catAs we approach the bell lap in 2014, anticipated full-year performance for the pet industry is starting to come into clearer focus.  For the first time since we have been blogging about the industry, we believe projected growth might fall short of APPA projections.  The industry continues to face structural headwinds that are dampening our expectations.  Notably, three metrics we commonly rely on as relative predictors of growth are lagging the benchmarks we feel are necessary for these projections to be achieved.

  1. Personal Consumption Expenditure (PCE), which consist of the actual and imputed expenditures of households by consumption category as measured by the U.S. Department of Commerce’s Bureau of Economic Analysis, for pet related goods and services showed growth of 3.7% in 1H2014 versus 5.7% in 1H2013;
  2. PetSmart same-store-sales comps (including inflation) for 1H2014 were -0.6% versus 3.5% for 1H2013;
  3. Adoption rates, as measures by PetHealth Inc.’s PetPoint Report shows that adoptions of canines have been weak through 1H2014, with feline adoptions also lagging in 1Q2014.

There are other factors that concern us as well.  Household formation has been sluggish, wage growth is stagnant, and the retail environment is tepid, at best.  However, offsetting these concerns is data that shows pet parents are spending more than ever, alternative sales channels such as online and farm and feed and experiencing strong growth, and conventional grocery is making significant investments in the category.  From experience, we also know the pet industry is like a cat — it always lands on its feet.

As we take stock of the industry here are the key themes we see shaping the current landscape:

  • Transaction Environment Heats Up. Acceleration in pet industry transaction volume began in 2010 driven by third party investment in emerging brands. After peaking in 2011, velocity tapered in 2012 and 2013. Based on YTD numbers, pet industry transaction volume is set to rebound, led by increased M&A activity. Consolidators are looking to gain greater exposure to faster growing segments of the market. Large amounts of liquidity in the market are driving up valuations, when combined by uncertainty in the retail channel, is motivating sellers. Notably, available liquidity options have now expanded to the public markets for mid-sized pure play pet companies with strong growth impetus. As market growth slows, we expect pressure to consolidate will heighten further giving this M&A velocity uptick legs through 2015.
  • Major Pet Specialty is Getting Pinched. Pet specialty retailers are facing slower comps and market share erosion from a myriad of drivers we have highlighted over the past few years. Margin is moderating for this channel as sales growth slows, at a time when investments are needed. We believe the successful response to these threats requires bold moves not currently being contemplated. While tweaks to the merchandising mix may help, rapidly expanding omni-channel capabilities through acquisition and investment and pursuing vertical integration opportunities are needed. Imagine PetSmart’s fortune if it had invested in Blue Buffalo ten years ago. Channel barriers are coming down and retailers need to think out of the box to protect their incumbent positions. Change takes time, so do not expect a near term rebound, but do not discount the power these retailers have with manufactures to mitigate losses.
  • Channel Barriers Are Eroding. The pet industry has a high percentage of channel tied merchandise. PetSmart derives nearly 30% of its revenue from product exclusives. Brands that bridge into FDM are generally shunned by independents. As comps slows in pet specialty, emerging brands are getting anxious about their own growth prospects, causing them to consider testing the prevailing merchandise borders. As conventional grocery attempt to reverse share losses realized over the past five years, expect them to expand their efforts to recruit leading brands or incentivize those brands to develop solutions that work at lower price points. The risk for the industry is that a broader carriage of authentic and emotive brands in conventional grocery at lower price points could result in the realization of a downgrade cycle.
  • Online Independents Enter End Game. While pet products growth online continues to be robust, profits associated with these sales remain thin. Being a sub-scale online pet retailer is a losing value proposition, literally. The best situated players are developing forms of differentiation – media and education assets, prescription capabilities, and private label offerings – to offset lower margin product sales. Those who are successful will be the attractive consolidation candidates. PetSmart’s acquisition of Pet360 is consistent with this thematic. Three other independent players are currently for sale. Some of these companies will be acquired for their differentiated capabilities, but we expect the others to become zombies or go away entirely. We expect that three years from now, there will be no meaningful independent traditional pet ecommerce retailer.

For a complete summary of our pet industry market insights, please contact me for a copy of my report.

/bryan

Source: American Pet Products Association, CapitalIQ, PetSmart, Inc., U.S. Department of Commerce

Note: The purpose of 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.

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

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

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

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

/bryan

images7CBOOO04

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

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

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

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

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

Contact me for a copy for my report.

/bryan

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

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

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

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

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

/bryan

elvisIt’s hot in Las Vegas in July.  I mean, uncomfortably hot if you ask me.  Maybe 10 years of living in the Pacific Northwest has made me a warm weather wimp, but facts don’t lie — Las Vegas averages over 100 degrees in July.   So when the SuperZoo tradeshow date was moved for 2013, the only thing I could think of was the possibility I would melt while wearing my show badge.  In reality, repositioning the show time to mid-summer makes a lot of sense, but still Las Vegas in July?

When the numbers of are tallied for this years show, I’m sure it will be a record, both in terms of number of attendees and exhibitors.  It felt like the number of companies renting booth space doubled either as a result of industry growth or the repositioning of the shows timing.  I had the opportunity to spend a few days both on and off the floor and below is a summary of my observations:

  • Performance is Solid, Expect Consolidation.  Overall, industry sentiment remains strong.  Existing companies are reporting solid growth driven by consistent consumer demand and new companies reported strong interest from both domestic and foreign retailers. Both operators and large strategic players I spoke with predicted the pace of consolidation would accelerate. Consolidators are looking for brands they can convert to mass as well as opportunities to develop relationships at independent pet specialty.  The later strategy is no longer lip service, as the dedicated pet channel continues to take share from mass.
  • Large Players are Trying to Peg the Customer. Grain-free, limited ingredient, organic, natural, regional formulations, raw/freeze dried/frozen, made in U.S. There are so many concepts that are currently in play in the pet industry.  However, there is lack of fundamental research as it relates to what is actually motivating consumers to transact.  As major pet food companies contemplate their next deal, the proof points inherent in any strategy need to be as developed as possible in order to motivate an acquisition.
  • Small Companies are Innovating We met with a number of small companies who were engaged in dialog at the show by the major pet specialty retailers.  This is a sign that retailers perceive that their offerings are innovative enough to draw traffic and do meaningful turns.  While I don’t think companies with limited SKUs are going to be able to compete with large product providers long term, we do see moment in time opportunities and for some that time is now.
  • Competition for Petco and PetSmart Continues to Mount. When we look at the growth in independent chains such as Petsense and Pet Food Express, it is clear to us that these concepts are resonating with consumers in a meaningful way.  You simply don’t get that sort of box growth without consumer demand. These retailers had a more open presence at the show and a number of product providers were discussing their positive experiences with them.  I continue to believe the proliferation of these concepts is good for the industry.

If you have been reading my blogs, you know I entered this year a skeptic, maybe even a pessimist, albeit a relative pessimist.  Based on the financial results we are seeing from core public companies, the economic data we are seeing related to the industry and the sentiment we experienced at the show, I am officially off the couch and on the bus with the bulls, maybe just in the back seat.

/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

During the second half of 2011, the pet industry endured a brief hiatus from its uninterrupted growth trajectory.  Against a backdrop of macroeconomic uncertainty, the pet industry suffered as consumer sentiment deteriorated.  Stagnant unemployment, coupled with a housing market laboring to recover, left the industry with a post-holiday hangover.   As a result, expectations for 2012 were modest given the industry was in transition as historical growth themes from the 2007 – 2010 period waned.  This commentary was front and center in our Spring 2012 report.  What we did not accurately predict was how quickly Humpty Dumpty would be put back together again.

As we approach the bell lap for 2013, the pet industry appears poised to beat expectations for the year.  Pet population growth has accelerated, the housing market has improved, and consumer sentiment is trending up and to the right again.  This has been good for the pet industry, which saw both revenue and earnings accelerate. Coupled with investments in innovation and further evidence of traction for the Total Pet Health trend, the near term outlook looks much brighter today. Below is a summary of the macro trends I see currently impacting the industry.

  • Industry in Major Innovation Push. In recent versions of my report, I expressed a belief that the pet industry was laboring through a period characterized by a lack of innovation.  Limited investment during the recession resulted in fewer new product introductions in 2010 and 2011.  While the 2012 tradeshow season did not produce evidence of breakthrough renewal, there are signs the industry is addressing the issue.  Product company CEOs tell me they are investing heavily in R&D, retailers are promoting innovation through launch support, and equity backers are funding unique start-ups.  Where there is innovation there will be further consolidation.  Expect more excitement at Global Pet Expo 2013.
  • Ecommerce Gaining Momentum. One of the most discussed topics at SuperZoo was direct-to-consumer for the pet industry.  There is evidence, based on web traffic patterns, and partner engagement, that the category is moving online and that ecommerce leaders are growing rapidly. As Amazon experiments with same day delivery and online retailers find partnerships that provide access to pet prescriptions, we expect this solution set to grow in acceptance, taking share of independent pet specialty stores. Notably, PetSmart, who has commented that they are not seeing any market share erosion from online competitors, recently changed their management bonus program to tie ecommerce sales to compensation; recognition by the industry’s top retailer that ecommerce is a real competitive threat in pets over the long term.
  • Public Pet Companies Breakout, Again.  During 2H2011, core publicly traded pet companies lost momentum. Lacking a cohesive growth driver, earnings contracted and pet equities traded on company fundamentals with mixed results.  The industry malaise did not last long, as our comp group collectively produced 12.1% revenue growth and 16.7% earning growth in 1H2012.  As a result, core pet equities, as a group, have outperformed the S&P500 by over 15% in 2012.   While the expected names (PetSmart and MWI Veterinary Supply) continue to perform, it’s notable that others, such as Neogen Corp (23.7% equity return), Central Garden & Pet (40.4%) and Oil Dri Corp (11.2%), which have lagged in prior periods, have all produce double digit returns.  The broad advance is, in my opinion, a very positive sign for the industry.
  • Big Deal Potential.  Headline deals are important influencers of transaction dynamics within an industry.  Deals beget deals, as buyers and investors look to take advantage of market shifts caused by consolidation. While the pet industry has enjoyed a number of high profile transactions over past 24 months, these deals have been spaced in such a manner so as to limit our ability to glean anything meaningful from the associated transaction multiples. A single data point is not indicative of a trend.  However, when multiple deals express the same characteristics, it has a powerful impact.  With the recent Sergeant’s  Pet Care Products transaction, the pending Zoetis (Pfizer Animal Health) IPO, and potential deals for Central Garden & Pet / Blue Buffalo / Natural Balance Pet Foods, the industry may have a run that re-frames market valuation dynamics, similar to 2006 when the revenue multiples for premium consumable companies were established through the Milk Bone and Meow Mix transactions.

While we have never soured on the long term potential for the pet industry, what we are seeing in terms of a recovery and re-acceleration is remarkable.  It is our expectation that 2012 will turn out to have been better than expected, providing the industry an opportunity to breach its prior apex within the coming years.

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

/bryan

For those of you who are regular readers of my blog, you will note that it’s been pretty silent around here the past few months.  I promise you, it has not been for lack of trying.  There have been many capital market items of note over the summer but nothing seemed to maintain sufficient momentum as to be blog worthy in my opinion.  That said, in my conversations with others the market context I have been able to convey, through firsthand experience, has been eye opening for them.  As such, I thought it was worthwhile to catalog a few observations here.

Generally speaking the market is giving off mixed signals.  On one hand all the ingredients necessary to  produce a robust M&A and equity capital market in 2012 are evident.  These include continuing unprecedented liquidity in the hands of private equity sponsors as well as on the balance sheets of Fortune 1000 companies.  Notably, private equity fundraising in 2Q2012 was the second best quarter in the past three years according to Pitchbook.  Additionally, there are over 4,000 private equity backed companies who received outside capital more than three years ago meaning they are of “sale vintage” (typically private equity investors look to exit within a 3 – 5 year window).  Further, the public equity markets, which appear constrained by the macroeconomic climate and political rhetoric, is heavily rewarding both size and growth, making M&A an attractive shareholder value creation opportunity.  Finally, you have pending tax code changes providing sellers’ impetus to do a transaction in 2012, when capital gains are likely to be lower absent political upheaval.   The last time we faced this same tax cliff (2010), M&A volume in the second half of the year, relative to the first half, increased by over 50%.

On the flip side of the coin are the facts with respect to actual market activity.  Private equity volume in 2Q2012 was down 10% sequentially and down 36% on a year-over-year basis according to Pitchbook.  While U.S. M&A market activity was up in this same period, according to Thomson Reuters, on a sequential basis it was down 18% on a year-over-year basis.  If one digs through the data weeds the sequential uptick was driven by a small number of deals in the oil and gas sector, and therefore not indicative of a broad based rally.  Net net, through June, year-to-date M&A activity was down nearly 30%.

The net result of the above is the market has bifurcated into what we call as “Tale of Two Cities” transaction economy.  On one hand you have large $15+ million EBITDA businesses that have the ability to garner significant amount of leverage to finance a leveraged buyout.   As a result of possessing this optionality it is forcing the hand of interested strategic buyers when it comes to M&A valuations involving these properties.  Small companies (sub $5 million in EBITDA) have fewer arrows in their quiver if a strategic buyer is not a willing suitor — take an equity deal and a lower valuation or stay the course.

Notwithstanding the above, we are seeing that some small companies that can affect sales and financings on attractive terms relative to historical norms.  Said differently, deals that are getting done are closing at attractive multiples.  These companies tend to have a number of common characteristics: a) growth — not just growth but sustainable above market growth with generally accepted barriers to entry (e.g., culture of innovation, intellectual property, contracts, etc.), b) best in class gross margins —  firms with thin margin profiles are viewed as higher risk and therefore ascribed lower valuations, c) customer attachment — brand value as evidenced by repeat customer relationships at attractive economic rates, and d) scarcity — market leaders are receiving premium valuations even if they are smaller companies.

Ultimately, I feel these conditions will prevail throughout the balance of 2012.   The pending presidential election is offering voters a choice between two widely divergent economic roadmaps.  Until one is anointed and investors or buyers are able to assess the potential for growth over the next four years, buyers will remain cautious.  As a result, bankers should expect long execution cycles and “take it or leave it” negotiation tactics in the interim.

/bryan