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PETM > SEC Filings for PETM > Form 10-K on 28-Mar-2013All Recent SEC Filings

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Form 10-K for PETSMART INC


28-Mar-2013

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could materially differ from those discussed here. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this section, as well as in the sections entitled "Competition," "Our Stores," "Distribution" and "Government Regulation" included in Item 1, Part I and Risk Factors included in Item 1A, Part I of this Annual Report on Form 10-K.

Overview
Based on our 2012 net sales of $6.8 billion, we are North America's leading specialty provider of products, services and solutions for the lifetime needs of pets. As of February 3, 2013, we operated 1,278 stores, and we plan to continue our store growth in 2013. Our stores carry a broad assortment of high-quality pet supplies at everyday low prices. We offer approximately 11,000 distinct items in our stores and 10,000 additional items on our website, PetSmart.com, including nationally recognized brand names, as well as an extensive selection of proprietary brands across a range of product categories.

We complement our extensive product assortment with a wide selection of pet services, including grooming, training, day camp for dogs and boarding. All our stores feature pet styling salons that provide high-quality grooming services and offer comprehensive pet training services. Our PetsHotels provide boarding for dogs and cats, which includes 24-hour supervision by caregivers who are PetSmart trained to provide personalized pet care, temperature controlled rooms and suites, daily specialty treats and play time, as well as day camp for dogs. As of February 3, 2013, we operated 196 PetsHotels.

We make full-service veterinary care available through our strategic relationship with certain third-party operators. As of February 3, 2013, full-service veterinary hospitals were in 816 of our stores. MMI Holdings, Inc., through a wholly owned subsidiary, Medical Management International, Inc., collectively referred to as "Banfield," operated 809 of the veterinary hospitals under the registered trade name of "Banfield, The Pet Hospital." The remaining 7 hospitals are operated by other third parties in Canada.

The principal challenges we face as a business are the highly competitive market in which we operate and volatility in the macro-economy. However, we believe we have a competitive advantage in our solutions for the Total Lifetime CareSM of pets, including pet services and proprietary brands, which we think cannot be easily duplicated. Additionally, we consider our cash flow from operations and cash on hand to be adequate to meet our operating, investing and financing needs in the foreseeable future, and we continue to have access to our revolving credit facility. We continuously assess the economic environment and market conditions to guide our decisions regarding our uses of cash, including capital expenditures, investments, dividends and the purchase of treasury stock.


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Executive Summary
The year ended February 3, 2013, consisted of 53 weeks while all other periods presented consisted of 52 weeks. As a result, all comparisons for the year ended February 3, 2013, other than comparable store sales, which was calculated on an equivalent 53 week basis, also reflect the impact of one additional week.
Diluted earnings per common share for 2012 increased 39.2% to $3.55 on net income of $389.5 million compared to diluted earnings per common share of $2.55 on net income of $290.2 million in 2011. The additional week increased diluted earnings per common share by approximately $0.17.

Net sales increased 10.5% to $6.8 billion in 2012 compared to $6.1 billion in 2011. The increase in net sales included an estimated impact from the additional week of $126.0 million and an unfavorable impact from foreign currency fluctuations of $1.9 million.

Comparable store sales, or sales in stores open at least one year, increased 6.3% during 2012 compared to a 5.4% increase during 2011.

Services sales increased 9.7% to $740.5 million, or 11.0% of net sales, for 2012 compared to $674.9 million, or 11.0% of net sales, during 2011. The increase in services sales included an estimated impact from the additional week of $12.8 million.

As of February 3, 2013, we had $335.2 million in cash and cash equivalents and $71.9 million in restricted cash. We had no short-term debt, and did not borrow against our revolving credit facility during 2012.

We purchased 7.2 million shares of our common stock for $456.6 million during 2012, and 7.6 million shares of our common stock for $336.8 million during 2011.

We added 46 net new stores during 2012, and operated 1,278 stores at the end of the year.

Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our estimates for inventory valuation reserves, asset impairments, reserve for closed stores, insurance liabilities and reserves, and income tax reserves. We base our estimates on historical experience and on various other assumptions we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Under different assumptions or conditions, actual results may differ from these estimates. We believe the following critical accounting policies reflect the more significant judgments and estimates we use in preparing our consolidated financial statements.

Although we believe that the judgments and estimates discussed herein are reasonable, actual results could differ, and we may be exposed to losses or gains that could be material.

Inventory Valuation Reserves
We have established reserves for estimated inventory shrinkage between physical inventories. Distribution centers perform cycle counts using a velocity based system that determines whether the inventory should be counted every 30, 90, 180, or 365 days. Stores generally perform physical inventories at least once a year. Between the physical inventories, stores perform counts on certain inventory items. For each reporting period presented, we estimate the inventory shrinkage based on a two-year historical trend analysis. Changes in shrink results or market conditions could cause actual results to vary from estimates used to establish the inventory reserves.

We also have reserves for estimated obsolescence and to reduce merchandise inventory to the lower of cost or market. We evaluate inventories for excess, obsolescence or other factors that may render inventories unmarketable at their historical cost. Factors included in determining obsolescence reserves include current and anticipated demand, customer preferences, age of merchandise, seasonal trends and decisions to discontinue certain products. If assumptions about future demand change, or actual market conditions are less favorable than those projected by management, we may require additional reserves.

We have not made any significant changes in the accounting methodology we use to establish our inventory valuation reserves during the past three fiscal years. We do not presently believe there is a reasonable likelihood of a material change in the accounting methodology and assumed factors used to create the estimates we use to calculate our inventory valuation reserves.


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As of February 3, 2013, and January 29, 2012, we had inventory valuation reserves of $11.8 million and $11.6 million, respectively. Additionally, we do not believe that a 10% change in our inventory valuation reserves would be material to our consolidated financial statements.

Asset Impairments
We review long-lived assets for impairment on a quarterly basis and whenever events or changes in circumstances indicate that the book value of such assets may not be recoverable.

We have not made any significant changes in our impairment loss assessment methodology during the past three fiscal years. We do not presently believe there is a reasonable likelihood that there will be a material change in the estimates or assumptions used to calculate long-lived asset impairment losses. No material asset impairments were identified during 2012, 2011 or 2010.

Reserve for Closed Stores
We continuously evaluate the performance of our stores and periodically close those that are under-performing. Closed stores are generally replaced by a new store in a nearby location. We establish reserves for future occupancy payments on closed stores in the period the store is closed. These costs are classified in operating, general and administrative expenses in the Consolidated Statements of Income and Comprehensive Income. As of February 3, 2013, and January 29, 2012, our reserve for closed stores was $8.7 million and $10.0 million, respectively. We do not believe there is a reasonable likelihood of a material change in the future estimates or assumptions used to determine our reserve for closed stores, including cash flow projections and sublease assumptions. We do not believe that a 10% change in our reserve for closed stores would be material to our consolidated financial statements.

Insurance Liabilities and Reserves
We maintain workers' compensation, general liability, product liability and property and casualty insurance. We utilize high deductible plans for each of these areas as well as a self-insured health plan for our eligible associates. Workers' compensation deductibles generally carry a $1.0 million per occurrence risk of claim liability. Our general liability plan specifies a $0.5 million per occurrence risk of claim liability. We establish reserves for claims under workers' compensation and general liability plans based on periodic actuarial estimates of the amount of loss for all pending claims, including estimates for which claims have been incurred but not reported. Our loss estimates rely on actuarial observations of ultimate loss experience for similar historical events and changes in such assumptions could result in an adjustment, favorable or adverse, to our reserves. As of February 3, 2013, and January 29, 2012, we had approximately $107.2 million and $102.8 million, respectively, in reserves related to workers' compensation, general liability and self-insured health plans.

We have not made any material changes in the accounting methodology we use to establish our insurance reserves during the past three years. We do not believe there is a reasonable likelihood of a material change in the estimates or assumptions used to calculate our insurance reserves, including factors such as historical claims experience, demographic factors, severity factors and other valuations. However, if actual results are not consistent with our estimates or assumptions, we may be exposed to losses or gains that could be material. A 10% change in our insurance reserves would have affected net income by approximately $6.7 million in 2012.

Income Tax Reserves
We establish deferred income tax assets and liabilities for temporary differences between the financial reporting bases and the income tax bases of our assets and liabilities at enacted tax rates expected to be in effect when such assets or liabilities are realized or settled. We record a valuation allowance on the deferred income tax assets to reduce the total to an amount we believe is more likely than not to be realized. Valuation allowances at February 3, 2013, and January 29, 2012, were principally to offset certain deferred income tax assets for net operating loss carryforwards.

We operate in multiple tax jurisdictions and could be subject to audit in any of these jurisdictions. These audits can involve complex issues that may require an extended period of time to resolve and may cover multiple years. To the extent we prevail in matters for which reserves have been established, or are required to pay amounts in excess of our reserves, our effective income tax rate in a given fiscal period could be materially affected. An unfavorable tax settlement would require use of our cash and could result in an increase in our effective income tax rate in the period of resolution. A favorable tax settlement could result in a reduction in our effective income tax rate in the period of resolution.


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Recently Issued Accounting Pronouncements See Note 2, Recently Issued Accounting Pronouncements, in the Notes to the Consolidated Financial Statements included in this Annual Report on Form 10-K for a description of recently issued accounting pronouncements, including the impact to our consolidated financial statements.

Results of Operations
The following table presents the percent to net sales of certain items included in our Consolidated Statements of Income and Comprehensive Income:

                                                                         Year Ended
                                                 February 3, 2013     January 29, 2012     January 30, 2011
                                                    (53 weeks)           (52 weeks)           (52 weeks)
Net sales                                              100.0  %             100.0  %             100.0  %
Total cost of sales                                     69.5                 70.5                 70.9
Gross profit                                            30.5                 29.5                 29.1
Operating, general and administrative expenses          20.9                 21.3                 21.5
Operating income                                         9.6                  8.2                  7.5
Interest expense, net                                   (0.8 )               (0.9 )               (1.0 )
Income before income tax expense and equity
income from Banfield                                     8.8                  7.3                  6.5
Income tax expense                                      (3.3 )               (2.7 )               (2.5 )
Equity income from Banfield                              0.2                  0.2                  0.2
Net income                                               5.7  %               4.7  %               4.2  %

2012 (53 weeks) Compared to 2011 (52 weeks) Net Sales
Net sales increased 10.5% to $6.8 billion in 2012, compared to net sales of $6.1 billion in 2011. The increase in net sales included an estimated impact of the additional week of $126.0 million and an unfavorable impact from foreign currency fluctuations of $1.9 million. Approximately 60% of the sales increase is due to a 6.3% increase in comparable store sales for 2012, 20% of the sales increase is due to the addition of 46 net new stores and 4 new PetsHotels since January 29, 2012, and 20% of the sales increase is due to the 53rd week.

Comparable store sales growth was driven by an increase in comparable transactions and average sales per comparable transaction. Comparable transactions were 2.4% for 2012, including the impact of the additional week, and 2.5% for 2011.

During 2012, we have implemented several initiatives to increase traffic and continue to improve average sales per transaction. We continue to see strength in our super premium/natural food category and sales of our channel exclusive foods represented more than 75% of our food sales. We expanded the space in these categories with a consumables reset during the thirteen weeks ended April 29, 2012, adding innovative new formulations and expanded grain-free and limited ingredient assortments in dog and cat. In hardgoods, we refreshed and rebranded the dog toy aisle during the thirteen weeks ended July 29, 2012, with the PetSmart Toy Chest reset. Also during the thirteen weeks ended July 29, 2012, we reset the aquatics and small animal categories to support the growing trends by adding hundreds of new items and improving the category adjacencies and flow. We also added solutions-based signage designed to inspire and educate in order to drive continued momentum in this category. During the thirteen weeks ended October 28, 2012, we began expanding our offerings of exclusive and proprietary brands. Finally, we have made more than twenty website enhancements this year and during the thirteen weeks ended October 28, 2012, we launched our Canada site on PetSmart.com.

Services sales, which include grooming, training, day camp for dogs and boarding, increased 9.7%, or $65.6 million, to $740.5 million for 2012, compared to $674.9 million for 2011. Services sales represented 11.0% of net sales for 2012 and 2011. The increase in services sales is primarily due to continued strong demand for our quality grooming services, the addition of 46 net new stores and 4 new PetsHotels since January 29, 2012, and the additional week, which increased services sales by $12.8 million.

Other revenue included in net sales during 2012, represents license fees and reimbursements for utilities and specific operating expenses charged to Banfield under the master operating agreement which comprised 0.6% of net sales, or $38.2 million, in 2012, compared to 0.6% of net sales, or $36.7 million, during 2011. There was no impact of the additional week on other revenue.


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Gross Profit
Gross profit increased 100 basis points to 30.5% of net sales for 2012, from 29.5% for 2011. Overall merchandise margin increased 15 basis points primarily due to rate improvement. Services margin increased 5 basis points. Store occupancy and supply chain costs included in margin provided 55 and 10 basis points of leverage, respectively. The additional week increased margin by 15 basis points.

Operating, General and Administrative Expenses Operating, general and administrative expenses decreased 40 basis points to 20.9% of net sales for 2012, from 21.3% of net sales for 2011. Operating, general and administrative expenses increased on a dollar basis by $109.6 million. The primary reasons for the year over year increase include store growth, planned incremental advertising spend focused on our differentiated offerings, and the additional week, which increased operating, general and administrative costs by $18.3 million.

Interest Expense, net
Interest expense, which is primarily related to capital lease obligations, decreased to $55.6 million for 2012, compared to $58.1 million for 2011 due to a decrease in capital lease obligations. Included in interest expense, net was interest income of $1.3 million for 2012 and for 2011.

Income Tax Expense
Income tax expense for 2012 and 2011 was $223.3 million and $167.0 million, respectively. Both 2012 and 2011 had an effective tax rate of 37.4%. The effective tax rate is calculated by dividing our income tax expense, which includes the income tax expense related to our equity income from Banfield, by income before income tax expense and equity income from Banfield.

Equity Income from Banfield
Our equity income from our investment in Banfield was $16.0 million and $10.9 million for 2012 and 2011, respectively, based on our 21.0% ownership in Banfield.

2011 (52 weeks) Compared to 2010 (52 weeks)

Net Sales
Net sales increased 7.4%, to $6.1 billion in 2011, compared to net sales of $5.7 billion in 2010. The increase in net sales was partially impacted by $11.2 million in favorable foreign currency fluctuations during 2011. Approximately 75% of the sales increase is due to a 5.4% increase in comparable store sales for 2011, and 25% of the sales increase is due to the addition of 45 net new stores and 12 new PetsHotels since January 30, 2011.

Comparable store sales growth was driven by an increase in comparable transactions and average sales per comparable transaction due to the impact of merchandising strategies, pricing strategies and new product offerings. Comparable transactions were 2.5% for 2011 and 2.1% for 2010.

Services sales, which include grooming, training, day camp for dogs and boarding, increased 9.1%, or $56.1 million, to $674.9 million for 2011, compared to $618.8 million for 2010. Services sales represented 11.0% and 10.9% of net sales for 2011 and 2010, respectively. The increase in services sales is primarily due to continued strong demand for our grooming services, and the addition of 45 net new stores and 12 new PetsHotels since January 30, 2011.

Other revenue included in net sales during 2011, represents license fees and reimbursements for utilities and specific operating expenses charged to Banfield under the master operating agreement which comprised 0.6% of net sales, or $36.7 million, in 2011, compared to 0.6% of net sales, or $34.2 million, during 2010.

Gross Profit
Gross profit increased 40 basis points to 29.5% of net sales for 2011, from 29.1% for 2010.

Overall merchandise margin increased 5 basis points due to a 20 basis point improvement in rate, which was offset by a 15 basis point decline in mix. The rate improvement is the result of increased sales of higher margin goods within the product categories and improvement in shrink during 2011, relative to 2010. Mix was negatively impacted as the sales growth in our consumables continued to outpace the sales growth of our higher margin hardgoods category. Hardgoods merchandise includes pet supplies


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such as collars, leashes, health care supplies, grooming and beauty aids, toys and apparel, as well as pet beds and carriers. Consumables merchandise sales, which include pet food, treats, and litter, generate lower gross margins on average compared to hardgoods merchandise.

Services margin increased 5 basis points primarily due to increased sales as well as a shift to higher margin offerings in our grooming services. Services sales typically generate lower gross margins than merchandise sales as service-related labor is included in cost of sales; however, services generate higher operating margins than merchandise sales.

Store occupancy costs included in margin provided 30 basis points due to leverage associated with the increase in net sales.

Operating, General and Administrative Expenses Operating, general and administrative expenses decreased 20 basis points to 21.3% of net sales for 2011, from 21.5% of net sales for 2010. Operating, general and administrative expenses increased on a dollar basis by $75.5 million. The primary reasons for the year over year increase include store growth, planned incremental advertising spend focused on our differentiated offerings and higher incentive compensation.

Interest Expense, net
Interest expense, which is primarily related to capital lease obligations, decreased to $58.1 million for 2011, compared to $59.6 million for 2010 due to a decrease in capital lease obligations. Included in interest expense, net was interest income of $1.3 million and $0.8 million for 2011 and 2010, respectively.

Income Tax Expense
For 2011, the $167.0 million income tax expense represents an effective tax rate of 37.4% compared with 2010, when we had income tax expense of $140.4 million, which represented an effective tax rate of 38.0%. The decrease in the effective tax rate was primarily due to a tax deductible dividend received from Banfield, partially offset by an increase in certain state tax liabilities. The effective tax rate is calculated by dividing our income tax expense, which includes the income tax expense related to our equity income from Banfield, by income before income tax expense and equity income from Banfield.

Equity Income from Banfield
Our equity income from our investment in Banfield was $10.9 million and $10.4 million for 2011 and 2010, respectively, based on our 21.0% ownership in Banfield.

Liquidity and Capital Resources
Cash Flow
We believe that our operating cash flow and cash on hand will be adequate to meet our operating, investing and financing needs in the foreseeable future. In addition, we have access to our $100.0 million revolving credit facility, which expires on March 23, 2017. However, there can be no assurance of our ability to access credit markets on commercially acceptable terms in the future. We expect to continuously assess the economic environment and market conditions to guide our decisions regarding our uses of cash, including capital expenditures, investments, dividends and the purchase of treasury stock.

We finance our operations, new store and PetsHotel growth, store remodels and other expenditures to support our growth initiatives primarily through cash generated by operating activities. Receipts from our sales come from cash, checks and third-party debit and credit cards, and therefore provide a significant source of liquidity. Cash is used in operating activities primarily to fund procurement of merchandise inventories and other assets, net of accounts payable and other accrued liabilities. Net cash provided by operating activities was $653.0 million for 2012, $575.4 million for 2011, and $457.6 million for 2010. The primary differences between 2012 and 2011 include increased net income of $99.3 million and an increase in trade accounts payable resulting from the extension of vendor payment terms of $51.3 million. This was partially offset by incremental increases in merchant receivables of $20.2 million and deferred income tax assets of $17.3 million in 2012 as compared to 2011. The primary differences between 2011 and 2010 include increased net income of $50.4 million, an increase in non-trade accounts payable resulting from the extension of vendor terms of $29.6 million, a reduction in growth of merchandise inventories of $21.8 million and the $16.0 million dividend received from Banfield in 2011, as no dividends were received in 2010.

Net cash used in investing activities consisted primarily of expenditures associated with opening new stores, reformatting existing stores, expenditures associated with equipment and computer software in support of our system initiatives, PetsHotel construction costs, and other expenditures to support our growth plans and initiatives. Net cash used in investing activities was $114.6 million for 2012, $155.4 million in 2011 and $147.9 million in 2010. The primary difference between 2012 and 2011 was


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a decrease in purchases of investments of $34.7 million, and an increase in maturities of investments of $13.0 million, offset by an increase in cash paid for property and equipment of $17.8 million. The primary difference between 2011 and 2010 was purchases of investments.

Net cash used in financing activities was $545.9 million for 2012, $369.4 million for 2011 and $328.1 million for 2010. Cash used in 2012 consisted primarily of cash paid for treasury stock, payments of cash dividends, payments on capital lease obligations, and a decrease in our bank overdraft, offset by net proceeds from common stock issued under equity incentive plans and excess tax benefits from stock-based compensation. The primary difference between 2012 and 2011 was an increase in cash paid for treasury stock of $98.5 million and a decrease in bank overdraft of $59.0 million. The primary differences between 2011 and 2010 were an increase in cash paid for treasury stock of $73.5 million and an increase in our bank overdraft of $31.2 million.

Free Cash Flow . . .

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