valuation


sbmIf you have not seen the digital age in pet coming, it’s arrival has now been fully announced.  In the past year, a remarkable number of meaningful events have happened to punctuate it’s arrival.  Many of those events were likely to have gone unnoticed at the time, but in aggregate its hard to ignore.  Notably the past last year was book-ended on one end by Mars acquisition of Whistle Labs (March 31, 2016) and the merger of A Place for Rover and Dog Vacay (March 29, 2017) on the other end.  In between we have witnessed the rise of Chewy.com at the expense of Petco, PetSmart, and even Amazon; Phillips Feed Services acquisition of Petflow for the purpose of arming independent retailers for the digital pet race; and a total $154 million dollars invested in 46 pet-tech deals.

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Historically, it has been easy to dismiss the digital pet movement as a novelty act, confined to products whose addressable market was small and whose value proposition was narrow.  It’s true that many of the first generation products were poorly designed or over engineered, and generally expensive.  Further, the arrival of pet tech was slowed by the inability of core pet retailers to sell the solution set.  Simply stated, Petco and PetSmart were not well set up to educate consumers on why they needed to own a $200 smart feeder or a $150 remote treating system.  Further, technology retailers, such as Best Buy, knew very little about the category and were therefore unable to effectively merchandise a pet technology set.

Despite these impediments, it’s hard to argue with the results of the market leaders.  Whistle Labs was acquired by Mars for $117 million, representing a high single digit multiple of revenue.  As we detailed in our last post, Chewy.com has achieved over 50% market share in online sales and anticipates 2017 sales of $1.5 billion. Finally, A Place for Rover (Rover.com) was valued at more then $308 million its $40 million Series E financing closed in October 2016.  Rover also announced that it acquired its primary domestic competitor Dog Vacay in a stock-for-stock transaction. In our discussion with other pet technology companies many of them appear poised to deliver strong growth and financial results in 2017.

The collective impact of these digital pet companies and their ascendancy in terms of industry importance can no longer be ignored.  While the negative comps produced by both Petco and PetSmart in 2016, and the recent deterioration of their leveraged loan valuations, can be attributed to a variety of factors, it’s hard to argue that the rise of Chewy.com and the lack of traffic drivers attractive to the Millennials, and subsequent generations, such as pet technology products, has been a key contributor.  The fact that the vast majority of pet food brands are available online, making their availability more commoditized, and not an influencer of store visits, is exacerbating the problem.  Further, Rover and DogVacay have served to disrupt the discretionary services segment of the market, for whom Petco and PetSmart (both boarding and grooming), along with VCA Antech (boarding) and Banfield Animal Health (boarding),  are the most established players.  Prior to the take private, PetSmart generated $750+ million in services revenue annually, accounting for ~ 12% of revenues.

The ability of incumbent players to catch-up digitally is limited.  Earnings based companies are hesitant to acquire companies without an established track record of profitability given their valuation paradigms consist of multiples of EBITDA or contribution margin.  Mars benefited from its private nature when considering the acquisition of Whistle.   A subset of major players we have spoken to are waiting around for these companies to stumble in hopes of acquiring them at bargain prices.  While companies like Chewy.com have “scraped paint” in the past, we see this strategy as unlikely to succeed in the near to medium term.  Those who are called to action, but partially paralyzed by their valuation paradigms will seek to partner.  Whether creating these bridges will be enough to move the needle or insulate them from risk remains to be seen.

/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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I recently had the opportunity to speak at the First Annual Pet Food Investor Forum, sponsored by Susquehanna  Financial Group. The conference was primarily geared towards public equity analysts and it was interesting to see this class of market observers collectively hone in on a few key questions that were affecting the public equities in the pet food sector. Among those questions, one that came up with the greatest frequency was the prospects for Blue Buffalo to penetrate the veterinary channel.  The array of speakers were almost universally asked to proffer our views on this issue, as it is central to the next leg of the Blue Buffalo growth story.

Since Blue Buffalo announced its intentions in the professional channel, I’ve held the belief that it was likely going to struggle to gain penetration quickly. My view was grounded on two basic premises, neither of which speaks to the quality of their solution set, of which I have no knowledge.  The first is that this channel has some very strong incumbents, who have a long history with the channel and its practitioners. The vets I have spoken to suggest that is going to be hard to overcome given how hard it is to create access. Second, was that building sales in the veterinary channel takes time and requires fundamental research that Blue Buffalo might have a hard time producing quickly, unless they had started this process long before the commercialization efforts came to light. Blue has obviously overcome significant hurdles in its history to become a near $5 billion market cap company, and there is reason to believe that if you give them a long enough time horizon that they will make inroads. I only see it as a question of magnitude.

However, last week something caused me to begin to rethink my paradigm.  Lawyers in the State of California, on behalf of California, Minnesota, Georgia, and North Carolina filed a class action lawsuit against the major players in prescription pet food (Mars, Nestle, Hills) and a subset of their primary distributors of their prescription products (Banfield, BluePearl Vet, PetSmart).  The lawsuit contends, among other things, the following, (a) there is nothing unique in the ingredient deck of prescription pet food to differentiate it from non-prescription pet food, (b) the marketing, labeling and sale of these products is deceptive, and (c) the defendants are engaged in anti-competitive practices to sell these solutions at above market prices to consumers.  If you want to read the full complaint it is here.

While I am not a lawyer or a Holiday Inn Express customer, at first blush, it would appear this case is good for Blue Buffalo’s potential franchise in the veterinary channel.  If the plaintiffs were to win their case, it would likely open up the channel to competition, giving Blue Buffalo a seat at the table. Further, if successful, the case could erode the brands of incumbent players in channel, driving faster penetration and sales of Blue Buffalo’s prescription solutions through consumer requests. That said, Blue Buffalo would also have to deal with any implications of the lawsuit given it operates in the category. However, when one digs deeper, it becomes apparent that this case is far from a done deal.

Let’s first deal with the issue as to whether prescription diets should be allowed to be labelled as such.  It is correct that prescription pet food diets do not contain controlled substances and are not manufactured under purview of the FDA. However, they are formulated for specific conditions and feeding them to an otherwise healthy pet is likely, over time, to have consequences. This is what allows the manufacturers to call them “prescription”.  This is merely a labeling issue, and if changed would not make feeding them under general conditions advisable. Further, I don’t think this makes them deceptive by definition. The marketing of these solutions generally indicates they were formulated to specifically treat a condition, not that they contain a drug. These products recommend you only feed them under the supervision of a veterinarian, in case they don’t address an issue that needs addressing or there are negative side effects of feeding them. Personally, I don’t see how labeling them prescription harms consumers and in fact the prescription protocol is, in most cases, necessary to protect pets from self-diagnosis by their owner and improper application. That all being said, these products could be labeled differently and if we adhere to a standard that the label prescription only covers controlled substances a change should be made. Whether that impacts anything beyond that does not, on the surface appear to be all that damaging.

The question of whether they are “different” is where things start to get muddy.  What defines a prescription diet is the inclusion of certain vitamins and minerals that are scientifically proven to help address a specific condition — kidney, cancer, obesity, skin, digestive, etc. The claim that these ingredients could be found in other pet food products sold without a prescription does not make them the same. The notion that pet food is pet food because all of the ingredients are generally available does not hold water in my view. If it did, pet food would only be sold in flavors, formulations and brands would not matter. I suspect lawyers from the manufactures cited in the cause of action have parsed these issues for their clients many times. We also know that brands matter in this category, Blue Buffalo’s success being a prime example of that.

Finally, I can’t speak to anti-competitive behavior, as I don’t know what goes on behind the scenes, but the pricing claims make me smile.  The cost of pet food has escalated significantly post-recession (40% on average on a per pound basis since 2011 according to GfK) without much of a peep from lawyers, despite the fact that class action lawsuits in the pet category have escalated significantly.  The prices of of most Hill’s Prescription Diet dry dog food solutions in 25 lb. bags runs between $80 – $85 online, approximately $3.25/lb.  This translates to approximately $2.40 per 1,000 calories, while higher than premium kibble at $1.75 – $2.25, this is significantly less than dehydrated ($5 – $8), premium cans ($7.5 – $10), frozen raw ($10 – $11) and premium freeze dried ($11 – $18).  If there is outrage around the price, it should be kept in context. When combined with the notion that these solutions are in fact different, these claims lose some of their veracity.  For me, you would have to believe that the veterinarians are coercing their clients into buying these solutions because they have no other choice and then providing them no other means of access than to pay the price for which they are selling them. However, these solutions are available online and transactions are facilitated through prescription verification providers such as Vetsource.  This feels much like a contact lens parallel.  Are there drugs in contact lens? Ponder that.

The net of all this is that it will spur dialog about labeling of these solution sets, and consumers who have purchased these products may end up with coupon books or rebates from manufacturers, but I don’t see that as providing a meaningful recasting of the competitive landscape for the prescription pet food.  And while Blue Buffalo should be a beneficiary in the near term, it is unlikely this provides them the runway they need to rapidly penetrate the channel.

/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.

skyThe pet industry continues to work through a series of fundamental issues — demographics, channel shift, brand attributes — that, over time, are expected to reshape the competitive landscape.  While fundamentals are favorable — consumption, consumer confidence, employment, real wages, housing — these tailwinds are not sufficient to float all boats.  When the market bifurcates into “leader” vs. “laggard”, and the historical leaders now find themselves playing catch-up, you get dynamic market shifts.  While there are signs of a transition in process, this cycle is only now gaining momentum, and inertia will take some time.  In the interim, here are the key trends we are keeping an eye on over the forward six months:

  • Growth On Pace for Anticipated Uptick.  The pet industry experienced a relative malaise in 2015, with industry growth, as measured by APPA figures, slowing to 3.8%, despite a 0.3% uptick in performance of the food category, the largest component of pet spend (~38%), to 3.5%. Based on macro indications the industry appears on pace to exceed projected 2016 growth of 4.3%, driven by an acceleration in consumables.  That said, a rising tide is not lifting all boats. Growth is manifesting itself in a much more pronounced way, from a percentage standpoint, among independent retailers and brands, from brands that have managed the digital migration of their message and products effectively, and from brands that rely on or incorporate alternative form factors. Growth, in isolation, masks a myriad of problems. Large retailers and major pet food marketers risk further erosion of their franchises if they don’t adapt more quickly to emerging ownership and channel realities.
  • Industry Working Through Transitionary State. The foundation of our Spring 2016 report was the observation that the industry was undergoing a restructuring, and would remain that way throughout 2017. This restructuring involves tactical changes to embrace evolving ownership demographics and consumer behavior patterns. We are seeing signs that many key players are in fact moving to action. A number of larger manufacturers are actively working through their digital strategies and assessing how they develop both ecommerce and customer analytics capabilities. Mid-sized box chains and distributors are evaluating alternatives for addressing online gaps. Several key pet specialty brands appear poised to move to FDM. Finally, online retailers and large distributors seem to be headed towards a convergence. While not all the key transitory events identified are in play, the industry is shifting before our eyes. These changes should drive increased M&A activity.
  • Small Box World is Consolidating.  The rise of the independent pet channel has been one of the greatest value creators for the pet industry post-recession. Growth in small box and mid-sized chains has paid significant dividends for the brands that cater to them, the distributors that serve them, and the owners of the most professionalized operations. This channel is viewed as the champion of the consumer, providing them with education and advice and, as a result, has attracted a slew of authentic brands seeking to monetize this connection. Now the channel is consolidating. While acquisitions by Tractor Supply, Pet Supplies Plus, and Pet Valu are most notable, so to is the external communication from companies like Chuck & Don’s and Bentley’s Pet Stuff that they are seeking acquisition opportunities. Many chains will have to choose whether to participate in this race for scale and geographic expansion, or temper their growth expectations.  Long term, omnicannel will win in both broader retail and pet.  However, to develop these capabilities a certain scale is required in order to justify the investment.
  • Deal Volume Increases but Not Realized Outcomes. When industries undergo evolution, transaction velocity predictably increases as companies try to reposition themselves for the next growth cycle. This phase began in 2H2014 when pet industry M&A activity spiked and continued through the record year of 2015.  While we continue to see elevated levels of market activity in 2016, it has yet to translate into a pace of closed deals that would match the prior year period, making it likely 2016 will be a down year for closed deals.  The reasons for this are multi-faceted. First, when large strategic buyers are working through their own portfolio issues they tend to prioritize their current brands at the expense of M&A. Second, as buyers step further out of their comfort zone, they tend to be more price sensitive. Finally, a number of buyers continue to digest their acquisitions from 2015, making them less aggressive on the M&A front. Couple this with continued high valuation expectations on the part of lower middle market sellers and you end up with more failed sale processes.

As always, a complete copy of our 2H2016 industry report is available by email.

/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.

dog-bowlBeing early, wrong, or both is no fun, at least not in the case of making industry predictions (traders will also say early is also wrong).  And when it comes to our views on the waning of the pet food upgrade cycle many people have made us aware that we were either early or wrong (or both!).  However, when you make market predictions based on limited information you are going to be wrong, sometimes with regularity (see my view on the inability for private equity to acquire PetSmart here, as just one notable example where I have missed the mark, but at least I correctly predicted that they would not combine with Petco, see here), and we are okay with that.  That said, here I am not sure we were either wrong or even that early in this case.

In 2013, we began to beat the drum about the deceleration of the pet food upgrade cycle (for those of you scoring at home you can see comments here and here).  Our view was that basic economic realities were fundamental headwinds — stagnant wage growth, slowing pet replacement, growth in small dog ownership, and continued food price inflation.  We then pointed to PetSmart comps going flat to negative, and fully negative ex-inflation, for most of 2014, had to be a sign this cycle was on life support.  However, all of these factors were explained away by other data — accelerating pet product Personal Consumption Expenditures in 2015 (Bureau of Economic Analysis), recovering pet adoptions in 2015 (PetPoint), accelerating pet food spend in 2015 (APPA), growth in alternative form factor pet food (GfK), mismanagement at PetSmart (pick your favorite equity analyst), and the successful Blue Buffalo IPO.  In short, for every fundamental premise we had on the offer, there was a data set that one could point to bolster their thesis.  The issue was that the evidence used to perpetuate the myth that the upgrade cycle was alive and well was easy to debunk, but nobody want to hear it, and they still don’t.

Fast forward to today, and we now see increasing direct evidence that supports our thesis.  First, last month The J.M. Smucker Company trimmed its full year earnings forecast on the basis of declining sales of pet food for the quarter, down 6%. While there was a positive spin around the narrative (difficult comps due to prior year sell-in, strong new brand sales prior year), it is concerning.  The company expects weakness to persist throughout the balance of the year.  Second, our survey of private mid-market pet food marketers ($100+ million in revenue) indicates that the malaise Smucker’s is experiencing is not isolated, though the magnitude is greater.  Most of the company’s we surveyed offered full year views of 0% – 2% growth domestically. Finally, Tractor Supply, which does a significant percentage of its business in livestock and pet supplies (44%), trimmed its quarterly earnings forecast and full year outlook for the second time this year.  The company now expects same-store-sales for the quarter to be flat to down 1% after being up 2.9% in the prior year period. While we may not think of Tractor Supply as the prime destination for the premium pet food consumer, they do sell a considerable number of premium brands – Blue Buffalo, Merrick, Natural Balance, and Wellness, among others.  The company pointed to slowing growth in the C.U.E. (consumables, usables, edibles) business. Translating the semantic hieroglyphics, this means their pet and animal products business, including pet food.  We suspect Tractor Supply is not alone.

What is more important here than being right or wrong as it relates to the state of pet food, is what will the implications be for the capital markets of the death of the cycle.  We do not believe that slowing pet food sales, premium or otherwise, is going to hamper capital formation. There remain multiple heuristics of emerging brands garnering footholds to grow their business rapidly to $25 – $50 million in sales with limited capital investment.  The scarcity of these businesses, coupled with the amount of institutional capital chasing these opportunities, means that growth equity investments in pet food, distinct from treats, will remain robust.  Of greater significance is whether this will jump start a new M&A cycle.  While large strategic acquirers tend to have a negative M&A bias during period of weak financial performance, it might just be such that they will uses these events to recognize the need to buy into niches that represent the future of the industry.  This could push multiples, which have been waning, albeit, at the margins over the past three years to begin to trend up.  Further, the fact that broader M&A statistics indicate we are almost certainly at the end of this M&A cycle, might cause more sellers to come to the table.  Watch closely for M&A volume in this segment to tick up over the coming year.

/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.

 

 

 

 

cowboyIn prior posts I have lamented about the reality that the pet consumables industry lacks a deep pool of brand consolidators.  Once you get past the “big three” (Nestle Purina, Big Heart Brands (The J.M. Smucker Company), and Mars), the industry possess a limited set of buyers who operate brand portfolios and who have deep pockets to afford the most attractive properties at prevailing transaction multiples.  That is not to say there are no other capable buyers of pet consumables properties, but rather that the current valuation paradigms of the second tier of buyers represents a significant drop from that of market leaders, whom simply can do more strategically and operationally with the assets they acquire.

Conventional wisdom has been that, over time, this reality would work itself out in four ways. First, was that the largest Tier 2 players would become aggressive in their M&A push in an effort to challenge the market leaders. Save for Spectrum Brands, who has been active, acquiring Proctor & Gamble’s European division, which includes the Iams and Eukanuba brands, and Salix Animal Health, a leading pet treat manufacturer, this segment of buyers has been largely stagnant.  Hill’s Pet Nutrition has participated in a few known M&A processes, but never at valuation levels necessary to challenge the companies it is chasing. Second, was that large private players would become more aggressive in acquiring emerging brands before they became of interest to the large industry players, creating a second economy, so to speak, for sellers.  Save for WellPet’s acquisition of Sojos, activity within this class of competitors, at least for consumables companies, has been muted.  Generally speaking, these companies have either opted not to run brand portfolios, or chosen to build rather than buy.  The third leg of this stool was that foreign buyers would enter the market.  Save for Agrolimen SA’s joint venture with Nature’s Variety, we have only heard crickets from the foreign buyer community on notable deals. Finally, the notion was that human food companies would crossover into pet in an effort to capture the growth and margin available to leading industry players. While many have talked-the-talk, they have not been able to close, primarily losing out to industry players on a valuation basis due to operational synergies.

This fact pattern is troubling for many of the emerging authentic brands in the category, who don’t want to be perceived to be selling out a major industry player. For some, the thought of a foreign buyer or a consumer packaged goods or natural food company acquiring them remains seductive.  So why has the industry seen such limited crossover appeal to these constituencies?  The answer has both quantitative and qualitative underpinnings.

The pet industry possesses a myriad of large foreign operators in the consumables sub-segment.  According to petfoodindustry.com, three of the world’s 10 largest pet food players are foreign — Unicharm, Deuerer, and Heristo AG.  Additionally, there are five other foreign market players (mostly Western European) producing between $400 – $600 million in annual revenue. Based on the prevailing margin profile for a pet consumables business, these companies would seem to have sufficient financial wherewithal to acquire a mid-sized U.S. pet food business. However, when you analyze this population, the following common traits emerge — largely private companies with closely held/family ownership (Unicharm being the most notable exception), owned manufacturing assets, and a limited acquisition history.  Where these companies have been acquisitive the targets have been in the buyer’s home market or in direct geographic adjacency. While some of these acquisitions have been of reasonable size, $50 – $150 million, it is clear that most of these companies are most comfortable sticking to what they know or prospecting only as far geographically as required.  Further, when you talk to executives of these companies they tend to cite three primary concerns about U.S. pet consumables M&A — a) a lack of knowledge of the U.S. pet food market, b) a lack of internal M&A capability internally, c) a perception that the market is hyper competitive and therefore of limited attractiveness, and d) the deal prices are high in light of these competitive concerns.  It seems logical to conclude that these dynamics are only likely to change if, and when, these companies experience a slowdown in their core business, if ever, and/or a professionalization movement stimulated by private equity drives them towards these outcomes.  Of note, some of the smartest U.S. private equity funds with a heritage in pet consumables are actively targeting Western Europe for their next pet deal, but I view the possibility of these parties being players for U.S. assets as being a ways off.

Consumer packaged goods companies, as potential buyers of pet businesses have had their own unique limitations.  Most notably, is the challenge these players have had with appreciating the gross margin profiles of the targets.  Companies like Clorox and Church & Dwight, who have actively courted pet companies involved in sale processes, are used to product level gross margins that push 50%.  We have yet to see a lower middle market pet food company that could produce those types of margins.  Scale operators like Blue Buffalo generate 40% gross margins.  Further, this class of buyers is not used to employing meat based inputs and concerns about recalls have led them to prioritize companies with owned production assets, which as a class of sellers have been experiencing the highest market valuation multiples in the most recent M&A cycle.  Finally, we find consumer product companies, who are used to spending considerable dollars on consumer marketing, do not appreciate the role the pet specialty retailer plays in motivating product sales, and therefore they build into their valuation models a level of additional spend that makes them less competitive on price. Absent a notable cross-over success story, we don’t foresee these sentiments changing. In fact we have seen more companies in this class give up the ghost than take us the charge.

Finally, we have the conundrum of the natural food companies.  It would seem logical to assume this class of companies would be interested in the pet space given the current parallels between the human and animal nutrition markets.  With the proliferation of grain-free and natural pet solutions, these two markets have never been more closely aligned.  There have been several instances where natural food businesses have pursued pet food assets where they appeared poised to win, only to go home empty handed. The challenges here have been both quantitative and qualitative.  On the quantitative side, the inability to drive revenue synergies has made them less price competitive, even though deals at prevailing levels for the most attractive properties would have been accretive on an earnings basis (as an example Hain Celestial trades at 16.5x LTM EBITDA). Further, this class of buyers needs a scale property to justify the adjacent market entry to their investor base, which leaves them both limited properties to choose from and puts them in direct competition with the big three.  On the qualitative side, two issues have surfaced consistently.  First, these companies are being actively pursued by large strategic buyers themselves, which means focus is critical to driving shareholder value and remaining independent if that is what is perceived to be in the best interest of shareholders. Second, is the intellectual conundrum of adding meat to the portfolio mix.  Of note, the three largest natural food products companies — General Mills, WhiteWave Foods, and Hain Celestial — orient their market offerings around plant based nutrition.  Adding meat into that marketing narrative makes for a bit of a conundrum, even if they are comfortable with the food handling risk.  My view is the right property will enable these buyers to overcome those concerns.  The attractiveness of the profit margin profile of well managed animal protein based businesses, nearly 2x on an EBITDA margin basis at scale, will be sufficient to motivate a natural products buyer with some vision. I view it as only a matter of time before one of these companies takes this leap of faith, but there is certainly no clarity on when that might happen.  WhiteWave Foods and Boulder Brands, the two natural products companies who have come closest to the finish line now find themselves in very different circumstances.

While the above narrative may lead one to conclude the glass is half empty, as opposed to half full, it is actually an improvement on the historical paradigm. Five years ago we would not be mentioning the other classes of buyers as possibilities, let alone probabilities.  Today, I see it more as a matter of when, not if.

/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.

 

 

 

 

beakersHistorically, the discourse around pet food delivered in alternative form factors (fresh/frozen, freeze-dried, dehydrated) has focused on the merits, or lack thereof, associated with feeding your pet raw protein. Lost behind the countless articles delving into the pros and cons of raw, has been the growth in both size and importance of this sub-category, and the value it has created for those who invested early in this category.

According to GfK point-of-sale data from the pet specialty channel for the 12 months ended August 2015, alternative form factor pet food was, in approximate terms, a $175 million market.  Based on these same figures for the prior year period, this represents 50%+ growth for the category.  When you add to this annualized IRI MULO data for fresh/frozen pet food sold in the mass market and apply an adjustment to GfK’s estimate of dehydrated pet food, which we know to be low, and the total market is approaching $750 million, growing at 30% – 35%.  While relative to dry kibble, this market is in fact small, it is meaningful, and in combination with its growth rate, cannot be ignored by the large strategic buyers in the space.

Validation of this notion began to accelerate in 2H2014 when Agrolimen SA, a Spanish privately-held producer of food and other consumer goods, quietly acquired a controlling stake in Nature’s Variety, the market leader in freeze-dried raw pet food, from Catterton Partners.  This was followed closely by the successful initial public offering by Freshpet, Inc. (NASDAQ: FPRT), which currently trades at 2.3x Revenue despite some challenges in the roll-out of their refrigerator program among several large retail accounts.

After a brief fallow period, further validation arrived in the form of Nestle SA’s acquisition of Merrick Pet Care. While Merrick’s market entry into the freeze dried raw space (Backcountry), was nascent, the fact that they had an in-market offering was clearly a benefit to the deal.  Around this same period, Stella & Chewy’s, LLC, a portfolio company of Stripes Group,  and the market leader in freeze-dried raw sold in the independent pet store channel, transitioned into a new 164,000 square-foot facility in Oak Creek, Wisconsin, funded by a debt package sourced by the company in early 2015.  On January 7, 2016, the company announced it had hired a highly seasoned consumer industry executive to run the company and recruited pet industry executive Mark Sapir as Chief Marketing Officer.  Sapir most recently served as VP of Marketing & Innovation at Merrick.  Finally, on January 8, 2016, it was disclosed that WellPet, LLC, a portfolio company of Berwind Corporation, and the owners of the Old Mother Hubbard (which had been previously owned by Catterton) and Eagle Pack Brands, had acquires Sojourner Farms, LLC, doing business as Sojos. Sojos is number two or three player in the dehydrated pet food space.  In addition to providing validation of both the freeze-dried raw and dehydrated solution set, it also provides further evidence that larger players in the consumables space will buy smaller brands, especially if those brands resonate with premium customers who shop independent pet specialty.

So what does this all mean? I believe there are two conclusions that can be drawn. First, that the alternative form factor pet food market is a real sub-category and mid-sized to large players need to pay attention to it, because consumers are buying into the category, and have a response for how to compete within it or counter its proliferation going forward. The category is no longer a novelty, something that market leaders can simply write off or ignore.  Second, it’s going to result in more transactions as strategics buy into the space in an effort to deliver a competitive response. The winners of this coming-of-age will be the entrepreneurs who pioneered the category and the private/growth equity firms that supported them.  With a limited set of properties available, it could send valuations, which have been trending down, back towards the upper end of the historical multiple range.

/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.

 

 

 

 

 

petcoOn November 23rd, CVC Capital Partners Limited and Canada Pension Plan Investment Board (the “Buyout Group”) signed a definitive agreement to acquire PETCO Animal Supplies, Inc. (“Petco”) from TPG Capital, L.P., Leonard Green & Partners, L.P., and friends for $4.6 billion. The deal values Petco at approximately 10.0x my pro-forma TTM Adjusted EBITDA for Petco as of October 31, 2015. This contrasts with the 9.0x TTM Adjusted EBITDA for the acquisition of PetSmart by BC Partners.  It is rumored that the Buyout Group was able to arrange approximately $3 billion of debt financing to support the deal.  Notably, both Petco and PetSmart will be owned by foreign investors assuming the deal closes.

It should come as no surprise that Petco opted for a private equity sale. Too much time had passed since the September 18th media leaks to believe a Petco / PetSmart combination would come together.  The case for public equity offering also faced numerous headwinds — a) broader stock market volatility driven by macro-political risk (Syria, ISIS, China), b) weaker than anticipated earnings among publicly traded retailers (as of November 20th over 40% of the retailers in the S&P 500 had posted earnings misses for 3Q2015), c) weak October retail sales (0.1% increase versus 0.3% consensus) and d) falling consumer confidence (lowest levels this year and a steep drop from October).  Against this backdrop, a trade sale was the most attractive option, even if debt market support for the deal had been choppy.  We generally consider 10.0X the break-point for specialty retailer M&A, above which history has not looked kindly on the buyer from a shareholder value creation standpoint.

The most pressing question now is who will lead the acquired organization going forward.  Jim Meyers, who has been in the CEO role since March 2004 (he was named Chairman earlier this year), and his team has lead Pecto back to a position of prominence.  Based on the S-1, Petco was posting stronger growth and better unit economics than its larger rival.  However, if history is a guide, large private equity deals seldom result in a staying of the course. In a small amount of irony, it is possible, though unlikely, that David Lenhardt could be running Petco a year after being ousted from PetSmart. Stranger things have happened.

If the Buyout Group is smart, they will purse incremental changes at Petco as opposed to a holistic approach to transformation. While there are certainly cost inefficiencies to be rung out of the system, Petco’s value is in how well it is currently situated from a growth standpoint with its greater emphasis on wellness, its multi-box positioning, its omnichannel reach and its under penetration in private label.  Further, with PetSmart deeply invested in its cost containment program, now is the time for Petco to press on the growth accelerator.  Someone is going to grab the brass ring and if not Petco, the chase will be led by Pet Supplies Plus, Pet Valu or a series of financially supported independent chains.

The next year should be an interesting one is large box pet retail land.  Regrettably we won’t be getting much transparency into either business any time soon.

/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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