Despite a challenging backdrop for the U.S. consumer, the pet industry continues to perform at or above expectations.  While the pet market has not proven to be “recession proof”, as touted by many, key pet verticals have demonstrated strong resistance to the macro-economic turmoil impacting the broader market. Notably, an earnings recovery, beginning in late 2008, sent equity values of core publicly traded pet companies higher.  This peer group out performed the S&P500 by ~ 16% in 2009.

While the macro outlook remains strong, a look into the performance of PetSmart, a proxy for pet retail, provides insight into the challenges facing the industry.  PetSmart’s equity value increased 44% in 2009, on the back of a strong rally (31%) in the fourth quarter.  However, a deeper look at the numbers reveals the impact the economic downturn had on the retail segment.  Notably, growth in average ticket size decelerated in 2009 and traffic volume continued to slow, despite core consumers seeking lower price alternatives and one-stop-shop solutions.  Further, a considerable amount of growth over the past two years was driven by commodity price inflation, mainly in the food category – but sales comps, excluding inflation, remained positive through 3Q09.   PetSmart’s management issued strong guidance for 4Q09; the company produced its first positive units comp since 1Q07; hardgoods comps continue to be negative, but are improving; service sales increased 8.0%, after declining 9.3% in 3Q09 — grooming outperformed training and hotels.

Throughout 2010, we encourage industry followers to keep an eye on PetSmart, as its fortunes will provide a very good proxy into the health of the industry.  In addition to keeping a keen eye on retail, here are other key trends we are tracking for 2010.

Facing the Facts

The reality is that the growth rate of the companion animal population is moderating, which will impact prospects for the industry.  That said, the future still looks bright.  The humanization of pets thesis remains strong, but growth will not be industry wide in the near term as economically challenged consumers face difficult purchasing decisions.  We expect sectors and products that tap into the core themes of value, health and wellness, and convenience to outperform the industry at large.  International opportunities will also be a source of growth for leading domestic suppliers.

Retail Landscape Continues to Evolve

In 2009, PetSmart and Petco lost market share to other big box retailers, grocery and independent pet specialty.  Wal Mart has established itself as a major force in mid-range pet retail, providing a compelling one-stop-shop solution.  Independent pet specialty continues to deliver a more attractive product mix and service solution for premium customers.  Recovery in generic foods enabled supermarkets and the natural channel to rebound. These realities are forcing changes into the PetSmart and Petco business models.   PetSmart is trying to create stronger customer bonds through adoption and services, which other channels cannot match, while Petco has launched “unleashed by Petco” to compete directly with independent pet specialty chains.  We expect further changes from Petco and PetSmart in an effort to protect share.

Healthcare in Focus

Pet health and wellness remains top of mind for pet owners due to the rising cost of care for pets.  Consumers continue to seek product solutions that deliver perceived health benefits to their companion animals.  Additionally, they are proactively trying to control health care costs by purchasing pet insurance products, products that may mitigate or delay large health related expenditures, and trading down to generics for pet prescriptions.  End of life care has become particularly challenging in light of current economic realities

Transaction Environment Transition

Over the past two years, the industry has seen capital inflows, primarily in the form of growth equity.  While the pet industry remains a key target for consumer-oriented equity funds, the transaction landscape is likely to be characterized by a greater M&A orientation.  Henry Schein Animal Health/Butler Animal Health,  Pet Valu/Roark Capital, International Absorbents/Kinderhook Industries, and the pending sale of Pets at Home (UK) are recent examples of what we see as an emerging trend.  We anticipate strategics will begin to use their balance sheets to purchase growth.  Lacking access to cheap debt, private equity buyers will be at a disadvantage.

As always, our full industry update is available upon request.