goggie1It’s been a while since I wrote about pets (no that is not a picture of a bat to the left), primarily because there has not been too much to talk about.  That said, there are many people who read my blog for my insights on that market and nothing else.  As such, I need to do a refresh for my fan base (yuk, yuk, yuk).  Over the past 45 days I’ve cobbled together some bits and pieces, that when laid out on a canvas makes a mural, a mural which doesn’t quite look like the one I painted 6 months ago.  Here is a substantive update on the current industry as I see it.  Alternative perspectives welcome.

Pet Businesses Get the Flu Too

Many pundits, myself included, put forth a view that the pet market was recession proof.  The view was that pet spending would be one of the last areas to go.   While we have not seen a collapse in the sector, we have certainly seen significant compression from a valuation perspective.  PetSmart, our public proxy for the retail channel, has seen its market cap erode by 40% based on a diminished retail outlook.  However, the company today reported that it met third quarter estimates but took down EPS projections for 2009 and used a very cautious tone with respect to forward prospects.  Overall a basket of pure play pet companies is down +/- 30%, and 50% from their highs in September, still slightly better than the S&P 500.

pet-industry-index-vs-sp-5001

The reality is consumers are trading down on food (except for me since now my dogs are eating “the ancestral diet”, I need to talk to my wife about that one), mass merchants are on the market share hunt, and price increases in the services sector are not going to be sufficient enough to offset falling demand.

With respect to food, prices have increased 15% – 25% across the board vs. a 4.9% increase in the Consumer Price Index.  This is putting the pinch on consumers pocket books.  Forty percent of pet owners claim to be economically sensitive with respect to pet food.  Therefore, it is no surprise that major producers are reporting declining sequential sales at retail and a mix shift from specialty brands to grocery and private label (gaining 2% points of share in 2008; however sales of Rx dog food, the top top end are accelerating, though from low comps).   Both PetSmart and PETCO have noted softening sales in their discussions., but have seen less trading down than diversified distributors.  Pet services passed on price increases of between 3% – 10% earlier this year.  However, Packaged Facts sited professional pet care and pet grooming as 2 of the top 3 areas for consumer cut backs in a recessionary environment. PetSmart reported slowing growth in pet services from 21.5% in 1Q2009 to 15% in 3Q2009.

Net net, pet businesses may not be feeling the same heat and other consumer discretionary, but they are still feeling a pretty big pinch.

Changing Face of Pet Retail

The current retail paradigm is set to see an overhaul in the pet market.  We expect the economic downturn to result in significant rationalization of the pet boutique market, especially in the more economically sensitive Midwest and South.   A contraction of 20% – 40% would not be unprecedented given the capitalization of these businesses and their exposure to discretionary items, include pet fashion, the top area for cutback in tight economic times.

Additionally, higher energy prices and a desire for bargains will push people to one-stop-shop alternatives at the expense of boutiques.  Purchase occasions for pet owners is expected to drop ~ 3% in 2008.  PETCO is attempting to skim off boutique customers by expanding their product lines to include natural and high end product alternatives, while at the same time compressing the lower end of the market by offering store labeled products.  My dogs don’t seem to mind PETCO branded rawhide.  PETCO is also expanding their service offerings to include third party insurance.  Services are an additional point of differentiation vis-a-vie boutiques.

That being said, PETCO and PetSmart will face stiff competition for core staples from WalMart.  In October, WalMart CEO, Eduardo Castro-Wright upgrade WalMart’s focus on the pet industry to a WIN category (categories that are growing, have scale and where WalMart can be the market share leader).  If in fact consumers continue to trade down, WalMart will be the beneficiary.  WalMart’s Ol’ Roy line (technically made by Nestle Purina) is the nations top selling dog food, and WalMart has aggressively moved into the premium market with its Natural Life brand.   PetSmart said they were not worried about WalMart back in May 2008.  I wonder if that sentiment has changed.

While WalMart and PETCO/PetSmart fight for the commodity and mid-tier, I expect to see considerable growth within and the evolution of regional specialty pet food and products chains.  Mud Bay, Muttropolis and emerging brands like Embark are, in my opinion, the wave of the future.  These chains offer a wide selection of better for you foods and staples and back it up with the acumen to sell it.  Their focus on service and building community will keep them well situated.   The demographic they are targeting comprise 33% of pet owners who purchase 43% of pet food and 51% of pet supplies and 62% of pet services (Packaged Facts).  This demographic seeks out natural and organic products and is willing to pay more for them.

The Businessman Trumps the Enthusiast

During the early stages of the pet growth cycle, the business landscape was cultivated by pet enthusiasts, people who had a strong affinity for the pet market and who wanted to find a way to blend their love of animals with a career.  In a market where a rising tide floats all boats, this was a salient strategy and produced nice outcomes for many business owners.  However, that landscape is changing.  Company formation around the pet space now centers on people who view the pet market as a business first and as an affinity play second.  That’s not to say that these folks are not pet owners and advocates, but rather they are not in the business because of their pets.

Some salient examples of this include, webvet, a new media play aimed at being the WebMD for the pet space.  Founder William Zacchero was an Executive Vice President with American Interactive Media, a developer of an marketer of entertainment content and programs.  VetSource provides outsourced services that enable veterinary clinics and animal hospitals to better meet the needs of their clients by extending their pharmacy services to include home delivery and continuous replenishment.  David Laurance, CEO of VetSource and his team have been together through two prior pharmacy companies.  Laurance was a seasoned Omnicare executive before he target the veterinary market as a big opportunity for outsourced services.  The team behind Embark, a next generation pet retail concept, includes serial entrepreneur Landon Pollock. Embrace Pet Insurance, which was recently closed its Series A, was founded by Laura Bennett, a 16 year veteran of the human side of the insurance industry.

If you think about venture capital and the prototype companies they back, investors tend to focus on experienced management teams.  As outside capital has become more focused on the industry it has attracted seasoned professionals to the business of pets.

Pet Products Get the Green Sheen

The organic movement within the pet space is morphing outside of food and deeper into products.  Nearly every corner of the U.S. product economy is spawning companies trying to benefit from the “greening of America”, and the pet space is no different.  Environmentally and health conscious consumers are driving this proliferation, sparked, in part, by the 2007 pet food recall.  The food scare provided everyone a wake up call and the desire to understand the underlying ingredients within and composition of a product has never been higher.

The potential lift in the pet organic space is substantial, as only 7.3% of consumers purchase organic dog products, flat from a year ago, versus the consumer population which, according to a market survey from BIGresearch, 52% of the time purchases organic products occasionally and 10% purchase organic products always.  Nearly half (48%) of pet households seek out natural and environmentally friendly products (Packaged Facts), in their personal lives.  Natural supermarkets are providing an additional access point for consumers to buy organic pet products.

Long term I expect organic and environmentally friendly products to play a fundamental role in the pet industry, but a much more subtle level.  Ingredient origins and product composition will standardize around inputs that are safe and natural.  The market, at its center, will demand it.  It will become the de facto standard.

Let’s Make a Deal

The key unknown is how the transaction environment will impact the pet space over the near term.  While I continue to believe there is venture funding for pet start-ups and private equity capital for lower middle market pet food and product companies, the question is what is going to happen to  companies like Dogswell, Ruff Wear, Zukes, Simplyshe and other leading companies in the industry.  In all likelihood they will simply keep on keeping on, creating generous annual profits for their shareholders.  However, at some point a strategic buyer population must emerge for this cycle to become self propelling.   Attractive exits must be realized for funding events to accelerate at the venture level.  The Furminator and Castor & Pollux transactions were a good start, but more data points are necessary to derive a solid regression.

/bryan

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