chicken_little_funny-t2Last week, PetSmart announced first quarter earnings. The company reported slowing growth and negative same store sales.  I believe it was the first negative comp quarter in 16 years for PetSmart. Management took full year comp store guidance down to zero, from 2%. The stock fell approximately 8% on the news, taking the year-to-date loss to -22%. Naturally, this has led some to question whether the sky is falling for PetSmart, the pet industry, or b0th.  To begin to answer these questions, we first need to uncouple them.

To assess the performance of PetSmart, separate and distinct from the industry, the best place to start seems to be in the context of broader retail.  Anyone who was surprised by softness in PetSmart’s numbers has probably not been keeping their pulse on the four wall retail environment. In January, 20 retailers pre-announced earnings shortfalls. This was the highest number post recession and on par with the levels the industry experienced in third and fourth quarter 2008. Howard Schultz blamed it on the Internet, others cited weather, consumer confidence, and wage stagnation. Notably, both Wal Mart (-0.4%) and Target (-2.5%) produced negative comps for the 1Q2014. We cataloged 1Q2014 revenue growth, EPS growth and performance versus guidance of some of the major big box retailers here — 1Q Retail EPS Performance. Notably, PetSmart was the only company within this comp group to exceed guidance on earnings. What this speaks to is the fact that PetSmart has a very good handle on the cost side of their business. While they experienced slight margin compression, unlike its peers PetSmart does not appear to be chasing the middle market consumer through a promotional discounting strategy. This underscores PetSmart’s relative market position in the industry as well as the ongoing attractiveness of the pet category.

When we shift our analytical purview to the broader industry, the cause and effect relationship is more apparent. While total consumer spending on pet products and services continues on a positive growth trajectory, total growth has been slowing, driven by a falling comps for pet products (see graph below).  What this demonstrates is that the industry is maturing and that drivers are changing.  As the pet food upgrade cycle has tapered products sales growth has slowed.  However, as a wellness focus has ascended, services revenue growth has accelerated.  Given that services is a much smaller part of PetSmart’s mix, it was bound to experience the malaise of the industry’s product sales growth trajectory.  PetSmart’s first quarter revenue growth was more or less inline with the growth in industry product sales.  Additionally, keep in mind that total pet industry sales, as measured by consumer expenditures by category, grew 12.6% between 2011 and 2013; at some point the “law of large numbers” catches up to everyone.Slide1A second lens we like to use to assess pet industry performance is the rate of adoptions.  An increase in ownership and multi-pet householders means an increase in expenditures.  However, as evidenced by the chart below, the growth rate for companion animal adoptions, as measured by shelters monitored by Pethealth, Inc., slowed markedly in 1Q2014, especially for dogs.  That said, a similar contraction was evident in 2011, a year of strong industry growth (4.7% according to the American Pet Products Association).  As such, we think it is too early to call it a year for the industry, but in combination with slowing pet products sales it is cause for some consternation.Slide2In looking at the total body of available data there is reason to be concerned about the pace of pet industry growth but not the overall health of the industry.  Slower growth has been anticipated and therefore should not come as a surprise. The industry has been defying skeptics for sometime, but all good things experience a tapering.  Further, it is too early to call the year from any analytical perspective.  The pet industry remains very attractive long term and while online players, adjacent market competitors, and emerging brands have eroded the leadership of both major retailers and product manufacturers, the threat to their overall industry position remains low.  Generally speaking, physical retail has experience a much more significant contraction, driven by share shift to mobile and online, recently even after you factor out the weather.  In that context one can view PetSmart’s performance in a relatively positive light.

I think I can say with authority, when it comes to all things pet there may be clouds in the sky, but it is not currently falling.

/bryan

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

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

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

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

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

Contact me for a copy for my report.

/bryan

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

down but not outEarlier this week, PetSmart’s public equity was downgraded by Deutsche Bank equity research analyst Mike Baker. Baker put a “Sell” rating on the stock, reducing his 12-month price target price from $73 to $65, or approximately 11%. In formulating his rationale, Baker cites two main drivers.  First, he views recent traffic erosion at the best in class pet retailer as being a longer term trend as opposed to a short term aberration.  Baker anticipates that slowing sales in super premium pet food coupled with limited food price inflation is going to make 2014 comps hard to deliver.  He views premium food as a key traffic driver for PetSmart. Second, Baker believes that the long term threat of ecommerce in the pet space is real.  He states that once consumers begin to recognize that free shipping is available on most pet food orders that adoption rates will increase.  Baker cites a Pethealth, Inc. survey wherein 89% of pet owners would purchase pet food online if shipping were free.

Notably, Baker’s has been negative on the stock for some time.  He’s had a “Hold” rating on the stock since February 2011 when Petsmart’s public equity was trading at $42, versus the $72 it was trading at prior to Baker’s downgrade.  As such, he missed a 71% movement in the stock over that time period.  While the arguments above are not new (maybe you actually read them here over a year ago), they are real.  However, as I have come to believe there is more to the story, and PetSmart may have more mechanisms available to combat these trends or find other growth avenues than one might expect.  Further, Baker’s call comes at a time where there is a lot of noise in the market, and therefore the significance of his observations from a timing perspective may, in fact be, overblown.  I explore each of these concepts below:

  • Holiday retail was weak all over.  First and foremost fourth quarter was tough for premises based retailers.  Fewer shopping days between Thanksgiving and Christmas, weather problems across the country, and political problems in Washington all conspired to make things tough on four wall retailers.  November store comps across all retailers missed guidance and online took share as a result of time compression and weather impediments.  While we are readily aware that ecommerce is growing faster than traditional retail, there is a lot of noise in the numbers; once that noise dies down we expect PetSmart to do just fine versus guidance.  Baker did not mention the bathwater when he threw out the baby.
  • Premium food rotation is slowing but growth levers in the category remain.  We were ahead of the curve in calling a category slowdown, but our experience has been that the slow of erosion has not been as steep as anticipated.  The category, which at one time was likely growing 25%, is estimated to grow at between 15% – 18% in 2014, a decent clip.  History has demonstrated that major pet specialty retailers still have levers to pull to combat this trend. PetSmart is pursing private/exclusive label concepts in the category, expansion of space dedicated to felines, and alternative form factors/niche brands as a means to combat slowing growth.  The fact they are undertaking a large consumables reset tells me they saw this coming. Further, with a rising stock market and falling unemployment what is not to say that retailers won’t seek price increases absent commodity inflation?  Nothing really. 
  • Other drivers of traffic and earnings remain.  PetSmart has done a great job over the past cycle driving traffic organically.  They have not become overly aggressive with promotions and they are not buying business by offering emerging products companies sweetheart deals or subsidizing ecommerce.  Their exclusive brands are a strong driver of customer visits and will likely be extended in both new and current categories.  Further, as they ramp up their smaller format stores it will enable them to grow faster in secondary geographies.  Couple this with slightly more aggressive promotions offset by continued share repurchases, more consumers coming into the fold as adoptions increase with the economic recovery, and innovation in the services segment and PetSmart finds itself fairly well positioned to meet expectations.  
  • Ecommerce threat is real but the competitive tension goes both ways. As you are likely to be aware, we ascribed to the theory that ecommerce is skimming customers from major pet specialty retailers. However, it is also clear that they don’t yet view the battle as worth fighting…yet.  While PetSmart has made some tangible moves to better position itself online, it has multiple tricks in its bag that independent ecommerce retailers can’t match.  For every store, PetSmart has a warehouse.  They can offer in store pick-up and returns.  They can bundle products and services.  They can get aggressive with pricing.  Until they rollout their full artillery on this front it’s hard to conclude that they can’t win back that which has been lost to date.

Net net, PetSmart is facing a number of headwinds impacting growth.  Some of their challenges are industry realities and some are self created.  However, we think the timing of these observations is being discounted.  PetSmart has major resets underway to combat these very concerns and multiple levers to pull if, as, and when needed.  The glory days may be gone but we have learned the hard way to bet heavily against the concept.  

/bryan

willieWillie Nelson once said, the early bird may get the worm, but the second mouse gets the cheese.  In this case, I’m not sure which mouse I was.  Just days after I published my fall pet report a number of news worthy items came into focus that would have merited a mention in my industry report.  However, several of the items provide direct validation of the trends I have been discussing here over the past year.

Of greatest significance was the headlines coming out of PetSmart’s Analyst Day presentation.  Just prior to their Analyst Day presentation on October 17th, management announced that they expected third quarter same-store-sales (“SSS”) comps to come in below the anticipated range. Management believes 3Q13 SSS will come in at 2.0% – 2.5% versus prior guidance of 3.0% – 4.0%. PetSmart has not seen comps this slow since 2009. Notwithstanding the company’s issues with driving traffic, management is sticking by its full year EPS guidance.

Notably, as part of their presentation, PetSmart finally addressed its web strategy in some detail.  CEO David Lenhardt noted that how to remain relevant to consumers across channels was one of his biggest concerns and that the company would be investing more of its marketing budget and CRM resources online. He went on to detail several new ecommerce initiatives include in-store inventory look-up online, improved mobile experience online, in-store pick-up, and opening of a new West Coast distribution center which will reduce shipping times. Lenhardt continues to believe that PetSmart’s position as a destination retailer and its services platform will continue to enable it to compete effectively against other online players.

Over the past year, I have been highlighting the risk of the internet to PetSmart.  I’ve not been alone in ringing this bell.  While I believe PetSmart is uniquely situated to perform well online long term, my concern has been that they have not had a coherent strategy. In light of recent financial performance, including 3Q13 guidance, I have to believe that other online players are succeeding at eroding some of the premium customer base of PetSmart’s and Petco, especially among a younger demographic.  The company’s willingness to detail their plan, after years of side stepping the question, tells me there is some truth to this theorem. While online will result in erosion of hardgoods share, because of the wide availability of these products online, the concern will not reach its apex unless and until pet specialty sees consumables share erosion to online.

Second, the long running narrative linking imported pet jerky story product to numerous pet deaths finally hit the headlines. News about pet death related to foreign jerky products have appeared in nearly every major online publication during the past week. My historical conversations with domestic manufacturers has been that regulatory bodies are not doing enough to protect consumers from imported product and instead have been myopically focused at cracking down on domestic producers.  While it is terrible that so many pets had to fall ill before we got to this point, it now seems we have arrive at the moment where the paradigm shifts. When the dust settles the winners will be consumers and branded treat companies with domestic sourcing and production pedigrees.

Third, Whole Foods announced that they are launching a house brand of premium value oriented pet products. Whole Paws will consist of 24 SKUs addressing both dogs and cats cutting across multiple categories ranging from grain-free food and treats to cat litter.  The attempts of traditional grocery to cut into pet specialty sales are, like the jerky story, old hat for those that follow the industry closely, but the within the natural segment pet remains an under monetized opportunity. Grocery continues to leak share to both mass and pet specialty, due to price and assortment respectively.  However, natural has a real market opportunity in my opinion because it can provide grocery consumers more of a one-stop-shop.  While space limitations will ultimately cap the potential of the natural channel within pet, this product line launch is a clear demonstration that store managers are starting to understand the potential of pets within their channel.  Natural could become a nice bed for incubation of emerging brands with a wellness oriented theme much the way it was in natural beverage, healthy snacks, and gluten free foods.

Finally, the relative pull of the pet industry on owners was again affirmed to me when I became aware that pet owners will purchase nearly $330 million of costumes for their pet this year. This amounts to approximate 22 million consumers spending, on average $15 annually.  What consumer pressures on pet?

/bryan

 

dogThe pet industry continues to chug along.  Based on the information available, the industry posted strong growth in 2012 and is demonstrating all the critical signs of continued health — rising ownership levels, increasing innovation, expanding consumer spend, earnings growth from publicly traded participants, and active capital markets, both private placements and M&A.  In a year that was challenging due to economic uncertainty and political gridlock, the pet market did not miss a beat.

That said, we are only cautiously optimistic about 2013 on a relative basis. While we expect the industry to deliver a solid year when compared to other consumer segments, the pet market may have a difficult time out doing itself in 2013 for three reasons. First, the super premium food rotation that continues to compel growth in consumables is slowing, just not at the pace previously predicted.  At some point it will wane as a driver; 2013 may not be that year but the rally is clearly in the later innings, having only been extended by consumers concerns about quality and an increasing ability to finance said premium food purchases through rising disposable incomes. Second, the industry delivered incredible results in 2012, and comping against those results would be a challenge for an industry.  Notably, public traded pure-play pet companies grew earnings by over 21% in 2012, compared to 9.3% for the S&P500.  As a result, public traded equity prices of these pet companies outperformed the broader market by 25%. Finally, the industry is in a transitional period. Core pet owner demographics are changing, with Baby Boomer influence waning and GenX/GenY/Hispanic influence on the ascendency. Wellness as a central growth theme has benefited product sales, but veterinary volume growth remains poor. Until the product and services side are in sync, it will have difficulty achieving full impact. And channel shift from premises to online is taking place, albeit at a slow pace.

The industry also has meaningful upside to 2013 projected growth of 4.3%. That upside comes from five (apparently not everything comes in three) factors. First, consumers are in an upgrade cycle, having spent 1.9% more per pet product unit in 2012 and 2011.  If consumers continue to upgrade, or the impetus to upgrade expands to a broader segment of pet owners, revenues will increase faster than anticipated. Second, convenience is on the rise. Products and services are becoming increasingly available and operating frameworks are evolving to enable manufacturers broader reach. If access accelerates at a faster pace, revenues growth will benefit. Third, non-health service offerings continue to improve in both concept and delivery.  If disposable income continues to rise, or rises faster than anticipated, for core pet consumers, service revenues will benefit due to their discretionary nature. Fourth, the potential for the wellness theme to converge across product and service is improving through the continuing investment in information services. Information has the ability to ease the tension between owner and health provider. If platform adoption/usage accelerates faster than anticipated that will be good for veterinary clinic utilization.  Finally, capital continues to target the industry for above market returns.  Professionalization of the industry is good for growth.  If private placement volume accelerates industry performance will benefit.

As always, a full copy of my industry report is available by email.

/b

k2The rise of PetSmart has been well chronicled on my blog and in my bi-annual pet industry report.  A well established track record of margin expansion, earnings beats and EPS growth has made the company a darling within the pet industry, the specialty retail community, and one of the most widely praised stocks of the post recession era (full disclosure: I do not own the stock, nor am I providing any stock advice herein).  Since November 2008, the stock has increased over 400% (versus 68% for the S&P 500).  PetSmart’s return on invested capital (ROIC) for this same period placed them in the 96th percentile of all publicly traded equities.  For every dollar management invested, it made over $0.30/annually during this period.

Those that follow the stock, as equity analysts, industry observers, and retail investors, have become conditioned to expect an endless stream of  good news and gawk at the stocks progression up-and-to-the-right.  When there were bumps in the road (e.g., 4Q2011) we found external factors to blame (i.e., commodity prices, weather, Europe, etc.).  That notwithstanding, PetSmart management seemed to have the Midas touch. So it came as a shock to many when Nomura Securities analyst Aram Rubinson downgraded PetSmart’s equity early last week, cutting his target price from $72/share to $55/share.  Rubinson had been sitting on a “neutral” rating, but now he was ready to tell his clients to reduce their holdings.   Prior to joining Nomura from hedge fund High Road Capital, Rubinson was a senior research analyst at Banc of America Securities, where he was the #1 ranked Hardlines Retailing analyst, according to Institutional Investor.

Rubinson’s downgrade sent PetSmart’s equity price tumbling 8.9%, 12% off its 52-week high.  The crux of Rubinson’s recommendation was as follows — Amazon.  His thesis was, largely, that Amazon would take share and put pressure on the company’s margin as PetSmart becomes forced to subsidize shipping in order to compete in a category that is migrating online.  This a bell I first rung, politely in 2008, with more fervor in 2011 and I practically pounded the table in November 2012.  My point is that while Aram has a large platform for broadcasting his opinion on PetSmart’s market opportunity, this was not new news.

Notably, Deutsche Bank raised their target price on PetSmart’s stock to $71 on November 15th after the company delivered another strong quarter. As part of their commentary they made is clear that margin and multiple compression was not of concern because.  Shortly thereafter, Barclays Capital upgraded the stock from equal weight to over weight.  Nine analysts have rated the stock with a buy rating, two have given an overweight rating, fourteen have issued a hold rating, and one has given a sell rating to the stock. PetSmart currently has an average rating of overweight and an average target price of $74.00.

Given that the Amazon issue has been on the table now for some time, why did the stock really take a turn south?

First, the stock was ripe for profit taking.  Again, the business has been on tear and the stock has followed.  At it’s peak, PetSmart traded at 19.0x foward year EPS and 9.0x forward year EBITDA, both significant premiums to the market (44% on a price-earnings basis).  This is the first substantive pullback since July 2010, but the drivers at that time were macro — Greece, double dip, etc.  PetSmart would report a strong quarter and raise full year estimates in August 2010.   So when the company announced a reshuffling of the management deck chairs (see below), traders used Rubinson’s downgrade as a reason to take profits that they could hide behind.

Second, the forthcoming management transition was poorly communicated and contains risk.   As part of a what we learned was a “planned management succession”, CEO Bob Moran is becoming Chairman while COO David Lenhardt gets the CEO job.  Further, Joseph O’Leary, Executive Vice President of Merchandising, Marketing, Supply Chain and Strategic Planning (that’s a long title), gets the nod as President and COO.  This comes on the back of CFO Chip Molloy’s previously announced departure in November 2012; he retires in March 2013.   Net net, this larger wave of changes caught the analyst community by surprise.  Moran had made no mention of near term retirement (he is 62 years old), and while this is largely an in-house promo parade, that program has not always been met with positive ends — see Coca-Cola Company circa 1997, Goizueta, Ivester, and Daft, which launched the iconic beverage company into a lost decade of stock appreciation.  Further, anytime a public company CFO departs it gives investors pause.  Molloy is only 50 years old.

Finally, Amazon, but not Rubinson’s Amazon.  Yes, Amazon is taking share in pets, faster than anyone would have anticipated but the fate of PetSmart does not hinge on being competitive in the delivery price of pet food.  The market has shown very little interest in pet food home delivery no matter what the perceived convenience or savings.  Tens of millions of dollars have been buried waiting for this market to arrive. Rather, the threat of Amazon and its online brethren to PetSmart is two fold.  First, online players are developing capabilities that will enable them to serve as a one-stop-shop for pets — food, consumables, products, medications (Rx and OTC).   On a value and convenience basis this will attract a tangible set of customers, especially as the e-commerce generation (those born after 1970) amasses further purchasing power.  Second, PetSmart has structural issues as it relates to its online efforts.  The company currently outsources its online efforts to GSI Commerce, an eBay corporation.  While this is fine for a general catalog online, to compete against Amazon, wag.com, Pet360 and others you need in house controls and capabilities.  PetSmart’s contract has years to run and it would take tens of millions of dollars to put in place the infrastructure necessary to control its own destiny online.  This makes the investment banker in me believe PetSmart will make a catch-up acquisition within the next two years.  Until then, management will continue to downplay the competitive threat while working tirelessly behind the scenes to limit the damage.

PetSmart remains a great company with a robust outlook.  However, there are cracks in the facade; cracks that it did not take an equity analyst to reval.  The company has tangible problems, but it has overcome challenges time and again.  While the recent equity price correction seems justified, it’s too early to say the company has peaked.

/bryan

It was recently brought to my attention that Amazon entered, or re-entered depending on your view of past events, the wine business last week. The new offering enables, oenophies, like myself, in 12 states (more coming soon!) the ability to access a selection of 1,000 wines ranging in price from $5 to $200. The direct delivery liquor business is one that is best characterized by red tape and unrealized potential. Few know this as well as Amazon who has been trying to break into the market for nearly 15 years. Amazon invested $30 million in Wineshopper.com in 1999, which subsequently went bust, and then sought a do-over through a partnership with New Vine Logistics, a concept that was felled by California regulators. This time around, Amazon has found a way to shift the regulatory burden onto its partners, the wineries, in order to enable the business model.

To the uninitiated, the above might simply be interpreted as another chapter in Amazon’s wine retail lore, a story about a company that is dogged in its pursuit of category leadership and not afraid to fail before it succeeds. However, to the trained eye there is more to the story. The reality is that Amazon’s ecommerce business is currently under intense pressure. Whether you believe that pressure is being driven by Amazon’s four wall retail competitors (such as Home Depot, Target or Wal Mart, among others) or the manufacturers themselves, Amazon’s dynamic pricing model has drawn the ire of the traditional retail supply chain to the point where they have started fighting back.  Notably, Target sent an open letter to manufacturers suggesting it was time to divide up the world and others have followed. So a logical response, while Amazon waits out (from its perspective) these merchandising reindeer games, would be for them to push into regulated markets where they can create real barriers to entry, and therefore garner favorable economics.

So how does this relate to pet ecommerce?  The answer is in pharmacy.  One of the most protected retail environments is, as you would expect, drug dispensary. Not only are there significant compliance hurdles at the state and national levels, the drug companies have the final say in who can operate in the market by controlling the supply. It would be logical to assume that if Amazon is going to make a play for regulated markets it would enter the pharmacy space, and as a corollary the pet pharmacy space.

However that strategy is not without its own issues. From an animal health perspective, the drug companies rely on the veterinarians to recommend and dispense their products, so any efforts to disintermediate them would be a non-starter. One might be tempted to assume that if Amazon could move a sufficient volume of human prescriptions, the drug companies would have to provide them access to their pet solutions. Given that Wal Mart moves hundreds of millions of dollars of human prescriptions on behalf of major pharmacy companies but does not have access to the animal health solutions from the same manufacturing base demonstrates the perils of that assumption.  Therefore Amazon needs a vet centric solution that is seamless to the customer, but as we have seen in their wine effort, “where there is a will there is a way”.

Setting aside the “how” and focusing on the “why” is also important. If Amazon can bring together the breadth of companion animal products currently available to them with pet prescriptions, they would have an unmatched merchandising mix in the industry.  Through its partnership with Banfield Pet Hospitals, PetSmart could conceivably replicate the strategy. However, PetSmart outsources its ecommerce infrastructure to GSI Commerce, and is contractually bound to them for some. Further, four wall retailers don’t pursue dynamic pricing strategies; this is akin to cutting off ones nose in spite of their face. Even if they could overcome the infrastructure hurdles and channel conflicts, they could not build a team that could compete with Amazon online (who can for that matter?). PetMed Express might seem like a competitive threat until one understands that they source their supply through diversion (authorized buyers re-selling product out their backdoor at a profit) and not directly from the manufacturers. Regulators and drug companies will eventually choke off this grey market supply chain. And that leaves Amazon as the last man standing.

I would not bet against them.

/bryan