petcoWhen Petco Animal Supplies agreed to be acquired by CVC Capital Partners and the Canada Pension Plan Investment Board for $4.6 billion, the Dow Jones Industrial Average was trading around 17,800.  The market had recovered from the August swoon that turned out to be the worst month for the index in five years. Concerns about a slowdown in China, falling oil prices, and possible rate hikes by the Federal Reserve, sent the index into a tailspin.  Now, a mere 90 days removed from that correction, the Dow stood within three percent of its 2015 high water mark, and little concern was expressed about mega-deals, such as the Petco transaction, getting to close.  Press releases for the deal indicated a closing would happen in 1Q2016.

When the deal was announced, it was also disclosed that the transaction would be supported by $3 billion in acquisition financing, underwritten by Barclays, Citigroup, Royal Bank of Canada, Credit Suisse, Nomura, and Macquarie.  The broad lender support was a function of the company’s strong credit profile and a favorable following with investors after multiple recapitalizations, which is reflected in its trading profile in the secondary loan market.  Further, PetSmart’s acquisition debt had been trading a favorable rates in the secondary market, boosting interest. However, the deal was subject to syndication that would happen in 1Q2016.  While there has been no indication with any issues in closing the deal, there is cause for concern.  When the debt package was originally negotiated, the credits market were choppy,  now they are downright turbulent with bankruptcies accelerating and junk bond issuances declining by over 70% year-over-year.  While these bankruptcies are primarily related to the energy markets and energy dependent segments, they have put a malaise into the large cap buyout credit market as a whole.  Notably, in January, Citigroup tweaked the terms of Petco’s loan package to make it more attractive to potential syndication partners.

I proffer an example of the credit market’s uneasiness in the case of Mills Fleet Farm Group. In 2015, KKR agreed to buy the family owned retailer of rural consumer goods, including pet products, for $1.2 billion. Mills Fleet operates 35 stores in Minnesota, Wisconsin, Iowa and North Dakota.  The deal was set to close in late 2015, before it ran into trouble with its debt package. No sell-side capital markets deck was willing to take the paper, and KKR was forced to sell finance a large portion of the debt package against a backdrop of large retailer earnings misses, which drove up pricing.  The sale of Mills Fleet closed on Leap Day 2016, fitting.

While we may not be able to draw a direct correlation between Mills Fleet and Petco, the deals fall into the same buyout class.  Further, if you look outside of these transactions not many large cap LBOs are closing.  Most of the recent multi-billion deals have involved strategic acquirors.  Ultimately, we expect the Petco transaction to close, but there may be more bumps in the road along the way.


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.



gordonOn December 14th, PetSmart agreed to be taken private in an $8.77 billion transaction led by BC Partners, a European based private equity fund with a history of consumer and retail investments, largely outside of the US. The deal, the largest private-equity buyout of 2104, values PetSmart at 9.1x the company’s adjusted trailing twelve month earnings before interest taxes and depreciation.  PetSmart’s equity holders will receive $83.00/share in consideration if a superior bid does not emerge and the transaction is approved.

The deal described above reflects a 39% premium to the prevailing per share equity price just prior to the disclosure of Jana Partners, an activist investor, equity position in the company in July 2014.  BC Partners and its co-investors — Caisse de depot et placement du Quebec, Longview Asset Management and StepStone Group, LP — outbid Apollo Global Management and KKR & Co., among others, for the asset. The buying group is financing an estimated 6.5x EBITDA to fund the transaction.  Citigroup, Nomura, Jefferies, Barclays and Deutsche Bank have committed to provide $6.95 billion of debt to pay for the deal. The financing package consists of $6.2 billion in fixed debt, expected to be split between roughly over $4 billion of term loans and $2 billion of bond, and a $750 million asset-based revolver to support daily operations. 

I am an on record as predicting that a transaction involving PetSmart was unlikely.  My view was that the necessary equity premium to justify a transaction PetSmart would have been exceedingly hard to generate for a private equity fund and that the strategic buyer landscape was small. I correctly surmised a combination between PetSmart and Petco would have too many impediments (though Petco was not given a real opportunity to buy the company but may proffer a superior bid if so chooses), including regulatory concerns. However, I underestimated how much debt financing would be available for a private equity buyer to support the purchase price.  In my defense the debt markets were roiled by macro fears at the time of prediction.

In thinking about the implications of the transaction, I offer the following summary:

  • Financial Engineering at Work. I view this transaction as a triumph of financial engineering.  A combination of excess liquidity in both the public and private debt markets as well pent up demand for large cash flow generating assets by private equity made this transaction viable.  The buyers must believe there are additional cost rationalization opportunities beyond the $200 million Profit Improvement Program management announced on the November earnings call.  More than one bidder who dropped out of the process proffered their view that additional opportunities appeared evident to support the required debt load. I am not expecting much change to the strategy and operating framework David Lenhardt laid out on the May 21, 2014 earnings call.  While being outside of the public reporting sphere, save for any public debt requirements, will allow PetSmart to pursue some strategies that sacrifice near term profits for long term growth, the anticipated transaction debt load will limit flexibility in this regard.  Moving PetSmart forward will be more about better execution of tactical store level decisions and incremental strategies, than “big bang” opportunities.
  • Lost Transparency. As we have detailed here previously, the pet industry lacks performance transparency. The vast majority of manufacturers and retailers are private companies or divisions of public enterprise with limited disclosure requirements. As a result, the industry is starved for timely fact based performance data. A publicly traded PetSmart provides the general public insight into the direction of the industry. That information is both free and timely. The company’s quarterly conference calls provide a wealth of information on category level performance and pet consumer trends.  Once private, this transparency will dissipate.  We think that is a real loss for the industry.
  • Not the Last Transformational Deal.  The take private of PetSmart is not the first transformational deal of this cycle and it won’t be the last. The number of large private pet companies across industry categories has swelled over the past five years. Whether it is an acquisition of Blue Buffalo, a public listing for Big Heart Brands, or a sale of Hartz Mountain, we expect that more big deals are on the horizon.


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.

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

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

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

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


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

playbookIn October, Del Monte Foods announced that they had sold their fruit and vegetable business for $1.68 billion.  While the world will still have Del Monte canned pineapple, whole kernel corn, and Contadina tomatoes to enjoy in perpetuity, the transaction speaks volumes about the attractiveness of the pet food business relative to its human corollary.  Del Monte’s pet products business will now operate under the Big Heart Pet Brands banner.

You may recall that back in 2010, when Del Monte Foods was taken private by a private equity syndicate headed by Kohlberg Kravis & Roberts (, I postulated that the deal was not about shelf stable fruits and vegetables but a bet on the macro fundamentals of the pet industry.  The sale of Del Monte’s Consumer Products business validates my thesis, as does the recent acquisition of Natural Balance Pet Food.  The real question is what comes next?

As a general rule, private equity backed companies are not keen to keep cash on their balance sheets.  Excess cash is used to make acquisitions, delever, or ends up as dividends to shareholders.  Given the size of the slimmed down Del Monte post sale (some $1.8 billion in revenue), I don’t see the later two options as being viable alternatives. As such, I expect that Del Monte will be an active player in the pet consolidation market, and with that much cheese at its disposal the target list includes brands others cannot contemplate.  So who will Del Monte buy? We handicap the candidates:

  • Blue Buffalo. The Blue is the biggest and best name on the block. Not a month goes by without a rumor surrounding the prospects of a Blue Buffalo acquisition by a major CPG company, but the reality is that the company has limited options for suitors at the purported price tag — $3.0+ billion.  Could Del Monte take it down?  Yes.  Will they? Unlikely.  First, Del Monte’s pet line-up is very much about a product portfolio and spending all your allowance on one product company runs a bit counter to that premise. Second, private equity backed companies do not have a propensity for being top payors.  When Del Monte acquired Natural Balance for $341 million, they paid between 1.0x – 1.5x Revenue.  I’m not sure what multiple of EBITDA a $3.0 billion deal for Blue implies, but it would be far greater than the 9.0x the private equity syndicated paid for Del Monte.  While Del Monte established the market multiples that pet companies aspire to achieve through their acquisitions of Meow Mix and Milk Bone, I don’t see them doing a highly dilutive deal with Blue Buffalo; the cost benefit tradeoff is misaligned. Odds: Not good.
  • Natura Pet Foods. The fate of Proctor & Gamble’s pet food portfolio has been a source of constant speculation.  P&G was rumored to be considering offloading its pet business when they acquired Natura Pet Foods in 2010 (, which some took as an about face. They never integrated Natura, which would make it the most likely candidate among the P&G portfolio to be acquired.  Natura would provide Del Monte another power house brand in premium natural, but of greater significance is the fact it would be buying a portfolio of products (EVO, Innova, California Natural, Healthwise), not a single brand.  This would also enable Del Monte to keep Natural Balance in pet specialty, as the Natura portfolio would meet the same needs in mass.  This strategy runs into two problems, one from each side of the transaction.  First, Natura was the subject of one of the widest recalls ever in June of this year, when the company voluntarily recalled every product it made with an expiration date before June 10, 2014. It was their fourth Natura recall in as many months.  Would Del Monte buy a dented egg?  For the right price I suspect they would.  Second, a sale of Natura would only generate proceeds of less than $500 million, a rounding error for P&G, and therefore not much motivation to transact.  Odds: Possible not probable.
  • Iams Pet Foods/Eukanuba. In contrast to a Natura transaction, the sale of Iams and Eukanuba would likely fetch between $3.0 – $3.5 billion ($2.5 – $3.0 billion of that being Iams). This would be worthy of some attention for both sides. Merging Iams/Eukanuba with Del Monte’s pet food brands would make it the number two player in the market, with 20% share versus 35% for Nestle Purina Pet Care. Notwithstanding my comment about check size above, this deal would be tempting for Del Monte to consider. Iams and Eukaneuba generated approximately $2 billion in revenue in 2012 (allocating the other $300 million of segment revenues to Natura), and therefore would be attractively priced, consistent with the Natural Balance transaction. Notably, in July 2013, Del Monte tabbed Giannella Alvarez as Executive Vice President and General Manager of the Pet Business.  As part of her work history, Ginnaella spent time at P&G, albeit involved in a Latin American paper joint venture, but she may have some relevant connectivity to current leadership. However, a deal of that size would likely require the private equity owners of Del Monte to invest more equity, something private equity firms can be loathe to do.  The transaction timeline would also be elongated by anti-trust concerns.  While this deal makes a lot of sense, there are clear barriers to a transaction.  Odds: Possible.
  • Champion Pet Foods. The brand that few talk about in this conversation is Champion Pet Foods, which manufacturers and markets the Orijen and Acana brands of super premium pet food.  Champion was acquired by Bedford Capital Management in 2012, and the business has grown rapidly since the transition, benefiting from Natura’s channel exit and growing distribution offset by production complications related to a plant fire in December 2012. Champion’s regional formulations may not create production economies of scale (yet), but they garner a premium price among consumers who value a limited ingredient solution with a known sourcing pedigree.  While Del Monte wants scale in the brands it acquires, Champion is growing quickly and will become a target of major pet CPG companies over the next 12 – 24 months.  An acquisition would provide Del Monte a very compelling product stack in pet specialty.  Odds: Long, but logical.

Net net, post sale transaction Del Monte finds itself in an enviable position — with both cash and intent.  I do not expect that the company will rush into any transaction, but they have to buy and given the limited competition for premium assets in the space, look for them to strike while the iron is hot, or at least warm.


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.


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.


For those of you who are regular readers of my blog, you will note that it’s been pretty silent around here the past few months.  I promise you, it has not been for lack of trying.  There have been many capital market items of note over the summer but nothing seemed to maintain sufficient momentum as to be blog worthy in my opinion.  That said, in my conversations with others the market context I have been able to convey, through firsthand experience, has been eye opening for them.  As such, I thought it was worthwhile to catalog a few observations here.

Generally speaking the market is giving off mixed signals.  On one hand all the ingredients necessary to  produce a robust M&A and equity capital market in 2012 are evident.  These include continuing unprecedented liquidity in the hands of private equity sponsors as well as on the balance sheets of Fortune 1000 companies.  Notably, private equity fundraising in 2Q2012 was the second best quarter in the past three years according to Pitchbook.  Additionally, there are over 4,000 private equity backed companies who received outside capital more than three years ago meaning they are of “sale vintage” (typically private equity investors look to exit within a 3 – 5 year window).  Further, the public equity markets, which appear constrained by the macroeconomic climate and political rhetoric, is heavily rewarding both size and growth, making M&A an attractive shareholder value creation opportunity.  Finally, you have pending tax code changes providing sellers’ impetus to do a transaction in 2012, when capital gains are likely to be lower absent political upheaval.   The last time we faced this same tax cliff (2010), M&A volume in the second half of the year, relative to the first half, increased by over 50%.

On the flip side of the coin are the facts with respect to actual market activity.  Private equity volume in 2Q2012 was down 10% sequentially and down 36% on a year-over-year basis according to Pitchbook.  While U.S. M&A market activity was up in this same period, according to Thomson Reuters, on a sequential basis it was down 18% on a year-over-year basis.  If one digs through the data weeds the sequential uptick was driven by a small number of deals in the oil and gas sector, and therefore not indicative of a broad based rally.  Net net, through June, year-to-date M&A activity was down nearly 30%.

The net result of the above is the market has bifurcated into what we call as “Tale of Two Cities” transaction economy.  On one hand you have large $15+ million EBITDA businesses that have the ability to garner significant amount of leverage to finance a leveraged buyout.   As a result of possessing this optionality it is forcing the hand of interested strategic buyers when it comes to M&A valuations involving these properties.  Small companies (sub $5 million in EBITDA) have fewer arrows in their quiver if a strategic buyer is not a willing suitor — take an equity deal and a lower valuation or stay the course.

Notwithstanding the above, we are seeing that some small companies that can affect sales and financings on attractive terms relative to historical norms.  Said differently, deals that are getting done are closing at attractive multiples.  These companies tend to have a number of common characteristics: a) growth — not just growth but sustainable above market growth with generally accepted barriers to entry (e.g., culture of innovation, intellectual property, contracts, etc.), b) best in class gross margins —  firms with thin margin profiles are viewed as higher risk and therefore ascribed lower valuations, c) customer attachment — brand value as evidenced by repeat customer relationships at attractive economic rates, and d) scarcity — market leaders are receiving premium valuations even if they are smaller companies.

Ultimately, I feel these conditions will prevail throughout the balance of 2012.   The pending presidential election is offering voters a choice between two widely divergent economic roadmaps.  Until one is anointed and investors or buyers are able to assess the potential for growth over the next four years, buyers will remain cautious.  As a result, bankers should expect long execution cycles and “take it or leave it” negotiation tactics in the interim.


They say there are two certainties in life, death and taxes.  That’s not entirely accurate since death comes at the end of life, but that is probably just quibbling.  Taxes are a certainty however, whether of not you choose to pay them.  If the 2012 presidential campaign has illuminated anything definitive to date, it is that not all income streams are equal from a tax standpoint; those who make the majority of their income through buying and selling investments (the Mitt Romney’s and Warren Buffet’s of the world) have much lower effective tax rates because their income is treated as capital gains instead of ordinary income — 15% versus 35% at the highest level.  Some form of equity is looming on the horizon.

In 1993, the Clinton Administration sought to tackle a $300 billion federal deficit through government spending cuts and increasing personal income taxes on top earners.  This resulted in a budget surplus in 1998, which grew to $230 billion by 2000. The surplus was a central discussion point in the 2000 presidential campaign.  George W. Bush suggested America was “owed a refund” and campaigned under a promise to lower taxes on the wealthy if elected.  The net result was the 2001 Economic Growth and Tax Relief Reconciliation Act and 2003 Growth Tax Relied Reconciliation Act, collectively referred to as the “Bush Tax Cuts”.

The Bush Tax Cuts lowered ordinary income tax rates 3%-5%, phased out the estate tax, reduced the marriage penalty, lowered rates on income from dividends and capital gains, and increased exemptions.   Critics argue over the long term impact of these changes, but two things are hard to dispute: a) the Bush Tax Cuts resulted in U.S. government losing billions of dollars of revenue over a 10 year period and b) keeping the cuts in place have become a central political platform for the Republican party.   While I am no political handicapper, the combination of a swelling U.S. deficit (and therefore the need for more revenue streams), the growing income gap between the wealthy and the middle class (as evidenced by the “Occupy” movement), and the clear improbability of the GOP winning both the White House and the Senate, mean the Bush Tax cuts are all but dead on the stroke of midnight December 31, 2012.

The implications of Cinderella leaving the ball are meaningful, as evidenced by the table below:

Estimated Changes Upon Expiration of Current Tax Program
2012 2013E % Increase
Ordinary Income 35% 43.4% 24%
Long-Term Capital Gains 15% 23.8% 59%
Qualified Dividends 15% 43.4% 189%
Estate and Gift 35% 55% 57%
Source: Moss Adams LLP Year-End Tax Planning Guide, November 2011

The question many are asking is whether these changes may light a fire under M&A for family owned businesses in 2012.   After all, if you own a business worth $100 million and  you sell in 2012 versus 2013 you save yourself at least 8.8%, but possibly much more if the”Buffet Rule” is enacted into law, which would put a minimum tax rate of 30% on all income streams if you make over $1 million annually.

History would tell us that taxes alone are not sufficient enough to push people towards transactions they would otherwise defer.  However, history has not seen this level of increase in the capital gains rate since the 1967 – 1972 period when rates increased 11.5%, but over a period of five years.  Here we are talking about 8.8% over night.  Further, the market has never enjoyed the levels of liquidity currently in the marketplace, from both strategic acquirors and private equity firms.  Excess liquidity tends to correlate with rising purchase prices.  Throw in a pinch of uncertainty regarding Europe over the next 24 months and you might have a convergence of circumstance strong enough to call some to action.

Despite the stars aligning only a subset of the market should be interested in this reality, and that would be companies on the larger end of the spectrum.  Yes, as enterprise value increases the impact of the capital gains rate changes increases, but more importantly so do transaction market multiples.  According to GF Data Resources, the spread between the multiples garnered by businesses worth greater than $50 million is a fully 2.0x in a leveraged buyout versus those with lower enterprise values.  The data shows that the “size premium”, so to speak, increased a full 1.0x in 2011.  Absent attractive purchase prices, people tend to sit on the sideline no matter how their tax bill changes from one year to the next.

Net net, I think 2012 will be a strong year for M&A because of the total market dynamics, but I don’t think taxes alone are going to stimulate a plethora of activity that would not otherwise be there on other merits.


In September 2008, a private equity group led by Hammond, Kennedy, Whitney & Company, Inc. (“HKW”),  acquired a majority interest in FURminator, Inc., a Fenton, Missouri based manufacturer and marketer of pet grooming products.  The FURminator’s products include small, medium, large, cat, and equine deshedding tools, shampoos and conditioners, treats, and dog food supplements. Terms of the deal were not disclosed.  However, at the time, I put out some estimates here.

On December 9th, United Pet Group, Inc., a subsidiary of Spectrum Brand Holdings, Inc., announced they had acquired the business for $140 million.  Disclosed latest twelve months revenue for the company was  “at least” $40 million, putting the deal value at between 3.0x – 3.5x latest twelve months revenue — as eye-popping a multiple as we have seen in the pet industry, excluding food, over the past three years, and certainly something we expect other sellers and potential sellers to latch on to when establishing their valuation expectations.

When HKW and friends acquired the company, it was, in my opinion, a bit of a head-scratcher.   FURminator had established itself as the leading player in the deshedding tool market and its intellectual property position provided the company with a tangible source of competitive advantage.   However, it was not clear where the subsequent growth was going to come from.   How many $40 deshedding tools does one household need?  The product is virtually indestructible and the pet population was, at the time, not growing.   Notably, HKW did not have any pet industry experience and while my estimate of the value associated with the buyout transaction were, in hindsight, overstated, the group paid a healthy premium for the business.

So how did the buyout group generate such a handsome return?  Oddly enough, it was the recession.

While the pet industry fared well, on a relative basis, during the recession, the services segment was hit harder than consumables.  As consumers cut back on discretionary spending services were the first to go.   However, that did not mean that owners stopped washing and grooming their dogs.  Instead they just became do-it-yourselfers, driving sales of grooming products to the consumer market (relative to the professional market).  As the top brand in this space, FURminator benefited.

Additionally, the major pet retailers (Petco and PetSmart), in an effort to drive store traffic and control costs, began to consolidate vendors in late 2009.  During the 2007 – 2009 period, the number of product providers (both hardgoods and consumables) had increased markedly, reducing economies of scale in operations.  Further, brand proliferation made it difficult to provide consumers a uniform experience across store venues.  As central merchandizing groups took back control of the aisles, they shifted their product strategy to focus on core brands store brands/proprietary product.  As a result “tier two” players were waylaid.   After all, if you were only going to carry one brand of deshedding tool it was going to be FURminator.

The last leg of the stool was that the recession kicked off a wave of strategic M&A as corporations sought to purchase growth.   Within pet, the merchandising changes at Petco and PetSmart began to drive deals in the products space — Doskocil Manufacturing, Tagworks, Bamboo and Fat Cat, Spotless Group, among other deals.  United’s acquisition of FURminator is simply an extension of this trend.   These deals price attractively because of the operational synergies — rationalization of facilities, people, distribution.   Notably, United stated that once integrated the effective multiple they will be paying for FURminator is 6x – 7x EBITDA.  Given United’s ability to push the product into international distribution and their resources to assert  and defend FURminator’s intellectual property position means 3x revenue does not look overly expensive.

Beyond that, let’s hope the trend continues — 3x revenue valuations for everyone.


If you have followed my pet industry musings for any duration, you know that I am not a big advocate of the service paradigm offered at large independent pet specialty chains — PETCO Animal Supplies, Inc. (“Petco”) and PetSmart, Inc. (“PetSmart”).  That is not to say I don’t see value in their services, as they play a fundamental role in growing the broader pet market.  Notably, I am and will continue to be a Petco customer.  Their store is only a mile from my residence, and while my purchases there constitute an increasingly shrinking percentage of my pet product basket, they offer me a level of convenience that I can’t find from my other pet vendors.

When we adopted our first dog, like moths to a flame we immediately went to Petco to buy our staples and stock up on food.  Over time I have moved my dogs onto other meal programs and built relationships with other product vendors.  As a result, my true need for Petco has diminished.  However, the reasons my traffic declined was one of product selection, and not what I constantly harp-on — the mediocre service paradigm that Petco, and PetSmart for that matter, offer.   It is this service paradigm that has enabled smaller independent pet specialty chains to take share.  The net result has been significant capital inflows into these secondary competitors as evidenced by Roark Capital’s acquisition of Pet Valu, Inc. and Irving Place Capital’s acquisition of Pet Supplies Plus/USA, Inc., the number three and number four players in the market respectively as measured by store count.

The service conundrum Petco and PetSmart find themselves in is unlikely to abate.  Both companies rely on legions of low priced labor that is prone to churn.  As a result, the average Petco and PetSmart front line employee never develops the expertise and relationships necessary to compete with the Pet Food Express, Inc. and Mud Bay, Inc.’s of the pet world, who differentiate themselves through the expertise they provide to their customers both in terms of product selection and in store service. can tell you all you need to know about the challenges of working for Petco or PetSmart.

Notably, the potential upside of these higher touch service formats attracted Petco Executive Vice President and Chief Merchandising Officer to take the helm of Pet Supplies Plus.   You can read Jim Meyers message about the departure here — Message from Jim Myers-PETCO.   Petco management has not exactly been a revolving door, but there has been consistent changes over the past three years.   All this despite, as the New York Times reported, “the company did not have a negative quarter throughout the recession.”  So why is it that five years after being taken private in a $1.85 billion transaction by TPG Capital and Leonard Green & Partners is the company not considering a public listing in the best initial public offering market we have seen in years?

One reason might be that the owners are quite happy with the benefit they are receiving from the company’s cash flow.  In November 2010, the company sought a $1.1 billion credit facility to finance a dividend to its shareholders.   The loan was later upsized to $1.225 billion.  Upon consummation, the transaction would have leveraged the company 5.5x latest twelve months EBITDA according to sources close to the deal.  And therein lies the rub.

If in fact Petco would have been leveraged at 5.5x at the time of the deal it would imply that the company was generating $200 million in EBITDA ($1.1B / 5.5 = $200M).  According to public filings, when the company went private its LTM EBITDA at the time was reported to be $209 million (as of July 30, 2006, the last reporting period prior to the transaction).    In contrast, PetSmart reported LTM EBITDA as of January 31, 2011 (the period most closely correlating with the time of the Petco leveraged dividend)  of $665 million in EBITDA.   It’s LTM EBITDA as of July 30, 2006 was $460 million.   Net net, PetSmart’s EBITDA grew ~ 45% over this timeframe where Petco’s was flat (a generous interpretation).

From a valuation standpoint, PetSmart’s equity has been on a tear the past twelve months, rising ~ 43% according to Yahoo! Finance.  This values the company at 7.8x LTM EBITDA on an enterprise basis.  Subtracting the net debt yields an equity market capitalization for PETM of ~ $5.1 billion.  Applying this same enterprise value multiple to Petco’s $200 million in EBITDA yields a value of $1.56 billion, ~ 16% less than the take private price.  Subtracting the $1.225 billion in debt yields an equity value of, well, not much.   While this comparison fails to account for all the interim distributions, including the leveraged dividend that has lowered the private equity firm’s cost basis, there is no way to put a smile on it.

Further, the above analysis appears conservative when you consider that Standard & Poor’s reported that Petco was actually leveraged 7.6x LTM EBITDA as of January 29, 2011, up from 6.0x at the same time one year prior.  Further, Petco sought an amendment to its loan agreement in February 2011, just three months post issuance.

Net net, it is clear that all is not going according to plan at Petco.  Management defections and flat EBITDA growth over the past five years, is symptomatic that consumers do not find its value proposition all that compelling.   Has it lost its mojo?  From my perspective — yes.  However, don’t count them out by any means…yet.