petcoOn November 23rd, CVC Capital Partners Limited and Canada Pension Plan Investment Board (the “Buyout Group”) signed a definitive agreement to acquire PETCO Animal Supplies, Inc. (“Petco”) from TPG Capital, L.P., Leonard Green & Partners, L.P., and friends for $4.6 billion. The deal values Petco at approximately 10.0x my pro-forma TTM Adjusted EBITDA for Petco as of October 31, 2015. This contrasts with the 9.0x TTM Adjusted EBITDA for the acquisition of PetSmart by BC Partners.  It is rumored that the Buyout Group was able to arrange approximately $3 billion of debt financing to support the deal.  Notably, both Petco and PetSmart will be owned by foreign investors assuming the deal closes.

It should come as no surprise that Petco opted for a private equity sale. Too much time had passed since the September 18th media leaks to believe a Petco / PetSmart combination would come together.  The case for public equity offering also faced numerous headwinds — a) broader stock market volatility driven by macro-political risk (Syria, ISIS, China), b) weaker than anticipated earnings among publicly traded retailers (as of November 20th over 40% of the retailers in the S&P 500 had posted earnings misses for 3Q2015), c) weak October retail sales (0.1% increase versus 0.3% consensus) and d) falling consumer confidence (lowest levels this year and a steep drop from October).  Against this backdrop, a trade sale was the most attractive option, even if debt market support for the deal had been choppy.  We generally consider 10.0X the break-point for specialty retailer M&A, above which history has not looked kindly on the buyer from a shareholder value creation standpoint.

The most pressing question now is who will lead the acquired organization going forward.  Jim Meyers, who has been in the CEO role since March 2004 (he was named Chairman earlier this year), and his team has lead Pecto back to a position of prominence.  Based on the S-1, Petco was posting stronger growth and better unit economics than its larger rival.  However, if history is a guide, large private equity deals seldom result in a staying of the course. In a small amount of irony, it is possible, though unlikely, that David Lenhardt could be running Petco a year after being ousted from PetSmart. Stranger things have happened.

If the Buyout Group is smart, they will purse incremental changes at Petco as opposed to a holistic approach to transformation. While there are certainly cost inefficiencies to be rung out of the system, Petco’s value is in how well it is currently situated from a growth standpoint with its greater emphasis on wellness, its multi-box positioning, its omnichannel reach and its under penetration in private label.  Further, with PetSmart deeply invested in its cost containment program, now is the time for Petco to press on the growth accelerator.  Someone is going to grab the brass ring and if not Petco, the chase will be led by Pet Supplies Plus, Pet Valu or a series of financially supported independent chains.

The next year should be an interesting one is large box pet retail land.  Regrettably we won’t be getting much transparency into either business any time soon.

/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.