UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-K

 

 

Commission file number 0-21888

 

 

 

 

PetSmart, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

19601 N. 27th Avenue
Phoenix, Arizona 85027
(Address of principal executive offices, including Zip Code)

 

Registrant’s telephone number, including area code:

(623) 580-6100

 

Securities registered pursuant to Section 12(b) of the Act:

None

 

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.0001 par value

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     No o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer þ      Accelerated Filer o     Non-Accelerated Filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).  Yes o     No þ

 

The aggregate market value of the common stock held by non-affiliates of the registrant, based on the closing sale price of the Registrant’s Common Stock on July 31, 2005, the last business day of the Registrant’s most recently completed second fiscal quarter, as reported on the NASDAQ National Market was approximately $4,233,374,000. This calculation excludes approximately 1,926,000 shares held by directors and executive officers of the Registrant. This calculation does not exclude shares held by such organizations whose ownership exceeds 5% of the Registrant’s outstanding Common Stock as of December 31, 2005 that have represented to the Registrant that they are registered investment advisers or investment companies registered under section 8 of the Investment Company Act of 1940.

 

The number of shares of the Registrants Common Stock outstanding as of March 28, 2006 was 140,036,473.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Proxy Statement for the Annual Meeting of Stockholders to be held on June  22, 2006, to be filed by May 8, 2006.

 

 

TABLE OF CONTENTS

 

 

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements relate to future events or our future financial performance. We have attempted to identify forward-looking statements by terminology including: “anticipate,” “believe,” “can,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “predict,” “should,” or “will” or the negative of these terms or other comparable terminology. These statements are only predictions and involve known and unknown risks, uncertainties and other factors, including the risks outlined under “Item 1A. Risk Factors” contained in Part I of this Annual Report that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements.

 

Although we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Our expectations are as of the date this Annual Report on Form 10-K is filed, and we do not intend to update any of the forward-looking statements after the date this Annual Report on Form 10-K is filed to conform these statements to actual results, unless required by law.

 

Our fiscal year consists of the 52 or 53 weeks ending on the Sunday nearest January 31 of the following year. Unless otherwise specified, all references in this Annual Report on Form 10-K to years are to fiscal years. The 2005, 2004 and 2003 fiscal years were 52-week years.

 

General

 

In fiscal 2005, we generated sales of $3.8 billion, making PetSmart the leading specialty provider of products, services and solutions for the lifetime needs of pets in North America. We have identified a large group of pet owners we call “pet parents,” who are passionately committed to their pets and consider their pets family members. Our strategy is to attract and keep these customers by becoming the preferred provider of Total Lifetime Care^sm for pets. As part of this strategy, we focus on driving efficiencies in our stores, on our processes and our systems, on growing our pet services business and on delighting our customers by providing a superior store environment, a superior shopping experience and superior service. We are focused on improving and expanding our distribution capabilities, implementing new management information systems, reformatting our stores around the needs of our customers, developing our pet services business and creating a culture of customer service.

 

We opened 100 net new stores in fiscal 2005 and, at the end of the fiscal year, operated 826 retail stores in North America. Our stores typically range in size from 19,000 to 27,000 square feet, and carry a broad and deep selection of high quality pet supplies at everyday low prices. We offer more than 12,800 distinct items, including nationally recognized brand names, as well as an extensive selection of private brands across a range of product categories.

 

We complement our strong product assortment with a selection of value-added pet services, including grooming, pet training, boarding and day camp. Virtually all our stores offer complete pet training services and feature pet styling salons that provide high-quality grooming services. Through our strategic relationship with Banfield, The Pet Hospital, operating under the registered trademark of Banfield, and other third-party operators, we made full-service veterinary care available in 525 of our stores as of January 29, 2006.

 

We also reach customers through our direct marketing channels, including PetSmart.com, one of the Internet’s most popular pet e-commerce sites, as well as an e-commerce site dedicated to equine products and an equine catalog. Our PetPerks loyalty campaign allows us to understand the needs of our customers and target offers directly to them.

 

The Pet Food and Pet Supply Industry

 

The pet product industry serves a large and growing market. The American Pet Products Manufacturers Association, or APPMA, estimated the 2005 market at approximately $35.9 billion, an increase of more than 100% since 1994. Based on the 2005/2006 APPMA National Pet Owners Survey, more than 69 million households in the

United States own a pet. This results in approximately 91 million cats and 74 million dogs. The APPMA also estimates 63% of United States households own a pet and 45% of those households own more than one pet.

 

The pet product industry can be divided into the following categories: food, supplies/medicines, veterinary care, pet services (such as grooming or boarding) and purchases of pets. The APPMA estimates that dog food, cat food and treats are the largest volume categories of pet-related products and, in 2005, approximated $14.5 billion, or 40% of the market. Many premium pet food brands, which offer higher levels of nutrition than non-premium brands, are not currently sold through supermarkets, warehouse clubs and other mass and retail merchandisers due to manufacturer’s restrictions, but are sold primarily through superstores, specialty pet stores, veterinarians and farm and feed stores.

 

Pet supplies and medicine sales account for approximately 25%, or $8.8 billion, of the market. These sales include dog and cat toys, collars and leashes, cages and habitats, books, vitamins and supplements, shampoos, flea and tick control and aquatic supplies. Veterinary care, pet services and purchases of pets represent approximately 24%, 7% and 4%, respectively, of the market.

 

Competition

 

Based on total sales, we are the largest specialty retailer of pet food, supplies and services in North America. The pet food and pet supply retail industry is highly competitive and can be organized into five different categories:

 

 

We believe the principal competitive factors influencing our business are product selection and quality, convenience of store locations, store environment, customer service, price and availability of pet services. We believe we compete effectively within our various markets; however, some of our supermarket, warehouse club and mass and retail merchandise competitors are larger in terms of overall sales volume and have access to greater capital.

 

We are currently the only major specialty pet retailer that markets to customers through stores, a catalog and the internet, and we believe this gives us a competitive advantage. In addition, we believe our pet services business is a competitive advantage which can not be easily duplicated.

 

Our Strategy

 

Our strategy is to be the preferred provider for the lifetime needs of pets. Our primary initiatives include:

 

Add stores in existing multi-store, new multi-store and new single-store markets.  We believe there is a potential for at least 1,400 PetSmart stores in North America. Our expansion strategy includes increasing our share in the top 60 existing multi-store markets, penetrating new multi-store and single-store markets and achieving operating efficiencies and economies of scale in distribution, procurement, marketing and store operations. During fiscal 2005, we opened 100 net new stores, and in fiscal 2006, we expect to open approximately 90 net new stores, primarily in multi-store markets.

 

Provide the right store format to meet the needs of our customers.  We completed the conversion of our store base to our new specialty store format in fiscal 2003. We believe our reformatted stores, combined with our other strategic initiatives, contribute to higher comparable store sales growth, profitability and return on investment. We continually evaluate our store format to ensure we are meeting the needs and expectations of our customers, while providing a return on investment to our shareholders. In fiscal 2004, we completed the roll out of an upgraded in-store sign package to better serve the needs of our customers. In fiscal 2005, we tested a new store refresh

program that builds on the initial reformat and emphasizes our highly differentiated training and adoption services. We will refresh our existing stores with this new format in fiscal 2006, 2007 and 2008.

 

Expand our pet services business.  Based on sales, we are the leading provider of pet services, which include professional grooming, pet training, boarding and day camp. Pet services are an integral part of our strategy, and we are focused on driving profitable growth in our services business. We believe services differentiate us from our competitors, drive traffic and repeat visits to our stores, provide cross-selling opportunities, allow us to forge a strong relationship with our customers, increase transaction size and enhance operating margins. In fiscal 2005, we began the roll out of the PetsHotel^tm, a full-service boarding and day camp service offered inside our stores. At the end of the fiscal year, we operated 32 PetsHotels in our stores in addition to one stand-alone location and seven additional in-store Doggie Day Camps that are not part of a full hotel, on our way to an ultimate build out of 300 hotels and 40 additional Doggie Day Camps. Pet services revenue, which includes grooming, pet training, PetSmart PetsHotel and Doggie Day Camp, grew by 24%, 24% and 25% in fiscal 2005, 2004 and 2003, respectively. We are confident in our ability to continue to expand the pet services portion of our business.

 

Through our strategic relationship with Banfield, The Pet Hospital, operating under the registered trademark of Banfield, and with other third-party operators, we made full-service veterinary care available in 525 of our stores as of January 29, 2006.

 

Offer superior customer service.  Our emphasis on the customer is designed to provide our customers with an unparalleled shopping experience every time they visit our stores. Using a detailed curriculum and role-playing techniques, we educate store associates to identify customer needs and provide appropriate solutions. We measure their success in every store, and a portion of the annual incentive program for managers, from the store level to the executive team, is linked to key customer service and in-stock metrics. By providing pet parents with expertise and solutions, we believe we are strengthening our relationships with customers, building loyalty and enhancing our leading market position.

 

Differentiate ourselves through effective brand management.  We are focused on developing and strengthening our brand identity. In August 2005, we announced a new marketing campaign that repositions the PetSmart brand from its current reputation as a “Mart” to “Smart” which emphasizes our capabilities as a resource of information, services and solutions. As part of the campaign, we changed our logo to highlight the “Smart” piece of the PetSmart name and rolled out new advertising that emphasizes our unique offerings for customers.

 

We are creating tools to effectively communicate our unique value proposition and vision of providing Total Lifetime Care^sm for pets, and we continue to build enduring relationships with our customers. We continue to roll out our customer loyalty program, the PetPerks^® savings card. As of January 29, 2006, PetPerks was available in all PetSmart stores capturing more than two-thirds of transactions and more than three-fourths of sales. We will continue using a centralized customer database that allows us to track and analyze customer shopping patterns. We intend to use this information to customize direct marketing and promotional materials and to more effectively communicate with customers across all channels.

 

We believe these strategic initiatives will continue to drive enhanced comparable store sales growth, profitability and return on investment.

 

Our Stores

 

Our stores are generally located in sites co-anchored by strong destination superstores and typically are in or near major regional shopping centers. We are engaged in an ongoing expansion program, opening new stores in both new and existing markets and relocating existing stores. Store activity for fiscal 2005, 2004 and 2003 is as follows:

 

In its first full year, we expect a new store to generate approximately $3.0 million in sales. We expect new stores to generate comparable store sales growth in the range of 19% to 21% in year two, 11% to 13% in year three, 8% to 9% in year four and 6% to 7% in year five. We believe there is a potential for a total of at least 1,400 PetSmart stores in North America. We expect to open approximately 90 net new stores in fiscal 2006.

 

Distribution

 

Our improved distribution network, combined with improved and integrated information systems, can optimize store inventory, and drives more efficient use of store labor, improved in-stock positions and better distribution center productivity. We currently employ a hybrid distribution system including full truckload shipments to individual stores and the splitting of full truckloads among several closely located stores and distribution centers. Our forward distribution centers handle products that require rapid replenishment. Our suppliers generally ship our merchandise to one of our distribution centers or forward distribution centers, which receive and allocate merchandise to our stores. We contract the transportation of merchandise from our distribution centers to stores through third-party vendors, and we do not own any trailers. We operate the following distribution centers:

 

 

In January 2006, we entered into an agreement to lease approximately 877,500 square feet in Newnan, Georgia to be used as a distribution center. We expect this facility to open in fiscal 2007, and it will replace the current 200,000 square foot forward distribution center we currently lease in Newnan, Georgia.

 

Information Systems

 

During fiscal 2005, we continued to enhance our information systems including, but not limited to, the following:

 

 

Merchandise

 

Merchandise, which has been decreasing as a percentage of net sales due to the higher growth rate in services, represented approximately 92% of our net sales in fiscal 2005, 93% in fiscal 2004, and 94% in fiscal 2003, and generally falls into three main categories:

 

 

 

Pet Services

 

Pet services, which include grooming, pet training, boarding and day camp, represented 8%, 7% and 6% of our net sales in fiscal 2005, 2004 and 2003, respectively. We offer full-service grooming and pet training services in virtually all our stores. We typically allocate an average of 800 square feet per store for high-quality, full-service grooming, including precision cuts, baths, toenail trimming and toothbrushing. Depending on their experience, our pet stylists are educated as part of a 15-week program that teaches exceptional grooming skills using safe and gentle techniques. Pet training services range from puppy classes to advanced and private courses.

 

PetsHotel provides boarding for dogs and cats, 24-hour supervision, an on-call veterinarian, temperature controlled rooms and suites, daily specialty treats and play time as well as day camp for dogs. In fiscal 2005, we began a national rollout of PetsHotel at selected locations. As of January 29, 2006, we operated 32 PetsHotels within our retail stores in addition to one stand-alone location.

 

In October 2004, we launched our test of the Doggie Day Camp concept, which is also available at our PetsHotel locations. During fiscal 2005, we expanded our test of Doggie Day Camps without a full hotel to six additional retail stores, for a total of seven Doggie Day Camps.

 

Total revenues from pet grooming, pet training, boarding and day camp services grew 24% from $240.7 million in fiscal 2004 to $298.9 million in fiscal 2005.

 

Veterinary Services

 

The availability of comprehensive veterinary care in our stores further differentiates us, drives sales in our stores and reflects our overall commitment to pet care. Full-service veterinary hospitals in 525 of our stores offer routine examinations and vaccinations, dental care, a pharmacy and routine and complex surgical procedures. As of January 29, 2006, 513 of these hospitals were operated by Medical Management International, Inc., or MMI, a third-party operator of veterinary hospitals, operating under the registered trade name of Banfield, The Pet Hospital. See Note 3 to the Notes to Consolidated Financial Statements for a discussion of our ownership interest in MMI. The remaining 12 hospitals are located in Canada and are operated by other third-parties.

 

PetSmart Charities and Adoptions

 

Through PetSmart Charities, Inc., an independent 501(c)(3) organization, we support the activities of animal welfare organizations in North America. PetSmart Charities creates and supports programs to help find a lifelong loving home for every pet, by:

 

 

Since 1994, PetSmart Charities has raised and donated more than $41 million to animal welfare programs and, through our in-store adoption programs, has saved the lives of more than 2.4 million pets.

Government Regulation

 

We are subject to various federal, state, provincial and local laws and regulations governing, among other things: our relationships with employees, including minimum wage requirements, overtime, working conditions and citizenship requirements; veterinary practices or the operation of veterinary hospitals in retail stores that may impact our ability to operate veterinary hospitals in certain facilities; the transportation, handling and sale of small pets; environmental regulations with respect to generation, handling, storage, transportation and disposal of waste and biohazardous materials; the distribution, import/export and sale of products; the handling, security, protection and use of customer information; and the licensing and certification of services.

 

We seek to structure our operations to comply with all federal, state, provincial and local laws and regulations of each jurisdiction in which we operate. Given varying and uncertain interpretations of these laws and regulations and the fact that the laws and regulations are enforced by the courts and by regulatory authorities with broad discretion, there can be no assurances that we would be found to be in compliance in all jurisdictions. We also could be subject to costs, including fines, penalties or sanctions and third party claims as a result of violations of, or liabilities under, these laws and regulations.

 

Intellectual Property

 

We believe our intellectual property has significant value and is an important component in our merchandising and marketing strategies. We have several service marks and trademarks registered with the United States Patent and Trademark Office, or USPTO, including PetSmart^®, PetSmart.com^®, PetSmart PetsHotel^®, PetPerks^®, Where Pets Are Family^® and All You Need For The Life Of Your Pet^®, as well as many others. We also own several service mark and trademark applications that are pending with the USPTO and anticipate filing additional applications in the future. We also own numerous registered service marks, trademarks and pending applications in other countries, including Canada, as well as several trade names, domain names and copyrights for use in our business.

 

Employees

 

As of January 29, 2006, we employed approximately 34,600 associates, approximately 16,800 of whom were employed full time. We continue to invest in education for our full and part-time associates as part of our emphasis on customer service and providing pet care solutions. We are subject to no collective bargaining agreements and have experienced no work stoppages. We consider our relationship with our associates to be good. Increases in the federal minimum wage in recent years have not had a material effect on our business.

 

Financial Information by Business Segment and Geographic Data

 

As of January 29, 2006, we had two operating segments, PetSmart North America, which included all retail locations, and PetSmart Direct, which included our internet operations and equine catalog. We evaluated our segment reporting requirements under Financial Accounting Standards Board, or FASB, Statement of Financial Accounting Standards, or SFAS, No. 131, “Disclosures about Segments of an Enterprise and Related Information,” and determined the PetSmart Direct operating segment does not meet the quantitative thresholds for disclosure as a reportable operating segment.

 

Net sales in the United States were $3.7 billion, $3.3 billion and $2.9 billion for fiscal 2005, 2004 and 2003, respectively. Net Canadian sales, denominated in United States dollars, were $107.7 million, $87.7 million and $75.7 million for fiscal 2005, 2004 and 2003, respectively. Substantially all our long-lived assets are located in the United States.

 

Available Information

 

We make available, free of charge through our internet web-site (www.petsmart.com), our Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q, our current reports on Form 8-K and amendments to those reports, as soon as reasonably practicable after we electronically file such material, or furnish it to the Securities and Exchange Commission.

PetSmart associates must act ethically at all times and in accordance with PetSmart’s Code of Business Ethics and Policies. We require full compliance with this policy, and all designated associates including our Principal Executive Officer, Principal Financial Officer, Principal Accounting Officer and such other individuals performing similar positions, have signed a certificate acknowledging that they have read, understand and will continue to comply with the policy. The policy is published and we will publish any amendments or waivers to the policy in the Corporate Governance section of the PetSmart internet web-site located at www.petm.com.

 

Management

 

Our executive officers and their ages and positions on April 1, 2006, are as follows:

 

 

Philip L. Francis has been a director of PetSmart since 1989, and Chief Executive Officer since March 1998. He was President from 1998 to 2001 and was named Chairman of the Board in 1999. From 1991 to 1998, he held various positions with Shaw’s Supermarkets, Inc., a subsidiary of J. Sainsbury plc., including Chief Executive Officer, Chief Operating Officer and President. Prior to that, he held several senior management positions for Roundy’s Inc., Cardinal Health and the Jewel Companies.

 

Robert F. Moran was appointed President and Chief Operating Officer in December 2001. He joined PetSmart as President of North American Stores in July 1999. From 1998 to 1999, he was President of Toys ‘R’ Us, Ltd., Canada. Prior to 1991, for a total of 20 years, he was with Sears, Roebuck and Company in a variety of financial and merchandising positions, including President and Chief Executive Officer of Sears de Mexico. He was also Chief Financial Officer and Executive Vice President of Galerias Preciados of Madrid, Spain from 1991 through 1993.

 

Timothy E. Kullman joined PetSmart as Senior Vice President and Chief Financial Officer in July 2002. Mr. Kullman also leads our real estate and construction group. From 2001 to 2002, Mr. Kullman was the Executive Vice President and Chief Financial Officer for Hagemeyer North America Holdings, Inc., part of a global distribution company based in the Netherlands. From 1997 to 2001, Mr. Kullman served as Senior Vice President and Chief Financial Officer of Genuardi’s Family Markets, Inc., a regional grocery retailer. From 1994 to 1997, Mr. Kullman served as Senior Vice President, Chief Financial Officer, Treasurer and Secretary for Delchamps, Inc., a grocery retailer in the southeastern United States. Prior to that, he held various positions with Farm Fresh, Inc., Blue Cross Blue Shield of Michigan, and Deloitte Haskins & Sells, the predecessor to Deloitte & Touche LLP.

 

Scott A. Crozier joined PetSmart as Senior Vice President and General Counsel in June 1999, and was appointed Secretary in June 2000 and Chief Compliance Officer in March 2005. From 1998 to 1999, Mr. Crozier was Chairman and Chief Executive Officer of Westpac Consulting, L.L.C., a real estate services company. From 1987 to 1998, Mr. Crozier served as Vice President and General Counsel for Phelps Dodge Corporation, a global mining and manufacturing company. Prior to that, he was Counsel for Talley Industries, Inc., and served as an

enforcement attorney with the Securities Division of the Arizona Corporation Commission and during that time, was also appointed as Special Assistant Attorney General with the Arizona Attorney General’s Office.

 

Donald Beaver joined PetSmart as Senior Vice President and Chief Information Officer in May 2005. Prior to joining PetSmart, Mr. Beaver was employed by H-E-B Grocery company where he held the position of Senior Vice President and CIO since 1999. Prior to that, he served 14 years at Allied Signal Aerospace, Inc. Mr. Beaver started his career at Eastman Kodak, where he was a programmer analyst.

 

Barbara A. Fitzgerald joined PetSmart as Senior Vice President of Store Operations in September 2000. Prior to joining PetSmart, Ms. Fitzgerald was President of Harmon AutoGlass, a leading provider of auto glass replacement and repair. From 1997 to 2000, Ms. Fitzgerald served in various positions at Toys ‘R’ Us, Inc., including, Vice President, General Manager of New York/New Jersey and Vice President of People Development. Prior to that, Ms. Fitzgerald spent 24 years with Sears, Roebuck and Company in various capacities, including Vice President and General Manager of Sears Hardware Stores.

 

Kenneth T. Hall was appointed Senior Vice President, Merchandising in January 2006 and has been Chief Marketing Officer since January 2003. He joined PetSmart as Vice President, Strategic Planning and Customer Relationships in October 2000 and was appointed Senior Vice President and Chief Marketing Officer in January 2003. From 1999 to 2000, Mr. Hall worked as a consultant for Bain & Company, Inc., a global management consulting firm. Prior to this, Mr. Hall held various operational and financial positions at EXXON Company, U.S.A.

 

David K. Lenhardt joined PetSmart as Senior Vice President of Services, Strategic Planning and Business Development in October 2000. From 1996 to 2000, Mr. Lenhardt was a manager with Bain & Company, Inc., where he led consulting teams for retail, technology, and e-commerce clients. Prior to that, he worked in the corporate finance and Latin American groups of Merrill Lynch & Co.’s investment banking division.

 

Francesca M. Spinelli joined PetSmart as Senior Vice President of People in September 2003. She served as Vice President of People for Radio Shack Corporation from 1998 to 1999, and Senior Vice President of People from 1999 to 2003. Previously, Ms. Spinelli was with Wal-Mart Stores, Inc., where she held the positions of Corporate Vice President, Organizational Development and Vice President, Human Resources — McLane Company, Inc., a former division of Wal-Mart. Prior to 1993, Ms. Spinelli held human resources positions with Dillashaw, Hawthorn and Company, P.C., and APS, Inc. In addition, Ms. Spinelli serves on the board of directors of Advance Auto Parts, Inc.

 

Raymond L. Storck was appointed Vice President of Finance, Chief Accounting Officer and Controller in March 2006. He joined PetSmart in May 2004 as Vice President and Controller. From 2000 to 2004, Mr. Storck served as Chief Financial Officer and Treasurer of MicroAge, Inc., an information technology products and services company, and from 1986 to 2000 he held various other executive positions at MicroAge, including Vice President and Controller. In April 2000, MicroAge, Inc. filed for protection under Chapter 11 of the United States Bankruptcy Code. Prior to MicroAge, he was with Grant Thornton in Minneapolis.

 

In the normal course of business, our financial position is routinely subjected to a variety of risks, including market risks associated with store expansion, investments in information systems, international expansion, vendor reliability, competitive forces and government regulatory actions. Our actual results could differ materially from projected results due to some or all of the factors discussed below. You should carefully consider the risks and uncertainties described below, as well as those discussed in Our Stores, Distribution, Information Systems, Competition and Government Regulation sections of this Annual Report on Form 10-K.

 

If we are unable to increase sales at our existing stores or successfully open new stores, our results of operations could be harmed.

 

Our continued revenue growth depends on our ability to increase sales at our stores. There can be no assurance that our stores will meet forecasted levels of sales and profitability. In addition, we expect to open approximately 90 net new stores in fiscal 2006. Our ability to open additional stores is dependent on various factors including:

 

 

 

To the extent we are unable to accomplish any of the above, our ability to open new stores may be harmed. In addition, there can be no assurance that we will be able to meet the forecasted level of sales or operate our new stores profitably.

 

New stores may place increasing demands on management and operating systems, may erode sales at existing stores and comparable store sales growth may decrease as stores grow older.

 

We currently operate stores in most of the major market areas of the United States and Canada. Our plans for fiscal 2006 include opening approximately 90 net new stores, primarily in existing multi-store markets. The increased demands placed on management by opening new stores could result in operational inefficiencies and less effective management of the business and associates, which could in turn adversely affect our financial performance. Opening new stores may attract some customers away from other stores already operated by us in those markets and diminish their sales.

 

Our comparable store sales increases were 4.2% and 6.3% for fiscal 2005 and 2004, respectively. As a result of new store openings in existing markets, and because older stores will represent an increasing proportion of our store base over time, our comparable store sales increases may be lower or sales could decrease in future periods.

 

Our operating margins at new stores may be lower than those of existing stores.

 

Preopening expenses and lower sales volumes associated with newly opened stores can impact operating margins. In some geographic regions, we expect certain new store operating costs, particularly those related to occupancy, to be higher than in the past. As a result of our increasing number of net new stores and the impact of these rising costs, our total store contribution and operating margins may be lower in future periods than they have been in the past.

 

A disruption, malfunction, or increased costs in the operation or expansion of our distribution centers or our supply chain would impact our ability to deliver merchandise to our stores or increase our expenses, which could harm our sales and results of operations.

 

Our vendors generally ship our merchandise to one of our distribution centers, which receive and allocate merchandise to our stores. Any interruption or malfunction in our distribution operations, including, but not limited to, the loss of a key vendor that provides transportation of merchandise from our distribution centers to stores, could harm our sales and the results of our operations. We operate one fish distribution center and have two fish distribution centers that are operated by a third-party vendor, and an interruption or malfunction to their business could harm our sales and results of operations. In such an event, there can be no assurance that we could contract with another third party to operate the fish distribution centers on favorable terms, if at all, or that we could successfully operate the fish distribution centers ourselves. In addition, if we are unable to successfully expand our distribution centers, our sales or results of operations could be harmed.

 

If our information systems fail to perform as designed or are interrupted for any reason for a significant period of time, our business could be harmed.

 

The efficient operation of our business is dependent on our information systems. In particular, we rely on our information systems to effectively manage our sales, financial data, warehousing, distribution, merchandise planning and replenishment functions and to maintain our in-stock positions. We possess offsite recovery capabilities for our key information systems. The failure of our information systems to perform as designed, or

any interruption of our information systems for any reason for a significant period of time could disrupt our business and harm our sales and profitability.

 

We continue to invest in our information systems. There can be no assurance that the costs of investments in our information systems will not exceed estimates or that they will be as beneficial as predicted. If we are unable to realize the benefits of improved systems, our results of operations could be harmed.

 

If we accidentally disclose sensitive customer information, our business could be harmed.

 

We routinely possess sensitive customer information such as credit card numbers, and a failure in our security procedures and operational controls could result in a release of that information. We could experience losses from lawsuits and negative publicity that may affect our business.

 

A decline in consumers’ discretionary spending could reduce our sales and harm our business.

 

Our sales depend on consumer spending, which is influenced by factors beyond our control, including general economic conditions, the availability of discretionary income, weather, consumer confidence and unemployment levels. We may experience declines in sales during economic downturns. Any material decline in the amount of discretionary spending could reduce our sales and harm our business.

 

Our results may fluctuate due to seasonal changes associated with the pet food and pet supply retailing industry and the timing of expenses, new store openings and store closures.

 

Our business is subject to seasonal fluctuation. We typically realize a higher portion of our net sales and operating profit during the fourth fiscal quarter. As a result of this seasonality, we believe that quarter-to-quarter comparisons of our operating results are not necessarily meaningful and that these comparisons cannot be relied upon as indicators of future performance. Controllable expenses, such as advertising, could fluctuate from quarter-to-quarter within a fiscal year. Sales of certain products and services are seasonal. Because our stores typically draw customers from a large trade area, sales may also be impacted by adverse weather or travel conditions, which are more prevalent during certain seasons of the year. Finally, as a result of our expansion plans, the timing of new store openings and related preopening expenses, the amount of revenue contributed by new and existing stores, and the timing and estimated obligations of store closures, our quarterly results of operations may fluctuate.

 

The pet food and pet supply retail industry is very competitive, and continued competitive forces may reduce our sales and profitability.

 

The pet food and pet supply retail industry is very competitive. We compete with supermarkets, warehouse clubs and other mass and retail merchandisers, many of which are larger and have significantly greater resources than we have. We also compete with a number of pet supply warehouse or specialty stores, smaller pet store chains, catalog retailers, Internet retailers and pet stores. The industry has become increasingly competitive due to the expansion of pet-related product offerings by certain supermarkets, warehouse clubs or other mass and retail merchandisers and the entrance of other specialty retailers into the pet food and pet supply market, some of which have developed store formats similar to ours. There can be no assurance we will not face greater competition from these or other retailers in the future. In particular, if our supermarket, warehouse club or other mass and retail competitors seek to gain or retain market share by reducing prices, we would likely reduce our prices in order to remain competitive, which may result in a decrease in our sales and profitability and require a change in our operating strategies.

 

The loss of any of our key vendors, a decision by our vendors to make their products available in supermarkets or through warehouse clubs and other mass and retail merchandisers, or the inability of our vendors to provide products in a timely or cost-effective manner, could harm our business.

 

We buy from several hundred vendors worldwide and, together, our two largest vendors accounted for approximately 15.1% of our total sales for fiscal 2005. Sales of premium pet food for dogs and cats comprise a significant portion of our revenues. Currently, most major vendors of premium pet foods do not permit their

products to be sold in supermarkets, warehouse clubs or through other mass and retail merchandisers. If any premium pet food or pet supply vendors were to make their products available in supermarkets or through warehouse clubs and other mass and retail merchandisers, our business could be harmed. In addition, if the grocery brands currently available to such retailers were to gain market share at the expense of the premium brands sold only through specialty pet food and pet supply outlets, our business could be harmed.

 

We purchase a substantial amount of pet supplies from a number of vendors with limited supply capabilities. There can be no assurance that our current pet supply vendors will be able to accommodate our anticipated needs or comply with existing or any new regulatory requirements. In addition, we purchase a substantial amount of pet supplies from vendors outside of the United States. There can be no assurance our overseas vendors will be able to satisfy our requirements including, but not limited to, timeliness of delivery, acceptable product quality, packaging and labeling requirements. Any inability of our existing vendors to provide products in a timely or cost-effective manner could harm our business. While we believe our vendor relationships are satisfactory we have no long-term supply commitments from our vendors, and any vendor could discontinue selling to us at any time.

 

We depend on key personnel and may not be able to retain or replace these employees or recruit additional qualified personnel, which could harm our business.

 

Our success is largely dependent on the efforts and abilities of our senior executive group and other key personnel. The loss of the services of one or more of our key executives or personnel, or the increased demands placed on our key executives and personnel by our continued growth, could adversely impact our financial performance and our ability to execute our strategies. In addition, our future success will depend on our ability to attract highly skilled store managers and qualified services personnel such as pet trainers and groomers. There is a high level of competition for these employees, and our ability to operate our stores and expand our services depends on our ability to attract and retain these personnel. In addition, there historically has been a shortage of qualified veterinarians. If Banfield cannot attract and retain a sufficient number of veterinarians, Banfield’s ability to provide veterinary services in our stores and increase the number of stores in which Banfield provides veterinary services, may be impacted.

 

Our international operations may result in additional market risks, which may harm our business.

 

We entered the Canadian market in 1996 and operated 30 stores in Canada as of January 29, 2006. As these operations grow, they may require greater management and financial resources. International operations require the integration of personnel with varying cultural and business backgrounds and an understanding of the relevant differences in the legal and regulatory environments. Our results may be increasingly affected by the risks of our international activities, including:

 

 

Our business may be harmed if the operation of veterinary hospitals at our stores is limited or fails to continue.

 

We and MMI Holdings, Inc (MMIH), the third party operator of Banfield, The Pet Hospital, are subject to statutes and regulations in various states and Canadian provinces regulating the ownership of veterinary practices, or the operation of veterinary hospitals in retail stores, that may impact our ability and MMI’s ability to operate veterinary hospitals within our facilities. A determination that we or MMI are in violation of any of these applicable statutes and regulations could require us or MMI to restructure our operations to comply or render us or MMI unable to operate veterinary hospitals in a given location. If MMIH or MMI were to experience financial or other operating difficulties that would force it to limit its operations, or if MMIH were to cease operating the veterinary hospitals in

our stores, our business may be harmed, both directly and due to a decrease in customer traffic. There can be no assurance that we could contract with another third party to operate the veterinary hospitals on favorable terms, if at all, or that we could successfully operate the veterinary hospitals ourselves. For a further discussion of our relationship with MMI, please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Related Party Transactions.”

 

Our business would be harmed if we were unable to raise any needed additional capital on acceptable terms.

 

We believe our capital resources and cash flows from operations will enable us to maintain our currently planned operations for the foreseeable future. If, however, we are unable to generate and maintain positive operating cash flows and operating income in the future, we may need additional funding. We may also choose to raise additional capital due to market conditions or strategic considerations even if we believe that we have sufficient funds for our current or future operating plans. Our credit facility is secured by substantially all our personal property assets, our subsidiaries and certain real property. This could limit our ability to obtain, or obtain on favorable terms, additional financing and may make additional debt financing outside our credit facility more costly. If additional capital were needed, an inability to raise capital on favorable terms would harm our business and financial condition. In addition, to the extent that we raise additional capital through the sale of equity or debt securities convertible into equity, the issuance of these securities could result in dilution to our stockholders.

 

A determination of a violation of any contractual obligations or government regulations could result in a disruption to our operations and could harm our business.

 

We are subject to various contractual obligations with third party providers and federal, state, provincial and local laws and regulations governing among other things: our relationships with employees, including minimum wage requirements, overtime, terms and conditions of employment, working conditions and citizenship requirements; veterinary practices, or the operation of veterinary hospitals in retail stores, that may impact our ability to operate veterinary hospitals in certain facilities; the transportation, handling and sale of small pets; environmental regulations with respect to the generation, handling, storage, transportation and disposal of waste and biohazardous materials; the distribution, import/export and sale of products; providing services to our customers; services contracted for with various third party providers; the handling, security, protection and use of customer information; and the licensing and certification of services.

 

We seek to structure our operations to comply with all federal, state, provincial and local laws and regulations of each jurisdiction in which we operate. Given varying and uncertain interpretations of these laws and regulations and the fact that the laws and regulations are enforced by the courts and by regulatory authorities with broad discretion, there can be no assurances that we would be found to be in compliance in all jurisdictions. We also could be subject to costs, including fines, penalties or sanctions and third party claims as a result of violations of, or liabilities under, the above referenced contracts, laws and regulations.

 

A determination by tax regulators may cause our provision for income and other taxes to be inadequate and may result in a material impact to our financial position.

 

We operate in multiple tax jurisdictions and believe an adequate provision for income and other taxes has been made. If, however, tax regulators in these jurisdictions determine that a position that we have taken on an issue is inappropriate, this may result in a material impact to our financial position. The Internal Revenue Service is currently examining our tax returns for fiscal 2002, 2003 and 2004. While the examination has not been finalized, no issues have been identified that would have a material impact on our financial position or results of operations.

 

Our business exposes us to claims that could result in adverse publicity, harm to our brand and a reduction in our sales.

 

We are occasionally subject to claims due to the injury or death of a pet in our stores or while under our care in connection with the pet services we provide. In addition, we sell certain small pets including fish, birds, reptiles and small rodents in our stores. Given the large number of small pets we sell, deaths or injuries of these small pets

sometimes occur while they are within our care. As a result, we may be subject to claims that we do not properly care for these small pets. We may also be subject to claims resulting from the transfer of diseases from pets in our stores to other animals, associates and customers. From time to time, we have been subject to product liability claims for some of the products we sell. Any negative publicity or claims relating to any of the foregoing could harm our reputation and business, as well as expose us to litigation expenses and damages.

 

Pending legislation, weather, disease or other factors could disrupt the supply of the small pets and products we sell, which could harm our reputation and decrease sales.

 

There is generally a significant amount of legislation pending at the federal, state, provincial and local levels regarding the handling of pets. This legislation may impair our ability to transport the small pets we sell in our stores. The small pets we sell in our stores are susceptible to diseases that can quickly decrease or destroy the supply of these pets. In addition, our supply of products may be negatively impacted by weather, disease, contamination or trade barriers. Any disruption in the supply of products to our stores, due to legislation, weather, disease or any other factor, could harm our reputation and decrease our sales.

 

Fluctuations in the stock market, as well as general economic and market conditions, including but not limited to fuel costs, may harm the market price of our common stock.

 

Over the last several years, the market price of our common stock has been subject to significant fluctuations. The market price of our common stock may continue to be subject to significant fluctuations in response to operating results and other factors including, but not limited to:

 

 

In addition, the stock market in recent years has experienced price and volume fluctuations that often have been unrelated or disproportionate to the operating performance of companies. These fluctuations, as well as general economic and market conditions, including but not limited to fuel costs, may harm the market price of our common stock.

 

We have implemented some anti-takeover provisions, including a stockholder rights plan that may prevent or delay an acquisition of us that may not be beneficial to our stockholders.

 

Our restated certificate of incorporation and bylaws include provisions that may delay, defer or prevent a change in management or control that our stockholders may not believe is in their best interests. These provisions include:

 

 

 

In addition, our restated certificate of incorporation requires a 662/3% vote of stockholders to:

 

 

In August 1997, our Board of Directors adopted a Stockholder Rights Plan, commonly referred to as a poison pill, under which one preferred share purchase right was distributed on August 29, 1997, for each share of common stock held on that date. We are also subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, and the application of Section 203 could have the effect of delaying or preventing an acquisition of PetSmart.

 

None.

 

Our stores are generally located in sites co-anchored by strong destination superstores and typically are in or near major regional shopping centers. The following table summarizes the locations of the stores by country and state as of January 29, 2006:

 

We lease substantially all of our stores, retail distribution centers and corporate offices under non-cancellable leases. The terms of the store leases, described below, generally range from 10 to 25 years and typically allow us to renew for three to five additional five-year terms. Store leases, excluding renewal options, expire at various dates through 2023. Certain leases require payment of property taxes, utilities, common area maintenance and insurance and, if annual sales at certain stores exceed specified amounts, provide for additional rent. We have paid minimal additional rent under these provisions during fiscal 2005, 2004 and 2003.

 

Our corporate offices cover approximately 219,000 square feet, and the leases expire beginning in 2009. Our distribution centers and respective lease expirations are as follows:

 

 

We also own and operate an internet fulfillment, equine catalog fulfillment and equine distribution center in Brockport, New York, which covers approximately 392,000 square feet.

 

In January 2006, we entered into an agreement to lease approximately 877,500 square feet in Newnan, Georgia to be used as a distribution center. This facility is expected to open in fiscal 2007 and will replace the current 200,000 square foot forward distribution center we currently lease in Newnan, Georgia.

 

We are involved in the defense of various legal proceedings that we do not believe are material to our business.

 

No matters were submitted to a vote of our security holders during the fourth quarter of the fiscal year ended January 29, 2006.

 

Price Range of Common Stock and Dividend Policy.  Our common stock is traded on the NASDAQ National Market under the symbol PETM. The following table indicates the intra-day quarterly high and low price per share of our common stock. These prices represent quotations among dealers without adjustments for retail mark-ups, markdowns or commissions, and may not represent actual transactions.

 

 

Dividends.  We believe our ability to generate cash allows us to invest in the growth of the business and, at the same time, distribute a quarterly dividend. Our credit facility permits us to pay dividends, so long as we are not in default and the payment of dividends would not result in default. In fiscal 2005, the following dividends were declared by the Board of Directors:

 

 

Holders.  On March 28, 2006, there were 4,288 holders of record of our common stock.

 

Equity Compensation Plan Information.  Information regarding our equity compensation plans will be included in our proxy statement with respect to our Annual Meeting of Stockholders to be held on June 22, 2006 under the caption “Equity Compensation Plans” and is incorporated by reference in this Annual Report on Form 10-K.

Stock Purchase Program.  The following table shows purchases of our common stock and the available funds to purchase additional common stock for each period in the thirteen weeks ended January 29, 2006:

 

 

 

 

The following selected financial data is derived from the consolidated financial statements of PetSmart, Inc. The data for periods prior to fiscal 2005 has been adjusted to reflect the adoption of SFAS No. 123(R), “Share-Based Payments” as described in “Note 2: Change in Accounting Principle and Reclassifications in Consolidated Financial Statements and Notes to Consolidated Financial Statements” under Notes to Consolidated Financial Statements included in Item 8, “Financial Statements and Supplementary Data” of this Form 10-K. The data below should be read in conjunction with Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Company’s consolidated financial statements and notes thereto.

 

 

 

 

Except for historical information, the following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could materially differ from those discussed here. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this section, as well as in the sections entitled Competition, Distribution, Information Systems and Government Regulation included in Item 1 Part I and Risk Factors included in Item 1 Part 1a of this Annual Report on Form 10-K.

 

The accompanying Management’s Discussion and Analysis of Financial Condition and Results of Operations includes the change in accounting principle and reclassifications discussed in Note 2 to the Notes to Consolidated Financial Statements.

 

Overview

 

Based on our fiscal 2005 sales of $3.8 billion, we are North America’s leading specialty provider of products, services and solutions for the lifetime needs of pets. As of January 29, 2006, we operated 826 stores, and we anticipate opening approximately 90 net new stores in fiscal 2006. Our stores carry a broad and deep selection of high-quality pet supplies at everyday low prices. We offer more than 12,800 distinct items, including nationally recognized brand names, as well as an extensive selection of private brands across a range of product categories. We continue to invest in education for our approximately 34,600 associates as part of our emphasis on customer service and providing pet care solutions.

 

We complement our extensive product assortment with a wide selection of value-added pet services, including grooming, pet training, boarding and day camp. All our stores offer complete pet training services, and virtually all our stores feature pet styling salons that provide high-quality grooming services.

 

Through our strategic relationship with Banfield, The Pet Hospital, and other third-party operators, we made full-service veterinary care available in 525 of our stores as of January 29, 2006. In fiscal 2005, we began a national roll out of the PetsHotel boarding and day camp concept. As of January 29, 2006, we operated 32 PetsHotels within our retail stores in addition to one stand-alone location. In October 2004, we launched our test of the Doggie Day Camp concept, which is also available at our PetsHotel locations. During 2005, we expanded our test of Doggie Day Camp to six additional stores without a full hotel, for a total of seven Doggie Day Camps. We believe we ultimately can operate 300 PetsHotels, as well as 40 additional in-store Doggie Day Camps.

 

We also reach customers through our direct marketing channels, including PetSmart.com, one of the Internet’s most popular pet e-commerce sites, an e-commerce site dedicated to equine products and an equine catalog.

 

Executive Summary

 

 

 

Critical Accounting Policies and Estimates

 

The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our estimates for inventory valuation reserves, insurance liabilities and reserves, reserve for closed stores, reserves against deferred tax assets and tax contingencies. We base our estimates on historical experience and on various other assumptions we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Under different assumptions or conditions, actual results may differ from these estimates. We believe the following critical accounting policies reflect the more significant judgments and estimates we use in preparing our consolidated financial statements.

 

Inventory Valuation Reserves

 

We have established reserves for estimated inventory shrinkage between physical inventories. Stores perform physical inventories once a year, and between the physical inventories, the stores perform counts on certain inventory items. Distribution centers and forward distribution centers perform cycle counts encompassing all inventory items at least once every quarter or perform an annual physical inventory. Due to the holiday season, the majority of the stores do not perform physical inventories during the last quarter of the fiscal year, but continue to perform counts on certain inventory items. Therefore, as of the end of a reporting period, there will be stores with certain inventory items that have not been counted. For each reporting period presented, we estimate inventory shrinkage based on a two-year historical trend analysis. Changes in shrink results or market conditions could cause actual results to vary from estimates used to establish the inventory reserves.

 

We also have reserves for estimated obsolescence and to reduce inventory to the lower of cost or market. We evaluate inventories for excess, obsolescence or other factors that may render inventories unmarketable at their recorded cost. Obsolescence reserves are recorded so inventories reflect the approximate net realizable value. Factors included in determining obsolescence reserves include current and anticipated demand, customer

preferences, age of merchandise, seasonal trends and decisions to discontinue certain products. If assumptions about future demand change or actual market conditions are less favorable than those projected by management, we may require additional reserves. During fiscal 2005, we increased our obsolescence reserve to account for certain obsolete inventory by $7.3 million to $8.5 million, as of January 29, 2006.

 

Reserve for Closed Stores

 

We continuously evaluate the performance of our retail stores and periodically close those that are under-performing. Closed stores are generally replaced by a new store in a nearby location. We establish reserves for future occupancy payments on closed stores in the period the store is closed, in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” These costs are classified in operating, general and administrative expenses in the Consolidated Statements of Operations. We calculate the costs for future occupancy payments, net of expected sublease income, associated with closed stores using the net present value method, at a credit-adjusted risk-free interest rate, over the remaining life of the lease. We use judgment to estimate the underlying real estate market related to the expected sublease income and timing of the sublease start date, and we can make no assurances that additional charges for these stores will not be required based on the changing real estate environment.

 

As of January 29, 2006 and January 30, 2005, we had 19 and 17 stores included in our closed store reserve, of which 12 and 12 were under sublease agreements, respectively. In addition to the stores with sublease agreements as of January 29, 2006, we have assumed that three stores will have sublease income in future periods, which represents a $1.5 million reduction to the reserve. If these sublease assumptions were extended by a year from the anticipated commencement date of the assumed sublease term, the reserve would increase by approximately $0.5 million. We closed seven stores in fiscal 2005 and nine stores in fiscal 2004, of which two stores in fiscal 2005 closed as scheduled due to lease expiration and two stores were closed under lease termination agreements. The closed store reserves are as follows (in thousands):

 

 

Insurance Liabilities and Reserves

 

We maintain standard property and casualty insurance on all our properties and leasehold interests, product liability insurance that covers products and the sale of pets, self-insured health plans, employer’s professional liability and workers’ compensation insurance. Property insurance covers approximately $1.2 billion in buildings and contents, including furniture and fixtures, leasehold improvements and inventory. Under our casualty and workers’ compensation insurance policies through January 31, 2004, we retained the initial risk of loss of $0.25 million for each policy per occurrence. Effective February 1, 2004, we engaged a new insurance provider. Under our casualty and workers’ compensation insurance policies with the new provider, we retain an initial risk of loss of $0.5 million for each policy per occurrence on or subsequent to February 1, 2004. We establish reserves for losses based on semi-annual independent actuarial estimates of the amount of loss inherent in that period’s claims, including losses for which claims have been incurred but not reported. Loss estimates rely on actuarial observations of ultimate loss experience for similar historical events, and changes in such assumptions could result in an adjustment to the reserves. As of January 29, 2006 and January 30, 2005, we had approximately $54.2 million and $41.6 million, respectively, in reserves related to casualty, self-insured health plans, employer’s professional liability and workers’ compensation insurance policies.

Income Taxes

 

We establish deferred income tax assets and liabilities for temporary differences between the financial reporting bases and the income tax bases of our assets and liabilities at enacted tax rates expected to be in effect when such assets or liabilities are realized or settled. We record a valuation allowance on the deferred income tax assets to reduce the total to an amount we believe is more likely than not to be realized. Valuation allowances at January  29, 2006 and January 30, 2005 were principally to offset certain deferred income tax assets for operating and capital loss carryforwards.

 

We accrue for potential income tax contingencies when it is probable that a liability to a taxing authority has been incurred and the amount of the liability can be reasonably estimated, based upon our view of the likely outcomes of current and future audits. We adjust our accrual for income tax contingencies for changes in circumstances and additional uncertainties, such as amendments to existing tax law, both legislated and concluded through the various jurisdictions’ tax court systems. At January 29, 2006, we had an accrual for income tax contingencies of $14.0 million. If the amounts ultimately settled with tax authorities are greater than the accrued contingencies, we must record additional income tax expense in the period in which the assessment is determined. To the extent amounts are ultimately settled for less than the accrued contingencies, or we determine that a liability to a taxing authority is no longer probable, the contingency is reversed as a reduction of income tax expense in the period the determination is made.

 

During the third quarter of fiscal 2005, we recorded a reduction to income tax expense of approximately $6.1 million. The period of assessment, during which additional tax may be imposed for years prior to 2002, has expired for several jurisdictions. As a result, we determined that approximately $6.5 million of tax contingency reserves are no longer probable of assertion and have reduced them accordingly, with approximately $6.1 million as a reduction in expense and approximately $0.4 million as an increase to additional paid-in capital. We also recorded additional tax expense during the third quarter of fiscal 2005 of approximately $2.3 million resulting from a correction of our deferred tax assets related to equity-based compensation recognized for periods prior to fiscal 2002. In the fourth quarter of 2005, we recorded additional tax expense of $2.0 million resulting from an adjustment to deferred tax assets and liabilities.

 

In the second quarter of fiscal 2004, we completed an analysis of our net operating loss carryovers related to our fiscal 2000 purchase of PetSmart.com, based on guidance issued from the Internal Revenue Service. As a result, we expect to utilize an additional $22.1 million of net operating losses previously considered unavailable. We recorded a total tax benefit of $7.7 million in the second quarter of fiscal 2004 related to the additional net operating loss utilization.

 

We operate in multiple tax jurisdictions and could be subject to audit in any of these jurisdictions. These audits can involve complex issues that may require an extended period of time to resolve and may cover multiple years. The Internal Revenue Service is currently examining our tax returns for fiscal 2002, 2003 and 2004. While the examination has not been finalized, no issues have been identified that would have a material impact on our financial position or results of operations.

 

During fiscal 2005, we raised an affirmative issue with the Internal Revenue Service with respect to the characterization of certain losses. Final agreement has not been reached with the Internal Revenue Service on this issue and, therefore, no benefit has been reflected in the consolidated financial statements related to this item. Management currently estimates that the range of potential benefit will be between zero and approximately $1.9 million. Any amount ultimately sustained would be reflected as a reduction of income tax expense in the fiscal quarter in which final agreement is reached with the Internal Revenue Service.

Results of Operations

 

The following table presents the percent to net sales of certain items included in our Consolidated Statements of Operations:

 

 

Fiscal 2005 Compared to Fiscal 2004

 

Net Sales

 

Fiscal 2005 net sales increased $397.0 million, or 11.8%, to $3.8 billion, compared to net sales of $3.4 billion in fiscal 2004, due to the addition of 100 net new stores since January 30, 2005 and a 4.2% increase in comparable store sales for fiscal 2005. Our comparable store sales growth was 6.3% for fiscal 2004. We believe the decrease in our comparable store sales growth rate during fiscal 2005 as compared to fiscal 2004 was due to general economic conditions, including increased fuel prices, which caused a decrease in consumer spending. In addition, we lost 437 days of sales from store closures due to the effect of hurricanes in the third quarter of fiscal 2005.

 

Services sales, which are included in our net sales and include grooming, pet training, boarding and day camp operations, increased by 24.2%, or $58.2 million, to $298.9 million. This increase was primarily due to an increase in grooming volume during fiscal 2005.

 

Gross Profit

 

Gross profit increased as a percentage of net sales to 31.3% for fiscal 2005, from 30.9% for fiscal 2004. The increase reflects higher margins on product sales due to improved buying practices, our ongoing pricing strategies and increased inventory levels resulting in more of our costs capitalized in inventory. These increases were partially offset by various fixed and variable expenses in cost of sales including occupancy, warehousing and transportation costs and inventory-related costs.

 

Store and occupancy costs increased as we opened more stores and opened our Illinois distribution facility. Warehousing and transportation costs increased due to additional variable expenses from our Illinois distribution facility and higher fuel prices. Inventory-related costs increased due to higher inventory shrinkage results and higher obsolescence charges.

 

In addition, gross profit on our services decreased as a percentage of net sales due to the increase in variable and infrastructure expenses associated with the opening of new PetsHotels.

 

Operating, General and Administrative Expenses

 

Operating, general and administrative expenses, or OG&A, decreased as a percentage of net sales to 23.0% for fiscal 2005, from 23.2% for fiscal 2004. This decrease was primarily driven by decreases in compensation costs and

legal settlements; partially offset by increases in advertising and store opening expenses. Compensation costs decreased as a result of a reduction in stock-based compensation recognized, charges incurred in fiscal 2004 related to workers’ compensation reserves which were not incurred at the same levels in fiscal 2005 and lower bonus expense recognized in fiscal 2005. Legal settlements recorded as a reduction of OG&A expenses were larger in fiscal 2005 as compared to fiscal 2004 primarily due to a one-time legal settlement recorded in the first quarter of fiscal 2005 and a Visa/Mastercard settlement recorded in the fourth quarter of fiscal 2005. Advertising expenses increased as a result of our “Mart” to “Smart” advertising initiative. Store opening expenses increased as a result of an increase in new store openings and the timing of openings.

 

Interest Income

 

Interest income increased to $9.0 million during fiscal 2005 compared to $4.8 million during fiscal 2004 primarily due to an increase in interest rates.

 

Interest Expense

 

Interest expense increased to $31.2 million for fiscal 2005, from $21.3 million for fiscal 2004. The increase was primarily due to an increase in capital lease obligations in fiscal 2005.

 

Income Tax Expense

 

For fiscal 2005, income tax expense was $106.7 million representing an effective rate of 36.9%. For fiscal 2004, income tax expense of $83.4 million represented an effective rate of 34.6%. The increase in the effective tax rate from fiscal 2004 to fiscal 2005 was primarily due to a tax benefit of $7.7 million recorded in the second quarter of fiscal 2004 related to the expected utilization of $22.1 million of net operating losses previously considered unavailable. We also recorded additional tax expense of $2.0 million in the fourth quarter of fiscal 2005 and $2.3 million in the third quarter of fiscal 2005 resulting primarily from adjustments to deferred tax assets and liabilities. Offsetting these increases to the effective rate, during the third quarter of fiscal 2005, we recorded a reduction to income tax expense of $6.1 million related to reductions in certain tax reserves that we determined would no longer be needed.

 

Fiscal 2004 Compared to Fiscal 2003

 

Net Sales

 

Net sales increased $370.3 million, or 12.4%, to $3.4 billion for fiscal 2004, compared to net sales of $3.0 billion for fiscal 2003. The sales increase was due to 83 net new stores and a 6.3% increase in comparable store sales for fiscal 2004. Services sales, which are included in our net sales and include grooming, pet training, pet boarding and day camp operations, increased by 24.4%, or $47.2 million, to $240.7 million.

 

Gross Profit

 

Gross profit increased as a percentage of net sales to 30.9% for fiscal 2004, from 30.1% for fiscal 2003. The increase primarily reflected higher margins on product sales during fiscal 2004 compared with fiscal 2003 due to improved buying practices and our ongoing pricing strategies. We also experienced lower inventory shrinkage and other inventory related expenses as a percentage of sales in fiscal 2004 compared to fiscal 2003. In addition, occupancy costs recorded in cost of sales decreased as a percentage of sales in fiscal 2004 compared to fiscal 2003. These items were partially offset by higher freight costs as a result of increased fuel prices.

 

Operating, General and Administrative Expenses

 

Operating, general and administrative expenses increased as a percentage of net sales to 23.2% for 2004, from 22.8% for 2003. The increase was primarily due to increases in workers’ compensation, general liability and medical insurance costs as well as higher repairs and maintenance costs in our stores. The higher insurance costs were primarily due to increases in actuarial estimates for workers’ compensation and general liability claims. In addition, we recognized a $4.1 million expense in the second quarter of fiscal 2004 primarily for the retirement of

assets and additional amortization related to store lighting replacements. The increases were offset by lower advertising, bonus and closed store expenses as a percentage of revenue in fiscal 2004 compared to fiscal 2003. We also recognized a $3.6 million gain from a legal settlement in the fourth quarter of 2004.

 

Interest Income

 

Interest income increased to $4.8 million during fiscal 2004 compared to $3.4 million during fiscal 2003 primarily due to an increase in interest rates.

 

Interest Expense

 

Interest expense increased to $21.3 million for fiscal 2004, from $19.3 million for fiscal 2003. The increase was primarily due to an increase in capital lease obligations in 2004.

 

Income Tax Expense

 

For fiscal 2004, income tax expense was $83.4 million representing an effective rate of 34.6%. For fiscal 2003, income tax expense of $78.0 million represents an effective rate of 38.4%. The reduction in the effective tax rate from fiscal 2003 to 2004 is primarily due to an analysis of our net operating loss carryovers related to our fiscal 2000 purchase of PetSmart.com. We completed the analysis in the second quarter of 2004 and it was based on guidance issued from the Internal Revenue Service. As a result, we expect to utilize an additional $22.1 million of net operating losses previously considered unavailable. We recorded a total tax benefit of $7.7 million in the second quarter of fiscal 2004, related to the additional net operating loss utilization. In addition, we recognized a legal settlement of $3.6 million in the fourth quarter of fiscal 2004, which allowed us to use a portion of our capital loss carryforwards. We reversed a previously established valuation allowance, and as a result, recorded a tax benefit of $1.2 million.

 

Liquidity and Capital Resources

 

Cash Flow and Balance Sheet Data

 

The following table represents our cash and cash equivalents and short-term investments (in thousands):

 

 

We manage our cash and cash equivalents and short-term investments in order to fund operating requirements. Cash and cash equivalents increased $23.4 million to $110.4 million as of January 29, 2006. Short-term investments decreased $93.7 million to $219.9 million as of January 29, 2006. Short-term investments mainly consist of Auction Rate Securities, or ARS. ARS generally have long-term maturities beyond three months but are priced and traded as short-term instruments.

 

Cash provided by operations increased $86.2 million to $342.3 million in 2005, compared with $256.1 million in fiscal 2004. Cash provided by operating activities was generated primarily by net income of $182.5 million and non-cash depreciation and amortization expenses of $139.6 million and stock-based compensation of $22.4 million. Cash is used in operating activities primarily to fund growth in inventory and other assets, net of accounts payable and other accrued liabilities. Inventory increased to $399.4 million at January 29, 2006 compared to $337.3 million at January 30, 2005 primarily due to the build up of inventory for our new distribution center, 100 net new stores in fiscal 2005 and a decision to slightly increase our average inventory per store in support of a strong and consistent in-stock position. Accounts payable increased by $25.1 million as a result of increased inventory levels. Other current liabilities increased $55.1 million as a result of increased taxes payable and accruals for advertising, capital invoices and freight.

Our primary long-term capital requirements consist of opening new stores, reformatting existing stores, expenditures associated with equipment and computer software in support of our system initiatives, PetsHotel construction costs and other expenditures to support our growth plans and initiatives. For fiscal 2005, we used $165.7 million in cash for capital expenditures, compared with $143.6 million for fiscal 2004. The fiscal 2005 expenditures were primarily related to new stores, remodel projects, information systems projects and fixtures and equipment for a new distribution center.

 

Net cash used in financing activities for 2005 was $251.7 million, which is comprised primarily of $265.0 million for the purchase of treasury stock, $17.2 million for dividends and $10.3 million for payments on capital lease obligations, offset by $33.1 million in proceeds from the exercises of stock options and from our employee stock purchase plan. Net cash used in financing activities for 2004 was $41.8 million.

 

Common Stock Purchase Program

 

In April 2000, the Board of Directors approved a plan to purchase our common stock. In March 2003, the Board of Directors extended the term of the purchase of our common stock for an additional three years through March 2006 and increased the authorized amount of annual purchases to $35.0 million. In September 2004, the Board of Directors approved a program, which replaced the March 2003 program, authorizing the purchase of up to $150.0 million of our common stock through fiscal 2005. During the first quarter of fiscal 2005, we purchased approximately 3,618,000 shares of our common stock for approximately $105.0 million which completed the authorized purchase of $150.0 million of our common stock under the September 2004 program.

 

In June 2005, the Board of Directors approved a program authorizing the purchase of up to $270.0 million of our common stock through fiscal 2006. During fiscal 2005, we purchased approximately 6,322,000 shares of our common stock for approximately $160.0 million under the June 2005 program.

 

Common Stock Dividends

 

We believe our ability to generate cash allows us to invest in the growth of the business and, at the same time, distribute a quarterly dividend. Our credit facility permits us to pay dividends, so long as we are not in default and the payment of dividends would not result in default. In fiscal 2005, the following dividends were declared by the Board of Directors:

 

 

On March 28, 2006, the Board of Directors declared a quarterly cash dividend of $0.03 per share, payable on May 12, 2006 to stockholders of record on April 28, 2006.

 

Operating Capital and Capital Expenditure Requirements

 

Substantially all our stores are leased facilities. We opened 100 net new stores in fiscal 2005. Generally, each new store requires capital expenditures of approximately $0.9 million for fixtures, equipment and leasehold improvements, approximately $0.2 million for inventory and approximately $0.1 million for preopening costs. We expect capital spending to be approximately $200 million to $230 million for fiscal 2006, based on our current plan to open approximately 90 net new stores and 30 new PetsHotels, to fixture and equip a new distribution center in Newnan, Georgia, which is expected to open in fiscal 2007, to continue our investment in the development of our information systems, to add to our services capacity with the expansion of certain grooming salons, to remodel or replace certain store assets and to roll out our store refresh program.

 

We believe our existing cash and cash equivalents, together with cash flows from operations, borrowing capacity under our bank credit facility and available lease financing, will provide adequate funds for our foreseeable working capital needs, planned capital expenditures and debt service obligations. Our ability to fund our operations,

make planned capital expenditures, scheduled debt payments and refinance indebtedness depends on our future operating performance and cash flow, which are subject to prevailing economic conditions and to financial, business and other factors, some of which are beyond our control.

 

Lease and Other Commitments

 

Operating and Capital Lease Commitments and Purchase Obligations

 

The following table summarizes our contractual obligations, net of estimated sublease income, and including obligations for executed agreements for which we do not yet have the right to control the use of the property at January 29, 2006, and the effect that such obligations are expected to have on our liquidity and cash flows in future periods (in thousands):

 

 

 

 

The operating and capital lease commitment payment schedule above is shown net of estimated sublease income. Sublease income for operating and capital leases at January 29, 2006 is as follows (in thousands):

 

 

Letters of Credit

 

We issue letters of credit for guarantees provided for insurance programs, capital lease agreements and utilities. As of January 29, 2006, $41.7 million was outstanding under our letters of credit.

 

Related Party Transactions

 

We have an investment in MMI Holdings, Inc., or MMIH, a provider of veterinary and other pet-related services. MMIH, through a wholly owned subsidiary, Medical Management International, Inc., or MMI, operates full-service veterinary hospitals inside 513 of our stores, under the registered trademark of Banfield, The Pet Hospital. Philip L. Francis, our Chairman and Chief Executive Officer, and Robert F. Moran, our President and Chief Operating Officer, are members of the board of directors of MMIH. Our investment consists of common and convertible preferred stock. During the second quarter of 2004, we purchased an additional $0.8 million of MMIH capital stock from certain MMIH stockholders, and as of January 29, 2006, we owned approximately 17.1% of the voting stock and approximately 37.0% of the combined voting and non-voting stock of MMIH. We charge MMI licensing fees for the space used by the veterinary hospitals, and we treat this income as a reduction of the retail

stores’ occupancy costs. We record occupancy costs as a component of cost of sales in our Consolidated Statements of Operations. Licensing fees are determined by fixed costs per square foot, adjusted for the number of days the hospitals are open and sales volumes achieved. We recognized licensing fees of $16.3 million in fiscal 2005, $13.1 million in fiscal 2004 and $10.5 million in fiscal 2003. We also charge MMI for its portion of specific operating expenses and treat the reimbursement as a reduction of the stores’ operating expenses. Receivables from MMI totaled $5.4 million and $5.5 million at January 29, 2006 and January 30, 2005, respectively, and were included in receivables in the Consolidated Balance Sheets.

 

Credit Facility

 

We have an available credit facility of $125.0 million, which expires April 30, 2008. Borrowings under the credit facility are subject to a borrowing base and bear interest, at our option, at either a bank’s prime rate plus 0% to 0.50% or LIBOR plus 1.25% to 1.75%. We are subject to fees payable to the lenders each quarter at an annual rate of 0.25% of the unused amount of the credit facility. Letter of credit issuances under the credit facility are subject to a borrowing base and bear interest of LIBOR plus 1.25% to 1.75% or LIBOR less 0.50%, depending on the type of letter of credit issued. The credit facility permits the payment of dividends, so long as we are not in default and the payment of dividends would not result in default of the facility. The credit facility is secured by substantially all our personal property assets, our subsidiaries and certain real property. As of January 29, 2006, we had no borrowings outstanding under the credit facility; however, we issue letters of credit for guarantees provided for insurance programs, capital lease agreements and utilities. Subsequent to January 29, 2006, we determined that we were in technical non-compliance under our credit facility during a portion of fiscal 2005. In March 2006, the lender group waived such past non-compliance, and we are currently in compliance with our credit facility.

 

Seasonality and Inflation

 

Our business is subject to seasonal fluctuations. We typically realize a higher portion of our net sales and operating profit during the fourth fiscal quarter. As a result of this seasonality, we believe that quarter-to-quarter comparisons of our operating results are not necessarily meaningful, and that these comparisons cannot be relied upon as indicators of future performance. Controllable expenses, such as advertising, could fluctuate from quarter-to-quarter in a fiscal year. Sales of certain products and services designed to address pet health needs are seasonal. Because our stores typically draw customers from a large trade area, sales also may be impacted by adverse weather or travel conditions, which are more prevalent during certain seasons of the year. Finally, as a result of our expansion plans, the timing of new store openings and related preopening expenses, the amount of revenue contributed by new and existing stores, and the timing and estimated obligations of store closures, our quarterly results of operations may fluctuate.

 

Recent Accounting Pronouncements

 

On December 16, 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes Accounting Principles Board Opinion, or APB, No. 25, “Accounting for Stock Issued to Employees”, and its related implementation guidance. SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their grant-date fair values. SFAS No. 123(R) is effective for public companies at the beginning of the first interim or annual period beginning after December 31, 2005. We adopted SFAS No. 123(R) in the first quarter of fiscal 2005 and utilized the modified retrospective transition method, which allows the adjustment of prior periods by recognizing compensation cost in the amounts previously reported in the pro forma footnote disclosures under the provisions of SFAS No. 123.

 

In November 2004, the FASB issued Emerging Issues Task Force, or EITF, No. 03-13, “Applying the Conditions in Paragraph 42 of FASB Statement No. 144 in Determining Whether to Report Discontinued Operations,” to assist entities in analyzing SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” EITF No. 03-13 specifically addresses paragraph 42 of SFAS No. 144, which states that the results of operations of a component of an entity that either has been disposed of or is classified as held for sale shall be reported in discontinued operations in accordance with certain provisions. EITF No. 03-13 is applicable to an enterprise’s component that is either disposed of or classified as held for sale in fiscal periods beginning after

December 15, 2004. We adopted EITF No. 03-13 in the first quarter of fiscal 2005, and the adoption had no impact on our consolidated financial statements.

 

In June 2005, the FASB issued EITF No. 05-6, “Determining the Amortization Period for Leasehold Improvements.” EITF No. 05-6 addresses the amortization period for leasehold improvements in operating leases that are either (a) placed in service significantly after and not contemplated at or near the beginning of the initial lease term or (b) acquired in a business combination. EITF No. 05-6 is effective for leasehold improvements that are purchased or acquired in reporting periods beginning after June 29, 2005. We adopted EITF No. 05-6 in the second quarter of 2005, and the adoption did not have a material impact on our consolidated financial statements.

 

In August 2005, the FASB issued Financial Interpretation, or FIN, 47, “Accounting for Conditional Asset Retirement Obligations,” which is an interpretation of SFAS No. 143, “Accounting for Asset Retirement Obligations.” FIN 47 clarifies terminology within SFAS No. 143 and requires an entity to recognize a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated. FIN 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN 47 is effective no later than fiscal years ending after December 15, 2005. We adopted FIN 47 in the fourth quarter of fiscal 2005, and the adoption did not have a material impact on our consolidated financial statements.

 

Other Information

 

Consistent with Section 10A(i)(2) of the Securities Exchange Act of 1934, as added by Section 202 of the Sarbanes-Oxley Act of 2002, PetSmart is responsible for listing the non-audit services approved in the fourth quarter of fiscal 2005 by the PetSmart Audit Committee to be performed by Deloitte & Touche LLP, our independent registered public accountants. Non-audit services are defined in the law as services other than those provided in connection with an audit or a review of the financial statements of PetSmart. There were no non-audit services approved by the Audit Committee in the fourth quarter of fiscal 2005.

 

We are subject to certain market risks arising from transactions in the normal course of our business. Such risk is principally associated with interest rate and foreign exchange fluctuations, as well as changes in our credit standing. In addition, a market risk exists associated with fuel prices.

 

Interest Rate Risk

 

We have the ability to use a revolving line of credit and short-term bank borrowings to support seasonal working capital needs and to finance capital requirements of the business. There were no borrowings during fiscal 2005 or 2004.

 

Foreign Currency Risk

 

Our Canadian subsidiary operates 30 stores and uses the Canadian dollar as the functional currency and the United States dollar as the reporting currency. We have certain exposures to foreign currency risk. However, we believe that such exposure does not present a significant risk due to a relatively limited number of transactions and accounts denominated in foreign currency. Approximately $107.7 million, or 2.9% of net sales for fiscal 2005, were denominated in the Canadian dollar. Transaction gains and losses on United States dollar denominated transactions are recorded within cost of sales or operating, general and administrative expenses in the Consolidated Statements of Operations, depending on the nature of underlying transactions. During the second quarter of 2004, we implemented a new structure in our Canadian subsidiary that we believe will allow us to minimize the impact of future transaction gains and losses. We had net exchange gains approximating $0.2 million and $2.4 million in fiscal 2005 and 2004, respectively, as well as net exchange losses approximating $0.4 million in fiscal 2003.

 

The information required by this Item is attached as Appendix F.

 

None.

 

PetSmart maintains disclosure controls and procedures that are designed to provide reasonable assurance that information required to be disclosed in our reports under the Securities Exchange Act of 1934, as amended or the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), as appropriate, to allow timely decisions regarding required disclosure.

 

As required by Rule 13a-15(b) under the Securities Exchange Act of 1934, as amended, our management conducted an evaluation (under the supervision and with the participation of our CEO and our CFO) as of the end of the period covered by this report, of the effectiveness of our disclosure controls and procedures as defined in Rule 13a-15(e) under the Exchange Act. In performing this evaluation, our CEO and CFO concluded that, as of January 29, 2006, our disclosure controls and procedures were (1) designed to ensure that material information relating to us, including our consolidated subsidiaries, is made known to our CEO and CFO by others within the entities, particularly during the period in which this report was being prepared and (2) effective, in that they provide reasonable assurance that information required to be discussed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

 

Management’s Report on Internal Control Over Financial Reporting

 

We are responsible for the preparation and integrity of the consolidated financial statements appearing in our Annual Report on Form 10-K. The financial statements were prepared in conformity with generally accepted accounting principles appropriate in the circumstances and, accordingly, include certain amounts based on our best judgments and estimates. Financial information in this Annual Report on Form 10-K is consistent with that in the financial statements.

 

We are responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rules 13a-15(f) under the Securities Exchange Act of 1934, as amended. Our internal controls over financial reporting are designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Consolidated Financial Statements. Our internal control over financial reporting is supported by a program of internal audits and appropriate reviews by management, written policies and guidelines, careful selection and training of qualified personnel and a written Code of Business Conduct adopted by our Company’s Board of Directors, applicable to all PetSmart Directors and all officers and employees of PetSmart and our subsidiaries.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements and even when determined to be effective, can only provide reasonable assurance with respect to financial statement preparation and presentation. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Management assessed the effectiveness of our internal control over financial reporting as of January 29, 2006. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control — Integrated Framework. Based on our assessment, management believes that PetSmart maintained effective internal control over financial reporting as of January  29, 2006.

 

Deloitte & Touche LLP, a registered public accounting firm, is appointed by the Audit Committee of the Company’s Board of Directors, subject to ratification by our stockholders. Deloitte & Touche LLP has audited and reported on the Consolidated Financial Statements of PetSmart and our subsidiaries and management’s assessment

of the effectiveness of our internal control over financial reporting. The reports of the independent registered public accounting firm are contained in this Annual Report.

 

Changes in Internal Control Over Financial Reporting

 

There was no change in our internal control over financial reporting, as defined in Rules 13a-15(f) and 15d-1(f) of the Exchange Act during the fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

Independent Registered Public Accountant Firm Report on Internal Control Over Financial Reporting

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

Board of Directors and Stockholders

PetSmart, Inc.

Phoenix, Arizona

 

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that PetSmart, Inc. and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of January 29, 2006, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

 

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of January 29, 2006, is fairly stated, in all material respects, based on the criteria established in

Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of January 29, 2006, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedule as of and for the year ended January 29, 2006 of the Company and our reports dated April 10, 2006 expressed an unqualified opinion on those financial statements and financial statement schedule and included an explanatory paragraph regarding the Company’s adoption of Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, using the modified retrospective transition method.

 

DELOITTE & TOUCHE LLP

 

Phoenix, Arizona

April 10, 2006

 

None

 

 

 

The information required by this item is incorporated by reference from the information under the caption “Corporate Governance and the Board of Directors” in our proxy statement for our Annual Meeting of Stockholders to be held on June 22, 2006.

 

The required information concerning our executive officers is contained in Item 1, Part 1 of this Annual Report on Form 10-K.

 

All PetSmart associates must act ethically at all times and in accordance with the policies in PetSmart’s Code of Business Ethics and Policies. We require full compliance with this policy and all designated associates including our Principal Executive Officer, Principal Financial Officer, Principal Accounting Officer and other individuals performing similar positions, to sign a certificate acknowledging that they have read, understand and will continue to comply with the policy. We publish the policy, and any amendments or waivers to the policy will be published in the Corporate Governance section of the PetSmart internet web-site located at www.petm.com.

 

 

The information required by this item is incorporated by reference from the information under the captions “Compensation Committee and Executive Compensation,” “Summary Compensation,” “Stock Option Grants, Exercises and Plans,” and “Employment and Severance Arrangements” in our proxy statement.

 

 

The information required by this item is incorporated by reference from the information under the captions “Security Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plans” in our proxy statement.

 

 

The information required by this item is incorporated by reference from the information under the caption “Certain Relationships and Transactions” in our proxy statement.

 

 

The information required by this item is incorporated by reference from the information under caption “Fees to Independent Registered Public Accounting Firm for Fiscal 2005 and 2004” in our proxy statement.

 

 

 

(a) The following documents are filed as part of this Annual Report on Form 10-K.

 

1. Financial Statements:  The financial statements of PetSmart are included as Appendix F of this Annual Report. See Index to Consolidated Financial Statements and Financial Statement Schedule on page F-1.

 

2. Financial Statement Schedule:  The financial statement schedule required under the related instructions is included within Appendix F of this Annual Report. See Index to Consolidated Financial Statements and Financial Statement Schedule on page F-1.

 

3. Exhibits:  The exhibits which are filed with this Annual Report or which are incorporated herein by reference are set forth in the Exhibit Index on page E-1.

SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on April 7, 2006.

 

PetSmart, Inc.

 

 

Philip L. Francis

Chairman of the Board of Directors,

and Chief Executive Officer

 

POWER OF ATTORNEY

 

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Philip L. Francis and Timothy E. Kullman and each of them, as his or her true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him or her and in his or her name, place, and stead, in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his or her substitute or substitutes, may lawfully do or cause to be done by virtue hereof.

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

 

APPENDIX E

 

PetSmart, Inc.

 

ANNUAL REPORT ON FORM 10-K

 

EXHIBIT INDEX

 

 

 

APPENDIX F

 

PetSmart, Inc. and Subsidiaries

 

Index to Consolidated Financial Statements and
Financial Statement Schedule

 

 

Board of Directors and Stockholders

PetSmart, Inc.

Phoenix, Arizona

 

We have audited the accompanying consolidated balance sheets of PetSmart, Inc. and subsidiaries (the “Company”) as of January 29, 2006 and January 30, 2005, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three fiscal years in the period ended January 29, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of PetSmart, Inc. and subsidiaries as of January 29, 2006 and January 30, 2005, and the results of their operations and their cash flows for each of the three fiscal years in the period ended January 29, 2006, in conformity with accounting principles generally accepted in the United States of America.

 

As discussed in Note 2 to the consolidated financial statements, on January 31, 2005, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, using the modified retrospective transition method.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of January 29, 2006, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated April 10, 2006 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

 

DELOITTE & TOUCHE LLP

 

Phoenix, Arizona

April 10, 2006

 

Consolidated Balance Sheets

(In thousands, except par value)