Economic Recovery It Helps, But It’s Not Sufficient to Stimulate the Transaction Environment

There is a growing belief – and it’s slowly being supported by market data – that the economy is improving. Traditionally, we would take this to mean that key indicators are accelerating; and, in some cases, such as manufacturing activity and worker productivity, they are. But the term “recovery” has also come to mean something akin to “not as bad as last time”; or, talking more like an economist, it’s become code for “a deceleration of the decline.”

So, whether we’re using lay language or professional parlance, we need to confront the fact that service sector activity, on which our economy is now largely based, continues to contract, and unemployment figures remain near historic highs. Both of these signposts should serve as a clear reminder that all is not well. And, despite professing that the current recession is “likely over,” Federal Reserve Chairman Ben Bernanke continues to urge caution with respect to the domestic economy.

If we move beyond the macro-indicators, there are also signs that a bottom in the transaction environment is imminent.

The most obvious key indicator is the public equity markets, where we have seen a very healthy recovery. The current bull market rally has driven the Dow Jones Industrial Average up 46%, the third-largest six-month rally in history. As a byproduct of the run-up, corporations have been able to pry open a new issuance window not seen in years. Further, credit spreads have tightened and issuance volumes of both investment grade and high yield debt will surpass 2008 figures. These have enabled corporations to access capital and much needed exits for financial investors, both of which are important to transaction velocity because liquidity drives the lifecycle.  In addition, CEO confidence, as measured by The Conference Board, surged in the second quarter into an “optimistic” reading. This means more views to the positive than to the negative. A favorable market outlook correlates strongly with corporate and financial buyer appetites.   Finally, there has been a spate of large deal announcements, driven primarily by large cap public companies seeking to capitalize on strategic synergies. These deals have changed the tone of the M&A market.

Based on available data, peak-to-trough contraction in M&A transaction volume has typically taken two years. The recessionary period of the late 1980s and the period at the outset of this century both conform to this pattern. As such, given that the current contraction began in late 2007, we would expect to see a bottom late this year. That said, we’ve seen improvements in market conditions, but we don’t believe circumstances are right for a quick return to normalcy for a number of reasons:

Sponsors on the Sidelines. While we have seen an increase in sponsor inquires regarding ongoing mandates, we have seen only a handful of term sheets and even fewer closed deals from this community. On the whole, the private equity industry is still struggling with problems within its existing portfolio. A lack of cheap debt capital to underwrite new deals has resulted in depressed sponsor-backed activity volumes. Year-to-date, global private equity activity is off over 66%, though.   The trailing four quarters have been slower than any four quarter period since the twelve months ended June 2002. Until sponsors are able to access cost-effective debt, total transaction volume will be muted.

Mezzanine Debt Not Solving the Last Mile Problem. Mezzanine debt was touted as the means through which leveraged buyouts were going to be effected when lenders scaled back on transaction leverage. It’s true that mezzanine fund-raising has reached unprecedented levels and subordinated debt has grown as a percentage of the deal capital structure, but company performance has declined significantly, rendering mezzanine of limited use for the buyout community. Further, lender return expectations have exceeded a level buyout professionals deem reasonable.  While mezzanine debt will be part of the solution during the recovery, company operating performance must improve in order for it to be accessed as intended.

Deal Velocity Absent in the Middle Market.  The composition of 2009 deal activity is heavily skewed toward transactions that are greater than $5 billion in value; but deal volume has dropped by approximately 23% in this segment. Even more telling, volume for deals involving companies valued at less than $1 billion (a traditional definition of the middle market) has fallen by over 50%. We’re seeing that most high-quality middle-market companies in the Pacific Northwest seem content to sit out the current market cycle. And deals that have gotten done, like RW Beck / SAIC, occurred at premium-market multiples that were justified by high levels of strategic value. The middle market makes up the largest percentage of transaction volume (33% in 2008); but until valuations improve, a true recovery in the transaction environment cannot be realized.

Strategic Buyers Continue to Show Caution.  While premiums paid for transactions in 2009 are well above the long-term historical average, this figure is skewed by a handful of large public deals. As an example, Dell offered a a 68% premium to the prior-day close to acquire technology services company Perot Systems. In reality, we are finding that strategic buyers are quite cautious with respect to tuck-in acquisitions. Most buyers views this as an opportune market to buy companies at cost-effective prices. But we don’t see these buyers stretching on valuation until operating results improve and financial buyers are able to provide a realistic alternative for sellers.

Ultimately, deal volume will return when the buyer’s ability to pay  and the seller’s expectations again converge. We now recognize that the market eroded so precipitously that a very large chasm was created; it’s also clear today that it will take time to build a solid and lasting bridge over that abyss. An improvement in the macro economy is definitely good for deal activity, but economic growth has to be reflected in the income statements of traditional middle market companies before we experience a return to normalized conditions.

 

Pet Industry Market Update – A View from Trade Show Season 2009

The fall trade show season for the retail segment of the pet industry has come and gone.  From a macro perspective, the industry continues to thrive.   Not only is innovation accelerating, but the core themes around humanization, health and wellness and convenience remain relevant.   That said, things are not all sweetness and light.   Of greatest significance is the reality that the economic contraction is having an impact on the industry, maybe not in the most obvious ways.  Additionally, the H.H. Backer Pet Industry Trade Show was flat relative to SuperZoo, just two weeks prior.   In the balance of this post, I discuss the key observations from walking the floor in Las Vegas and my interpretation of front line accounts from those attending H.H. Backer.

Recession Resistant, But Not Proof

Anyone who pays attention to pet media has been inundated with articles touting the industry as a safe haven from the downturn in the economy.  While, technically speaking, the industry continues to grow, it is by no means moving along unscathed.   The show season provided ample evidence that the industry is feeling the pinch.   Notably in this regard, paid attendance was down across the two shows both in terms of buyers and exhibitors.   Many who normally exhibit at both shows chose one or the other, but not both.  Second, growth rates for most of the industry has slowed, in  the majority of cases significantly, though outliers still remain and in a world where “flat is the new up” any movement up and to the right should be commended.  Third, buyers (in the retailing sense as opposed to the M&A transaction sense) were clearly more cautious, many were there to browse and keep updated on the evolution of the merchandising mix,  but we saw a lot of “wait and see” from people in independent pet specialty who normally travel with their checkbook.

When one factors in that access to capital is currently quite limited, especially for small companies, these signs point towards consolidation in the industry.  Or at the very least a bifurcation of the market into leaders and laggards.  Cash flow generating businesses who can attract capital will drive growth through marketing spend, while those who cannot access funds will be challenged to allocation their limited resource base.

I’ll Take a Treat As Opposed to a Meal

While subtle it is notable; I felt the “presence” of the treat companies exceeded that of food companies at SuperZoo.  That is not to say there was an absence of food folks on the floor of the show.  In fact they were there in force, as always.   However, their participation was much less extravagant and a number of up-and-coming brands were absent.   Part of my conclusion is that there has been limited innovation among the major independent players, they are too busy duking it out  for shelf space.

The most notable innovator in my mind has been Merrick, which launched Whole Earth Farms.   Whole Earth is a premium natural line of dog food targeted to the value oriented consumer.  On one hand this makes complete sense to me, as consumers are forced to trade down, this product offers product attributes that are very appealing at an attractive price per pound.   Possibly of greater significance it may be attractive enough to pull up consumers who generally buy mass, but would prefer to feed their dogs natural.   With Pet Promise going away a healthy percentage of these customers are looking for a new home.  At the same time, I wonder if these two groups can live harmoniously.  Value orientated natural has not been highly successful in the human realm.  I offer Whole Foods 365 Everyday Value as Exhibit A.

I give runner up accolades on the food side to Mulligan Stew’s launch of their baked soft kibble and Honest Kitchen with their display of feathers signifying their move to free range chicken in their chicken based diets.  For the later, it made the point nicely.

At the same time we were more impressed with the evolution and innovation in treats, not only in terms of ingredients but also in terms or blurring the line between reward and core wellness.   At the show we saw an increasing number  (relative to the prior year) of treat companies promoting their offerings (or an offering) as “source verified”.    Further, numerous treat companies are marketing formulations with an ingredient count that only requires a few fingers.  Fruit and vegetable based treats are also on the rise.  Finally, many treat companies now have offerings that  promote general wellness or help alleviate specific issues experienced by companion animals — joint health, dental wellness, skin and coat support, digestive health.  Kudos to the likes of Zukes, Fruitables, Pegetables, Terrabone,  Petit Four Legs  (shameless plug) and a host of others.

LOHAS Movement A Foot in Pet

The lifestyle of health and sustainability movement continues to gain momentum within the pet industry.   Nearly every company I visited with that offered bedding and toys has a product incorporating some form of recycled material.   Sustainability has become more prominent in marketing, especially for companies where the link is less obvious.

Of greater significance is the proliferation of health related offerings.  Not only is the supplement space gaining in competitors, but sophistication from a product formulation and branding standpoint has also evolved.  New comers such as 3M and The Brampton Companies (which purchased Vet’s + Best) were just two of the more notable booths, coupled with industry incumbents Nutri-Vet, NaturVet, Ark Naturals, PetAg, and a handful of others.  Of the condition specific issues being addressed most prominently, dental health and weight management have joined hip and joint as the most commonly addressed.

Finally, there were a host of other target specific health solutions ranging from pet first aid kits to electronic emergency pet reference manuals to ear thermometers to therapeutic treadmills.   Most notable was Anti-Lick Strips from Nurtured Pets.  These all natural peel and stick bandages deter unwanted behavior and prevent small problems from becoming big problems.

Better Branding

A final note, packaging and associated branding in the pet industry has come a long way in the past 2 years.  This is consistent with my thesis that more companies have entered the market with traditional consumer packaged goods experience and who are looking at the industry as a business (the professional trumps the enthusiast).   It used to be that packaging was a source of competitive advantage.  Now, in some segments, sophisticated presentation is the bar for entry.  Anyone who knows Vets + Best pre-Brampton, can attest to what a makeover can do.   Other notable packaging came from the Get Naked line of health supplement from NPIC, Zupreem, Flexi, and Nutramax.  I expect more innovation next year as others refresh their image to keep up with their competitors.

/bryan

 

Andrew Lahde Appreciation Day – October 17, 2009

Andrew Lahde might not be a name you know well, but you should.  Lahde was the sole principal at Lahde Capital Management, a small California hedge fund that returned between 866% and 1000% (depending on who you believe) within a year betting on the decline of the sub-prime mortgage market.  And then he called it quits — at the peak of the market.   Ladhe tapped because he, well, hated his job.

Lahde, an MBA from the Anderson School at UCLA, honed his skill not at Goldman Sachs,  Morgan Stanley, or some big name hedge fund, but from the more modest platforms of Roth Capital, Gerard Klauer Mattison, Kayne Anderson Rudnick Investment Management and TD Waterhouse.

In November 2007, he called the forthcoming decline of the U.S. financial services industry, our domestic currency, and the global equity markets.  The problem was nobody knew who he was.  He had no platform.

So today we remember and salute Lahde by re-publishing his farewell missive, dated October 17, 2008, that someone called the “best thing written since Don Quixote“. The letter address a broad range of topics, and I don’t support all of his positions, but it is worth the read, because it serves as a reminder of how disconnected we became from reality.

Enjoy.

/bryan

Today I write not to gloat. Given the pain that nearly everyone is experiencing, that would be entirely inappropriate. Nor am I writing to make further predictions, as most of my forecasts in previous letters have unfolded or are in the process of unfolding. Instead, I am writing to say goodbye.

Recently, on the front page of Section C of the Wall Street Journal, a hedge fund manager who was also closing up shop (a $300 million fund), was quoted as saying, “What I have learned about the hedge fund business is that I hate it.” I could not agree more with that statement. I was in this game for the money. The low hanging fruit, i.e. idiots whose parents paid for prep school, Yale, and then the Harvard MBA, was there for the taking. These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government. All of this behavior supporting the Aristocracy only ended up making it easier for me to find people stupid enough to take the other side of my trades. God bless America.

There are far too many people for me to sincerely thank for my success. However, I do not want to sound like a Hollywood actor accepting an award. The money was reward enough. Furthermore, the endless list of those deserving thanks know who they are.

I will no longer manage money for other people or institutions. I have enough of my own wealth to manage. Some people, who think they have arrived at a reasonable estimate of my net worth, might be surprised that I would call it quits with such a small war chest. That is fine; I am content with my rewards. Moreover, I will let others try to amass nine, ten or eleven figure net worths. Meanwhile, their lives suck. Appointments back to back, booked solid for the next three months, they lookforward to their two week vacation in January during which they will likely be glued to their Blackberries or other such devices. What is the point? They will all be forgotten in fifty years anyway. Steve Balmer, Steven Cohen, and Larry Ellison will all be forgotten. I do not understand the legacy thing. Nearly everyone will be forgotten. Give up on leaving your mark. Throw the Blackberry away and enjoy life.

So this is it. With all due respect, I am dropping out. Please do not expect any type of reply to emails or voicemails within normal time frames or at all. Andy Springer and his company will be handling the dissolution of the fund. And don’t worry about my employees, they were always employed by Mr. Springer’s company and only one (who has been well-rewarded) will lose his job.

I have no interest in any deals in which anyone would like me to participate. I truly do not have a strong opinion about any market right now, other than to say that things will continue to get worse for some time, probably years. I am content sitting on the sidelines and waiting. After all, sitting and waiting is how we made money from the subprime debacle. I now have time to repair my health, which was destroyed by the stress I layered onto myself over the past two years, as well as my entire life – where I had to compete for spaces in universities and graduate schools, jobs and assets under management – with those who had all the advantages (rich parents) that I did not. May meritocracy be part of a new form of government, which needs to be established.

On the issue of the U.S. Government, I would like to make a modest proposal. First, I point out the obvious flaws, whereby legislation was repeatedly brought forth to Congress over the past eight years, which would have reigned in the predatory lending practices of now mostly defunct institutions. These institutions regularly filled the coffers of both parties in return for voting down all of this legislation designed to protect the common citizen. This is an outrage, yet no one seems to know or care about it. Since Thomas Jefferson and Adam Smith passed, I would argue that there has been a dearth of worthy philosophers in this country, at least ones focused on improving government. Capitalism worked for two hundred years, but times change, and systems become corrupt. George Soros, a man of staggering wealth, has stated that he would like to be remembered as a philosopher. My suggestion is that this great man start and sponsor a forum for great minds to come together to create a new system of government that truly represents the common man’s interest, while at the same time creating rewards great enough to attract the best and brightest minds to serve in government roles without having to rely on corruption to further their interests or lifestyles. This forum could be similar to the one used to create the operating system, Linux, which competes with Microsoft’s near monopoly. I believe there is an answer, but for now the system is clearly broken.

Lastly, while I still have an audience, I would like to bring attention to an alternative food and energy source. You won’t see it included in BP’s, “Feel good. We are working on sustainable solutions,” television commercials, nor is it mentioned in ADM’s similar commercials. But hemp has been used for at least 5,000 years for cloth and food, as well as just about everything that is produced from petroleum products. Hemp is not marijuana and vice versa. Hemp is the male plant and it grows like a weed, hence the slang term. The original American flag was made of hemp fiber and our Constitution was printed on paper made of hemp. It was used as recently as World War II by the U.S. Government, and then promptly made illegal after the war was won. At a time when rhetoric is flying about becoming more self-sufficient in terms of energy, why is it illegal to grow this plant in this country? Ah, the female. The evil female plant – marijuana. It gets you high, it makes you laugh, it does not produce a hangover. Unlike alcohol, it does not result in bar fights or wife beating. So, why is this innocuous plant illegal? Is it a gateway drug? No, that would be alcohol, which is so heavily advertised in this country. My only conclusion as to why it is illegal, is that Corporate America, which owns Congress, would rather sell you Paxil, Zoloft, Xanax and other addictive drugs, than allow you to grow a plant in your home without some of the profits going into their coffers. This policy is ludicrous. It has surely contributed to our dependency on foreign energy sources. Our policies have other countries literally laughing at our stupidity, most notably Canada, as well as several European nations (both Eastern and Western). You would not know this by paying attention to U.S. media sources though, as they tend not to elaborate on who is laughing at the United States this week. Please people, let’s stop the rhetoric and start thinking about how we can truly become self-sufficient.

With that I say goodbye and good luck.

All the best,

Andrew Lahde”

 

The Tao of the Dow

It’s hot, too hot for my liking.  I’m sleeping in my basement with my dogs, while my hometown enjoys a record heat wave.  While laying awake at night stewing in my own juices I began running through some old blog posts in my head and thought it might be worth revisiting the status of the financial markets.

Over the past three weeks, we have seen another unprecedented run in the DOW and S&P 500.   On July 10th, I began to ask myself if we were headed back into the abyss as the DOW seemed intent on testing the 8,000 barrier once again.   On its way there, it apparently got spooked and went the other direction, breaking through 9,000 with ease.   On a percentage basis, the DOW ran 12.6% from July 10th to July 31st.   This move is rather consistent with the way stocks behave during significant economic contractions, in that they are prone to high levels of volatility and can swing excessively.

To understand the reason why that is, we need to review what a stock price really is.  We know it is the discounted value of all the future earnings associated with that ownership instrument.   Those projected streams are subject to two main risks — macroeconomic risk and company execution (let’s exclude investor sentiment for the moment), to be revisited in another entry).  When stocks as a herd run down, the causation is usually macroeconomic uncertainty, as opposed to company specific factors.   Since the impact of macroeconomic conditions on forward earnings is a science lacking a high level of precision, corrections can be significant as clarity increases.   Said differently, as our financial system was melting down with great rapidity last winter you had an over correction to the downside as equity analysts predicted a massive impact of our structural problems on forward corporate earnings.   As second quarter (2009) earnings were released these past two weeks they came with a number of “positive surprises”.  However, these were not surprises at all in my estimation, but rather poor forecasting to begin with.   Coupled with some positives on the consumer confidence (consumer confidence index has doubled off the lows; new home sales increased 11% in June), treasury spreads have increased (spread between 10-year and 3-month increased nearly a full percentage point, meaning people were beginning to favor longer term instruments) , unemployment (job loss increased, but the pace of job loss slowed), economic growth (ISM manufacturing index topped 50, above which means growth) and banking system stability, the market ran quickly to its current position — aided of course by the media.

With that explanation behind us, we can no turn our attention to where does the DOW go from here.   The truth is, I don’t know, but my inkling is that we don’t have much room for upside right now.   My basic premise rests upon the reality that corporate earnings surprises were largely based on the realignment of costs with revenue opportunities; there was no real growth of the top line.  As such, we continue to contract, albeit at a slower rate.  Until we can truly rightsize consumer sentiment, we will struggle with generating real growth.

Further, there are significant structural hurdles.

• Industrial Production.  Based on Federal Reserve disclosures, nearly one-third of our manufacturing capacity remains idle.   This is the lowest rate of production since the Fed started to record this data.  The last parallel we can find was 70.9% in December 1982.   The picture is just as bleak on a global level.  Such excess capacity cannot be rationalized quickly and is more likely to result in price based competition, which can only lead to further calamity.   On the plus side there appears to be very little inventory in the channel, as companies have moved aggressively to cut cost.  However, until trade and inventory credit loosens further, it will not rebound.

• Tax Base.   Across the board the domestic economic system is facing an economic shortfall of catastrophic proportions.  The U.S. government has spent nearly $2.7 trillion this year, versus collections of $1.6 trillion.   In cumulative, state government deficits total $120 billion.   Forty nine states require balance budgets however. (Vermont is your holdout).  Personal income taxes have dropped by over 25%, with no quick path to renewal.   Yet, we somehow need to find ways to underwrite huge government programs and keep the lights on at the local level.  The imbalance is massive and budget gaps will result in further market disruption.

• Consumer Sentiment.  As the consumer goes, so goes the economy given our asset lite service based model.   The problem is the consumer is underwater and expected to remain so for some time.   Jobless rates have reached double digits and it will take years for reabsorbtion.   Over 4 million Americans have been looking for work for more than six months, an unprecedented level.   Retails sales were down a further 5.1% in June versus a projected 4.5%.    We have yet to experience the wave of personal bankruptcies that will surely arrive as people walk away from their mortgages and face the music on their mountain of personal credit card debt.

• Banks.  The banking system remains unhealthy, though the risks of a full scale collapse remains unlikely.   Deep skepticism with respect to real estate will result in regional and local market lending dislocation.   Rather than facing loan losses head on, banks are preferring to extend and pretend on the consumer level.   Without dependable credit consumers and businesses cannot grow.

Net net, it is not at all clear where growth is going to come from.   However, it is clear that we have found bottom, as evidenced by the slowing declines.  More than likely we are in for an extended period of sideways, with growth coming from stimulus and government programs (e.g., cash for clunkers, health care reform).     This will be jobless recovery with  companies surviving on lean diet of capital expenditures.   No one is forecasting robust growth.   In short I can’t see much upside.  Further, if this downturn has fundamentally changed consumer behavior, than the market will continue to shrink and stock prices will follow it down.

/bryan

 

Five Realities to Consider As We Wait for Prosperity to Return

The dark clouds that loomed over our economy appear to have dissipated, but the sun is still not shining.  Even though second quarter economic data have brought hope for a steady economic recovery in late 2009, there are still systemic issues that require our attention; these issues have been brought on, in part, by  efforts to keep the economic ship afloat.

The good news for business owners and operators, however, is that they can once again expand their focus – keeping both day-to-day and strategic growth and liquidity issues top of mind.  To help with this always-complicated juggling act, I offer five core realities that are essential today – especially since the brave new world we once knew may have been lost in the storm clouds of 2009.

• Taxes Will Increase – In order to underwrite the tab for our massive stimulus and bailout programs, taxes will have to increase.  While it is a foregone conclusion, based on recent campaign rhetoric, that capital gains taxes will increase along with income taxes on the highest income earners, keep your eye on H.R. 436 (“Certain Estate Tax Relief Act of 2009”), better known as the Pomeroy Bill.  This legislation was deigned to restrict perceived abuses of estate and gift planning through the use of business entities.  The Pomeroy Bill, among other things, proposes to eliminate any discount for lack of control and marketability on transfers of non-controlling interests in family-controlled entities.  The net effect will be to drive valuations and taxes up, which will diminish the value of family limited partnerships as an estate planning strategy.

• Changes in Accounting Will Impact the Bottom Line – A number of GAAP changes are currently under discussion, and they are designed – not surprisingly – to increase the amount of taxes paid by businesses and limit their ability to book losses.  The most concerning change for many is the contemplated repeal of last-in-first-out (LIFO) accounting.  LIFO has a dampening effect on net income because of a cumulative downward impact on inventory valuation.  LIFO helps minimize taxes in a period of rising prices if the most recently purchased inventory is used to calculate the cost of goods sold.  A repeal of LIFO would result in higher taxes in the current period as well as in back-tax obligations and future inventory management challenges.

• Inflation Will Rise and the Dollar Will Fall – Quantitative easing, or the purchase of U.S. Treasury bonds by the Federal Reserve, is an inflationary measure that has put pressure on the U.S. dollar.  As evidenced by recent price retrenchment in the bond market, interest rates are rising and inflation is building.  The good news is that this inflationary cycle appears predictable.  Businesses should begin taking steps to adjust prices and lock in labor rates where possible in order to avoid the negative consequences of changes in real income.  As we all know, persistent inflation has the ability to once again undermine the functioning of our economic system.

• Now is the Time to Recruit Talent – National unemployment will likely peak around 10%. While the Pacific Northwest has held up reasonably well relative to the rest of the country, there is talent aplenty seeking new opportunities.  Now is the time to consider upgrading your human capital in areas where you might be vulnerable.

• Don’t Take Your Eye Off Your Bank – While the national banking picture appears to have stabilized, more than 300 banks remain on watch by bank regulators.  Most of these are regional banks in markets where housing prices have decline precipitously.  Talk to other business executives and agents to understand who is lending, and begin to build relationships with back-up lenders in case your line is pulled or reigned in for reasons beyond your control.

For those seeking growth capital or liquidity, multiples remain near their lows; this is, in part, due to a slow lending environment.  While we wait for the markets to thaw, try to get ahead of the curve on the issues we’ve mentioned above.  If you can do that, you stand a better chance for a successful deal dynamic as the recovery takes hold in 2010.

/bryan

 

Pet Industry Market Trends – Spring 2009 Update

Against a backdrop of macroeconomic uncertainty, the pet industry continues to thrive.   While the prevailing theory that the industry is “recession proof” is being sternly tested, market fundamentals of pet ownership remain strong and consumers are skimping on themselves as opposed to their pets and/or children.  Further, the premium demographic continues to have a voracious appetite for efficacious products that are good for their pets as well as the environment.

That being said, the recession has set in motion a number of trends that will, in my view, forever change the pet industry landscape.  While several of these trends are in the “early innings” so to speak, the momentum behind them is significant.  The companies that stand to win during the next phase are those that recognize the seachange and position themselves to take advantage of the wave.  This period will separate the leaders from the pack, to steal a phrase.

Recession Not Found Here?

Pure play equities of pet related companies fell precipitously with the market during the second half of 2008.  However, unlike the general market, these equity began to experience their recovery in November 2008.   The primary driver of equity price contraction was based on fundamentals — earnings for these core names fell 30% from the prior quarter, which spooked the market (in truth some of this could be chalked up to seasonality).

In reality 3Q2008 was up year-over-year from an earning perspective, albeit only slightly.  In a world where flat is the new “up”, this should have been investors first signal that the market was overreacting in this category and  pet related equities were becoming oversold.  Notably, earnings rebounded strongly in 4Q2008 posting year-over-year growth of ~ 4% (weighted by market capitalization), driving a correction with respect to public company valuations.   Thus, the prospects for a technical recession in the pet industry are in fact quite low.

Notably, the macro economic environment did not constrain equity deals in the pet space.  Key deals including Hammond Kennedy Whitney/FURminator, TSG Consumer Partners/Dogswell and Tyson/Freshpet were all announced against a declining or, even abysmal backdrop.   Appetite for pet related concepts has never been higher among growth equity funds due to the prevailing dynamics and long term fundamentals.

Key Trends for 2009

So what are the seismic shifts of which I speak?

First, I believe we are in the early innings of a major shift in the pet retail landscape. PetSmart and Petco are facing significant competition from Wal Mart as they battle to be the one-stop-shop for the mid-tier pet buyer. Wal Mart’s merchandising acumen coupled with their reach and financial strength make them daunting opponents. Large pet specialty will take share among the most attractive demographic and thrive amidst the chaos among big box players. Their ability to educate buyers and offer patrons a favorable service experience situates them to be long term partners of both customers and the most compelling pet related brands. They will also take share from contracting boutiques hit be financial hardship.

Second, in bad times value trumps luxury.  The downturn in the U.S. economy has eroded the balance sheets of mainstream consumers. While companion animals will continue to a growing part of our society, consumers will become more fickle as it relates to spending on their pets. Product (excluding consumables) and service providers must give pet owners a compelling value proposition if they expect to experience continued growth. This change is expected to be lasting.

Third, consumers want to know what they are paying for.  In the food arena, efficacy is going to become important, a concept which many have taken at face value.  The market has become saturated with better-for-you pet food brands whose differentiation has become hard to appreciate. Supply chain control and organic are no longer differentiators. As distribution opportunities contract, due to contraction in the boutique market, and funding dries up, solutions that can demonstrate high degrees of efficacy will prevail. Customers will begin to demand results for their incremental dollar.

Finally, pet health will come in to focus as owners make difficult choices with their limited free cash flow.  Pet related health care is even more inefficient than its human corollary. Relations between veterinarians and their customers is strained by the high cost of service and medications and the limited proliferation of pet insurance. Further, compliance rates on even basic pet medications are sub-standard. Solutions will arrive that deliver compelling value throughout the pet health care supply chain, driving operating and cost savings at the clinic level, compliance rates among drug applications and ultimately satisfaction for pets and their owners.

Net net, I expect the balance of 2009 to be challenging but good for pet related industries.   Notably, I believe we will see additional pet related equity deals as investors seek to put capital to work in sectors that continue to grow.  As the debt market improves, leveraged buyouts of some of growing bell weathers of the industry (a la FURminator) begin to come in to play, assuming valuation expectations have come down due to market realities.   One would also expect public pet companies to seek to buy growth in a effort to fuel their lagging equity prices.  This could kick of a consolidation phase in the middle market, but I’m not overly optimistic.

As always, you can contact me for a complete version of our market presentation.

/bryan

 

When Will It End?

We Ask the Lenders—But Nobody Knows for Sure

It has long been our view that the economic recovery will begin when some liquidity returns to the lending markets. Businesses rely on the ability to borrow cost-effective capital to underwrite their daily operations, and debt is an essential cog in leveraged transactions; purchase price multiples rely on it.

With debt generally unavailable, the transaction and capital markets have dried up. On a micro-level, many companies we talk to are currently unable to pursue compelling opportunities because of a lack of credit that that would have been available a year ago. Other firms are facing tougher “survival mode” decisions in which cash is squeezed from any and every available source.

We don’t anticipate a rapid return to normalcy, but we are seeing signs that the market is making incremental gains.
High-yield issuance volume has remained robust; premium-quality second lien deals are starting to find interested buyers; the Federal Reserve’s intervention at the long end of the yield curve has diminished the opportunity for banks to buy loans on the secondary market at yields more attractive than those on new issuances; and The Toxic-Asset Relief Plan will also better position major lending institutions to recapitalize their balance sheets and begin new originations.

Unfortunately, these macro viewpoints are not much help to companies that need to make tactical decisions on how to fund their operations. In an effort to deliver better actionable information, Cascadia decided to go directly to the source and ask lenders what they’re up to, how the world has changed and, most importantly, when they think the market will improve.

As you might expect, some lenders were reluctant to make predictions or disclose information due to the fluctuating condition of the market and their business. Others were only willing to speak to us on an anonymous basis. Both of these factors are telling and, in our mind, do nothing to diminish the value of the content in the attached.

Read on for greater insight and—as always—let me know what you think.

/bryan

When Will It End?

 

The Sound of Silence

It’s been a while since I posted about the current state of our economy, its prospects for recovery and how that is impacting the transaction environment.   It hasn’t been for lack of interest, but rather the pace of play with the dynamics changing at an alarmingly fast rate.   Further, with the recent market up tick, I have been enjoying the sound of silence.

As the market was shedding hundreds of basis points daily between late January and early March, a number of educated parties with whom I have regular contact were search for flavor of the moment remedies to advocate on behalf of, sometimes with true relentless vigor.  The most consistent was the call to nationalize the banking system, based on the Swedish model for de-levering financial institutions.    Never mind that that the parallels between the two systems don’t match up well — at all (let alone that neither political party wants to be responsible for wiping out shareholders completely, a symptom of the myopia brought on by our political system), it was sensible that people wanted to see a quick shift in the paradigm in order to stem the flow of red on their brokerage statements.  Unfortunately, it is just not that simple given the gravity and scope of what we are facing.

While I do not believe the fundamentals of our situation have changed more than at the margins, I do see signs that things are beginning to improve, maybe only for the interim.  Most significantly is that we have broken the negative media cycle that the sky is falling and we are all going to be crushed under its weight.   News stories from sources who stood to benefit from undermining the stability of our financial system appear to have tapered off, or at the very least people have begun to tune enough of it out to limits its implications.   The sad part is that what turned the tide was a leaked memo from Citibank with really no corroborative substance.   In place of constant negativity we have begun the fine art of finger pointing, pouncing on issues of fairness as opposed to issues of fundamentals.   The stupidity of AIG paying bonuses and people taking them is just that — stupidity.  If we were facing certain demise I don’t think it would dominant the headlines and be the source of job security questions around the Secretary of the Treasury.

Beyond our changing media pH, there are most tangible signs of life.  Most significantly, in my view, and largely unnoticed by most is that a number of second-lien deals are drawing interest from buyers.   While the tranches are small, relatively speaking (hundreds of millions of dollars), the willingness of lenders to stand behind the asset based lenders/senior secured is significant.   Second lien deals tend to have longer maturities and lighter covenant packages  in return for healthy economics.   The ability of a company to trade out of expiring term debt and in to a longer maturity instrument is favorable under these conditions.   Combined with continuing robust high yield issuances and you have yourself the makes of the base of a debt market in absence of air ball or cash flow loans.

Assuming you don’t read the Gold Sheets or have access to a GE finance professional to feed you all the latest loan data, there were other, more overt signposts that one might view as favorable.    Unexpectedly, February new home sales rose (4.7%), the first uptick since July 2008, as did durable goods orders (3.4%).   I take less comfort from the former, as it likely reflects the builder community liquidating inventory to free up cash to enable them to start projects whose permit limits would otherwise be lost.   These are distressed or quasi-distressed sales, based on the percentage decline in price (-18%).  Further, favorable evidence of improvement can be seen in the narrowing spread to LIBOR, the taming of the VIX index and the stability of energy prices.  It is worth noting that, you can pin some of the tail on the donkey due to overly cautious economic forecasting on behalf of a community which has been much maligned recently for its overly optimistic viewpoint.

Lastly, we continue to see a solid flow of opportunity from our little slice of investment banking.   While deals that would be characterized as “b” or “c” deals are not getting done,  many very well situated companies are looking to see how they may in fact get ahead by using this down cycle as a buying opportunity.  Equity players are eager to see good deal flow and multiples have not fallen significantly due to the flight to quality.

Dead cat bounce?  I don’t think so.  More like a bear market rally which will fizzle around 8,000.  The gains made from 6,600 back to the 7,500 level were not based on any tangible data, but rather hope.   The market had become way oversold and therefore the slightest bit of favorable sentiment sent the market soaring.   What a difference a few months makes.   The last time we saw Tim Geithner make a major policy announcement, the market sank like a stone.  Upon the unveiling on the Toxic-Asset Plan it soared.   Expect the market to tread water here until we get more consistent solid economic news as opposed to mere drops in the bucket.   Weak GDP data and corporate earnings should keep a ceiling on any rally.   A spike in energy prices would also be  a very big deterrent.  Then again, the leading edge is always the most hard to call.

/bryan

 

A Survival Guide for Family Owned Middle Market Companies

On February 10, 2009, Secretary of the Treasury Timothy Geithner announced the new administration’s plan for stabilizing the U.S. financial system.  The following day, Congress agreed to a compromise on the pending economic stimulus bill aimed at providing consumers with both economic relief and opportunity.  When the cost of both programs is added to the capital committed to date for the financial bailout, the total bill being assumed by the U.S. government and its tax payers climbs to $9.7 trillion (including the Federal Reserves loans and guarantees).

Despite calls for political leaders to come together to help our nation avoid an economic “catastrophe,” as President Obama characterized it, the political tenor in Washington has been disappointing, providing Americans with little comfort that anything will be done quickly or correctly.  We have little assurance that these programs, both individually and cumulatively, will stem the decline.  The Federal Reserve and our political leaders lack true historical parallels and are working from a playbook that is being written and re-written on the fly.  In addition, lawmakers seem intent on presenting their voters with pork barrel projects and punishing people for past transgressions rather than focusing on the core mission of the programs and the timeliness of their implementation.

No Quick Fix

While we agree that quick action is imperative – especially as jobs continue to be shed and production continues to fall – we must not be naive about the consequences of our actions.  There is no quick fix and there are substantive pitfalls inherent in the path our leaders have chosen.  For example, based on historical precedent, the endless printing of money will result in downstream inflation and protectionist approaches to trade that have historically undermined our long-term industrial competitiveness.  Unfortunately, our political system encourages short-term myopia at the expense of improvement in future generations’ standards of living.

Even with all this negativity, we take comfort from the resistance that has been shown by the Dow Jones Industrial Average.  It would have been our expectation that the endless barrage of bad news and a general lack of faith in our government’s path thus far would have driven us well below the November 2008 lows. Further, we note the recent re-test has largely been caused by the financial sector, as only two of 10 S&P 500 sectors are negative since November 2008. A decline of this nature, which lacks market breadth, to historical lows, does not preclude the creation of a firm bottom.  That said, if industry breadth expands we will have to revisit our thesis.

Notably, the number of 52-week lows has diminished significantly since last November.  Further, corporate debt issuances also continue to improve as spreads narrow, though these offerings have largely been confined to large cap market leaders who are offering investors a compelling risk-reward tradeoff.  In January, issuances more than doubled the previous record for the same month.

As the prospects for a turnaround in 2009 fade to black, we offer family-owned middle-market companies the following advice for managing through the recession:

Plan, Monitor and Re-plan

While most organizations engage in an annual budgeting exercise, those that utilize scenario planning are the exception, not the rule.  Given the economic environment, we would encourage companies to revisit their financial plan on a monthly, if not weekly, basis.  While creating accurate projections in turbulent times can be challenging, updating your view on forward financial performance is essential to identifying capital needs (size and timing) and eliminating waste.  Further, it will help identify when it is prudent to pursue hiring and growth opportunities.

Understand Source and Uses

Substantial business value is often lost when companies require capital on an expedited basis.  Lacking flexibility and options, the cost of short term debt and equity solutions can be exorbitant and put personal finances at risk, let alone the future of the business.   Avoiding these scenarios requires a company to understand at a very granular level how it creates cash flow and where it consumes resources, and what flexibility it has on either axis.  Economic contraction will elongate receivable and payable cycles and change the terms on inventory purchasing.  A well-run company will engage in frequent dialogue with parties throughout its supply chain in order to determine how the flow of cash is changing.  If there are downstream needs, they must be identified and aggressively dealt with, and will often require difficult decisions.  Companies that are proactive in the management of their capital needs stand the best chance of weathering the storm.

Seek Counsel

These are unprecedented times, but you need not navigate them alone. Most family-owned businesses value their privacy, especially when it comes to financial matters.  While we understand and appreciate this view, a company does not necessarily need to disclose all critical information about its operations in order to benefit from valuable insight from third parties.  Similarly situated business executives, lawyers, accountants, family planners and commercial and investment bankers can all be great sources of ideas and information.  These parties are situated on the front lines of deal activity and capital formation.  We are seeing smart, well-run family business seek our counsel and those of our partners, and many of these companies are trying to understand how they can take advantage of this downturn.  If you have ever considered instituting a board of directors and advisory board, now would be an ideal time to surround yourself with people who will give you candid and actionable advice.

Consider Creative Alternatives for Liquidity

While a number of traditional liquidity avenues are closed or are offering low valuations to owners, viable options do exist for creating owner liquidity in the current environment.  Mezzanine debt continues to be an avenue for companies generating at least $3 million of EBITDA.  We are also seeing a limited number of leveraged buyouts and take-private transactions being consummated at attractive valuations utilizing debt from Canadian financial institutions, who seem to be lending more liberally.  Finally, we expect ESOPs to make a strong comeback as the valuation of contributed equity is based more on technical parameters as opposed to recently observed market multiples.  Both private equity and debt alternatives remain available to underwrite ESOPs.

There is no panacea for our economic ailments, but family-owned middle-market companies can take steps to ensure their long-term future. Doing this, however, means embracing a more open and proactive approach. Companies that adopt prudent and decisive action will be poised to prosper when a recovery takes hold.

/bryan

 

Coping With Economic Realities

Last in the series I had been working, which you can download it here.

The contraction of the U.S. economy has resulted in upheaval in the middle market transaction environment. Both private equity and strategic buyers are facing challenges in getting deals done. That said, we believe the popular press has gone too far in their characterizations in an effort to remain relevant.

While we see 2009 as a challenging year at best, opportunities remain available to attract capital and achieve liquidity for shareholders. The capital markets are not closed and M&A is not dead. That’s not to say that everyone will enjoy the same alternatives.

In the final piece of our three part series, we provide insight into the deals that will get done in 2009 and how companies can best situate themselves to take advantage of those opportunities. In short, this is an availability of capital market, not a cost of capital market.

/bryan jaffe