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.

 

 

 

 

unicornOn Wednesday, as anticipated, Blue Buffalo, the pet industry’s most prominent unicorn, filed to raise up to $500 million in a public offering (see form S-1 here).  The company intends to trade on the NASDAQ under the “BUFF” ticker symbol.  J.P. Morgan and Citigroup are the lead underwriters. BUFF reports generating $918 million in revenue in 2014 ($940 million for the latest 12 months ended March 31, 2015). The company estimates it holds a 6% share of the total pet food market and 34% share within its competitive set, which it defines as the Wholesome Natural market segment.

A number of items that are notable from the S-1:

  • The company’s growth strategy lays out a thinly veiled plan for ubiquity in product access, noting that Blue Buffalo currently feeds only 4% of dogs and 2% of cats.  Growth will come from 1) building U.S. market share by expanding the availability of Blue Buffalo products, which we assume means a move into mass, 2) entering into therapeutic diets, and 3) select international opportunities (Canada, Mexico, Japan).
  • Blue Buffalo products tend to over index with younger households (Gen X and Gen Y) as well as younger pets (ages 0 – 1), providing some belief that it will increase market share as these owners age by capturing them early in the lifecycle.  Approximately 4% of Blue Buffalo sales occur online, versus 2% of the total market according to Blue Buffalo, which makes sense given the demographic where the brand is resonating strongly.
  • The business has delivered impressive growth over both the recent and longer term time horizon.  Revenues increased from $190 million in 2010 to $918 million in 2014, representing a compound annual growth rate (“CAGR”) of 48%.  During this same period Operating Income grew at an 86% CAGR from $15 million to $179 million.  Operating Income margins have increased from ~ 8% in 2010 to nearly 20% in 2014.  While future growth rates are projected to taper, it appears to be more associated to with the “law of large numbers” catching up with the business, as opposed to any change in fundamentals.
  • Management plans to continue its movement towards vertical integration as it relates to production. The company notes that in-sourcing a substantial portion of its product manufacturing, whether at the existing Heartland plant (which is expected to produce 50% – 60% of Blue Buffalo volume) or to future owned facilities, will yield significant cost savings. The Gross Margin profile of the business is healthy for this category, at around 40%, but has not shown much in terms of scale benefits. That said, that fact is not all that surprising given the level of production outsourcing and variable cost of protein inputs.
  • The company is building a dedicated sales force for the veterinary channel.  Blue Buffalo views veterinarians as key influencers and believes it can develop a set of differentiated products that will create disruptive results in this channel.
  • The company incurred $2.9 million of legal expenses in 2014, which are costs related primarily to the litigation with Nestle Purina.

The filing highlights the reason BUFF has not pursued an M&A exit.  Historically, the high water mark for pet food M&A has trended at 3.0x Revenue.  However, if Blue Buffalo were valued at $3 billion, that would imply the company was worth 15.5x Adjusted EBITDA of $193.2 million, which feels considerably light for the leading independent natural pet food brand. Consider Freshpet, which is smaller, unprofitable, and has not produced as impressive growth, trades at over 6.0x Revenue. While we don’t see Freshpet as the perfect comp those who are not close to the industry are naturally going to make that comparison. Our expectation is that a public Blue Buffalo will be valued closer to $5 billion, too big a piece of cheese for even the largest industry mouse to swallow. That valuation assumes that the company can detail a tangible plan to grow outside its core channels and in lower cost products, improve its gross margin profiles, and deliver higher level of surety around its product inputs.

/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.

fresh2Earlier this month, pet food marketer, Freshpet pulled off a successful initial public offering, raising $156 million. The company, which generated $74.5 million in sales and $23.1 million in losses for the 12 month period ended June 30, 2014, priced its IPO at $15, higher than the anticipated $12 – $14 range. The stock enjoyed an opening day “pop” of approximately 27%.  Freshpet occupies some pretty attractive real estate in the form of 12,500 branded refrigerators.  Those units include distribution (as of September 30, 2014) in Wal Mart (1,607 stores), PETCO (1,364 stores), PetSmart (1,306 stores), Target (1,157 stores), Kroger (972 stores) and Whole Foods Market (226 stores).  The company was backed by Mid-Ocean Partners, a New York based private equity fund, who, for all intents and purposes, salvaged the company in 2011 after it burned through the original undisclosed investment it received from Tyson’s Foods, who is the primary protein supplier to the company and remains a minority shareholder.

At is current enterprise value of $676 million (November 24, 2014), Freshpet’s public equity trades at 9.1x multiple of revenue.  In contrast, publicly observable acquisition multiples for the most attractive pet food assets have historically topped out at 3.7x revenue (Del Monte Foods / The Meow Mix Company, March, 2006). This convergence of circumstances has led many too ask, often using colorful language, how the market might justify such a premium. Here is my response:

  • When a Number if Not the Number. When a company goes public, there is a collaborative process to create positive momentum for the stock price.  The supply chain has the company selling at a discount to the underwriter who in turn sells at a discount to institutional investors and sprinkles some of the well connected general investing public. Those not in this inner circle who seek to access the stock are forced to bid it up in an effort to acquire a position.  The resulting supply/demand imbalance generally buoys the stock price for some period, ideally until fundamentals catch-up to the price. In the period immediately following a public offering, there is limited downward pressure, outside of broader market fundamentals, on the stock until it posts earnings or the lock-up period expires. As such, the prevailing price is simply the price you can buy or sell the stock for right now rather than indicative of the long range, or fair-market valuation of the company.  You can see other examples of this trend in practice with other recent pet related IPOs Pets-At-Home Group (LSE:PETS) and Trupanion (NYSE:TRUP) both of which, after a brief honeymoon period wherein the stock was supported by the supply/demand imbalance, have seen their multiples revert to the mean for their business respective models.
  • Don’t Underestimate the Pent-Up Demand. Retail investors love the pet space because, for companion animal owners, it is easy for them to understand. However, as we have detailed before, there is a lack of pure play pet companies, especially in the consumables category.  Investors can play the retail space through PetSmart (NasdaqGS:PETM) and Pets-At-Home, the health care space through VCA Antech (NasdaqGS:WOOF), Zoetis (NYSE:ZTS), and Neogen (NasdaqGS:NEOG), and distribution through MWI Veterinary Supply (NasdaqGS:MWIV). However, opportunities to invest directly in pet food and treats are non-existent.  The three biggest players — Purina (subsidiary), Mars (private), and Big Heart Brands (private) do not currently offer that opportunity. As someone who subscribes to the Peter Lynch theory of investing (i.e., go with what you know) I can see why retail investors might be willing to pay a premium to get access to the sub-sector given its growth profile, consolidation multiples, and recession resistant dynamics.
  • Compelling Business Attributes.  What is overlooked in the analysis above is the fact that Freshpet has some compelling business attributes that should be ascribed a premium price.  The company’s refrigerator inventory occupies some valuable real estate and the business model is such that retailers are unlikely to support multiple players, providing Freshpet with a first mover advantage and considerable barriers to entry once that cost is underwritten.  Ultimately, the company might become a toll taker whereby it is paid to host third party products in its established real estate. Also consider that Freshpet reports that its refrigerator units reach cash flow breakeven in 15 months. If we assume the company will generate approximately $81.6 million in sales this year (the most recent reported quarter (2Q2014) annualized), this translates to approximate $18/per refrigerator/day to support this breakeven point.  One and one half six pound tubes of the company’s Vital brand would essentially cover that daily revenue bogey.  As revenues scale breakeven per refrigerator will come more quickly, thereby enhancing cash flow.  Finally, the cost premium, while significant is not that far out of market for owners already feeding their pet super premium solutions.  Consider that an active 50 pound dog would go through at 28.6 pound bag of Orijen premium pet food (made by Champion Pet Foods) in 23 – 27 days (based on the brand’s feeding guidelines here) at a cost of approximately $3.75 – $4.25/day based on an in-store retail ring with sales tax.  That same active 50 pound dog would go through a six pound tube of Freshpet Vital in 4 – 5 days, at a cost of approximately $3.50 – $4.40/day. While the disparity gets larger with the size of your dog or as you indulge in more exotic Freshpet offerings, and the price variance is much greater versus mass market kibble, it is not all that out of line for a premium consumer.

The net of all this is that the current equity price of Freshpet is hard to fathom.  While the current price is being artificial inflated, the business has some operating characteristics that support a premium.  I won’t hazard to guess what Freshpet will be worth once the trading shackles are off, but we have seen examples of where companies that are pioneering unique niches in the food space can enjoy strong multiples from some time (see Annie’s).  However, invariably company performance will have to accelerate meaningful to support even the prevailing enterprise value.

/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.

CPO2In prior posts we have explored the notion that pet industry transaction volume is accelerating, and by all available measures in fact it is.  We have also delved into rumors of a public offering by Blue Buffalo later this year, noting the lack of public traded pure play pet companies. On Tuesday, Trupanion, a venture backed provider of health insurance for dogs and cats, announced it intended to file for an IPO on the New York Stock Exchange. We are also aware of at least one other company in the process of filing, and the concept of going public has been increasingly discussed in my industry coverage meetings.  This begs the question, are the public markets the most viable exit opportunity for a variety of midsized pet companies?

What is most notable about the Trupanion filing is the size of the company.  The business, of which I am a customer, disclosed that it was covering 181,634 pets as of March 31, 2014 and generated revenue of $83.8 million for the year ended December 31, 2013. On a quarterly basis, the company said it has posted quarter-over-quarter revenue growth since the first quarter of 2010. In the most recent quarter, ended March 31, the company reported revenue of $25.6 million, a 44% increase from the same period a year earlier.  However, also in the disclosure was the insight that the company lost $8.2 million in 2013 and has never made money.  That said, Trupanion has a huge intangible data asset, having covered a large population of pets for nearly 14 years; data that would be highly valuable to a variety of players in the pet supply chain. That notwithstanding, it is hard to believe that Trupanion, even at the most generous valuations, is going to achieve an offering price that results in a market capitalization that will motivate meaningful analyst coverage, given its size and earnings profile. Trupanion’s primary competitor, the larger Veterinary Pet Insurance Company, remains private. Other pet insurance companies have not met with favorable results in the public markets due, primarily in my estimation, size.

Often public filings are practical way of putting a “For Sale” sign on a business. Whether or not this is Trupanion’s intention, the mere optionality of a public listing would act as another catalyst for industry transaction volume.  Further, if successful it could pave the way for other midsized pet companies to explore the go public alternative.  Certainly companies such as Radio Systems Corp, Hartz Mountain (which is owned by publicly traded Uni-Charm Corporation) and United Pet Products (owned by publicly traded Spectrum Brands) would be well situated to tap the public markets for liquidity or acquisition capital. Further, brands such as Champion Pet Food, Dosckocil Manufacturing, Freshpet, Kong Company, Nature’s Variety and Merrick Pet Care would gain another exit alternative.

The analysis above separates the issues of “could” from “should”. While Trupanion has a clear path to a diversified growth plan through its data asset, the ability to sustain public company momentum for many of the companies listed above is limited. We have already questioned whether the much bigger Blue Buffalo can remain channel tied as a public company and it dwarfs most of the above listed companies in size and brand awareness.  However, more public pet companies would be good for the industry, which generally lacks a broad set of consolidators.

/bryan

 

 

 

 

noseFor those of you who are consistent followers of my blog, you might recall earlier this year I was rather sanguine (on a relative basis) with respect to the prospects for the pet industry in 2013. My thesis was based upon three factors. First, that a tepid recovery would result in slower pet population growth and the waning of the pet food upgrade cycle. Second, that slowing comp (same-store-sales) growth at PetSmart was in fact a proxy for the industry. Finally, that declining influence of the baby boomers, who have slowed pet replacement, would not be sufficiently supplanted by the necessarily levels of spending growth by Gen X/Y to propel the industry forward at projected levels.

As we round the final turn in the calendar year and head for home, things have not played out quite as I had expected.  The industry has proven itself to again be resilient and more adaptable than even I recognized. The economic recovery has been aided by strong equity returns and rising home prices that have exceeded most pundits expectations. Notably, this has resulted in solid growth in industry related personal consumption expenditures that indicate the industry should deliver projected 2013 results. While PetSmart comps are in fact slowing, management has found ways to adapt — prolonging the pet food upgrade cycle through expanding offerings and more square footage dedicated to the premium aisle, resetting key categories such as canine hardgoods, and evolving service offerings to be more compelling.  Management also reported their belief that the company’s online strategy is producing above market returns. Finally, pet adoption rates, a key driver of spend, have accelerated in 1H2013 adding additional reason for optimism. While there may be clouds on the horizon, rain does not appear imminent. As such, we expect the industry to hit its annual growth projections.

In addition to strong growth, we are also predicting that 2013 be a good year for industry related transactions, both M&A and private placements. One of the best predictors of future M&A volume is trailing private placement volume. Generally speaking, private and growth equity firms have three to five year hold periods. From 2010 – 2012 private placement volume met or exceeded M&A volume in the pet industry. Investments made in 2010 are now starting to come into season. Given the number of companies that will enter their exit window over the next two years we expect transaction velocity to continue to grow. Consumables, distribution, and hardgoods are expected to lead the way. Based on 2013 private placement volume we expect this to become a long-term trend.

The year has also produced a number of trends that we expect will have long term implications. Among these, we are seeing acquisition rationales of large strategic acquirers focus on the value of acquired brands in the pet specialty channel. As an example, when Del Monte Foods acquired Natural Balance Pet Foods, it was the latest in a long line of wellness oriented pet properties snapped up by a large strategic acquirer. Historically, these acquired brands have migrated out of pet specialty and into mass where the market opportunity is perceived to be greater. Our understanding is that Del Monte intends to keep Natural Balance in its current channel. Sure we have heard this before from other buyers, but if you consider that mass is losing sales to pet specialty and currently there is a lack of large brands in independent pet specialty with traffic pull, we may be reaching the tipping point where taking share in broader pet specialty is the more attractive opportunity. Increasingly, we see large strategics seeking ways to connect with a premium consumer in pet specialty and believe that acquisition rationales will increasingly rely on this inherent logic.

Additionally, we are seeing a proliferation of direct-to-consumer models in the pet industry. While ecommerce is the most well known business model for direct sales to consumers, a number of alternative models (flash sales, curated retail, marketplace) have emerged post-recession. During the past twenty-four months, companies promoting these models have begun targeting the pet space.  Notably, Bark & Co. (curated retail), Dog Vacay (marketplace), and A Place for Rover (marketplace), have all raised significant amounts of capital. What these companies, and their backers, are betting on is that as Gen X/Y, demographics that have grown up transacting online, ascend in purchasing power these models will see increasing adoption.

As always, a more complete exploration of these topics and the broader industry are available in my report (post here or email me to request a copy).

/bryan

arrowAs most of you are well aware, the pet industry is in fact quite large.  Depending on how you measure industry size, the pet industry is the fourth largest consumer segment of the U.S. economy (excluding health care).  And where there are large market opportunities, logically, they are capital inflows from investors, both public and private, seeking to create wealth from changing dynamics in those markets.   As an example, if you were an investor in PetSmart’s public shares over the past five years, you have enjoyed a handsome return from the specialty retail chains’ ascendency, as consumers spent more on their pets as part of the broader humanization trend.

Pet companies have also received a considerable amount of interest from private equity funds seeking to capitalize on the growth trends inherent in the industry.  While I do not have purview into every equity funds predilections, I have yet to come across a consumer oriented growth equity or buyout fund that does not have an interest in the pet space.  Many of them long to replicate the success of Eagle Pack Pet Food, Old Mother Hubbard and Banfield Pet Hospitals.  This “professionalization” of the industry has been a thematic I have waxed on about at length in my prior reports.

However, despite the size of the opportunity and the amount of available capital seeking that very opportunity, private equity transaction volume in the pet industry has in fact been quite limited.  To put this in perspective, according to the Pitchbook platform, there were 364 private equity transactions completed in 2012 that involved consumer facing companies.  Of that deal volume, the pet industry made up just over five percent of private equity deal volume with 19 reported transactions.  The is a decline from the past three years, where pet industry transaction volume made up just over seven percent of total consumer transaction volume.  The chart below tracks the trend over time (source: Pitchbook).

GraphThrough April 2013, there have been six reported private equity investments in the pet industry, putting the industry trend at risk for a second consecutive deceleration.  So what gives?  A few thoughts based on my experience.  First, the interest of private equity in the industry does not align well with the size of its participants.  As a general rule, private equity firms target companies with at least $5 million in Operating Income, with a strong preference for more.  That is not to say that growth equity and buyout deals don’t get done involving pet businesses of every size, but the core interest from these investors is in companies with a strong track record of profitability.  The pet industry has a limited number of companies that fit this mold, with most businesses being bigger or well below that threshold.  Second, there is an active consolidator market in the industry which is a headwind for private equity firms to get a deal done.  If a seller can get a better valuation from a strategic, they will often bypass the private equity market all together and wait to do a strategic sale. Finally, the interest of private equity in the space tends to be disproportionately oriented around pet food and veterinary clinics. A lack of opportunities in these segments has increased focus on retailers, distributors and, more recently treat companies, but a historical sector bias has certainly limited deal volume.

I remain long term bullish on private equity and the pet industry, but, as evidenced by the above, the relationship between the two has some inherent complexity.  However, as private equity gets a track record of success in a broader segment of industry sectors look for the industry to embrace outside equity more fully.  Deals beget deals.

/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

skullOne of the challenges in forecasting is failing to recognize the inherent frictions in the market.  For over two years I have been predicting a major IPO for the pet industry against the backdrop of expanding public company market multiples.  My initial thesis was that PetSmart’s market valuation heuristics would compel Petco to consider a listing.  Two dividend recaps later, the private equity owners of Petco seem happy to milk their cash cow with no public offering in site.  Natura? Sold.  Sergeant’s Pet Care? Sold, and probably too small anyway.  Pets at Home? Sold. Radio Systems? Private bond offering. Hartz Mountain? Recapped. Blue Buffalo? Crickets.  During this same period, a number of pet related public companies have been taken private (Del Monte, you see a food company while I see a pet company, and International Absorbents, as examples). So net net the market had experienced entropy where I predicted order.

There is a saying that “100% of shots not taken result in goals not scored”.  While I had taken my shots, it resulted in the same outcome — a bagel.  However, next week I get a consolation prize when Pfizer spins off its Animal Health Division into a new corporation, Zoetis Inc., listed on the New York Stock Exchange.  Zoetis engages in the discovery, development, manufacture, and commercialization of animal health medicines and vaccines.  The company derives 65% of its revenue from the livestock market and 35% from the companion animal space.  The company’s name is derived from zoetic, meaning “pertaining to life”.

Zoetis is a big business by pet industry standards, having generated over $4 billion in revenue and over $1 billion in EBITDA for the twelve month period ended July 1, 2012.   Post spin, the company will be the largest standalone manufacturer of animal health products globally, with roughly a 19% market share.  Vaccines and medicines for animals represents a $22 billion market globally according to Pfizer, of which approximately 30% represents veterinary vaccines for companion animals.  The U.S. market for these products is expected to grow at annual rate of 5.8% over the next five years, slightly higher than the total domestic vaccine market whose growth, over the same period, is projected at 5.3% according to Transparency Market Research. Notably, Zoetis grew approximately 30% in 2010 (in part due to the acquisition of Wyeth, whose animal health division, Fort Dodge, generated over $1 billion in revenue at the time of the transaction), 18% in 2011 and 4% over the first half of 2012.  Pfizer estimates that the public company value of Zoetis could be as high as $12.5 billion, or approximately 12.0x estimated 2012 EBITDA.  After the spin off Pfizer will own 80% of Zoetis.

Yes, the Zoetis IPO is essentially an overdue backdoor validation of my thesis – it’s not a products or consumables company or a specialty retailer, it’s an animal health empire.  Further, Zoetis was nurtured inside the womb of one of the largest global phrmara companies and not built from the ground up.  That said, the cloud has a silver lining:

  •  Yes, someone had to go first.  Often times a sector IPO leads to others, assuming it gets a warm market reception.  Given that Zoetis is a cash cow, it should be welcomed with open arms by retail investors.
  • The pro-forma valuation of Zoetis is healthy.   The company is expected to trade at a significant premium to core human pharma names, consistent with my belief that the companion animal health care market has strong tail winds and a large opportunity set ahead.  Notably, the valuation does a lot to validate the price paid for Perrigo’s acquisition of Sergeant’s, which I estimated at 10.0x EBITDA.
  • The pet market is lacking for public companies that focus solely on the industry.  Having greater transparency into industry related valuations is good for capital recruitment and exit market dynamics.

In closing, it’s notable that Pfizer spent nearly two years considering alternatives for Zoetis.  So while I predict other pet IPOs, I don’t suggest holding your breath until the next one.

/bryan

debt freeOne of the most frustrating aspects of following the pet industry is the lack of transparency we have into the operational results of bellwether companies that comprise the market.  With only a handful of pure-play public companies, and even fewer with meaningful analyst coverage, we are left to rely on publicly available market studies, which are often dated and/or at a cursory level, expensive third party research, or, more often than not, rumors and conjecture.  As evidence, approximately 25% of search terms that led people to this blog are related to market rumors (e.g. “Blue Buffalo acquired”) or data searches on private pet company performance (e.g. “Petco 2012 EBITDA”). However, the availability of cheap leverage to fund organic and acquired growth is providing us a rare opportunity to understand how some of these large private pet names are performing.

In October 2012, Moody’s Investor Services assigned a B3 rating (speculative) to a $250 million private bond issuance from Radio Systems Corporation, the privately held market leader in pet containment products and training systems.  The proceeds from the issuance went to replace existing balance sheet debt and purchase a putable equity stake valued at roughly $90 million.  According to Moody’s, the transaction would leave Radio Systems with a debt-to-EBITDA ratio of 4.7x.   The report also states that the company generated sales of $270 million for the twelve month period ended June 30, 2012.  So what can we glean from this disclosure?

  • Based on the company’s debt-to-EBITDA of 4.7x, this would imply Radio Systems had somewhere in the neighborhood of $50 million – $55 million in trailing EBITDA as of June 30, 2012.  Based on $270 million in sales for the coinciding period, this would imply an EBITDA margin of 18.5% – 20.0%, a good metric for a company of this size in this segment of the industry but certainly with room for expansion.
  • If we valued Radio Systems at an EBITDA multiple similar to the Sergeant’s Pet Care Products / Perrigo transaction or based on the public trading multiples of Garmin or Spectrum Brands, this would produce an implied enterprise value for Radio Systems of $500 – $550 million.
  • Finally, it appears safe to assume that TSG Consumer Partners, whose equity put is being acquired, will make a 3.0x return on its investment of $30 million made in 2006.  This returns Randy Boyd to full ownership of the company.

Moody’s rating of Blue Buffalo’s $470 million financing (rating B1) also provides us some salient insight into the company and its capital structure.  According to Moody’s, the proceeds of the transaction will go to fund a special dividend for the owners, including equity partner Invus Group.  While Moody’s did not peg a debt-to-EBITDA multiple for Blue Buffalo at the time of the transaction, it does state that “Moody’s expects that the company will be able to generate sufficient free cash flow to de-leverage rapidly, such that debt-to-EBITDA will be below five times in the next 12 months.”  The report also states that the company generated sales of $400 million for the twelve month period ended March 31, 2012.   So what can we glean from this disclosure?

  • If we assume the debt financing reflects the total leverage of Blue Buffalo, it is safe to assume that the company generated somewhere in the neighborhood of $80 – $90 million of EBITDA for the twelve month period ended March 31, 2012.  Based on $400 million in sales of the coinciding period, this would imply an EBITDA margin of 20.0% – 22.5%, a very good metric for a company of this size in this segment of the industry, especially one who is funding a national television advertising campaign.
  • Setting aside whether they were true or not, the rumors that were swirling around earlier this year that Blue Buffalo was entertaining sale dialogs with a starting price of $800 million, denotes an implied revenue multiple of 2.0x and an implied EBITDA multiple of +/- 10.0x, which do not appear out of line, maybe even light on the profitability side of the equation.
  • This confirms, what many people speculated, that Bill Bishop had sold a meaningful portion of the firm to a third party equity firm sometime within the last three years.  Invus, which has an evergreen fund structure, and therefore can hold positions for long periods, is a sensible partner.  Invus is also well credentialed in food, with historical investments in Keebler, Harry’s and Weight Watchers.

Finally, Petco Animal Supplies is again tapping the debt markets for $550 million in senior notes.  You might recall the company refinanced its balance sheet to the tune of $1.7 billion back in 2010, in part to finance a $700 million dividend to its owners, enabling them to repatriate 90% of their invested capital.  This time around, the notes along with balance sheet cash will be used to fund a $603 million distribution to shareholders.   I hashed out the Petco situation here before, but the most salient point that can be gleaned from Moody’s disclosure is that the company grew revenue from $3.0 billion to $3.3 billion from 2011 to 2012, a rate consistent with Petsmart for the same period, reflecting a greater equilibrium in the balance of power.

Net net, while much of the above might have been pieced together by an informed observer these conclusions were often difficult to corroborate because we lacked factual information.  One benefit of low interest rates, is we have gained some transparency in the process and therefore can substantiate some of the speculation rampant in the industry.

/bryan