Being early, wrong, or both is no fun, at least not in the case of making industry predictions (traders will also say early is also wrong). And when it comes to our views on the waning of the pet food upgrade cycle many people have made us aware that we were either early or wrong (or both!). However, when you make market predictions based on limited information you are going to be wrong, sometimes with regularity (see my view on the inability for private equity to acquire PetSmart here, as just one notable example where I have missed the mark, but at least I correctly predicted that they would not combine with Petco, see here), and we are okay with that. That said, here I am not sure we were either wrong or even that early in this case.
In 2013, we began to beat the drum about the deceleration of the pet food upgrade cycle (for those of you scoring at home you can see comments here and here). Our view was that basic economic realities were fundamental headwinds — stagnant wage growth, slowing pet replacement, growth in small dog ownership, and continued food price inflation. We then pointed to PetSmart comps going flat to negative, and fully negative ex-inflation, for most of 2014, had to be a sign this cycle was on life support. However, all of these factors were explained away by other data — accelerating pet product Personal Consumption Expenditures in 2015 (Bureau of Economic Analysis), recovering pet adoptions in 2015 (PetPoint), accelerating pet food spend in 2015 (APPA), growth in alternative form factor pet food (GfK), mismanagement at PetSmart (pick your favorite equity analyst), and the successful Blue Buffalo IPO. In short, for every fundamental premise we had on the offer, there was a data set that one could point to bolster their thesis. The issue was that the evidence used to perpetuate the myth that the upgrade cycle was alive and well was easy to debunk, but nobody want to hear it, and they still don’t.
Fast forward to today, and we now see increasing direct evidence that supports our thesis. First, last month The J.M. Smucker Company trimmed its full year earnings forecast on the basis of declining sales of pet food for the quarter, down 6%. While there was a positive spin around the narrative (difficult comps due to prior year sell-in, strong new brand sales prior year), it is concerning. The company expects weakness to persist throughout the balance of the year. Second, our survey of private mid-market pet food marketers ($100+ million in revenue) indicates that the malaise Smucker’s is experiencing is not isolated, though the magnitude is greater. Most of the company’s we surveyed offered full year views of 0% – 2% growth domestically. Finally, Tractor Supply, which does a significant percentage of its business in livestock and pet supplies (44%), trimmed its quarterly earnings forecast and full year outlook for the second time this year. The company now expects same-store-sales for the quarter to be flat to down 1% after being up 2.9% in the prior year period. While we may not think of Tractor Supply as the prime destination for the premium pet food consumer, they do sell a considerable number of premium brands – Blue Buffalo, Merrick, Natural Balance, and Wellness, among others. The company pointed to slowing growth in the C.U.E. (consumables, usables, edibles) business. Translating the semantic hieroglyphics, this means their pet and animal products business, including pet food. We suspect Tractor Supply is not alone.
What is more important here than being right or wrong as it relates to the state of pet food, is what will the implications be for the capital markets of the death of the cycle. We do not believe that slowing pet food sales, premium or otherwise, is going to hamper capital formation. There remain multiple heuristics of emerging brands garnering footholds to grow their business rapidly to $25 – $50 million in sales with limited capital investment. The scarcity of these businesses, coupled with the amount of institutional capital chasing these opportunities, means that growth equity investments in pet food, distinct from treats, will remain robust. Of greater significance is whether this will jump start a new M&A cycle. While large strategic acquirers tend to have a negative M&A bias during period of weak financial performance, it might just be such that they will uses these events to recognize the need to buy into niches that represent the future of the industry. This could push multiples, which have been waning, albeit, at the margins over the past three years to begin to trend up. Further, the fact that broader M&A statistics indicate we are almost certainly at the end of this M&A cycle, might cause more sellers to come to the table. Watch closely for M&A volume in this segment to tick up over the coming year.
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.