If you’re like most Americans, you probably own a pet and spend hundreds of dollars each year to keep your furry friend happy and healthy. As it turns out, man’s best friend can also be an intriguing investment angle. Last year alone, Americans spent $48.3 billion on their pets, including $10.8 billion for pet supplies and medications, according to the American Pet Products Association (APPA). Even more remarkable is the fact that pet spending has nearly tripled since 1994. In fact, the number of households that own a pet has reached an all-time high of 72.9 million, the APPA says.

It’s easy to see then how pet care has become a huge business. For instance, the APPA expects pet owners to spend $12.2 billion for veterinary care this year, up from $11 billion last year and $8.2 billion five years ago. More importantly, the pet industry has proven resilient during downturns and economic crises, according to the APPA. This kind of supercharged growth in a recession-proof industry makes a strong case for investing in pet-care companies.

If you’re enticed by this pet-spending growth trajectory, I encourage you to take a closer look at PetMed Express (Nasdaq: PETS),which is the United States’ largest pet pharmacy, with about 6.1 million customers nationwide. PetMed sells pet medicines directly to consumers through its online pharmacy, 1-800-PetMeds. The company carries flea- and tick-control products, vitamins and joint supplements as well as prescription medicines such as heartworm preventatives, arthritis and diabetes drugs, antibiotics and specialty medicines, among other products.

PetMed used to be a darling of growth-stock investors. It increased sales from just $32 million in 2002 to $231.6 million in 2011, a gigantic improvement of 624%, or a yearly average growth rate of 24.3%. The stock price skyrocketed a whopping 2,000% from $0.73 in 2002 to peak at more than $23 in 2009. Since then, however, PetMed shares have been on the decline and now sit near $10. The main reason for the price drop is PetMed’s slowing growth rate, which is largely due to increasing competition from the likes of Amazon (Nasdaq: AMZN) and other online retailers.

The bad news is that consensus analyst estimates suggest the growth curve for PetMed will likely continue to flatten. PetMed’s earnings per share (EPS) growth had averaged 28% a year for the past five years, but EPS fell in fiscal 2011. Analysts now forecast growth to slow to just 12% a year during the next five years. 

Despite this growth deceleration, there is still much to like about PetMed, most notably the company’s rising cash flow and generous 5% yield. Although fiscal 2011 EPS were about the same as fiscal 2009, PetMed’s cash flow more than doubled from $14.9 million to $30.1 million during this three-year span. Cash flow was $30.1 million in the year ended March 31, 2011, and easily covered $10.7 million in dividend payments, while leaving plenty of cushion for dividend growth.

In addition to strong cash flow, PetMed has a pristine balance sheet with zero long-term debt and net cash of $2.76 per share. That means that for a $10 investment, you own a share of PetMed plus $2.76 of cash. And if you strip out net cash, it reduces the cost of PetMed shares to roughly $7.25 and boosts the dividend yield to almost 7%.

PetMed raised its dividend 25% last year to an annualized rate of $0.50 per share. The company also returned capital to investors through frequent share repurchases: last year, it bought back $12.2 million of its own stock, and in early August approved a fourth-consecutive share repurchase of $20 million.

And even at slower growth, PetMed continues to acquire new customers at a steady rate. The company added 645,000 new customers in 2011 and has doubled its customer base from 3.1 million in 2007 to 6.1 million so far this year. This is important because nearly 80% of PetMed’s business consists of reorders from existing customers. As the customer base grows, so should recurring revenue.

An area that presents both opportunity and risk for PetMed is sourcing its pet medication supplies. Most pharmaceutical manufacturers won’t sell directly to PetMed or its competitors, which forces these companies to buy drug supplies from distributors. If PetMed could establish direct-selling agreements with pharmaceutical manufacturers, then gross margins would likely rise. There is some evidence this may happen: last year, Bayer began making its products directly available to PetMed, which may cause other manufacturers to follow suit.

Some investors worry about competition from veterinarians, who mostly control sales of prescription medicine for pets and are reluctant to give up this lucrative part of their business. I don’t see this as a major threat to PetMed, however, since more than 60% of the company’s business comprises nonprescription medicines such as heartworm, flea and tick treatments.

Although competition from other online retailers poses a threat, PetMed can grow just by maintaining market share, because demand for pet products is expanding. Despite the recession, spending on pet care grew 6% last year and analysts expect pent-up demand for pet products and services to kick in as the economy strengthens. Some analysts predict industry sales reaching $72 billion by 2014.

PetMed reported first-quarter EPS for fiscal 2012 in July of $0.22, which came in two cents below analyst estimates and resulted in an 18% share-price decline. The stock is down nearly 40% since the beginning of this year, and shares are selling near the five-year bottom of their valuation range at 12 times earnings. This is much less than pet store chain PetSmart (Nasdaq: PETM), which is trading at a P/E of 17.

Action to Take –> In my opinion, P/E of 12 is quite cheap for a 5% yielder, making PetMed a great bargain based on its growing dividend, debt-free balance sheet and rising cash flow. With shares trading near their five-year low, there may never be a more opportune time to buy this stock.

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