Where you stand, depends on where you sit.” — Rufus Miles, Princeton University

m8bAs we round the “club house turn” for the calendar year, it is natural to begin focusing on the year ahead and what it might hold (or bring, depending on your preference).  It is common for these final days to be filled with conversations about what we are seeing today and what we anticipate tomorrow.  As we catalog perspectives, through these conversations, as it relates to the next twelve months for the pet industry, the narratives fall into one of two camps — the sky is falling or the sun is sure to rise tomorrow.  It appears which camp one finds themselves in is highly correlated to whether the outlook might benefit the prognosticating party.  This is the classic application of Miles Law.

Your guess is as good as mine with respect to where the industry might go in 2018.  However, here are the key things to watch:

  • Blue Boom or Blue Gloom? — If you talk to equity analysts, Blue Buffalo has become a battleground stock.  The long narrative is about growth as penetration increases.  The short narrative is tied to slower uptake and discounting in FDM, retailer retaliation, and class action litigation.  The recent sales data is compelling but it includes a considerable amount of sell-in and discount driven velocity.  One would be wise to wait until 2Q2018 to pass judgement, but patience is boring.  Bull Case: Gravity and Blue Buffalo have seldom been bedfellows, and today is not the day for them to become better acquainted.  Bear Case: When margin compression and the inevitable pet specialty scaleback hits the stock, it will be a wake up call for investors.  Magic 8-Ball Says: Signs point to yes.
  • PetSmart: Comeback Kid or Sophomore Slump? — The biggest unknown is how the revised PetSmart strategy will resonate in 2018.  The March consumables reset will provide meaningful insight into their Blue Buffalo sales replacement strategy.  We hear the new set is a literal “dogs breakfast” — something for everyone, including FDM brands bridging to major pet specialty.  How Pinnacle Pet Store performs will be critical.  Currently, the brands on promo are an eclectic mix.  We also know multiple PetSmart/Petco brands are in current FDM tests. I don’t put much weight into the prevailing theory that Chewy.com will get spun out from under the bondholders, but never underestimate private equity owners to further their own interest at the expense of debtors. With MAP pricing getting more prevalent, and with the major distributors over leveraged (see below), PetSmart could see improved traffic trends.  The bigger issue is how they create greater leverage with Chewy.com.  Currently, PetSmart is trading 40% gross margin customers for 10% gross margin customers.  We assume the loss of Champion and Fromm means any earnout in the deal is underwater making Chewy leadership a flight risk.  Bull Case: Blue FDM stalls, PetSmart gets traction with omnichannel capabilities, the bonds hit 80.  Bear Case: Did you know the private equity owners also control a crisis management PR firm?.  Magic 8-Ball Says: Cannot predict now.
  • Indy Sink of Swim? — Independents are also at a critical moment.  They have held the upper hand on selection and access and continue to enjoy that advantage due to Champion and Fromm channel conviction and access to emerging brands and alternative form factor foods. However, they generally lack an ecommerce strategy and a recession looms, all though tax reform may push that event down the road.  Of note, both Animal Supply and Phillips Feed Service are overlevered and credit analysis points to softness in the independent channel.  If the independent channel experiences product access constraints due to its reliance on these distributors, it will make it hard to effectively merchandise and retain customers.  Bull Case: Continued PetSmart malaise and erosion of online advantage through MAP keep indy on the front foot.  Bear Case: PetSmart turnaround coupled with distributor issues drives contraction within the category.  Magic 8-Ball Says: Ask again later.
  • Private Equity: Buyer or Seller? — Given late market cycle dynamics we are sure to see an uptick in transaction opportunities in 2018.  With a meaningful subset of strategic consolidators under pressure (some through no fault of their own) or hunting for transformative acquisitions (good luck), private equity is expected to play a larger role in the deal landscape during the balance of the cycle.  The recent sale of Outward Hound and Manna Pro Products, are evidence that private equity will pay-up for scale pet properties that have robust M&A pipelines. Further, the defensive nature of the pet industry is an attractive for private equity given the potential for a recession during their holding period.  Bull Case: Private equity uses the current market opportunity to create a number of new consolidator platforms.  Bear Case: Rising credit costs and channel concerns curtail interest.  Magic 8-Ball Says: Outlook good.

No matter where you stand, based on your last point of rest, it is hard to argue that the pet industry is no longer in the honeymoon phase. The change cycle that began nearly two years ago, continues. Signs point to further volatility ahead. However, with turbulence comes opportunity. Magic 8-Ball Says: It is decidedly so.

/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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