“I was worried about Walmart coming into that [PetSmart] business, just the way people were worried Walmart would come into Best Buy’s. I was too, too, nervous.  It looks to me, I got it wrong…Walmart did not even lay a glove on them.” — CNBC’s Mad Money 12/16/2009

On Wednesday’s Mad Money a caller asked Cramer about PetSmart (PETM) during his Lightening Round.  Even as the stock is breaking new 52-week highs recently, Cramer issued a mea culpa on his former bearishness and is now bullish on the specialty pet retailer.  In the past, Cramer had been scared by Walmart’s (WMT) possible expansion into the Pet retail space.  Apparently, Walmart has not affected PetSmart’s business as the company has been one of the most consistent performers in all of retail.  It just goes to show you consumers will continue to buy food, toys, and grooming services for their pets even when money gets tight.

As you can see from our historical ratings chart for PetSmart, we have felt this stock has been Undervalued for quite some time.  We have observed the company slowly but surely continue to improve their fundamentals that underpin any business, namely sales and cash earnings.  Perhaps, as the company has started to find some momentum, the market is starting to come around to the underlying value in the stock.   Looking back at how the market has historically viewed PETM, the stock has normally traded at a price-to-cash earnings somewhere between 7.95x and 14.31x.  Even at the latest 52-week high price that metric stands below the historical range at 7.59x.  Similarly, the current price-to-sales per share stands at .63x, whereas the historical range is somewhat higher at .66x and 1.18x.

For a long term investor, we believe it is reasonable to assume that the market will begin to value PetSmart more in line with its previous valuations.  That assumption would translate to the stock trading in the low-$30 territory before too long.  We are reaffirming our Undervalued stance on Petsmart as it is one of the most consistent and best managed stocks in the retail space.  We can understand why Cramer was so nervous by Walmart’s foray into pet products, but up until now it has had a minimal effect on PetSmart.

Gamestop (GME) reported fiscal first quarter results to the market today that were in line with estimates with EPS coming in at $.42.  Revenue was also reported in-line with expectations of $1.98 billion, which shows growth of 9.8% from a year ago.  However, GME stock is trading down nearly 17% on Thursday afternoon after the company lowered second quarter earnings guidance and comparable store sales.  At Ockham, we are always looking to find disproportionate responses to earnings releases because often value can be found in a stock that has just endured a major downtrend.  We believe this could be just that sort of opportunity for investors that have a long term time frame.

“Gamestop down 15%, they lowered their outlook, second quarter outlook. They cut it based on what they’re seeing but also beat so Gamestop doing really well with a couple big video games — people are buying video games they’re staying at home, need entertainment.” Fox Business Network 5/21/2009

Ok, so Gamestop reported same store sales were down 1.5%-2% in the recent quarter, and expects that important measure of retail to fall 8% to 11% in the following quarter.  So it  sounds like sales and earnings are going to struggle, why would we be considering an upgrade at this time?  First of all, the company is reaffirming expectations for the full year 2010 earnings, guidance calls for a range of $2.83 to $2.93 with the mid point of that range being slightly better than analysts estimates of $2.87.  Assuming that Gamestop can hit the $2.87 over the next three quarters, they are selling at only 7.6 times earnings or only 9 times fiscal 2009’s already reported EPS of $2.40.  That is a fairly cheap multiple for an established company, and an extremely cheap multiple for a retailer that is growing sales at 43% per annum in the last 5 years. Earnings growth has been equally impressive growing at a 35% clip in the last five years.  Furthermore, even though the growth rate may have slowed in the past year, it is growing none the less as earnings are expected to grow at a rate of 19% this year.

Additionally, the lower same store sales and earnings for the 2Q are being compared to the quarter a year ago that featured major game releases including the latest titles of Grand Theft Auto and Guitar Hero.  Those are two of the most successful games of all time, and the coming quarter simply does not have the blockbuster games that were released a year ago.  This is not necessarily great news for Gamestop but it shows that it is not an internal problem that is causing the second quarter slowdown.

Coming into the day, with Gamestop trading in the mid $20’s we had a Fairly Valued rating but the current price-to-cash flow and price-to-sales metrics were very near breaking through the low end of their historical ranges.  The stock trading down 16% on news that we find to be not all that distressing.  Game sales have been particularly recession resistant as evidenced by Gamestop’s growth.  The company has shown solid performance despite the cutbacks in consumer spending around the country.  So, we see this rapid price decline today as a possible entry point for the opportune investor who wants to hold for the next few months.  As far as specialty retailers, which is a scary segment of the market, this is one of the better values available based on current fundamentals.

Netflix (NFLX) originally found success by making the movie rental business more convenient that ever before.  They caught the heavyweights in the industry including Blockbuster (BBI) napping, as they were too late to adopt and rental by mail model.  The result has been sustained growth by Netflix, stealing market share away from both Blockbuster and Hollywood Video and other chains, all without the necessity for a brick and mortar store presence.  Noting the rise of broadband internet and the ability to download and stream larger files than before, Netflix was the first to offer rental movies directly onto your computer screen thus bypassing the wait time of the mail service.  Today, Netflix is announcing another way to reach a great number of customers with convenience in mind.

The latest partnership for Netflix announced today is to put a video on demand feature directly into Microsoft’s (MSFT) Windows Media software on all Vista machines.  Netflix had previously teamed up with Microsoft’s Xbox systems so that users could stream movies, even high-definition movies, providing further access to the millions of Xbox owners.  Access to that system cost nothing additional to a normal Netflix subscription, and we assume the Vista partnership will be the same way.  In comparison, there are many times more Vista computers out there than Xbox’s.  The goal is clearly to get as many people exposure to Netflix as possible and show just how simple it can be to sign up and rent.

Netflix is managing to upstage their competitors at every turn it seems, as Blockbuster is simply trying to stay above water, staving off bankruptcy rumors earlier this year.  Netflix’s CEO Reed Hastings, has recently said that he believes the stiffest competition will come from grocery and convenience store kiosks, “By the end of the year, kiosks will likely be our number one competitor as video stores fall inversely.”

Ockham reiterates the Fairly Valued valuation on Netflix shares, as of our report this week.  The stock is by no means cheap selling at 24 times expected fiscal 2009 earnings, but there is always a premium for growth.  Furthermore, the industry trends seem to be in Netflix’s favor for the time being as they continue to take market share and come up with partnerships to give better ease of access to clients.  There may be competition from these kiosks but they have obvious limitations, including smaller selection and the necessity for a physical location to return the movie.  Netflix is doing the right things by bringing their product into consumers living rooms, one partnership at a time.