Normally I wait until after SuperZoo to publish an update to my biannual, but there has been too much noteworthy happenings since my update in January to delay it any longer.   As always if you want the full report, feel free to post here or email me.   I think this is the best report yet, and with each iteration, and your feedback, it continues to improve.    So now on with it.

The pet industry continues to be a star performer along the consumer landscape.   While growth rates have been moderating (given that the industry is tied to the macroeconomic environment and housing market conditions this should be no surprise) the pet industry should produce growth that doubles domestic GDP expansion in 2010; not many industries will be able to make the same claim.  Further, I expect the majority of that growth to be driven by increase spend, as opposed to an expanding pet population.

As you might expect, given the positive forecast for growth, public equities of pet related companies have outperformed the S&P 500 in 2010 by approximately 4%.  Of significance, earnings for my sector index showed year-over-year growth in the second quarter.   This should set up the comp group for a strong full year from an earnings growth perspective due to the easy comp quarters ahead, resulting from the full weight of the recession.  As earnings go, so do prevailing equity prices.

Among the strongest reporters of earning growth within the industry was PetSmart.  The company beat estimates, raised full year projections, and even outcomped Wal-Mart Stores (“Wal-Mart”) on a same-store sales basis through the first half of 2010.   Also notable was the performance by category, which showed a decline in consumables, likely resulting from food price deflation,  but an improvement in hardgoods (two positive comp quarters).  Services continue to grow, albeit at a slower pace.   Live Goods continues to contract, which may be a harbinger of things to come, or may simply be a shift towards adoption and smaller breeders as a result of negative publicity.

Of equal importance are pending changes to PetSmart’s merchandising strategy.  In October 2009, PetSmart agreed to partner with Martha Stewart on an exclusive line of pet products.  Martha Stewart PetsTM launched on June 30th with 160 SKUs and has been, according to management, favorably received by customers in the opening weeks.  This fall, PetSmart will rollout a co-branded consumables line of vitamins and supplements in partnership with GNC Corp.   PetSmart expects these partnerships to drive store traffic, comp transactions and gross margin.  If successful, they will meaningfully influence how major pet retailers merchandise in the future.

The transaction market for pet related properties continues to improve and shows signs of resilience.   As an example, we believe the Natura transaction took place at multiples that were in-line with the Berwind Corporation/Old Mother Hubbard, Inc. deal, which would mean that multiples on major properties are essentially unchanged from 2008.  The independent pet specialty space continues to see high levels of M&A activity as well as investment; a trend we don’t see changing.  Further, a number of equity firms with whom we have regular contact are in fact ramping up their efforts in the pet industry.  Some of the most notable deals in 2010 are summarized below.

Private placements within the industry have also been robust in 2010 as well, with Animal Supply, Champion Pet Food (makers of Orijen), Phillips Feed Service, Petra Pet and Strategic Pharmaceutical Solutions (d/b/a VetSource) all successfully placing equity for growth or recapitalization.

Of all the deals that have been done, M&A or otherwise, none are of greater importance, in my opinion than Natura Pet Products/Procter & Gamble (“P&G”).   This is a transaction for the ages, and one that reverses a number of prevailing assumptions and sets off a litany of questions.  Most notably, the market had long been expecting P&G to exit the pet space, putting Iams in play.  Instead, the company doubled down and immediately positioned itself as a leading provider of natural pet food products.

The transaction has implications for P&G vs. other major pet players, PetSmart vs. Wal-Mart, and mass channel vs. independent pet specialty.  Its no secret that I expect for Natura brands to be in the mass channel in 2011.   After all, Wal-Mart is P&G’s biggest customer, but the company has a relationship with other major pet retailers.  Additionally, I anticipate it will spur additional investment and M&A in the food category.

Regardless of what happens during the balance of 2010, the pet industry will have had an exciting year.   The industry continues to evolve and improve, for the benefit of pet owners and industry participants.