If you have followed my pet industry musings for any duration, you know that I am not a big advocate of the service paradigm offered at large independent pet specialty chains — PETCO Animal Supplies, Inc. (“Petco”) and PetSmart, Inc. (“PetSmart”).  That is not to say I don’t see value in their services, as they play a fundamental role in growing the broader pet market.  Notably, I am and will continue to be a Petco customer.  Their store is only a mile from my residence, and while my purchases there constitute an increasingly shrinking percentage of my pet product basket, they offer me a level of convenience that I can’t find from my other pet vendors.

When we adopted our first dog, like moths to a flame we immediately went to Petco to buy our staples and stock up on food.  Over time I have moved my dogs onto other meal programs and built relationships with other product vendors.  As a result, my true need for Petco has diminished.  However, the reasons my traffic declined was one of product selection, and not what I constantly harp-on — the mediocre service paradigm that Petco, and PetSmart for that matter, offer.   It is this service paradigm that has enabled smaller independent pet specialty chains to take share.  The net result has been significant capital inflows into these secondary competitors as evidenced by Roark Capital’s acquisition of Pet Valu, Inc. and Irving Place Capital’s acquisition of Pet Supplies Plus/USA, Inc., the number three and number four players in the market respectively as measured by store count.

The service conundrum Petco and PetSmart find themselves in is unlikely to abate.  Both companies rely on legions of low priced labor that is prone to churn.  As a result, the average Petco and PetSmart front line employee never develops the expertise and relationships necessary to compete with the Pet Food Express, Inc. and Mud Bay, Inc.’s of the pet world, who differentiate themselves through the expertise they provide to their customers both in terms of product selection and in store service.  Glassdoor.com can tell you all you need to know about the challenges of working for Petco or PetSmart.

Notably, the potential upside of these higher touch service formats attracted Petco Executive Vice President and Chief Merchandising Officer to take the helm of Pet Supplies Plus.   You can read Jim Meyers message about the departure here — Message from Jim Myers-PETCO.   Petco management has not exactly been a revolving door, but there has been consistent changes over the past three years.   All this despite, as the New York Times reported, “the company did not have a negative quarter throughout the recession.”  So why is it that five years after being taken private in a $1.85 billion transaction by TPG Capital and Leonard Green & Partners is the company not considering a public listing in the best initial public offering market we have seen in years?

One reason might be that the owners are quite happy with the benefit they are receiving from the company’s cash flow.  In November 2010, the company sought a $1.1 billion credit facility to finance a dividend to its shareholders.   The loan was later upsized to $1.225 billion.  Upon consummation, the transaction would have leveraged the company 5.5x latest twelve months EBITDA according to sources close to the deal.  And therein lies the rub.

If in fact Petco would have been leveraged at 5.5x at the time of the deal it would imply that the company was generating $200 million in EBITDA ($1.1B / 5.5 = $200M).  According to public filings, when the company went private its LTM EBITDA at the time was reported to be $209 million (as of July 30, 2006, the last reporting period prior to the transaction).    In contrast, PetSmart reported LTM EBITDA as of January 31, 2011 (the period most closely correlating with the time of the Petco leveraged dividend)  of $665 million in EBITDA.   It’s LTM EBITDA as of July 30, 2006 was $460 million.   Net net, PetSmart’s EBITDA grew ~ 45% over this timeframe where Petco’s was flat (a generous interpretation).

From a valuation standpoint, PetSmart’s equity has been on a tear the past twelve months, rising ~ 43% according to Yahoo! Finance.  This values the company at 7.8x LTM EBITDA on an enterprise basis.  Subtracting the net debt yields an equity market capitalization for PETM of ~ $5.1 billion.  Applying this same enterprise value multiple to Petco’s $200 million in EBITDA yields a value of $1.56 billion, ~ 16% less than the take private price.  Subtracting the $1.225 billion in debt yields an equity value of, well, not much.   While this comparison fails to account for all the interim distributions, including the leveraged dividend that has lowered the private equity firm’s cost basis, there is no way to put a smile on it.

Further, the above analysis appears conservative when you consider that Standard & Poor’s reported that Petco was actually leveraged 7.6x LTM EBITDA as of January 29, 2011, up from 6.0x at the same time one year prior.  Further, Petco sought an amendment to its loan agreement in February 2011, just three months post issuance.

Net net, it is clear that all is not going according to plan at Petco.  Management defections and flat EBITDA growth over the past five years, is symptomatic that consumers do not find its value proposition all that compelling.   Has it lost its mojo?  From my perspective — yes.  However, don’t count them out by any means…yet.