asiaOn January 9, 2017, Mars, Inc., owner of the Banfield Pet Hospital veterinary group, the largest pet hospital chain in the nation (~900 units), agreed to acquire VCA, Inc., the markets number two player (~760 units), in a deal valued at $9.1 billion.  The deal represents a 31% premium to the prevailing stock price, just prior to the transaction, and reflects an acquisition multiple of just over 19.0x LTM EBITDA, generally in line with other top tier animal health company acquisitions (15.0x – 20.0x).

VCA’s equity had experienced strong appreciation in the year leading up to the transaction, rising ~32%.  The company was enjoying renewed momentum in its hospital business in 2016 with comps growing 6.3% in 2Q2016 after posting a gain of 7.6% in 1Q.  However, 3Q2016 comp growth of 5.4% was viewed as a sign of deceleration against a back drop of a $0.02 EPS miss. The company’s equity had rebounded to near peak levels before the transaction was announced.

As part of the announcement, Mars indicated that VCA would continue to be led by Bob Antin and will operate as a separate business unit. Antin holds a 3.12% equity stake in VCA, which is valued at ~$240 million in the transaction.  It is our expectation that the two hospital chains will be merged at some point to realize the clear operating synergies between the organizations.  Antitrust is not the reason the businesses are expected to be kept separate in the near term.  There are approximately 26,000 pet hospitals in the U.S. and Banfield and VCA operate under different service models.

The business logic of the deal is hard to question.  Key reasons for the acquisition include the following:

  • Economies of Scope. While VCA and Banfield operate under different service models, they are vying for the same customer.  By owning the two biggest banners in the space, Mars can begin strategically thinking about how to rationalize current and future locations to maximize performance within its portfolio.  The data available to them for strategic planning purposes alone should be invaluable. The combined expertise should enable Mars to bring the highest quality of animal care to the largest addressable market.
  • Economies of Scale. Setting aside, for now, the clear potential to consolidate back office operations, the deal comes with ample potential scale benefits.  One of the most attractive aspects of VCA is its lab business, Antech Diagnostics.  While Antech is already the reference lab for Banfield, they also drive meaningful volumes for IDEXX (in-house diagnostics and consumables) and ABAXIS (hematology).  Some of this business is expected to flow to Antech over time.  Additionally, the two organizations have distinct distributor relationships, with VCA linked with Henry Schein and Banfield working with MWI.  We would expect this business will soon be up for grabs.
  • Acquisitions. While we expect Mars will be out of the hospital acquisition game for a short period, given that there is 90% of the market still to capture and roll-ups continuing to happen, we expect they will be back in the market as a buyer within 12 months.  However, the combination will remove a meaningful source of price inflation in the market, where VCA and Mars have historically gone head-to-head for attractive deals, thereby driving up price. Unless someone else fills this void, I would expect sellers would lose leverage as private equity is unlikely to be a competitor in a rising interest rate world.
  • Shifting Exposure. As the largest veterinary asset in the Mars portfolio, Banfield presents some unique problems in that its growth is largely tied to unit growth at PetSmart.  PetSmart was previously a 21% owner of Banfield’s parent, Medical Management, Inc.  Mars repurchased PetSmart’s interest in the company in late 2015, in a deal that has largely gone under the radar. The majority of Banfield hospitals operate inside PetSmart locations.  In contrast, VCA clinics are standalone operations.  With PetSmart box growth rate waning, gaining additional exposure to the standalone clinic market diversifies risk for Mars.

While the transaction between Mars and VCA may make very good business sense, it remains to be seen how consumers will benefit.  Most of the marketplace discussion has been about the potential for limited choice and rising prices, as opposed to better service and value for consumers.  As Millennials grow in terms of pet ownership, they may also view this as a further “corporatization” of the veterinary market and seek service elsewhere. Only time will tell.

/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.

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I recently had the opportunity to speak at the First Annual Pet Food Investor Forum, sponsored by Susquehanna  Financial Group. The conference was primarily geared towards public equity analysts and it was interesting to see this class of market observers collectively hone in on a few key questions that were affecting the public equities in the pet food sector. Among those questions, one that came up with the greatest frequency was the prospects for Blue Buffalo to penetrate the veterinary channel.  The array of speakers were almost universally asked to proffer our views on this issue, as it is central to the next leg of the Blue Buffalo growth story.

Since Blue Buffalo announced its intentions in the professional channel, I’ve held the belief that it was likely going to struggle to gain penetration quickly. My view was grounded on two basic premises, neither of which speaks to the quality of their solution set, of which I have no knowledge.  The first is that this channel has some very strong incumbents, who have a long history with the channel and its practitioners. The vets I have spoken to suggest that is going to be hard to overcome given how hard it is to create access. Second, was that building sales in the veterinary channel takes time and requires fundamental research that Blue Buffalo might have a hard time producing quickly, unless they had started this process long before the commercialization efforts came to light. Blue has obviously overcome significant hurdles in its history to become a near $5 billion market cap company, and there is reason to believe that if you give them a long enough time horizon that they will make inroads. I only see it as a question of magnitude.

However, last week something caused me to begin to rethink my paradigm.  Lawyers in the State of California, on behalf of California, Minnesota, Georgia, and North Carolina filed a class action lawsuit against the major players in prescription pet food (Mars, Nestle, Hills) and a subset of their primary distributors of their prescription products (Banfield, BluePearl Vet, PetSmart).  The lawsuit contends, among other things, the following, (a) there is nothing unique in the ingredient deck of prescription pet food to differentiate it from non-prescription pet food, (b) the marketing, labeling and sale of these products is deceptive, and (c) the defendants are engaged in anti-competitive practices to sell these solutions at above market prices to consumers.  If you want to read the full complaint it is here.

While I am not a lawyer or a Holiday Inn Express customer, at first blush, it would appear this case is good for Blue Buffalo’s potential franchise in the veterinary channel.  If the plaintiffs were to win their case, it would likely open up the channel to competition, giving Blue Buffalo a seat at the table. Further, if successful, the case could erode the brands of incumbent players in channel, driving faster penetration and sales of Blue Buffalo’s prescription solutions through consumer requests. That said, Blue Buffalo would also have to deal with any implications of the lawsuit given it operates in the category. However, when one digs deeper, it becomes apparent that this case is far from a done deal.

Let’s first deal with the issue as to whether prescription diets should be allowed to be labelled as such.  It is correct that prescription pet food diets do not contain controlled substances and are not manufactured under purview of the FDA. However, they are formulated for specific conditions and feeding them to an otherwise healthy pet is likely, over time, to have consequences. This is what allows the manufacturers to call them “prescription”.  This is merely a labeling issue, and if changed would not make feeding them under general conditions advisable. Further, I don’t think this makes them deceptive by definition. The marketing of these solutions generally indicates they were formulated to specifically treat a condition, not that they contain a drug. These products recommend you only feed them under the supervision of a veterinarian, in case they don’t address an issue that needs addressing or there are negative side effects of feeding them. Personally, I don’t see how labeling them prescription harms consumers and in fact the prescription protocol is, in most cases, necessary to protect pets from self-diagnosis by their owner and improper application. That all being said, these products could be labeled differently and if we adhere to a standard that the label prescription only covers controlled substances a change should be made. Whether that impacts anything beyond that does not, on the surface appear to be all that damaging.

The question of whether they are “different” is where things start to get muddy.  What defines a prescription diet is the inclusion of certain vitamins and minerals that are scientifically proven to help address a specific condition — kidney, cancer, obesity, skin, digestive, etc. The claim that these ingredients could be found in other pet food products sold without a prescription does not make them the same. The notion that pet food is pet food because all of the ingredients are generally available does not hold water in my view. If it did, pet food would only be sold in flavors, formulations and brands would not matter. I suspect lawyers from the manufactures cited in the cause of action have parsed these issues for their clients many times. We also know that brands matter in this category, Blue Buffalo’s success being a prime example of that.

Finally, I can’t speak to anti-competitive behavior, as I don’t know what goes on behind the scenes, but the pricing claims make me smile.  The cost of pet food has escalated significantly post-recession (40% on average on a per pound basis since 2011 according to GfK) without much of a peep from lawyers, despite the fact that class action lawsuits in the pet category have escalated significantly.  The prices of of most Hill’s Prescription Diet dry dog food solutions in 25 lb. bags runs between $80 – $85 online, approximately $3.25/lb.  This translates to approximately $2.40 per 1,000 calories, while higher than premium kibble at $1.75 – $2.25, this is significantly less than dehydrated ($5 – $8), premium cans ($7.5 – $10), frozen raw ($10 – $11) and premium freeze dried ($11 – $18).  If there is outrage around the price, it should be kept in context. When combined with the notion that these solutions are in fact different, these claims lose some of their veracity.  For me, you would have to believe that the veterinarians are coercing their clients into buying these solutions because they have no other choice and then providing them no other means of access than to pay the price for which they are selling them. However, these solutions are available online and transactions are facilitated through prescription verification providers such as Vetsource.  This feels much like a contact lens parallel.  Are there drugs in contact lens? Ponder that.

The net of all this is that it will spur dialog about labeling of these solution sets, and consumers who have purchased these products may end up with coupon books or rebates from manufacturers, but I don’t see that as providing a meaningful recasting of the competitive landscape for the prescription pet food.  And while Blue Buffalo should be a beneficiary in the near term, it is unlikely this provides them the runway they need to rapidly penetrate the channel.

/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.

thAnxiety 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.

 

skyThe pet industry continues to work through a series of fundamental issues — demographics, channel shift, brand attributes — that, over time, are expected to reshape the competitive landscape.  While fundamentals are favorable — consumption, consumer confidence, employment, real wages, housing — these tailwinds are not sufficient to float all boats.  When the market bifurcates into “leader” vs. “laggard”, and the historical leaders now find themselves playing catch-up, you get dynamic market shifts.  While there are signs of a transition in process, this cycle is only now gaining momentum, and inertia will take some time.  In the interim, here are the key trends we are keeping an eye on over the forward six months:

  • Growth On Pace for Anticipated Uptick.  The pet industry experienced a relative malaise in 2015, with industry growth, as measured by APPA figures, slowing to 3.8%, despite a 0.3% uptick in performance of the food category, the largest component of pet spend (~38%), to 3.5%. Based on macro indications the industry appears on pace to exceed projected 2016 growth of 4.3%, driven by an acceleration in consumables.  That said, a rising tide is not lifting all boats. Growth is manifesting itself in a much more pronounced way, from a percentage standpoint, among independent retailers and brands, from brands that have managed the digital migration of their message and products effectively, and from brands that rely on or incorporate alternative form factors. Growth, in isolation, masks a myriad of problems. Large retailers and major pet food marketers risk further erosion of their franchises if they don’t adapt more quickly to emerging ownership and channel realities.
  • Industry Working Through Transitionary State. The foundation of our Spring 2016 report was the observation that the industry was undergoing a restructuring, and would remain that way throughout 2017. This restructuring involves tactical changes to embrace evolving ownership demographics and consumer behavior patterns. We are seeing signs that many key players are in fact moving to action. A number of larger manufacturers are actively working through their digital strategies and assessing how they develop both ecommerce and customer analytics capabilities. Mid-sized box chains and distributors are evaluating alternatives for addressing online gaps. Several key pet specialty brands appear poised to move to FDM. Finally, online retailers and large distributors seem to be headed towards a convergence. While not all the key transitory events identified are in play, the industry is shifting before our eyes. These changes should drive increased M&A activity.
  • Small Box World is Consolidating.  The rise of the independent pet channel has been one of the greatest value creators for the pet industry post-recession. Growth in small box and mid-sized chains has paid significant dividends for the brands that cater to them, the distributors that serve them, and the owners of the most professionalized operations. This channel is viewed as the champion of the consumer, providing them with education and advice and, as a result, has attracted a slew of authentic brands seeking to monetize this connection. Now the channel is consolidating. While acquisitions by Tractor Supply, Pet Supplies Plus, and Pet Valu are most notable, so to is the external communication from companies like Chuck & Don’s and Bentley’s Pet Stuff that they are seeking acquisition opportunities. Many chains will have to choose whether to participate in this race for scale and geographic expansion, or temper their growth expectations.  Long term, omnicannel will win in both broader retail and pet.  However, to develop these capabilities a certain scale is required in order to justify the investment.
  • Deal Volume Increases but Not Realized Outcomes. When industries undergo evolution, transaction velocity predictably increases as companies try to reposition themselves for the next growth cycle. This phase began in 2H2014 when pet industry M&A activity spiked and continued through the record year of 2015.  While we continue to see elevated levels of market activity in 2016, it has yet to translate into a pace of closed deals that would match the prior year period, making it likely 2016 will be a down year for closed deals.  The reasons for this are multi-faceted. First, when large strategic buyers are working through their own portfolio issues they tend to prioritize their current brands at the expense of M&A. Second, as buyers step further out of their comfort zone, they tend to be more price sensitive. Finally, a number of buyers continue to digest their acquisitions from 2015, making them less aggressive on the M&A front. Couple this with continued high valuation expectations on the part of lower middle market sellers and you end up with more failed sale processes.

As always, a complete copy of our 2H2016 industry report is available by email.

/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.

dog-bowlBeing early, wrong, or both is no fun, at least not in the case of making industry predictions (traders will also say early is also wrong).  And when it comes to our views on the waning of the pet food upgrade cycle many people have made us aware that we were either early or wrong (or both!).  However, when you make market predictions based on limited information you are going to be wrong, sometimes with regularity (see my view on the inability for private equity to acquire PetSmart here, as just one notable example where I have missed the mark, but at least I correctly predicted that they would not combine with Petco, see here), and we are okay with that.  That said, here I am not sure we were either wrong or even that early in this case.

In 2013, we began to beat the drum about the deceleration of the pet food upgrade cycle (for those of you scoring at home you can see comments here and here).  Our view was that basic economic realities were fundamental headwinds — stagnant wage growth, slowing pet replacement, growth in small dog ownership, and continued food price inflation.  We then pointed to PetSmart comps going flat to negative, and fully negative ex-inflation, for most of 2014, had to be a sign this cycle was on life support.  However, all of these factors were explained away by other data — accelerating pet product Personal Consumption Expenditures in 2015 (Bureau of Economic Analysis), recovering pet adoptions in 2015 (PetPoint), accelerating pet food spend in 2015 (APPA), growth in alternative form factor pet food (GfK), mismanagement at PetSmart (pick your favorite equity analyst), and the successful Blue Buffalo IPO.  In short, for every fundamental premise we had on the offer, there was a data set that one could point to bolster their thesis.  The issue was that the evidence used to perpetuate the myth that the upgrade cycle was alive and well was easy to debunk, but nobody want to hear it, and they still don’t.

Fast forward to today, and we now see increasing direct evidence that supports our thesis.  First, last month The J.M. Smucker Company trimmed its full year earnings forecast on the basis of declining sales of pet food for the quarter, down 6%. While there was a positive spin around the narrative (difficult comps due to prior year sell-in, strong new brand sales prior year), it is concerning.  The company expects weakness to persist throughout the balance of the year.  Second, our survey of private mid-market pet food marketers ($100+ million in revenue) indicates that the malaise Smucker’s is experiencing is not isolated, though the magnitude is greater.  Most of the company’s we surveyed offered full year views of 0% – 2% growth domestically. Finally, Tractor Supply, which does a significant percentage of its business in livestock and pet supplies (44%), trimmed its quarterly earnings forecast and full year outlook for the second time this year.  The company now expects same-store-sales for the quarter to be flat to down 1% after being up 2.9% in the prior year period. While we may not think of Tractor Supply as the prime destination for the premium pet food consumer, they do sell a considerable number of premium brands – Blue Buffalo, Merrick, Natural Balance, and Wellness, among others.  The company pointed to slowing growth in the C.U.E. (consumables, usables, edibles) business. Translating the semantic hieroglyphics, this means their pet and animal products business, including pet food.  We suspect Tractor Supply is not alone.

What is more important here than being right or wrong as it relates to the state of pet food, is what will the implications be for the capital markets of the death of the cycle.  We do not believe that slowing pet food sales, premium or otherwise, is going to hamper capital formation. There remain multiple heuristics of emerging brands garnering footholds to grow their business rapidly to $25 – $50 million in sales with limited capital investment.  The scarcity of these businesses, coupled with the amount of institutional capital chasing these opportunities, means that growth equity investments in pet food, distinct from treats, will remain robust.  Of greater significance is whether this will jump start a new M&A cycle.  While large strategic acquirers tend to have a negative M&A bias during period of weak financial performance, it might just be such that they will uses these events to recognize the need to buy into niches that represent the future of the industry.  This could push multiples, which have been waning, albeit, at the margins over the past three years to begin to trend up.  Further, the fact that broader M&A statistics indicate we are almost certainly at the end of this M&A cycle, might cause more sellers to come to the table.  Watch closely for M&A volume in this segment to tick up over the coming year.

/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.

 

 

 

 

cowboyIn prior posts I have lamented about the reality that the pet consumables industry lacks a deep pool of brand consolidators.  Once you get past the “big three” (Nestle Purina, Big Heart Brands (The J.M. Smucker Company), and Mars), the industry possess a limited set of buyers who operate brand portfolios and who have deep pockets to afford the most attractive properties at prevailing transaction multiples.  That is not to say there are no other capable buyers of pet consumables properties, but rather that the current valuation paradigms of the second tier of buyers represents a significant drop from that of market leaders, whom simply can do more strategically and operationally with the assets they acquire.

Conventional wisdom has been that, over time, this reality would work itself out in four ways. First, was that the largest Tier 2 players would become aggressive in their M&A push in an effort to challenge the market leaders. Save for Spectrum Brands, who has been active, acquiring Proctor & Gamble’s European division, which includes the Iams and Eukanuba brands, and Salix Animal Health, a leading pet treat manufacturer, this segment of buyers has been largely stagnant.  Hill’s Pet Nutrition has participated in a few known M&A processes, but never at valuation levels necessary to challenge the companies it is chasing. Second, was that large private players would become more aggressive in acquiring emerging brands before they became of interest to the large industry players, creating a second economy, so to speak, for sellers.  Save for WellPet’s acquisition of Sojos, activity within this class of competitors, at least for consumables companies, has been muted.  Generally speaking, these companies have either opted not to run brand portfolios, or chosen to build rather than buy.  The third leg of this stool was that foreign buyers would enter the market.  Save for Agrolimen SA’s joint venture with Nature’s Variety, we have only heard crickets from the foreign buyer community on notable deals. Finally, the notion was that human food companies would crossover into pet in an effort to capture the growth and margin available to leading industry players. While many have talked-the-talk, they have not been able to close, primarily losing out to industry players on a valuation basis due to operational synergies.

This fact pattern is troubling for many of the emerging authentic brands in the category, who don’t want to be perceived to be selling out a major industry player. For some, the thought of a foreign buyer or a consumer packaged goods or natural food company acquiring them remains seductive.  So why has the industry seen such limited crossover appeal to these constituencies?  The answer has both quantitative and qualitative underpinnings.

The pet industry possesses a myriad of large foreign operators in the consumables sub-segment.  According to petfoodindustry.com, three of the world’s 10 largest pet food players are foreign — Unicharm, Deuerer, and Heristo AG.  Additionally, there are five other foreign market players (mostly Western European) producing between $400 – $600 million in annual revenue. Based on the prevailing margin profile for a pet consumables business, these companies would seem to have sufficient financial wherewithal to acquire a mid-sized U.S. pet food business. However, when you analyze this population, the following common traits emerge — largely private companies with closely held/family ownership (Unicharm being the most notable exception), owned manufacturing assets, and a limited acquisition history.  Where these companies have been acquisitive the targets have been in the buyer’s home market or in direct geographic adjacency. While some of these acquisitions have been of reasonable size, $50 – $150 million, it is clear that most of these companies are most comfortable sticking to what they know or prospecting only as far geographically as required.  Further, when you talk to executives of these companies they tend to cite three primary concerns about U.S. pet consumables M&A — a) a lack of knowledge of the U.S. pet food market, b) a lack of internal M&A capability internally, c) a perception that the market is hyper competitive and therefore of limited attractiveness, and d) the deal prices are high in light of these competitive concerns.  It seems logical to conclude that these dynamics are only likely to change if, and when, these companies experience a slowdown in their core business, if ever, and/or a professionalization movement stimulated by private equity drives them towards these outcomes.  Of note, some of the smartest U.S. private equity funds with a heritage in pet consumables are actively targeting Western Europe for their next pet deal, but I view the possibility of these parties being players for U.S. assets as being a ways off.

Consumer packaged goods companies, as potential buyers of pet businesses have had their own unique limitations.  Most notably, is the challenge these players have had with appreciating the gross margin profiles of the targets.  Companies like Clorox and Church & Dwight, who have actively courted pet companies involved in sale processes, are used to product level gross margins that push 50%.  We have yet to see a lower middle market pet food company that could produce those types of margins.  Scale operators like Blue Buffalo generate 40% gross margins.  Further, this class of buyers is not used to employing meat based inputs and concerns about recalls have led them to prioritize companies with owned production assets, which as a class of sellers have been experiencing the highest market valuation multiples in the most recent M&A cycle.  Finally, we find consumer product companies, who are used to spending considerable dollars on consumer marketing, do not appreciate the role the pet specialty retailer plays in motivating product sales, and therefore they build into their valuation models a level of additional spend that makes them less competitive on price. Absent a notable cross-over success story, we don’t foresee these sentiments changing. In fact we have seen more companies in this class give up the ghost than take us the charge.

Finally, we have the conundrum of the natural food companies.  It would seem logical to assume this class of companies would be interested in the pet space given the current parallels between the human and animal nutrition markets.  With the proliferation of grain-free and natural pet solutions, these two markets have never been more closely aligned.  There have been several instances where natural food businesses have pursued pet food assets where they appeared poised to win, only to go home empty handed. The challenges here have been both quantitative and qualitative.  On the quantitative side, the inability to drive revenue synergies has made them less price competitive, even though deals at prevailing levels for the most attractive properties would have been accretive on an earnings basis (as an example Hain Celestial trades at 16.5x LTM EBITDA). Further, this class of buyers needs a scale property to justify the adjacent market entry to their investor base, which leaves them both limited properties to choose from and puts them in direct competition with the big three.  On the qualitative side, two issues have surfaced consistently.  First, these companies are being actively pursued by large strategic buyers themselves, which means focus is critical to driving shareholder value and remaining independent if that is what is perceived to be in the best interest of shareholders. Second, is the intellectual conundrum of adding meat to the portfolio mix.  Of note, the three largest natural food products companies — General Mills, WhiteWave Foods, and Hain Celestial — orient their market offerings around plant based nutrition.  Adding meat into that marketing narrative makes for a bit of a conundrum, even if they are comfortable with the food handling risk.  My view is the right property will enable these buyers to overcome those concerns.  The attractiveness of the profit margin profile of well managed animal protein based businesses, nearly 2x on an EBITDA margin basis at scale, will be sufficient to motivate a natural products buyer with some vision. I view it as only a matter of time before one of these companies takes this leap of faith, but there is certainly no clarity on when that might happen.  WhiteWave Foods and Boulder Brands, the two natural products companies who have come closest to the finish line now find themselves in very different circumstances.

While the above narrative may lead one to conclude the glass is half empty, as opposed to half full, it is actually an improvement on the historical paradigm. Five years ago we would not be mentioning the other classes of buyers as possibilities, let alone probabilities.  Today, I see it more as a matter of when, not if.

/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.

 

 

 

 

mockingjayEarlier this month, Petco Animal Supplies and PetSmart stores in Topeka, Kansas, and adjacent Lawrence, Kansas, removed from their shelves Hill’s Science Diet and Ideal Balance products.  Store managers have been telling customers that the brands is not coming back on shelf.  Notably, Hill’s Pet Nutrition, a subsidiary of Colgate Palmolive, is headquartered in Topeka.

Consider the above action a shot across the bow in the dynamically evolving landscape of pet food retail.  To better understand the future, and what this gambit might mean, one must begin with a look at the past.

Hill’s Pet Nutrition was founded in 1907. The company started in the rendering business.  By 1930, the company had evolved into packing company, producing animal feed, dog food, and horsemeat for human consumption in Norway, Finland, and Sweden.  In 1948, Dr. Mark Morris contacted Hill’s seeking a producer for Canine k/d, his brand of healthy scientifically engineered pet food.  In 1968, Canine k/d was made available to veterinarians as Hill’s Science Diet.  The brand evolved into a broad line of prescription and breed specific solutions available through veterinarians and pet specialty retailers.  In 1978, Hill’s became part of the Colgate family through a merger of Hill’s parent company.  In 1999, Hill’s sales reached $1 billion.

What is particularly significant was the fact that Hill’s was at the forefront of the healthy pet food revolution, albeit with a scientific approach. Further, long before there was Blue Buffalo, Hill’s, along with Nutro, was one of the biggest drivers of customer traffic to pet specialty retailers on the market.  Thus, for Petco and PetSmart to declare war on Hill’s is, for lack of a better term, A BIG DEAL.

The makings of this feud can be traced back five years.  Beginning in 2011, Hill’s pet food sales began to stagnate.  The company, whose products evoked images of white lab coats and engineers, found itself on the wrong side of a change in consumer preference, and therefore purchase intent.  Instead of favoring science based nutrition solutions, pet owners began to favor products whose ingredient panels best mirrored their own diet.  White lab coats were replaced by images of roasted turkey, market vegetables, and whole grains.  Natural triumphed over engineered.

Hill’s, being part of a large consumer packaged goods firm, was not content to let its franchise slip away. The company tried to change with the market, launching Science Diet Nature’s Best, a naming convention approaching the absurd.  Not surprisingly the disconnect remained.  Hill’s responded with the launch of Ideal Balance, its “natural” solution, but was slow to win back customers. While Hill’s revenues had grown to $2.2 billion in 2015, this number represented essentially flat growth between 2011 – 2015.  To maintain sales, Hill’s embraced the internet as a channel.  In 2015, Hill’s represented 7.5% of online pet food sales, taking the third position behind Blue Buffalo (12.3%) and Wellness (9.0%).  It attained that position by turning a blind eye to the price discount pet food retailers where charging for its solution set, thereby drawing the ire of Petco and PetSmart.  And you understand why we-are-where-we-are.

One has to surmise that Hill’s knows quite well what it is doing and the consequences of its actions. My understanding is they have recently put pressure on major online retail sites to enforce their MAP policy based, in turn, on pressure from Petco and PetSmart. However, if Hill’s cannot get back in the good graces of its top premise based retailers, prepare to find Science Diet and Ideal Balance at big box store near you.  The likes of Target and Wal Mart would welcome Hill’s and its customer base with open arms. Whether this is a brilliant move by Colgate or the straw that breaks the brands back remains to be seen.

Of greater interest is what this means for Blue Buffalo.  A big box Hill’s is not going to be a welcome site for the veterinary community who drives the disproportionate sales of prescription diets and is a big influencer of Science Diet sales.  Blue Buffalo has staked the next leg of its growth stool on its veterinary line of products.  If Hill’s defects, that will create a fracture in the relationship between the company and the veterinary community that Blue Buffalo could be poised to exploit.  That’s not to say it won’t have fierce competition for that mind share from the likes of Royal Canin and Purina, but thirty days ago that market looked much tougher to crack.

Let the games begin.

/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.