Private Equity Sheds FURminator to United Pet Group, Netting Healthy Return

In September 2008, a private equity group led by Hammond, Kennedy, Whitney & Company, Inc. (“HKW”),  acquired a majority interest in FURminator, Inc., a Fenton, Missouri based manufacturer and marketer of pet grooming products.  The FURminator’s products include small, medium, large, cat, and equine deshedding tools, shampoos and conditioners, treats, and dog food supplements. Terms of the deal were not disclosed.  However, at the time, I put out some estimates here.

On December 9th, United Pet Group, Inc., a subsidiary of Spectrum Brand Holdings, Inc., announced they had acquired the business for $140 million.  Disclosed latest twelve months revenue for the company was  “at least” $40 million, putting the deal value at between 3.0x – 3.5x latest twelve months revenue — as eye-popping a multiple as we have seen in the pet industry, excluding food, over the past three years, and certainly something we expect other sellers and potential sellers to latch on to when establishing their valuation expectations.

When HKW and friends acquired the company, it was, in my opinion, a bit of a head-scratcher.   FURminator had established itself as the leading player in the deshedding tool market and its intellectual property position provided the company with a tangible source of competitive advantage.   However, it was not clear where the subsequent growth was going to come from.   How many $40 deshedding tools does one household need?  The product is virtually indestructible and the pet population was, at the time, not growing.   Notably, HKW did not have any pet industry experience and while my estimate of the value associated with the buyout transaction were, in hindsight, overstated, the group paid a healthy premium for the business.

So how did the buyout group generate such a handsome return?  Oddly enough, it was the recession.

While the pet industry fared well, on a relative basis, during the recession, the services segment was hit harder than consumables.  As consumers cut back on discretionary spending services were the first to go.   However, that did not mean that owners stopped washing and grooming their dogs.  Instead they just became do-it-yourselfers, driving sales of grooming products to the consumer market (relative to the professional market).  As the top brand in this space, FURminator benefited.

Additionally, the major pet retailers (Petco and PetSmart), in an effort to drive store traffic and control costs, began to consolidate vendors in late 2009.  During the 2007 – 2009 period, the number of product providers (both hardgoods and consumables) had increased markedly, reducing economies of scale in operations.  Further, brand proliferation made it difficult to provide consumers a uniform experience across store venues.  As central merchandizing groups took back control of the aisles, they shifted their product strategy to focus on core brands store brands/proprietary product.  As a result “tier two” players were waylaid.   After all, if you were only going to carry one brand of deshedding tool it was going to be FURminator.

The last leg of the stool was that the recession kicked off a wave of strategic M&A as corporations sought to purchase growth.   Within pet, the merchandising changes at Petco and PetSmart began to drive deals in the products space — Doskocil Manufacturing, Tagworks, Bamboo and Fat Cat, Spotless Group, among other deals.  United’s acquisition of FURminator is simply an extension of this trend.   These deals price attractively because of the operational synergies — rationalization of facilities, people, distribution.   Notably, United stated that once integrated the effective multiple they will be paying for FURminator is 6x – 7x EBITDA.  Given United’s ability to push the product into international distribution and their resources to assert  and defend FURminator’s intellectual property position means 3x revenue does not look overly expensive.

Beyond that, let’s hope the trend continues — 3x revenue valuations for everyone.

/bryan

 

The Pet Industry Through an Alternative Lens

Despite its size, the pet industry, as a whole, is under analyzed.  That is not to say there is a lack of analysis, but rather a lack of diverse perspectives.  The reason for the homogenous set of  “points of view” is largely structural.   There are a handful of very big companies that drive the pet industry from the product side — Mars, Nestle SA, Procter & Gamble, Del Monte, etc.  However, we have limited transparency into the granular performance of their pet brands because they either have no reporting obligation (Mars) or their pet business is quite small relative to their overall income statement or balance sheet.  Notably Nestle, who controls some 30% of the pet food business, does not report  its pet food segment separately.  The same can be said about pet retail — Petco, Petsmart, Wal Mart.   The primary industry reporters — Packaged Facts, Mintel, IBIS — rely, largely, on the same survey methodology.

Given the above, you can understand why I was excited to get my hands on Todd Hale’s “State of the [Pet] Industry 2011″.   Todd is SVP, Consumer Shopper Insights for The Nielsen Company.  Simply put, I think Todd brings a different and unique perspective to the table.  Because his firm has access to unprecedented amounts of transaction data, he is best situated to look at the industry from a consumer standpoint, as opposed to from a product or individual retailer standpoint, and of equal significance, put pet consumer behavior in the context of consumer behavior in other retail environments.

With that as my long winded set up, here are some key takeaways from his presentation (all data credits to The Nielsen Company):

• The Polarized Consumer.  We often talk about consumers in terms of median household income.   One can then analyze consumer behavior across stratified income bands.  This is really nothing new.  But what Nielsen scan data (actual product movement and basket purchases) provides is the opportunity to, on a rolling 52-week basis, analyze purchasing behavior within these income bands and compare the results to prior year periods.   This data does not need a +/- 4% confidence interval because it relies on actual transactions, as opposed to sentiment.  What Hale’s data shows is that the consumer population is very polarized.  While the wealthiest 20% of the consumer population have exited the recession, as evidenced by growth in shopping trips and shopping dollars, all other income bands have contracted.   This demonstrates the fragility of the retail industry and validates how important the premium demographic is to the health of all retail, not just pet.   Using the same methodology, Hale shows that that the affluent (those with household incomes in excess of $70,000) purchase 40% of the pet food and consume 42% of the pet services, despite making up less than a third of the consumer population.   As a result, it is easy to conclude that the pet industry remains as vulnerable as other retail categories.

• Pet is En Fuego.  If you look across U.S. retail formats, as measured by store counts, value and convenience are winning.   The number of warehouse clubs, supercenters, dollar stores, supermarkets and convenience stores have all increased since 2005.  Only drug and mass merch have contracted.   However, when you dig into the specialty retail category, home improvement and pet have shown meaningful store count growth during this same period, with pet doors increasing 43% and home improvement moving 10.5% to the positive.  Further, pet is the only store category that has shown positive household penetration over the past 10 years, increasing from 30% to 32%.   In short, pet specialty industry has been star performer in the retail landscape over the past six years.

• PetSmart is More En Fuego.  We have covered the performance of PetSmart on this blog in some depth.  Our historical analysis demonstrated that once PetSmart stopped focusing on topline growth and embraced a balanced scorecard (same store sales, product level gross margin, earnings per share) it quickly became the premier retailer in the pet industry.   Hale puts PetSmart’s performance in perspective across all retailers, noting that PetSmart has produce a 14 quarter “winning streak” of positive comp store sales.   Nordstrom came in second in the discretionary spending category at six quarters.  Among all other retailers (discretionary, value, club), only Sam’s Club and the “dollar” stores (Dollar Tree, Family Dollar, Dollar General) have comparable winning streaks, with only Family Dollar and Dollar General having higher average comp store sales since 2008 than PetSmart.  While the bar for domination of the pet specialty channel is in fact low, Hale’s data proves how impressive the company’s performance has been relative to all retailers.

• Inflation is Hurting/Helping Pet.  Based on Nielsen scan data for the past two years, prices have risen across the board, with the exception of alcoholic beverages and pet food, though pet food prices increased over 4%  in 2011.  Pet care and pet treats also experienced inflation of 2% and 3% respectively in 2011.   While inflation is hitting consumers at times when incomes are down, price increases have helped the pet industry grow to new heights (sort of perverse).  Notably, Hale’s data shows more pet industry inflation than PetSmart has reported, meaning price increases at grocery and mass have been more substantial than in pet specialty.

• Brands Hang Tough.   The recession kicked off a new chapter in the branded versus private label tug-of-war across consumer categories.   As Hale points out, private label brands hovered at 19% – 21.5% of unit volume from 2005 to the middle of 2008.  During the recession, store brand volume shot up and has remained at 21.5% – 23.5% post-recession.   Since 2007, store brands have grown 21% in dollar volume versus 3% for branded items.  Notably within pet, all major categories have a lower penetration of store brands than the product average, and private label penetration has fallen in pet care, food and treat over the past year.   This is logical given that store brand attachment falls as income rises, and the pet industry is driven (per above) by the higher income demographics.

In summary, Hale’s data provides us a different lens through which to view the pet industry.   The dominant perspective, to date, has been that of the product provider, and we are led to believe that the manufacturer dictates to the customer what he/she wants and consumes.  Hale helps us understand that the tail may in fact be wagging the dog — consumer behavior, and the ability of pet retailers to incent that behavior, may have been the more powerful force in driving the growth of the industry over the past five years.

/bryan

 

Expect Castor & Pollux Sale Process to have Industry Ramifications

Castor and Pollux were brothers, twin brothers in fact.   Both shared a mother in Leda, but Castor was the mortal son of Tyndareus while Pollux was the divine son of Zeus.  Confusing I know; twins from two fathers.  Anyway, overlooking that scientific conundrum, when Castor was killed, Pollux asked Zeus if he could share his immortality with his twin, and, as a result, the two were transformed into the constellation Gemini.  Notably, Helen of Troy was a sister.

I can’t say I know much Greek mythology, so Castor & Pollux has always been a pet food company to me.   The Oregon based company was founded by Shelley Gunton and her husband Brian Connolly, who had been successful pet food distributors in a previous life.  Castor & Pollux Natural Petworks (“C&P”) was the first line of specialty pet foods to use all natural ingredients.   The company has since grown into the leading premium pet food brand in the natural grocery channel and also the leading organic pet food brand across all channels.   Notably, C&P held the rights to the Cesar Milan pet food line, but the company was not well capitalized to take advantage of his rising popularity, and the brand did not gain traction at major pet specialty before being discontinued.

The story of C&P can be told in three “acts”, each involving a capital markets transaction.  The first act took place around 2000 when the company took a modest amount of funding from two small business investment corporations (SBICs).  These SBIC “loans” included equity kickers and they joined the board as part of the transaction.  We will call this “Act I”.  Act I was a period of high growth for C&P.  The company grew revenues from approximately $2 million in 2004 to over $10 million in 2007.  This is where things got a little messy.

Desirous of returning money, the SBICs pushed the company for a liquidity event.  Reluctantly, the company agreed and put itself on the market seeking a recapitalization.   By June 2008, it became public (here) that the company had raised $21 million.  It would later come to light that the investors were two east coast based private equity firms — Monitor Clipper Partners and Highland Capital.   This was Act II.   One can assume that the $21 million deal bought +/- 80% the company and valued it at about 2x revenue.  However, I have no evidence that this was the case.

Shortly after Act II commenced, the company brought in a new CEO, Robb Caseria, a beverage industry veteran who held managerial positions at both Coors Brewing Company and the subsequent Coors-Molsen Brewing Company.  Previously he had also held managerial positions at Frito-Lay.  Caseria’s strategy appeared to be two fold — utilized promotions to drive C&P deeper into the grocery channel (taking a page from the beverage industry playbook) and spend more on sales and marketing to increase turns at major pet specialty.  Notably, one of the new owners was also on the board at Petsmart and the brand received new carriage as a result (previously it was a Petco exclusive).  While the brand was successful in nearly tripling revenue between 2007 – 2011, the strategy did not yield tangible profitability improvement, and as a result the business was never adequately capitalized to compete at major pet specialty.   And so ended Act II.

On the back of the Natura transaction, C&P quietly put itself on the market in late 2010, kicking off Act III, seeking a valuation rumored to be 3.0x revenue from one of the major strategics.  Unfortunately for the investment team, there were no takers at that price and things returned to business as usual before the company hired a major Wall Street investment bank to sell the business in the fall of 2011.  A broad process involving both strategics and private equity firms is currently underway.

The results of the C&P sale process will likely have major implications on the pet food M&A landscape.  The most significant implication is it will again define the requisite size threshold for a major CPG company to buy a pet food brand.  In February 2011, Swander Pace Capital acquired Merrick Pet Care in, for lack of a better term, a “busted auction”.   Merrick was slightly bigger than C&P, and had its own production facility,  but was unable to attract real strategic interest.  If C&P does not trade to a strategic it will send a message to all smaller pet food brands that reaching a $25 or even $40 million sales milestone is not sufficient to garner interest from strategics.

Second, a C&P sale at an unattractive multiple will lead to valuation compression at the lower end of the market.  Consistent with the Merrick transaction, which took place at +/- 1.0 – 1.5x revenue, this will establish a chasm between the “haves” and “have nots”, measured as a multiple of revenue.    It seems realistic that the “new normal” for these businesses will be revenue multiples of 1.0x – 1.5x.

Finally, this deal is a referendum on the power of organic labeling in the pet food industry.   C&P has the number one organic dog food brand across all channels.  Despite the proliferation of organic  food on the human side, organic pet food has not elevated itself versus natural, grain free, and source verified protein.   As the requirements to adhere to an organic standard are surly compressing C&P’s gross margin, if this does not translate into a higher multiple, one will be left to conclude organic is not a differentiator in pet food.

Stay tuned as results are expected in 1Q2012.

/bryan

 

Pet Industry Market Trends – 2011 Fall Update

One of the joys of the fall edition to my pet industry update is I have the benefit of hindsight.   While in an ideal world we would have real time industry statistics for the prior year delivered to us on January 2nd, that is not our reality.  In fact, we really don’t get a true beat on the prior year until May when all the industry data is crunched and available for public consumption, paying members first.  For some of you, this edition marks the first time you really get a glimpse into prior year results.   While this information may not be timely,  in relative terms, this year it is quite illuminating as it dispels a few industry myths, for the better.   Only through an objective look at the industry can it identify new ways to grow and thrive.

With calendar year 2010 statistics now available, we have a clear picture of how the pet industry performed exiting the recession.  While the industry grew in 2010, and at an impressive rate relative to the consumer economy, the recession clearly took a toll – the pet industry is not recession proof after all.  Notably, according to Packaged Facts: a) specialty retail lost share to discount stores, b) total food sales produced anemic growth (1.5% for dogs and -0.2% for cats), albeit growth, c) super premium food sales decelerated (growing 2.4% after years of double digit gain) and d) spending by higher income households contracted.  Non-medical pet services was the only major category to meet forecast.   Food,  pet products and health care all fell short of projected growth.

Stop. Pause. Breathe.  Yes, sometimes good industries have bad years.  And relative to the rest of the economy, this was no bad year.

That all being said, there are many reasons to feel positive about the forward outlook – sales of public pet companies produce strong second quarter comps, PetSmart increased full year earnings guidance 3%, and super premium food sales are again accelerating.  More importantly, industry consolidation has given way to renewal.

The pet industry entered into a natural consolidation phase coming out of the financial downtown.  As growth moderated, strategics looked to acquire revenue and leverage their existing cost structure to drive margin.   As a result, we witnessed an increase in consolidating transactions across all major industry segments.  While this consolidation phase is ongoing, we are also seeing significant acceleration in company formation and growth equity investments within the industry.  Superzoo featured dozens of emerging companies in consumables, food, and hardgoods.  Further, pet industry private placements have increased in 2H2011, after a near dormant showing through mid-year.  We view this as a healthy sign, which bodes well for long term transaction momentum within the industry.

On the retail front, PetSmart continues to deliver.  In 2009, PetSmart took on Wal Mart and won.  In 2010, it became transparent that PetSmart had also left Petco it is rear view mirror.  In the past 12 months, PetSmart grew revenue and EBITDA 7.3% and 10.1% respectively.  The most recent quarter was a continuation of the trend.  For 2Q2011, PetSmart posted impressive same-store-sales (5.0% versus a consensus estimate of 4.6%), a favorable mix shift (customers trading up and expanding their basket), and a strong increase in average ticket price ex-inflation.  Analysts are now calling PetSmart the “best run specialty retailer”.  The only negative is we continue to hear conflicting stories with respect PetSmart exclusives, reflected in decelerating hardgoods transactions.  One area where we see PetSmart as vulnerable is with respect to direct-to-consumer.

The post-recession retail landscape is undergoing fundamental change.  Progressive retailers are seeking to reign in their physical footprint and push customers to lower cost channels.  The pet industry has been slow to embrace ecommerce; the belief was that delivering 50 lb. bags of dog food was a money losing proposition. However, that belief is again being challenged.  In July, Amazon.com subsidiary Quidsi launched Wag.com, a major pet ecommerce portal leveraging Amazon.com’s logistics infrastructure.  During the same period, other major independent pet ecommerce players raised substantive amounts of capital.  An analysis of these sites yields the conclusion that while product costs at PetSmart.com and Petco.com are more favorable, total landed cost (product cost plus tax plus shipping) favors these alternative e-tailers.  The ability to eschew a poor customer experience at the pet majors and eliminate the risk of in store stock outs, will invariably push a segment of customers online.   While this has the potential to erode share from pet specialty we believe it will be a slow process.

Net net, the pet industry remains on solid footing and the outlook for the component sectors is in fact quite good in the long term.  However, until the economy begins to improve — as measured by  GDP growth, the unemployment rate, and housing starts — the industry will continue to post modest growth, by historical standards.   These market conditions provide innovative companies the opportunity to differentiate themselves from the pack.

As always, full report available via email.

/bryan

 

It’s SuperZoo Time. Vegas Baby! Vegas!

I’m not a big fan of Las Vegas.  Generally speaking it’s too hot during the day and too cold at night for my enjoyment.  Further, as I have aged I’ve become less of a fan of noise and crowds and rooms without windows.  While you won’t find me hitting the strip on a personal vacation, I make an exception for SuperZoo, the “National Show for Pet Retailers”.

Of the major pet shows, SuperZoo is, in my opinion, the most valuable to attend for someone who surveys the industry.  Part of that charm is due to the shortcomings of the other major retail shows.  As an example, Global Pet, the largest pet show in the nation, is, well, as you might expect, big and dominated by the presence of the large industry players.  Sprinkled in between are a host of import companies and the mid-market is pushed into the corners of the room.  The booths of the innovators are usually quite crowded and getting an audience is pretty tough; product providers are there to do business after all.   In its defense, Global Pet has the best press room.  Further, the benefit of Global Pet is that is sets the tone for the year, even if you have to travel to Orlando.

In contrast, SuperZoo helps you see take a pulse on the state of the year.  The show provides a great sense of what retailers have done year-to-date and what they will be emphasizing for the holiday season.  Of significance, the show, because it is perceived as regional, is not dominated by the large multinational CPG players; the mid-market is well represented.  Further, it is much easier to get access to business owners and learn about the state of the industry company-by-company.   SuperZoo also has the best food (Lotus of Siam is my favorite), which is important in picking your tradeshow.  It also means that our bi-annual report publication date is just around the corner.

As I prepare for my fourth SuperZoo, I’m very interested in what I will see for a variety of reasons.   First, I’m interested to get a read on how the industry is doing in light of the broader economic climate.   Prior to the 2009 recession, the pet industry was viewed as “recession proof”.   While the industry thrived relative to other consumer facing franchises during financial downturn, the contraction did take some wind out of its sails and the message was recast as “recession resistent”.   In contrast to 2009, where the impact of reduced liquidity was so broad, we should be able to get a real read on how decoupled (or coupled) the pet industry is to the general economy.  Currently, we have stagnant GDP growth and high unemployment but also rising consumer incomes and improving individual balance sheets.  Notably, Petsmart (our pet industry public company proxy) posted strong 2Q2011 results with same-store-sales increasing 5%, comp transactions growing 2%, total sales increasing 7% and earnings growing 32%.   So is this a case where Petsmart is executing impeccably, or is the industry thriving against a relatively sanguine economic backdrop?  Conversations at SuperZoo should yield some insight.

Second, I’m interested in getting a better sense on the state of pet food, dog food in particular.   While any pet pundit would pursue this line of inquiry at anindustry show, I am now more interested than ever as I believe the market dynamics are changing.   Notably, the super premium category is seeing hyper-competition driven by big budget CPG acqusitions, large independents increasing sales and marketing spend (Blue Buffalo television commercials anyone?), and in-house brand launches for the largest independent pet retailers.   I see this environment as very challenging for a mid-market kibble manufacturer who does not have a meaningful angle of differentiation.  However, I also see this as a great time for food companies pushing alternative form factors (dehydrated, raw, freeze-dried) as all the kibble marketing messages now seem to blend together.   I’ll be looking to see if the recent equity raised by the upstarts in this niche translates into an increase presence at their booths.

Lastly, I remain interested in other opinions about pet e-commerce.   We’ve heard the party line from Petsmart in their 2Q earnings call, but I want to get it from the product providers perspective.   Of greatest interest is how their wholesale pricing is being impacted by what is clearly price competition in the industry.  Further, with the increase in proprietary product at the major pet retailers, I want to know if the mid-market pet players see the direct channel as their future, and if so how they are going to change their operating model.

If you are going to be in Vegas for the show.  Give me a shout, and hopefully we can meet up and chat.

/bryan

 

Pet Ecommerce Heats Up

Within the capital markets, ecommerce is of the hottest areas for growth and private equity investors.   The favorable bias from the investment community stems from the belief that online vendors can provide consumers a more compelling shopping experience than premises-based alternatives.  More compelling in terms of selection, price, and convenience.   Ecommerce retailers in shoes, books, groceries, diapers, electronics, furniture and a host of other categories are taking a bite out of the pocket book of bricks and mortar retailers.  Further, the first ecommerce generation is growing up and their comfort with the online consumer experience coupled with their growing purchasing power is driving category growth.

That all being said, the pet industry has not been a central participant in ecommerce revolution.  The overarching issue was that 50 pound bags of dog food are not cost effective to ship to consumers.  Therefore a dog owner, who had to seek out a premise-based retail concept for his best friend’s staples was much more likely to satisfy as much of his pet basket through a trusted retailer offering a one-stop-shop environment.  And now you know what Petsmart’s stock price has done so well over the past three years.

In fact, the only pet segment that seems to have benefited from the ecommerce revolution is pet health.  The ability to eschew a vet visit in order to get flea and tick and other remedies enabled 1800-Pet-Meds to go public in 2004.   A number of start-ups attempted to leap into the void.  Most memorably was pets.com, funded in part by Amazon.com, which launched in February 1999.  After considerable success the company jumped the shark with its 2000 Superbowl advertisement.  The company was out of business by the end of the year.   Pet based ecommerce has been rather dormant since then with the pet majors doing just enough to limit the potential for new market entrants — until now.

On July 6. 2011, Amazon.com, through its subsidiary Quidsi, Inc., better known as diapers.com, which was acquired nearly 10 years to the day after the demise of pets.com, launched wag.com, a comprehensive ecommerce portal for all things pet.   As an example, wag.com offers 44 brands of dry dog food, ranging from the mainstream to the obscure.   The site will have over 10,000 products for dogs, cats and a variety of other small companion animals.   Of greatest significance, the site leverages Amazon’s warehouse and distribution capabilities and shipping rates, enabling them to offer free shipping on all orders greater than $49, no exclusions.  Notably, the food I give my dogs is cheaper through wag.com after sales tax than through my pet specialty retailer.  However, I have no intention of switching.

Wag.com is not alone in petstuffonline.com 2.0, one day after wag.com launched, Lightspeed Ventures announced it had invested $10 million in Petflow, LLC, manager of the petflow.com website.  Petflow is in fact the old pets.com.  Petflow raised $5 million in 2010 from Westwood Ventures, and is reportedly moving over 500,000 pounds of petfood a month.  Further, on June 29, 2011 Pet360, an information and ecommerce site for pets raised $18 million from Updata Partners and LLR Partners.  Pet360 operates petfooddirect.com and nationalpetpharmacy.com two of the more established ecommerce players in the pet space.

The winner is this new movement is the consumer, who benefits from more choice and greater access to specialty brands in a high convenience format.  The ability to access all your pet needs online without be burdened by unreasonable shipping costs should give the pet majors some heartburn.   The opportunity to eschew the poor service of a big box retailer as well as save time and travel expenses is also compelling.

The biggest question is can these sites make money.  The vast majority of site traffic, and therefore potential customers, will be driven to these properties through search engine optimization — the buying traffic through Google and friends based on paying for placement of a site when specific key word searches are entered (“pet food delivery” as an example).  As competition increases, so too does the cost of the most attractive key word alternatives.  Major ecommerce sites generally run at EBITDA margins of between 3% – 6%, leaving little room for real profits (Amazon is the gold standard at long term average of 6%).  Notably, CSN Stores, which runs over 200 ecommerce micro-sites (luggage.com, furniture.com, etc.), recently raised $165 million from five equity investors to expand its footprin.  It’s margin profile does not approach that of Amazon’s despite over $350 million in sales.   In short search engine and offline marketing will eat up a healthy percentage of these sites’ margin profile.

Then one must consider the fact that price and loyalty competition is surely to ensue as site and online vs. offline formats compete for market share.    Ecommerce provides customers the ability to get their product of choice at the lowest cost if they choose.  Most sites offer significant concessions to win a customer’s first order, with the hopes of locking them in long term, ideally through an automatic food reordering program.  As an example, you literally cannot buy something off petfooddirect.com without be offered some form of discount.  As product providers begin to assert themselves with respect to minimum advertised price, which enables product vendors to ensure that no one channel has an advantage over the other, these discounts will take a bite directly out of the sites operating margin.

Finally, the shipping dilemma remains a major hurdle.  Surely Amazon has the best logistics infrastructure, but eating the cost on delivery for a 50 pound bag of dog food in a competitive category is not sustainable long term.  These vendors must believe that pet food has enough margin to absorb most of this expense, and that over time they will be able to provide consumers with an increasing percentage of their pet purchasing basket, enabling them to operate profitably.  I suspect it will work for some, but not all.

/bryan

 

Has PETCO Lost its Mojo?

If you have followed my pet industry musings for any duration, you know that I am not a big advocate of the service paradigm offered at large independent pet specialty chains — PETCO Animal Supplies, Inc. (“Petco”) and PetSmart, Inc. (“PetSmart”).  That is not to say I don’t see value in their services, as they play a fundamental role in growing the broader pet market.  Notably, I am and will continue to be a Petco customer.  Their store is only a mile from my residence, and while my purchases there constitute an increasingly shrinking percentage of my pet product basket, they offer me a level of convenience that I can’t find from my other pet vendors.

When we adopted our first dog, like moths to a flame we immediately went to Petco to buy our staples and stock up on food.  Over time I have moved my dogs onto other meal programs and built relationships with other product vendors.  As a result, my true need for Petco has diminished.  However, the reasons my traffic declined was one of product selection, and not what I constantly harp-on — the mediocre service paradigm that Petco, and PetSmart for that matter, offer.   It is this service paradigm that has enabled smaller independent pet specialty chains to take share.  The net result has been significant capital inflows into these secondary competitors as evidenced by Roark Capital’s acquisition of Pet Valu, Inc. and Irving Place Capital’s acquisition of Pet Supplies Plus/USA, Inc., the number three and number four players in the market respectively as measured by store count.

The service conundrum Petco and PetSmart find themselves in is unlikely to abate.  Both companies rely on legions of low priced labor that is prone to churn.  As a result, the average Petco and PetSmart front line employee never develops the expertise and relationships necessary to compete with the Pet Food Express, Inc. and Mud Bay, Inc.’s of the pet world, who differentiate themselves through the expertise they provide to their customers both in terms of product selection and in store service.  Glassdoor.com can tell you all you need to know about the challenges of working for Petco or PetSmart.

Notably, the potential upside of these higher touch service formats attracted Petco Executive Vice President and Chief Merchandising Officer to take the helm of Pet Supplies Plus.   You can read Jim Meyers message about the departure here — Message from Jim Myers-PETCO.   Petco management has not exactly been a revolving door, but there has been consistent changes over the past three years.   All this despite, as the New York Times reported, “the company did not have a negative quarter throughout the recession.”  So why is it that five years after being taken private in a $1.85 billion transaction by TPG Capital and Leonard Green & Partners is the company not considering a public listing in the best initial public offering market we have seen in years?

One reason might be that the owners are quite happy with the benefit they are receiving from the company’s cash flow.  In November 2010, the company sought a $1.1 billion credit facility to finance a dividend to its shareholders.   The laon was later upsized to $1.225 billion.  Upon consummation, the transaction would have leveraged the company 5.5x latest twelve months EBITDA according to sources close to the deal.  And therein lies the rub.

If in fact Petco would have been leveraged at 5.5x at the time of the deal it would imply that the company was generating $200 million in EBITDA ($1.1B / 5.5 = $200M).  According to public filings, when the company went private its LTM EBITDA at the time was reported to be $209 million (as of July 30, 2006, the last reporting period prior to the transaction).    In contrast, PetSmart reported LTM EBITDA as of January 31, 2011 (the period most closely correlating with the time of the Petco leveraged dividend)  of $665 million in EBITDA.   It’s LTM EBITDA as of July 30, 2006 was $460 million.   Net net, PetSmart’s EBITDA grew ~ 45% over this timeframe where Petco’s was flat (a generous interpretation).

From a valuation standpoint, PetSmart’s equity has been on a tear the past twelve months, rising ~ 43% according to Yahoo! Finance.  This values the company at 7.8x LTM EBITDA on an enterprise basis.  Subtracting the net debt yields an equity market capitalization for PETM of ~ $5.1 billion.  Applying this same enterprise value multiple to Petco’s $200 million in EBITDA yields a value of $1.56 billion, ~ 16% less than the take private price.  Subtracting the $1.225 billion in debt yields an equity value of, well, not much.   While this comparison fails to account for all the interim distributions, including the leveraged dividend that has lowered the private equity firm’s cost basis, there is no way to put a smile on it.

Further, the above analysis appears conservative when you consider that Standard & Poor’s reported that Petco was actually leveraged 7.6x LTM EBITDA as of January 29, 2011, up from 6.0x at the same time one year prior.  Further, Petco sought an amendment to its loan agreement in February 2011, just three months post issuance.

Net net, it is clear that all is not going according to plan at Petco.  Management defections and flat EBITDA growth over the past five years, is symptomatic that consumers do not find its value proposition all that compelling.   Has it lost its mojo?  From my perspective — yes.  However, don’t count them out by any means…yet.

/bryan

 

Mezzanine Debt Providers Evolve, Out of Necessity

Mezzanine debt, sometimes referred to as junior debt or subordinated debt, came into vogue during the “go-go” 1990s buyout boom.   The origins of mezzanine debt are rather cloudy, but the instrument was invented to allow private equity firms the ability to limit the amount of equity dollars they put at risk in a deal.   Once a purchase price was agreed and senior debt (bank financing secured against the assets of the company) was arranged, buyers would offer mezzanine debt funds the opportunity to get 15% – 20% return by taking an unsecured position ahead of the equity slug.   Interest rates on mezzanine debt was in the low teens with 66% – 75% of the interest being cash pay and the balance paid-in-kind interest (interest that accrues and is added to the principal and then paid when the debt is retired).  The balance of the targeted returns were achieved by issuing at-the-money or penny warrants to the debt provider.

Limited partners (pensions, endowments, and the like that make up the capital used by institutional funds) liked the mezzanine concept as it enabled them to get attractive risk adjusted returns, with the cash interest protecting them on the downside and the warrants juicing their returns on the back end.  In a strong bull market of rising tides, mezzanine funds did very well as default rates ran very low and equity returns exceeded expectations.  Many hedge funds got into the act by making similar investments in operating companies with a more risky profile.  These investments targeting slightly higher returns than institutional mezzanine.

Shortly after the Internet bubble burst, mezzanine debt, in its traditional form, went in to decline.  A flood of cheap bank debt made mezzanine less attractive to sponsors and the emergence of publicly traded Business Development Companies, offering one stop financings (senior debt, junior debt, and equity — often referred to as unitranche debt) , cut into mezzanines traditional markets.   Any gaps between purchase price multiples and bank availability was bridged through the emergence of second lien notes (debt that took a second position on fixed assets and real estate), which offered a lower cost of capital relative to mezzanine debt.   Traditional lenders, including second lien, were offering to cover as much as 95% of the purchase price, so there was no need to offer excess returns to anyone.  Between 2005 – 2007, mezzanine debt went in to hibernation.

By 2007, mezzanine began to make its comeback.   As purchase price multiples reached into the stratosphere mezzanine returned to filling its initial mission.  Any incremental dollar of debt meant an incremental $0.50 – $0.75 of purchase price.  Based on this improving demand function, mezzanine debt funds raised $15.7 billion in 2007.  In 2008, nearly 60 funds raised over $34 billion.  These funds were meant to fund the last mile on leveraged buyout transactions but then the music stopped.  By 1Q2009 the buyout market was bone dry.

Flush with capital, mezzanine debt providers were left to contemplate a “buyoutless” world.   In response to these changing circumstances funds separated into two camps — those determined to define their own identity (Camp I) and those intent to wait out the storm (Camp II).

While Camp II sat dormant, Camp I’s initial response was to seek to make stand alone mezzanine investments.  After all, mezzanine looked like a good tool to achieve short term liquidity relative to taking equity at depressed prices, if it was even available.   However, these funds were not well situated to do de novo deals, having historically relied on the diligence of their equity partners to get comfortable with a transaction.  As a result, targeted returns spiked and mezzanine debt became visually and economically unpalatable.   Lenders began targeting returns of 25% – 30% to compensate for their diligence risks (after all there was no equity to save them).   Many awesome deal stories followed.

However, as the buyout market has roared back to life, Camp I has shown that its evolution has staying power, while Camp II has returned to business as usual.   In fact Camp I is pitching itself as an alternative to institutional equity — faster, cheaper, without the governance hangover.  Notably, terms sheets from Camp I funds look much like those from the old public traded business development corporations, only without the senior debt.   Today a typical mezzanine term sheet will have a subordinated debt component, with cash and paid-in-kind interest and dollars allocated to an equity investment in lieu of warrants.   These mezzanine funds can stretch far on valuation because they have the downside protection of the coupon and no private equity partner to be beholden to.  The script has flipped.

As we enter into a period of uncertainty with respect to how this cycle will build and how long it will last, mezzanine debt players are better situated than their counterparts to take deal volume from other parts of the capital structure.   As a result, I expect to see standalone mezzanine debt volume grow dramatically through the balance of the year.

/bryan

 

Pet Industry Market Trends – 2011 Spring Update

Fresh off our visit to Global Pet Expo in Orlando, Florida, I am pleased to offer you my updated views on the pet industry.   The timing of this reports reflects my intended go forward publishing calendar — post Global Pet Expo for spring, and post SuperZoo for fall.   As always your comments and feedback are welcome.  Full access of the report is always available via email.

/bryan

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The factory of the future will have only two employees, a man and a dog.  The man will be there to feed the dog.  The dog will be there to keep the man from touching the equipment. — Warren Bennis

Global Pet Expo was by all measures a solid show — more exhibitors, more attendees,  and more hype.   And while the convention did a great job of displaying how far the industry has come in the past 5-years, it also did little to create dialog regarding the challenges the industry will face in the near to medium term.

While I remain bullish on the pet industry, I try to take a balanced perspective allowing myself to be guided by the facts; I’m a realist mixed with a pinch of idealism.  To me, there is plenty to indicate that the pace of innovation  within the industry has slowed over the past 12-months.   Everything I saw at Global Pet Expo was incremental in nature — new companies offering “me too” product, product companies offering solutions that address very narrow niches, and a fair amount of “packaging updates” (albeit nice ones).   As an example, I don’t believe a company should exist just because its products are made from recycled material — there as to be more.  Further, my dialogs with pet food manufacturers and distributors suggest the segment did not have a cohesive plan for the pending inflationary cycle that will begin to manifest itself in the second half of 2011.

To the positive, industry fundamentals remain solid.  According to the American Pet Products Association the industry grew 6.1% in 2010 and is expected to grow another 5.1% in 2011.  The pet population is growing driven by an increase in the number of multi-pet households.   Spend on pets as a percentage of personal consumption reached an all time high in November 2010 according to the Bureau of Economic Analysis.   Further, most of the major pet companies produced solid growth in 2010 (Central Garden & Pet, the notable exception).

As always, PetSmart provides a great window into the state of consumer pet spend.   The company’s equity valuation handily outperformed the S&P500 during the second half of 2010, increasing 33.1% versus 14.2% for the S&P500.  Further, same store sales averaged 5.9% over the second half of 2010 versus 0.9% for the prior year period.   The company continues to out comp Walmart and Target with respect to same store sales.   Sales were up, earnings were up, comp transactions were  up.   Further, PetSmart management expressed strong satisfaction with the early results of its proprietary product launched, stated that private label and exclusive product sales had increased in from 16% to 18% in the fourth quarter of 2010 versus a five year target of 25%.

Periods of lower innovation tend to drive more active consolidation as established companies seek to buy strong product development companies and expand market share.   What is notable is that these efforts continue to be driven by the private equity community.    Most of the notable acquisitions of the past six months, save for Nestle’s acquisition of Waggin Train and The Hillman Company’s acquisition of TagWorks, LLC, have involved private equity.  However, as these two deals indicate a consolidator market is emerging for properties with a threshold level of revenues +/- $50 million.

Where we go from here is going to be a function of whether expectations converge.   Market multiples of public traded pet companies continue to expand.   This pattern is relatively consistent with other stock categories that have significant exposure to discretionary consumer spending; in short the market is pricing in a recovery.    These multiples along with the deals of 2007 – 2009 continue to set valuation expectations for sellers.   However, buyers seem increasingly less willing to pay a significant premium for pet properties, in part because there are other segments of the market that appear more attractively priced.   Further, one has to believe the market will separate into the leaders and the laggards, with the leaders demonstrating true innovation and enjoying the valuation premium that goes with that disposition.

Look for the balance of 2011 to be instrumental in setting the tone for the balance of the cycle.  A strong year for the industry could set of us off again, just like 2007.

/bryan

 

Are Pet Food Valuations Compressing?

The private equity community has taken a modest fascination to the pet industry over the past five years.  While investment in the pet industry is nothing new – Thomas H. Lee Partners acquired PETCO Animal Supplies, Inc. in 1988 – interest accelerated markedly in since 2007.  According to the Pitchbook Platform, 46 investors had completed investments in 44 pet related companies over the past five years.  Further, pet industry deal volume grew from 2009 – 2010, from seven to 11 deals, in contrast to the broader consumer marketplace which contracted.  From a transaction volume standpoint, 2011 is off to a strong start for the pet industry with five announced deals in January to-date.

Pet food and treats have been the source of a large percentage of this transaction volume.  Given the growth in the pet population and the percentage of owner spend target towards consumables, it was relatively easy to see why these properties would experience tangible growth.  Further, the proliferation in channels where pet food and treats are sold coupled with the increased willingness of consumers to spend on premium pet food have pushed the category to impressive heights.   The net result was there were nine major pet food investments/acquisitions in the 2007 – 2011 timeframe.

Of the major acquisitions and investments the two most talked about transactions took place prior to the recession.  In October 2007, Swander Pace Capital, a California based consumer oriented private equity firm, sold Eagle Pack Pet Foods, Inc. for an undisclosed amount to Berwind Corporation.  Swander Pace made its initial investment in Eagle Pack in 2004.   Monies were used to drive sales and marketing and to acquire additional talent into the business.  In August 2008, Berwind followed up its Eagle Pack acquisition by purchasing Old Mother Hubbard, Inc. for $400 million from Catterton Partners, a Connecticut based consumer oriented private equity firm.  Like Swander Pace, Catterton had made its initial investment in Old Mother Hubbard in 2004, to drive sales and marketing, investing $45 million for an undisclosed ownership percentage.   Berwind went on to combine the two brands to form WellPet, LLC, which is an active consolidator in the pet food/treat space today.

Little was publicly disclosed regarding the transaction multiples associated with the buys outlined above.  However, general consensus was these transactions took place in the range of 2.5x – 3.0x latest twelve months revenue.  The relevance of those multiples was established a year earlier by Del Monte Foods Co. in its acquisitions of The Meow Mix Company, LLC (3.7x latest twelve months revenue) and Kraft Foods Inc., Milk Bone Dog Food Business (3.2x latest twelve months sales).  Subsequent pet food/treat deals have all involved a comparison to this multiple set and collectively they have formed the basis for seller expectations thereafter.   Notably these multiples are consistent with branded consumer goods companies during the same period.

While seller expectations in the pet food/treat space have remained anchored in the past, the general transaction market has undergone significant turmoil.   A collapse of the debt market rendered private equity dormant for much of 2009 – 2010, with market activity bottoming in 2Q2009 and only modestly recovering over the next 18 months.  Without private equity as a foil, public company buyers felt less challenged to pay a premium for attractive properties, and valuation multiples contracted.  The net result is a number of pet food/treat deals have died over the anchoring on these historical multiples.  In short sellers’ expectations have not changed with the times, in part due to the belief that the pet industry holds a sacred place in the consumer transaction landscape, a notion that has received considerable validation.

According to the Swander Pace website, the private equity fund recently closed on a new pet food platform acquisition, acquiring Merrick Pet Care, Inc., a manufacturer and marketer of wet and dry dog and cat food under the Merrick, Before Grain and Whole Earth Farms brands.  While there has been no deal announcement to date (one does not appear imminent consistent with the Monitor Clipper/Highland Capital Partners/Castor & Pollux transaction of 2008) and transaction value and associated multiples have not been disclosed, the data points we are hearing, validated by several sources, point to a significant contraction relative to the multiples above.   My opinion is that the sale of Merrick Pet Care will mark a meaningful bifurcation in pet food/treat transaction multiples.  This parsing of the market is just what private equity has been hoping for in order to unlock transaction volume in the pet industry.

The above is not to say that premium multiples for pet companies are no longer available.  In fact, there is ample evidence, based on the Natura Pet Products, Inc. and Waggin’ Train, LLC transactions, that the 2006 – 2008 data set remains relevant, but no longer are we looking at a one size fits all world in pet food/treats.  Rather, premium multiples will be reserved for deals with characteristics common to premium deals in other consumer markets – brand awareness and value, operating leverage and economies of scale, defensible intellectual property, and proven management.  Large multi-brand properties that command significant shelf space across multiple sales channels will be the beneficiary of these valuations.

From time-to-time I expect emerging companies with truly innovative products and defensible market positions in the pet industry to command premium multiples, even in excess of those outlined above.   Companies that meet this criterion will (a) have products that can be sold across the pet channel spectrum, in general mass, and in specialty retail environments, (b) meet an emerging need that is not well addressed by existing alternatives, rather than being a new twist on an existing formula, (c) solve a long term structural industry problem that impacts cash flow, and (d) be lead by management teams with proven industry experience.   However, for all intents and purposes, the axis of the pet transaction world was effectively bent by the Swander Pace/Merrick Pet Care transaction, and possibly for the better of total transaction volume.

/bryan