pet industry


“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.

 

 

 

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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.

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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.

 

 

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

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

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

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

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

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

/bryan

Note: This blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change. While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.

 

 

 

 

 

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

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

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

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

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

/bryan

Note: This blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change. While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.

 

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