no saleIn mid-August, bowing to pressure from activist investors, PetSmart announced that it would explore strategic alternatives, including a sale of the business.  Slowing sales growth and poor comps (same-store-sales, traffic, and average ticket) were cited by outside investors as a sign that management was not up to the challenge of turning around the leading independent pet retailer and creating shareholder value.  Additionally, Jana Partners, the antagonist in this saga, postulated that PetSmart would have many transaction opportunities given the liquidity in the private equity and associated debt markets as well as the potential for a highly synergistic combination with competition Petco Animal Supplies.

One month later and all quiet on the western front, for now.  Here is my assessment as to why:

  • Business Fundamentals.  Notwithstanding PetSmart’s leadership position, its business is struggling as core industry drivers shift.  The premiumization food movement has largely run its course in the dog category. Adding head winds is the fact that the pet population is not growing at a sufficient rate to bring new owners into the market who would be target customers for PetSmart’s and therefore present opportunities to sell them premium products that drive margin.  PetSmart’s latest food strategy — expanding its share of shelf dedicated to mass brands to siphon off customers who can then be converted to premium and super premium — will take time to play out.  Further, the company also faces market share erosion from independent pet specialty, online, and an increasingly organized conventional and natural grocery landscape. In order to incent shareholders into a take private or strategic sale, they will have to be offered a meaningful premium.  That a tall order given the current state of the business.
  • Private Equity Scenario Possible, but Unlikely. The concept of a leveraged buyout for PetSmart is intriguing to pundits evaluating PetSmart’s options, but the path to realizing this outcome is challenged. In round numbers the current equity price for PetSmart is ~ $71/share. Assuming it would take a 20% premium to entice shareholders to even consider a deal, this would value the equity of PetSmart at approximately $8.5 billion and the company at $8.8 billion on an enterprise value basis.  Assuming the largest equity check a sponsor would write in a mega-buyout would be 20%, this implies a take private would require just over $7.0 billion in debt and at least $1.5 billion in equity.  Based on current EBITDA figures, this would mean that PetSmart would be valued at 7.5x Debt / EBITDA, before considering the lease capitalization.  This seems significantly elevated in light of the uncertainty around growth and margin expansion.  A buyout at these levels would limit the company’s ability to make investments at a time where they are needed.  If Jana were to roll its equity the scenario becomes more palatable, but it does not solve the problem in its entirety.  Calls for looking at the equity premium based on the pre-Jana price will fall on deaf ears. Additionally, at these valuation levels a sponsor would likely be generating IRRs in the 15% – 20% range before accounting for execution and market risk.  I don’t see that return profile as being all that attractive given the risk. Third, while I could identify approximate 10 – 15 logical investors who invest in retail and could write, individually or in a two firm combination, a $1.5 billion equity check, nearly half of them are conflicted due to their investments in other pet specialty retailers or product providers.  Finally, see business fundamentals above.
  • A Strategic Deal Does Not Involve a Combination with Petco. After a private equity deal, the other most commonly cited outcome for PetSmart is a combination with Petco.  While that is conceptually attractive, its theoretically impractical if not impossible. A PetSmart / Petco combination would have ample synergies but it would significantly expand the physical footprint of the combined company, something that has been proven to be a bad strategy in this current retail environment. Second, Petco is facing the same business conditions that are negatively impacting PetSmart, meaning there is not a high likelihood that it is a sensible time for it to pursue a major deal.  That notwithstanding, a combination would likely extend the current PE syndicates ownership of Petco, which already stands at nine years versus a typical five year hold period. Next is the conundrum of who would manage the business going forward. Given that PetSmart is nearly twice the size of Petco, I don’t see current management going quietly into the night or sticking around in secondary roles. Finally, we would bank on significant anti-trust hurdles.  While in combination the business would have 27% of total pet product market share, the industry is defined by channel tied products.  Under a more narrow definition, the business would control 64% of pet specialty product sales with nearly 50% of their merchandising mix exclusive to one of the two banners. I see that as problematic.
  • There Really is Only One Logical Buyer. The only logical strategic buyer in my view is Tractor Supply.  Tractor Supply has an $8.2 billion market cap and is unlevered.  The company has experienced a 550% increase in its equity valuation over the past five years.  A key driver of this has been growth in their companion pet revenue.  A combination would help Tractor lessen its exposure to the farm segment of its business that has been challenged. Further, there is significantly less physical overlap between PetSmart and Tractor Supply, than there would be in a Petco combination scenario. Further, there would be significant supply chain synergies. That all being said, this would be a big swing for a company that does not have a meaningful acquisition history.  While sensible, I ascribe a low probability.

Net net, we believe the opportunity for a sale of PetSmart’s business to have passed. A deal remains possible, but we discount that prospect.  For shareholders sake it would be best if an outcome, sale or no sale, happens quickly so that management can return to running the business assuming it remains independent.

/bryan

Disclosure: I have a contractual relationship with PetSmart as it relates to their acquisition of Pet360.  I do not have any position in the stock of the Company, nor any intention of establishing a position.