October 2014


fly in soupOn its way to a date with a public security listing, Blue Buffalo ran into a small problem.  It seems there was a fly in their soup; one which they claim to have been blissfully unaware.  Equally embarrassing was the fact their fiercest rival, Nestle Purina, had been the source of the discovery.  What followed the initial accusation is either evidence of the power the independent premium pet food company wields or the first act in a Greek tragedy. The outcome is likely to have an impact on the pet food industry investment and the pet food M&A landscape.

In March 2014, it was leaked that Blue Buffalo, the $600+ million revenue independent premium pet food marketer, had selected a trio of lead arrangers for its public offering. The company had, for years, been rumored to be on and off the market seeking a buyer at prices between $2 – $3 billion depending on the timing of the speculation. It appeared that the company was now ready to tap the public markets for liquidity, an event that filled the industry with equal parts fear and excitement.

Two months after the leak, Nestle Purina filed a lawsuit in federal court alleging its competitor was lying about the contents of its products. Nestle claimed that independent tests show that Blue Buffalo uses chicken byproducts and corn in some of its food formulations — despite making marketing claims to the contrary.  Nestle would later amend its case to dispute other product claims on kibble, treats, and even cat litter. The fact that the industries top dog would undertake efforts to undermine Blue Buffalo came as a surprise to many.  Many speculated it was a tactic to lower the potential acquisition price for the brand.  Blue Buffalo returned the volley several days later counter-suing Purina for defamation, a summary of which can be seen here.

In a letter to customers, Blue Buffalo Founder and Chairman, Bill Bishop wrote:

“It is an easy thing to make unsubstantiated claims, put them in a lawsuit and then publish them all over the Web to disparage and defame a company. It is quite another thing to prove those allegations… We will prove these and other matters in court with good reliable evidence, and we look forward to disproving the voodoo science that Nestlé Purina relied on to support their outrageous allegations.”

The complete responses from Bishop can be seen here and here. Later, Bishop would go all in on a letter to the editor of Businessweek that can be seen here.  During the process, the National Advertisers Review Board (NARB) recommended that Blue Buffalo modify marketing claims it was making about competing products.  While Blue Buffalo disagreed with the the conclusions of the NARB, they agreed to take into account their recommendations in the future.  Details of the review hearing, recommendation, and associated reaction can be seen here.

Upon reading the first letter of response, I knew Nestle had something.  History has shown that the de facto strategy for the guilty is to attack not the claim but the science of the test and the party administering it. If professional sports is a relevant proxy, sometimes that plan works.  So Blue Buffalo then set out to undermine the validity of the Purina’s independent test going so far as to claim the laboratory involved had “dubious scientific credentials.”  The company’s critique of Windsor Labs and its scientific findings can be seen here.

As it appeared the two sides were heading to court, Blue Buffalo issued a statement that one of its suppliers had mislabeled ingredients sent to their customers, which could (that choice of words is important) have resulted in Blue Buffalo product being made with poultry by-product meal.  That statement can be seen here.  While it is notable that Blue Buffalo is acknowledging some of Nestle’s claims, it is passing the buck to its supplier.  While Wilber-Ellis has a history of recall related issues, the names of other pet food companies who may have received mislabeled ingredients, as Blue Buffalo claims, have not surfaced.  Since the FDA and Wilber are choosing to remain silent on this issue (the FDA views those names, if any, to be confidential information), it would be natural to speculate that there are no other names and in fact, this circumstance was known to Blue Buffalo.  However, that is merely speculative. What is also interesting is that Blue Buffalo has not issued a voluntary recall (the FDA does not mandate a recall in cases where the ingredients involved do not have a reasonable probability of causing serious adverse health consequences), has not disclosed probable lot numbers, or offered to refund customers their money.  So far the strategy seems to be working as they have not wavered from their approach.

What happens next is likely to impact pet food investing and M&A.  If the circumstance above results in Blue Buffalo modifying or pulling its IPO plans, or going public and experiencing diminished value, or selling at a diminished value, it will be yet another cautionary tale of how supply chain issues can quickly erase equity returns hard earned over time in the pet space.  This may lead to investors pursuing pet consumables investments with greater caution and scrutiny.  Further, pet consumables M&A may come with more strings attached — broader seller representations and warranties, higher indemnification caps, etc. — or at lower valuations to account for this risk.  Companies that can demonstrate control over the product they put in the bag should also be ascribed a premium.  Owning your production assets becomes, in fact, more valuable. That written, if Blue Buffalo is able to hold shelf space, avoid a recall, and move forward with its liquidity plans, it will, in fact, validate how powerful the leading independent brand really is.

My view is the marketer is ultimately responsible for ensuring that the product in the bag matches the associated claims.  However, absent consumer lash-back, Blue Buffalo is unlikely to suffer much.  Further, given how much traffic their products drive at retail, pet specialty chains are more likely to accept the “it’s not our fault” explanation.  In the meantime, Blue Buffalo may get to see the results of the Freshpet IPO before confirming its path.  Freshpet is expected to price on November 6th.  At the mid-point of the range, Freshpet would command a fully diluted value of $414 million.  Based on estimated 2014 revenue, that would value the company at 3.5x – 4.0x revenue.  Those multiples would only serve to validate Blue Buffalo purported $3 billion price tag.

/bryan

Note: This blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change.  While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.

Advertisements

catAs we approach the bell lap in 2014, anticipated full-year performance for the pet industry is starting to come into clearer focus.  For the first time since we have been blogging about the industry, we believe projected growth might fall short of APPA projections.  The industry continues to face structural headwinds that are dampening our expectations.  Notably, three metrics we commonly rely on as relative predictors of growth are lagging the benchmarks we feel are necessary for these projections to be achieved.

  1. Personal Consumption Expenditure (PCE), which consist of the actual and imputed expenditures of households by consumption category as measured by the U.S. Department of Commerce’s Bureau of Economic Analysis, for pet related goods and services showed growth of 3.7% in 1H2014 versus 5.7% in 1H2013;
  2. PetSmart same-store-sales comps (including inflation) for 1H2014 were -0.6% versus 3.5% for 1H2013;
  3. Adoption rates, as measures by PetHealth Inc.’s PetPoint Report shows that adoptions of canines have been weak through 1H2014, with feline adoptions also lagging in 1Q2014.

There are other factors that concern us as well.  Household formation has been sluggish, wage growth is stagnant, and the retail environment is tepid, at best.  However, offsetting these concerns is data that shows pet parents are spending more than ever, alternative sales channels such as online and farm and feed and experiencing strong growth, and conventional grocery is making significant investments in the category.  From experience, we also know the pet industry is like a cat — it always lands on its feet.

As we take stock of the industry here are the key themes we see shaping the current landscape:

  • Transaction Environment Heats Up. Acceleration in pet industry transaction volume began in 2010 driven by third party investment in emerging brands. After peaking in 2011, velocity tapered in 2012 and 2013. Based on YTD numbers, pet industry transaction volume is set to rebound, led by increased M&A activity. Consolidators are looking to gain greater exposure to faster growing segments of the market. Large amounts of liquidity in the market are driving up valuations, when combined by uncertainty in the retail channel, is motivating sellers. Notably, available liquidity options have now expanded to the public markets for mid-sized pure play pet companies with strong growth impetus. As market growth slows, we expect pressure to consolidate will heighten further giving this M&A velocity uptick legs through 2015.
  • Major Pet Specialty is Getting Pinched. Pet specialty retailers are facing slower comps and market share erosion from a myriad of drivers we have highlighted over the past few years. Margin is moderating for this channel as sales growth slows, at a time when investments are needed. We believe the successful response to these threats requires bold moves not currently being contemplated. While tweaks to the merchandising mix may help, rapidly expanding omni-channel capabilities through acquisition and investment and pursuing vertical integration opportunities are needed. Imagine PetSmart’s fortune if it had invested in Blue Buffalo ten years ago. Channel barriers are coming down and retailers need to think out of the box to protect their incumbent positions. Change takes time, so do not expect a near term rebound, but do not discount the power these retailers have with manufactures to mitigate losses.
  • Channel Barriers Are Eroding. The pet industry has a high percentage of channel tied merchandise. PetSmart derives nearly 30% of its revenue from product exclusives. Brands that bridge into FDM are generally shunned by independents. As comps slows in pet specialty, emerging brands are getting anxious about their own growth prospects, causing them to consider testing the prevailing merchandise borders. As conventional grocery attempt to reverse share losses realized over the past five years, expect them to expand their efforts to recruit leading brands or incentivize those brands to develop solutions that work at lower price points. The risk for the industry is that a broader carriage of authentic and emotive brands in conventional grocery at lower price points could result in the realization of a downgrade cycle.
  • Online Independents Enter End Game. While pet products growth online continues to be robust, profits associated with these sales remain thin. Being a sub-scale online pet retailer is a losing value proposition, literally. The best situated players are developing forms of differentiation – media and education assets, prescription capabilities, and private label offerings – to offset lower margin product sales. Those who are successful will be the attractive consolidation candidates. PetSmart’s acquisition of Pet360 is consistent with this thematic. Three other independent players are currently for sale. Some of these companies will be acquired for their differentiated capabilities, but we expect the others to become zombies or go away entirely. We expect that three years from now, there will be no meaningful independent traditional pet ecommerce retailer.

For a complete summary of our pet industry market insights, please contact me for a copy of my report.

/bryan

Source: American Pet Products Association, CapitalIQ, PetSmart, Inc., U.S. Department of Commerce

Note: The purpose of this blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change.  While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.