m&a


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.

 

Advertisements

wall2I know what you are thinking.  I’m not talking about that wall.  I’m talking about this wall, the one Blue Buffalo, post-acquisition, seems hurtling towards.  Recently, we received further evidence that the risk of gravity catching up with the brand may be more likely than not.

General Mills released first quarter earnings (note: for GIS, fiscal 1Q aligns with calendar 3Q), which include a decline in North American sales, across all sources of revenue, of 2.1%.  While pet food sales rose 14% in quarter, sales at retailers (sell-in) increased only 9%.  These numbers are optically appealing, but represent a slowdown of Blue Buffalo’s growth rate pre-acquisition.  Also factoring into the equation was that the quarter had an extra selling week, which, when considered, means the business grew mid-single-digits.  Adding to the woes was reported input cost inflation as well as continued expenses associated with the new production plant.

To rewind, prior to the acquisition Blue was growing at a healthy clip, delivering quarterly sales growth of 18.4% in 3Q17 and 14.2% in 4Q17, the two quarters immediately preceding the acquisition. The company had effectively explained away the performance malaise that it is experienced in 1H2018 (7.9% in 1Q and 2.8% in 2Q), as a failure on behalf of major pet specialty to execute and leveraged that narrative to move a subset of their product line into FDM. The size and timing of the FDM rollout masked issues with the company’s business in several ways.  Of greatest significance, it gave the company a greenfield revenue opportunity which juiced their comps, making comparisons between historical and current periods to be akin to comparing apples and oranges.  However, the size and scope of the rollout, in combination, with the stealth nature of the lead-up to launch, obscured the fact that the initial velocity growth was heavily aided by promotions and discounts.  It’s quite common for this to be the case, but it was also not something Blue Buffalo drew out in its narrative to the street.  It’s notable, the brands data, as tracked by IRI in the weeks leading up to the deal dropped off the table, declining from 13.4% to 1.9%.

What was unknown at the time of the deal, was what impact, if any, retaliatory action taken by retailers would have on the business.  Petco and PetSmart sales and traffic, have continued to flag.  However, PetSmart has completed a major reset of its consumables aisle and its bond prices have appreciated materially, in part based on 22% sales growth at Chewy.com. Additionally, based on my store visits in various geographies ranging from major coastal cities to smaller towns in middle America (certainly not scientific by any means) there is some de-emphasizing of the brand in terms of placement, promotion, and mind share.

Further, post deal, Amazon launched its own private label pet food, Wag. While the Wag rollout, has not been seamless, the product generally enjoys 4-star reviews from an increasing number of verified purchases. Approximately 50% of customers have given the product 5-stars on both the 5-lb. and 30-lb. bags, though the 5-lb. bags experienced some problems with product delivery during the initial rollout, according to One Click Retail.  Amazon experienced 30% growth in pet products sales in the first half of 2018.

What the future holds here is unknown, but the bloom seems to be off the bull case. Analysts have taken their estimates of Blue Buffalo organic sales down to mid-single-digits from low-double-digits, despite management re-affirming the sales guidance for the higher amount.  The brand starts to lap the initial FDM rollout in the back half of the year, so comps get tougher.  Further, management stressed that it sees opportunities to repair their relationships with Petco and PetSmart, enhance in-store execution, and increase visibility of channel exclusive innovation in pet specialty. Given that the leadership of major pet specialty chains learned about the FDM rollout just prior to the general public, I am not sure enough time has passed to heal those wounds, though both entities now have new CEOs. Finally, while the China trade war tariffs are not impacting food, they are touching a broad range of pet products, which may reduce store visits, especially in major pet specialty.  This should factor into the calculus.

While Blue Buffalo may have a softer landing than we expect, it is clear that the stakes for General Mills are already higher than anyone expected them to be. How high can a buffalo jump?

/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.

 

 

 

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.

/

 

 

 

blue bffThese things always happen when you are on vacation.

Just prior to my departure on family vacation, I got a call from a reporter passing along a rumor that Blue Buffalo was going to be acquired.  I hear about non-existent pet food M&A rumors week in and week out.  The past month has been no exception.  Most of it is smoke, without the fire.  My response to the reporter — who has $8 billion to spend? On the plus side, I had the price pegged.  Kudos to her for getting the beat correct.

In reality, there are many large corporations with access to those sorts of funds.  Mars had recently doled out $9 billion for VCA after all, and Nestle has a little over $8 billion in cash on its balance sheet.  Apple has $77 billion of cash on its balance sheet, but they tend to favor in house innovation.  The key point is that major pet consumables acquirors have focused largely on product acquisitions to fill portfolio gaps as opposed to transformational M&A.  After all, Purina could have easily acquired Blue Buffalo for $3 – $4 billion prior to its public offering and the two sides could have avoided a lot of subsequent legal fees (further evidence that lawyers always win). I don’t see any of them coming in with a topping bid — Blue in the hands of General Mills is less formidable than Blue in the hands on a proven competitor.  That said, Blue in the hands of General Mills might make General Mills a more attractive takeout target for Nestle.  After all we are likely going to see more mega food M&A as these players grapple with changing operating dynamics for global food companies.

Food companies buying into the pet space is not unprecedented.  The J.M. Smucker Company acquired Big Heart Brands for nearly $6 billion back in 2015.  When Merrick Pet Food was sold, a major food company was the cover bid when Nestle acquired the business.  That said, I don’t see this as establishing a pattern whereby food companies quickly seek to align themselves with pet food brands in an effort to top one another.  Rather, I expect food companies will be more open to kicking the tires in auction processes but that acquisitions are likely to be focused only on true market leaders, consistent with what we have seen thus far.  That said, major food companies could offer pet food leaders unprecedented valuations, given their propensity to pay 5.0x – 6.0x revenue for the growth associated with disruptive brands (e.g., Rx Bar, Daiya, Krave, Suja, to name a few).

Finally, we have to give Blue Buffalo kudos.  They very effectively ran the business into a highly attractive exit (6.3 x Revenue / 25.5x EBITDA).  Twelve months ago, the company seemed stalled.  Growth was clearly flattening due to performance malaise in PetSmart and Petco, who were both undergoing inventory deleveraging, consistent with what was happening in broader retail, at a time when traffic and transaction metrics in these boxes were sagging.  The launch of their veterinary product line, while conceptually interesting, would have a long lead times in terms of sales – veterinarians seem to enjoy the status quo.  Thus, the jump to FDM, made possible by the weakness in major pet specialty, breathed life into the equity.  The company’s stock climbed 40% during the past six months, despite the fact that the FDM roll-out lagged expectations and sales were highly incentivized through discounts and promotions.  All we can say is well played and congratulations to the Bishop family and the Invus Group.

What will surely follow this acquisition is a public airing of grievances about a brand selling out and trip down memory lane for the industry recalling times where brands had values.  This will not be the last time this record is played.  However, the pet industry has been professionalized over the past 10 years and operates with a profit motive, we should have no expectations that capitalistic intentions will be subjugated in an effort to adhere to historical edicts. Rather mourn the transparency again lost through a publicly traded pet company gone private or having been acquired.

/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.

happy faceThe pet industry, for all its interest and fanfare, is a data starved segment of the consumer landscape.  The industry lacks for data solutions that would provide a dynamic understanding of industry, channel, and company level performance.  Instead, operators and investors are left to rely on summary level government reporting, annual data releases from industry associations, specialized proprietary data reporting from industry participants, and select data points from publicly traded companies, that when put together provide a general understanding of industry growth and direction.  As the pet industry further expands into the food, drug, and mass channel data should improve, but this will take time.

As we wait for APPA data to be released at Global Pet Expo in March, we thought it might be useful to use the other available data sources to paint an industry picture ahead of the tradeshow season.

  • Growth:  The pet industry continues to grow at levels in excess GDP (2.3% in 2017).  Pet related Personal Consumption Expenditures, measured by the Bureau of Labor Statistics posted 6.5% growth in 2017, driven by 9.7% growth in Services PCE.  Product PCE growth was more muted at 4.2%.  The industry experienced a deflationary trend in pet food of 1%. Services inflation continued at just short of 2%.  The variance in PCE versus APPA growth figures has been expanding, meaning the data sets are getting less correlated, for reasons that are unclear. However, based on the underlying PCE data it is safe to assume that growth was steady in 2017, but it is unlikely that we returned to 4%+ growth.  Continued deflationary pressure in pet food is a long-term headwind, which services inflation could constrain pet population growth for cash starved Millennial pet owners.
  • Economic Tail/Head Winds: Growth in the pet industry is, in our experience, tied to three economic factors.  First is employment.  People who are employed are more likely to have income to afford a companion animal and a living situation that would allow for pet ownership.  Currently, unemployment is at a structural barrier, which has been good for pet ownership growth over the past 12 – 18 months.  However, it seems the industry is getting as much benefit from the employment situation as one can expect. Unemployment has also declined due to people leaving the workforce, meaning the benefits of full employment on the pet industry in recent years is somewhat overstated.  Second, is disposable income.  The cost of owning a pet continues to increase. According to the APPA Pet Ownership Survey 2017 – 2018, the annual cost of owning a dog is greater than $1,500.  Some surveys put the lifetime cost at over $25,000.  To afford these costs, pet owners need disposable income. Yet growth in disposable income has been tepid over the past over the past 24-months. The recently passed tax reform should benefit income trends, but potentially at the expense of inflation. Psychologically income trends should be healthy for pet ownership as consumers tend to overlook cost inflation in the near term. Third, is home formation.  When a family unit purchases a home, it is often a catalyst for purchasing a companion animal.  Low interest rates and sustained economic growth have led to a strong demand for housing, despite concerns about affordability given current home prices.  Home formation trends should continue to benefit the industry, though rising interest rates may cause home formation trends to taper.
  • FDM Growth: The launch of Blue Buffalo in the mass and grocery channel is a game changer for the industry.  A myriad of other brands are launching outside the pet specialty channel, such as Nutro in Walmart, and we expect PetSmart and Petco will be offering a competitive response in their next reset.  The issue is that PetSmart and Petco cannot offer brands the same growth trajectory they have enjoyed in the post-recession period.  Quite simply, consumables availability has become ubiquitous; consumers are simply choosing a transaction venue based on convenience weighted cost.  The consumer relationship is with the brand, not the retailer.  Even with only six months of Blue Buffalo exposure, which has slightly underperformed and been aided by significant discounting and promotional spend, in 2017 pet consumables growth in FDM is estimated to have exceeded that in pet specialty — 2% compared to 1.5%.  This bodes well for growth among brands with existing FDM shelf space, though the ability to hold that space going forward is going to become increasingly competitive.
  • Ecommerce Growth Continues:  In 2016, industry analysts, based on very limited information, estimated that ecommerce penetration in the pet industry would eventually grow to 20%.  At the time penetration was estimated to be +/- 5%.  According to Amazon, they estimate ecommerce penetration in the pet space will reach 18% in 2018, meaning the industry will almost certainly breach 20% and do so in 2020.  Amazon recently stated that they viewed the industry as a “unique and highly valuable category” and they intend to make growing their online sales of pet products a 2018 business priority.  Additionally, the proliferation of direct-to-consumer pet food brands (Ollie, JustFoodForDogs, etc.) and sales platforms (Petnet, PetCube), many of whom are now venture backed, will give the broader sales channel additional tailwinds. We also see aging pet parents as a further opportunity to grow pet ecommerce. As consumers get mobility constrained they are increasingly turning to online venues for product acquisition. We believe they will do so with their pet spend, especially pet medications. The unanswered question is how MAP pricing might impact online channel sales.  Ecommerce has grown substantially based on its pricing advantage.  As that narrows, it would logically impact purchase intent unless it offers convenience benefits that outweigh the alternatives.

For the past two years, we have talked about an industry in flux.  While we believe the industry continues in a state of transformation, we think we are through the most volatile phase of the change cycle.  The truth is there is some stable thematics — steady growth aided by modest tailwinds, customer first retail, and dissolving incumbent paradigms.  Companies that can build a salient customer value proposition and innovate stand to do just fine against this continually evolving backdrop.  Those that rely on historical paradigms as a means of competitive advantage seem more likely to get run 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.

 

 

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.

 

Next Page »