As we approach the bell lap in 2014, anticipated full-year performance for the pet industry is starting to come into clearer focus. For the first time since we have been blogging about the industry, we believe projected growth might fall short of APPA projections. The industry continues to face structural headwinds that are dampening our expectations. Notably, three metrics we commonly rely on as relative predictors of growth are lagging the benchmarks we feel are necessary for these projections to be achieved.
- Personal Consumption Expenditure (PCE), which consist of the actual and imputed expenditures of households by consumption category as measured by the U.S. Department of Commerce’s Bureau of Economic Analysis, for pet related goods and services showed growth of 3.7% in 1H2014 versus 5.7% in 1H2013;
- PetSmart same-store-sales comps (including inflation) for 1H2014 were -0.6% versus 3.5% for 1H2013;
- Adoption rates, as measures by PetHealth Inc.’s PetPoint Report shows that adoptions of canines have been weak through 1H2014, with feline adoptions also lagging in 1Q2014.
There are other factors that concern us as well. Household formation has been sluggish, wage growth is stagnant, and the retail environment is tepid, at best. However, offsetting these concerns is data that shows pet parents are spending more than ever, alternative sales channels such as online and farm and feed and experiencing strong growth, and conventional grocery is making significant investments in the category. From experience, we also know the pet industry is like a cat — it always lands on its feet.
As we take stock of the industry here are the key themes we see shaping the current landscape:
- Transaction Environment Heats Up. Acceleration in pet industry transaction volume began in 2010 driven by third party investment in emerging brands. After peaking in 2011, velocity tapered in 2012 and 2013. Based on YTD numbers, pet industry transaction volume is set to rebound, led by increased M&A activity. Consolidators are looking to gain greater exposure to faster growing segments of the market. Large amounts of liquidity in the market are driving up valuations, when combined by uncertainty in the retail channel, is motivating sellers. Notably, available liquidity options have now expanded to the public markets for mid-sized pure play pet companies with strong growth impetus. As market growth slows, we expect pressure to consolidate will heighten further giving this M&A velocity uptick legs through 2015.
- Major Pet Specialty is Getting Pinched. Pet specialty retailers are facing slower comps and market share erosion from a myriad of drivers we have highlighted over the past few years. Margin is moderating for this channel as sales growth slows, at a time when investments are needed. We believe the successful response to these threats requires bold moves not currently being contemplated. While tweaks to the merchandising mix may help, rapidly expanding omni-channel capabilities through acquisition and investment and pursuing vertical integration opportunities are needed. Imagine PetSmart’s fortune if it had invested in Blue Buffalo ten years ago. Channel barriers are coming down and retailers need to think out of the box to protect their incumbent positions. Change takes time, so do not expect a near term rebound, but do not discount the power these retailers have with manufactures to mitigate losses.
- Channel Barriers Are Eroding. The pet industry has a high percentage of channel tied merchandise. PetSmart derives nearly 30% of its revenue from product exclusives. Brands that bridge into FDM are generally shunned by independents. As comps slows in pet specialty, emerging brands are getting anxious about their own growth prospects, causing them to consider testing the prevailing merchandise borders. As conventional grocery attempt to reverse share losses realized over the past five years, expect them to expand their efforts to recruit leading brands or incentivize those brands to develop solutions that work at lower price points. The risk for the industry is that a broader carriage of authentic and emotive brands in conventional grocery at lower price points could result in the realization of a downgrade cycle.
- Online Independents Enter End Game. While pet products growth online continues to be robust, profits associated with these sales remain thin. Being a sub-scale online pet retailer is a losing value proposition, literally. The best situated players are developing forms of differentiation – media and education assets, prescription capabilities, and private label offerings – to offset lower margin product sales. Those who are successful will be the attractive consolidation candidates. PetSmart’s acquisition of Pet360 is consistent with this thematic. Three other independent players are currently for sale. Some of these companies will be acquired for their differentiated capabilities, but we expect the others to become zombies or go away entirely. We expect that three years from now, there will be no meaningful independent traditional pet ecommerce retailer.
For a complete summary of our pet industry market insights, please contact me for a copy of my report.
Source: American Pet Products Association, CapitalIQ, PetSmart, Inc., U.S. Department of Commerce
Note: The purpose of this blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change. While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.