plantThe pet industry delivered another strong year of relative growth in 2014.  According to the American Pet Products Association (“APPA”), the industry grew 4.2% to just over $58.0 billion in total revenues.  While growth was again strong relative to other consumer sectors, it was 0.8% below estimates. This shortfall represents the first time in the past five years that the industry did not meet or exceed APPA projections.

From a growth rate standpoint, the industry was again driven by veterinary services (+4.7%) and non-health care services (+9.8%).  The industry benefited from 0.9% of product inflation and 2.9% of services inflation, which puts volume/unit growth in perspective. With the pet population growing at a slow pace, the industry has benefited from price escalation to overcome anemic volume growth.  Industry growth was again constrained by consumables which grew at 3.2%, 1.6% short of estimates. It appears that the industry may in fact be hitting the ceiling on the pet food upgrade cycle, as premium pet food market share was flat from 2012 to 2014 at 42% of pet food sales.

The slowdown in industry growth was, to the informed observer, not unexpected. The industry can’t grow at 5% when the largest specialty retailer produces flat comps. However, what was more meaningful in the APPA disclosures was the rate at which new owners were entering the inudstry. The APPA estimates indicate that as much as 10% of the pet ownership population came into the fold during the past 12 months, reflecting a rising rate of companion animal ownership among younger demographics at the expense of the Baby Boomers, who continue to slow pet replacement and when they do they favor smaller companion animals.  If in fact industry purchasing power is transitioning to Gen X and Gen Y and this rapid pace it will have meaningful implications on what products are purchased and where.

In our bi-annual industry summary contemplate these changes are other key observations as outlined below.

  • Convergence Gathers Momentum. Convergence between industries serving the human population and those serving companion animals is not an all together new trend. Not since Nestlé’s acquisition of Ralston Purina (2001) and Del Monte’s acquisition of Milk Bone and Meow Mix (2006), has the consumer landscape seen this phenomenon in play on such a grand scale. However, the J.M. Smucker Company/Big Heart Brands and AmerisourceBergen/MWI Veterinary Supply transactions are evidence that mainstream acquirers are again seeing the potential of buying into the pet industry. These buyers are seeking access to the growth inherent in the pet industry as a means to offset slowing growth or contraction in their core businesses. If this trend trickles down to the lower middle market it will be a game changer in terms of exit alternatives for leading pet players. Expect sellers to test this theory.
  • Demographic Shift has Accelerated. In earlier reports we tied the recent performance erosion of major pet specialty to shifting industry ownership demographics. Our analysis postulated that rising spend from new pet owners, who are predominately part of Gen X and Gen Y, was benefiting independent retailers and online players at the expense of major pet specialty. A recent study by the APPA indicates that the industry added eight million new pet owners in the past year, nearly 10% of the owner population. Growth in first time pet ownership is accelerating faster than previously anticipated. If the rise of Gen Y, and to a lesser extent Gen X, in terms of purchasing power continues at this pace it will have significant impacts on industry spend. Notably, Gen X/Y pet owners exhibit less channel loyalty and ascribes more importance to convenience. Additionally, they place greater value on wellness which bodes well for retailers, product manufacturers, and service providers catering to these pet needs.
  • Exit Dynamics for Consumables Improving. A challenge for pet consumable companies seeking to exit has been a decided lack of strategic acquirers. Consolidation has historically been dominated by a handful of major industry participants leaving smaller companies with few options for synergistic exits. However, this landscape is now changing. Most notably, investment in companies with production assets is creating a new class of acquirers. Existing brands such as Merrick & Company and Nature’s Variety as well as traditional producers including Ainsworth Pet Nutrition and Pro-Pet have become net buyers of assets as a result of third party investment. Additionally, consumer companies in adjacent segments have shown an interest in buying brands that control their own manufacturing capabilities. Finally, the successful public offering of Freshpet is likely to lead other mid-market pet food players to pursue public offerings, which will create more acquisition currency. This multiplexing of exit options is good for the ecosystem and will support additional consolidation.
  • Expect a Blue IPO in 2015. In 2014, it leaked that Blue Buffalo had selected underwriters for an anticipated public offering. However, its plans were impacted when, in late 2014, it came to light that the company had received improperly labeled shipments from one of its suppliers resulting in animal by-products being introduced to some of their formulations. Since that announcement, there has been little news related to lawsuit brought by Nestlé that resulted in the non-conforming ingredient disclosure or about Blue Buffalo’s plans for a listing. In the interim, there has been continued speculation of an acquisition. We don’t buy it. Blue Buffalo’s valuation in the public markets would dwarf any buyers willingness and ability to pay in an M&A event. Looks for Blue to renew its listing push in 2H2015.

As always our pet industry report is available by commenting here or emailing me directly.

/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.

aisleThe first quarter of 2015 has seen an unprecedented amount of announced and closed deals for the pet industry.  In combination, the acquisitions of Big Heart Brands and MWI Veterinary Supply coupled with the take private of PetSmart resulted in a combined deal consideration of $17 billion.  Not since Nestle S.A.’s acquisition of Ralston Purina for $12.1 billion in 2001 has the industry experienced such transaction volume, measured on a dollar basis, in a concentrated period. What is most notable about the Big Heart Brands and MWI Veterinary Supply transactions, beyond the headline valuations, is that they were driven by a convergence theme — that the companion animal industry has becoming comparable to its human corollary as to justify combinations across the aisle.  So much so, that major players on the human side can justify buying into the pet side at premium prices.

Consider Smucker’s acquisition of Big Heart.  Smucker’s, best known for their business in fruit spreads, coffee, and food service, has been experiencing revenue contraction and profit erosion since 2013, driven by declines in all lines of business. In an effort to reverse these declines the company, with one stroke of a pen, morphed itself into a pet business. Big Heart Brands is expected to deliver $2.4 billion in sales in 2015 to the combined entity, more than any other current line of business for Smucker’s. Big Heart is expected to grow between 5% – 6% each of the next two years, versus the balance of the company whose growth declined 4.9% in 2014 and whose growth is expected to decline another 4.1% in 2015. Three notable quotes from the company as part of the transaction speak to the convergence rationale of the acquisition:

  • “With approximately two-thirds of U.S. households having at least one family pet, we will now be able to serve the mealtime and snacking needs of the whole family.”
  • “[Big Heart Brands] fits extremely well with our purpose of bringing families together to share memorable meals and moments. And one of the key parts of the family nowadays, and probably has been historically, is your family pet.”
  • “Our competency is really connecting with our consumers and building an emotional bond with our customers. Pet foods is the same way. And so, we really see a real opportunity for continuing to build that bond with the consumer. And once you do that, you can really have great products at a right price.”

Additionally, as conventional grocery seeks to recover its share of the companion animal consumables pie, Smucker’s will be serving largely the same retailer base from a supply standpoint adding additional comfort to the contemplated transaction.

The acquisition of MWI Veterinary Supply by AmerisourceBergen is not the first instance of a veterinary supply business merging into a company involved in servicing the human health market. However, the deal between the largest human pharmaceutical distribution company and one of the leading independent players in pet medications was also borne out of their similarities. In a discussion of the deal rationale, the following key comments are notable from AmerisourceBergen CEO Steve Collis as it relates to convergence:

  • “As we got to know the MWI business better, it was more pharmaceutical-centric than we had realized.”
  • “We really felt that there was a lot of complexity in this business, a lot of ability to drive new products, working with manufacturers, and an opportunity for global expansion that really dovetailed well into some of the past experiences AmerisourceBergen had enjoyed and had experience and been successful at.”
  • “You know, they’re just a strong cultural fit. These are operators that are passionate about their business, that are trying to draw value for their customers and their stakeholders every day, so the two companies just could not have got on better.”

Notably in the deal announcement, AmerisourceBergen  stated that entering into the animal health market was a logical extension for the company and the fact that each of the businesses relied largely on the same core competencies gave them comfort in the potential for the combination.  Like the Smucker’s/Big Heart deal above, Collis made it clear they pursued the combination for the growth potential the pet industry offered them despite the fact AmerisourceBergen has produced robust topline growth in each of the past two fiscal years.

It will be interesting to watch how each of these deals delivers, or fails to deliver, on the anticipated potential of the combination.  To the extent that these transactions are part of a broader theme, multiples for pet related exits could reach even further into the stratosphere. The pet industry has been wanting for improved exit market dynamics and these examples provide optimism that companies serving the human market might now be ready to become serial acquirors of pet related properties. 

/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.

piggyAs has often been discussed, the post recession rise of the pet industry is often linked to the ongoing upgrade cycle in pet food. Pet owners, fueled by a combination of love for their companion animals, human food trends, and supply chain concerns associated with foreign sourced product, began to spend more on what they were putting into their pets bowl on a daily basis, focusing on solutions with higher quality ingredients, known sourcing, and production integrity. The result was a proliferation of brands targeting consumers with premium and super premium offering that met these emerging needs. Premium solutions now make up 42% of total consumables sales according to Packaged Facts. The net result was that the pet food upgrade cycle fueled a disproportionate percentage of industry growth.

From 2008 to 2014 estimated year end, according to the American Pet Products Association, sales of pet food increased from $16.8 billion to $22.6 billion, over 35% or nearly 5.1% annually. What is less often discussed is that this period of time coincided with de minimus growth in the pet population, especially large dogs who are the primary driver of pet food volume. If consumers of pet food were not growing, and therefore volume was flat to down, the resulting rise in pet food sales had to be price driven. In fact, during this period annual pet food inflation averaged over 3.0% annually according to Federal Reserve Economic Data.

screen shot 2015-02-14 at 8.26.25 amWhile rising pet food prices have been a boon for the industry, a lack of real wage growth has meant that these premium solutions are increasingly cutting into the discretionary spend of pet owners. While on the surface this may not be a problem for the industry — sales afterall continue to be robust — over the long term it is and will be. Our belief is that cost inhibits ownership, and for the industry to continue to grow the population must expand. Further, the increasing presence of higher cost solutions can serve to undermine the trust relationship between the retailer and the pet owner given that most of the benefits of these premium solutions are not easily observable.

When I walked the aisles of my local pet store, I noted that approximately 15% – 20% of the dog food SKUs would result in an after tax price of over $100.  A few other stores I sampled had SKU counts that comprised between 10% – 30% of their dog food merchandising mix at, or above, this price point.  This highlights a further concern of the pet food upgrade cycle for independent pet specialty stores. As conventional and natural grocery introduce more emotive brands with similar product characteristics, in an effort to capture their share of the pet food pie, the risk of consumers defecting the channel increases. Why would one pay $100 for a 40 lb bag of dog food when they could get a solution with a high percentage of the same attributes for 60% – 75% of the cost? According to Packaged Facts, 69% of pet product shoppers look for lower prices when they shop for pet products; further, 74% of pet owners believe that many pet products are becoming too expensive; finally, 52% of dog and cat owners are actively channel shopping. Given that premium and super premium solutions command a higher profit margin profile for both the pet specialty retailers who carry the products and the manufacturers/marketers who supply the channel, a pet food “downgrade cycle” could be devastating.  Absent a change in the personal economic fortunes of pet owners, we see the potential in this thesis.

The net of this is that the pet industry needs to become more acutely focused on product transparency and value. Manufactures/marketers of pet food and the retailers who sell their products need to be doing more to help consumers understand what they are getting for their premium price and why it is justified or they risk losing customers to lower priced solutions would in turn slow industry growth. Companies that cater to the value oriented wellness segment of the market stand to benefit from these changes in pet consumer behavior.

/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.

fly in soupOn its way to a date with a public security listing, Blue Buffalo ran into a small problem.  It seems there was a fly in their soup; one which they claim to have been blissfully unaware.  Equally embarrassing was the fact their fiercest rival, Nestle Purina, had been the source of the discovery.  What followed the initial accusation is either evidence of the power the independent premium pet food company wields or the first act in a Greek tragedy. The outcome is likely to have an impact on the pet food industry investment and the pet food M&A landscape.

In March 2014, it was leaked that Blue Buffalo, the $600+ million revenue independent premium pet food marketer, had selected a trio of lead arrangers for its public offering. The company had, for years, been rumored to be on and off the market seeking a buyer at prices between $2 – $3 billion depending on the timing of the speculation. It appeared that the company was now ready to tap the public markets for liquidity, an event that filled the industry with equal parts fear and excitement.

Two months after the leak, Nestle Purina filed a lawsuit in federal court alleging its competitor was lying about the contents of its products. Nestle claimed that independent tests show that Blue Buffalo uses chicken byproducts and corn in some of its food formulations — despite making marketing claims to the contrary.  Nestle would later amend its case to dispute other product claims on kibble, treats, and even cat litter. The fact that the industries top dog would undertake efforts to undermine Blue Buffalo came as a surprise to many.  Many speculated it was a tactic to lower the potential acquisition price for the brand.  Blue Buffalo returned the volley several days later counter-suing Purina for defamation, a summary of which can be seen here.

In a letter to customers, Blue Buffalo Founder and Chairman, Bill Bishop wrote:

“It is an easy thing to make unsubstantiated claims, put them in a lawsuit and then publish them all over the Web to disparage and defame a company. It is quite another thing to prove those allegations… We will prove these and other matters in court with good reliable evidence, and we look forward to disproving the voodoo science that Nestlé Purina relied on to support their outrageous allegations.”

The complete responses from Bishop can be seen here and here. Later, Bishop would go all in on a letter to the editor of Businessweek that can be seen here.  During the process, the National Advertisers Review Board (NARB) recommended that Blue Buffalo modify marketing claims it was making about competing products.  While Blue Buffalo disagreed with the the conclusions of the NARB, they agreed to take into account their recommendations in the future.  Details of the review hearing, recommendation, and associated reaction can be seen here.

Upon reading the first letter of response, I knew Nestle had something.  History has shown that the de facto strategy for the guilty is to attack not the claim but the science of the test and the party administering it. If professional sports is a relevant proxy, sometimes that plan works.  So Blue Buffalo then set out to undermine the validity of the Purina’s independent test going so far as to claim the laboratory involved had “dubious scientific credentials.”  The company’s critique of Windsor Labs and its scientific findings can be seen here.

As it appeared the two sides were heading to court, Blue Buffalo issued a statement that one of its suppliers had mislabeled ingredients sent to their customers, which could (that choice of words is important) have resulted in Blue Buffalo product being made with poultry by-product meal.  That statement can be seen here.  While it is notable that Blue Buffalo is acknowledging some of Nestle’s claims, it is passing the buck to its supplier.  While Wilber-Ellis has a history of recall related issues, the names of other pet food companies who may have received mislabeled ingredients, as Blue Buffalo claims, have not surfaced.  Since the FDA and Wilber are choosing to remain silent on this issue (the FDA views those names, if any, to be confidential information), it would be natural to speculate that there are no other names and in fact, this circumstance was known to Blue Buffalo.  However, that is merely speculative. What is also interesting is that Blue Buffalo has not issued a voluntary recall (the FDA does not mandate a recall in cases where the ingredients involved do not have a reasonable probability of causing serious adverse health consequences), has not disclosed probable lot numbers, or offered to refund customers their money.  So far the strategy seems to be working as they have not wavered from their approach.

What happens next is likely to impact pet food investing and M&A.  If the circumstance above results in Blue Buffalo modifying or pulling its IPO plans, or going public and experiencing diminished value, or selling at a diminished value, it will be yet another cautionary tale of how supply chain issues can quickly erase equity returns hard earned over time in the pet space.  This may lead to investors pursuing pet consumables investments with greater caution and scrutiny.  Further, pet consumables M&A may come with more strings attached — broader seller representations and warranties, higher indemnification caps, etc. — or at lower valuations to account for this risk.  Companies that can demonstrate control over the product they put in the bag should also be ascribed a premium.  Owning your production assets becomes, in fact, more valuable. That written, if Blue Buffalo is able to hold shelf space, avoid a recall, and move forward with its liquidity plans, it will, in fact, validate how powerful the leading independent brand really is.

My view is the marketer is ultimately responsible for ensuring that the product in the bag matches the associated claims.  However, absent consumer lash-back, Blue Buffalo is unlikely to suffer much.  Further, given how much traffic their products drive at retail, pet specialty chains are more likely to accept the “it’s not our fault” explanation.  In the meantime, Blue Buffalo may get to see the results of the Freshpet IPO before confirming its path.  Freshpet is expected to price on November 6th.  At the mid-point of the range, Freshpet would command a fully diluted value of $414 million.  Based on estimated 2014 revenue, that would value the company at 3.5x – 4.0x revenue.  Those multiples would only serve to validate Blue Buffalo purported $3 billion price tag.

/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.

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.

no saleIn mid-August, bowing to pressure from activist investors, PetSmart announced that it would explore strategic alternatives, including a sale of the business.  Slowing sales growth and poor comps (same-store-sales, traffic, and average ticket) were cited by outside investors as a sign that management was not up to the challenge of turning around the leading independent pet retailer and creating shareholder value.  Additionally, Jana Partners, the antagonist in this saga, postulated that PetSmart would have many transaction opportunities given the liquidity in the private equity and associated debt markets as well as the potential for a highly synergistic combination with competition Petco Animal Supplies.

One month later and all quiet on the western front, for now.  Here is my assessment as to why:

  • Business Fundamentals.  Notwithstanding PetSmart’s leadership position, its business is struggling as core industry drivers shift.  The premiumization food movement has largely run its course in the dog category. Adding head winds is the fact that the pet population is not growing at a sufficient rate to bring new owners into the market who would be target customers for PetSmart’s and therefore present opportunities to sell them premium products that drive margin.  PetSmart’s latest food strategy — expanding its share of shelf dedicated to mass brands to siphon off customers who can then be converted to premium and super premium — will take time to play out.  Further, the company also faces market share erosion from independent pet specialty, online, and an increasingly organized conventional and natural grocery landscape. In order to incent shareholders into a take private or strategic sale, they will have to be offered a meaningful premium.  That a tall order given the current state of the business.
  • Private Equity Scenario Possible, but Unlikely. The concept of a leveraged buyout for PetSmart is intriguing to pundits evaluating PetSmart’s options, but the path to realizing this outcome is challenged. In round numbers the current equity price for PetSmart is ~ $71/share. Assuming it would take a 20% premium to entice shareholders to even consider a deal, this would value the equity of PetSmart at approximately $8.5 billion and the company at $8.8 billion on an enterprise value basis.  Assuming the largest equity check a sponsor would write in a mega-buyout would be 20%, this implies a take private would require just over $7.0 billion in debt and at least $1.5 billion in equity.  Based on current EBITDA figures, this would mean that PetSmart would be valued at 7.5x Debt / EBITDA, before considering the lease capitalization.  This seems significantly elevated in light of the uncertainty around growth and margin expansion.  A buyout at these levels would limit the company’s ability to make investments at a time where they are needed.  If Jana were to roll its equity the scenario becomes more palatable, but it does not solve the problem in its entirety.  Calls for looking at the equity premium based on the pre-Jana price will fall on deaf ears. Additionally, at these valuation levels a sponsor would likely be generating IRRs in the 15% – 20% range before accounting for execution and market risk.  I don’t see that return profile as being all that attractive given the risk. Third, while I could identify approximate 10 – 15 logical investors who invest in retail and could write, individually or in a two firm combination, a $1.5 billion equity check, nearly half of them are conflicted due to their investments in other pet specialty retailers or product providers.  Finally, see business fundamentals above.
  • A Strategic Deal Does Not Involve a Combination with Petco. After a private equity deal, the other most commonly cited outcome for PetSmart is a combination with Petco.  While that is conceptually attractive, its theoretically impractical if not impossible. A PetSmart / Petco combination would have ample synergies but it would significantly expand the physical footprint of the combined company, something that has been proven to be a bad strategy in this current retail environment. Second, Petco is facing the same business conditions that are negatively impacting PetSmart, meaning there is not a high likelihood that it is a sensible time for it to pursue a major deal.  That notwithstanding, a combination would likely extend the current PE syndicates ownership of Petco, which already stands at nine years versus a typical five year hold period. Next is the conundrum of who would manage the business going forward. Given that PetSmart is nearly twice the size of Petco, I don’t see current management going quietly into the night or sticking around in secondary roles. Finally, we would bank on significant anti-trust hurdles.  While in combination the business would have 27% of total pet product market share, the industry is defined by channel tied products.  Under a more narrow definition, the business would control 64% of pet specialty product sales with nearly 50% of their merchandising mix exclusive to one of the two banners. I see that as problematic.
  • There Really is Only One Logical Buyer. The only logical strategic buyer in my view is Tractor Supply.  Tractor Supply has an $8.2 billion market cap and is unlevered.  The company has experienced a 550% increase in its equity valuation over the past five years.  A key driver of this has been growth in their companion pet revenue.  A combination would help Tractor lessen its exposure to the farm segment of its business that has been challenged. Further, there is significantly less physical overlap between PetSmart and Tractor Supply, than there would be in a Petco combination scenario. Further, there would be significant supply chain synergies. That all being said, this would be a big swing for a company that does not have a meaningful acquisition history.  While sensible, I ascribe a low probability.

Net net, we believe the opportunity for a sale of PetSmart’s business to have passed. A deal remains possible, but we discount that prospect.  For shareholders sake it would be best if an outcome, sale or no sale, happens quickly so that management can return to running the business assuming it remains independent.

/bryan

Disclosure: I have a contractual relationship with PetSmart as it relates to their acquisition of Pet360.  I do not have any position in the stock of the Company, nor any intention of establishing a position.

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

 

 

 

 

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