July 2015


lone starOn the morning that Blue Buffalo priced its IPO, above the expected range I might add, Nestle Purina announced that it had acquired Merrick Pet Care, owner of the Merrick, Castor & Pollux, Whole Earth Farms, and Backcountry pet food brands. Terms of the transaction were not disclosed. However the deal likely garnered the leading EBITDA multiple for a pet consumable transaction in this transaction cycle.  Merrick had experienced strong growth in the years following the majority recapitalization by Swander Pace Capital.  This is the second headline grabbing exit for the San Francisco based private equity firm, that earlier this year sold Applegate Farms to Hormel Food Corp for $775 million, or approximately 2.3x estimated 2015 sales.

On the surface this deal is of little surprise.  Merrick filled a well-defined hole in the Purina pet food product mix as it relates to natural pet food.  While Merrick had only recently entered into the freeze dried raw category, the acquisition also provides Purina with a platform in that space after missing out on the possibility of acquiring Nature’s Variety, who elected to do a transaction with Spanish pet food manufacturer Agolimen SA without engaging in a broader marketing process.  Rounding out the appeal was likely the integrated manufacturing assets and the foothold it gains in the natural channel through the acquisition of the Castor & Pollux brand, though whether that channel exposure sticks remains to be seen given the historical experience with Pet Promise.

However, when one digs a little deeper there are secondary facts worth noting:

  • Come from behind victory.  We heard from several sources that Purina was not the leader after the initial round of bidding.  However, as the most logical buyer with the deepest pockets they likely knew that they would get the last look so coming out too strong had no material advantages.  In the end, winning is all that matters.
  • Convergence theme in play. Also of note is that at least one of the final bidders was not currently in the pet space.  We believe this was a US based food company, though that is simply speculation. Our assumption was that Merrick would have been big enough to tempt someone on the outside to possibly buy-in, especially given the company’s focus on natural and its integrated manufacturing capabilities. That control of production has been an important consideration in our historical conversations with adjacent market strategic buyers.
  • Past precedent was important. It’s natural for a company with a meaningful presence in the independent channel to have concerns about on-going carriage once acquired by a major industry player.  It is also logical for retailers and consumers to have doubts when a transaction like this occurs.  However, in this case, Purina is able to point to their experience with Zuke’s, which has remained focused on the specialty channel and who Nestle actually pulled out of direct-to-consumer sales channels, as a proxy for how it will manage Merrick.  The fact pattern has given them some credibility with these retailers to push back against reduced carriage.
  • Castor & Pollux owners win too. When Merrick acquired Castor & Pollux Pet Works they did so in a stock deal, where the consideration was equity in the combined entity.  While Castor & Pollux was the leading player in organic pet food before growth in natural pet food exploded, it had plateaued at the time it sought an exit.  The company struggled to drive growth given its limited available resources. The gross margin profile associated with a sub-scale brand reliant on outsourced manufacturing and organic inputs is less attractive. Taking stock in Merrick, as opposed to cash at close, now looks to have been a very good decision.

We believe this deal makes the end of a the M&A cycle for major independent pet food players.  This current cycle included the sales of Natural Balance, Nature’s Variety and now Merrick.  We don’t see another headline grabbing pet food deal until Champion Pet Foods chooses to test the market, unless one of the large family owned operators decides it is time to exit.  Assuming this is the case, at least it ended with a bang.

/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.

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nickelLast week, Blue Buffalo filed an amended S-1 providing an expected price range for its sale of 29.5 million shares of common equity, with an overallotment allocation of 4.4 million shares.  The company expects to raise in excess of $500 million in its IPO and will trade under the ticker symbol BUFF.

Based on an expected valuation range of between $16-$18 per share, at the mid-point ($17/share) Blue Buffalo would have an equity value of approximately $3.3 billion and total enterprise value of over $3.5 billion based on net debt of $241 million as of the March 31, 2015. This would imply a valuation of just over 18x trailing twelve months Adjusted EBITDA (as defined by the company) as of March 31, 2015.  The above stated range fell below my expectations in terms of anticipated value.  A few factors are likely to be weighing on institutional investors’ minds in light of a more complete analysis of the company’s S-1.

  • Too many eggs in one basket.  Companies that are subject to customer concentration issues generally receive discounts in the capital and M&A markets. In the case of pet food the customers are the retailers.  As disclosed in the  S-1, 73% of Blue Buffalo’s sales were to national pet superstores, PetSmart and Petco.  Based on my personal analysis and those of third parties I consulted, collectively we estimated that PetSmart likely accounts for between 66% – 75% of Blue Buffalo’s national pet specialty volume. This would imply that PetSmart is responsible for approximately 50% of the company’s total sales volume. This puts Blue Buffalo is in a more complex position vis-a-vis a move to mass.  While we think such a move for Blue Buffalo is inevitable, it may complicate the process or drive up the cost.  Clearly, PetSmart and Blue Buffalo need each other, for now. That said, last week PetSmart announced, what many had already known, that Natural Balance would now be available throughout their store network and online properties. I view Natural Balance as a perfect comp for Blue Buffalo from a product positioning standpoint. If PetSmart is able to obtain access to Merrick it would add a second leg to that protective stool.
  • Share and share alike, not really. According to Blue Buffalo’s own market segmentation analysis, in 2014 it owned a 34% share of what it terms the “Wholesome Natural” segment, which it defines as dry dog food using only natural ingredients (based on AAFCO), that have whole meat or meat meals, with the animal protein type clearly identified as their principal ingredient.  These traits are distinguished from the “Engineered” segment, which are characterized by the fact they typically do not contain whole meal or meat meal as their principal ingredient and/or they use lower cost proteins (by-product meal, corn/wheat gluten) and contain lower-cost starches (corn, wheat, fractionated grains). Setting aside the current supply chain issues as it relates to Blue Buffalo’s self classification, this nuance allows Blue Buffalo to inflate its market share. While we can appreciate the desire to isolate one’s difference in terms of ingredient panel and adherence to certain standards, this segmentation allows Blue Buffalo to exclude a meaningful set of Brands/SKUs from their market share calculation, thereby overstating the company’s position.  Talk to a seasoned pet food merchandiser and they will tell you this is not how they, or their end customers, think about the market.  I also note that several of the of brands in the Wholesome Natural segmentation analysis are either overstated or understated based on what I know to be their 2014 sales.  This simply speaks to the imprecise nature of the analysis.
  • About that lawsuit. Blue Buffalo’s S-1 makes it clear that they are responsible for directing their suppliers to purchase the ingredients they approve, from the people they approve, based on the terms they themselves negotiate.  Yet somehow Blue seems to be getting a free ride as it relates to their recent sourcing issues. However, several people I have spoken to recently expressed greater conviction about the probability of a countersuit from Wilber Ellis and/or a Purina victory.  If Purina does in fact play this out and wins an injunction against Blue Buffalo as it relates to its ingredient claims, it would undermine the Blue Buffalo story, in addition to having meaningful financial implications.  I note that the company has not set up a litigation reserve due to the fact that the lawsuit is in the early stages (as self defined), it is unclear the damages the plaintiffs are seeking, and the fact that Blue Buffalo maintains its counter claims.  It seems quite reasonable that institutional investors are factoring potential losses into their valuation models.

Notwithstanding the issues above, we expect Blue Buffalo to have a successful IPO later this month and for it soon to be trading at an enterprise value in excess of $4 billion.  Even a modest first day pop would get the company there. Get your popcorn, this should be fun to watch.

/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.