spinoffI enjoy the holidays as much as the next person.  Every year I seem to make some new friends during the party circuit that accompanies each Yuletide.  This year was no exception.  However, who those friends were was a departure from historical norms. All my new pals had one thing in common — they were PetSmart bondholders.

My firm does not engage in sales or trading of public equity or debt securities, nor do we provide any research products tied to specific companies or offerings, so for a critical mass of hedge fund managers to end up at my doorstep was a bit of a surprise.  All of them wanted to know if I thought PetSmart would spinoff Chewy.com.  To better understand why that was such a pressing question some context is required.

When PetSmart acquired Chewy in April 2017, they financed the purchase with a combination of debt ($3.25 billion) and equity. The debt component include two tranches of publicly traded notes (first and second lien).  The price of the debt began to slide within one month of the close, and picked-up steam when Blue Buffalo jumped the channel in August followed closely by the departure of PetSmart’s CEO. A third quarter earnings miss added fuel to the fire (EBITDA down 34% year-over-year).  The company’s second lien notes have traded as low as the mid-50s, while the first lien note have traded as low as the mid-70s, a healthy discount to par.  The notes were among the worst performing junk debt issuances of 2017.  However, what caused PetSmart bondholders to worry most was the fact that the covenant package tied to the debt would allow the private equity syndicate to separate Chewy from PetSmart for its own benefit, and to the detriment of creditors.

The primary motivation of private equity investors is first and foremost financial gain.  That is not to say they do not provide a direct or indirect public good, but rather I would never put it past this class of investors to pursue what was in their own best interest.  While separating Chewy from PetSmart might be theoretically viable under the terms of the bonds, we think the carve-out has more risk than reward.

While Chewy remains the market leading ecommerce property in the pet space, its value proposition is eroding.  Post-closing of the transaction, a small number of notable brands exited the platform, dealing the company a topline financial hit. The transaction also accelerated a movement within the retail community for the implementation of MAP pricing policies.  While MAP can be hard for smaller brands to enforce, it appears that most companies are making reasonable efforts to communicate and enforce these policies.  Of greater significance is the fact that Chewy was losing money at the time of the sale, meaning it would need more cash to sustain its growth.  Separating from PetSmart would result in the loss of significant purchasing leverage, meaning even further losses.  Absent a major cash infusion, Chewy would need a public float to perpetuate the business model.  Public comps with this business model trade at 1.0x – 2.0x revenue, much lower than the multiples paid for the banner.

The net of all this is that I do not see a full separation as a likely outcome.  At the very least it would lead to years of expensive litigation. Rather, I believe the private equity syndicate will use the threat of a spinoff to renegotiate with bondholders if and when needed.  If a spinoff does occur, expect it to involve less then 50% of Chewy, such that the entity can continue to be consolidated for financial reporting purposes and enjoy the benefit of PetSmart’s purchasing power to offset losses.

/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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