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.

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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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With the benefit of hindsight, we know the pet industry produced another solid year for performance in 2013, generating growth of 4.5%.  Industry revenues climbed to $55.7 billion, with growth exceeding forecast by 0.2%.  Revenues benefited from inflation of 1.3%, including food price inflation of 1.1%.  Growth was relatively uniform across the core segments with services (+5.0%) and veterinary care (+4.9%) leading the way.  While growth is projected to accelerate to 5.0% in 2014, we expect companies in the space to experience more widely divergent fates.  Our thesis is that the industry is undergoing structural changes that will result in stronger performance from the leaders and slower performance from the laggards.

Structural change is being driven by slower growth in the key drivers of performance over the past five years.  On the retail side, we are seeing smaller retail chains ascend at the expense of large pet specialty players. Notably, PetSmart same-store-sales slowed to 2.0% in 2H2013.  In contrast, PetSmart produced, on average, quarterly same-store-sales growth of 5.2%  from fiscal 2010 through 2Q2013.  Further, among top 25 pet retailers, 55% of box growth came outside of Petco/PetSmart in 2013, up from 41% in 2011. Finally, ecommerce growth in pet products is expected to accelerate from 35% in 2013 to 38% in 2014 as online pet venues both consolidate and proliferate.

Product manufacturers are also experiencing the impetus for change.  Looking for new sources of growth they are pursuing new channel strategies.  Big Heart Brands’ acquisition of Natural Balance Pet Foods and Nestle Purina PetCare’s acquisition of Zuke’s underscore this theme.  Notably,  the number of companies with pet specialty distribution that exhibited at Expo West (meaning they are looking for Whole Foods distribution) doubled in 2014. Additionally, the pending Blue Buffalo initial public offering is, in our view, a prelude for the brands entry to mass. Collectively, these companies will blur the lines between sales channels for pet consumers.

Net net, change is the air and change drives deal velocity. Below are the other key pet industry trends for 2014:

  • Prelude for Sale or a Move to Mass? In March, news leaked that Blue Buffalo Company Ltd. had selected underwriters for an anticipated 2014 initial public offering. When the company took a leveraged dividend in 2012, we predicted a sale or filing within three years. Blue generated $600 million in sales in 2013 and EBITDA margins are said to be nearing 20%. The company is approaching the size of The Nutro Company when it was acquired by Mars, Inc. While Blue has no lack of suitors, the purported asking price of $1.5 – $2.0 billion would be hard for even the largest companies to swallow in an environment where product recalls can rapidly erode brand equity. A listing would place a public sale price on the business, which may facilitate a transaction, but we think the more likely outcome is that Blue is headed to mass. The growth requirements for a public company are more than the pet specialty channel alone can support. If the brand jumps to FDM under its existing label, which we think is possible, you can add another brick in the wall of change.
  • Natural Leads Grocery Resurgence. Grocery has been steadily losing market share to pet specialty post recession. Simply put, FDM has been out-thought and out-merchandised. Lacking access to key independent brands coupled with limited selection depth, consumers have migrated their spend elsewhere. Grocery buyers and store planners did not recognize the strategic value in the pet aisle. However, this is changing. Major chains such as Kroger and Whole Foods have or are set to launch large pet assortments made up of staple, emerging, and house brands system-wide. Increasingly, brands are being built for the grocery channel or seeking to make the jump. Notably, the number of pet consumables companies exhibiting at Expo West doubled in 2014. Given its size and a lack of compelling incumbent brands, the pull of the FDM channel is strong. As the channel regains momentum outside of the natural and gourmet segments, it has the potential to change where consumers shop for premium and how brands are built.
  • Change Will Drive Deals. As manufacturers, retailers, distributors, and brands seek to align themselves with emerging realities, we expect to see increased deal activity. Deal velocity in sectors such as consumables should accelerate both acquisitions and private placements. Specialty retail, a sector whose transaction volume has been rather muted, should see a resurgence as leading micro-box and online platforms enjoy increased capital formation to expand their footprint or are acquired by mass and major pet specialty retailers seeking to expand omni-channel capabilities. For the most attractive properties, valuations will increase due to broader and deeper interest from buyers and investors.

Contact me for a copy for my report.

/bryan

Sources: APPA, Cleveland Research, New Hope Natural Media, Pet Business, Reuters, U.S. Bureau of Economic Activity

noseFor those of you who are consistent followers of my blog, you might recall earlier this year I was rather sanguine (on a relative basis) with respect to the prospects for the pet industry in 2013. My thesis was based upon three factors. First, that a tepid recovery would result in slower pet population growth and the waning of the pet food upgrade cycle. Second, that slowing comp (same-store-sales) growth at PetSmart was in fact a proxy for the industry. Finally, that declining influence of the baby boomers, who have slowed pet replacement, would not be sufficiently supplanted by the necessarily levels of spending growth by Gen X/Y to propel the industry forward at projected levels.

As we round the final turn in the calendar year and head for home, things have not played out quite as I had expected.  The industry has proven itself to again be resilient and more adaptable than even I recognized. The economic recovery has been aided by strong equity returns and rising home prices that have exceeded most pundits expectations. Notably, this has resulted in solid growth in industry related personal consumption expenditures that indicate the industry should deliver projected 2013 results. While PetSmart comps are in fact slowing, management has found ways to adapt — prolonging the pet food upgrade cycle through expanding offerings and more square footage dedicated to the premium aisle, resetting key categories such as canine hardgoods, and evolving service offerings to be more compelling.  Management also reported their belief that the company’s online strategy is producing above market returns. Finally, pet adoption rates, a key driver of spend, have accelerated in 1H2013 adding additional reason for optimism. While there may be clouds on the horizon, rain does not appear imminent. As such, we expect the industry to hit its annual growth projections.

In addition to strong growth, we are also predicting that 2013 be a good year for industry related transactions, both M&A and private placements. One of the best predictors of future M&A volume is trailing private placement volume. Generally speaking, private and growth equity firms have three to five year hold periods. From 2010 – 2012 private placement volume met or exceeded M&A volume in the pet industry. Investments made in 2010 are now starting to come into season. Given the number of companies that will enter their exit window over the next two years we expect transaction velocity to continue to grow. Consumables, distribution, and hardgoods are expected to lead the way. Based on 2013 private placement volume we expect this to become a long-term trend.

The year has also produced a number of trends that we expect will have long term implications. Among these, we are seeing acquisition rationales of large strategic acquirers focus on the value of acquired brands in the pet specialty channel. As an example, when Del Monte Foods acquired Natural Balance Pet Foods, it was the latest in a long line of wellness oriented pet properties snapped up by a large strategic acquirer. Historically, these acquired brands have migrated out of pet specialty and into mass where the market opportunity is perceived to be greater. Our understanding is that Del Monte intends to keep Natural Balance in its current channel. Sure we have heard this before from other buyers, but if you consider that mass is losing sales to pet specialty and currently there is a lack of large brands in independent pet specialty with traffic pull, we may be reaching the tipping point where taking share in broader pet specialty is the more attractive opportunity. Increasingly, we see large strategics seeking ways to connect with a premium consumer in pet specialty and believe that acquisition rationales will increasingly rely on this inherent logic.

Additionally, we are seeing a proliferation of direct-to-consumer models in the pet industry. While ecommerce is the most well known business model for direct sales to consumers, a number of alternative models (flash sales, curated retail, marketplace) have emerged post-recession. During the past twenty-four months, companies promoting these models have begun targeting the pet space.  Notably, Bark & Co. (curated retail), Dog Vacay (marketplace), and A Place for Rover (marketplace), have all raised significant amounts of capital. What these companies, and their backers, are betting on is that as Gen X/Y, demographics that have grown up transacting online, ascend in purchasing power these models will see increasing adoption.

As always, a more complete exploration of these topics and the broader industry are available in my report (post here or email me to request a copy).

/bryan

arrowAs most of you are well aware, the pet industry is in fact quite large.  Depending on how you measure industry size, the pet industry is the fourth largest consumer segment of the U.S. economy (excluding health care).  And where there are large market opportunities, logically, they are capital inflows from investors, both public and private, seeking to create wealth from changing dynamics in those markets.   As an example, if you were an investor in PetSmart’s public shares over the past five years, you have enjoyed a handsome return from the specialty retail chains’ ascendency, as consumers spent more on their pets as part of the broader humanization trend.

Pet companies have also received a considerable amount of interest from private equity funds seeking to capitalize on the growth trends inherent in the industry.  While I do not have purview into every equity funds predilections, I have yet to come across a consumer oriented growth equity or buyout fund that does not have an interest in the pet space.  Many of them long to replicate the success of Eagle Pack Pet Food, Old Mother Hubbard and Banfield Pet Hospitals.  This “professionalization” of the industry has been a thematic I have waxed on about at length in my prior reports.

However, despite the size of the opportunity and the amount of available capital seeking that very opportunity, private equity transaction volume in the pet industry has in fact been quite limited.  To put this in perspective, according to the Pitchbook platform, there were 364 private equity transactions completed in 2012 that involved consumer facing companies.  Of that deal volume, the pet industry made up just over five percent of private equity deal volume with 19 reported transactions.  The is a decline from the past three years, where pet industry transaction volume made up just over seven percent of total consumer transaction volume.  The chart below tracks the trend over time (source: Pitchbook).

GraphThrough April 2013, there have been six reported private equity investments in the pet industry, putting the industry trend at risk for a second consecutive deceleration.  So what gives?  A few thoughts based on my experience.  First, the interest of private equity in the industry does not align well with the size of its participants.  As a general rule, private equity firms target companies with at least $5 million in Operating Income, with a strong preference for more.  That is not to say that growth equity and buyout deals don’t get done involving pet businesses of every size, but the core interest from these investors is in companies with a strong track record of profitability.  The pet industry has a limited number of companies that fit this mold, with most businesses being bigger or well below that threshold.  Second, there is an active consolidator market in the industry which is a headwind for private equity firms to get a deal done.  If a seller can get a better valuation from a strategic, they will often bypass the private equity market all together and wait to do a strategic sale. Finally, the interest of private equity in the space tends to be disproportionately oriented around pet food and veterinary clinics. A lack of opportunities in these segments has increased focus on retailers, distributors and, more recently treat companies, but a historical sector bias has certainly limited deal volume.

I remain long term bullish on private equity and the pet industry, but, as evidenced by the above, the relationship between the two has some inherent complexity.  However, as private equity gets a track record of success in a broader segment of industry sectors look for the industry to embrace outside equity more fully.  Deals beget deals.

/bryan

fishySpeculation is fun.  Speculation about others is more fun.  The pet industry loves speculation.  Given the insular nature of the industry, it’s often all we have to rely on.  So when Procter & Gamble Co. (“P&G”) announced 2Q2013 earnings (P&G is on a June 30th fiscal year end), and made nary a mention of their Pet Care division a reputable pet author set the blogosphere abuzz pondering the implications of this “over site”.

The fate of P&G’s pet portfolio, which features the Iams and Eukanuba pet food brands, has been the subject of speculation for years.  That speculation has roots in a 2007 disclosure that P&G had hired the Blackstone Group to review strategic alternatives for its Folgers, Pringles, and Duracell brands.   After being a net buyer of assets from 2000 – 2005, P&G was preparing to be a net seller in an effort boost its earnings growth and enhance focus.  At the time, a divestiture of Pet Care was dismissed in favor of new management in an effort to turn around the flagging division, which in combination with the Snack group, had experienced a contraction of over 30% (revenue and earnings) between 2006 and 2007.

Speculation about P&G Pet Care end game died down after the company sold the Folgers Coffee brand for $3.3 billion in 2008 and its pharmaceuticals group for $2.2 billion in 2009, before launching a stock buyback program of up to $8 billion.  In the interim the Snack and Pet Care division had recovered its growth trajectory, even if the slope of the curve was modest.

And then P&G stunned the pet market through its winning bid for Natura Pet Products in 2010. The transaction, which likely cost them $500+ million was not the behavior of a net seller of pet related assets.  Natura was believed to be doing $200 – $250 million in sales before the acquisition. However, when P&G agreed to sell The Wimble Company (aka Pringles) to Diamond Foods for $2.35 billion in 2011 (a deal which fell through over some improper payments to walnut growers before the asset was sold to the Kellogg Company in 2012), speculation about the fate of Pet Care returned to the surface.  When Bill Ackman, an activist investor with a penchant for identifying under valued brands, made his largest ever investment in a company, the simmer became a boil, which continues today.

That said, P&G’s failure to discuss its Pet Care business on an earnings call does not have any veiled meaning.  The reality is that when Wimble was sold, Pet Care was reclassified into the company’s Fabric and Home Care reporting unit.  Pet Care as a separate P&L was no longer relevant given that Pringles made up 50% of the Snack and Pet Care divisions revenues.  Further, the fact that Pet Care on its owned is dwarfed in sales by ever other P&G revenue division by at least a factor or 8x means it was unlikely to get the same executive airtime in earnings conference calls.  In fact, the division has only received fleeting mention in ant of the three prior earnings calls.

The reality is that Pet Care does not have many places it could go even if P&G wanted it off the balance sheet.  Collectively the brands likely generate $2.5 billion in revenue meaning a market valuation of +/- $5 billion.  Most of the companies who could afford that figure would likely be facing anti-trust scrutiny if they tried to acquire the business, so it would have to be an adjacent market buyer or a foreign market entrant.  A second option would be to sell the business to a private equity firm.  However, I don’t think the numbers work.  Assuming, generously, 20% EBITDA margins and the ability to borrow 6x EBITDA to finance the deal, a financial buyer would still need to pony up approximately $2 billion in equity.  Not many firms have that sort of dry kibble.  Further, this would be akin to the Del Monte take private with half the revenue and a third of the profitability.  Pet food is not a great margin business once marketing costs are factored into the equation.  A third option would be to spin the business into a public company, a la Pifzer / Zoetis.  While having a pure play pet food comp would be nice, the transparency would make the brands vulnerable on a number of fronts.  I don’t know what a public listing would otherwise accomplish.

Net net pet industry pundits must accept that it’s not always about pet care when it comes to global brands.

/bryan

k2The rise of PetSmart has been well chronicled on my blog and in my bi-annual pet industry report.  A well established track record of margin expansion, earnings beats and EPS growth has made the company a darling within the pet industry, the specialty retail community, and one of the most widely praised stocks of the post recession era (full disclosure: I do not own the stock, nor am I providing any stock advice herein).  Since November 2008, the stock has increased over 400% (versus 68% for the S&P 500).  PetSmart’s return on invested capital (ROIC) for this same period placed them in the 96th percentile of all publicly traded equities.  For every dollar management invested, it made over $0.30/annually during this period.

Those that follow the stock, as equity analysts, industry observers, and retail investors, have become conditioned to expect an endless stream of  good news and gawk at the stocks progression up-and-to-the-right.  When there were bumps in the road (e.g., 4Q2011) we found external factors to blame (i.e., commodity prices, weather, Europe, etc.).  That notwithstanding, PetSmart management seemed to have the Midas touch. So it came as a shock to many when Nomura Securities analyst Aram Rubinson downgraded PetSmart’s equity early last week, cutting his target price from $72/share to $55/share.  Rubinson had been sitting on a “neutral” rating, but now he was ready to tell his clients to reduce their holdings.   Prior to joining Nomura from hedge fund High Road Capital, Rubinson was a senior research analyst at Banc of America Securities, where he was the #1 ranked Hardlines Retailing analyst, according to Institutional Investor.

Rubinson’s downgrade sent PetSmart’s equity price tumbling 8.9%, 12% off its 52-week high.  The crux of Rubinson’s recommendation was as follows — Amazon.  His thesis was, largely, that Amazon would take share and put pressure on the company’s margin as PetSmart becomes forced to subsidize shipping in order to compete in a category that is migrating online.  This a bell I first rung, politely in 2008, with more fervor in 2011 and I practically pounded the table in November 2012.  My point is that while Aram has a large platform for broadcasting his opinion on PetSmart’s market opportunity, this was not new news.

Notably, Deutsche Bank raised their target price on PetSmart’s stock to $71 on November 15th after the company delivered another strong quarter. As part of their commentary they made is clear that margin and multiple compression was not of concern because.  Shortly thereafter, Barclays Capital upgraded the stock from equal weight to over weight.  Nine analysts have rated the stock with a buy rating, two have given an overweight rating, fourteen have issued a hold rating, and one has given a sell rating to the stock. PetSmart currently has an average rating of overweight and an average target price of $74.00.

Given that the Amazon issue has been on the table now for some time, why did the stock really take a turn south?

First, the stock was ripe for profit taking.  Again, the business has been on tear and the stock has followed.  At it’s peak, PetSmart traded at 19.0x foward year EPS and 9.0x forward year EBITDA, both significant premiums to the market (44% on a price-earnings basis).  This is the first substantive pullback since July 2010, but the drivers at that time were macro — Greece, double dip, etc.  PetSmart would report a strong quarter and raise full year estimates in August 2010.   So when the company announced a reshuffling of the management deck chairs (see below), traders used Rubinson’s downgrade as a reason to take profits that they could hide behind.

Second, the forthcoming management transition was poorly communicated and contains risk.   As part of a what we learned was a “planned management succession”, CEO Bob Moran is becoming Chairman while COO David Lenhardt gets the CEO job.  Further, Joseph O’Leary, Executive Vice President of Merchandising, Marketing, Supply Chain and Strategic Planning (that’s a long title), gets the nod as President and COO.  This comes on the back of CFO Chip Molloy’s previously announced departure in November 2012; he retires in March 2013.   Net net, this larger wave of changes caught the analyst community by surprise.  Moran had made no mention of near term retirement (he is 62 years old), and while this is largely an in-house promo parade, that program has not always been met with positive ends — see Coca-Cola Company circa 1997, Goizueta, Ivester, and Daft, which launched the iconic beverage company into a lost decade of stock appreciation.  Further, anytime a public company CFO departs it gives investors pause.  Molloy is only 50 years old.

Finally, Amazon, but not Rubinson’s Amazon.  Yes, Amazon is taking share in pets, faster than anyone would have anticipated but the fate of PetSmart does not hinge on being competitive in the delivery price of pet food.  The market has shown very little interest in pet food home delivery no matter what the perceived convenience or savings.  Tens of millions of dollars have been buried waiting for this market to arrive. Rather, the threat of Amazon and its online brethren to PetSmart is two fold.  First, online players are developing capabilities that will enable them to serve as a one-stop-shop for pets — food, consumables, products, medications (Rx and OTC).   On a value and convenience basis this will attract a tangible set of customers, especially as the e-commerce generation (those born after 1970) amasses further purchasing power.  Second, PetSmart has structural issues as it relates to its online efforts.  The company currently outsources its online efforts to GSI Commerce, an eBay corporation.  While this is fine for a general catalog online, to compete against Amazon, wag.com, Pet360 and others you need in house controls and capabilities.  PetSmart’s contract has years to run and it would take tens of millions of dollars to put in place the infrastructure necessary to control its own destiny online.  This makes the investment banker in me believe PetSmart will make a catch-up acquisition within the next two years.  Until then, management will continue to downplay the competitive threat while working tirelessly behind the scenes to limit the damage.

PetSmart remains a great company with a robust outlook.  However, there are cracks in the facade; cracks that it did not take an equity analyst to reval.  The company has tangible problems, but it has overcome challenges time and again.  While the recent equity price correction seems justified, it’s too early to say the company has peaked.

/bryan