Chewy.com Financing Extends Pet Ecommerce Runway

Anxiety about ecommerce in the pet industry is not a new phenomenon.  I’ve had it for a while; it seems to come in waves.  Often the “worry” is overcome through the most limited acceptable response from a market participant, just sufficient enough to satisfy my concerns. Most recently, my unease related to the future of Chewy.com, the leading independent ecommerce player in the industry.  My fear was that should Chewy be cut off from the capital markets, it could lead to a meltdown given its operating profile and cash burn, setting the online component of the industry back for a decade, from which it may not recover.  Thankfully, for the moment, my concern has been assuaged with the announcement of the company’s most recent funding, a $75 million investment from investment management firm Blackrock.

Pet ecommerce is a bit of an enigma, wrapped inside a riddle, wrapped inside a conundrum.  The conundrum — the perceived potential for cannibalization of four wall retail revenue — started it all in my opinion (others will quibble here, but to do so would merely be a digression).  For years, Petco and PetSmart buried their head in the sand about the potential for ecommerce in the pet industry. As the dominant retailers in the category, their view was akin to “why promote it, if you don’t want it to happen?”. The number three and four retail players possess a limited to non-existent ecommerce capability set as well.  The riddle was how to get a 25 – 40 lb. bag of dog food to a customer’s door without going broke in the process.  The failures of those who tried to solve the riddle, before the needs of customers were sufficient to want it or the infrastructure was available to make it happen, only served to reinforce the conundrum.  The cost problem has been addressed in a variety of ways ranging from infrastructure partnerships, to rising consumer demand, to subscription services, to more effective cross selling of higher margin products to online consumers.  The enigma remains how much ecommerce is influencing the pet industry and the trajectory of its largest retail players.

Depending on what you believe, online sales of pet products accounts for 6% – 10% of industry sales, or $4 – $6 billion.  Again, depending on your source, online sales for pet products is growing at 12% – 20% and enjoys the highest sales penetration of any home care category in the U.S.  However, the U.S. trails both the UK and China in terms of sales penetration of pet food online.  Of these estimated sales, we now know Chewy.com makes up $880 million of them, according to a Bloomberg article where the notoriously secret company disclosed details of it’s most recent funding, a $75 million equity financing from Blackrock.

To date, Chewy.com has raised $236 million (or $248 million depending on your source) in equity from a variety of institutional investors.  There is no complete data source that can reconcile that number — mapping the who, the when, and the how much.  However, we do know investors have migrated from traditional venture capitalist (Volition Capital and Greenspring Associates) to mutual funds whose investments often are a precursor to an IPO (T. Rowe Price and Blackrock). These fund have been necessary to fuel the company’s hyper growth, which has been driven by aggressive customer acquisition and rock bottom pricing for customers.  You don’t go from $0 to $880 million in online revenue in five years without a significant war chest and a willingness to buy customers at essentially whatever cost is required

However, on the way to becoming a pet industry unicorn, Chewy.com’s world began to morph.  First, Jet.com added the category and began to compete aggressively for customers driving up acquisition costs for all the major players and driving down profits for price matching entities as Jet sought to undercut the market when possible. With Jet’s acquisition by Wal-Mart, this issue may abate over time in the name of its parent company’s earnings and ROI requirements. Second, the major physical retailers began to quietly fight back, threatening punitive action for brands that would not enforce MAP online.  While MAP would be a net positive of Chewy’s margin profile, it would likely have come at the cost of growth, a necessity to access the capital markets.  Finally, was the issue of the most recent election cycle.  As Chewy sought to fund its business it was likely going to be pushed towards foreign markets or an IPO, as a trade sale at an attractive price appears unlikely unless you view the business as a capability acquisition and not a category play. Based on the trade and capital markets forecasts for the incoming political regime, there are concerns about slowing foreign investment in U.S. companies against a back drop of changing trade policies and the potential for the IPO window to close as a result of a market contraction.  While neither of these may come to pass, the concerns are real.  This makes the most recent announcement by Chewy to be welcome news, in my opinion, for all independent pet ecommerce players.

Should the public capital markets continue to be inviting, expect an S-1 sometime in 2017 for Chewy.com.  Further, cross off another of our anticipated transitional events for the pet industry in 2016 – 2017 (see here).

/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 – Fall 2015

As 2015 hits the homestretch, all signs indicate that the pet industry is poised to outperform expectations for the calendar year. According to the American Pet Products Association (APPA), industry growth for 2015 was projected at just under 4.4%, a slight acceleration from 2014’s growth rate and a reversal of a four-year growth deceleration trend.

The reasons for slowing industry growth are structural in nature.  For total industry performance to accelerate we need more pet parents with larger disposable incomes.  Working against those realities are macroeconomics and population dynamics.  Pet owners are experiencing rising costs for both products and services, but are not enjoying higher wages or wealth creation through the stock market.  The Baby Boomers, the largest pet owning generation, is also aging out while Millennials, who are delaying home formation, are aging in.  The pet industry is not made up of alchemists after all.

As industry growth slows to a more modest pace, consolidation accelerates.  Pet industry M&A transactions will outpace private placements in 2015, extending a three year trend not seen since the most recent recession.  However, from this lull we expect renewal to emerge as market opportunities emerge from areas abandoned by acquired companies.

As we look back on 2015, as industry observers, here are the key themes and trends that resonate with us:

• Growth on Pace for Uptick. Since 2010, the pet industry has experienced slowing sequential growth rates as measured by the APPA. While total industry spend has increased nearly $10 billion, annual growth has fallen from 6.2% in 2010 to 4.2% in 2014. Against a backdrop of slow/flat pet population growth and a waning pet food upgrade cycle, we questioned the potential for growth to accelerated in 2015. However, as the year enters the final quarter, all signs point to modest improvement in the industry. Improving adoption trends, increased spend on pet healthcare, and falling channel barriers are all contributing to a stabilization of the industry’s growth trajectory.

• Emphasis on Big Deals Continues. In the past 18 months, the pet industry has witnessed five M&A transactions in excess of a billion dollars, highlighted by the acquisitions of PetSmart ($8.9 billion) and Big Heart Brands ($5.8 billion). Seven deals involving companies valued at between $250 million – $1 billion were also consummated in that period. In our tracking of pet M&A, no other period exhibits a similar velocity involving major industry players. Add to this dynamic the Blue Buffalo IPO, which is now valued at $4.4 billion, and a potential IPO or M&A trade involving Petco Animal Supplies, this period becomes even more distinguished. The implication is that large strategic acquirers have become focused on market share and economies of scale, as opposed to acquired innovation. This may open up the market for more private and growth equity transactions as the revenue hurdle for a strategic takeout pushes higher.

• Facility Investments Paying Off. In the pre-recession period, investments in fixed assets were seen as a sub-optimal use of capital. The abundance of third party manufacturing capacity abroad led to asset light models being favored in pet consumables. Based on the perceived premium multiples garnered in recent transactions involving vertically integrated players and the robust growth of independent brands with owned production assets that thesis appears to have come full circle. As domestic capacity in key sub-segments has become constrained, those with existing infrastructure are able to provide supply chain surety to consumers that others can’t match, proving a meaningful form of differentiation. “Made in the USA” claims for consumables is important to pet specialty retailers and premium customers.

• Signs Point to Petco Trade Sale, but Not a Merger. While the performance of pet industry IPOs have been strong out of the gate, that momentum has been short lived. Even Blue Buffalo, which had a strong IPO debut, is down 28% from its offering price, relative to the S&P 500 which was off 8.6% during that same period. Given that broader market volatility shows no signs of abating, a trade sale for Petco looks increasingly likely. Several parties who pursued the PetSmart take private are actively evaluating the business. Additionally, it has been reported that merger talks with PetSmart are also under consideration, after having been eschewed less than a year ago by Petco’s backers over antitrust concerns. While a merger with its rival would make sense financially, the potential for a deal to clear antitrust is at best a coin-toss. Absent a broad market definition for the sales of pet products, the combined Petco/PetSmart would have untenable market share. Even a broad industry definition would likely result in scrutiny over the concentration of premium and super premium pet food sales controlled by the top two specialty chains. At the very least a merger would result in significant door closures. We think the risks may be too much to overcome, making a private equity deal the most likely outcome.

For a copy of our Pet Industry Report – Fall 2015, please contact 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 Growth Continues to be Strong, Albeit at a Slowing Pace

The pet industry delivered another strong year of relative growth in 2014.  According to the American Pet Products Association (“APPA”), the industry grew 4.2% to just over $58.0 billion in total revenues.  While growth was again strong relative to other consumer sectors, it was 0.8% below estimates. This shortfall represents the first time in the past five years that the industry did not meet or exceed APPA projections.

From a growth rate standpoint, the industry was again driven by veterinary services (+4.7%) and non-health care services (+9.8%).  The industry benefited from 0.9% of product inflation and 2.9% of services inflation, which puts volume/unit growth in perspective. With the pet population growing at a slow pace, the industry has benefited from price escalation to overcome anemic volume growth.  Industry growth was again constrained by consumables which grew at 3.2%, 1.6% short of estimates. It appears that the industry may in fact be hitting the ceiling on the pet food upgrade cycle, as premium pet food market share was flat from 2012 to 2014 at 42% of pet food sales.

The slowdown in industry growth was, to the informed observer, not unexpected. The industry can’t grow at 5% when the largest specialty retailer produces flat comps. However, what was more meaningful in the APPA disclosures was the rate at which new owners were entering the inudstry. The APPA estimates indicate that as much as 10% of the pet ownership population came into the fold during the past 12 months, reflecting a rising rate of companion animal ownership among younger demographics at the expense of the Baby Boomers, who continue to slow pet replacement and when they do they favor smaller companion animals.  If in fact industry purchasing power is transitioning to Gen X and Gen Y and this rapid pace it will have meaningful implications on what products are purchased and where.

In our bi-annual industry summary contemplate these changes are other key observations as outlined below.

• Convergence Gathers Momentum. Convergence between industries serving the human population and those serving companion animals is not an all together new trend. Not since Nestlé’s acquisition of Ralston Purina (2001) and Del Monte’s acquisition of Milk Bone and Meow Mix (2006), has the consumer landscape seen this phenomenon in play on such a grand scale. However, the J.M. Smucker Company/Big Heart Brands and AmerisourceBergen/MWI Veterinary Supply transactions are evidence that mainstream acquirers are again seeing the potential of buying into the pet industry. These buyers are seeking access to the growth inherent in the pet industry as a means to offset slowing growth or contraction in their core businesses. If this trend trickles down to the lower middle market it will be a game changer in terms of exit alternatives for leading pet players. Expect sellers to test this theory.

• Demographic Shift has Accelerated. In earlier reports we tied the recent performance erosion of major pet specialty to shifting industry ownership demographics. Our analysis postulated that rising spend from new pet owners, who are predominately part of Gen X and Gen Y, was benefiting independent retailers and online players at the expense of major pet specialty. A recent study by the APPA indicates that the industry added eight million new pet owners in the past year, nearly 10% of the owner population. Growth in first time pet ownership is accelerating faster than previously anticipated. If the rise of Gen Y, and to a lesser extent Gen X, in terms of purchasing power continues at this pace it will have significant impacts on industry spend. Notably, Gen X/Y pet owners exhibit less channel loyalty and ascribes more importance to convenience. Additionally, they place greater value on wellness which bodes well for retailers, product manufacturers, and service providers catering to these pet needs.

• Exit Dynamics for Consumables Improving. A challenge for pet consumable companies seeking to exit has been a decided lack of strategic acquirers. Consolidation has historically been dominated by a handful of major industry participants leaving smaller companies with few options for synergistic exits. However, this landscape is now changing. Most notably, investment in companies with production assets is creating a new class of acquirers. Existing brands such as Merrick & Company and Nature’s Variety as well as traditional producers including Ainsworth Pet Nutrition and Pro-Pet have become net buyers of assets as a result of third party investment. Additionally, consumer companies in adjacent segments have shown an interest in buying brands that control their own manufacturing capabilities. Finally, the successful public offering of Freshpet is likely to lead other mid-market pet food players to pursue public offerings, which will create more acquisition currency. This multiplexing of exit options is good for the ecosystem and will support additional consolidation.

• Expect a Blue IPO in 2015. In 2014, it leaked that Blue Buffalo had selected underwriters for an anticipated public offering. However, its plans were impacted when, in late 2014, it came to light that the company had received improperly labeled shipments from one of its suppliers resulting in animal by-products being introduced to some of their formulations. Since that announcement, there has been little news related to lawsuit brought by Nestlé that resulted in the non-conforming ingredient disclosure or about Blue Buffalo’s plans for a listing. In the interim, there has been continued speculation of an acquisition. We don’t buy it. Blue Buffalo’s valuation in the public markets would dwarf any buyers willingness and ability to pay in an M&A event. Looks for Blue to renew its listing push in 2H2015.

As always our pet industry report is available by commenting here or emailing 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 Market Trends — Fall 2013

For those of you who are consistent followers of my blog, you might recall earlier this year I was rather sanguine (on a relative basis) with respect to the prospects for the pet industry in 2013. My thesis was based upon three factors. First, that a tepid recovery would result in slower pet population growth and the waning of the pet food upgrade cycle. Second, that slowing comp (same-store-sales) growth at PetSmart was in fact a proxy for the industry. Finally, that declining influence of the baby boomers, who have slowed pet replacement, would not be sufficiently supplanted by the necessarily levels of spending growth by Gen X/Y to propel the industry forward at projected levels.

As we round the final turn in the calendar year and head for home, things have not played out quite as I had expected.  The industry has proven itself to again be resilient and more adaptable than even I recognized. The economic recovery has been aided by strong equity returns and rising home prices that have exceeded most pundits expectations. Notably, this has resulted in solid growth in industry related personal consumption expenditures that indicate the industry should deliver projected 2013 results. While PetSmart comps are in fact slowing, management has found ways to adapt — prolonging the pet food upgrade cycle through expanding offerings and more square footage dedicated to the premium aisle, resetting key categories such as canine hardgoods, and evolving service offerings to be more compelling.  Management also reported their belief that the company’s online strategy is producing above market returns. Finally, pet adoption rates, a key driver of spend, have accelerated in 1H2013 adding additional reason for optimism. While there may be clouds on the horizon, rain does not appear imminent. As such, we expect the industry to hit its annual growth projections.

In addition to strong growth, we are also predicting that 2013 be a good year for industry related transactions, both M&A and private placements. One of the best predictors of future M&A volume is trailing private placement volume. Generally speaking, private and growth equity firms have three to five year hold periods. From 2010 – 2012 private placement volume met or exceeded M&A volume in the pet industry. Investments made in 2010 are now starting to come into season. Given the number of companies that will enter their exit window over the next two years we expect transaction velocity to continue to grow. Consumables, distribution, and hardgoods are expected to lead the way. Based on 2013 private placement volume we expect this to become a long-term trend.

The year has also produced a number of trends that we expect will have long term implications. Among these, we are seeing acquisition rationales of large strategic acquirers focus on the value of acquired brands in the pet specialty channel. As an example, when Del Monte Foods acquired Natural Balance Pet Foods, it was the latest in a long line of wellness oriented pet properties snapped up by a large strategic acquirer. Historically, these acquired brands have migrated out of pet specialty and into mass where the market opportunity is perceived to be greater. Our understanding is that Del Monte intends to keep Natural Balance in its current channel. Sure we have heard this before from other buyers, but if you consider that mass is losing sales to pet specialty and currently there is a lack of large brands in independent pet specialty with traffic pull, we may be reaching the tipping point where taking share in broader pet specialty is the more attractive opportunity. Increasingly, we see large strategics seeking ways to connect with a premium consumer in pet specialty and believe that acquisition rationales will increasingly rely on this inherent logic.

Additionally, we are seeing a proliferation of direct-to-consumer models in the pet industry. While ecommerce is the most well known business model for direct sales to consumers, a number of alternative models (flash sales, curated retail, marketplace) have emerged post-recession. During the past twenty-four months, companies promoting these models have begun targeting the pet space.  Notably, Bark & Co. (curated retail), Dog Vacay (marketplace), and A Place for Rover (marketplace), have all raised significant amounts of capital. What these companies, and their backers, are betting on is that as Gen X/Y, demographics that have grown up transacting online, ascend in purchasing power these models will see increasing adoption.

As always, a more complete exploration of these topics and the broader industry are available in my report (post here or email me to request a copy).

/bryan

 

Pet Industry Private Equity Transaction Volume Over Time

As most of you are well aware, the pet industry is in fact quite large.  Depending on how you measure industry size, the pet industry is the fourth largest consumer segment of the U.S. economy (excluding health care).  And where there are large market opportunities, logically, they are capital inflows from investors, both public and private, seeking to create wealth from changing dynamics in those markets.   As an example, if you were an investor in PetSmart’s public shares over the past five years, you have enjoyed a handsome return from the specialty retail chains’ ascendency, as consumers spent more on their pets as part of the broader humanization trend.

Pet companies have also received a considerable amount of interest from private equity funds seeking to capitalize on the growth trends inherent in the industry.  While I do not have purview into every equity funds predilections, I have yet to come across a consumer oriented growth equity or buyout fund that does not have an interest in the pet space.  Many of them long to replicate the success of Eagle Pack Pet Food, Old Mother Hubbard and Banfield Pet Hospitals.  This “professionalization” of the industry has been a thematic I have waxed on about at length in my prior reports.

However, despite the size of the opportunity and the amount of available capital seeking that very opportunity, private equity transaction volume in the pet industry has in fact been quite limited.  To put this in perspective, according to the Pitchbook platform, there were 364 private equity transactions completed in 2012 that involved consumer facing companies.  Of that deal volume, the pet industry made up just over five percent of private equity deal volume with 19 reported transactions.  The is a decline from the past three years, where pet industry transaction volume made up just over seven percent of total consumer transaction volume.  The chart below tracks the trend over time (source: Pitchbook).

Through April 2013, there have been six reported private equity investments in the pet industry, putting the industry trend at risk for a second consecutive deceleration.  So what gives?  A few thoughts based on my experience.  First, the interest of private equity in the industry does not align well with the size of its participants.  As a general rule, private equity firms target companies with at least $5 million in Operating Income, with a strong preference for more.  That is not to say that growth equity and buyout deals don’t get done involving pet businesses of every size, but the core interest from these investors is in companies with a strong track record of profitability.  The pet industry has a limited number of companies that fit this mold, with most businesses being bigger or well below that threshold.  Second, there is an active consolidator market in the industry which is a headwind for private equity firms to get a deal done.  If a seller can get a better valuation from a strategic, they will often bypass the private equity market all together and wait to do a strategic sale. Finally, the interest of private equity in the space tends to be disproportionately oriented around pet food and veterinary clinics. A lack of opportunities in these segments has increased focus on retailers, distributors and, more recently treat companies, but a historical sector bias has certainly limited deal volume.

I remain long term bullish on private equity and the pet industry, but, as evidenced by the above, the relationship between the two has some inherent complexity.  However, as private equity gets a track record of success in a broader segment of industry sectors look for the industry to embrace outside equity more fully.  Deals beget deals.

/bryan

 

Pet Industry Market Trends – Spring 2013

The pet industry continues to chug along.  Based on the information available, the industry posted strong growth in 2012 and is demonstrating all the critical signs of continued health — rising ownership levels, increasing innovation, expanding consumer spend, earnings growth from publicly traded participants, and active capital markets, both private placements and M&A.  In a year that was challenging due to economic uncertainty and political gridlock, the pet market did not miss a beat.

That said, we are only cautiously optimistic about 2013 on a relative basis. While we expect the industry to deliver a solid year when compared to other consumer segments, the pet market may have a difficult time out doing itself in 2013 for three reasons. First, the super premium food rotation that continues to compel growth in consumables is slowing, just not at the pace previously predicted.  At some point it will wane as a driver; 2013 may not be that year but the rally is clearly in the later innings, having only been extended by consumers concerns about quality and an increasing ability to finance said premium food purchases through rising disposable incomes. Second, the industry delivered incredible results in 2012, and comping against those results would be a challenge for an industry.  Notably, public traded pure-play pet companies grew earnings by over 21% in 2012, compared to 9.3% for the S&P500.  As a result, public traded equity prices of these pet companies outperformed the broader market by 25%. Finally, the industry is in a transitional period. Core pet owner demographics are changing, with Baby Boomer influence waning and GenX/GenY/Hispanic influence on the ascendency. Wellness as a central growth theme has benefited product sales, but veterinary volume growth remains poor. Until the product and services side are in sync, it will have difficulty achieving full impact. And channel shift from premises to online is taking place, albeit at a slow pace.

The industry also has meaningful upside to 2013 projected growth of 4.3%. That upside comes from five (apparently not everything comes in three) factors. First, consumers are in an upgrade cycle, having spent 1.9% more per pet product unit in 2012 and 2011.  If consumers continue to upgrade, or the impetus to upgrade expands to a broader segment of pet owners, revenues will increase faster than anticipated. Second, convenience is on the rise. Products and services are becoming increasingly available and operating frameworks are evolving to enable manufacturers broader reach. If access accelerates at a faster pace, revenues growth will benefit. Third, non-health service offerings continue to improve in both concept and delivery.  If disposable income continues to rise, or rises faster than anticipated, for core pet consumers, service revenues will benefit due to their discretionary nature. Fourth, the potential for the wellness theme to converge across product and service is improving through the continuing investment in information services. Information has the ability to ease the tension between owner and health provider. If platform adoption/usage accelerates faster than anticipated that will be good for veterinary clinic utilization.  Finally, capital continues to target the industry for above market returns.  Professionalization of the industry is good for growth.  If private placement volume accelerates industry performance will benefit.

As always, a full copy of my industry report is available by email.

/b

 

And Finally a Pet Company IPO

One of the challenges in forecasting is failing to recognize the inherent frictions in the market.  For over two years I have been predicting a major IPO for the pet industry against the backdrop of expanding public company market multiples.  My initial thesis was that PetSmart’s market valuation heuristics would compel Petco to consider a listing.  Two dividend recaps later, the private equity owners of Petco seem happy to milk their cash cow with no public offering in site.  Natura? Sold.  Sergeant’s Pet Care? Sold, and probably too small anyway.  Pets at Home? Sold. Radio Systems? Private bond offering. Hartz Mountain? Recapped. Blue Buffalo? Crickets.  During this same period, a number of pet related public companies have been taken private (Del Monte, you see a food company while I see a pet company, and International Absorbents, as examples). So net net the market had experienced entropy where I predicted order.

There is a saying that “100% of shots not taken result in goals not scored”.  While I had taken my shots, it resulted in the same outcome — a bagel.  However, next week I get a consolation prize when Pfizer spins off its Animal Health Division into a new corporation, Zoetis Inc., listed on the New York Stock Exchange.  Zoetis engages in the discovery, development, manufacture, and commercialization of animal health medicines and vaccines.  The company derives 65% of its revenue from the livestock market and 35% from the companion animal space.  The company’s name is derived from zoetic, meaning “pertaining to life”.

Zoetis is a big business by pet industry standards, having generated over $4 billion in revenue and over $1 billion in EBITDA for the twelve month period ended July 1, 2012.   Post spin, the company will be the largest standalone manufacturer of animal health products globally, with roughly a 19% market share.  Vaccines and medicines for animals represents a $22 billion market globally according to Pfizer, of which approximately 30% represents veterinary vaccines for companion animals.  The U.S. market for these products is expected to grow at annual rate of 5.8% over the next five years, slightly higher than the total domestic vaccine market whose growth, over the same period, is projected at 5.3% according to Transparency Market Research. Notably, Zoetis grew approximately 30% in 2010 (in part due to the acquisition of Wyeth, whose animal health division, Fort Dodge, generated over $1 billion in revenue at the time of the transaction), 18% in 2011 and 4% over the first half of 2012.  Pfizer estimates that the public company value of Zoetis could be as high as $12.5 billion, or approximately 12.0x estimated 2012 EBITDA.  After the spin off Pfizer will own 80% of Zoetis.

Yes, the Zoetis IPO is essentially an overdue backdoor validation of my thesis – it’s not a products or consumables company or a specialty retailer, it’s an animal health empire.  Further, Zoetis was nurtured inside the womb of one of the largest global phrmara companies and not built from the ground up.  That said, the cloud has a silver lining:

•  Yes, someone had to go first.  Often times a sector IPO leads to others, assuming it gets a warm market reception.  Given that Zoetis is a cash cow, it should be welcomed with open arms by retail investors.

• The pro-forma valuation of Zoetis is healthy.   The company is expected to trade at a significant premium to core human pharma names, consistent with my belief that the companion animal health care market has strong tail winds and a large opportunity set ahead.  Notably, the valuation does a lot to validate the price paid for Perrigo’s acquisition of Sergeant’s, which I estimated at 10.0x EBITDA.

• The pet market is lacking for public companies that focus solely on the industry.  Having greater transparency into industry related valuations is good for capital recruitment and exit market dynamics.

In closing, it’s notable that Pfizer spent nearly two years considering alternatives for Zoetis.  So while I predict other pet IPOs, I don’t suggest holding your breath until the next one.

/bryan

 

Leverage Providing Rare Glimpse into Large Private Pet Companies

One of the most frustrating aspects of following the pet industry is the lack of transparency we have into the operational results of bellwether companies that comprise the market.  With only a handful of pure-play public companies, and even fewer with meaningful analyst coverage, we are left to rely on publicly available market studies, which are often dated and/or at a cursory level, expensive third party research, or, more often than not, rumors and conjecture.  As evidence, approximately 25% of search terms that led people to this blog are related to market rumors (e.g. “Blue Buffalo acquired”) or data searches on private pet company performance (e.g. “Petco 2012 EBITDA”). However, the availability of cheap leverage to fund organic and acquired growth is providing us a rare opportunity to understand how some of these large private pet names are performing.

In October 2012, Moody’s Investor Services assigned a B3 rating (speculative) to a $250 million private bond issuance from Radio Systems Corporation, the privately held market leader in pet containment products and training systems.  The proceeds from the issuance went to replace existing balance sheet debt and purchase a putable equity stake valued at roughly $90 million.  According to Moody’s, the transaction would leave Radio Systems with a debt-to-EBITDA ratio of 4.7x.   The report also states that the company generated sales of $270 million for the twelve month period ended June 30, 2012.  So what can we glean from this disclosure?

• Based on the company’s debt-to-EBITDA of 4.7x, this would imply Radio Systems had somewhere in the neighborhood of $50 million – $55 million in trailing EBITDA as of June 30, 2012.  Based on $270 million in sales for the coinciding period, this would imply an EBITDA margin of 18.5% – 20.0%, a good metric for a company of this size in this segment of the industry but certainly with room for expansion.

• If we valued Radio Systems at an EBITDA multiple similar to the Sergeant’s Pet Care Products / Perrigo transaction or based on the public trading multiples of Garmin or Spectrum Brands, this would produce an implied enterprise value for Radio Systems of $500 – $550 million.

• Finally, it appears safe to assume that TSG Consumer Partners, whose equity put is being acquired, will make a 3.0x return on its investment of $30 million made in 2006.  This returns Randy Boyd to full ownership of the company.

Moody’s rating of Blue Buffalo’s $470 million financing (rating B1) also provides us some salient insight into the company and its capital structure.  According to Moody’s, the proceeds of the transaction will go to fund a special dividend for the owners, including equity partner Invus Group.  While Moody’s did not peg a debt-to-EBITDA multiple for Blue Buffalo at the time of the transaction, it does state that “Moody’s expects that the company will be able to generate sufficient free cash flow to de-leverage rapidly, such that debt-to-EBITDA will be below five times in the next 12 months.”  The report also states that the company generated sales of $400 million for the twelve month period ended March 31, 2012.   So what can we glean from this disclosure?

• If we assume the debt financing reflects the total leverage of Blue Buffalo, it is safe to assume that the company generated somewhere in the neighborhood of $80 – $90 million of EBITDA for the twelve month period ended March 31, 2012.  Based on $400 million in sales of the coinciding period, this would imply an EBITDA margin of 20.0% – 22.5%, a very good metric for a company of this size in this segment of the industry, especially one who is funding a national television advertising campaign.

• Setting aside whether they were true or not, the rumors that were swirling around earlier this year that Blue Buffalo was entertaining sale dialogs with a starting price of $800 million, denotes an implied revenue multiple of 2.0x and an implied EBITDA multiple of +/- 10.0x, which do not appear out of line, maybe even light on the profitability side of the equation.

• This confirms, what many people speculated, that Bill Bishop had sold a meaningful portion of the firm to a third party equity firm sometime within the last three years.  Invus, which has an evergreen fund structure, and therefore can hold positions for long periods, is a sensible partner.  Invus is also well credentialed in food, with historical investments in Keebler, Harry’s and Weight Watchers.

Finally, Petco Animal Supplies is again tapping the debt markets for $550 million in senior notes.  You might recall the company refinanced its balance sheet to the tune of $1.7 billion back in 2010, in part to finance a $700 million dividend to its owners, enabling them to repatriate 90% of their invested capital.  This time around, the notes along with balance sheet cash will be used to fund a $603 million distribution to shareholders.   I hashed out the Petco situation here before, but the most salient point that can be gleaned from Moody’s disclosure is that the company grew revenue from $3.0 billion to $3.3 billion from 2011 to 2012, a rate consistent with Petsmart for the same period, reflecting a greater equilibrium in the balance of power.

Net net, while much of the above might have been pieced together by an informed observer these conclusions were often difficult to corroborate because we lacked factual information.  One benefit of low interest rates, is we have gained some transparency in the process and therefore can substantiate some of the speculation rampant in the industry.

/bryan

 

Pet Industry Market Trends – Fall 2012

During the second half of 2011, the pet industry endured a brief hiatus from its uninterrupted growth trajectory.  Against a backdrop of macroeconomic uncertainty, the pet industry suffered as consumer sentiment deteriorated.  Stagnant unemployment, coupled with a housing market laboring to recover, left the industry with a post-holiday hangover.   As a result, expectations for 2012 were modest given the industry was in transition as historical growth themes from the 2007 – 2010 period waned.  This commentary was front and center in our Spring 2012 report.  What we did not accurately predict was how quickly Humpty Dumpty would be put back together again.

As we approach the bell lap for 2013, the pet industry appears poised to beat expectations for the year.  Pet population growth has accelerated, the housing market has improved, and consumer sentiment is trending up and to the right again.  This has been good for the pet industry, which saw both revenue and earnings accelerate. Coupled with investments in innovation and further evidence of traction for the Total Pet Health trend, the near term outlook looks much brighter today. Below is a summary of the macro trends I see currently impacting the industry.

• Industry in Major Innovation Push. In recent versions of my report, I expressed a belief that the pet industry was laboring through a period characterized by a lack of innovation.  Limited investment during the recession resulted in fewer new product introductions in 2010 and 2011.  While the 2012 tradeshow season did not produce evidence of breakthrough renewal, there are signs the industry is addressing the issue.  Product company CEOs tell me they are investing heavily in R&D, retailers are promoting innovation through launch support, and equity backers are funding unique start-ups.  Where there is innovation there will be further consolidation.  Expect more excitement at Global Pet Expo 2013.

• Ecommerce Gaining Momentum. One of the most discussed topics at SuperZoo was direct-to-consumer for the pet industry.  There is evidence, based on web traffic patterns, and partner engagement, that the category is moving online and that ecommerce leaders are growing rapidly. As Amazon experiments with same day delivery and online retailers find partnerships that provide access to pet prescriptions, we expect this solution set to grow in acceptance, taking share of independent pet specialty stores. Notably, PetSmart, who has commented that they are not seeing any market share erosion from online competitors, recently changed their management bonus program to tie ecommerce sales to compensation; recognition by the industry’s top retailer that ecommerce is a real competitive threat in pets over the long term.

• Public Pet Companies Breakout, Again.  During 2H2011, core publicly traded pet companies lost momentum. Lacking a cohesive growth driver, earnings contracted and pet equities traded on company fundamentals with mixed results.  The industry malaise did not last long, as our comp group collectively produced 12.1% revenue growth and 16.7% earning growth in 1H2012.  As a result, core pet equities, as a group, have outperformed the S&P500 by over 15% in 2012.   While the expected names (PetSmart and MWI Veterinary Supply) continue to perform, it’s notable that others, such as Neogen Corp (23.7% equity return), Central Garden & Pet (40.4%) and Oil Dri Corp (11.2%), which have lagged in prior periods, have all produce double digit returns.  The broad advance is, in my opinion, a very positive sign for the industry.

• Big Deal Potential.  Headline deals are important influencers of transaction dynamics within an industry.  Deals beget deals, as buyers and investors look to take advantage of market shifts caused by consolidation. While the pet industry has enjoyed a number of high profile transactions over past 24 months, these deals have been spaced in such a manner so as to limit our ability to glean anything meaningful from the associated transaction multiples. A single data point is not indicative of a trend.  However, when multiple deals express the same characteristics, it has a powerful impact.  With the recent Sergeant’s  Pet Care Products transaction, the pending Zoetis (Pfizer Animal Health) IPO, and potential deals for Central Garden & Pet / Blue Buffalo / Natural Balance Pet Foods, the industry may have a run that re-frames market valuation dynamics, similar to 2006 when the revenue multiples for premium consumable companies were established through the Milk Bone and Meow Mix transactions.

While we have never soured on the long term potential for the pet industry, what we are seeing in terms of a recovery and re-acceleration is remarkable.  It is our expectation that 2012 will turn out to have been better than expected, providing the industry an opportunity to breach its prior apex within the coming years.

As always, a full copy of my report is available by email.

/bryan

 

Pet Industry Market Trends – Spring 2012

“For the times they are a-changin'” – Bob Dylan

The pet industry produced another solid year of growth according to the American Pet Products Association.   Total industry revenue increased 5.3%, to $51.0 billion in 2011 driven by growth in all major segments of the industry.   Sales benefited  from pet population growth, which returned after a two year absence, and price inflation in all categories.  Discretionary services produced the strongest growth rate at 7.9%.

During the past five years the industry has grown 20%, a remarkable rate under any conditions, but especially in light of the economic contraction experienced in 2009 – 2010.   Expansion was fueled by the “Humanization of Pets” movement.  The trend toward treating pets as family members shifted spend into higher priced categories such as premium food, driving growth in the absence of population expansion.  While this theme remains relevant, its influence has tapered as the product rotation it stimulated nears completion.  As evidence, premium food market share is flat over the past two years.  In contrast, private label pet food and supermarket channel share, both associated with value, have grown.   While a value focus will continue due to the domestic economic climate, it will not drive industry volume but rather shift mix.  Instead, I believe an accelerating focus on pet wellness and population growth will fuel the industry in 2012, albeit at lower growth rates than seen in the past few years.

While the concept of “wellness” and the pet population is not new per se,  I see it coming together in a new and integrated way, which I call “Total Pet Health”.  Previously wellness was about giving your pet “better” food, augmenting their nutrition with consumables that provided perceived benefits, and then taking your pet to the veterinarian and listening to their advice about dental health and weight management.   Today the concept of wellness is about empowering yourself to make the most informed decisions about your pets long term well being using all available resources, rather than relying on pseudo experts.  It is about making product decisions based on actual results, not marketing claims.  It is about selecting the best product for the need at the time rather than blindly associating with a brand.  Its about having a relationship with your veterinarian around preventative care and using insurance to control total cost of care.

To adapt to these changes in owner behavior, I expect to see pet brands morphing from product or service providers into wellness brands.   As an example, in July 2011, VCA Antech, the nations leading owner and operator of animal hospitals, acquired Vetstreet (d/b/a Vetinsight.com) a provider of client communications, pet education, and home delivery of pet medications and supplies.  Against a backdrop of strained relationships between pet owners and veterinarians driven by veterinary services price inflation, VCA took measurable steps to empower pet owners.  Vetstreet’s information solutions enable pet owners to educate themselves about pet health conditions, learn what tangible steps they can take to remedy those conditions at home, and understand what to expect if they do take their companion to the clinic in order to avoid unnecessary service or charges.  Through this transaction, VCA transitioned itself from being a perceived source of the problem to being a wellness solutions provider.

A summary of my Total Pet Health theme is below:

From a pet industry transaction standpoint, I expect slower growth will result in further consolidation.  While the pet industry saw substantive consolidation in 2011, it also saw renewal as growth remained robust.  Private placement volume within the industry accelerated in 2H2011.  However, in a slower growth environment it will be harder for emerging companies to gain scale.  Further, interest from institutional equity sources in highly competitive pet categories will logically recede absent lower valuations.  If capital is lacking innovation will also be limited.  To the positive, truly innovative companies should enjoy premium valuations – see United Pet Group’s acquisition of FURminator as a prime example of this reality.  These conditions point to transaction volume being oriented around consolidating segments – distribution, hardgoods, retail, and veterinary services – in the near term.

Despite a fundamental bias towards consolidation, I expect pet industry transaction volume to be modest in 2012 absent a major transaction on the consumables side.  When Procter & Gamble acquired Natura Pet Products in 2010 it sent shock waves through the industry, especially in light of the fact that P&G was rumored to be exiting of the pet sector.   While the industry has seen active M&A and capital markets since that time, it appears wanton for another marquee transaction to provide it stimulus and buzz.  The recent United Pet Group/FURminator transaction caught the attention of the product side of the industry, but consumables have been lacking a bellwether since Nestle Purina acquired Waggin’ Train in 2010.  Given the prospects for an industry growth taper, as well as downstream tax motivations, it seems plausible Blue Buffalo Company or Natural Balance Pet Foods, the two largest independent pet food companies, could trade in 2012.  If they do, expect a flurry of activity in their wake.

As always, my full report is available by request.

/bryan