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Neil Currie is 20+ year Industry Veteran and 5-time member of the Institutional Investor All-America Research Team. Neil has been profiled by various industry media outlets, including appearances on

CNBC and Bloomberg LP TV.

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The Power of Emotional Content: PETM, LB, WFM, TGT, DIS, COST

By Neil Currie, June 25, 2014

Price and range are becoming harder for retailers to differentiate in a multi-channel

environment Winning retailers often focus on other factors to win market share and secure

customer loyalty We highlight emotional content as one critical factor that has led to retailer success

and assess the emotional connection of certain public retailers Long-term winners in terms of emotional content include PetSmart, Whole Foods

Market, L Brands (Victoria’s Secret), Disney and Costco. Target has been a winner in the past, but questions remain about whether the company can regain its mojo.

PETM, LB and WFM look interesting long-term plays in the context of current vs. historic valuation

Location. Price. Range. Quality. Customer Service. These have been the cornerstones on which great retail businesses are founded. In the past couple of decades, with the rise of Category Killers, Supercenters and, more recently, Internet retailers, many of the winners of market share have been those who have been able to offer compelling (wide) ranges along with low prices, or at least a promise to match low prices. For many brick and mortar retailers, this environment is tough to deal with – how can retailers compete on price when the customer can use a search engine to find the lowest price on pretty much any product and either get it delivered or pick it up from a store? And how can retailers promise to be range specialists when, similarly, shoppers can find what they are looking for with a click of their mouse or phone?

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Everything is now cheap – it’s official. And we can get everything. If a retailer hasn’t already convinced its customers of their credibility in these areas, it is probably too late, or too expensive to change perceptions. It is possible to buck this trend, however. One way is to have a unique product offering that can’t be bought anywhere else. Examples of this would include single-branded apparel or accessory retailers – although being totally unique is rare; Coach and Michael Kors sell similarly styled bags at similar prices. One brand just happens to be “on the up” and the other “on the way down”. However, there are some retailers that have moved the conversation with customers away from simply range and price to something that is hard to quantify, but has become a major factor in shoppers’ decision-making processes – emotional connection. Whole Foods Market (NYSE:WFM) There are many supermarkets selling wide ranges of food, some doing it better than others. But Whole Foods has driven an emotional connection with its customers that has transcended simply having nice stores and a wide range of organic product. Sure, the company has been delighting customers for many years with its high quality offering and beautiful stores, but many supermarkets - as Wall Street keeps trying to remind us – have caught up with organic ranges and better fresh/convenience food items. Whole Foods, however, continues to drive sales growth ahead of the industry despite having sales densities more than double conventional retailers, including other “Fresh” retailers such as Sprouts and The Fresh Market. Whole Foods has cultivated a brand that represents and answer to those seeking to improve their health and wellbeing through diet and access to quality ingredients, while paying respect to the environment and how food is sourced. This is no longer just an organic food store – it is part of a way of life. As a result, we don’t buy into scare stories about encroachment into organic foods by other retailers – this is not a new story. How Whole Foods sells organic foods is the key to its success. While same store sales growth has moderated, it is still well ahead of the industry – on such a productive base, this is still something to be lauded. We would view Whole Foods’ share price drop in the past quarter as an opportunity for the long term. WFM’s share price has fallen almost 40% since its late 2013 peak and the consensus forward PE from over 30x to 23x. History has shown the benefit of taking advantage of short-term breakdowns. WFM has historically been priced for perfection and imperfect moments such as Q2’s earnings release are often the moments to pounce.

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PetSmart (NASDAQ:PETM) Perhaps one of the best examples of using emotional content as a tool to resurrect a business is PetSmart. A former “Category Killer”, in 2000, PetSmart was a struggling company, with a 2% Operating Margin and achieving a Net Loss. The company started as a pet food warehouse in 1986, selling a wide range of pet products. Like many other specialty retailers in the 1990’s and 2000’s, PetSmart began to lose share in key categories, such as dog food, as Walmart and other mass retail models grew, attracting customers with one-stop shopping across a broad range of high-volume items. It had lost the argument on price, and having a wide range of slower-moving items was not enough on which to base a business model. In 2000, PetSmart introduced a new store prototype and a new Vision Statement that said little about price and range. The company promised: “To provide total lifetime care for every pet, every parent, every time”. The new store prototype also introduced new services for pet owners. PetSmart now has full grooming facilities and dog training services in all of its 1,300+ stores. 63% have full veterinary care service through its joint venture with Banfield. PetSmart is now seen as a solutions center. With the continuing humanization of pets, PetSmart has taken a leadership roll in enabling pet owners to pamper their beloved animals. In-store services have given PetSmart a halo that gives customers more reasons to visit the store, has helped the company regain authority as a pet specialist, created a barrier to competition against mass merchants and helped create an emotional bond with pet owners. Pet Services, excluding veterinary, only account for 11% of total revenues, but the impact on PetSmart’s underlying business has been significant. Not only has PetSmart been able to defend its business better against competition but since embarking on its new vision, the

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company has grown sales and profitability over a sustained period like few others in retail have. Over the past decade PetSmart has grown EPS an average 17% per year. The company generates an EBITDA margin of 13.7%, a stellar return for any retail business, let alone one where consumables account for 54% of sales. ROIC is an equally impressive 36.2%.

PetSmart continues to develop its emotional content and its dialogue with customers and is developing more personalized relationships with individual pet parents through technology and loyalty schemes. Its marketing, even its pet food ads, touch on nutrition and health before getting to the business message of range and value. Pet owners no longer see PetSmart as simply a place to buy pet products – PetSmart “has their back”. But let’s not get too far from the real point here – in a classic case of obliquity, PetSmart is selling more dog food. It may be doing so in a more sophisticated way than previously, and the use of emotional content is genuine and now ingrained in the company’s DNA, but in an era where consumers are more informed than ever and have more choice than ever, PetSmart has built a lasting business model that is more difficult to undermine with disruptive competitive activity. PetSmart is emerging from a stellar period of comparable store sales growth, the metric that has such an important influence on share price direction, especially in the short term. PetSmart has recently seen a slow down in comp store sales, partly due to tough two-year comparisons and partly due to greater competition. This has been reflected in PetSmart’s share price, which has retreated by almost 25% since its early October 2013 high. Consensus forward PE has fallen from almost 17x to just over 12x.

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In Q1 2014, comp sales declined 0.6%. The market was, not unreasonably, vexed at this and to some extent this was not a surprise given the strength of the Q1 performances in the previous two years. However, it was a little more than anticipated, with the 3-year comp trend (a trend we closely follow) showing some continued moderation. Nevertheless, the share price is now discounting a lot of negativity. Comparisons will ease meaningfully as the fiscal year progresses and comp growth should resume from Q3. The pet market is one of the most robust in retail and PetSmart’s exposure to the even faster

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growing pet services market should provide a level of comfort for investors looking to take advantage of the low multiple PETM is trading on right now. So if PetSmart and Whole Foods are case studies for the power of emotional content, which other companies can we identify as transcending mere price and range and is answering key emotional questions in shoppers’ minds? And are there any opportunities for investor? Target (NYSE:TGT) Target became more than simply “Expect More, Pay Less” as it morphed into “Cheap Chic” during the last decade. With the help of Michael Francis and Isaac Mizrahi, Target hit the fashion pages and became a highly credible alternative for shoppers wanting Wal-Mart prices allied with contemporary design. However, with Target focusing more and more on food (where its ranges are not so differentiated), Mizrahi departing for Liz Claiborne and Michael Francis leaving for JC Penney, Target’s differentiation seems to have been diluted. Additionally, with the advent of new value fashion entrants in the US, such as H&M, Forever 21 and Uniqlo, Target is no longer unique. We think the company needs time to refocus its efforts; perhaps something its new CEO can focus on. Meantime, there are perhaps too many questions to make Target a compelling long-term opportunity right now. We sense there is a renewed focus to rediscover the company’s lost mojo, but this could take time to translate into earnings revisions. Meantime, valuation is not compelling and we would wait for evidence of renewed brand focus and/or a forward PE closer to 11-12x before getting more interested.

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L Brands - Victoria’s Secret (NYSE:LB) One word – “Sexy”. VS has never wavered in it core mission to help women look and feel sexy, even faced with economic uncertainty. As a result it has developed a commanding lead in the US intimate apparel market and is now looking to rule the World – its seems that there are enormous opportunities to export this appeal and International could be a key driver of L Brands’ growth longer term. Perhaps the best opportunity to buy L Brands was back in February following a period of sharp underperformance between issuing its fourth quarter trading statement in January and its January sales release. However, we see Victoria Secret’s global emotional appeal as the foundation of a strong long-term growth story and wouldn’t regard 13.5x consensus EPS as overly expensive.

Disney (NYSE:DIS) The company’s internal message is “Family Magic”. If a project does not fit these criteria, it isn’t for Disney. At a forward PE multiple of 18x, the stock’s share price reflects its success in executing this strategy. Holders should remain happy.

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Costco (NASDAQ:COST) While Costco does little advertising and has no catchy slogan, its members, who in turn evangelize the benefits of being a Costco cardholder, love the company – a tough emotion to evoke. Costco is a smart place to shop and the company works hard to justify its annual membership fees (the majority of profits) through low product prices (driven by margin ceilings) and high quality. Its low-frill stores seemingly reinforce the message that delivering value is the sole purpose of the business. Additionally, Costco has, for many years, defied Wall Street by paying premium wages and benefits – we see this as a smart move economically as it has led to some of the most productive employees in retail, as well as one of the lowest rates of employee turnover. If we have one reservation about Costco it is that its customer base has grown with the company and Costco ‘s product range is not necessarily as up to date with the tastes of today’s family formers, as it was in the past. Costco may need to introduce a little more freshness. However, as ever with Costco, we continue to look for compelling long term entry points. We are just not sure that 22x consensus EPS estimates is overly compelling.

Neil Currie Managing Director

Consumer Markets Strategist ncurrie@mischlerfinancial.com

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