“For the times they are a-changin'” – Bob Dylan

The pet industry produced another solid year of growth according to the American Pet Products Association.   Total industry revenue increased 5.3%, to $51.0 billion in 2011 driven by growth in all major segments of the industry.   Sales benefited  from pet population growth, which returned after a two year absence, and price inflation in all categories.  Discretionary services produced the strongest growth rate at 7.9%.

During the past five years the industry has grown 20%, a remarkable rate under any conditions, but especially in light of the economic contraction experienced in 2009 – 2010.   Expansion was fueled by the “Humanization of Pets” movement.  The trend toward treating pets as family members shifted spend into higher priced categories such as premium food, driving growth in the absence of population expansion.  While this theme remains relevant, its influence has tapered as the product rotation it stimulated nears completion.  As evidence, premium food market share is flat over the past two years.  In contrast, private label pet food and supermarket channel share, both associated with value, have grown.   While a value focus will continue due to the domestic economic climate, it will not drive industry volume but rather shift mix.  Instead, I believe an accelerating focus on pet wellness and population growth will fuel the industry in 2012, albeit at lower growth rates than seen in the past few years.

While the concept of “wellness” and the pet population is not new per se,  I see it coming together in a new and integrated way, which I call “Total Pet Health”.  Previously wellness was about giving your pet “better” food, augmenting their nutrition with consumables that provided perceived benefits, and then taking your pet to the veterinarian and listening to their advice about dental health and weight management.   Today the concept of wellness is about empowering yourself to make the most informed decisions about your pets long term well being using all available resources, rather than relying on pseudo experts.  It is about making product decisions based on actual results, not marketing claims.  It is about selecting the best product for the need at the time rather than blindly associating with a brand.  Its about having a relationship with your veterinarian around preventative care and using insurance to control total cost of care.

To adapt to these changes in owner behavior, I expect to see pet brands morphing from product or service providers into wellness brands.   As an example, in July 2011, VCA Antech, the nations leading owner and operator of animal hospitals, acquired Vetstreet (d/b/a Vetinsight.com) a provider of client communications, pet education, and home delivery of pet medications and supplies.  Against a backdrop of strained relationships between pet owners and veterinarians driven by veterinary services price inflation, VCA took measurable steps to empower pet owners.  Vetstreet’s information solutions enable pet owners to educate themselves about pet health conditions, learn what tangible steps they can take to remedy those conditions at home, and understand what to expect if they do take their companion to the clinic in order to avoid unnecessary service or charges.  Through this transaction, VCA transitioned itself from being a perceived source of the problem to being a wellness solutions provider.

A summary of my Total Pet Health theme is below:

From a pet industry transaction standpoint, I expect slower growth will result in further consolidation.  While the pet industry saw substantive consolidation in 2011, it also saw renewal as growth remained robust.  Private placement volume within the industry accelerated in 2H2011.  However, in a slower growth environment it will be harder for emerging companies to gain scale.  Further, interest from institutional equity sources in highly competitive pet categories will logically recede absent lower valuations.  If capital is lacking innovation will also be limited.  To the positive, truly innovative companies should enjoy premium valuations – see United Pet Group’s acquisition of FURminator as a prime example of this reality.  These conditions point to transaction volume being oriented around consolidating segments – distribution, hardgoods, retail, and veterinary services – in the near term.

Despite a fundamental bias towards consolidation, I expect pet industry transaction volume to be modest in 2012 absent a major transaction on the consumables side.  When Procter & Gamble acquired Natura Pet Products in 2010 it sent shock waves through the industry, especially in light of the fact that P&G was rumored to be exiting of the pet sector.   While the industry has seen active M&A and capital markets since that time, it appears wanton for another marquee transaction to provide it stimulus and buzz.  The recent United Pet Group/FURminator transaction caught the attention of the product side of the industry, but consumables have been lacking a bellwether since Nestle Purina acquired Waggin’ Train in 2010.  Given the prospects for an industry growth taper, as well as downstream tax motivations, it seems plausible Blue Buffalo Company or Natural Balance Pet Foods, the two largest independent pet food companies, could trade in 2012.  If they do, expect a flurry of activity in their wake.

As always, my full report is available by request.

/bryan

In September 2008, a private equity group led by Hammond, Kennedy, Whitney & Company, Inc. (“HKW”),  acquired a majority interest in FURminator, Inc., a Fenton, Missouri based manufacturer and marketer of pet grooming products.  The FURminator’s products include small, medium, large, cat, and equine deshedding tools, shampoos and conditioners, treats, and dog food supplements. Terms of the deal were not disclosed.  However, at the time, I put out some estimates here.

On December 9th, United Pet Group, Inc., a subsidiary of Spectrum Brand Holdings, Inc., announced they had acquired the business for $140 million.  Disclosed latest twelve months revenue for the company was  “at least” $40 million, putting the deal value at between 3.0x – 3.5x latest twelve months revenue — as eye-popping a multiple as we have seen in the pet industry, excluding food, over the past three years, and certainly something we expect other sellers and potential sellers to latch on to when establishing their valuation expectations.

When HKW and friends acquired the company, it was, in my opinion, a bit of a head-scratcher.   FURminator had established itself as the leading player in the deshedding tool market and its intellectual property position provided the company with a tangible source of competitive advantage.   However, it was not clear where the subsequent growth was going to come from.   How many $40 deshedding tools does one household need?  The product is virtually indestructible and the pet population was, at the time, not growing.   Notably, HKW did not have any pet industry experience and while my estimate of the value associated with the buyout transaction were, in hindsight, overstated, the group paid a healthy premium for the business.

So how did the buyout group generate such a handsome return?  Oddly enough, it was the recession.

While the pet industry fared well, on a relative basis, during the recession, the services segment was hit harder than consumables.  As consumers cut back on discretionary spending services were the first to go.   However, that did not mean that owners stopped washing and grooming their dogs.  Instead they just became do-it-yourselfers, driving sales of grooming products to the consumer market (relative to the professional market).  As the top brand in this space, FURminator benefited.

Additionally, the major pet retailers (Petco and PetSmart), in an effort to drive store traffic and control costs, began to consolidate vendors in late 2009.  During the 2007 – 2009 period, the number of product providers (both hardgoods and consumables) had increased markedly, reducing economies of scale in operations.  Further, brand proliferation made it difficult to provide consumers a uniform experience across store venues.  As central merchandizing groups took back control of the aisles, they shifted their product strategy to focus on core brands store brands/proprietary product.  As a result “tier two” players were waylaid.   After all, if you were only going to carry one brand of deshedding tool it was going to be FURminator.

The last leg of the stool was that the recession kicked off a wave of strategic M&A as corporations sought to purchase growth.   Within pet, the merchandising changes at Petco and PetSmart began to drive deals in the products space — Doskocil Manufacturing, Tagworks, Bamboo and Fat Cat, Spotless Group, among other deals.  United’s acquisition of FURminator is simply an extension of this trend.   These deals price attractively because of the operational synergies — rationalization of facilities, people, distribution.   Notably, United stated that once integrated the effective multiple they will be paying for FURminator is 6x – 7x EBITDA.  Given United’s ability to push the product into international distribution and their resources to assert  and defend FURminator’s intellectual property position means 3x revenue does not look overly expensive.

Beyond that, let’s hope the trend continues — 3x revenue valuations for everyone.

/bryan

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.

pet-industry-3-30-09

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.

pet-industry-3-30-091

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

On September 18th, 2008, Hammond, Kennedy, Whitney & Company, Inc. (HWK) a private equity firm, headquartered in Indianapolis, specializing in leveraged buyouts of privately owned businesses,  and Cardinal Equity Partners (Cardinal),  of pretty much the same ilk, acquired a majority interest in FURminator, Inc., a Fenton, Missouri based manufacturer and marketer of pet grooming products.  The FURminator’s products include small, medium, large, cat, and equine deshedding tools, shampoos and conditioners, treats, and dog food supplements. Terms of the deal were not disclosed.

FURminator was founded in 2002, by Anglea and David Porter, a husband and wife team.  Angela, or Angie as she is referred to on the company website, a professional groomer, and owner of Groomingdales’s, an upscale pet salon in south St. Louis, identified the need for a next generation deshedding and David (Top Dog by title) helped her run with the idea.  In 2004, the company generated sales of $700,000, which grew to $25.3 million in 2007.  Sales are projected to top $35 million in 2008.  FURminator ranked the highest among the top 50 St. Louis companies that made Inc. magazine’s list of the nation’s 5,000 fastest-growing private companies (see list here).

The FURminator product line was launched into the professional channel — groomers, veterinary offices, pet retail.  The price point was +/- $40.  The company was soon able to garner placement on QVC, creationg national awareness in a short period of time, and was then picked up by national retailers.  FURminator deShedding tools and products are available at national pet retails such as PetSmart and Petco, and at independent pet retailers, veterinarians, groomers and rescue organizations nationally.  Leveraging their brand in grooming products, the company has successful expanded into shampoos, treats and supplements.

The company was boot strapped by the founders since inception, financing growth with bankroll from David’s marketing day job and Groomingdale’s profits.  The company moved early to protect its intellectual property by patenting the product design.  Currently the company has four patents.

Hammond, Kennedy, Whitney & Company, Inc. was founded in 1903 by Paul Hammond as a merchant bank for wealthy families.  Since that date, it has evolved to be a generalist private equity firm focusing on the lower end of the middle market.  As a general rule their investments come with low risk of technological obsolescence. HKW focuses on management buy-outs of companies which have revenues between $20  – $200 million, EBITDA between $2 – $20 million, and enterprise values between $10 – $150 million.  The FURminator represents a departure for HWK in that it is their first investment in the pet space and it is much more consumer oriented than their previous investments, though they do list consumer discretionary as a focus area.

If I drew up a sketch of Cardinal, it would be much the same, only smaller, with slightly more exposure to the discretionary consumer market.

This deal interests me along many levels.  First, it is a pet deal and I follow the space.  Second, is that it’s a majority recapitalization.  A majority recapitalization involves purchasing more than 50% of the equity of the company, but more often 75% – 80%.  Given the decline in the credit environment we haven’t seen many of those lately, and as someone who is currently representing parties in those types of deals, I know how hard they can be to get done in today’s environment.  While financial terms were not disclosed insider knowledge (not mine, see source here),  says that the deal was north of $80 million and that HWK and Cardinal put up approximately $50 million with the balance coming from bank debt and a few smaller individual investors.  My gut (me now making up numbers) tells me that the deal likely penciled out at 3.0x TTM (trailing twelve months) sales, or ~ $90 million in enterprise value (that’s debt plus equity).  Assuming the company had a 35% – 40% EBITDA margins on $30ish million of TTM sales at the time of the deal that would imply they were able to garner 2.5x – 3.0x leverage, which in today’s environment is a solid out outcome.  I admit the potential to be underestimating their margin profile. In tighter economic times, debt capacity notwithstanding, I’ve found investors hesitant to provide such large cash outs to founders assuming they will be disincentivised to work for the larger payout.  One of the ways that I suspect this was overcome was the regional proximity of the key players — St. Louis and Indianapolis.  The physical proximity makes it easier to monitor the deal.  Finally, I’m interested in the deal because FURminator used a banker, The Fortune Group out of St. Louis.  What is unknown to me is whether FURminator was responding to inbound interest or running a process.  I’m guessing it was the former.

So why would investors pay such a healthy price for FURminator.   I’m hoping to talk to HWK to confirm, but I can devise a pretty solid rationale.  First, despite the gloom and doom in consumer discretionary, the pet vertical continues to perform and has a solid forward outlook.  The market is large and growing double digits.  Second, in a contracting consumer environment, people view grooming services as a place to cut back (ranked 3rd, 68% in a Fleishman-Hillard survey) and in fact grooming services at chain retail are leveling off as an expenditure.  In tough economic times we become a do-it-yourself society, in contrast to a do-it-for-me populous.  This bodes well for FURminator sales.  Lastly, I suspect there is an international angle to be accelerated.

I can already read the headline when they sell, “Private Equity Firms Shed FURminator”. Maybe I will get to play a role.

/bryan