petcoOn Monday, Petco Animal Supplies filed for a public offering. Goldman Sachs, Bank of America and J.P. Morgan are the lead underwriters on the offering. If-as-and-when successful, this will be the third time the company has tapped the public markets. A brief synopsis of Petco’s ownership/liquidity history can be summarized as follows:

  • 1994 IPO. Largest pet specialty retailer in the country.  Owned by private equity firm Thomas H. Lee Partners (currently the owner of Phillips Feed Service). For the fiscal year ended January 31, 1994, Petco’s 208 stores generated approximately $180 million in sales at less than $3 million of operating income (EBITDA figure was not available). Trading on NASDAQ under the ticker symbol PETC.
  • 2000 Take Private. $600 million transaction (6.1x LTM EBITDA) led by Leonard Green Partners (LGP) and Texas Pacific Group (TPG).
  • 2002 IPO. $275 million IPO, again on the NASDAQ.  For the fiscal year ended February 2, 2002, Petco’s 548 stores generated $1.3 billion of revenue and $109 million of EBITDA.
  • 2006 Take Private. $1.85 billion transaction (8.5x LTM EBITDA) by LGP and TPG using an abundance of cheap debt financing to underwrite the purchase price.  LGP and TPG contributed approximately $765 million in equity (total equity check was $775 million).
  • 2010 and 2012 Leverage Dividends. Company financed approximately $1.2 billion in distributions through two leveraged dividends (1.5x Invested Equity).

In short, Petco has been the pet industry’s transaction bellwether, and that is before you take into account the acquisitions and strategic investments the business has made historically. However, this trajectory is more a function of the company’s economic fortunes overlaid against the broader capital markets backdrop. After being the clear market leader in pet specialty in the early 1990s, the company found its position usurped by PetSmart later that decade. A relative comparison of the two leading pet specialty players looks as follows (Fiscal Year, Revenue/EBITDA, $million):

  • 2000. Petco, $990/$88; PetSmart, $2,110, $128
  • 2006. Petco, $1,996/$209; PetSmart, $4,234, $440
  • 2015. Petco, $3,995/$411; PetSmart, $7,070, $944

In 2011, I wrote this piece suggesting that maybe Petco had been done and dusted by PetSmart, a fact that was supported by the data at the time.  While PetSmart remains the dominant player from a financial perspective, Petco has certainly made up ground, producing slightly better same-store-sales than PetSmart over the latest twelve month reported period. That said, it could be argued that Petco is poised for a better near term run for the following reasons:

  • Store Format.  Petco currently operates 130 Unleashed stores in addition to their 1,279 Petco locations.  Unleashed units are 5,000 square feet and currently located in 14 major urban markets. They target a premium customer who values a small box specialty experience. These stores also appeal to a Millennial customer who often lives in an urban center.  Based on our experience, leading small box pet concepts are experiencing growth rates in excess of 15% percent (many of them are producing 20%+ growth), providing Petco exposure to a higher growth segment of the market. Further, Millennials are the fastest growing category within pet ownership. Unleashed units also provide Petco an opportunity to have a specialized merchandise mix, which allows them to embrace emerging brands earlier in the lifecycle. Notably, as part of its go-public preparations, Brad Weston, who was previously President of Unleashed, was made President of the company.
  • Digital Assets. Petco’s .com properties generated $185 million in Net Sales in the first half of fiscal 2015.  While it is hard to validate the company’s claim that they have the largest integrated ecommerce offering in pet specialty, we also have no reason to dispute the assertion.  Of greater significance is the fact that throughout the growth of pet food supplies online, Petco has maintained control over its digital assets and made significant investments in technology to enhance both customer engagement and omnichannel capabilities.  Petco is currently implementing technology that will facilitate cross-selling across physical and online properties as well as enable same-day delivery.  Additionally, the company is making investments in store resident technology to offer endless aisle support.  Finally, Petco has partnerships with major online properties such as Instacart and Rover.com that augments its digital footprint and offerings.  As online grows in pet, Petco is well situated to benefit.
  • Operational Upside. Based on the substance of Petco’s regulatory filing, there is clear upside to be harvested through operational improvements.  As an example, Petco currently generates 15% of sales from private label/owned brand products versus 27.5%+ for PetSmart.  Given the ability of house brands to drive traffic and take margin, a greater emphasis by Petco on this initiative should provide meaningful earnings growth.  The acquisition of Drs. Foster & Smith, which has significant private label capabilities, offers one direct point of leverage in both consumables and wellness solutions.  A second example is the potential for greater sales in higher margin product categories. Notably, Petco generates ~ 38% of sales from consumables and ~ 8% of sales from services versus ~ 50% and ~ 11% respectively for PetSmart. While these categories remain competitive, and are subject to pricing pressure, the potential to drive greater sales through these higher margin verticals would drive earnings growth.

Based on market chatter, a publicly traded Petco could be valued at $4 – $4.5 billion, or +/- 8.5x – 9.5x Adjusted EBITDA.  This compares to 9.0x EBITDA for the PetSmart take private, and the low end of the range is in-line with the historical take private, about where I would expect it to land. The question is whether there remains pent up demand for public pet industry equity in light of the first day run-up in Blue Buffalo’s equity valuation.  While public investors are sure to view Petco’s operational upside favorably, PetSmart’s experience provides a cautionary note.

/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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