aisleEarlier this week, Blue Buffalo released its 2Q2017 financial results.  While the numbers are always interesting, analysts were looking for further clarity on the company’s FDM launch and its anticipated impact on full year results, as well as insights as to where the brand is migrating and how it might offset dilution associated with a multi-channel strategy.  In short, the quarterly results were only the appetizer and the FDM launch narrative the main course. Reactions from the call seem to fall squarely into two camps — satisfied or bewildered.  The stock was up 6.6% on the day, which tells you which camp Wall Street fell into, but off its high during the trading session.  The stock had been up a double digit percentage during the session.

The quantitative metrics made for a mixed bag.  The company delivered in line EPS despite a – 2.5% topline miss.  Management attributed the miss to inventory delevering at major pet specialty accounts.  Organic sales growth was +2.8% (+3.3% in dry and +0.7% in WTO) driven by +1.8% mix gain and +0.9% inflation.  Sell through was ~ 7% representing sequential growth over 1Q2017.  Notably pet superstore sell through declined ~ 6% versus sell-in and was down ~ 11% year-over-year.  In contrast ecommerce growth was robust leading to a total sell through growth rate of ~ 30% in the channel. Gross Margin was also up +235 bps year-over-year, driven by supply chain efficiencies and lower input costs.  This appeared to be +125 bps over consensus.  The company affirmed full year guidance for both top and bottom line. The long short is Wall Street likes earnings and in combination with margin gains, it was enough to look past the sale miss.  The narrative appeared something akin to the following — “We will make it up in FDM!”

Management elaborated on its FDM launch, stating the four retailers it has partnered with represent between 8% – 9% of the pet food market on a dollar basis.  This expands Blue Buffalo’s addressable market by ~ 20%.  The company’s products will now be available in an additional 6,000 doors. Given that FDM over indexes on cat and wet/treats, management believes this unlocks some potential for growth in WTO.  Based on some early looks at the product set in Publix, it appears FDM will be selling 25 lb. bags of Life Protection Formula for a price consistent with a 30 lb. bag on Chewy.com. Blue Buffalo is targeting a high single digits/low double digits share in its FDM accounts.  Said differently, they are targeting 8% – 10% share within the retailers that account for 8% – 9% share of the pet food market.

The most notable aspect of the call, was the fact that Blue Buffalo did not speak to PetSmart or Petco before announcing the launch, which had been in the works for close to a year.  Thus, there was no way for them to weigh the competitive response from their major pet specialty retail partners. Management’s response to analyst queries was akin to, “we are hoping for the best.”  Whether it was coincidental or contributory, PetSmart CEO, Michael Massey, resigned today (see press release here).  My sense is that Blue Buffalo did not want to alert these retailers ahead of their pending category resets.  This would have likely led to greater near term shelf losses as the superstores increase shelf space for their premium private label offerings.  Blue has demonstrated they understand the timing game and are playing it to their advantage.

And the pace of change for the pet industry keeps accelerating…

/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 dogOver the past year, we have covered, at length, the transitional phase that the pet industry now finds itself in.  We have encouraged market participants to question everything they have come to know as the “status quo” for the industry and assess the likelihood that it will continue to prevail over the next three, six, twelve months and beyond.  For those who have dismissed the potential for wholesale industry change, we have pointed to the current political environment as a proxy, where the historical standard for how business gets done has descended into a state of entropy.  While the pet industry’s state of change has not reached the point of chaos, many traditional barriers have in fact fallen and are not likely to be seen again.

And another one goes…

Yesterday, Blue Buffalo began informing customers that it has begun distributing a subset of the BLUE Life Protection Formula (LFP) to select mass and grocery retailers.  Product will begin showing up on the shelves of Target, Kroger, Meijer, and Publix in August.  The company stated, “We have decided that broadening the distribution of LFP, our entry-level natural pet food line, is the natural evolution of our go-to-market strategy.”  The company intends to focus on smaller bag sizes and more mainstream formulations in its FDM solution set.  The company’s other lines will continue to be pet specialty exclusives.  See the full letter here.

To some this will come as a surprise.  After all, the pet industry has relied on well-maintained channel boundaries wherein brands choose to focus on and remain loyal to either pet specialty or FDM as a means of garnering retailer support.  Within these buckets there are soft boundaries between independent pet specialty and major pet specialty and between mass grocery and natural grocery.   When a big brand jumps the turnstile it is a BIG DEAL.  However, in this case it appeared to be inevitable.

When Blue Buffalo went public in 2015, pet superstores accounted for approximately 70% of the company’s revenue and was growing at over 7%.  Fast forward to 2017, and pet superstores are expected to account for less than 55% of total company sales and their growth rate will contract over 6%.  This trend line is not expected to change, with further contraction contemplated going forward.  To offset the challenges within its core channel, Blue Buffalo launched other growth initiatives focused on the veterinary channel and international markets. We viewed these as simply stop-gap measures while the company waited for the right time to make its move to mass.  That time has apparently arrived.  However, it arrived in a somewhat unanticipated way.  Our assumption was that the company would partner with Walmart, but instead it chose Target and conventional grocery.  This leads us to believe that a Walmart launch will be a 2019 event.  Blue Buffalo will wait until its Target and grocery channel account sales anniversary and then launch in other mass accounts, providing them four years of baked in growth optics based on mid-year launches.  That is public company behavior hard at work.  As of this writing the stock is down ~ 2% on the news, but don’t expect it to stay that way.

Now that Blue Buffalo has made its move, the question is what is the competitive response.  Just last week Champion Petfoods and Fromm Family Foods were showered with praise from independent retailers due to their willingness to move off Chewy.com in light of its acquisition by PetSmart.  Just a week later they now are faced with a different decision as they both could undoubtedly enjoy a national roll out at PetSmart, Petco, or both if they are willing to embrace that opportunity.  Other brands that are likely to benefit include Chewy’s own American Journey, which could easily transition to an online/offline brand.  Nulo is another prime candidate given its performance in PetSmart and the emergence of its Freestyle line in independent pet specialty.  Brands like Nulo, who effectively straddle the inner channel boundaries, are likely to welcome the news of a Blue FDM launch.

From a retailer perspective, one has to believe that Blue Buffalo shelf space will decline in the near term, if only as a psychological feel-good moment.  The pet specialty channel has a strong reliance on Blue Buffalo, so it’s ability to have a meaningful response is, to a large extent, muted.  Some back of the envelope math would suggest that nearly 25% of Petco and PetSmart food sales are in Blue Buffalo products.  The likely answer will be less retailer financed marketing support, though Blue Buffalo can take up that spend through national ad campaigns.  Notably, the company intends to begin tagging commercials for its pet specialty exclusive lines with “available at your favorite pet specialty store”.  Independents may have greater perceived influence by curtailing product recommendations, but that only works if they can effectively steer potential customers into alternative brands. Many retailers have found that converting Blue Buffalo customers is harder than it looks.

Finally, we come to the leading FDM brands.  It’s natural to assume that Freshpet, Rachel Ray, and I & Love & You should be concerned.  After all, there is only so much space available for the pet category within these retail environments.  However, each of these companies have forms of differentiation that they can rely on be it form factor or brand attributes, so Blue Buffalo’s ability to drive traffic to the channel may in fact benefit them as consumers begin to rethink the role of their grocery retailer in fulfilling a critical mass of their pet spend basket.

Every day, the pet industry looks less like a behavioral outlier, and more like its human industry peer group.  The change the industry has undergone over the past 12 months is dramatic, but a new end game is starting to come into focus.  That should excite companies with innovative products, salient marketing messages, and strong execution capabilities.  To the victor go the spoils.

ETA: PetSmart bond prices have declined almost 4% since the announcement.

petm

/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.

mockingjayEarlier this month, Petco Animal Supplies and PetSmart stores in Topeka, Kansas, and adjacent Lawrence, Kansas, removed from their shelves Hill’s Science Diet and Ideal Balance products.  Store managers have been telling customers that the brands is not coming back on shelf.  Notably, Hill’s Pet Nutrition, a subsidiary of Colgate Palmolive, is headquartered in Topeka.

Consider the above action a shot across the bow in the dynamically evolving landscape of pet food retail.  To better understand the future, and what this gambit might mean, one must begin with a look at the past.

Hill’s Pet Nutrition was founded in 1907. The company started in the rendering business.  By 1930, the company had evolved into packing company, producing animal feed, dog food, and horsemeat for human consumption in Norway, Finland, and Sweden.  In 1948, Dr. Mark Morris contacted Hill’s seeking a producer for Canine k/d, his brand of healthy scientifically engineered pet food.  In 1968, Canine k/d was made available to veterinarians as Hill’s Science Diet.  The brand evolved into a broad line of prescription and breed specific solutions available through veterinarians and pet specialty retailers.  In 1978, Hill’s became part of the Colgate family through a merger of Hill’s parent company.  In 1999, Hill’s sales reached $1 billion.

What is particularly significant was the fact that Hill’s was at the forefront of the healthy pet food revolution, albeit with a scientific approach. Further, long before there was Blue Buffalo, Hill’s, along with Nutro, was one of the biggest drivers of customer traffic to pet specialty retailers on the market.  Thus, for Petco and PetSmart to declare war on Hill’s is, for lack of a better term, A BIG DEAL.

The makings of this feud can be traced back five years.  Beginning in 2011, Hill’s pet food sales began to stagnate.  The company, whose products evoked images of white lab coats and engineers, found itself on the wrong side of a change in consumer preference, and therefore purchase intent.  Instead of favoring science based nutrition solutions, pet owners began to favor products whose ingredient panels best mirrored their own diet.  White lab coats were replaced by images of roasted turkey, market vegetables, and whole grains.  Natural triumphed over engineered.

Hill’s, being part of a large consumer packaged goods firm, was not content to let its franchise slip away. The company tried to change with the market, launching Science Diet Nature’s Best, a naming convention approaching the absurd.  Not surprisingly the disconnect remained.  Hill’s responded with the launch of Ideal Balance, its “natural” solution, but was slow to win back customers. While Hill’s revenues had grown to $2.2 billion in 2015, this number represented essentially flat growth between 2011 – 2015.  To maintain sales, Hill’s embraced the internet as a channel.  In 2015, Hill’s represented 7.5% of online pet food sales, taking the third position behind Blue Buffalo (12.3%) and Wellness (9.0%).  It attained that position by turning a blind eye to the price discount pet food retailers where charging for its solution set, thereby drawing the ire of Petco and PetSmart.  And you understand why we-are-where-we-are.

One has to surmise that Hill’s knows quite well what it is doing and the consequences of its actions. My understanding is they have recently put pressure on major online retail sites to enforce their MAP policy based, in turn, on pressure from Petco and PetSmart. However, if Hill’s cannot get back in the good graces of its top premise based retailers, prepare to find Science Diet and Ideal Balance at big box store near you.  The likes of Target and Wal Mart would welcome Hill’s and its customer base with open arms. Whether this is a brilliant move by Colgate or the straw that breaks the brands back remains to be seen.

Of greater interest is what this means for Blue Buffalo.  A big box Hill’s is not going to be a welcome site for the veterinary community who drives the disproportionate sales of prescription diets and is a big influencer of Science Diet sales.  Blue Buffalo has staked the next leg of its growth stool on its veterinary line of products.  If Hill’s defects, that will create a fracture in the relationship between the company and the veterinary community that Blue Buffalo could be poised to exploit.  That’s not to say it won’t have fierce competition for that mind share from the likes of Royal Canin and Purina, but thirty days ago that market looked much tougher to crack.

Let the games begin.

/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 bowelTracking growth in the pet industry has historically been a static exercise.  Industry observers have become beholden to annual disclosures from the American Pet Products Association (APPA) or one of the third party research organizations that track the industry’s performance (Packaged Facts, Mintel, GfK, etc.).  Garnering a read in between reporting mileposts has required the application of inference to lagging data.  The take private of PetSmart removed a valuable leg to the data stool on which many inferences relied. However, in the case of pet consumables, recent public offerings and acquisitions of major pet properties by public companies, provides us greater transparency from which to make educated guesses.  Consider the following August 13th reporting disclosures:

  • Nestle Purina disclosed segment level growth data for the first half of 2015 for all of its businesses (note, European public companies report on a half yearly basis).  The Petcare division delivered ~ $5.63 billion in Sales in 1H2015 (reflects conversion of CHF to USD as of the data of publication), up 4.9% over the same period in 2014.  Nestle also disclosed that its Petcare division increased Operating Income margin by 1.1%.  Healthy growth given the size of the numbers involved.
  • Blue Buffalo reported strong second quarter sales and earnings performance.  Sales for the quarter totaled $254 million, or 16% growth versus the same period in 2014. While earnings were up for the period by 14%, Blue Buffalo posted a 2.0% decline in Operating Income margin for 2Q2015.  Volume growth for the quarter was 15%, with dry food posting a 16% gain.  However, the company noted that dry volume growth was more a function of timing, based on sell-in shipment dates. For the full year Blue Buffalo anticipates that wet food and treat growth will outpace the growth of dry food from a percentage standpoint. Gross Margin was 0.4% higher than the same period in 2014, though 0.7% lower than 1Q2015 due to the ramp-up in the companies owned production facility (Heartland).  The balance of the Operating Income compression is explained by IPO related expenses, investments in new product introductions, and brand related expenses.
  • Freshpet also reported strong second quarter sales and earnings performance.  Sales for the quarter totaled $28.4 million, or 39% growth versus the same period in 2014.  Approximately 4.8% of this growth was attributable to new product tests, as the company seeks to enter the kibble sub-segment. Freshpet reported a 9.1% increase on Operating Margin as losses narrowed. However, the company experienced a 1.3% decline in Gross Margin versus the same period in 2014, driven primarily by mix.

While these three data points do not reflect all brands or channels, they do provide us a reasonable cross section from which to extrapolate. If we compare these results to the APPA projections for 2015, it would seem we are on track to meet or exceed projected growth in the largest category of pet spending.  For calendar 2015, the APPA projected total industry growth of 4.4% and 3.5% growth within the consumables.  If the largest industry player is growing 4.9%, albeit globally, and two key emerging but established independents are growing at healthy double digit rates, it would seem to augur for an up year in pet consumables. For further triangulation, we add to this the J.M. Smuckers disclosure that its Big Heart Brand’s acquisition is growing at a 4% – 5% annual rate. In the future, a publicly traded Petco, will only further add to our ability to predict in year category performance.

The above certainly does not represent perfect science, but in the absence of real time data, it does provide me some comfort as it relates to anticipated annual growth for the industry.

/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.

lone starOn the morning that Blue Buffalo priced its IPO, above the expected range I might add, Nestle Purina announced that it had acquired Merrick Pet Care, owner of the Merrick, Castor & Pollux, Whole Earth Farms, and Backcountry pet food brands. Terms of the transaction were not disclosed. However the deal likely garnered the leading EBITDA multiple for a pet consumable transaction in this transaction cycle.  Merrick had experienced strong growth in the years following the majority recapitalization by Swander Pace Capital.  This is the second headline grabbing exit for the San Francisco based private equity firm, that earlier this year sold Applegate Farms to Hormel Food Corp for $775 million, or approximately 2.3x estimated 2015 sales.

On the surface this deal is of little surprise.  Merrick filled a well-defined hole in the Purina pet food product mix as it relates to natural pet food.  While Merrick had only recently entered into the freeze dried raw category, the acquisition also provides Purina with a platform in that space after missing out on the possibility of acquiring Nature’s Variety, who elected to do a transaction with Spanish pet food manufacturer Agolimen SA without engaging in a broader marketing process.  Rounding out the appeal was likely the integrated manufacturing assets and the foothold it gains in the natural channel through the acquisition of the Castor & Pollux brand, though whether that channel exposure sticks remains to be seen given the historical experience with Pet Promise.

However, when one digs a little deeper there are secondary facts worth noting:

  • Come from behind victory.  We heard from several sources that Purina was not the leader after the initial round of bidding.  However, as the most logical buyer with the deepest pockets they likely knew that they would get the last look so coming out too strong had no material advantages.  In the end, winning is all that matters.
  • Convergence theme in play. Also of note is that at least one of the final bidders was not currently in the pet space.  We believe this was a US based food company, though that is simply speculation. Our assumption was that Merrick would have been big enough to tempt someone on the outside to possibly buy-in, especially given the company’s focus on natural and its integrated manufacturing capabilities. That control of production has been an important consideration in our historical conversations with adjacent market strategic buyers.
  • Past precedent was important. It’s natural for a company with a meaningful presence in the independent channel to have concerns about on-going carriage once acquired by a major industry player.  It is also logical for retailers and consumers to have doubts when a transaction like this occurs.  However, in this case, Purina is able to point to their experience with Zuke’s, which has remained focused on the specialty channel and who Nestle actually pulled out of direct-to-consumer sales channels, as a proxy for how it will manage Merrick.  The fact pattern has given them some credibility with these retailers to push back against reduced carriage.
  • Castor & Pollux owners win too. When Merrick acquired Castor & Pollux Pet Works they did so in a stock deal, where the consideration was equity in the combined entity.  While Castor & Pollux was the leading player in organic pet food before growth in natural pet food exploded, it had plateaued at the time it sought an exit.  The company struggled to drive growth given its limited available resources. The gross margin profile associated with a sub-scale brand reliant on outsourced manufacturing and organic inputs is less attractive. Taking stock in Merrick, as opposed to cash at close, now looks to have been a very good decision.

We believe this deal makes the end of a the M&A cycle for major independent pet food players.  This current cycle included the sales of Natural Balance, Nature’s Variety and now Merrick.  We don’t see another headline grabbing pet food deal until Champion Pet Foods chooses to test the market, unless one of the large family owned operators decides it is time to exit.  Assuming this is the case, at least it ended with a bang.

/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.

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

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

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

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

/bryan

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