This pet stock is in the doghouse, but now may be a golden opportunity to buy.

It’s been an ugly couple of years. Petco (WOOF 14.57%).

Shares of the diversified pet products retailer are now down 90% from their peak (2021 initial public offering). Several factors combined to send the stock plunging.

The pet industry boomed during the pandemic, but during the economic reopening, demand has declined as consumers shift their spending to other sectors, particularly those affected by the pandemic such as travel and food. Duran was out of bounds. Discretionary spending has tightened in an inflationary environment. This is a problem not only for Petco, but also for the partners. The chewerwhich recently hit an all-time low.

But it’s not just category-level demand that’s troubling Petco. Profit margins have also sunk. In the third quarter of fiscal 2023, gross margin fell to 36.8 percent from 39.8 percent in the year-ago quarter. The company also lost money on an adjusted basis with a net loss of $14.5 million compared to an adjusted profit of $30.0 million last year.

Management responded by promising to cut costs, targeting $150 million in cost savings by the end of 2025, but the stock still fell 29 percent on the report.

Image source: Getty Images.

It’s not all bad.

While overall numbers are clearly an issue for Petco, the company is making progress on key strategic initiatives. Third-quarter revenue from services, which includes veterinary visits and grooming, rose 15% year-over-year. This is important because the segment builds customer loyalty by helping to grow the company’s membership program, VitalCare Premier, which now has 672,000 subscribers.

It’s also expanding its veterinary program, adding 433 vets this quarter (up 21% year-over-year) and seeing a 17% increase in the number of pets it sees. Digital sales continued to increase by 5%, and consumer goods sales were also positive, up 1.5%.

Management aims to improve profitability in 2024 by responding to changing consumer buying patterns as the pre-COVID stimulus payouts fade. It also said the upfront cost of labor and logistics to get new products on the shelves has hurt profits, though it expects to see a benefit from those initiatives next year.

Why this could be a great buying opportunity.

Petco stock may have fallen, but it’s not a company that’s going out of business. It is the second-largest pet products chain in the country, by locations, just behind PetSmart. And it’s well ahead of the No. 3 company, Pet Valu.

The pet products industry is in no danger of dying out. Not only is petting a sustainable business, it’s recession proof because pet owners still need to spend on their pets in a down economy.

In other words, Petco faces mostly temporary setbacks, some self-inflicted and some from changes in consumer demand, but the stock price is as if the business is fundamentally broken. It now trades at one. Price-to-sales ratio At only 0.14, an unusually low price even for a retailer.

To put this in perspective, if a company had a profit margin of only 1%, it would have a Price-to-earnings ratio If it is able to generate a 2% or even 3% profit margin (as it has), its P/E will fall to 7 or 5, respectively, at current stock price and revenue levels.

The higher the profit margin the company can drive, the higher the stock price will go, not just for valuation reasons but because it will reflect a stronger business.

Management’s turnaround plan looks plausible: Add brands that customers want, even when it reduces gross margins, and reduce costs and drive efficiencies where available. Consumer discretionary spending won’t be low forever, and most investors now expect interest rates to start coming down next year, which will hurt Petco’s bottom line due to interest on its variable-rate debt. There will be a boost by reducing costs.

Although the company has a lot of work to do to fix the business, the stock is quite undervalued at the current price. Petco stock may be risky, but investors who shrug off the uncertainty could be rewarded with a multibagger down the road.

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