Petmed Express, Inc.

Overview: On 12/21 we purchased 415 shares of Petmed Express, Inc. (ticker symbol: PETS) and are looking to purchase more in the event of any price weakness.

Investment Thesis: PETS operates an online and telephone pharmacy for prescription and non-prescription pet medicine, mostly for dogs, cats and horses, and is the market leader in the roughly $3.6B pet medicine market. PETS is a simple business and we have a simple investment thesis: We believe we've found an extremely capital light and scalable business with secular tailwinds and sustainable competitive advantages (a developing brand, a positive consumer experience and low prices) trading at a very reasonable valuation.

Business; Business Advantages: Despite PETS recent successes, most pet medicine today (roughly 80%) is sold through a veterinarian for marked up prices which reflect an expensive middleman. PETS is taking square aim at this large market. We, along with PETS management, believe that the long-term internet retail trend could very well affect the pet medicine market as much as the book or music markets. Setting aside emergency treatments, pet medicine is a product that translates easily to online sales - there isn't a consumer need for a unique or local experience and the product is small, light and easily shipped across long distances. Pet medicine is manufactured and sold by national pharmaceutical companies that have an interest in the greater consumption and consumer goodwill which results from lower retail prices. While the major pharmaceutical manufacturers have declined to sell directly to marketing companies such as PETS and instead sell indirectly to PETS through third party suppliers, PETS is working to develop direct supply channels with pharmaceutical companies for some widely purchased medicines. If successful, PETS could offer these medicines at even greater discounts which would further improve their competitive position. In addition to the broad-based internet consumption trend, we are attracted to the pet medicine business because it's anything but faddish, is recession resistant and is lightly regulated (unlike human medicine). We think it a foregone conclusion that spending on pet medicine will increase over time. We believe PETS is well positioned to participate in any increase in the broader pet medicine market while also gaining market share. In the grips of recession, the company attracted 802,000 new customers in 2009 vs. 710,000 in 2008.

Financials: The competitive advantages discussed above are demonstrated in PETS ten-year financials. In 2000, PETS generated $14.7M in revenue and lost $1.8M. In 2002, the company's first profitable year, PETS generated $32M in revenue, and $.8M in net income. In 2009, the company generated $219.4M in revenue and $23M in net income. PETS is one of those rare, scalable businesses where the bottom line grows quicker than the top line. The company's five-year average revenue growth rate is 18.5%, and five-year average net income growth rate is 31.4%. This difference can be explained by the operating leverage and cash flows an online retail operation can generate. As a very capital-light business, cash which doesn't need to be reinvested in the business can be used to repurchase the company's shares. PETS spent $11.6M in 2008 and $18.5M in 2009 in share repurchases. In 2009, the company began a quarterly dividend, rare for a young, high-growth company. Often a company's long-term competitive advantages can be seen in its annual return on assets and return on equity. PETS has maintained return on assets in the high 20s, and returns on equity in the low 30s over the last five years while offering consumers low prices for their pet medicine, an impressive feat that demonstrates the strength of this business.

Valuation: We think that PETS current price doesn't accurately reflect PETS growth prospects and business strengths. PETS trades at roughly 14.5x our estimate of fiscal year 2009 earnings, less on an enterprise value basis due to the more than $50M in excess cash on the company's balance sheet and its lack of debt. We think that it likely that both per share earnings and the stock's earnings multiple expand over the medium to long term, resulting in market-beating returns for this investment. Compare this multiple to other market-leading internet retailers: Amazon (AMZN) trades at roughly 74x trailing earnings, and Blue Nile Inc., the diamond retailer (NILE), trades at roughly 80x trailing earnings. Based on earnings growth and return on assets alone - admittedly a simplistic criteria - PETS is arguably a stronger company than either. (Note that we are not suggesting that PETS rivals Amazon in business strength or competitive advantages – we simply think we’re getting a much better bargain with PETS.)

The Amazon/Walmart Risk: We think that the market’s subdued enthusiasm for PETS can be largely attributed to the sense that the company's market position and continued growth is susceptible to a bigger, stronger competitor’s foray into the online pet medicine market, such as Amazon or Walmart. We think that it far more likely that a larger retailer would choose to purchase PETS at a hefty price given its growing customer base and customer goodwill. We also believe that the current thinking about Amazon – that it will become the Walmart of the internet, squeezing out niche online retailers – is an analogy to brick and mortar retail that doesn’t quite translate. Switching web pages is a much different experience than physically visiting many retail stores to purchase the goods one could buy at the lowest prices in a big box retailer. Finally, we think that purchasing pet medicine through PETS is a sticky user experience. As the market leader with the lowest prices and a quick and easy platform for repeat purchases, we find it unlikely that pet owners will actively shop around for pet medicine once plugged into the PETS system. Nevertheless, given PETS recent financial successes, we have little doubt that the online pet medicine business will attract competition and view the success of this competition as the single largest risk to this investment. We see the success of the company's advertising and the steps the company takes to create an increasingly efficient and enjoyable user experience as the two most critical components to staving off competition. Given the low capital requirements of the business, we wouldn't mind seeing an increase in advertising spending and website development at the expense of short term earnings.