petcoOn November 23rd, CVC Capital Partners Limited and Canada Pension Plan Investment Board (the “Buyout Group”) signed a definitive agreement to acquire PETCO Animal Supplies, Inc. (“Petco”) from TPG Capital, L.P., Leonard Green & Partners, L.P., and friends for $4.6 billion. The deal values Petco at approximately 10.0x my pro-forma TTM Adjusted EBITDA for Petco as of October 31, 2015. This contrasts with the 9.0x TTM Adjusted EBITDA for the acquisition of PetSmart by BC Partners.  It is rumored that the Buyout Group was able to arrange approximately $3 billion of debt financing to support the deal.  Notably, both Petco and PetSmart will be owned by foreign investors assuming the deal closes.

It should come as no surprise that Petco opted for a private equity sale. Too much time had passed since the September 18th media leaks to believe a Petco / PetSmart combination would come together.  The case for public equity offering also faced numerous headwinds — a) broader stock market volatility driven by macro-political risk (Syria, ISIS, China), b) weaker than anticipated earnings among publicly traded retailers (as of November 20th over 40% of the retailers in the S&P 500 had posted earnings misses for 3Q2015), c) weak October retail sales (0.1% increase versus 0.3% consensus) and d) falling consumer confidence (lowest levels this year and a steep drop from October).  Against this backdrop, a trade sale was the most attractive option, even if debt market support for the deal had been choppy.  We generally consider 10.0X the break-point for specialty retailer M&A, above which history has not looked kindly on the buyer from a shareholder value creation standpoint.

The most pressing question now is who will lead the acquired organization going forward.  Jim Meyers, who has been in the CEO role since March 2004 (he was named Chairman earlier this year), and his team has lead Pecto back to a position of prominence.  Based on the S-1, Petco was posting stronger growth and better unit economics than its larger rival.  However, if history is a guide, large private equity deals seldom result in a staying of the course. In a small amount of irony, it is possible, though unlikely, that David Lenhardt could be running Petco a year after being ousted from PetSmart. Stranger things have happened.

If the Buyout Group is smart, they will purse incremental changes at Petco as opposed to a holistic approach to transformation. While there are certainly cost inefficiencies to be rung out of the system, Petco’s value is in how well it is currently situated from a growth standpoint with its greater emphasis on wellness, its multi-box positioning, its omnichannel reach and its under penetration in private label.  Further, with PetSmart deeply invested in its cost containment program, now is the time for Petco to press on the growth accelerator.  Someone is going to grab the brass ring and if not Petco, the chase will be led by Pet Supplies Plus, Pet Valu or a series of financially supported independent chains.

The next year should be an interesting one is large box pet retail land.  Regrettably we won’t be getting much transparency into either business any time soon.


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.






puzzleLast week, it became public knowledge that PetSmart and Petco Animal Supplies were engaged in “merger” discussions.  Back when PetSmart was under pressure from activist shareholders, we discounted the potential for a deal that would bring together the two leading pet specialty retailers. Our analysis was based on the notion that if these two companies were ever to combine, PetSmart would be the more natural acquirer given its relative size, strong balance sheet, and cleaner ownership dynamic. However, companies in play don’t tend to be net buyers of assets. As expected the deal did not come to pass.

Since that time, much has changed.  Most notably, the two companies are both private entities, which makes a deal more likely in our estimation.  Bringing these two assets together will be a messy process given the high levels of overlap between the two businesses — retail locations, warehouses, systems, people, processes.  For a merger integration process of that complexity to play out within the purview of the public markets would be problematic at best.  Additionally, the information playing field has been leveled with the filing of Petco’s S-1.  Previously, dialog between these two companies was hampered by the fact that PetSmart did not want to further educate its primary competitor on the details of its business without some transparency into the condition of Petco as a buyer. With the filing of the S-1 we now have insight into Petco’s historical and current business performance and that data should be sufficient for PetSmart to form a preliminary view as to the attractiveness of a combination. Of greatest significance, it will enable them to ascertain whether a deal could be financed solely with debt. If so, the probability of PetSmart making a strong play for Petco would increase. Third, we now have some clear transaction motivation at Petco — go public or be acquired.  A year ago, such impetus was lacking. Given that the recent volatility in the equity markets has made a public offering less likely, a sale to the party who can underwrite the most synergies makes more sense than ever.

While the fact pattern above is compelling, a combination will likely come down to the perception that the transaction can clear antitrust.  Recall that PetSmart had numerous discussions with what appeared to be Petco during its exploration of alternatives and came to the conclusion that the deal would not clear antitrust (article here).  It appears Petco was more concerned about the potential for an antitrust review to have an unfavorable outcome. A review of the transaction by the Federal Trade Commission (FTC) will hinge upon traditional benchmarks such as market share and price competitiveness, but also market concentration, which is also a consideration with horizontal mergers. While we are not antitrust experts, we believe the deal would undergo considerable scrutiny as follows:

  • Market Definition. How the FTC defines the competitive market for the sale of pet products will be the central risk to a transaction.  The FTC has previously scuppered deals (Whole Foods – Wild Oats, Staples – Office Depot) where it defined the sales market for the product narrowly. If the FTC views PetSmart’s and Petco’s competitive position to include all FDM retailers as well the veterinary supply channel, it’s market share hovers around 20% for both pet products broadly as well as pet food sales. However, if the competitive landscape is viewed as other pet specialty retailers, including independents, that market share rises to unacceptable levels from an antitrust perspective, and would likely result in strong resistance to a deal.  While a more broad market definition has some inherent logic, the channel tied nature of the product mix, especially as it relates to consumables, undermines that logic.
  • Pricing. Pricing is a paramount consideration for the FTC when evaluating a business combination.  Ultimately, the government seeks to protect consumers from being disadvantaged at the cash register when choice contracts. Of interest to the FTC in these circumstances is how pricing might react in defined geographies.  While we do not have access to, or know of for that matter, any comprehensive pricing studies for the pet specialty market, we do not believe that, on its face, pricing related risk is elevated here. However, if there is an Achilles heel in this analysis it is that PetSmart and Petco collectively control in excess of 50% of the sale of channel exclusive pet foods. That said, both PetSmart and Petco experience pricing pressure from both independent retailers and the online channel as it relates to the consumables category, the later being important given the shifting demographics of pet ownership away from Baby Boomers and towards Millennials, who are more prone to using online venues to procure products. Additionally, we have seen a proliferation of premium food in FDM. Further, numerous substitutes for these products are available in the independent channel. Ultimately, the FTC may choose to evaluate the sale of premium pet food as its own market and assess the potential antitrust risk accordingly.
  • Concentration. The FTC also considers the potential for market concentration from horizontal mergers. There is significant overlap in retail footprints of Petco and PetSmart. Over 70% of PetSmart stores are within five miles of a Petco location. The FTC analyzes market concentration according to the Herfindahl-Hirschman Index (HHI).  Where HHI levels are elevated, meaning increased concentration, there is more scrutiny applied to the transaction. HHI is influenced by the number and size of competitors in a given MSA. Therefore if the market is defined more broadly per the above, the potential for HHI risk being exacerbated declines.  We believe that a narrowly defined market definition would likely result if considerable HHI driven scrutiny, which may result in required levels of store divestitures in order to obtain antitrust clearance.

The potential for a PetSmart / Petco combinations really comes down to two factors.  First, if the private equity owners of PetSmart are willing to take the merger integration risk of a Petco combination this early in their ownership lifecycle. Second, is whether you believe the FTC will take a broad view when defining the market for the sale of pet products.  We see support for arguments on both sides.


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.

petcoOn Monday, Petco Animal Supplies filed for a public offering. Goldman Sachs, Bank of America and J.P. Morgan are the lead underwriters on the offering. If-as-and-when successful, this will be the third time the company has tapped the public markets. A brief synopsis of Petco’s ownership/liquidity history can be summarized as follows:

  • 1994 IPO. Largest pet specialty retailer in the country.  Owned by private equity firm Thomas H. Lee Partners (currently the owner of Phillips Feed Service). For the fiscal year ended January 31, 1994, Petco’s 208 stores generated approximately $180 million in sales at less than $3 million of operating income (EBITDA figure was not available). Trading on NASDAQ under the ticker symbol PETC.
  • 2000 Take Private. $600 million transaction (6.1x LTM EBITDA) led by Leonard Green Partners (LGP) and Texas Pacific Group (TPG).
  • 2002 IPO. $275 million IPO, again on the NASDAQ.  For the fiscal year ended February 2, 2002, Petco’s 548 stores generated $1.3 billion of revenue and $109 million of EBITDA.
  • 2006 Take Private. $1.85 billion transaction (8.5x LTM EBITDA) by LGP and TPG using an abundance of cheap debt financing to underwrite the purchase price.  LGP and TPG contributed approximately $765 million in equity (total equity check was $775 million).
  • 2010 and 2012 Leverage Dividends. Company financed approximately $1.2 billion in distributions through two leveraged dividends (1.5x Invested Equity).

In short, Petco has been the pet industry’s transaction bellwether, and that is before you take into account the acquisitions and strategic investments the business has made historically. However, this trajectory is more a function of the company’s economic fortunes overlaid against the broader capital markets backdrop. After being the clear market leader in pet specialty in the early 1990s, the company found its position usurped by PetSmart later that decade. A relative comparison of the two leading pet specialty players looks as follows (Fiscal Year, Revenue/EBITDA, $million):

  • 2000. Petco, $990/$88; PetSmart, $2,110, $128
  • 2006. Petco, $1,996/$209; PetSmart, $4,234, $440
  • 2015. Petco, $3,995/$411; PetSmart, $7,070, $944

In 2011, I wrote this piece suggesting that maybe Petco had been done and dusted by PetSmart, a fact that was supported by the data at the time.  While PetSmart remains the dominant player from a financial perspective, Petco has certainly made up ground, producing slightly better same-store-sales than PetSmart over the latest twelve month reported period. That said, it could be argued that Petco is poised for a better near term run for the following reasons:

  • Store Format.  Petco currently operates 130 Unleashed stores in addition to their 1,279 Petco locations.  Unleashed units are 5,000 square feet and currently located in 14 major urban markets. They target a premium customer who values a small box specialty experience. These stores also appeal to a Millennial customer who often lives in an urban center.  Based on our experience, leading small box pet concepts are experiencing growth rates in excess of 15% percent (many of them are producing 20%+ growth), providing Petco exposure to a higher growth segment of the market. Further, Millennials are the fastest growing category within pet ownership. Unleashed units also provide Petco an opportunity to have a specialized merchandise mix, which allows them to embrace emerging brands earlier in the lifecycle. Notably, as part of its go-public preparations, Brad Weston, who was previously President of Unleashed, was made President of the company.
  • Digital Assets. Petco’s .com properties generated $185 million in Net Sales in the first half of fiscal 2015.  While it is hard to validate the company’s claim that they have the largest integrated ecommerce offering in pet specialty, we also have no reason to dispute the assertion.  Of greater significance is the fact that throughout the growth of pet food supplies online, Petco has maintained control over its digital assets and made significant investments in technology to enhance both customer engagement and omnichannel capabilities.  Petco is currently implementing technology that will facilitate cross-selling across physical and online properties as well as enable same-day delivery.  Additionally, the company is making investments in store resident technology to offer endless aisle support.  Finally, Petco has partnerships with major online properties such as Instacart and that augments its digital footprint and offerings.  As online grows in pet, Petco is well situated to benefit.
  • Operational Upside. Based on the substance of Petco’s regulatory filing, there is clear upside to be harvested through operational improvements.  As an example, Petco currently generates 15% of sales from private label/owned brand products versus 27.5%+ for PetSmart.  Given the ability of house brands to drive traffic and take margin, a greater emphasis by Petco on this initiative should provide meaningful earnings growth.  The acquisition of Drs. Foster & Smith, which has significant private label capabilities, offers one direct point of leverage in both consumables and wellness solutions.  A second example is the potential for greater sales in higher margin product categories. Notably, Petco generates ~ 38% of sales from consumables and ~ 8% of sales from services versus ~ 50% and ~ 11% respectively for PetSmart. While these categories remain competitive, and are subject to pricing pressure, the potential to drive greater sales through these higher margin verticals would drive earnings growth.

Based on market chatter, a publicly traded Petco could be valued at $4 – $4.5 billion, or +/- 8.5x – 9.5x Adjusted EBITDA.  This compares to 9.0x EBITDA for the PetSmart take private, and the low end of the range is in-line with the historical take private, about where I would expect it to land. The question is whether there remains pent up demand for public pet industry equity in light of the first day run-up in Blue Buffalo’s equity valuation.  While public investors are sure to view Petco’s operational upside favorably, PetSmart’s experience provides a cautionary note.


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.

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.


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. 


 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.


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.


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.


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