puzzleLast week, it became public knowledge that PetSmart and Petco Animal Supplies were engaged in “merger” discussions.  Back when PetSmart was under pressure from activist shareholders, we discounted the potential for a deal that would bring together the two leading pet specialty retailers. Our analysis was based on the notion that if these two companies were ever to combine, PetSmart would be the more natural acquirer given its relative size, strong balance sheet, and cleaner ownership dynamic. However, companies in play don’t tend to be net buyers of assets. As expected the deal did not come to pass.

Since that time, much has changed.  Most notably, the two companies are both private entities, which makes a deal more likely in our estimation.  Bringing these two assets together will be a messy process given the high levels of overlap between the two businesses — retail locations, warehouses, systems, people, processes.  For a merger integration process of that complexity to play out within the purview of the public markets would be problematic at best.  Additionally, the information playing field has been leveled with the filing of Petco’s S-1.  Previously, dialog between these two companies was hampered by the fact that PetSmart did not want to further educate its primary competitor on the details of its business without some transparency into the condition of Petco as a buyer. With the filing of the S-1 we now have insight into Petco’s historical and current business performance and that data should be sufficient for PetSmart to form a preliminary view as to the attractiveness of a combination. Of greatest significance, it will enable them to ascertain whether a deal could be financed solely with debt. If so, the probability of PetSmart making a strong play for Petco would increase. Third, we now have some clear transaction motivation at Petco — go public or be acquired.  A year ago, such impetus was lacking. Given that the recent volatility in the equity markets has made a public offering less likely, a sale to the party who can underwrite the most synergies makes more sense than ever.

While the fact pattern above is compelling, a combination will likely come down to the perception that the transaction can clear antitrust.  Recall that PetSmart had numerous discussions with what appeared to be Petco during its exploration of alternatives and came to the conclusion that the deal would not clear antitrust (article here).  It appears Petco was more concerned about the potential for an antitrust review to have an unfavorable outcome. A review of the transaction by the Federal Trade Commission (FTC) will hinge upon traditional benchmarks such as market share and price competitiveness, but also market concentration, which is also a consideration with horizontal mergers. While we are not antitrust experts, we believe the deal would undergo considerable scrutiny as follows:

  • Market Definition. How the FTC defines the competitive market for the sale of pet products will be the central risk to a transaction.  The FTC has previously scuppered deals (Whole Foods – Wild Oats, Staples – Office Depot) where it defined the sales market for the product narrowly. If the FTC views PetSmart’s and Petco’s competitive position to include all FDM retailers as well the veterinary supply channel, it’s market share hovers around 20% for both pet products broadly as well as pet food sales. However, if the competitive landscape is viewed as other pet specialty retailers, including independents, that market share rises to unacceptable levels from an antitrust perspective, and would likely result in strong resistance to a deal.  While a more broad market definition has some inherent logic, the channel tied nature of the product mix, especially as it relates to consumables, undermines that logic.
  • Pricing. Pricing is a paramount consideration for the FTC when evaluating a business combination.  Ultimately, the government seeks to protect consumers from being disadvantaged at the cash register when choice contracts. Of interest to the FTC in these circumstances is how pricing might react in defined geographies.  While we do not have access to, or know of for that matter, any comprehensive pricing studies for the pet specialty market, we do not believe that, on its face, pricing related risk is elevated here. However, if there is an Achilles heel in this analysis it is that PetSmart and Petco collectively control in excess of 50% of the sale of channel exclusive pet foods. That said, both PetSmart and Petco experience pricing pressure from both independent retailers and the online channel as it relates to the consumables category, the later being important given the shifting demographics of pet ownership away from Baby Boomers and towards Millennials, who are more prone to using online venues to procure products. Additionally, we have seen a proliferation of premium food in FDM. Further, numerous substitutes for these products are available in the independent channel. Ultimately, the FTC may choose to evaluate the sale of premium pet food as its own market and assess the potential antitrust risk accordingly.
  • Concentration. The FTC also considers the potential for market concentration from horizontal mergers. There is significant overlap in retail footprints of Petco and PetSmart. Over 70% of PetSmart stores are within five miles of a Petco location. The FTC analyzes market concentration according to the Herfindahl-Hirschman Index (HHI).  Where HHI levels are elevated, meaning increased concentration, there is more scrutiny applied to the transaction. HHI is influenced by the number and size of competitors in a given MSA. Therefore if the market is defined more broadly per the above, the potential for HHI risk being exacerbated declines.  We believe that a narrowly defined market definition would likely result if considerable HHI driven scrutiny, which may result in required levels of store divestitures in order to obtain antitrust clearance.

The potential for a PetSmart / Petco combinations really comes down to two factors.  First, if the private equity owners of PetSmart are willing to take the merger integration risk of a Petco combination this early in their ownership lifecycle. Second, is whether you believe the FTC will take a broad view when defining the market for the sale of pet products.  We see support for arguments on both sides.

/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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