StockTalk:
TMF Interview With PETsMART
CFO Neil Watanabe
With Yi-Hsin Chang (TMF Puck)
and Brian Graney (TMF Panic)

June 17, 1998

With us today is Neil Watanabe, chief financial officer of PETsMART <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: PETM)") else Response.Write("(Nasdaq: PETM)") end if %>, the world's largest operator of pet supply and services superstores with about 500 stores in the U.S., Canada, and the U.K. On May 27, the Phoenix-based company reported a breakeven first quarter compared with earning $0.05 a share before charges in the same year-earlier period. The company has been working to improve overall performance as well as shareholder returns.

TMF: Mr. Watanabe, thank you for joining us today.

Watanabe: Thank you.

TMF: PETsMART's stock price peaked in September 1996 around $29; today it's trading around $7. Were the earnings warnings and repeated one-time charges that caused the stock to tumble a result of the company expanding too fast through acquisitions? If so, has this made you rethink your acquisition strategy? Are you planning to make more acquisitions later this year?

Watanabe: Well, first of all, our stock is actually doing a little bit better than that -- we're trading around $9 right now. In answer to your question, let me take that in pieces. The first one is that the company's restructuring charge last year was due, in part, to the necessity to close 33 underperforming or overlapping stores, which were acquired as part of the previous acquisitions. As you're aware, with any acquisition you assume certain store sites which may not meet the company's demographic or store configuration requirements, which was the case. The restructuring charge also represented the exiting of the company from the Discovery human merchandise categories, which lost some excitement for our customers and we ended up reacting and replacing it with items much more desirable.

The real problems last year surfaced around three main items. One of them was a change in our pricing strategy during late fall of '96, which was a departure from our "every day low pricing" strategy. We also had a change in our advertising strategy in our first quarter of '97, which focused less on newspaper insert advertising and focused more on direct mail and television ads. And the last item that had an impact was a significant reduction of inventory levels at Q1 '97, which resulted in significant out-of-stock conditions last year.

We have corrected these items during fiscal year '97 and are continuing to focus on '98 with a return to "back to basics" strategy. This entails a return to "every day low pricing," resuming the proven advertising vehicles which worked well in the past in driving traffic into our stores, and a planned reduction of inventory without impacting the out-of-stocks. As part of the strategy, in answer to your question, we've also slowed the growth to about 72 new stores in North America and U.K. markets in 1998, and we don't have any plans for any further acquisitions in '98.

TMF: PETsMART recently announced a reshuffling of some of the top-tier executives. Could you talk a little about the new look of the management team and how it will work to build shareholder value going forward?

"We've also slowed the growth to about 72 new stores in North America and U.K. markets in 1998, and we don't have any plans for any further acquisitions in '98."

Watanabe: Phil Francis, our CEO, has recently assumed direct responsibility for our North America operations. This reflects Phil's desire to become much more involved in the day-to-day operation of the business and allows him to be close to the areas which needed to have strategic changes reflected. Sam Parker, our chairman, will have direct responsibility for the U.K. catalog operation, and veterinary and services [operations]. With this level of senior management involvement, it is anticipated that it will allow the company to expedite the improvement of PETsMART's financial performance as we enter 1998.

TMF: What are your plans for increasing operating margins, both for the company as a whole and at individual stores?

Watanabe: Well, we're currently focusing on improving operating margins through specifically identified expense-control measures, both at the central office and in the stores. We're in the process of installing new systems which we anticipate will allow us to operate more efficiently and smarter, with better drill down analysis of our business elements. We are also focusing on topline sales growth. With this we plan to improve margins through focus on reduction of shrinkage, lower distribution costs, through a strategic shift in our supply-chain management process, among other initiatives in our merchandising areas.

TMF: Stores are starting to offer other non-traditional retail services such as veterinary services or grooming for animals. How are these new services going to drive the company's future growth? If they're not the growth drivers, what products will be in the future?

Watanabe: Well, we see the service portion of our business as the key element of our future growth strategy. These services provide a tremendous value and fulfill a growing need to our customers. We see tremendous benefit in these businesses to restore economics, improving profitability both directly and indirectly. By increasing our penetration in these businesses, we also achieve increased shopping visits, which improve our opportunity to sell additional products. So we really feel very strongly that this is a big part of our future.

TMF: You mentioned inventory problems briefly. How's your inventory flow now? Are you still experiencing some build-up there?

"Phil Francis, our CEO, has recently assumed direct responsibility for our North America operations. This reflects Phil's desire to become much more involved in the day-to-day operation of the business."

Watanabe: Our inventory flow and level has been greatly improved over a year ago. Our inventory composition is in much better condition and is actually lower by 5% on a per-store basis this year versus last year for the first quarter. We are continuing to reduce excess inventory levels in our stores without impacting our out-of-stock conditions. We're seeing the benefits in improved store efficiencies through reduced freight and handling costs, as well as strengthening our balance sheet. So we are very comfortable with the progress we've made in this area.

TMF: Well, would you say your inventory flow is at the level that you want it to be or is there going to be further improvement on that?

Watanabe: We see further improvement. We believe that based on better supply-chain management, quicker response to getting our merchandise to our stores, and the other benefits of keeping lower inventory in our stores, allows our store associates to keep stock better on the shelves. With more inventory they have to shuffle it more, and in most cases, we have had more weeks of supply on hand than we really need. So, we see further reductions in those areas; with the right quantities we can definitely get down. We can't quantify how much, but we know that there's continued opportunity to better manage our inventories.

TMF: Turning back to growth for a little bit, PETsMART has already established a pretty good presence in the U.K., where you currently operate 89 retail stores. Do you have plans for more international expansion down the road? How will that expansion contribute to the financial performance of the company?

Watanabe: Well, we don't currently have any plans to expand internationally in other countries with stores at this time. We are pursuing the offering of catalogs and the Internet to gain additional market share in other countries. Currently, our international operations in the U.K. represents approximately 9% of the company's sales for 1997 -- to give you a composition of how much that business segment contributes towards sales revenue.

TMF: Do you think at some point you might saturate the market here in North America?

Watanabe: We believe that the opportunity for sites here in the U.S. with superstores approaches 900 to 1,000. At that point, that would put us in all the major markets, which we already have presence in, but there's an opportunity to backfill those without severe cannibalization. Once we reach that point, we do believe that we would reach a saturation point. As part of our long-term strategy, we always had anticipated that we needed a vehicle to continue our growth.

"We're currently focusing on improving operating margins through specifically identified expense-control measures, both at the central office and in the stores."

That's where the U.K. introduction made sense for the company -- to start a foothold in that market -- and over time we would have an entity we could expand similarly to how we did in the U.S. At this point in time, though, we are obviously reassessing and trying to improve the economics of the U.K. [business] before we make any type of rapid expansion as we've done in the North America operation.

TMF: What made the U.K. a more attractive country for operation rather than another European country?

Watanabe: Well, one of the things that was attractive was that we did an acquisition. So, there was an actual operating division of stores out there that we saw would be easier to introduce the values and benefits we could provide without having to build brick and mortar and open up a chain of stores from the ground level. We already had a clientele and a business that we assumed, so that was what was attractive. Also, there was no Petco <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: PETC)") else Response.Write("(Nasdaq: PETC)") end if %>, there's no Wal-Mart <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WMT)") else Response.Write("(NYSE: WMT)") end if %>, there's no grocery competition out there. So we felt this was an area we could be very successful in capturing quick ownership and becoming the category killer out there.

TMF: Well, speaking of grocery stores and Wal-Marts, how do you plan to compete with some of these stores that carry pet food? They might have lower prices. Would you consider lowering your prices to undercut them?

Watanabe: We feel that we compete very effectively with the grocery and discount stores. Our "every day low pricing" strategy that we currently have allows us to be at their sale price on an everyday basis. We also offer a selection of over 12,000 items versus their limited assortment. In addition, we offer premium dog and cat food which are unavailable at discount and grocery chains. We continue to monitor our pricing by market to ensure we are achieving and reacting to this competitive segment. We believe we've continued to take market share away from these businesses as we have become the full service, one-stop shopping store for the pet customer.

TMF: Great. Thank you so much, Mr. Watanabe, for speaking with us today.

Watanabe: OK, thank you for the opportunity to represent PETsMART.

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