mockingjayEarlier this month, Petco Animal Supplies and PetSmart stores in Topeka, Kansas, and adjacent Lawrence, Kansas, removed from their shelves Hill’s Science Diet and Ideal Balance products.  Store managers have been telling customers that the brands is not coming back on shelf.  Notably, Hill’s Pet Nutrition, a subsidiary of Colgate Palmolive, is headquartered in Topeka.

Consider the above action a shot across the bow in the dynamically evolving landscape of pet food retail.  To better understand the future, and what this gambit might mean, one must begin with a look at the past.

Hill’s Pet Nutrition was founded in 1907. The company started in the rendering business.  By 1930, the company had evolved into packing company, producing animal feed, dog food, and horsemeat for human consumption in Norway, Finland, and Sweden.  In 1948, Dr. Mark Morris contacted Hill’s seeking a producer for Canine k/d, his brand of healthy scientifically engineered pet food.  In 1968, Canine k/d was made available to veterinarians as Hill’s Science Diet.  The brand evolved into a broad line of prescription and breed specific solutions available through veterinarians and pet specialty retailers.  In 1978, Hill’s became part of the Colgate family through a merger of Hill’s parent company.  In 1999, Hill’s sales reached $1 billion.

What is particularly significant was the fact that Hill’s was at the forefront of the healthy pet food revolution, albeit with a scientific approach. Further, long before there was Blue Buffalo, Hill’s, along with Nutro, was one of the biggest drivers of customer traffic to pet specialty retailers on the market.  Thus, for Petco and PetSmart to declare war on Hill’s is, for lack of a better term, A BIG DEAL.

The makings of this feud can be traced back five years.  Beginning in 2011, Hill’s pet food sales began to stagnate.  The company, whose products evoked images of white lab coats and engineers, found itself on the wrong side of a change in consumer preference, and therefore purchase intent.  Instead of favoring science based nutrition solutions, pet owners began to favor products whose ingredient panels best mirrored their own diet.  White lab coats were replaced by images of roasted turkey, market vegetables, and whole grains.  Natural triumphed over engineered.

Hill’s, being part of a large consumer packaged goods firm, was not content to let its franchise slip away. The company tried to change with the market, launching Science Diet Nature’s Best, a naming convention approaching the absurd.  Not surprisingly the disconnect remained.  Hill’s responded with the launch of Ideal Balance, its “natural” solution, but was slow to win back customers. While Hill’s revenues had grown to $2.2 billion in 2015, this number represented essentially flat growth between 2011 – 2015.  To maintain sales, Hill’s embraced the internet as a channel.  In 2015, Hill’s represented 7.5% of online pet food sales, taking the third position behind Blue Buffalo (12.3%) and Wellness (9.0%).  It attained that position by turning a blind eye to the price discount pet food retailers where charging for its solution set, thereby drawing the ire of Petco and PetSmart.  And you understand why we-are-where-we-are.

One has to surmise that Hill’s knows quite well what it is doing and the consequences of its actions. My understanding is they have recently put pressure on major online retail sites to enforce their MAP policy based, in turn, on pressure from Petco and PetSmart. However, if Hill’s cannot get back in the good graces of its top premise based retailers, prepare to find Science Diet and Ideal Balance at big box store near you.  The likes of Target and Wal Mart would welcome Hill’s and its customer base with open arms. Whether this is a brilliant move by Colgate or the straw that breaks the brands back remains to be seen.

Of greater interest is what this means for Blue Buffalo.  A big box Hill’s is not going to be a welcome site for the veterinary community who drives the disproportionate sales of prescription diets and is a big influencer of Science Diet sales.  Blue Buffalo has staked the next leg of its growth stool on its veterinary line of products.  If Hill’s defects, that will create a fracture in the relationship between the company and the veterinary community that Blue Buffalo could be poised to exploit.  That’s not to say it won’t have fierce competition for that mind share from the likes of Royal Canin and Purina, but thirty days ago that market looked much tougher to crack.

Let the games begin.

/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.

 

 

 

phoenisThe pet industry stands at the precipice of a tactical sea change.  The industry entered into this transitional phase in 2014 and is expected to remain there through 2017.  The industry entered into this state as a result of slowing growth and macroeconomic headwinds.  The historical catalysts for growth — Baby Boomers as the driver of industry spend, pet food upgrade cycle, premise based retail — have waned.  However, the future change drivers — pet ownership among Millennials, grain-free and alternative form factor pet food, ecommerce, connected pet — are individually not yet sufficient to resurface the landscape. Yet we expect, after another year of gestation, these trends, will set of the next phase of industry growth, market share shift, and strategic acquisitions.

As we muddle through the tail end of this transitional phased, here are trends we are keeping an eye on in 2016:

  • Industry Offers More Upside Opportunity than Downside Risk. Despite the slowing sequential growth rate for the industry and the limited innovation in consumables, we believe the industry stands poised to outperform in 2016. Our premise relies on three factors. First, the acceleration in pet adoptions experienced in the 2H2015 will have a knock-on effect on pet spending in 2016 as these new owners generate a full year of expenditures and trade up to premium solutions. This adoption spike is consistent with the 2012 – 2013 period where growth was 4.5%, albeit from a smaller base. Second, while the pet food upgrade cycle may be running on fumes, a proliferation in food additives, convenience offerings, and premium cat solutions will provide the industry with a growth impetus. Finally, we view the macro economic stability for employment, wage growth, and consumer sentiment as remaining favorable through the balance of 2016.
  • Expect Transaction Velocity to Remain High. 2015 was a return to normalized transaction velocity levels for the industry after a two year hiatus. We expect transaction velocity will remain high in 2016 as consolidation themes continue and sellers try to take advantage of the tail end of the capital markets cycle. What will change is the types of deals that are getting done. In 2014 and 2015, the industry was the subject of a large number of headline grabbing transactions involving key industry names – Big Heart Brands, PetSmart, Petco, MWI Veterinary Supply.  Absent a sale of Champion Petfoods, we expect most of the velocity to be among companies valued at less than $250 million. Notably, the M&A rumor mill was at peak decibel levels at Global Pet Expo. However, the number of companies pursuing deals pursuant to organized processes appears lower, meaning the number of potential deals that could get done pursuant to one-off dialogs is elevated.
  • Consumables Lines Blurring in New Ways. Five years ago, the thought of a pet treat business being able to bridge into pet food was unthinkable. Today there exist a myriad of treat brands which have developed a trusted connection with consumers in the pet specialty channel that might allow them to make that leap. Notably, several of these brands launched food solutions at Global Pet Expo to very favorable retailer response. While it is unclear if and how quickly these solutions can scale, it speaks to the fact that the delineation between food and treat brands continues to decrease.  As premium pet food companies find market share gains harder to come by, we expect they will seek to expand sales volume through increased treat offerings and acquisitions of treat companies. Further, treat company valuations will benefit from buyers factoring in potential product line extensions into food, though not all brands will benefit.
  • Ecommerce Landscape Changes Ahead. Sales of pet products continues to grow online fueled by price based competition and increased convenience. The impact of growing online sales can been seen acutely in the comps of Petco and PetSmart prior to their representative transactions. However, the pain has spread to the independent channel as well, as more brands have embraced ecommerce as a driver of growth and customer acquisition. In response, retailers are putting pressure on manufacturers to enforce MAP policies or, in some cases, choose sides. However, many of the brands caught in the battle among retail formats are not well equipped to do either. Assuming that Chewy.com continues to find fuel for its growth, and that Jet.com continues to find brands willing to embrace its platform, this problem will grow. Pressuring brands will not solve the problem. Rather, the winners in retail will be those who deliver the best consumer service experience as measured by selection, price, and convenience. Independent retailers will need to develop capabilities that enable their customers to shop online and get accelerated delivery, presenting an opportunity for distributors to fill this void.

 

As always, a complete copy of our 2016 industry report is available by email.

/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.

 

dwarfEarlier this week it was announced that Mars Petcare had acquired Whistle Labs, designer and marketer of activity monitoring and asset tracking solutions for small companion animals.  The deal was valued at $117 million (or $119 million depending on the source of information).  Whistle had raised $25 million in outside capital, including $21 million in two institutional rounds, including a $15 million Series B round in January 2015, led by Nokia Growth Partners.  The Series B also including participation from, among others,  Melo7 Tech Ventures (the equity fund of Carmelo Anthony, NBA superstar) and QueensBridge Venture Partner (the equity fund of Nasir Jones, world famous rapper).  The post-money on the Series B was reported to be $26.65 million, meaning these investors made a ~ 4.5x cash-on-cash return on the sale and triple digit internal rate of return based on the short duration.

When Whistle launched its solution set the market was bifurcated between activity monitoring and asset tracking.  The asset tracking side was being addressed largely by companies that were re-purposing technology that had been deployed in more traditional markets, such as logistics, automobile tracking, or human tracking (yes these do exist).  However, these companies did not necessarily recognize the emotional engagement aspects of the pet space, and did little to build community.  The network costs of these businesses were high, and the user base was small.  Given that the initial hardware purchase was subsidized, these businesses lost money, sometimes large amounts of it.  Further, there was no effective retail channel for this class of products as the major pet specialty retailers were not well situated to sell a $200 device with a monthly subscription attached thereto or explain the value proposition effectively to customers, and therefore the market was slow to emerge. Traditional channels, such as consumer electronics and mobile phone centers, were no more effective at attracting pet owners let alone articulating the purchase rationale.  It did not help that most of these solutions had large form factors and minimal visual appeal.

In contrast, Whistle brought to market an activity tracker with a high level of aesthetic appeal at a much lower cost.  Of significance, gone were the monthly subscriptions.  The problem was the market wanted asset tracking as the linkage between the activity monitor and the benefits use case was just not obvious to pet owners.  In short, there was data but not much to do with it and sharing it was cumbersome.  Much like the early human activity tracking sector, the real value of these devices did not emerge until the ecosystem and community aspect developed. Whistle would use part of its Series B financing to acquire Snaptracs, the Qualcomm based asset tracking solution that it spun out in 2013.  Using their industrial engineering acumen, Whistle combined the two solution sets into a best of breed offering and the business began to accelerate.

About the time of the Series B, Whistle began collaborating with Mars on the use cases of its device.  The challenge became how do you balance the venture capitalists agenda — drive brand, drive sales, drive community — with the Mars agenda around linking the data to wellness outcomes and product sales.  In the end, we believe Mars acquired Whistle to enable its agenda to become central to the future of the business.  Given that the lifetime value of a subscriber was high as the revenue was recurring, shareholder value increased exponentially.

While the acquisition and the prevailing purchase price will certainly give momentum to the connected pet space, the perceived rationale is somewhat vexing to rationalize.  Connected pet solutions that have been funded and launched into the market over the past few years have focused more on emotive connections (remote viewing, remote treating, automated feeding) than wellness outcomes, and here we have an acquisition rationale that we believe is tied more to healthcare outcomes than humanization. That is not to say the deal won’t be effective in catalyzing more investment and further M&A; the return profile will ensure that happens.

This deal very much validates the space, and we have been on record suggesting more large consolidators get into connected pet since 2013, when we marketed the Snaptracs business for sale.  We believe other large players will have to take notice and find avenues to take a position in connected pet. Further, we think the Mars acquisition rationale is specific to them and does not require a pivot by other operators to enhance their focus on wellness.  Mars is unique in that it is the only enterprise that has both veterinary hospitals and branded companion animal consumables, and therefore could view Whistle in a unique way and justify the purchase price as a result. It does help that they are a very large private enterprise and do not have to kowtow to outside shareholders.

One of the key themes we witnessed at the most recent Global Pet Expo was a proliferation of solutions aimed at connecting owners to their pets wherever they were resident at the time — the home, the grooming salon, the daycare or dog walker, the boarding facility. etc.  Expect the Whistle deal to give them all more conviction and attract a host of new entrants seeking to capitalize on the market opportunity. Ultimately, pet owners stand to benefit most.

/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.

 

 

beakersHistorically, the discourse around pet food delivered in alternative form factors (fresh/frozen, freeze-dried, dehydrated) has focused on the merits, or lack thereof, associated with feeding your pet raw protein. Lost behind the countless articles delving into the pros and cons of raw, has been the growth in both size and importance of this sub-category, and the value it has created for those who invested early in this category.

According to GfK point-of-sale data from the pet specialty channel for the 12 months ended August 2015, alternative form factor pet food was, in approximate terms, a $175 million market.  Based on these same figures for the prior year period, this represents 50%+ growth for the category.  When you add to this annualized IRI MULO data for fresh/frozen pet food sold in the mass market and apply an adjustment to GfK’s estimate of dehydrated pet food, which we know to be low, and the total market is approaching $750 million, growing at 30% – 35%.  While relative to dry kibble, this market is in fact small, it is meaningful, and in combination with its growth rate, cannot be ignored by the large strategic buyers in the space.

Validation of this notion began to accelerate in 2H2014 when Agrolimen SA, a Spanish privately-held producer of food and other consumer goods, quietly acquired a controlling stake in Nature’s Variety, the market leader in freeze-dried raw pet food, from Catterton Partners.  This was followed closely by the successful initial public offering by Freshpet, Inc. (NASDAQ: FPRT), which currently trades at 2.3x Revenue despite some challenges in the roll-out of their refrigerator program among several large retail accounts.

After a brief fallow period, further validation arrived in the form of Nestle SA’s acquisition of Merrick Pet Care. While Merrick’s market entry into the freeze dried raw space (Backcountry), was nascent, the fact that they had an in-market offering was clearly a benefit to the deal.  Around this same period, Stella & Chewy’s, LLC, a portfolio company of Stripes Group,  and the market leader in freeze-dried raw sold in the independent pet store channel, transitioned into a new 164,000 square-foot facility in Oak Creek, Wisconsin, funded by a debt package sourced by the company in early 2015.  On January 7, 2016, the company announced it had hired a highly seasoned consumer industry executive to run the company and recruited pet industry executive Mark Sapir as Chief Marketing Officer.  Sapir most recently served as VP of Marketing & Innovation at Merrick.  Finally, on January 8, 2016, it was disclosed that WellPet, LLC, a portfolio company of Berwind Corporation, and the owners of the Old Mother Hubbard (which had been previously owned by Catterton) and Eagle Pack Brands, had acquires Sojourner Farms, LLC, doing business as Sojos. Sojos is number two or three player in the dehydrated pet food space.  In addition to providing validation of both the freeze-dried raw and dehydrated solution set, it also provides further evidence that larger players in the consumables space will buy smaller brands, especially if those brands resonate with premium customers who shop independent pet specialty.

So what does this all mean? I believe there are two conclusions that can be drawn. First, that the alternative form factor pet food market is a real sub-category and mid-sized to large players need to pay attention to it, because consumers are buying into the category, and have a response for how to compete within it or counter its proliferation going forward. The category is no longer a novelty, something that market leaders can simply write off or ignore.  Second, it’s going to result in more transactions as strategics buy into the space in an effort to deliver a competitive response. The winners of this coming-of-age will be the entrepreneurs who pioneered the category and the private/growth equity firms that supported them.  With a limited set of properties available, it could send valuations, which have been trending down, back towards the upper end of the historical multiple range.

/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.

 

 

 

 

 

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.

/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.

 

 

 

 

 

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.

/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.

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 Rover.com 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.

/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.

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