With the benefit of hindsight, we know the pet industry produced another solid year for performance in 2013, generating growth of 4.5%. Industry revenues climbed to $55.7 billion, with growth exceeding forecast by 0.2%. Revenues benefited from inflation of 1.3%, including food price inflation of 1.1%. Growth was relatively uniform across the core segments with services (+5.0%) and veterinary care (+4.9%) leading the way. While growth is projected to accelerate to 5.0% in 2014, we expect companies in the space to experience more widely divergent fates. Our thesis is that the industry is undergoing structural changes that will result in stronger performance from the leaders and slower performance from the laggards.
Structural change is being driven by slower growth in the key drivers of performance over the past five years. On the retail side, we are seeing smaller retail chains ascend at the expense of large pet specialty players. Notably, PetSmart same-store-sales slowed to 2.0% in 2H2013. In contrast, PetSmart produced, on average, quarterly same-store-sales growth of 5.2% from fiscal 2010 through 2Q2013. Further, among top 25 pet retailers, 55% of box growth came outside of Petco/PetSmart in 2013, up from 41% in 2011. Finally, ecommerce growth in pet products is expected to accelerate from 35% in 2013 to 38% in 2014 as online pet venues both consolidate and proliferate.
Product manufacturers are also experiencing the impetus for change. Looking for new sources of growth they are pursuing new channel strategies. Big Heart Brands’ acquisition of Natural Balance Pet Foods and Nestle Purina PetCare’s acquisition of Zuke’s underscore this theme. Notably, the number of companies with pet specialty distribution that exhibited at Expo West (meaning they are looking for Whole Foods distribution) doubled in 2014. Additionally, the pending Blue Buffalo initial public offering is, in our view, a prelude for the brands entry to mass. Collectively, these companies will blur the lines between sales channels for pet consumers.
Net net, change is the air and change drives deal velocity. Below are the other key pet industry trends for 2014:
- Prelude for Sale or a Move to Mass? In March, news leaked that Blue Buffalo Company Ltd. had selected underwriters for an anticipated 2014 initial public offering. When the company took a leveraged dividend in 2012, we predicted a sale or filing within three years. Blue generated $600 million in sales in 2013 and EBITDA margins are said to be nearing 20%. The company is approaching the size of The Nutro Company when it was acquired by Mars, Inc. While Blue has no lack of suitors, the purported asking price of $1.5 – $2.0 billion would be hard for even the largest companies to swallow in an environment where product recalls can rapidly erode brand equity. A listing would place a public sale price on the business, which may facilitate a transaction, but we think the more likely outcome is that Blue is headed to mass. The growth requirements for a public company are more than the pet specialty channel alone can support. If the brand jumps to FDM under its existing label, which we think is possible, you can add another brick in the wall of change.
- Natural Leads Grocery Resurgence. Grocery has been steadily losing market share to pet specialty post recession. Simply put, FDM has been out-thought and out-merchandised. Lacking access to key independent brands coupled with limited selection depth, consumers have migrated their spend elsewhere. Grocery buyers and store planners did not recognize the strategic value in the pet aisle. However, this is changing. Major chains such as Kroger and Whole Foods have or are set to launch large pet assortments made up of staple, emerging, and house brands system-wide. Increasingly, brands are being built for the grocery channel or seeking to make the jump. Notably, the number of pet consumables companies exhibiting at Expo West doubled in 2014. Given its size and a lack of compelling incumbent brands, the pull of the FDM channel is strong. As the channel regains momentum outside of the natural and gourmet segments, it has the potential to change where consumers shop for premium and how brands are built.
- Change Will Drive Deals. As manufacturers, retailers, distributors, and brands seek to align themselves with emerging realities, we expect to see increased deal activity. Deal velocity in sectors such as consumables should accelerate both acquisitions and private placements. Specialty retail, a sector whose transaction volume has been rather muted, should see a resurgence as leading micro-box and online platforms enjoy increased capital formation to expand their footprint or are acquired by mass and major pet specialty retailers seeking to expand omni-channel capabilities. For the most attractive properties, valuations will increase due to broader and deeper interest from buyers and investors.
Contact me for a copy for my report.
Sources: APPA, Cleveland Research, New Hope Natural Media, Pet Business, Reuters, U.S. Bureau of Economic Activity