consumer products and services


chewyChewy filed an S-1 on April 29th (see filing here).  The offering, if executed will be managed by Allen & Company, J.P. Morgan and Morgan Stanley (list in alphabetical order).  The company will trade under the CHWY ticker. As yet unclear is which exchange they intend to file on, the amount of proceeds (currently there is a $100 million placeholder, which is standard tactic), or the use of proceeds beyond working capital and general corporate purposes.  However, there is much to learn from the filing.

Before wading in, let’s a take a short trip down memory lane.  Chewy was acquired by PetSmart for $3 billion in May 2017. As part of a PetSmart refinancing, the buyer borrowed $8.2 billion and the private equity ownership syndicate injected $1.3 billion of equity.  The publicly traded component of that debt experienced significant volatility post issuance in-light-of PetSmart’s declining performance. The senior debt tranche traded as low as 70% in May 2018, before rebounding to current levels of 87.5%.  The junior tranche traded down to 48%, and today trades at 82.5%, reflecting a much rosier outlook. In June 2018, the ownership group took advantage of an asset stripping clause of the indenture to move 16.5% of the Chewy stock to an unrestricted subsidiary and dividend the parent company 20% of the stock.  The value of Chewy at that time was $4.45 billion and notably Chewy will no longer guarantee PetSmart’s debt. Through this process, the equity owners created a war chest that could be monetized to potentially generate a return on their investment or buy themselves out of debt purgatory at a discount. As you might expect, the creditors disputed the parent company’s legality to undertake the asset stripping, questioning whether the business was insolvent. Earlier this month, the two sides agreed to modify the terms of the debt in exchange for dropping the lawsuit.  The company’s bond prices spiked upon the announcement of the Chewy S-1 (source: Bloomberg):

petm bond

Now that we are all on the same page, let’s dig in.

Chewy.com generated $3.5 billion in Net Revenue during 2018, a growth rate of 68%.  This figure is slightly more than the estimate category sales on Amazon of $3.3B. Based on the S-1, ecommerce penetration in the category stands at 14%, with growth to 25% in 2022. Notably, Chewy generated a $268 million Net Loss, down from a $338 million Net Loss in 2017. The company warns that profitability may never be achieved, though this is a standard disclaimer.  The business currently has 10.6 million customers who order, on average, $334 annually. In 2012, this figure was $223, representing a ~ 7.0% six-year CAGR.  Notably, the company states that embedded growth among its customer base is 20%. This is growth that the Chewy would expect to experience through expansion of wallet share if it did not acquire any new customers.  Active customers spend, on average $500 in their second year and $750 after their sixth year, 1.5x their second year spend, which is usually their first full year on the platform.  The S-1 does not address customer churn.  Chewy generates approximately 80% of sales from consumables, of which 5.3% of total Net Sales are attributable to its housebrands.

While all the above is well and good and interesting, the most notable metric is the ratio of customer life-time-value to acquisition-cost, commonly referred to as LTV / CAC. This ratio speaks to how sustainable your customer acquisition engine is and a common predictor of future results. Based on the performance of its 2015 cohort, which is now three years aged, Chewy’s LTV / CAC was 2.4x.  The generally accepted benchmark for healthy performance on this metric is 3.0x, indicating some concern with the health of the business model and its ability to become profitable over time.

In thinking about what Chewy might be worth in an IPO, the comp that we gravitate towards is Wayfair.  The online retailer of furniture and home goods currently generates $6.8 billion of net sales, losing $404 million of EBITDA. The business currently trades at 2.1x LTM Revenues.  When you dig into the comp set analysts rely on in pricing the stock, that group trades at ~ 1.15x Fiscal 2018 Revenue and 1.0x Fiscal 2019 Revenue. This would value the business at $4.1 billion based on 2018 figures and $4.4 billion based on 2019 figures, assuming a 25% growth rate for 2019, with the caveat that no forward guidance is offered in the S-1 but in-line with the June 2018 valuation.

In our Spring Pet Industry report, we postulated that PetSmart may need to sell or IPO Chewy, but the realization of that option is manifesting itself sooner than we had anticipated.  The public markets are being tested with offerings of conceptually attractive businesses with a proclivity for losing money.  The net of this is the risk reward tradeoff being contemplated here is not without an ample helping of downside potential.

/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.

Advertisements

And we are back…

The pet industry continues to evolve towards its new normal.  However, while it appears the volatility within the industry has decreased, tremors continue and several events could catalyze a second wave of transformational change.  Central going forward is that the industry now finds itself facing some new pain points with no clear path to resolution.

Of increasing significance, latency between consumer trends and pet trends has compressed from years to months, which will put immense pressure on the industry’s antiquated regulatory framework. Consumer demand for pet products that incorporate CBD, human diet concepts such as Keto and Paleo, and protein alternatives is significant but lacks regulatory and, in some cases, legal clarity. That has not stopped manufacturers or retailers from bringing these products to market in order to satisfy demand. If AAFCO cannot evolve to become more nimble and responsive, the industry will become more risky to all involved.

Also of significance, is that the risk associated with the repositioning of Petco and PetSmart could result in major downstream implications. As Petco forges ahead with its new wellness enabled vision, PetSmart has largely stood still lacking financial flexibility.  The success of Petco’s strategy could put pressure on PetSmart to sell or IPO Chewy, it’s most valuable liquid asset. Notably, a Chew S-1 was filed on April 29th (see here). Tepid operational results for Petco or from investors during a Chewy IPO roadshow, could place these two organizations on a merger path in order to remain relevant.

Slower industry growth is driving consolidation, a theme that will continue for the foreseeable future. The cost of doing business in the pet industry has increased as physical and online retailers monetize their market positions, making it more difficult for midsized and emerging brands to compete. Given the pace of change, strategics are under more pressure to acquire assets that enable them to meet emerging customer needs, or risk losing out on the ability to monetize faster growing market opportunities. Private equity is leading the consolidation charge due to broader business malaise prevalent among large strategics, which will enhance focus on profitability as the key criteria underlying acquisitions and put downward pressure on valuations

Notwithstanding slower growth and more turbulent competitive dynamics, we believe the current environment offers a market opportunity that may not manifest itself again for some time.  The other key trends we are keeping our eye include:

  • Blue Buffalo Banks Further on FDM. General Mills announced that they intend to double Blue Buffalo’s retail availability by April 2019. Central to this strategy will be launching Wilderness in FDM. When Blue transitioned Life Protection Formula in August 2017, it communicated its intention to protect the pet specialty channel by preserving exclusive access to its others brands. The quest for growth and profits rendered that commitment fleeting. By the end of April, according to General Mills earnings presentation Blue will have a retail ACV of 65%, up from 32% in October 2018.  Retail sales declines in pet specialty necessitated the move according to General Mills executive leadership. Notably, Blue also posted 24% ecommerce growth for the nine months ending February 2019.  If there is anything left in the relationship between Blue and pet specialty we will soon find out.
  • Amazon Accelerates but Housebrands Not a Category Killer. According to Packaged Facts, Amazon generated pet category sales of $3.3 billion in 2018, giving it a 6% share of the market. Amazon pet food sales exceeded $1 billion in 2018, up over 20%.  However, Amazon’s own housebrand Wag, launched in mid-2018, only accounted for $2 million of these sales. While Amazon housebrand sales will invariably increase over time and benefit from the launch of complementary brands, such as Solimo, owning the buy box is not yet translating into changing consumer behavior. Most Wag and Solimo product ratings are 3.5 to 4 stars, evidence of mix sentiment, and the launch has been plagued by production issues. A study by Marketplace Pulse suggested that Amazon housebrands across categories were having limited impact on brand sales online. With estimates for online penetration of pet food sales reaching as high as 50% over time, Amazon stands to benefit anyway you look at it.
  • Petco Launches Repositioning Strategy. Petco is ushering in a comprehensive new strategy firmly rooted in the health and wellness driver of industry growth. Petco’s approach involves eliminating products whose formulations feature artificial ingredients. As part of this process, Petco will seek to transition customers in many leading national brands to its housebrands and other channel dedicated brands. Criticism has ensued as Petco’s housebrand formulations may not fully comply with their own standards and many brands they are removing appear to be for financial or competitive reasons. Additionally, Petco launched its PetCoach store which “offers the highest quality suite of personalized pet services, products and experiences – all designed through a veterinary lens – to address total pet health and wellness.” While its competitor runs in place, we applaud Petco for its efforts to reframe its appeal and relevancy to pet owners. However, if traffic and transactions don’t materialize, Petco may lack the flexibility for a further pivot. Get your magic 8-ball ready.
  • Follow the Funds to See the Industry’s Future. 2018 was a record year for industry consolidation, but it also outperformed in terms of private placements, as equity flowed into the category at record levels. Over $1 billion of equity capital was invested in pet related enterprises since 2017. Notably, the year was punctuated by larger deals, with the median deal size of $45 million among transactions whose proceeds yielded more than $5 million. Investments in dog-walking apps accounted for 40% of deal value, but 23% went into ingredient manufacturing companies, with an additional 7% flowing to direct-to-consumer dog food brands. Institutional equity is flocking to these opportunities because they are not well served by existing market participants. The deals of today will fuel the exits three to five years down the road, which will only serve to extend the consolidation cycle. However, the subsectors attracting capital speak to a much broader market opportunity within the industry.

As always, if you are interested in accessing our full report you can reach out to me directly.

/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.

 

 

roller coasterLike other consumer industries, the pet sector is discovering that today change in constant.  While this seems obvious, in the five years following the recession, the prevailing status quo enabled the pet industry to enjoy substantial and consistent growth.  The period that follows stability is often best characterized as turmoil, regardless of the amplitude or velocity of change.  Even modest changes after a long period of calm can appear daunting.  Over time disorder then turns into a new paradigm; the pet industry appears to be moving into its new status quo.  However, there is little rest for the weary as new challenges, such as trade policy and house brands, that pose new treats to incumbents.  And when those threats dissipate, new ones will rise in their place.  Industry evolution is now characterized by persistent change.

As we keep our eye on industry change drivers, the four themes we are focused on this fall, include the following:

  • Independents’ Conundrum Multiplexes. In our Spring report, we commented on the potential impact of Blue Buffalo’s move into FDM and subsequent acquisition would have on independents, many of which have historically “divested” brands that jumped the channel or were acquired by large CPG firms. In our store visits since the acquisition closed, we have certainly seen a deemphasizing of the Blue brand in specialty, though it remains widely available in the channel. The brand that has historically benefited most from independents scaling back on Blue has been Champion, a process that began when several prominent chains reduced or excluded Blue in wake of the 2015 labeling scandal. If, in fact, Champion is acquired by Nestle Purina, this would further complicate the merchandising strategies for independents. Many of the brands poised to fill the potential shelf space void lack the name recognition to drive traffic, the ability to rapidly expand production, or the marketing dollars to drive trade spend. Independents have survived upheaval before, but this time things may be more challenging and it leaves them more vulnerable to ecommerce.
  • Trade Policy Could Impact Growth. In September, the US expanded the tariffs imposed on Chinese goods to $250 billion worth of products. Of greater significance, the tariffs applied will increase from 10% to 25% on January 1, 2019. While the pet consumables supply chain has meaningfully shifted to US-sourced products, a broad range of pet products will be impacted, with hard and softgoods having the greatest exposure. What is unknown is how these tariffs will impact retail traffic, purchase intent, and transactions. Given that real wage growth has been muted for some time, there is potential that pet population growth could be impacted, which will have a trickle down effect on all industry categories. While there was once a widely held belief that China trade tensions would blow over quickly, we find market participants are preparing for a longer game, which includes seeking alternative sourcing in Vietnam, South America, and Mexico given favorable labor rates. Only time will tell.
  • House Brands and Private Label Growing. Consumer industries, broadly speaking, are experiencing a dramatic proliferation of house brands and private label offerings, as retailers seek to cash in on growth trends and the ability to control real and virtual shelf space. In the last two years, Target has introduced 20 brands, Walmart 18 brands, and Amazon 72 brands across different categories. Amazon’s owned brands are on pace to generate $7.5 billion of revenue in 2018, and grow to $25 billion in 2022. With manufacturer margins of 2x – 3x retailer margins, house brands make strategic sense. With consumers increasingly looking for value, private label could redirect $64 billion of purchases. Within pet, Amazon has launched house brand premium (Wag) and value (Solimo) kibble and wet (Simply Perfection) for dogs, as well as a supplies line (Pet Craft Supply). While these brands, and others that follow (dehydrated, freeze dried, super premium, etc.), will create competitive tension among marketers, it provides a segment of the industry that service these brands with a meaningful growth driver.
  • Private Equity Becoming Buyer of Lower Middle Market Pet. 2018 is on pace to be a record year for pet industry consolidation. Shifting consumer demographics, channel dynamics, and, now, trade policy are the key drivers of acquisitions. What is most notable, is not the volume or velocity, but who is doing the buying. Historically, when strategic buyers wanted something, their “ability-to-pay” priced financial buyers out of the market.  Today, the large strategic consolidators are hyper-focused on specific assets that address business model deficiencies and portfolio challenges, leaving a larger population of acquisition targets for the likes of private equity and private equity-backed strategics. This includes the food category, where the pricing advantage of strategics is magnified. Expect more deal announcement from financial motivated players, and invariably the valuation compression that comes from selling to a profitability motivated buyer.

Transformation in the pet industry continues to progress at a rapid pace, with market participants homogenizing around a common set of growth strategies. Major competitive moves continue to unfold, changing the strategic and operational landscape, with more dominoes to fall.  For market participants we suggest you hold on. While this roller coaster we are now on may have lost amplitude, the ride is far from over.

/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.

 

freddieThe fate of Champion Pet Foods has long been a source of speculation among industry insiders.  While most deal rumors in the industry spread like wildfire, over the past three years rumors about Champion have been without peer. Not a show goes by without speculation. We’ve heard, and have bought into at some level, various iterations — IPO, Canadian pension fund buyouts, Blue Buffalo/Mars/Nestle acquisition.  Knowledgeable people, including myself, have been hoodwinked many a time.  As such, when acquisition rumors hit the media in early July, the reaction was met by many with a shrug of the shoulders – “oh good, now we know.” However, should an acquisition of Champion by Nestle Purina PetCare in fact be consummated, it feels like there will be no winners.

Shortly after the Nestle rumor hit with pages of the Wall Street Journal, Champion issued a statement that could only be characterized as a “non-denial denial”.  There was no, “we are not for sale” but rather a “of course people should want to buy us.” If the rumor needed any credence, it was received.  What is most notable to me is that while a deal might happen, I am not sure anyone, even those on both sides of the transaction, want it to. To better assess this statement, let’s consider the transaction from all sides.

From Champion’s perspective, and those of its primary backers, a sale to Nestle would bring a financial windfall; of that, we can be certain. With a potential $2 billion price tag, we can only assume that Champion would be selling for a multiple that is aligned to recent sales of Blue Buffalo and Ainsworth.  While industry websites report Champion’s sales in 2017 at $170 million, we believe it to be significantly higher.  If you sell pet food in 80 countries, and are in the process of building a $200 million production facility (see details here) you better be selling a lot more kibble than that.  However, or greater importance is that historically Champion has pursued a moral high ground with respect to its formulation and production (see here) and its channel strategy.  When Pet360 and, later, Chewy were acquired by PetSmart, Champion exited both platforms, supporting the independent retailers in their battle with major pet specialty and leading online sites they control.  Champion grew on the backs of independent pet retail, greatly benefiting from this channel’s reduction in exposure to Blue Buffalo through various brand dilutive events.  As such, a sale to Nestle would seem antithetical to much that Champion stands for.  Further, a financial windfall for the sellers seems available through a myriad of other avenues that don’t involve a perceived selling out.

On the other side of the coin is Nestle’s pet food subsidiary.  If you have been following closely, Nestle’s core food business, like many of its peers, has been under siege.  Large food companies, as a class of competitors, have been struggling to adapt to changing demographics and consumer preferences and the associated evolving channel dynamics.  Activist investors are pressuring these companies to evolve their brand portfolios faster and seek mergers to rationalize costs.  Against this backdrop, Purina has been performing.  If you dig deep in the back of Nestle’s Half-Yearly Report 2018 (page 28), you will notice Purina was a top performing segment, generating 3.8% growth in the first half of the year.  Now consider what handcuffs Champion as a premium seller might extract in a transaction — No PetSmart, Petco or Chewy? No FDM? No formulation changes? No management changes?  If you are Purina management, you are likely to inherit a business at very high price tag that is unlikely to realize the necessary return profile to be attractive in the near to medium term.  The deal appears to be a Daniel Loeb pet food aisle clean-up special, as opposed to a good organic M&A idea.  For Purina management, you can sense the apathy from afar, especially if the deal curtails your ability to pursue transactions for which you have a higher degree of conviction.

Finally, let’s consider the independent retailers. Many operators in this class of retail have benefited greatly from the growth of Orijen, Acanca, and, to a lesser extent, Heritage, as well as Champion’s conviction to this channel, at the expense of growth.  Champion provides these retailers a recurring high price point sale opportunity.  Many of them have become reliant on the company’s product offerings at multiple premium price points, and, in turn, Champion benefited from these retailers recommending their product and scaling back on Blue Buffalo considering its politics.  While we don’t know what constraints might be a byproduct of any deal negotiation, these retailers could potentially lose exclusivity to one of the backbones in their pet food merchandising mix.  A blow of this magnitude will reverberate across the channel.

When a brand seeks to take the moral high ground in a product category, it is lauded, and it often should be.  However, capitalism never stops calling, and when you take outsiders money you eventually take the next call. I’m not privy to Champion’s financials, but it would seem they possess a myriad of options outside of this contemplated transaction. If consummated, its repercussions, mostly negative, will be felt by all directly and indirectly involved.  In turn, consumers will get more jaded about what we expect from the companies we rely on to keep our companion animals healthy and happy.  Emerging brands will in turn inherit those expectations and the cycle will begin anew.

/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.

 

 

 

“In my 25 plus years in the industry, this is the first time I can say, I don’t know what is going to happen;  I don’t have a good answer.”

run to the lightGiven the proximity to Interzoo and Global Pet Expo, this year’s SuperZoo trade show allowed for more shop talk than in prior years. Given the heat nobody wanted to move anyway, so the conversations were fulsome, as opposed to being fleeting in nature. The topic du jour, so to speak, was the future of PetSmart, and to a lesser extent Petco.  Adding fuel to the fire was recent data indicating pet food sales in major pet specialty had been down over 10% in the past four weeks, a trend that was accelerating as opposed to contracting. The italiziced statement above was made in that context, and its concerning given that it came from a very smart, very seasoned, pragmatic industry executive whose predictive capabilities over the years have proven to quite accurate.

The pet industry needs a healthy national retail ecosystem and its major retailers are, well, reeling. The cure for what ails them is not obvious. That said, both Petco and PetSmart are not standing still, with both organizations appointing new CEOs in the past 45 days. More changes are likely on their way, whether they be structural (Chewy.com spinoff?), strategic, or modestly tactical.

Below are some summary thoughts on my conversations in Las Vegas:

Petco Animal Supplies

With respect to Petco, most people I talked to put a lot of stock in the hiring of Ron Coughlin, the former President of HP’s personal computer business.  When you read the narratives of those who have written, most with excitement, about his hiring, they put considerable weight behind his ability to develop strategies that connect with emerging consumer cohorts, such as Millennials.  While Ron is new to me, his real value appears to be in driving sales and differentiation against a backdrop of product commoditization. Connecting with Millennials, and subsequent generations, is a strength of Apple, not HP.  That said, Ron’s experience at PepsiCo, should be valuable assuming Petco continues to double down on its private label strategy, as his marketing credentials are meaningful.  He seems like a great hire.

The other strategy that received some attention at the bar, was related to the fate of Unleashed. Once a key differentiator, and a darling for emerging brands that were seeking to bridge the gap from independent pet specialty to major pet specialty, it appears that Unleashed has become a drag, at least to manufacturers. Many brands indicated allocating funds to support online efforts were yielding much greater results than promo spend and exclusives in Petco’s smaller boxes. Essentially, the professionalized box chains (Chuck & Don, Kriser’s, Pet Food Express, etc.) have siphoned off the customer Unleashed was meant to target, and Petco has not maintained the strategic differentiation between its core box and its smaller cousin.  Some suggested spinning off the box chain a la Petsense.

Finally, there was the natural discussion about the private label brands, and their future.  Most people I spoke to did not expect a tactical departure from the current strategy, but likened it to a secondary line of business – i.e., pick up some kibble after your dog is done at the groomer. What this says is that Petco has more work to do to make its brands traffic drivers and find a balance between house brands and third-party brands.  Petco is currently banking on its investments in engagement and services to drive brand attachment and store/online traffic. It certainly has a technology advantage, but it needs to translate that into traffic and transactions, and not let it languish as “potential”.

PetSmart

While most liken the Petco rehabilitation process to a home remodeling project, when people talk about PetSmart’s road back, the narrative is more akin to taking things down to the studs. Maybe it is the drama and intrigue that continues to be associated with the retailer, but more likely it is a function that people cannot clearly see the path out of the predicament the chain currently finds itself mired in. That is not a surprise, given the high stakes poker that has begun between PetSmart’s private equity owners and the company’s debt holders. After spinning off 36.5% of Chewy, PetSmart’s debt prices improved (see recent charts here), seeing the move as more benign than anticipated. However, the other lens through which it can be viewed is the asset stripping provides more fuel for a public listing of Chewy, the proceeds of which could be used to repurchase debt at a steep discount. The more salient question is whether the financial engineering machinations gets in the way of forging ahead with a new operational strategy. My assumption is that J.K. Symancyk would not have joined unless he felt he could begin effectively addressing PetSmart’s challenges against this backdrop.

With respect to that new operational strategy, the same general principles are commonly cited among third parties. First is the need to integrate Chewy on both the back and front end, enabling PetSmart to fully leverage the assets it acquired over a year ago. My long held assumption was that the only way to wring the benefits out of the transaction was to fully integrate the two businesses, but that any contingent consideration owed to Chewy stakeholders was going to inhibit that effort in the near term. With Ryan Cohen having now departed and likely any earnout potential lost, work can now begin in earnest. This includes both warehouse and inventory rationalizations, but also the technology work to enable Chewy to leverage PetSmart’s infrastructure to offer pick-up in store and delivery from store for added convenience. Additionally, PetSmart needs to implement technology strategies that enables them to have a complete picture of their customers across all their sales platforms, leveraging this knowledge to drive customers to the transaction venue that offers the most desirable outcome, whether that is tied to revenue, profitability, or retention.  A continual race to the bottom through escalating customer acquisition seems pointless to most.

The second most commonly discussed action is to change the mental paradigm as it relates to both suppliers and end customers. Historically, major pet specialty has viewed themselves as the customers advocate and educator, despite having a transient workforce. When costs were cut post take private this included spend on training these resources. As the primary retailer of pet food and supplies, major pet specialty retailers controlled access to product and the promotion of the product to pet owners. In this role, they leveraged their position to extract value from the brands to support their financial profile. While brands consistently complained the cost of doing business in these channels was onerous, it what was necessary. That is no longer the case, brands can find alternative sources of growth online and through professionalized chains. Therefore succeeding going forward for PetSmart requires a change to this paradigm. Pet food and supplies are now widely available and owners pursue product discovery in a variety of ways, not necessarily tied to the physical sale location.  This means finding a way to embrace emerging brands and offering them a financial paradigm that enables a win-win scenario, as opposed to offering them a loss of 10% – 15% of margin in addition to seeking meaningful promotional dollars.  This would likely involve trusting that these brands undertake the necessary effort to build a customer following and driving them to PetSmart’s sales venues, crediting them for marketing spend that drives awareness and transactions.  This trust is going to be necessary if there is going to be success in driving ROI for brands that might bring traffic and loyalty.

Finally, several people commented on the need for greater transparency — in everything they do for everyone they touch. This goes right down to the mission and speaks to culture. PetSmart has been historically insular, and that was successful until the access paradigm flattened and the knowledge paradigm multiplexed.  PetSmart need to seek to create relationships as opposed to adversaries.  Easier said than done, but trying will help mend fences.

The net of all of this is that there is work to be done.  Failure may lead to a consolidation of these boxes, while success will elevate the entire industry.  Mr. Symancyk and Mr. Coughlin, we wish you both well.  We all need you right now.  However, we should not fear that brighter days are ahead.  The industry has successfully navigated challenging periods and companies including Walmart and Target found their way against a similar backdrop, though they both had more levers to pull.  Collectively, we have to have faith.

/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.

 

 

 

Blue Buffalo MashmellowsBlue Buffalo has been one of the greatest disrupting forces in the pet industry post-recession. Against a meaningfully competitive backdrop in pet food, Blue grew a $1.25 billion revenue brand that became the industry’s most meaningful driver of purchase traffic and transactions both in store and online. The company’s meteoric rise defied all known industry convention, and the brand gained a stranglehold over its retail partners, most of whom were used to dictating the terms of engagement. Blue even broke the cardinal rule in pet specialty, launching into FDM.  All of this culminated in the sale of the company to General Mills for $8.3 billion dollars. As I have said previously, Blue played the game, and played it well.

For some, this is where the story will end, as a real-life fairy-tail. However, for most there is another chapter, and when one digs deeper, the conclusion is that this may not all come up aces, creating repercussions for many that follow. While few can dispute that Blue Buffalo adroitly navigated a complex equation over the past ten years, growth and perception have masked some stark realities.

Consider first, while FDM sales are Blue Buffalo’s current and future narrative, it still derives the disproportionate amount of its sales in major pet specialty, and major pet specialty is flagging when it comes to pet food.  Pet superstore market share, according to Euromonitor, declined from ~ 25% of sales in 2015 to ~ 21% in 2017.  This represents a three percent annual decay function.  At the same time, Blue Buffalo’s sales in pet superstores declined from 68% in 1Q2016 to 45% in 4Q2017, dropping in every sequential quarter.  However, Blue Buffalo’s sales in pet superstores declined almost 9% from 2016 – 2017, accelerating in 2H2017 vs. 1H2017.  All of this is pre- retailer repercussions of channel jumping.

The logical response to the above is to cite growth in online sales of both pet food and Blue Buffalo’s solution set. During the 2015 – 2017 period, online sales of pet food grew from ~ 4% – 5% share to ~ 13% – 14% share, and Blue Buffalo became the number one selling brand of pet food online. However, several factors need to be considered going forward.  First, online pet food sales are generally at a lower margin, due to both price transparency and price based competition.  All sales are therefore not created equal, though volume based discounts to major retail partners offsets some of this compression.  Second, the online channel is getting increasingly competitive through the introduction of housebrands (Tylee and American Journey at Chewy.com and Wag at Amazon.com).  Given online is where volume is growing, it is natural to expect Blue Buffalo would experience some market share erosion from brands competing more aggressively in the channel.  Finally, one has to consider the long-term impacts of direct-to-consumer pet food brands.  While small in terms of overall sales, Ollie ($17 million), The Farmer’s Dog ($10.1 million), NomNomNow ($13 million), and its peers have raised considerable amounts of capital to disrupt the category, likely taking with them consumers who purchased through third party ecommerce platforms.

Next, consider that most channel jumping corollaries have been accompanied by share erosion over time and sales velocity deceleration once initial pipeline fills are complete. When Hill’s began emphasizing the online channel in 2016, it experienced sharp declines in growth tied to two factors. First, was the natural latency in ramping up awareness and velocity in an adjacent channel. Second, was due to reprisals from major pet specialty retailers, who reduced shelf space and SKUs and/or relocated the product with respect to its orientation in the store, moving it to less desirable real estate. Additionally, when Iams jumped to FDM post acquisition, it initially began to grow market share (up ~ 2%) over a five-year period, a time where category competition was less pitched and online sales were virtually non-existent, before engaging in a steady decline (down ~ 6%) over the next 10 years.

Finally, we need to consider Blue Buffalo’s track record of innovation. While Blue Buffalo has certainly been innovative in its core product line as well as its marketing strategies to build brand awareness and consumer loyalty, its innovation has been muted in recent years.  I was reminded of this by a close industry friend. Brands (Earth Essentials), form factors (meat rolls), and ancillary products (cat litter) have all been launched and either under performed or been discontinued. Veterinary sales efforts have been virtually non-existent.  Finally, brand awareness outside the U.S. is low and would take meaningful dollars to ignite. There is a general pattern of large CPG companies buying innovative brands and losing that innovation DNA in the process.

The net of all of this should be cause for concern – your core distribution channel is under significant pressure, your growth channel is getting increasingly competitive, your mitigating actions can only sustain you for so long, and it does not appear likely you can innovate yourself out of the dilemma.  While this may seem dire, there is hope, but it is masked by uncertainty.  The ability of General Mills to retain management and ramp up innovation, as they did post acquisition of Annie’s, will be critical. How they navigate the landscape with the sales force is also important.

While only time Blue Buffalo’s flame appears to be burning a little less bright.

/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.

normalThe pet industry appears closer to arriving at a “new normal” that more closely resembles its human corollary.  The consumer has migrated to the center of the ecosystem, dictating the what, when, where, and how much, as opposed to having to select from a limited set of curated choices prescribed by brands and retailers. Brands are now closer to the consumer than physical retailers, thereby occupying more coveted intellectual real estate, and as a result are better positioned to influence behavior. Large channel dedicated physical retailers are left to compete on the basis of price, leading to a downward spiral in performance, which will persist until they can find ways to differentiate through merchandise mix and/or convenience.

The two largest drivers of disruption have been acquired, which represents an opportunity for the emergence of a new competitive landscape. As Blue Buffalo migrates further into FDM, it provides pet specialty retailers an opportunity to break away from their dependency on the brand for both customer acquisition and growth. Changes in Chewy.com ownership and management, coupled with PetSmart’s debt burden, is likely to usher in a more cost focused form of competition.

We believe these collective changes will manifest themselves in meaningful ways over time. Independent pet retail will return to its role of facilitating brand discovery and educating consumers, reducing dedicated Blue Buffalo shelf space – the manifestation of its conviction to place support behind channel exclusive brands. Major pet specialty will reorient its merchandising strategies around solutions, reducing dependency on brand blocks and ensuring a product mix that offers consumers a range of options and various price points (ultra premium, premium, premium value, etc.) and place greater emphasis on services to drive traffic and transactions. Manufacturers will look for opportunities to engage in direct sales with consumers to diversify channel risk and to offer end customers solutions that are customized for their pet’s situation.

The changing nature of competition will continue to drive industry consolidation. We believe large retailers will make acquisitions to add alternative store formats, service capabilities, additional direct-to-consumer channels, and supporting technologies – but lacking financial resources their options may be constrained.  In the case of PetSmart and Petco, we believe this could lead to a merger given the opportunity to rationalize costs. Leading food brands will look for ways to get closer to the customer, either through technology or acquisitions that have distribution outside of traditional retail. Product companies will look to acquire solutions that can diversify their mix and add capabilities that will enable them to address emerging channel opportunities.

To read about our complete set of industry insights, contact me to receive a complete copy of our Spring 2018 Pet Industry Report.

/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.

/

 

 

 

Next Page »