Chewy Drops S-1, What We Learned

Chewy filed an S-1 on April 29th (see filing here).  The offering, if executed will be managed by Allen & Company, J.P. Morgan and Morgan Stanley (list in alphabetical order).  The company will trade under the CHWY ticker. As yet unclear is which exchange they intend to file on, the amount of proceeds (currently there is a $100 million placeholder, which is standard tactic), or the use of proceeds beyond working capital and general corporate purposes.  However, there is much to learn from the filing.

Before wading in, let’s a take a short trip down memory lane.  Chewy was acquired by PetSmart for $3 billion in May 2017. As part of a PetSmart refinancing, the buyer borrowed $8.2 billion and the private equity ownership syndicate injected $1.3 billion of equity.  The publicly traded component of that debt experienced significant volatility post issuance in-light-of PetSmart’s declining performance. The senior debt tranche traded as low as 70% in May 2018, before rebounding to current levels of 87.5%.  The junior tranche traded down to 48%, and today trades at 82.5%, reflecting a much rosier outlook. In June 2018, the ownership group took advantage of an asset stripping clause of the indenture to move 16.5% of the Chewy stock to an unrestricted subsidiary and dividend the parent company 20% of the stock.  The value of Chewy at that time was $4.45 billion and notably Chewy will no longer guarantee PetSmart’s debt. Through this process, the equity owners created a war chest that could be monetized to potentially generate a return on their investment or buy themselves out of debt purgatory at a discount. As you might expect, the creditors disputed the parent company’s legality to undertake the asset stripping, questioning whether the business was insolvent. Earlier this month, the two sides agreed to modify the terms of the debt in exchange for dropping the lawsuit.  The company’s bond prices spiked upon the announcement of the Chewy S-1 (source: Bloomberg):

Now that we are all on the same page, let’s dig in.

Chewy.com generated $3.5 billion in Net Revenue during 2018, a growth rate of 68%.  This figure is slightly more than the estimate category sales on Amazon of $3.3B. Based on the S-1, ecommerce penetration in the category stands at 14%, with growth to 25% in 2022. Notably, Chewy generated a $268 million Net Loss, down from a $338 million Net Loss in 2017. The company warns that profitability may never be achieved, though this is a standard disclaimer.  The business currently has 10.6 million customers who order, on average, $334 annually. In 2012, this figure was $223, representing a ~ 7.0% six-year CAGR.  Notably, the company states that embedded growth among its customer base is 20%. This is growth that the Chewy would expect to experience through expansion of wallet share if it did not acquire any new customers.  Active customers spend, on average $500 in their second year and $750 after their sixth year, 1.5x their second year spend, which is usually their first full year on the platform.  The S-1 does not address customer churn.  Chewy generates approximately 80% of sales from consumables, of which 5.3% of total Net Sales are attributable to its housebrands.

While all the above is well and good and interesting, the most notable metric is the ratio of customer life-time-value to acquisition-cost, commonly referred to as LTV / CAC. This ratio speaks to how sustainable your customer acquisition engine is and a common predictor of future results. Based on the performance of its 2015 cohort, which is now three years aged, Chewy’s LTV / CAC was 2.4x.  The generally accepted benchmark for healthy performance on this metric is 3.0x, indicating some concern with the health of the business model and its ability to become profitable over time.

In thinking about what Chewy might be worth in an IPO, the comp that we gravitate towards is Wayfair.  The online retailer of furniture and home goods currently generates $6.8 billion of net sales, losing $404 million of EBITDA. The business currently trades at 2.1x LTM Revenues.  When you dig into the comp set analysts rely on in pricing the stock, that group trades at ~ 1.15x Fiscal 2018 Revenue and 1.0x Fiscal 2019 Revenue. This would value the business at $4.1 billion based on 2018 figures and $4.4 billion based on 2019 figures, assuming a 25% growth rate for 2019, with the caveat that no forward guidance is offered in the S-1 but in-line with the June 2018 valuation.

In our Spring Pet Industry report, we postulated that PetSmart may need to sell or IPO Chewy, but the realization of that option is manifesting itself sooner than we had anticipated.  The public markets are being tested with offerings of conceptually attractive businesses with a proclivity for losing money.  The net of this is the risk reward tradeoff being contemplated here is not without an ample helping of downside potential.

/bryan

Note: 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.

 

Pet Industry Market Trends – Spring 2019

And we are back…

The pet industry continues to evolve towards its new normal.  However, while it appears the volatility within the industry has decreased, tremors continue and several events could catalyze a second wave of transformational change.  Central going forward is that the industry now finds itself facing some new pain points with no clear path to resolution.

Of increasing significance, latency between consumer trends and pet trends has compressed from years to months, which will put immense pressure on the industry’s antiquated regulatory framework. Consumer demand for pet products that incorporate CBD, human diet concepts such as Keto and Paleo, and protein alternatives is significant but lacks regulatory and, in some cases, legal clarity. That has not stopped manufacturers or retailers from bringing these products to market in order to satisfy demand. If AAFCO cannot evolve to become more nimble and responsive, the industry will become more risky to all involved.

Also of significance, is that the risk associated with the repositioning of Petco and PetSmart could result in major downstream implications. As Petco forges ahead with its new wellness enabled vision, PetSmart has largely stood still lacking financial flexibility.  The success of Petco’s strategy could put pressure on PetSmart to sell or IPO Chewy, it’s most valuable liquid asset. Notably, a Chew S-1 was filed on April 29th (see here). Tepid operational results for Petco or from investors during a Chewy IPO roadshow, could place these two organizations on a merger path in order to remain relevant.

Slower industry growth is driving consolidation, a theme that will continue for the foreseeable future. The cost of doing business in the pet industry has increased as physical and online retailers monetize their market positions, making it more difficult for midsized and emerging brands to compete. Given the pace of change, strategics are under more pressure to acquire assets that enable them to meet emerging customer needs, or risk losing out on the ability to monetize faster growing market opportunities. Private equity is leading the consolidation charge due to broader business malaise prevalent among large strategics, which will enhance focus on profitability as the key criteria underlying acquisitions and put downward pressure on valuations

Notwithstanding slower growth and more turbulent competitive dynamics, we believe the current environment offers a market opportunity that may not manifest itself again for some time.  The other key trends we are keeping our eye include:

• Blue Buffalo Banks Further on FDM. General Mills announced that they intend to double Blue Buffalo’s retail availability by April 2019. Central to this strategy will be launching Wilderness in FDM. When Blue transitioned Life Protection Formula in August 2017, it communicated its intention to protect the pet specialty channel by preserving exclusive access to its others brands. The quest for growth and profits rendered that commitment fleeting. By the end of April, according to General Mills earnings presentation Blue will have a retail ACV of 65%, up from 32% in October 2018.  Retail sales declines in pet specialty necessitated the move according to General Mills executive leadership. Notably, Blue also posted 24% ecommerce growth for the nine months ending February 2019.  If there is anything left in the relationship between Blue and pet specialty we will soon find out.
• Amazon Accelerates but Housebrands Not a Category Killer. According to Packaged Facts, Amazon generated pet category sales of $3.3 billion in 2018, giving it a 6% share of the market. Amazon pet food sales exceeded $1 billion in 2018, up over 20%.  However, Amazon’s own housebrand Wag, launched in mid-2018, only accounted for $2 million of these sales. While Amazon housebrand sales will invariably increase over time and benefit from the launch of complementary brands, such as Solimo, owning the buy box is not yet translating into changing consumer behavior. Most Wag and Solimo product ratings are 3.5 to 4 stars, evidence of mix sentiment, and the launch has been plagued by production issues. A study by Marketplace Pulse suggested that Amazon housebrands across categories were having limited impact on brand sales online. With estimates for online penetration of pet food sales reaching as high as 50% over time, Amazon stands to benefit anyway you look at it.
• Petco Launches Repositioning Strategy. Petco is ushering in a comprehensive new strategy firmly rooted in the health and wellness driver of industry growth. Petco’s approach involves eliminating products whose formulations feature artificial ingredients. As part of this process, Petco will seek to transition customers in many leading national brands to its housebrands and other channel dedicated brands. Criticism has ensued as Petco’s housebrand formulations may not fully comply with their own standards and many brands they are removing appear to be for financial or competitive reasons. Additionally, Petco launched its PetCoach store which “offers the highest quality suite of personalized pet services, products and experiences – all designed through a veterinary lens – to address total pet health and wellness.” While its competitor runs in place, we applaud Petco for its efforts to reframe its appeal and relevancy to pet owners. However, if traffic and transactions don’t materialize, Petco may lack the flexibility for a further pivot. Get your magic 8-ball ready.
• Follow the Funds to See the Industry’s Future. 2018 was a record year for industry consolidation, but it also outperformed in terms of private placements, as equity flowed into the category at record levels. Over $1 billion of equity capital was invested in pet related enterprises since 2017. Notably, the year was punctuated by larger deals, with the median deal size of $45 million among transactions whose proceeds yielded more than $5 million. Investments in dog-walking apps accounted for 40% of deal value, but 23% went into ingredient manufacturing companies, with an additional 7% flowing to direct-to-consumer dog food brands. Institutional equity is flocking to these opportunities because they are not well served by existing market participants. The deals of today will fuel the exits three to five years down the road, which will only serve to extend the consolidation cycle. However, the subsectors attracting capital speak to a much broader market opportunity within the industry.

As always, if you are interested in accessing our full report you can reach out to me directly.

/bryan

Note: 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.

 

 

 

Pet Industry’s Evolution Continues — Industry Trends, Fall 2018

Like other consumer industries, the pet sector is discovering that today change in constant.  While this seems obvious, in the five years following the recession, the prevailing status quo enabled the pet industry to enjoy substantial and consistent growth.  The period that follows stability is often best characterized as turmoil, regardless of the amplitude or velocity of change.  Even modest changes after a long period of calm can appear daunting.  Over time disorder then turns into a new paradigm; the pet industry appears to be moving into its new status quo.  However, there is little rest for the weary as new challenges, such as trade policy and house brands, that pose new treats to incumbents.  And when those threats dissipate, new ones will rise in their place.  Industry evolution is now characterized by persistent change.

As we keep our eye on industry change drivers, the four themes we are focused on this fall, include the following:

• Independents’ Conundrum Multiplexes. In our Spring report, we commented on the potential impact of Blue Buffalo’s move into FDM and subsequent acquisition would have on independents, many of which have historically “divested” brands that jumped the channel or were acquired by large CPG firms. In our store visits since the acquisition closed, we have certainly seen a deemphasizing of the Blue brand in specialty, though it remains widely available in the channel. The brand that has historically benefited most from independents scaling back on Blue has been Champion, a process that began when several prominent chains reduced or excluded Blue in wake of the 2015 labeling scandal. If, in fact, Champion is acquired by Nestle Purina, this would further complicate the merchandising strategies for independents. Many of the brands poised to fill the potential shelf space void lack the name recognition to drive traffic, the ability to rapidly expand production, or the marketing dollars to drive trade spend. Independents have survived upheaval before, but this time things may be more challenging and it leaves them more vulnerable to ecommerce.
• Trade Policy Could Impact Growth. In September, the US expanded the tariffs imposed on Chinese goods to $250 billion worth of products. Of greater significance, the tariffs applied will increase from 10% to 25% on January 1, 2019. While the pet consumables supply chain has meaningfully shifted to US-sourced products, a broad range of pet products will be impacted, with hard and softgoods having the greatest exposure. What is unknown is how these tariffs will impact retail traffic, purchase intent, and transactions. Given that real wage growth has been muted for some time, there is potential that pet population growth could be impacted, which will have a trickle down effect on all industry categories. While there was once a widely held belief that China trade tensions would blow over quickly, we find market participants are preparing for a longer game, which includes seeking alternative sourcing in Vietnam, South America, and Mexico given favorable labor rates. Only time will tell.
• House Brands and Private Label Growing. Consumer industries, broadly speaking, are experiencing a dramatic proliferation of house brands and private label offerings, as retailers seek to cash in on growth trends and the ability to control real and virtual shelf space. In the last two years, Target has introduced 20 brands, Walmart 18 brands, and Amazon 72 brands across different categories. Amazon’s owned brands are on pace to generate $7.5 billion of revenue in 2018, and grow to $25 billion in 2022. With manufacturer margins of 2x – 3x retailer margins, house brands make strategic sense. With consumers increasingly looking for value, private label could redirect $64 billion of purchases. Within pet, Amazon has launched house brand premium (Wag) and value (Solimo) kibble and wet (Simply Perfection) for dogs, as well as a supplies line (Pet Craft Supply). While these brands, and others that follow (dehydrated, freeze dried, super premium, etc.), will create competitive tension among marketers, it provides a segment of the industry that service these brands with a meaningful growth driver.
• Private Equity Becoming Buyer of Lower Middle Market Pet. 2018 is on pace to be a record year for pet industry consolidation. Shifting consumer demographics, channel dynamics, and, now, trade policy are the key drivers of acquisitions. What is most notable, is not the volume or velocity, but who is doing the buying. Historically, when strategic buyers wanted something, their “ability-to-pay” priced financial buyers out of the market.  Today, the large strategic consolidators are hyper-focused on specific assets that address business model deficiencies and portfolio challenges, leaving a larger population of acquisition targets for the likes of private equity and private equity-backed strategics. This includes the food category, where the pricing advantage of strategics is magnified. Expect more deal announcement from financial motivated players, and invariably the valuation compression that comes from selling to a profitability motivated buyer.

Transformation in the pet industry continues to progress at a rapid pace, with market participants homogenizing around a common set of growth strategies. Major competitive moves continue to unfold, changing the strategic and operational landscape, with more dominoes to fall.  For market participants we suggest you hold on. While this roller coaster we are now on may have lost amplitude, the ride is far from over.

/bryan

Note: 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.

 

 

About That Wall…

I know what you are thinking.  I’m not talking about that wall.  I’m talking about this wall, the one Blue Buffalo, post-acquisition, seems hurtling towards.  Recently, we received further evidence that the risk of gravity catching up with the brand may be more likely than not.

General Mills released first quarter earnings (note: for GIS, fiscal 1Q aligns with calendar 3Q), which include a decline in North American sales, across all sources of revenue, of 2.1%.  While pet food sales rose 14% in quarter, sales at retailers (sell-in) increased only 9%.  These numbers are optically appealing, but represent a slowdown of Blue Buffalo’s growth rate pre-acquisition.  Also factoring into the equation was that the quarter had an extra selling week, which, when considered, means the business grew mid-single-digits.  Adding to the woes was reported input cost inflation as well as continued expenses associated with the new production plant.

To rewind, prior to the acquisition Blue was growing at a healthy clip, delivering quarterly sales growth of 18.4% in 3Q17 and 14.2% in 4Q17, the two quarters immediately preceding the acquisition. The company had effectively explained away the performance malaise that it is experienced in 1H2018 (7.9% in 1Q and 2.8% in 2Q), as a failure on behalf of major pet specialty to execute and leveraged that narrative to move a subset of their product line into FDM. The size and timing of the FDM rollout masked issues with the company’s business in several ways.  Of greatest significance, it gave the company a greenfield revenue opportunity which juiced their comps, making comparisons between historical and current periods to be akin to comparing apples and oranges.  However, the size and scope of the rollout, in combination, with the stealth nature of the lead-up to launch, obscured the fact that the initial velocity growth was heavily aided by promotions and discounts.  It’s quite common for this to be the case, but it was also not something Blue Buffalo drew out in its narrative to the street.  It’s notable, the brands data, as tracked by IRI in the weeks leading up to the deal dropped off the table, declining from 13.4% to 1.9%.

What was unknown at the time of the deal, was what impact, if any, retaliatory action taken by retailers would have on the business.  Petco and PetSmart sales and traffic, have continued to flag.  However, PetSmart has completed a major reset of its consumables aisle and its bond prices have appreciated materially, in part based on 22% sales growth at Chewy.com. Additionally, based on my store visits in various geographies ranging from major coastal cities to smaller towns in middle America (certainly not scientific by any means) there is some de-emphasizing of the brand in terms of placement, promotion, and mind share.

Further, post deal, Amazon launched its own private label pet food, Wag. While the Wag rollout, has not been seamless, the product generally enjoys 4-star reviews from an increasing number of verified purchases. Approximately 50% of customers have given the product 5-stars on both the 5-lb. and 30-lb. bags, though the 5-lb. bags experienced some problems with product delivery during the initial rollout, according to One Click Retail.  Amazon experienced 30% growth in pet products sales in the first half of 2018.

What the future holds here is unknown, but the bloom seems to be off the bull case. Analysts have taken their estimates of Blue Buffalo organic sales down to mid-single-digits from low-double-digits, despite management re-affirming the sales guidance for the higher amount.  The brand starts to lap the initial FDM rollout in the back half of the year, so comps get tougher.  Further, management stressed that it sees opportunities to repair their relationships with Petco and PetSmart, enhance in-store execution, and increase visibility of channel exclusive innovation in pet specialty. Given that the leadership of major pet specialty chains learned about the FDM rollout just prior to the general public, I am not sure enough time has passed to heal those wounds, though both entities now have new CEOs. Finally, while the China trade war tariffs are not impacting food, they are touching a broad range of pet products, which may reduce store visits, especially in major pet specialty.  This should factor into the calculus.

While Blue Buffalo may have a softer landing than we expect, it is clear that the stakes for General Mills are already higher than anyone expected them to be. How high can a buffalo jump?

/bryan

Note: 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.

 

 

 

 

 

 

Is There a Cure for What Ails Major Pet Specialty?

“In my 25 plus years in the industry, this is the first time I can say, I don’t know what is going to happen;  I don’t have a good answer.”

Given the proximity to Interzoo and Global Pet Expo, this year’s SuperZoo trade show allowed for more shop talk than in prior years. Given the heat nobody wanted to move anyway, so the conversations were fulsome, as opposed to being fleeting in nature. The topic du jour, so to speak, was the future of PetSmart, and to a lesser extent Petco.  Adding fuel to the fire was recent data indicating pet food sales in major pet specialty had been down over 10% in the past four weeks, a trend that was accelerating as opposed to contracting. The italiziced statement above was made in that context, and its concerning given that it came from a very smart, very seasoned, pragmatic industry executive whose predictive capabilities over the years have proven to quite accurate.

The pet industry needs a healthy national retail ecosystem and its major retailers are, well, reeling. The cure for what ails them is not obvious. That said, both Petco and PetSmart are not standing still, with both organizations appointing new CEOs in the past 45 days. More changes are likely on their way, whether they be structural (Chewy.com spinoff?), strategic, or modestly tactical.

Below are some summary thoughts on my conversations in Las Vegas:

Petco Animal Supplies

With respect to Petco, most people I talked to put a lot of stock in the hiring of Ron Coughlin, the former President of HP’s personal computer business.  When you read the narratives of those who have written, most with excitement, about his hiring, they put considerable weight behind his ability to develop strategies that connect with emerging consumer cohorts, such as Millennials.  While Ron is new to me, his real value appears to be in driving sales and differentiation against a backdrop of product commoditization. Connecting with Millennials, and subsequent generations, is a strength of Apple, not HP.  That said, Ron’s experience at PepsiCo, should be valuable assuming Petco continues to double down on its private label strategy, as his marketing credentials are meaningful.  He seems like a great hire.

The other strategy that received some attention at the bar, was related to the fate of Unleashed. Once a key differentiator, and a darling for emerging brands that were seeking to bridge the gap from independent pet specialty to major pet specialty, it appears that Unleashed has become a drag, at least to manufacturers. Many brands indicated allocating funds to support online efforts were yielding much greater results than promo spend and exclusives in Petco’s smaller boxes. Essentially, the professionalized box chains (Chuck & Don, Kriser’s, Pet Food Express, etc.) have siphoned off the customer Unleashed was meant to target, and Petco has not maintained the strategic differentiation between its core box and its smaller cousin.  Some suggested spinning off the box chain a la Petsense.

Finally, there was the natural discussion about the private label brands, and their future.  Most people I spoke to did not expect a tactical departure from the current strategy, but likened it to a secondary line of business – i.e., pick up some kibble after your dog is done at the groomer. What this says is that Petco has more work to do to make its brands traffic drivers and find a balance between house brands and third-party brands.  Petco is currently banking on its investments in engagement and services to drive brand attachment and store/online traffic. It certainly has a technology advantage, but it needs to translate that into traffic and transactions, and not let it languish as “potential”.

PetSmart

While most liken the Petco rehabilitation process to a home remodeling project, when people talk about PetSmart’s road back, the narrative is more akin to taking things down to the studs. Maybe it is the drama and intrigue that continues to be associated with the retailer, but more likely it is a function that people cannot clearly see the path out of the predicament the chain currently finds itself mired in. That is not a surprise, given the high stakes poker that has begun between PetSmart’s private equity owners and the company’s debt holders. After spinning off 36.5% of Chewy, PetSmart’s debt prices improved (see recent charts here), seeing the move as more benign than anticipated. However, the other lens through which it can be viewed is the asset stripping provides more fuel for a public listing of Chewy, the proceeds of which could be used to repurchase debt at a steep discount. The more salient question is whether the financial engineering machinations gets in the way of forging ahead with a new operational strategy. My assumption is that J.K. Symancyk would not have joined unless he felt he could begin effectively addressing PetSmart’s challenges against this backdrop.

With respect to that new operational strategy, the same general principles are commonly cited among third parties. First is the need to integrate Chewy on both the back and front end, enabling PetSmart to fully leverage the assets it acquired over a year ago. My long held assumption was that the only way to wring the benefits out of the transaction was to fully integrate the two businesses, but that any contingent consideration owed to Chewy stakeholders was going to inhibit that effort in the near term. With Ryan Cohen having now departed and likely any earnout potential lost, work can now begin in earnest. This includes both warehouse and inventory rationalizations, but also the technology work to enable Chewy to leverage PetSmart’s infrastructure to offer pick-up in store and delivery from store for added convenience. Additionally, PetSmart needs to implement technology strategies that enables them to have a complete picture of their customers across all their sales platforms, leveraging this knowledge to drive customers to the transaction venue that offers the most desirable outcome, whether that is tied to revenue, profitability, or retention.  A continual race to the bottom through escalating customer acquisition seems pointless to most.

The second most commonly discussed action is to change the mental paradigm as it relates to both suppliers and end customers. Historically, major pet specialty has viewed themselves as the customers advocate and educator, despite having a transient workforce. When costs were cut post take private this included spend on training these resources. As the primary retailer of pet food and supplies, major pet specialty retailers controlled access to product and the promotion of the product to pet owners. In this role, they leveraged their position to extract value from the brands to support their financial profile. While brands consistently complained the cost of doing business in these channels was onerous, it what was necessary. That is no longer the case, brands can find alternative sources of growth online and through professionalized chains. Therefore succeeding going forward for PetSmart requires a change to this paradigm. Pet food and supplies are now widely available and owners pursue product discovery in a variety of ways, not necessarily tied to the physical sale location.  This means finding a way to embrace emerging brands and offering them a financial paradigm that enables a win-win scenario, as opposed to offering them a loss of 10% – 15% of margin in addition to seeking meaningful promotional dollars.  This would likely involve trusting that these brands undertake the necessary effort to build a customer following and driving them to PetSmart’s sales venues, crediting them for marketing spend that drives awareness and transactions.  This trust is going to be necessary if there is going to be success in driving ROI for brands that might bring traffic and loyalty.

Finally, several people commented on the need for greater transparency — in everything they do for everyone they touch. This goes right down to the mission and speaks to culture. PetSmart has been historically insular, and that was successful until the access paradigm flattened and the knowledge paradigm multiplexed.  PetSmart need to seek to create relationships as opposed to adversaries.  Easier said than done, but trying will help mend fences.

The net of all of this is that there is work to be done.  Failure may lead to a consolidation of these boxes, while success will elevate the entire industry.  Mr. Symancyk and Mr. Coughlin, we wish you both well.  We all need you right now.  However, we should not fear that brighter days are ahead.  The industry has successfully navigated challenging periods and companies including Walmart and Target found their way against a similar backdrop, though they both had more levers to pull.  Collectively, we have to have faith.

/bryan

Note: 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.

 

 

 

 

Is Blue Buffalo Heading for the Wall?

Blue Buffalo has been one of the greatest disrupting forces in the pet industry post-recession. Against a meaningfully competitive backdrop in pet food, Blue grew a $1.25 billion revenue brand that became the industry’s most meaningful driver of purchase traffic and transactions both in store and online. The company’s meteoric rise defied all known industry convention, and the brand gained a stranglehold over its retail partners, most of whom were used to dictating the terms of engagement. Blue even broke the cardinal rule in pet specialty, launching into FDM.  All of this culminated in the sale of the company to General Mills for $8.3 billion dollars. As I have said previously, Blue played the game, and played it well.

For some, this is where the story will end, as a real-life fairy-tail. However, for most there is another chapter, and when one digs deeper, the conclusion is that this may not all come up aces, creating repercussions for many that follow. While few can dispute that Blue Buffalo adroitly navigated a complex equation over the past ten years, growth and perception have masked some stark realities.

Consider first, while FDM sales are Blue Buffalo’s current and future narrative, it still derives the disproportionate amount of its sales in major pet specialty, and major pet specialty is flagging when it comes to pet food.  Pet superstore market share, according to Euromonitor, declined from ~ 25% of sales in 2015 to ~ 21% in 2017.  This represents a three percent annual decay function.  At the same time, Blue Buffalo’s sales in pet superstores declined from 68% in 1Q2016 to 45% in 4Q2017, dropping in every sequential quarter.  However, Blue Buffalo’s sales in pet superstores declined almost 9% from 2016 – 2017, accelerating in 2H2017 vs. 1H2017.  All of this is pre- retailer repercussions of channel jumping.

The logical response to the above is to cite growth in online sales of both pet food and Blue Buffalo’s solution set. During the 2015 – 2017 period, online sales of pet food grew from ~ 4% – 5% share to ~ 13% – 14% share, and Blue Buffalo became the number one selling brand of pet food online. However, several factors need to be considered going forward.  First, online pet food sales are generally at a lower margin, due to both price transparency and price based competition.  All sales are therefore not created equal, though volume based discounts to major retail partners offsets some of this compression.  Second, the online channel is getting increasingly competitive through the introduction of housebrands (Tylee and American Journey at Chewy.com and Wag at Amazon.com).  Given online is where volume is growing, it is natural to expect Blue Buffalo would experience some market share erosion from brands competing more aggressively in the channel.  Finally, one has to consider the long-term impacts of direct-to-consumer pet food brands.  While small in terms of overall sales, Ollie ($17 million), The Farmer’s Dog ($10.1 million), NomNomNow ($13 million), and its peers have raised considerable amounts of capital to disrupt the category, likely taking with them consumers who purchased through third party ecommerce platforms.

Next, consider that most channel jumping corollaries have been accompanied by share erosion over time and sales velocity deceleration once initial pipeline fills are complete. When Hill’s began emphasizing the online channel in 2016, it experienced sharp declines in growth tied to two factors. First, was the natural latency in ramping up awareness and velocity in an adjacent channel. Second, was due to reprisals from major pet specialty retailers, who reduced shelf space and SKUs and/or relocated the product with respect to its orientation in the store, moving it to less desirable real estate. Additionally, when Iams jumped to FDM post acquisition, it initially began to grow market share (up ~ 2%) over a five-year period, a time where category competition was less pitched and online sales were virtually non-existent, before engaging in a steady decline (down ~ 6%) over the next 10 years.

Finally, we need to consider Blue Buffalo’s track record of innovation. While Blue Buffalo has certainly been innovative in its core product line as well as its marketing strategies to build brand awareness and consumer loyalty, its innovation has been muted in recent years.  I was reminded of this by a close industry friend. Brands (Earth Essentials), form factors (meat rolls), and ancillary products (cat litter) have all been launched and either under performed or been discontinued. Veterinary sales efforts have been virtually non-existent.  Finally, brand awareness outside the U.S. is low and would take meaningful dollars to ignite. There is a general pattern of large CPG companies buying innovative brands and losing that innovation DNA in the process.

The net of all of this should be cause for concern – your core distribution channel is under significant pressure, your growth channel is getting increasingly competitive, your mitigating actions can only sustain you for so long, and it does not appear likely you can innovate yourself out of the dilemma.  While this may seem dire, there is hope, but it is masked by uncertainty.  The ability of General Mills to retain management and ramp up innovation, as they did post acquisition of Annie’s, will be critical. How they navigate the landscape with the sales force is also important.

While only time Blue Buffalo’s flame appears to be burning a little less bright.

/bryan

Note: 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.

 

Pet Industry Should Find Greater Stability in 2018

The pet industry, for all its interest and fanfare, is a data starved segment of the consumer landscape.  The industry lacks for data solutions that would provide a dynamic understanding of industry, channel, and company level performance.  Instead, operators and investors are left to rely on summary level government reporting, annual data releases from industry associations, specialized proprietary data reporting from industry participants, and select data points from publicly traded companies, that when put together provide a general understanding of industry growth and direction.  As the pet industry further expands into the food, drug, and mass channel data should improve, but this will take time.

As we wait for APPA data to be released at Global Pet Expo in March, we thought it might be useful to use the other available data sources to paint an industry picture ahead of the tradeshow season.

• Growth:  The pet industry continues to grow at levels in excess GDP (2.3% in 2017).  Pet related Personal Consumption Expenditures, measured by the Bureau of Labor Statistics posted 6.5% growth in 2017, driven by 9.7% growth in Services PCE.  Product PCE growth was more muted at 4.2%.  The industry experienced a deflationary trend in pet food of 1%. Services inflation continued at just short of 2%.  The variance in PCE versus APPA growth figures has been expanding, meaning the data sets are getting less correlated, for reasons that are unclear. However, based on the underlying PCE data it is safe to assume that growth was steady in 2017, but it is unlikely that we returned to 4%+ growth.  Continued deflationary pressure in pet food is a long-term headwind, which services inflation could constrain pet population growth for cash starved Millennial pet owners.

• Economic Tail/Head Winds: Growth in the pet industry is, in our experience, tied to three economic factors.  First is employment.  People who are employed are more likely to have income to afford a companion animal and a living situation that would allow for pet ownership.  Currently, unemployment is at a structural barrier, which has been good for pet ownership growth over the past 12 – 18 months.  However, it seems the industry is getting as much benefit from the employment situation as one can expect. Unemployment has also declined due to people leaving the workforce, meaning the benefits of full employment on the pet industry in recent years is somewhat overstated.  Second, is disposable income.  The cost of owning a pet continues to increase. According to the APPA Pet Ownership Survey 2017 – 2018, the annual cost of owning a dog is greater than $1,500.  Some surveys put the lifetime cost at over $25,000.  To afford these costs, pet owners need disposable income. Yet growth in disposable income has been tepid over the past over the past 24-months. The recently passed tax reform should benefit income trends, but potentially at the expense of inflation. Psychologically income trends should be healthy for pet ownership as consumers tend to overlook cost inflation in the near term. Third, is home formation.  When a family unit purchases a home, it is often a catalyst for purchasing a companion animal.  Low interest rates and sustained economic growth have led to a strong demand for housing, despite concerns about affordability given current home prices.  Home formation trends should continue to benefit the industry, though rising interest rates may cause home formation trends to taper.

• FDM Growth: The launch of Blue Buffalo in the mass and grocery channel is a game changer for the industry.  A myriad of other brands are launching outside the pet specialty channel, such as Nutro in Walmart, and we expect PetSmart and Petco will be offering a competitive response in their next reset.  The issue is that PetSmart and Petco cannot offer brands the same growth trajectory they have enjoyed in the post-recession period.  Quite simply, consumables availability has become ubiquitous; consumers are simply choosing a transaction venue based on convenience weighted cost.  The consumer relationship is with the brand, not the retailer.  Even with only six months of Blue Buffalo exposure, which has slightly underperformed and been aided by significant discounting and promotional spend, in 2017 pet consumables growth in FDM is estimated to have exceeded that in pet specialty — 2% compared to 1.5%.  This bodes well for growth among brands with existing FDM shelf space, though the ability to hold that space going forward is going to become increasingly competitive.

• Ecommerce Growth Continues:  In 2016, industry analysts, based on very limited information, estimated that ecommerce penetration in the pet industry would eventually grow to 20%.  At the time penetration was estimated to be +/- 5%.  According to Amazon, they estimate ecommerce penetration in the pet space will reach 18% in 2018, meaning the industry will almost certainly breach 20% and do so in 2020.  Amazon recently stated that they viewed the industry as a “unique and highly valuable category” and they intend to make growing their online sales of pet products a 2018 business priority.  Additionally, the proliferation of direct-to-consumer pet food brands (Ollie, JustFoodForDogs, etc.) and sales platforms (Petnet, PetCube), many of whom are now venture backed, will give the broader sales channel additional tailwinds. We also see aging pet parents as a further opportunity to grow pet ecommerce. As consumers get mobility constrained they are increasingly turning to online venues for product acquisition. We believe they will do so with their pet spend, especially pet medications. The unanswered question is how MAP pricing might impact online channel sales.  Ecommerce has grown substantially based on its pricing advantage.  As that narrows, it would logically impact purchase intent unless it offers convenience benefits that outweigh the alternatives.

For the past two years, we have talked about an industry in flux.  While we believe the industry continues in a state of transformation, we think we are through the most volatile phase of the change cycle.  The truth is there is some stable thematics — steady growth aided by modest tailwinds, customer first retail, and dissolving incumbent paradigms.  Companies that can build a salient customer value proposition and innovate stand to do just fine against this continually evolving backdrop.  Those that rely on historical paradigms as a means of competitive advantage seem more likely to get run over.

/bryan

Note: 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.

 

 

 

Assessing the Likelihood and Viability of a Chewy Spinoff

I enjoy the holidays as much as the next person.  Every year I seem to make some new friends during the party circuit that accompanies each Yuletide.  This year was no exception.  However, who those friends were was a departure from historical norms. All my new pals had one thing in common — they were PetSmart bondholders.

My firm does not engage in sales or trading of public equity or debt securities, nor do we provide any research products tied to specific companies or offerings, so for a critical mass of hedge fund managers to end up at my doorstep was a bit of a surprise.  All of them wanted to know if I thought PetSmart would spinoff Chewy.com.  To better understand why that was such a pressing question some context is required.

When PetSmart acquired Chewy in April 2017, they financed the purchase with a combination of debt ($3.25 billion) and equity. The debt component include two tranches of publicly traded notes (first and second lien).  The price of the debt began to slide within one month of the close, and picked-up steam when Blue Buffalo jumped the channel in August followed closely by the departure of PetSmart’s CEO. A third quarter earnings miss added fuel to the fire (EBITDA down 34% year-over-year).  The company’s second lien notes have traded as low as the mid-50s, while the first lien note have traded as low as the mid-70s, a healthy discount to par.  The notes were among the worst performing junk debt issuances of 2017.  However, what caused PetSmart bondholders to worry most was the fact that the covenant package tied to the debt would allow the private equity syndicate to separate Chewy from PetSmart for its own benefit, and to the detriment of creditors.

The primary motivation of private equity investors is first and foremost financial gain.  That is not to say they do not provide a direct or indirect public good, but rather I would never put it past this class of investors to pursue what was in their own best interest.  While separating Chewy from PetSmart might be theoretically viable under the terms of the bonds, we think the carve-out has more risk than reward.

While Chewy remains the market leading ecommerce property in the pet space, its value proposition is eroding.  Post-closing of the transaction, a small number of notable brands exited the platform, dealing the company a topline financial hit. The transaction also accelerated a movement within the retail community for the implementation of MAP pricing policies.  While MAP can be hard for smaller brands to enforce, it appears that most companies are making reasonable efforts to communicate and enforce these policies.  Of greater significance is the fact that Chewy was losing money at the time of the sale, meaning it would need more cash to sustain its growth.  Separating from PetSmart would result in the loss of significant purchasing leverage, meaning even further losses.  Absent a major cash infusion, Chewy would need a public float to perpetuate the business model.  Public comps with this business model trade at 1.0x – 2.0x revenue, much lower than the multiples paid for the banner.

The net of all this is that I do not see a full separation as a likely outcome.  At the very least it would lead to years of expensive litigation. Rather, I believe the private equity syndicate will use the threat of a spinoff to renegotiate with bondholders if and when needed.  If a spinoff does occur, expect it to involve less then 50% of Chewy, such that the entity can continue to be consolidated for financial reporting purposes and enjoy the benefit of PetSmart’s purchasing power to offset losses.

/bryan

Note: 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.

 

 

 

 

 

 

Is Pet Industry Hurtling Towards a New Dawn or its Moment of Reckoning?

“Where you stand, depends on where you sit.” — Rufus Miles, Princeton University

As we round the “club house turn” for the calendar year, it is natural to begin focusing on the year ahead and what it might hold (or bring, depending on your preference).  It is common for these final days to be filled with conversations about what we are seeing today and what we anticipate tomorrow.  As we catalog perspectives, through these conversations, as it relates to the next twelve months for the pet industry, the narratives fall into one of two camps — the sky is falling or the sun is sure to rise tomorrow.  It appears which camp one finds themselves in is highly correlated to whether the outlook might benefit the prognosticating party.  This is the classic application of Miles Law.

Your guess is as good as mine with respect to where the industry might go in 2018.  However, here are the key things to watch:

• Blue Boom or Blue Gloom? — If you talk to equity analysts, Blue Buffalo has become a battleground stock.  The long narrative is about growth as penetration increases.  The short narrative is tied to slower uptake and discounting in FDM, retailer retaliation, and class action litigation.  The recent sales data is compelling but it includes a considerable amount of sell-in and discount driven velocity.  One would be wise to wait until 2Q2018 to pass judgement, but patience is boring.  Bull Case: Gravity and Blue Buffalo have seldom been bedfellows, and today is not the day for them to become better acquainted.  Bear Case: When margin compression and the inevitable pet specialty scaleback hits the stock, it will be a wake up call for investors.  Magic 8-Ball Says: Signs point to yes.
• PetSmart: Comeback Kid or Sophomore Slump? — The biggest unknown is how the revised PetSmart strategy will resonate in 2018.  The March consumables reset will provide meaningful insight into their Blue Buffalo sales replacement strategy.  We hear the new set is a literal “dogs breakfast” — something for everyone, including FDM brands bridging to major pet specialty.  How Pinnacle Pet Store performs will be critical.  Currently, the brands on promo are an eclectic mix.  We also know multiple PetSmart/Petco brands are in current FDM tests. I don’t put much weight into the prevailing theory that Chewy.com will get spun out from under the bondholders, but never underestimate private equity owners to further their own interest at the expense of debtors. With MAP pricing getting more prevalent, and with the major distributors over leveraged (see below), PetSmart could see improved traffic trends.  The bigger issue is how they create greater leverage with Chewy.com.  Currently, PetSmart is trading 40% gross margin customers for 10% gross margin customers.  We assume the loss of Champion and Fromm means any earnout in the deal is underwater making Chewy leadership a flight risk.  Bull Case: Blue FDM stalls, PetSmart gets traction with omnichannel capabilities, the bonds hit 80.  Bear Case: Did you know the private equity owners also control a crisis management PR firm?.  Magic 8-Ball Says: Cannot predict now.
• Indy Sink of Swim? — Independents are also at a critical moment.  They have held the upper hand on selection and access and continue to enjoy that advantage due to Champion and Fromm channel conviction and access to emerging brands and alternative form factor foods. However, they generally lack an ecommerce strategy and a recession looms, all though tax reform may push that event down the road.  Of note, both Animal Supply and Phillips Feed Service are overlevered and credit analysis points to softness in the independent channel.  If the independent channel experiences product access constraints due to its reliance on these distributors, it will make it hard to effectively merchandise and retain customers.  Bull Case: Continued PetSmart malaise and erosion of online advantage through MAP keep indy on the front foot.  Bear Case: PetSmart turnaround coupled with distributor issues drives contraction within the category.  Magic 8-Ball Says: Ask again later.
• Private Equity: Buyer or Seller? — Given late market cycle dynamics we are sure to see an uptick in transaction opportunities in 2018.  With a meaningful subset of strategic consolidators under pressure (some through no fault of their own) or hunting for transformative acquisitions (good luck), private equity is expected to play a larger role in the deal landscape during the balance of the cycle.  The recent sale of Outward Hound and Manna Pro Products, are evidence that private equity will pay-up for scale pet properties that have robust M&A pipelines. Further, the defensive nature of the pet industry is an attractive for private equity given the potential for a recession during their holding period.  Bull Case: Private equity uses the current market opportunity to create a number of new consolidator platforms.  Bear Case: Rising credit costs and channel concerns curtail interest.  Magic 8-Ball Says: Outlook good.

No matter where you stand, based on your last point of rest, it is hard to argue that the pet industry is no longer in the honeymoon phase. The change cycle that began nearly two years ago, continues. Signs point to further volatility ahead. However, with turbulence comes opportunity. Magic 8-Ball Says: It is decidedly so.

/bryan

Note: 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.

 

 

Blue Buffalo Delivers Further FDM Plan Insights

Earlier this week, Blue Buffalo released its 2Q2017 financial results.  While the numbers are always interesting, analysts were looking for further clarity on the company’s FDM launch and its anticipated impact on full year results, as well as insights as to where the brand is migrating and how it might offset dilution associated with a multi-channel strategy.  In short, the quarterly results were only the appetizer and the FDM launch narrative the main course. Reactions from the call seem to fall squarely into two camps — satisfied or bewildered.  The stock was up 6.6% on the day, which tells you which camp Wall Street fell into, but off its high during the trading session.  The stock had been up a double digit percentage during the session.

The quantitative metrics made for a mixed bag.  The company delivered in line EPS despite a – 2.5% topline miss.  Management attributed the miss to inventory delevering at major pet specialty accounts.  Organic sales growth was +2.8% (+3.3% in dry and +0.7% in WTO) driven by +1.8% mix gain and +0.9% inflation.  Sell through was ~ 7% representing sequential growth over 1Q2017.  Notably pet superstore sell through declined ~ 6% versus sell-in and was down ~ 11% year-over-year.  In contrast ecommerce growth was robust leading to a total sell through growth rate of ~ 30% in the channel. Gross Margin was also up +235 bps year-over-year, driven by supply chain efficiencies and lower input costs.  This appeared to be +125 bps over consensus.  The company affirmed full year guidance for both top and bottom line. The long short is Wall Street likes earnings and in combination with margin gains, it was enough to look past the sale miss.  The narrative appeared something akin to the following — “We will make it up in FDM!”

Management elaborated on its FDM launch, stating the four retailers it has partnered with represent between 8% – 9% of the pet food market on a dollar basis.  This expands Blue Buffalo’s addressable market by ~ 20%.  The company’s products will now be available in an additional 6,000 doors. Given that FDM over indexes on cat and wet/treats, management believes this unlocks some potential for growth in WTO.  Based on some early looks at the product set in Publix, it appears FDM will be selling 25 lb. bags of Life Protection Formula for a price consistent with a 30 lb. bag on Chewy.com. Blue Buffalo is targeting a high single digits/low double digits share in its FDM accounts.  Said differently, they are targeting 8% – 10% share within the retailers that account for 8% – 9% share of the pet food market.

The most notable aspect of the call, was the fact that Blue Buffalo did not speak to PetSmart or Petco before announcing the launch, which had been in the works for close to a year.  Thus, there was no way for them to weigh the competitive response from their major pet specialty retail partners. Management’s response to analyst queries was akin to, “we are hoping for the best.”  Whether it was coincidental or contributory, PetSmart CEO, Michael Massey, resigned today (see press release here).  My sense is that Blue Buffalo did not want to alert these retailers ahead of their pending category resets.  This would have likely led to greater near term shelf losses as the superstores increase shelf space for their premium private label offerings.  Blue has demonstrated they understand the timing game and are playing it to their advantage.

And the pace of change for the pet industry keeps accelerating…

/bryan

Note: 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.