $300B by 2030 (12% CAGR).
• Consumables & Supplies: $80B (67% of market)
• Veterinary Services: $35B (29%)
• Non-Vet Services & Other: $5B (4%)
• Growth Drivers:
• Volume: Pet ownership at 67% of U.S. households (85M), up from 40% in 1960. COVID added 11M pets, with millions of new pet-owning households.
• Price: Spend per pet rose from $650 (2009) to $1,000 (2022), projected to hit $2,000 by 2030.
• Industry Growth Stack: Population growth, rising pet ownership, and premiumization of pet care.
• 3 KDs (Key Drivers):
1. Pet ownership penetration (67% and growing).
2. Spend per pet ($1,000 to $2,000).
3. Shift to specialty retail and services.

Market Structure

• Fragmented: No player dominates, with Petco at 4-5% share, PetSmart and Chewy slightly larger (~8% each). Grocery/mass channels hold ~50% of spend.
• Minimum Efficient Scale (MES): Moderate, requiring 100-200 stores to achieve economies of scale. Petco’s 1,500 stores provide a defensible position.
• Competitors: PetSmart, Chewy, Amazon, grocery chains (e.g., Walmart), and independent specialty retailers.
• Traits: Secular growth, recession-resistant, low regulation, high customer loyalty.

Competitive Positioning

• Matrix: Petco competes on convenience (one-stop shop), expertise (veterinary, owned brands), and premium products, targeting higher-income pet owners.
• Risk of Disintermediation: High for commodity products (pet food) due to Chewy/Amazon, low for services and exclusive brands.
• Market Share: 4-5% overall, ~8% in specialty retail. Stable but under pressure from e-commerce.

Hamilton’s 7 Powers Analysis

1. Economies of Scale: Strong. 1,500 stores spread fixed costs (rent, labor), with store-level margins of 20-25%. MES supports Petco’s position, deterring smaller entrants.
2. Network Effects: Weak. No significant network effects, as pet care is individualized.
3. Branding: Moderate. Owned brands (27% of sales) and exclusive partnerships (e.g., Freshpet) build loyalty, but Petco lacks the brand strength of Chewy or Amazon.
4. Counter-Positioning: Moderate. Veterinary services and same-day delivery differentiate from e-commerce, but digital strategy lags (C-grade).
5. Cornered Resource: Moderate. Exclusive brands (e.g., Orijen, Freshpet) and owned brands provide access to premium products unavailable on Chewy/Amazon.
6. Process Power: Weak. No unique operational processes noted, with generic retail execution.
7. Switching Costs: Strong. Owned brands and veterinary services create stickiness, as customers must return to Petco for refills or care.

Competitive Forces (Porter’s Five Forces)

1. New Entrants: Moderate. High capital requirements (stores, inventory) and MES deter small entrants, but e-commerce lowers barriers for digital players.
2. Threat of Substitutes: High. Commodity products (e.g., Purina) available at grocery stores, Chewy, Amazon. Services and owned brands reduce substitution risk.
3. Supplier Power: Moderate. Fragmented suppliers, but exclusive brands give Petco leverage. Owned brands reduce dependency.
4. Buyer Power: Moderate. Pet owners are loyal but price-sensitive for commodity products. Premium customers (spending $1,000/pet) are less sensitive.
5. Industry Rivalry: High. Intense competition from PetSmart, Chewy, Amazon, and grocery chains. High fixed costs drive price competition on commodity products.

Strategic Logic

• Capex Bets: Veterinary clinic expansion (120 to 900) is offensive, aiming to capture high-margin, recurring revenue. Store maintenance is defensive to sustain comp sales.
• Economies of Scale: Petco operates at MES with 1,500 stores, but further growth risks diseconomies (e.g., bureaucracy, logistics challenges).
• Vertical Integration: Veterinary services integrate downstream, enhancing customer loyalty and margins. Owned brands integrate upstream, reducing supplier dependency.
• Horizontal Expansion: Limited, with focus on U.S. market and existing categories. Missed opportunities in adjacencies (e.g., Chewy, Rover).
• M&A: Conservative, primarily store acquisitions. Missed high-impact deals like Chewy ($3B to $34B valuation).

Valuation and Market Outlook

Market Outlook

The pet care market is a secular growth story, driven by:

• Pet Ownership: 67% of U.S. households, with COVID adding millions of new pet owners.
• Spend per Pet: $1,000/year, growing to $2,000 by 2030.
• Premiumization: Shift to specialty products and services (e.g., raw food, veterinary care).
• Digital Adoption: E-commerce penetration accelerated by COVID, with Petco’s digital comps at 130% over two years.

Risks include:

• E-commerce Pressure: Chewy and Amazon erode retail margins on commodity products.
• Market Saturation: Potential slowdown if pet ownership or spend per pet plateaus.
• Competition: PetSmart and independents challenge Petco’s service expansion.

Valuation

• Market Cap: Not explicitly stated, but Petco is a public company with a valuation likely in the $5-10B range, given $5.2B revenue and 10-15x EBITDA multiples typical for specialty retail.
• Upside Case: If Petco doubles its market cap in 5-10 years, it will likely:
• Scale veterinary clinics to 900, boosting services to 20-30% of revenue.
• Grow owned brands to 35-40% of sales, enhancing margins.
• Maintain 8-10% revenue CAGR, tracking industry growth to $300B.
• Achieve 12-15% EBITDA margins through operating leverage.
• Downside Case: If market cap halves, it may result from:
• Margin compression from Chewy/Amazon on commodity products.
• Failure to scale veterinary services profitably.
• Slowing market growth or overcapacity in specialty retail.
• High fixed costs eroding profitability.

Key Dynamics and Unique Aspects

Unique Business Model Elements

1. Owned Brands (27% of Sales): Petco’s high proportion of owned brands is rare for specialty retail, surpassing Costco (25%) and Dick’s (10-15%). This drives exclusivity, higher margins, and customer loyalty, as customers must return to Petco for refills.
2. Veterinary Clinic Expansion: The pivot to 900 veterinary clinics by 2030 is a bold bet on recurring, high-margin revenue. Unlike grooming or training (low frequency), veterinary care addresses a frequent need (e.g., annual shots), strengthening Petco’s “hierarchy of loyalties.”
3. Omni-Channel Fulfillment: 70-80% of e-commerce orders are fulfilled in-store, leveraging Petco’s 1,500-store footprint as distribution centers. Same-day delivery via DoorDash differentiates from Chewy’s slower shipping.
4. Hierarchy of Loyalties: Petco aims to be the “highest trust source” for pet advice, addressing the information gap in pet care. Acquisitions like Pet Coach and veterinary expansion deepen customer relationships, driving repeat visits.

Standout Interviewee Insights

• Market Selection: The interviewee emphasizes Petco’s success as a function of operating in a “first quartile” market ($120B to $300B by 2030). This secular growth masks operational challenges, allowing Petco to thrive despite a “third quartile” business model.
• Customer Loyalty: The concept of a “hierarchy of loyalties” is unique, reflecting the fragmented touchpoints in pet care (breeders, vets, walkers). Petco’s strategy to own this loyalty through expertise and services is a key differentiator.
• Missed Opportunities: The interviewee highlights Petco’s “sins of omission” (e.g., not acquiring Chewy, underinvesting in digital). This critical perspective underscores Petco’s conservative approach in a dynamic market.
• Distribution Advantage: Petco’s ability to pivot from commoditized pet food to services and owned brands leverages its existing store network, a strategic flexibility not easily replicated by e-commerce players.

Critical Analysis

Petco’s business model is resilient but faces structural challenges:

• Strengths: Secular market growth, owned brands, and veterinary expansion provide a defensible moat. Operating leverage (fixed costs) amplifies profitability as comp sales grow.
• Weaknesses: Underdeveloped digital strategy (12% e-commerce penetration, C-grade app) lags peers. Missed M&A opportunities (Chewy, Rover) reflect risk-averse capital allocation.
• Opportunities: Veterinary services and owned brands offer high-margin growth. Deepening customer loyalty through expertise can counter e-commerce threats.
• Threats: Chewy and Amazon pressure retail margins, while PetSmart’s stronger execution (e.g., Chewy acquisition) poses a competitive risk. High fixed costs (~40% of revenue) could erode profitability if comp sales falter.

Conclusion

Petco’s business model is a compelling case study in navigating a high-growth, fragmented market. Its pivot to veterinary services and owned brands addresses the commoditization of pet food retail, leveraging its physical footprint to drive loyalty and recurring revenue. However, its underdeveloped digital strategy and conservative M&A approach leave it vulnerable to e-commerce disruptors. The company’s success hinges on executing its veterinary expansion and deepening customer trust, capitalizing on the pet care market’s projected growth to $300B by 2030. Investors should weigh Petco’s resilient market position against competitive pressures and operational risks, recognizing its potential for both significant upside and downside depending on strategic execution.