One of the joys of the fall edition to my pet industry update is I have the benefit of hindsight.   While in an ideal world we would have real time industry statistics for the prior year delivered to us on January 2nd, that is not our reality.  In fact, we really don’t get a true beat on the prior year until May when all the industry data is crunched and available for public consumption, paying members first.  For some of you, this edition marks the first time you really get a glimpse into prior year results.   While this information may not be timely,  in relative terms, this year it is quite illuminating as it dispels a few industry myths, for the better.   Only through an objective look at the industry can it identify new ways to grow and thrive.

With calendar year 2010 statistics now available, we have a clear picture of how the pet industry performed exiting the recession.  While the industry grew in 2010, and at an impressive rate relative to the consumer economy, the recession clearly took a toll – the pet industry is not recession proof after all.  Notably, according to Packaged Facts: a) specialty retail lost share to discount stores, b) total food sales produced anemic growth (1.5% for dogs and -0.2% for cats), albeit growth, c) super premium food sales decelerated (growing 2.4% after years of double digit gain) and d) spending by higher income households contracted.  Non-medical pet services was the only major category to meet forecast.   Food,  pet products and health care all fell short of projected growth.

Stop. Pause. Breathe.  Yes, sometimes good industries have bad years.  And relative to the rest of the economy, this was no bad year.

That all being said, there are many reasons to feel positive about the forward outlook – sales of public pet companies produce strong second quarter comps, PetSmart increased full year earnings guidance 3%, and super premium food sales are again accelerating.  More importantly, industry consolidation has given way to renewal.

The pet industry entered into a natural consolidation phase coming out of the financial downtown.  As growth moderated, strategics looked to acquire revenue and leverage their existing cost structure to drive margin.   As a result, we witnessed an increase in consolidating transactions across all major industry segments.  While this consolidation phase is ongoing, we are also seeing significant acceleration in company formation and growth equity investments within the industry.  Superzoo featured dozens of emerging companies in consumables, food, and hardgoods.  Further, pet industry private placements have increased in 2H2011, after a near dormant showing through mid-year.  We view this as a healthy sign, which bodes well for long term transaction momentum within the industry.

On the retail front, PetSmart continues to deliver.  In 2009, PetSmart took on Wal Mart and won.  In 2010, it became transparent that PetSmart had also left Petco it is rear view mirror.  In the past 12 months, PetSmart grew revenue and EBITDA 7.3% and 10.1% respectively.  The most recent quarter was a continuation of the trend.  For 2Q2011, PetSmart posted impressive same-store-sales (5.0% versus a consensus estimate of 4.6%), a favorable mix shift (customers trading up and expanding their basket), and a strong increase in average ticket price ex-inflation.  Analysts are now calling PetSmart the “best run specialty retailer”.  The only negative is we continue to hear conflicting stories with respect PetSmart exclusives, reflected in decelerating hardgoods transactions.  One area where we see PetSmart as vulnerable is with respect to direct-to-consumer.

The post-recession retail landscape is undergoing fundamental change.  Progressive retailers are seeking to reign in their physical footprint and push customers to lower cost channels.  The pet industry has been slow to embrace ecommerce; the belief was that delivering 50 lb. bags of dog food was a money losing proposition. However, that belief is again being challenged.  In July, subsidiary Quidsi launched, a major pet ecommerce portal leveraging’s logistics infrastructure.  During the same period, other major independent pet ecommerce players raised substantive amounts of capital.  An analysis of these sites yields the conclusion that while product costs at and are more favorable, total landed cost (product cost plus tax plus shipping) favors these alternative e-tailers.  The ability to eschew a poor customer experience at the pet majors and eliminate the risk of in store stock outs, will invariably push a segment of customers online.   While this has the potential to erode share from pet specialty we believe it will be a slow process.

Net net, the pet industry remains on solid footing and the outlook for the component sectors is in fact quite good in the long term.  However, until the economy begins to improve — as measured by  GDP growth, the unemployment rate, and housing starts — the industry will continue to post modest growth, by historical standards.   These market conditions provide innovative companies the opportunity to differentiate themselves from the pack.

As always, full report available via email.