happy-puppehAgainst a backdrop of macroeconomic uncertainty, the pet industry continues to thrive.   While the prevailing theory that the industry is “recession proof” is being sternly tested, market fundamentals of pet ownership remain strong and consumers are skimping on themselves as opposed to their pets and/or children.  Further, the premium demographic continues to have a voracious appetite for efficacious products that are good for their pets as well as the environment.

That being said, the recession has set in motion a number of trends that will, in my view, forever change the pet industry landscape.  While several of these trends are in the “early innings” so to speak, the momentum behind them is significant.  The companies that stand to win during the next phase are those that recognize the seachange and position themselves to take advantage of the wave.  This period will separate the leaders from the pack, to steal a phrase.

Recession Not Found Here?

Pure play equities of pet related companies fell precipitously with the market during the second half of 2008.  However, unlike the general market, these equity began to experience their recovery in November 2008.   The primary driver of equity price contraction was based on fundamentals — earnings for these core names fell 30% from the prior quarter, which spooked the market (in truth some of this could be chalked up to seasonality).

In reality 3Q2008 was up year-over-year from an earning perspective, albeit only slightly.  In a world where flat is the new “up”, this should have been investors first signal that the market was overreacting in this category and  pet related equities were becoming oversold.  Notably, earnings rebounded strongly in 4Q2008 posting year-over-year growth of ~ 4% (weighted by market capitalization), driving a correction with respect to public company valuations.   Thus, the prospects for a technical recession in the pet industry are in fact quite low.

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Notably, the macro economic environment did not constrain equity deals in the pet space.  Key deals including Hammond Kennedy Whitney/FURminator, TSG Consumer Partners/Dogswell and Tyson/Freshpet were all announced against a declining or, even abysmal backdrop.   Appetite for pet related concepts has never been higher among growth equity funds due to the prevailing dynamics and long term fundamentals.

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Key Trends for 2009

So what are the seismic shifts of which I speak?

First, I believe we are in the early innings of a major shift in the pet retail landscape. PetSmart and Petco are facing significant competition from Wal Mart as they battle to be the one-stop-shop for the mid-tier pet buyer. Wal Mart’s merchandising acumen coupled with their reach and financial strength make them daunting opponents. Large pet specialty will take share among the most attractive demographic and thrive amidst the chaos among big box players. Their ability to educate buyers and offer patrons a favorable service experience situates them to be long term partners of both customers and the most compelling pet related brands. They will also take share from contracting boutiques hit be financial hardship.

Second, in bad times value trumps luxury.  The downturn in the U.S. economy has eroded the balance sheets of mainstream consumers. While companion animals will continue to a growing part of our society, consumers will become more fickle as it relates to spending on their pets. Product (excluding consumables) and service providers must give pet owners a compelling value proposition if they expect to experience continued growth. This change is expected to be lasting.

Third, consumers want to know what they are paying for.  In the food arena, efficacy is going to become important, a concept which many have taken at face value.  The market has become saturated with better-for-you pet food brands whose differentiation has become hard to appreciate. Supply chain control and organic are no longer differentiators. As distribution opportunities contract, due to contraction in the boutique market, and funding dries up, solutions that can demonstrate high degrees of efficacy will prevail. Customers will begin to demand results for their incremental dollar.

Finally, pet health will come in to focus as owners make difficult choices with their limited free cash flow.  Pet related health care is even more inefficient than its human corollary. Relations between veterinarians and their customers is strained by the high cost of service and medications and the limited proliferation of pet insurance. Further, compliance rates on even basic pet medications are sub-standard. Solutions will arrive that deliver compelling value throughout the pet health care supply chain, driving operating and cost savings at the clinic level, compliance rates among drug applications and ultimately satisfaction for pets and their owners.

Net net, I expect the balance of 2009 to be challenging but good for pet related industries.   Notably, I believe we will see additional pet related equity deals as investors seek to put capital to work in sectors that continue to grow.  As the debt market improves, leveraged buyouts of some of growing bell weathers of the industry (a la FURminator) begin to come in to play, assuming valuation expectations have come down due to market realities.   One would also expect public pet companies to seek to buy growth in a effort to fuel their lagging equity prices.  This could kick of a consolidation phase in the middle market, but I’m not overly optimistic.

As always, you can contact me for a complete version of our market presentation.

/bryan

I’m too old for Las Vegas, or at least that is what I keep telling myself.   But when the opportunity to attend WWPIA Superzoo 2008 (show website here) at the Mandalay Bay Hotel for free availed itself through my wife’s business, I knew I had to put my Vegas issues aside.  Superzoo is the third largest show of its kind in North America, and its exhibitors and attendees list is steadily growing.  The show falls at an ideal time for retailers, who are now beginning to turn their attention to stocking their shelves for the holiday season.  What I like about Superzoo is that the show is an ideal size to be an observer, large enough to attract many of the top retailers and small enough to be able to walk the show multiple times a day.

For me Superzoo was about meeting, but also about observing and learning.  I set a modest goal for myself to meet five companies from the extended Pacific Northwest and five interesting brands outside the region.  My central category focus was on alternative food, given the projected growth in the sector and the developing brands in the space and their lateral mobility into treats.  I also wanted to hear from boutique retailers how they were feeling about the industry and the prospects for their business given the challenging macro economic climate.  Finally, I wanted to see what the buyers were into by watching the traffic flow into the single product company booths.

Based on my two days of walking the floor, here are some summary observations.

Humanization of Pets Movement is Maturing.  A lot has been said, written and posted about the humanization of pets movement.   The history of the phrase (or at least based on what I have found) dates back to 2005, when Pet Channel published an article about a the growing trend of pet insurance.   In that article, Pet Channel noted that we were “treating our cats and dogs more like children than ever before.”  The movement was validated in 2006 when the head of Del Monte’s food and pet division was quoted saying that “the humanization of pets is the single biggest trend driving our business”.  In 2007, Packaged Facts, a leading market research organization, published a projection that non-food sales, relating to the humanization of pet, would grow to be a $15 billion by 2011.

Despite the definition advanced by Pet Channel, the first wave of pet humanization was largely perceived as simply pampering your pet, a willingness to do more for and spend more on them as a means of communicating to others their importance in your “pack”.  Based on what I observed at Superzoo, that definition has morphed to be more sophisticated, eliciting a symbiotic contrast between pet and owner — what I do for me, I do for my pet.  To me this is true humanization.

Superzoo featured a bevy of product and service companies facilitating this symbiosis.  Pet related OTC health products are proliferating.  A number of new vitamin and supplement companies have emerged. Lotions and potions have also come a way, with products now available to treat skin conditions, style hair and mitigate smells.  Their packaging increasingly sophisticated and marketing draws human parallels.  Alternative food companies, many of them who have been making formulas for some time are gaining market traction, due in part to the pet food recall, but also in part due to this maturing of the humanization movement.  Many of their booths featured pictures of the human ingredients including in their products. Treat companies, incorporating nutrients and human foods were well trafficked by buyers at the show.

The Alternative Food and Treat World is Merging Into One.  The pet food recall of 2007 served to open up the pet food market to alternative and organic food brands who were otherwise idling in relative obscurity, serving a defined “hardcore” niche.  The headlines caused by the supply chain failures of much larger brands, allowed them to emerge from the shadows and enter the spot light as consumers sought clarity with respect to the ingredients underlying the products they were feeding their pets.  According to Packaged Facts, 14% of consumers switched food brands as a result of the recall. The alternative food category was a key beneficiary, buoyed by the fact that a cross section of these brands had been operating for decades and they had control over their own sourcing and production.  As a result, these brands developed affinity in the market relatively quickly, capturing enhanced distribution through secondary retail and the natural foods channels.

In an attempt to leverage their momentum, these producers arrived at Superzoo with treat lines to augment their core food offerings.  Hoping to benefit from their brand attachment with consumers they are expanding into the lucrative treat space.  Most producers told me that the product sales velocity in the space coupled with the enhanced margin profile for treats made it an easy decision for most.   In return, Dogswell, a premium player in the better-for-you treat world, introduced their own wet food and biscuit treat lines.   The two worlds are clearly converging.   This makes complete sense given the the fungiblity of a brand across these two product categories.  What will be interesting to watch is who has the greater brand pull across categories.  While Dogswell is a major treat player, I suspect it will be more challenged relative to Primal Pet Foods, Steve’s Real Food, Evanger’s, etc.  TBD.

Mass Pet Retail is About to Undergo a Second Evolution.  Given the current economic climate, consumers are looking for one-stop-shopping.  Consider that trips to the pet store will fall nearly 3.0% in 2008, after falling nearly 2.0% in 2007 (again thank you Packaged Facts).  Further consider that the mass pet retail market made a heavy push into grooming services, which is in the top three list of things consumers view as highly discretionary in a turbulent economy.  In a contracting services world, the major pet retailers appear to be trying to find ways to nibble at the edges of the boutique world, seeking out premium products.   They will augment this by adding additional services, including co-branding pet insurance to leverage their brand and add additional convenience to the pet consumers shopping experience.

The question is whether we will see store-within-a-store concept,s trying to siphon off high end customers who continue to utilize larger store formats to augment their purchases or to acquire food from major brand players not otherwise carried by their boutique retailer.  Clearly they will have to raise the service bar to do so.

On the outside looking in is Amazon.com.  E-commerce offerings in the pet space are underwhelming, to say the least.  Given, again, variable service levels at mass pet retail, their ability to create a sizable dent in the marketplace is without question.  However, while they have identified the opportunity they have done little to date to organize themselves effectively, which is a daunting task.  That said, I see Amazon Fresh as a potentially big vehicle for deliver of alternative food products and over time I expect Amazon.com to become a sizeable part of the delivery supply chain.

All in Superzoo was a great experience.  I expect to encapsulate all my learning’s into an updated market presentation shortly after year end.  On a side note, if you are ever looking for a great meal in Las Vegas outside all the hubbub, Lotus of Siam (see review here) should be on your agenda.

/bryan