investment banking


dylan“The times they are a-changin” – Bob Dylan

Industry analysis is easy when everything is moving up and to the right.  When market conditions are such that a rising tide does not float all boats, it is harder to draw conclusions that are applicable to a broad set of market participants.  The pet industry now finds itself in an operating environment where company execution will most likely determine the winners in this phase of the cycle.

The  pet industry has hit a transformative moment.  The humanization movement, though it continues to be cited regularly, has achieved its point of arrival — pets are treated like members of the family.  Kids today only know of pets as their equal.  As a result, there are no longer large cohorts of pet owners who are available to upgrade.  At the same time, younger generations now represent the largest segment of pet owners, and they think and act differently than their parents generations.  However, they also lack the same disposable financial resources, meaning they have to make tradeoffs today.

These realities are changing the power paradigm in the category.  The pet consumer is in the ascendancy at the expense of all others who participate in the supply chain.  Today the pet owner is able to choose among channels and brands based in their personal values.  Effectively product access has been commoditized. Consumers are now able to dictate to manufacturers what attributes they seek, not vice-versa.  In the future this paradigm will move across the sub-categories within in pets to redefine who wins and who gets left behind.

When market dynamics shift with significant force, it usually leads to elevated levels of industry consolidation. The 2015 – 2016 period was the greatest period of consolidation the industry has witnessed, and we expect that will continue.  With that as a backdrop, we present our pet industry capital market themes for the Spring of 2017:

  • Major Pet Specialty Franchises Struggling. It was not long ago that PetSmart and Petco could do no wrong. The major pet specialty chains were posting SSS comps that were the envy of retail analysts; the gap between the two biggest pet retailers and the balance of the industry seemed vast and unbridgeable. How quickly things can change. Over the past three years, major pet specialty has watched its franchise erode. Independent pet retailers out-serviced them; FDM retailers poached manufacturers and offered customers a better cost value proposition; and ecommerce providers out-priced and out-“convenienced” them. In 2016, we estimate that PetSmart comped down 3% – 4% (mature stores) and that Petco comps were flat to down 2% (mature stores). With their loan packages trading below par, both companies are under pressure to innovate. Petco’s turnaround strategy appears focused on private label and house brands.  PetSmart is focusing on ecommerce, as evidenced by its acquisition of Chewy. What is clear is that there is no silver bullet for what ails them. Expect things to get worse, before they get better as brands begin to feel pressure to find other sources of growth and as Petco and PetSmart refine their respective strategies.
  • Treat Acquisitions are Focused on Sustainable Competitive Advantage. The treat space has been actively consolidating as manufacturers compete for the discretionary portion of the pet owner’s shopping basket. However, what is rapidly changing is the attributes these consolidators are seeking in their acquisition targets. Deep customer relationships built through an emotive brand are now the table stakes.  Buyers want some form of competitive advantage that has greater barriers to justify prevailing multiples. The acquisition of Salix Animal Health (Spectrum Brands) and Whimzees (WellPet) are examples of this in practice. Other major pet treat IP players, including Petmatrix, are most likely to get snapped up by the large industry players. This will in turn create an opportunity for private equity to acquire mid-stage brands and invest in building these attributes.  The phrase “innovate or perish” has never been truer than in the treat space today.
  • Digital Pet Age Has Arrived. Historically, pet industry incumbents have been dismissive of the potential for category disruption through technology innovation. Major pet retailers were not well situated to sell the solution set; legacy pet ownership generations, the Baby Boomers, did not understand it; market leaders were not organized to innovate into the category. As a result, Chewy, A Place for Rover, Bark Box, Whistle, and their peers rose up to fill the market void, creating substantial shareholder value as pet ownership dynamics shifted to favor the digital generations. In 2016, $154 million dollars was invested in 46 pet-tech deals, a pace that has been increasing since 2012. Even in its nascency the pet tech movement is showing signs of making a lasting impact. As Millennials further outpace Baby Boomers in terms of pet ownership, digital will gain more momentum in the pet category. This realization will leave strategic buyers who have not made a tech play scrambling to play catch-up.  This trend augers well for acquisition valuations in this sector of the market.
  • Expect M&A Transaction Velocity to Remain High. Since 2014, transaction bias in the pet industry has been towards M&A. 2015 – 2016 was the greatest period of industry consolidation as measured by transaction volume. As company’s reposition themselves to compete in a rapidly changing landscape, we expect elevated M&A activity to continue in 2017. Market leaders will seek to plug remaining portfolio gaps while small and midsized players will be looking to exit at the tail end of the cycle. While acquisitions may be plentiful, there will also be a flight to quality with differentiated assets – brand, scale, channel (direct or proprietary) – garnering premium valuations, while those lacking it face commodity multiples. If the U.S. implements tax reform, volume should spike across asset classes providing private equity a unique opportunity to buy into the category.  Financial buyers will be banking on these assets to carry them through the next recession.

As always, our full pet industry report is available by request.

/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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nickelLast week, Blue Buffalo filed an amended S-1 providing an expected price range for its sale of 29.5 million shares of common equity, with an overallotment allocation of 4.4 million shares.  The company expects to raise in excess of $500 million in its IPO and will trade under the ticker symbol BUFF.

Based on an expected valuation range of between $16-$18 per share, at the mid-point ($17/share) Blue Buffalo would have an equity value of approximately $3.3 billion and total enterprise value of over $3.5 billion based on net debt of $241 million as of the March 31, 2015. This would imply a valuation of just over 18x trailing twelve months Adjusted EBITDA (as defined by the company) as of March 31, 2015.  The above stated range fell below my expectations in terms of anticipated value.  A few factors are likely to be weighing on institutional investors’ minds in light of a more complete analysis of the company’s S-1.

  • Too many eggs in one basket.  Companies that are subject to customer concentration issues generally receive discounts in the capital and M&A markets. In the case of pet food the customers are the retailers.  As disclosed in the  S-1, 73% of Blue Buffalo’s sales were to national pet superstores, PetSmart and Petco.  Based on my personal analysis and those of third parties I consulted, collectively we estimated that PetSmart likely accounts for between 66% – 75% of Blue Buffalo’s national pet specialty volume. This would imply that PetSmart is responsible for approximately 50% of the company’s total sales volume. This puts Blue Buffalo is in a more complex position vis-a-vis a move to mass.  While we think such a move for Blue Buffalo is inevitable, it may complicate the process or drive up the cost.  Clearly, PetSmart and Blue Buffalo need each other, for now. That said, last week PetSmart announced, what many had already known, that Natural Balance would now be available throughout their store network and online properties. I view Natural Balance as a perfect comp for Blue Buffalo from a product positioning standpoint. If PetSmart is able to obtain access to Merrick it would add a second leg to that protective stool.
  • Share and share alike, not really. According to Blue Buffalo’s own market segmentation analysis, in 2014 it owned a 34% share of what it terms the “Wholesome Natural” segment, which it defines as dry dog food using only natural ingredients (based on AAFCO), that have whole meat or meat meals, with the animal protein type clearly identified as their principal ingredient.  These traits are distinguished from the “Engineered” segment, which are characterized by the fact they typically do not contain whole meal or meat meal as their principal ingredient and/or they use lower cost proteins (by-product meal, corn/wheat gluten) and contain lower-cost starches (corn, wheat, fractionated grains). Setting aside the current supply chain issues as it relates to Blue Buffalo’s self classification, this nuance allows Blue Buffalo to inflate its market share. While we can appreciate the desire to isolate one’s difference in terms of ingredient panel and adherence to certain standards, this segmentation allows Blue Buffalo to exclude a meaningful set of Brands/SKUs from their market share calculation, thereby overstating the company’s position.  Talk to a seasoned pet food merchandiser and they will tell you this is not how they, or their end customers, think about the market.  I also note that several of the of brands in the Wholesome Natural segmentation analysis are either overstated or understated based on what I know to be their 2014 sales.  This simply speaks to the imprecise nature of the analysis.
  • About that lawsuit. Blue Buffalo’s S-1 makes it clear that they are responsible for directing their suppliers to purchase the ingredients they approve, from the people they approve, based on the terms they themselves negotiate.  Yet somehow Blue seems to be getting a free ride as it relates to their recent sourcing issues. However, several people I have spoken to recently expressed greater conviction about the probability of a countersuit from Wilber Ellis and/or a Purina victory.  If Purina does in fact play this out and wins an injunction against Blue Buffalo as it relates to its ingredient claims, it would undermine the Blue Buffalo story, in addition to having meaningful financial implications.  I note that the company has not set up a litigation reserve due to the fact that the lawsuit is in the early stages (as self defined), it is unclear the damages the plaintiffs are seeking, and the fact that Blue Buffalo maintains its counter claims.  It seems quite reasonable that institutional investors are factoring potential losses into their valuation models.

Notwithstanding the issues above, we expect Blue Buffalo to have a successful IPO later this month and for it soon to be trading at an enterprise value in excess of $4 billion.  Even a modest first day pop would get the company there. Get your popcorn, this should be fun to watch.

/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.

fresh2Earlier this month, pet food marketer, Freshpet pulled off a successful initial public offering, raising $156 million. The company, which generated $74.5 million in sales and $23.1 million in losses for the 12 month period ended June 30, 2014, priced its IPO at $15, higher than the anticipated $12 – $14 range. The stock enjoyed an opening day “pop” of approximately 27%.  Freshpet occupies some pretty attractive real estate in the form of 12,500 branded refrigerators.  Those units include distribution (as of September 30, 2014) in Wal Mart (1,607 stores), PETCO (1,364 stores), PetSmart (1,306 stores), Target (1,157 stores), Kroger (972 stores) and Whole Foods Market (226 stores).  The company was backed by Mid-Ocean Partners, a New York based private equity fund, who, for all intents and purposes, salvaged the company in 2011 after it burned through the original undisclosed investment it received from Tyson’s Foods, who is the primary protein supplier to the company and remains a minority shareholder.

At is current enterprise value of $676 million (November 24, 2014), Freshpet’s public equity trades at 9.1x multiple of revenue.  In contrast, publicly observable acquisition multiples for the most attractive pet food assets have historically topped out at 3.7x revenue (Del Monte Foods / The Meow Mix Company, March, 2006). This convergence of circumstances has led many too ask, often using colorful language, how the market might justify such a premium. Here is my response:

  • When a Number if Not the Number. When a company goes public, there is a collaborative process to create positive momentum for the stock price.  The supply chain has the company selling at a discount to the underwriter who in turn sells at a discount to institutional investors and sprinkles some of the well connected general investing public. Those not in this inner circle who seek to access the stock are forced to bid it up in an effort to acquire a position.  The resulting supply/demand imbalance generally buoys the stock price for some period, ideally until fundamentals catch-up to the price. In the period immediately following a public offering, there is limited downward pressure, outside of broader market fundamentals, on the stock until it posts earnings or the lock-up period expires. As such, the prevailing price is simply the price you can buy or sell the stock for right now rather than indicative of the long range, or fair-market valuation of the company.  You can see other examples of this trend in practice with other recent pet related IPOs Pets-At-Home Group (LSE:PETS) and Trupanion (NYSE:TRUP) both of which, after a brief honeymoon period wherein the stock was supported by the supply/demand imbalance, have seen their multiples revert to the mean for their business respective models.
  • Don’t Underestimate the Pent-Up Demand. Retail investors love the pet space because, for companion animal owners, it is easy for them to understand. However, as we have detailed before, there is a lack of pure play pet companies, especially in the consumables category.  Investors can play the retail space through PetSmart (NasdaqGS:PETM) and Pets-At-Home, the health care space through VCA Antech (NasdaqGS:WOOF), Zoetis (NYSE:ZTS), and Neogen (NasdaqGS:NEOG), and distribution through MWI Veterinary Supply (NasdaqGS:MWIV). However, opportunities to invest directly in pet food and treats are non-existent.  The three biggest players — Purina (subsidiary), Mars (private), and Big Heart Brands (private) do not currently offer that opportunity. As someone who subscribes to the Peter Lynch theory of investing (i.e., go with what you know) I can see why retail investors might be willing to pay a premium to get access to the sub-sector given its growth profile, consolidation multiples, and recession resistant dynamics.
  • Compelling Business Attributes.  What is overlooked in the analysis above is the fact that Freshpet has some compelling business attributes that should be ascribed a premium price.  The company’s refrigerator inventory occupies some valuable real estate and the business model is such that retailers are unlikely to support multiple players, providing Freshpet with a first mover advantage and considerable barriers to entry once that cost is underwritten.  Ultimately, the company might become a toll taker whereby it is paid to host third party products in its established real estate. Also consider that Freshpet reports that its refrigerator units reach cash flow breakeven in 15 months. If we assume the company will generate approximately $81.6 million in sales this year (the most recent reported quarter (2Q2014) annualized), this translates to approximate $18/per refrigerator/day to support this breakeven point.  One and one half six pound tubes of the company’s Vital brand would essentially cover that daily revenue bogey.  As revenues scale breakeven per refrigerator will come more quickly, thereby enhancing cash flow.  Finally, the cost premium, while significant is not that far out of market for owners already feeding their pet super premium solutions.  Consider that an active 50 pound dog would go through at 28.6 pound bag of Orijen premium pet food (made by Champion Pet Foods) in 23 – 27 days (based on the brand’s feeding guidelines here) at a cost of approximately $3.75 – $4.25/day based on an in-store retail ring with sales tax.  That same active 50 pound dog would go through a six pound tube of Freshpet Vital in 4 – 5 days, at a cost of approximately $3.50 – $4.40/day. While the disparity gets larger with the size of your dog or as you indulge in more exotic Freshpet offerings, and the price variance is much greater versus mass market kibble, it is not all that out of line for a premium consumer.

The net of all this is that the current equity price of Freshpet is hard to fathom.  While the current price is being artificial inflated, the business has some operating characteristics that support a premium.  I won’t hazard to guess what Freshpet will be worth once the trading shackles are off, but we have seen examples of where companies that are pioneering unique niches in the food space can enjoy strong multiples from some time (see Annie’s).  However, invariably company performance will have to accelerate meaningful to support even the prevailing enterprise value.

/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.

no saleIn mid-August, bowing to pressure from activist investors, PetSmart announced that it would explore strategic alternatives, including a sale of the business.  Slowing sales growth and poor comps (same-store-sales, traffic, and average ticket) were cited by outside investors as a sign that management was not up to the challenge of turning around the leading independent pet retailer and creating shareholder value.  Additionally, Jana Partners, the antagonist in this saga, postulated that PetSmart would have many transaction opportunities given the liquidity in the private equity and associated debt markets as well as the potential for a highly synergistic combination with competition Petco Animal Supplies.

One month later and all quiet on the western front, for now.  Here is my assessment as to why:

  • Business Fundamentals.  Notwithstanding PetSmart’s leadership position, its business is struggling as core industry drivers shift.  The premiumization food movement has largely run its course in the dog category. Adding head winds is the fact that the pet population is not growing at a sufficient rate to bring new owners into the market who would be target customers for PetSmart’s and therefore present opportunities to sell them premium products that drive margin.  PetSmart’s latest food strategy — expanding its share of shelf dedicated to mass brands to siphon off customers who can then be converted to premium and super premium — will take time to play out.  Further, the company also faces market share erosion from independent pet specialty, online, and an increasingly organized conventional and natural grocery landscape. In order to incent shareholders into a take private or strategic sale, they will have to be offered a meaningful premium.  That a tall order given the current state of the business.
  • Private Equity Scenario Possible, but Unlikely. The concept of a leveraged buyout for PetSmart is intriguing to pundits evaluating PetSmart’s options, but the path to realizing this outcome is challenged. In round numbers the current equity price for PetSmart is ~ $71/share. Assuming it would take a 20% premium to entice shareholders to even consider a deal, this would value the equity of PetSmart at approximately $8.5 billion and the company at $8.8 billion on an enterprise value basis.  Assuming the largest equity check a sponsor would write in a mega-buyout would be 20%, this implies a take private would require just over $7.0 billion in debt and at least $1.5 billion in equity.  Based on current EBITDA figures, this would mean that PetSmart would be valued at 7.5x Debt / EBITDA, before considering the lease capitalization.  This seems significantly elevated in light of the uncertainty around growth and margin expansion.  A buyout at these levels would limit the company’s ability to make investments at a time where they are needed.  If Jana were to roll its equity the scenario becomes more palatable, but it does not solve the problem in its entirety.  Calls for looking at the equity premium based on the pre-Jana price will fall on deaf ears. Additionally, at these valuation levels a sponsor would likely be generating IRRs in the 15% – 20% range before accounting for execution and market risk.  I don’t see that return profile as being all that attractive given the risk. Third, while I could identify approximate 10 – 15 logical investors who invest in retail and could write, individually or in a two firm combination, a $1.5 billion equity check, nearly half of them are conflicted due to their investments in other pet specialty retailers or product providers.  Finally, see business fundamentals above.
  • A Strategic Deal Does Not Involve a Combination with Petco. After a private equity deal, the other most commonly cited outcome for PetSmart is a combination with Petco.  While that is conceptually attractive, its theoretically impractical if not impossible. A PetSmart / Petco combination would have ample synergies but it would significantly expand the physical footprint of the combined company, something that has been proven to be a bad strategy in this current retail environment. Second, Petco is facing the same business conditions that are negatively impacting PetSmart, meaning there is not a high likelihood that it is a sensible time for it to pursue a major deal.  That notwithstanding, a combination would likely extend the current PE syndicates ownership of Petco, which already stands at nine years versus a typical five year hold period. Next is the conundrum of who would manage the business going forward. Given that PetSmart is nearly twice the size of Petco, I don’t see current management going quietly into the night or sticking around in secondary roles. Finally, we would bank on significant anti-trust hurdles.  While in combination the business would have 27% of total pet product market share, the industry is defined by channel tied products.  Under a more narrow definition, the business would control 64% of pet specialty product sales with nearly 50% of their merchandising mix exclusive to one of the two banners. I see that as problematic.
  • There Really is Only One Logical Buyer. The only logical strategic buyer in my view is Tractor Supply.  Tractor Supply has an $8.2 billion market cap and is unlevered.  The company has experienced a 550% increase in its equity valuation over the past five years.  A key driver of this has been growth in their companion pet revenue.  A combination would help Tractor lessen its exposure to the farm segment of its business that has been challenged. Further, there is significantly less physical overlap between PetSmart and Tractor Supply, than there would be in a Petco combination scenario. Further, there would be significant supply chain synergies. That all being said, this would be a big swing for a company that does not have a meaningful acquisition history.  While sensible, I ascribe a low probability.

Net net, we believe the opportunity for a sale of PetSmart’s business to have passed. A deal remains possible, but we discount that prospect.  For shareholders sake it would be best if an outcome, sale or no sale, happens quickly so that management can return to running the business assuming it remains independent.

/bryan

Disclosure: I have a contractual relationship with PetSmart as it relates to their acquisition of Pet360.  I do not have any position in the stock of the Company, nor any intention of establishing a position.

CPO2In prior posts we have explored the notion that pet industry transaction volume is accelerating, and by all available measures in fact it is.  We have also delved into rumors of a public offering by Blue Buffalo later this year, noting the lack of public traded pure play pet companies. On Tuesday, Trupanion, a venture backed provider of health insurance for dogs and cats, announced it intended to file for an IPO on the New York Stock Exchange. We are also aware of at least one other company in the process of filing, and the concept of going public has been increasingly discussed in my industry coverage meetings.  This begs the question, are the public markets the most viable exit opportunity for a variety of midsized pet companies?

What is most notable about the Trupanion filing is the size of the company.  The business, of which I am a customer, disclosed that it was covering 181,634 pets as of March 31, 2014 and generated revenue of $83.8 million for the year ended December 31, 2013. On a quarterly basis, the company said it has posted quarter-over-quarter revenue growth since the first quarter of 2010. In the most recent quarter, ended March 31, the company reported revenue of $25.6 million, a 44% increase from the same period a year earlier.  However, also in the disclosure was the insight that the company lost $8.2 million in 2013 and has never made money.  That said, Trupanion has a huge intangible data asset, having covered a large population of pets for nearly 14 years; data that would be highly valuable to a variety of players in the pet supply chain. That notwithstanding, it is hard to believe that Trupanion, even at the most generous valuations, is going to achieve an offering price that results in a market capitalization that will motivate meaningful analyst coverage, given its size and earnings profile. Trupanion’s primary competitor, the larger Veterinary Pet Insurance Company, remains private. Other pet insurance companies have not met with favorable results in the public markets due, primarily in my estimation, size.

Often public filings are practical way of putting a “For Sale” sign on a business. Whether or not this is Trupanion’s intention, the mere optionality of a public listing would act as another catalyst for industry transaction volume.  Further, if successful it could pave the way for other midsized pet companies to explore the go public alternative.  Certainly companies such as Radio Systems Corp, Hartz Mountain (which is owned by publicly traded Uni-Charm Corporation) and United Pet Products (owned by publicly traded Spectrum Brands) would be well situated to tap the public markets for liquidity or acquisition capital. Further, brands such as Champion Pet Food, Dosckocil Manufacturing, Freshpet, Kong Company, Nature’s Variety and Merrick Pet Care would gain another exit alternative.

The analysis above separates the issues of “could” from “should”. While Trupanion has a clear path to a diversified growth plan through its data asset, the ability to sustain public company momentum for many of the companies listed above is limited. We have already questioned whether the much bigger Blue Buffalo can remain channel tied as a public company and it dwarfs most of the above listed companies in size and brand awareness.  However, more public pet companies would be good for the industry, which generally lacks a broad set of consolidators.

/bryan

 

 

 

 

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With the benefit of hindsight, we know the pet industry produced another solid year for performance in 2013, generating growth of 4.5%.  Industry revenues climbed to $55.7 billion, with growth exceeding forecast by 0.2%.  Revenues benefited from inflation of 1.3%, including food price inflation of 1.1%.  Growth was relatively uniform across the core segments with services (+5.0%) and veterinary care (+4.9%) leading the way.  While growth is projected to accelerate to 5.0% in 2014, we expect companies in the space to experience more widely divergent fates.  Our thesis is that the industry is undergoing structural changes that will result in stronger performance from the leaders and slower performance from the laggards.

Structural change is being driven by slower growth in the key drivers of performance over the past five years.  On the retail side, we are seeing smaller retail chains ascend at the expense of large pet specialty players. Notably, PetSmart same-store-sales slowed to 2.0% in 2H2013.  In contrast, PetSmart produced, on average, quarterly same-store-sales growth of 5.2%  from fiscal 2010 through 2Q2013.  Further, among top 25 pet retailers, 55% of box growth came outside of Petco/PetSmart in 2013, up from 41% in 2011. Finally, ecommerce growth in pet products is expected to accelerate from 35% in 2013 to 38% in 2014 as online pet venues both consolidate and proliferate.

Product manufacturers are also experiencing the impetus for change.  Looking for new sources of growth they are pursuing new channel strategies.  Big Heart Brands’ acquisition of Natural Balance Pet Foods and Nestle Purina PetCare’s acquisition of Zuke’s underscore this theme.  Notably,  the number of companies with pet specialty distribution that exhibited at Expo West (meaning they are looking for Whole Foods distribution) doubled in 2014. Additionally, the pending Blue Buffalo initial public offering is, in our view, a prelude for the brands entry to mass. Collectively, these companies will blur the lines between sales channels for pet consumers.

Net net, change is the air and change drives deal velocity. Below are the other key pet industry trends for 2014:

  • Prelude for Sale or a Move to Mass? In March, news leaked that Blue Buffalo Company Ltd. had selected underwriters for an anticipated 2014 initial public offering. When the company took a leveraged dividend in 2012, we predicted a sale or filing within three years. Blue generated $600 million in sales in 2013 and EBITDA margins are said to be nearing 20%. The company is approaching the size of The Nutro Company when it was acquired by Mars, Inc. While Blue has no lack of suitors, the purported asking price of $1.5 – $2.0 billion would be hard for even the largest companies to swallow in an environment where product recalls can rapidly erode brand equity. A listing would place a public sale price on the business, which may facilitate a transaction, but we think the more likely outcome is that Blue is headed to mass. The growth requirements for a public company are more than the pet specialty channel alone can support. If the brand jumps to FDM under its existing label, which we think is possible, you can add another brick in the wall of change.
  • Natural Leads Grocery Resurgence. Grocery has been steadily losing market share to pet specialty post recession. Simply put, FDM has been out-thought and out-merchandised. Lacking access to key independent brands coupled with limited selection depth, consumers have migrated their spend elsewhere. Grocery buyers and store planners did not recognize the strategic value in the pet aisle. However, this is changing. Major chains such as Kroger and Whole Foods have or are set to launch large pet assortments made up of staple, emerging, and house brands system-wide. Increasingly, brands are being built for the grocery channel or seeking to make the jump. Notably, the number of pet consumables companies exhibiting at Expo West doubled in 2014. Given its size and a lack of compelling incumbent brands, the pull of the FDM channel is strong. As the channel regains momentum outside of the natural and gourmet segments, it has the potential to change where consumers shop for premium and how brands are built.
  • Change Will Drive Deals. As manufacturers, retailers, distributors, and brands seek to align themselves with emerging realities, we expect to see increased deal activity. Deal velocity in sectors such as consumables should accelerate both acquisitions and private placements. Specialty retail, a sector whose transaction volume has been rather muted, should see a resurgence as leading micro-box and online platforms enjoy increased capital formation to expand their footprint or are acquired by mass and major pet specialty retailers seeking to expand omni-channel capabilities. For the most attractive properties, valuations will increase due to broader and deeper interest from buyers and investors.

Contact me for a copy for my report.

/bryan

Sources: APPA, Cleveland Research, New Hope Natural Media, Pet Business, Reuters, U.S. Bureau of Economic Activity

accross the pongI often talk about PetSmart and VCA Antech being proxies for the direction and health of the domestic pet market because of the transparency it provides us into consumer pet product and healthcare spend through quarterly earnings reports and third party equity research.  However, the U.S. market should not be viewed as a proxy for the global pet industry.  Absent the transparency we enjoy through publicly traded U.S. pet companies our view of global pet markets is tied to a reliance on third party data firms (Euromonitor, Mintel, etc.). While these firms produce excellent research, there is an inherent latency to their content, making it hard to measure real time performance.  A partial solution to that problem looks to be coming in the form of a public listing for the UKs largest pet retailer, Pets At Home, Ltd. (“PAH”).

Earlier this week PAH filed for an initial public offering on the London Stock Exchange.  The company plans to raise £275 million, giving PAH a valuation of around £1.5 billion. Thew company operates 369 retail stores, 246 small animal veterinary centers and 116 in-store grooming salons across Britain.  Estimates puts the company’s share of its home pet retail market at around 12%. The British market is highly fragmented, with PAH’s five largest competitors totaling just 225 stores combined. The company should have ample opportunity to grow both its retail base and veterinary services concept given these market dynamics. PAH plans to open an additional 131 stores, 400 veterinary clinics, and 200 grooming salons.  The company would be the only listed pet retailer in Europe.

PAH was acquired by a private equity consortium led by U.S. based Kohlberg Kravis Roberts & Co (“KKR”), which also owns Big Heart Brands, the Del Monte Foods pet products division, in January 2010 for £960 million.  At the time, the company had trailing twelve month revenues of £402 million and EBITDA of £70 million, resulting in an implied valuation of 2.4x Revenue and 13.6x EBITDA.  Bridgeport Equity, the seller, had acquired the business for £230 million in July 2004. Assuming a £1.5 billion enterprise value for PAH, it would imply that the value of the business has increased over 55% since being taken over by KKR and friends.

According to the recently announced listing, PAH had sales of £598 million for its year ending on March 28, 2013. The company said its revenue increased 11.7% for 40-week period ending on January 2, 2104.  Extrapolating this growth for the full year yields revenue of approximately £700 million, resulting in an implied valuation at listing of 2.14x Revenue. At the time of its listing PAH expects EBITDA of £110 million, resulting in an implied valuation of 13.6x EBITDA.  This would value PAH at multiples nearly two times those prevailing for U.S. leader PetSmart (1.0x Revenue and 7.3x EBITDA) despite the two companies having similar same-store-sales for the prior 12 month period.  While PAH has produced better topline growth over the past year versus PetSmart and enjoys a better profit margin profile due to its services revenue, this still amounts to a very healthy premium even after you account for the 17% decline in PetSmart’s stock since October 2013.

Whether PAH is overvalued or correctly valued is likely a debate with no end, the truth likely lies somewhere in the middle.  Either way, KKR has made a handsome return in a short period, even after you consider the company has reinvested over £100 million in growth initiatives.  However, the real value for those that follow the industry, will be increased data and transparency.  While PAH’s market capitalization will be approximately 37% of PetSmart’s, it should receive solid coverage from equity analysts with strong UK sales and trading networks.  That coverage will help us better pinpoint how the British pet market is performing, and ultimately enable us to draw parallels between a key foreign market and our own as well as the leading retailers in both geographies.

/bryan

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