Pet 'moms and dads' are spending more on their furry family, setting these stocks up for growth

Published Sun, Aug 28 20228:43 AM EDTUpdated Sun, Aug 28 20228:53 AM EDT

Christina Cheddar Berk @in/christina-cheddar-berk-b864404/

The "pandemic pups" you pass on a stroll around the neighborhood have been a huge windfall for the pet industry. But unlike other booms, the inevitable pullback in demand could be eased by two factors unique to this situation. The first is that pets will continue to require food and care, driving future spending. Second, as pets become cherished family members, owners are more inclined toward buying premium-priced foods, treats and services . Together, this means spending on pets is expected to normalize at a higher level. "Prior to the pandemic, there wasn't that much volatility in the growth of the dog and cat populations," said Anne Scott Livingston, a research analyst at Euromonitor. But the desire for companionship during the early days of the Covid health crisis, led to a boom in pet adoptions in 2020 and 2021, she said. Media reports at the time detailed that some animal shelters were completely emptied of dogs and cats . While that initial explosion has eased — and shelters are inevitably filling up again — people are still adding new pets to their homes at a greater rate than they were in 2019, Livingston said. "Obviously, some level of consumer mobility has returned, but a lot of companies have established the work from home or hybrid models, so a lot of consumers … have realized, 'Oh, I will be spending a lot more time at home than I was in 2019,' which has helped to boost adoptions even further this year and last year," Livingston said. Euromonitor expects the pace to normalize next year, but the ripple effects are already evident. Morgan Stanley estimates that there are about 5 million more pets in the U.S. today than there were in 2019. But that approximately 4% increase in pet ownership has led to an 11% gain in per-pet spending, according to the bank's research. In a recent research note, analysts led by Simeon Gutman said a large portion of new pet parents are younger adults, who tend to spend more on their companions. Millennial "pet moms and dads" have smaller families or have delayed having children, the analysts said. Many have just moved into their first home, and they are ready to lavish their animals with affection – and treats and toys. This is creating a tailwind that will help accelerate the pet industry's sales growth in the years to come, according to Gutman. He expects average annual pet-related spending to grow at an accelerated pace of about 8% from 2019 to 2030. This would boost the industry's sales to $277 billion by 2030, according to the firm's baseline forecast. Notably, this momentum outpaces the compound annual growth rate of nearly all other retail sub-segments, the firm said. But, Morgan Stanley's top pet industry stock picks might not be the first names that spring to mind. Instead of picking retail names like Petco Health and Wellness and Chewy , Gutman expects it's best for investors to play the pet market by focusing on service providers. A bet on the power of vets Morgan Stanley named Zoetis, a specialty pharmaceutical company that makes heartworm prevention and other medication and vaccines for animals, as its top pick in the space. It also likes Idexx Laboratories , which is a leading maker of diagnostic tests used by veterinarians. The bank has an overweight rating on both stocks. For Zoetis, it has a $264 price target, which implies roughly 60% upside from where the stock closed on Thursday. Shares have lost roughly a third of their value since January. For Idexx shares, Morgan Stanley set a price target of $603, which would mean a gain of nearly 63% from Thursday's close. While food and treats make up the largest chunk of a pet owner's budget, vet services rank second, and by Morgan Stanley's estimates, it's the fastest growing segment. Also, while spending on cat toys, a fancy dog bed or an elaborate fish tank can be discretionary, once consumers fall in love with their pet, regular veterinary care is seen as a must. Morgan Stanley's consumer surveys have shown that the majority of pet owners visit vets for routine care and place a lot of value in their medical expertise. At the moment, not many of those visits include bloodwork for preventative diagnostic tests, but Gutman expects that will change over time. "While we think wellness testing should expand over time, we expect near- to medium-term penetration will expand at a more measured pace, given that preventive care protocols, vet training, and pet owner education around the importance of these measures will take time," he wrote. Gutman also anticipates greater use of Zoetis' Simparica Trio, a next-generation combination flea, tick and heartworm parasiticide, over time. The product, which launched in 2020, tallied $168 million in global sales in its first year. Morgan Stanley said more vets are recommending the product over other options, so sales should grow off that base. Even the pet products retailers have realized the importance of veterinary care in their business models. Petco has repositioned itself as a health and wellness company. Chewy recently added CarePlus, a line of pet wellness and insurance plans to its existing health offerings, which already include an online pharmacy, telehealth services and an online marketplace specifically geared to vets. Both retailers see pet health as a way to be competitive against Walmart and Amazon , which have broadened their reach in the pet care aisle. Both Walmart, which leads in in-store sales of pet supplies, and Amazon can compete aggressively on price, so Petco and Chewy are trying to claim their turf as the experts in the field. Having the voice of highly trained vets on their side, can bolster this image. Euromonitor's Livingston, who focuses on food and nutrition, said online channels are particularly important for pet products. About a third of the industry's sales are generated online, she said. A shift to 'human-grade' food Pet owners like the convenience of ordering items like pet food through an online subscription, which has contributed to this trend, according to Livingston. Most major pet products retailers are offering some form of this service. On an earnings call Wednesday , Petco management talked about the importance of the premium pet food brands it sells — some exclusively — to driving repeat visits from shoppers. It said shoppers who buy pet food and other consumable products generate about 30% more lifetime value than customers who don't shop these categories with Petco. Also Wednesday, the retailer announced WholeHearted Fresh Recipes, a line of frozen, human-grade meals for dogs. According to Livingston, the new brand is very much on trend . Owners have been "humanizing" their pets. They want to give them foods packed with the same kinds of healthy nutrients they are looking for in their own food, even if that comes with a steeper price tag. "People are really viewing their pets as valued family members and a lot of those people will cut costs in other areas of life before they will downgrade their pet food," she said. Sales of nutritional supplements for pets are also on the rise as well, according to Euromonitor. Petco sees premium pet food and its Vital Care program, which had 282,000 members as of its fiscal second quarter, ways to build loyalty and grow sales. The recently revamped program allows customers to receive discounts for vet exams as well as products and services like teeth brushing and nail trimming for a $19.99 per month fee. On the company's earnings call, CEO Ron Coughlin said the program prompts customers to shop more frequently at its stores and it boosts their spending by "double digits." "We captured far greater share of wallet, with around 30% of Vital Care customers new to food with us, and 40% new to services, both up versus Vital Care 1.0, [the original version of the loyalty program]," he said. The growth in the program — up 180% from the year-ago period and 28% from the first quarter — has been helped by the addition of members of Thrive Pet Healthcare, a veterinary network it acquired earlier this year . In a research note, Goldman Sachs analyst Kate McShane said Vital Care could be very attractive to customers looking to save in the current inflationary environment. Meanwhile, Petco benefits from the recurring revenue of the membership fees as well as the higher spending levels of its members. Petco said it estimates Vital Care customers have a lifetime value that is 3.5 times greater than its typical shopper. Still, Petco shares fell 8.8% Wednesday as investors reacted to a lowered forecast for fiscal 2022. The company is being hit with higher costs and weaker demand for more discretionary items. McShane has a buy rating on Petco, but trimmed her 12-month price target by $1 to $20 to account for the lower earnings estimates. She said she continues to view the stock favorably and expects its strategies will drive revenue and margin expansion over the longer term. Petco shares closed Thursday at $15.23, down 23% since January. This coming Tuesday, Chewy will report its results. Analysts will be paying close attention to customer churn rates. The fear is the company will need to spend more on marketing to attract new clientele. Wedbush analyst Seth Basham downgraded Chewy to neutral in late July. One concern he had was that search rates for pet-related products have fallen, and Apple's privacy changes have made it harder to target potential customers online. The upcoming quarterly results will show if these trends have affected Chewy. As of Thursday's close, the stock is down 31% year to date. That said, Chewy's strength comes from its dominant position among customers buying staples like pet food online. Since these purchases are so essential, Chewy has a solid position. Livingston said history offers some reassurance here. During the Great Recession, in 2008 to 2009, spending on pets actually rose, she said.