lone starOn the morning that Blue Buffalo priced its IPO, above the expected range I might add, Nestle Purina announced that it had acquired Merrick Pet Care, owner of the Merrick, Castor & Pollux, Whole Earth Farms, and Backcountry pet food brands. Terms of the transaction were not disclosed. However the deal likely garnered the leading EBITDA multiple for a pet consumable transaction in this transaction cycle.  Merrick had experienced strong growth in the years following the majority recapitalization by Swander Pace Capital.  This is the second headline grabbing exit for the San Francisco based private equity firm, that earlier this year sold Applegate Farms to Hormel Food Corp for $775 million, or approximately 2.3x estimated 2015 sales.

On the surface this deal is of little surprise.  Merrick filled a well-defined hole in the Purina pet food product mix as it relates to natural pet food.  While Merrick had only recently entered into the freeze dried raw category, the acquisition also provides Purina with a platform in that space after missing out on the possibility of acquiring Nature’s Variety, who elected to do a transaction with Spanish pet food manufacturer Agolimen SA without engaging in a broader marketing process.  Rounding out the appeal was likely the integrated manufacturing assets and the foothold it gains in the natural channel through the acquisition of the Castor & Pollux brand, though whether that channel exposure sticks remains to be seen given the historical experience with Pet Promise.

However, when one digs a little deeper there are secondary facts worth noting:

  • Come from behind victory.  We heard from several sources that Purina was not the leader after the initial round of bidding.  However, as the most logical buyer with the deepest pockets they likely knew that they would get the last look so coming out too strong had no material advantages.  In the end, winning is all that matters.
  • Convergence theme in play. Also of note is that at least one of the final bidders was not currently in the pet space.  We believe this was a US based food company, though that is simply speculation. Our assumption was that Merrick would have been big enough to tempt someone on the outside to possibly buy-in, especially given the company’s focus on natural and its integrated manufacturing capabilities. That control of production has been an important consideration in our historical conversations with adjacent market strategic buyers.
  • Past precedent was important. It’s natural for a company with a meaningful presence in the independent channel to have concerns about on-going carriage once acquired by a major industry player.  It is also logical for retailers and consumers to have doubts when a transaction like this occurs.  However, in this case, Purina is able to point to their experience with Zuke’s, which has remained focused on the specialty channel and who Nestle actually pulled out of direct-to-consumer sales channels, as a proxy for how it will manage Merrick.  The fact pattern has given them some credibility with these retailers to push back against reduced carriage.
  • Castor & Pollux owners win too. When Merrick acquired Castor & Pollux Pet Works they did so in a stock deal, where the consideration was equity in the combined entity.  While Castor & Pollux was the leading player in organic pet food before growth in natural pet food exploded, it had plateaued at the time it sought an exit.  The company struggled to drive growth given its limited available resources. The gross margin profile associated with a sub-scale brand reliant on outsourced manufacturing and organic inputs is less attractive. Taking stock in Merrick, as opposed to cash at close, now looks to have been a very good decision.

We believe this deal makes the end of a the M&A cycle for major independent pet food players.  This current cycle included the sales of Natural Balance, Nature’s Variety and now Merrick.  We don’t see another headline grabbing pet food deal until Champion Pet Foods chooses to test the market, unless one of the large family owned operators decides it is time to exit.  Assuming this is the case, at least it ended with a bang.

/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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nickelLast week, Blue Buffalo filed an amended S-1 providing an expected price range for its sale of 29.5 million shares of common equity, with an overallotment allocation of 4.4 million shares.  The company expects to raise in excess of $500 million in its IPO and will trade under the ticker symbol BUFF.

Based on an expected valuation range of between $16-$18 per share, at the mid-point ($17/share) Blue Buffalo would have an equity value of approximately $3.3 billion and total enterprise value of over $3.5 billion based on net debt of $241 million as of the March 31, 2015. This would imply a valuation of just over 18x trailing twelve months Adjusted EBITDA (as defined by the company) as of March 31, 2015.  The above stated range fell below my expectations in terms of anticipated value.  A few factors are likely to be weighing on institutional investors’ minds in light of a more complete analysis of the company’s S-1.

  • Too many eggs in one basket.  Companies that are subject to customer concentration issues generally receive discounts in the capital and M&A markets. In the case of pet food the customers are the retailers.  As disclosed in the  S-1, 73% of Blue Buffalo’s sales were to national pet superstores, PetSmart and Petco.  Based on my personal analysis and those of third parties I consulted, collectively we estimated that PetSmart likely accounts for between 66% – 75% of Blue Buffalo’s national pet specialty volume. This would imply that PetSmart is responsible for approximately 50% of the company’s total sales volume. This puts Blue Buffalo is in a more complex position vis-a-vis a move to mass.  While we think such a move for Blue Buffalo is inevitable, it may complicate the process or drive up the cost.  Clearly, PetSmart and Blue Buffalo need each other, for now. That said, last week PetSmart announced, what many had already known, that Natural Balance would now be available throughout their store network and online properties. I view Natural Balance as a perfect comp for Blue Buffalo from a product positioning standpoint. If PetSmart is able to obtain access to Merrick it would add a second leg to that protective stool.
  • Share and share alike, not really. According to Blue Buffalo’s own market segmentation analysis, in 2014 it owned a 34% share of what it terms the “Wholesome Natural” segment, which it defines as dry dog food using only natural ingredients (based on AAFCO), that have whole meat or meat meals, with the animal protein type clearly identified as their principal ingredient.  These traits are distinguished from the “Engineered” segment, which are characterized by the fact they typically do not contain whole meal or meat meal as their principal ingredient and/or they use lower cost proteins (by-product meal, corn/wheat gluten) and contain lower-cost starches (corn, wheat, fractionated grains). Setting aside the current supply chain issues as it relates to Blue Buffalo’s self classification, this nuance allows Blue Buffalo to inflate its market share. While we can appreciate the desire to isolate one’s difference in terms of ingredient panel and adherence to certain standards, this segmentation allows Blue Buffalo to exclude a meaningful set of Brands/SKUs from their market share calculation, thereby overstating the company’s position.  Talk to a seasoned pet food merchandiser and they will tell you this is not how they, or their end customers, think about the market.  I also note that several of the of brands in the Wholesome Natural segmentation analysis are either overstated or understated based on what I know to be their 2014 sales.  This simply speaks to the imprecise nature of the analysis.
  • About that lawsuit. Blue Buffalo’s S-1 makes it clear that they are responsible for directing their suppliers to purchase the ingredients they approve, from the people they approve, based on the terms they themselves negotiate.  Yet somehow Blue seems to be getting a free ride as it relates to their recent sourcing issues. However, several people I have spoken to recently expressed greater conviction about the probability of a countersuit from Wilber Ellis and/or a Purina victory.  If Purina does in fact play this out and wins an injunction against Blue Buffalo as it relates to its ingredient claims, it would undermine the Blue Buffalo story, in addition to having meaningful financial implications.  I note that the company has not set up a litigation reserve due to the fact that the lawsuit is in the early stages (as self defined), it is unclear the damages the plaintiffs are seeking, and the fact that Blue Buffalo maintains its counter claims.  It seems quite reasonable that institutional investors are factoring potential losses into their valuation models.

Notwithstanding the issues above, we expect Blue Buffalo to have a successful IPO later this month and for it soon to be trading at an enterprise value in excess of $4 billion.  Even a modest first day pop would get the company there. Get your popcorn, this should be fun to watch.

/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.

unicornOn Wednesday, as anticipated, Blue Buffalo, the pet industry’s most prominent unicorn, filed to raise up to $500 million in a public offering (see form S-1 here).  The company intends to trade on the NASDAQ under the “BUFF” ticker symbol.  J.P. Morgan and Citigroup are the lead underwriters. BUFF reports generating $918 million in revenue in 2014 ($940 million for the latest 12 months ended March 31, 2015). The company estimates it holds a 6% share of the total pet food market and 34% share within its competitive set, which it defines as the Wholesome Natural market segment.

A number of items that are notable from the S-1:

  • The company’s growth strategy lays out a thinly veiled plan for ubiquity in product access, noting that Blue Buffalo currently feeds only 4% of dogs and 2% of cats.  Growth will come from 1) building U.S. market share by expanding the availability of Blue Buffalo products, which we assume means a move into mass, 2) entering into therapeutic diets, and 3) select international opportunities (Canada, Mexico, Japan).
  • Blue Buffalo products tend to over index with younger households (Gen X and Gen Y) as well as younger pets (ages 0 – 1), providing some belief that it will increase market share as these owners age by capturing them early in the lifecycle.  Approximately 4% of Blue Buffalo sales occur online, versus 2% of the total market according to Blue Buffalo, which makes sense given the demographic where the brand is resonating strongly.
  • The business has delivered impressive growth over both the recent and longer term time horizon.  Revenues increased from $190 million in 2010 to $918 million in 2014, representing a compound annual growth rate (“CAGR”) of 48%.  During this same period Operating Income grew at an 86% CAGR from $15 million to $179 million.  Operating Income margins have increased from ~ 8% in 2010 to nearly 20% in 2014.  While future growth rates are projected to taper, it appears to be more associated to with the “law of large numbers” catching up with the business, as opposed to any change in fundamentals.
  • Management plans to continue its movement towards vertical integration as it relates to production. The company notes that in-sourcing a substantial portion of its product manufacturing, whether at the existing Heartland plant (which is expected to produce 50% – 60% of Blue Buffalo volume) or to future owned facilities, will yield significant cost savings. The Gross Margin profile of the business is healthy for this category, at around 40%, but has not shown much in terms of scale benefits. That said, that fact is not all that surprising given the level of production outsourcing and variable cost of protein inputs.
  • The company is building a dedicated sales force for the veterinary channel.  Blue Buffalo views veterinarians as key influencers and believes it can develop a set of differentiated products that will create disruptive results in this channel.
  • The company incurred $2.9 million of legal expenses in 2014, which are costs related primarily to the litigation with Nestle Purina.

The filing highlights the reason BUFF has not pursued an M&A exit.  Historically, the high water mark for pet food M&A has trended at 3.0x Revenue.  However, if Blue Buffalo were valued at $3 billion, that would imply the company was worth 15.5x Adjusted EBITDA of $193.2 million, which feels considerably light for the leading independent natural pet food brand. Consider Freshpet, which is smaller, unprofitable, and has not produced as impressive growth, trades at over 6.0x Revenue. While we don’t see Freshpet as the perfect comp those who are not close to the industry are naturally going to make that comparison. Our expectation is that a public Blue Buffalo will be valued closer to $5 billion, too big a piece of cheese for even the largest industry mouse to swallow. That valuation assumes that the company can detail a tangible plan to grow outside its core channels and in lower cost products, improve its gross margin profiles, and deliver higher level of surety around its product inputs.

/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.

plantThe pet industry delivered another strong year of relative growth in 2014.  According to the American Pet Products Association (“APPA”), the industry grew 4.2% to just over $58.0 billion in total revenues.  While growth was again strong relative to other consumer sectors, it was 0.8% below estimates. This shortfall represents the first time in the past five years that the industry did not meet or exceed APPA projections.

From a growth rate standpoint, the industry was again driven by veterinary services (+4.7%) and non-health care services (+9.8%).  The industry benefited from 0.9% of product inflation and 2.9% of services inflation, which puts volume/unit growth in perspective. With the pet population growing at a slow pace, the industry has benefited from price escalation to overcome anemic volume growth.  Industry growth was again constrained by consumables which grew at 3.2%, 1.6% short of estimates. It appears that the industry may in fact be hitting the ceiling on the pet food upgrade cycle, as premium pet food market share was flat from 2012 to 2014 at 42% of pet food sales.

The slowdown in industry growth was, to the informed observer, not unexpected. The industry can’t grow at 5% when the largest specialty retailer produces flat comps. However, what was more meaningful in the APPA disclosures was the rate at which new owners were entering the inudstry. The APPA estimates indicate that as much as 10% of the pet ownership population came into the fold during the past 12 months, reflecting a rising rate of companion animal ownership among younger demographics at the expense of the Baby Boomers, who continue to slow pet replacement and when they do they favor smaller companion animals.  If in fact industry purchasing power is transitioning to Gen X and Gen Y and this rapid pace it will have meaningful implications on what products are purchased and where.

In our bi-annual industry summary contemplate these changes are other key observations as outlined below.

  • Convergence Gathers Momentum. Convergence between industries serving the human population and those serving companion animals is not an all together new trend. Not since Nestlé’s acquisition of Ralston Purina (2001) and Del Monte’s acquisition of Milk Bone and Meow Mix (2006), has the consumer landscape seen this phenomenon in play on such a grand scale. However, the J.M. Smucker Company/Big Heart Brands and AmerisourceBergen/MWI Veterinary Supply transactions are evidence that mainstream acquirers are again seeing the potential of buying into the pet industry. These buyers are seeking access to the growth inherent in the pet industry as a means to offset slowing growth or contraction in their core businesses. If this trend trickles down to the lower middle market it will be a game changer in terms of exit alternatives for leading pet players. Expect sellers to test this theory.
  • Demographic Shift has Accelerated. In earlier reports we tied the recent performance erosion of major pet specialty to shifting industry ownership demographics. Our analysis postulated that rising spend from new pet owners, who are predominately part of Gen X and Gen Y, was benefiting independent retailers and online players at the expense of major pet specialty. A recent study by the APPA indicates that the industry added eight million new pet owners in the past year, nearly 10% of the owner population. Growth in first time pet ownership is accelerating faster than previously anticipated. If the rise of Gen Y, and to a lesser extent Gen X, in terms of purchasing power continues at this pace it will have significant impacts on industry spend. Notably, Gen X/Y pet owners exhibit less channel loyalty and ascribes more importance to convenience. Additionally, they place greater value on wellness which bodes well for retailers, product manufacturers, and service providers catering to these pet needs.
  • Exit Dynamics for Consumables Improving. A challenge for pet consumable companies seeking to exit has been a decided lack of strategic acquirers. Consolidation has historically been dominated by a handful of major industry participants leaving smaller companies with few options for synergistic exits. However, this landscape is now changing. Most notably, investment in companies with production assets is creating a new class of acquirers. Existing brands such as Merrick & Company and Nature’s Variety as well as traditional producers including Ainsworth Pet Nutrition and Pro-Pet have become net buyers of assets as a result of third party investment. Additionally, consumer companies in adjacent segments have shown an interest in buying brands that control their own manufacturing capabilities. Finally, the successful public offering of Freshpet is likely to lead other mid-market pet food players to pursue public offerings, which will create more acquisition currency. This multiplexing of exit options is good for the ecosystem and will support additional consolidation.
  • Expect a Blue IPO in 2015. In 2014, it leaked that Blue Buffalo had selected underwriters for an anticipated public offering. However, its plans were impacted when, in late 2014, it came to light that the company had received improperly labeled shipments from one of its suppliers resulting in animal by-products being introduced to some of their formulations. Since that announcement, there has been little news related to lawsuit brought by Nestlé that resulted in the non-conforming ingredient disclosure or about Blue Buffalo’s plans for a listing. In the interim, there has been continued speculation of an acquisition. We don’t buy it. Blue Buffalo’s valuation in the public markets would dwarf any buyers willingness and ability to pay in an M&A event. Looks for Blue to renew its listing push in 2H2015.

As always our pet industry report is available by commenting here or emailing me directly.

/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.

fresh2Earlier this month, pet food marketer, Freshpet pulled off a successful initial public offering, raising $156 million. The company, which generated $74.5 million in sales and $23.1 million in losses for the 12 month period ended June 30, 2014, priced its IPO at $15, higher than the anticipated $12 – $14 range. The stock enjoyed an opening day “pop” of approximately 27%.  Freshpet occupies some pretty attractive real estate in the form of 12,500 branded refrigerators.  Those units include distribution (as of September 30, 2014) in Wal Mart (1,607 stores), PETCO (1,364 stores), PetSmart (1,306 stores), Target (1,157 stores), Kroger (972 stores) and Whole Foods Market (226 stores).  The company was backed by Mid-Ocean Partners, a New York based private equity fund, who, for all intents and purposes, salvaged the company in 2011 after it burned through the original undisclosed investment it received from Tyson’s Foods, who is the primary protein supplier to the company and remains a minority shareholder.

At is current enterprise value of $676 million (November 24, 2014), Freshpet’s public equity trades at 9.1x multiple of revenue.  In contrast, publicly observable acquisition multiples for the most attractive pet food assets have historically topped out at 3.7x revenue (Del Monte Foods / The Meow Mix Company, March, 2006). This convergence of circumstances has led many too ask, often using colorful language, how the market might justify such a premium. Here is my response:

  • When a Number if Not the Number. When a company goes public, there is a collaborative process to create positive momentum for the stock price.  The supply chain has the company selling at a discount to the underwriter who in turn sells at a discount to institutional investors and sprinkles some of the well connected general investing public. Those not in this inner circle who seek to access the stock are forced to bid it up in an effort to acquire a position.  The resulting supply/demand imbalance generally buoys the stock price for some period, ideally until fundamentals catch-up to the price. In the period immediately following a public offering, there is limited downward pressure, outside of broader market fundamentals, on the stock until it posts earnings or the lock-up period expires. As such, the prevailing price is simply the price you can buy or sell the stock for right now rather than indicative of the long range, or fair-market valuation of the company.  You can see other examples of this trend in practice with other recent pet related IPOs Pets-At-Home Group (LSE:PETS) and Trupanion (NYSE:TRUP) both of which, after a brief honeymoon period wherein the stock was supported by the supply/demand imbalance, have seen their multiples revert to the mean for their business respective models.
  • Don’t Underestimate the Pent-Up Demand. Retail investors love the pet space because, for companion animal owners, it is easy for them to understand. However, as we have detailed before, there is a lack of pure play pet companies, especially in the consumables category.  Investors can play the retail space through PetSmart (NasdaqGS:PETM) and Pets-At-Home, the health care space through VCA Antech (NasdaqGS:WOOF), Zoetis (NYSE:ZTS), and Neogen (NasdaqGS:NEOG), and distribution through MWI Veterinary Supply (NasdaqGS:MWIV). However, opportunities to invest directly in pet food and treats are non-existent.  The three biggest players — Purina (subsidiary), Mars (private), and Big Heart Brands (private) do not currently offer that opportunity. As someone who subscribes to the Peter Lynch theory of investing (i.e., go with what you know) I can see why retail investors might be willing to pay a premium to get access to the sub-sector given its growth profile, consolidation multiples, and recession resistant dynamics.
  • Compelling Business Attributes.  What is overlooked in the analysis above is the fact that Freshpet has some compelling business attributes that should be ascribed a premium price.  The company’s refrigerator inventory occupies some valuable real estate and the business model is such that retailers are unlikely to support multiple players, providing Freshpet with a first mover advantage and considerable barriers to entry once that cost is underwritten.  Ultimately, the company might become a toll taker whereby it is paid to host third party products in its established real estate. Also consider that Freshpet reports that its refrigerator units reach cash flow breakeven in 15 months. If we assume the company will generate approximately $81.6 million in sales this year (the most recent reported quarter (2Q2014) annualized), this translates to approximate $18/per refrigerator/day to support this breakeven point.  One and one half six pound tubes of the company’s Vital brand would essentially cover that daily revenue bogey.  As revenues scale breakeven per refrigerator will come more quickly, thereby enhancing cash flow.  Finally, the cost premium, while significant is not that far out of market for owners already feeding their pet super premium solutions.  Consider that an active 50 pound dog would go through at 28.6 pound bag of Orijen premium pet food (made by Champion Pet Foods) in 23 – 27 days (based on the brand’s feeding guidelines here) at a cost of approximately $3.75 – $4.25/day based on an in-store retail ring with sales tax.  That same active 50 pound dog would go through a six pound tube of Freshpet Vital in 4 – 5 days, at a cost of approximately $3.50 – $4.40/day. While the disparity gets larger with the size of your dog or as you indulge in more exotic Freshpet offerings, and the price variance is much greater versus mass market kibble, it is not all that out of line for a premium consumer.

The net of all this is that the current equity price of Freshpet is hard to fathom.  While the current price is being artificial inflated, the business has some operating characteristics that support a premium.  I won’t hazard to guess what Freshpet will be worth once the trading shackles are off, but we have seen examples of where companies that are pioneering unique niches in the food space can enjoy strong multiples from some time (see Annie’s).  However, invariably company performance will have to accelerate meaningful to support even the prevailing enterprise value.

/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.

On March 16, 2007, Menu Foods, an unincorporated open-ended trust established under the laws of the Province of Ontario (TSX:MEW.UN) and a leading North American private-label/contract manufacturer of pet food products sold by supermarket retailers, mass merchandisers, pet specialty retailers and other retail and wholesale outlets set off a chain of events that would go on to expose a fundamental gap in the North American food supply chain. What started a a “precautionary recall” would expand to incorporate 38 brands of cat food and 46 brands of dog food over the next 24 hours. Nearly 1% of all dog food was recalled within a week. Michael Dillion (Dillion Media, LLC), an industry consultant, was quoted in The Economist as estimating pet deaths from the recall would grow into the thousands.

Within 4 days, Menu Foods had lost 45% of its market capitalization (see chart here)

ABC News broke the story on March 23, 2007 that rodenticide (associated chemical name aminopterin), illegal for use in the U.S., was found on imported wheat gluten and used by Menu Foods in approximately 100 brands of dog and cat food. Suddenly, the industry had a sourcing problem, and a big one. The problem was exacerbated on March 29, 2007 when, after a number of complaints related to dry food, melamine, a chemical used in the manufacturing of plastics, was found in the affected wet food, in the kidneys of animals, and in the imported wheat gluten touching off a dry food recall.

After regaining approximately 16% of the value it lost in the stock market between March 16 and March 20, Menu Foods gave back all these gains when it adopted a rights plan to prevent the possibility of an outside party pursuing a hostile take over.

Throughout the balance of March and through April and May, numerous brands were added to the recall list (see full up to date list here). The FDA raided distributors, began sampling all wheat gluten coming from China and even solicited the help of the Chineste government on cracking down on parties responsible for contamination and cross-contamination. U.S. Senator Dick Durbin (D-IL) introduced an amendment that would strengthening human and pet food monitoring, labeling and inspection standards. The Reauthorization Bill, S.1082, which included Mr. Durbin’s amendment passed by a near unanimous vote. In the meantime the recalls go on.

On May 30, 2008, Menu Foods set up a $24 million Settlement Fund to enable parties to recover up to 100% of the economic damages incurred by pet owners, subject to certain limitations. The Settlement Fund, administered by a neutral claims administrator, will be available to persons in the U.S. and Canada who purchased or obtained, or whose pets used or consumed, recalled pet food. The fund amounts to approximately 10% of the company’s revenues for the past 12 months and 120% of the company’s operating income for the past 12 months. Today the company trades at 18.6% of its equity value prior to the recall.

The “demise” of Menu Foods has parallels in other industries. The tort phalanx has biten numerous companies in the pharmacy industry beginning with A.H. Robbins, of Dalkon Shiled fame, Wyeth, of Fen-phen, and more recently Merck & Co., Inc. in civil class action lawsuits associated with Cox-based inhibitor Vioxx. Merck was accused of burying information about risks associated with its blockbuster drug, intimidating scientists and pushing the sales of a drug it knew was dangerous. While the initial break of the Vioxx scandal shaved 40% of Merck’s market capitalization, it had an incredibly strong balance sheet to fund litigation expenses and restructure the company. Two years later the company had recovered all of the lost value.

Another anticipated parallel is Tyson Foods, Inc. Despite being the subject of numerous recalls dating back over 25 years, Tyson’s stock has never lost more than 17% of its value on any one day since January 1, 2000. The dates of the company’s largset losses related to acquisition announcements and indictments related to illegal hiring practices. When the largest beef recall every was announced on February 18, 2008 (some 143 million pounds), Tyson’s stock increased by nearly 10% of its value over a two day period as consumers were expected to increase chicken consumption in light of the news.

If we look for valuation parallels among other publicly traded pet food companies, we don’t find much satisfaction either. Due to their diversified nature, an index of the ten largest public companies with pet food operations tracks, very closely, the S&P 500 during the time of the recall as evidenced by the chart below.

Based on the data above, not much can be derived scientifically. However, my experience has told me the following anecdotal conclusions can be drawn:

1) Since the recall commenced there have been a number of benchmark transactions in the U.S. pet food space, including Mars/Nutro Products (May 2007), Berwind/Eagle Pack Pet Foods (October 2007), Highland Capital/Castor & Pollux (May 2008) and Berwind/Wellness Pet Foods (August 2008). While all the data on these deal (including the date of close for the Castor & Pollux deal) are not in the public domain, it is believed that all of these deals occurred at revenue multiples of between 2.5x – 3.0x. This would be inline with major deals occurring prior to the recall. However, is is our expectation that in order to sustain these multiples going forward sellers will have to have established brand value and be able to demonstrate a requisite amount of control over their input supply chain.

2) It is my view the companies that provide fulfillment pursuant to a co-pack arrangements will experience lower valuations going forward than those that source, manufacturer and pack themselves. That said, these parties are likely to have lower margin profiles and therefore higher multiples may not translate into substantially higher valuations than if they had a co-pack relationship. It is a function of what the multiple is applied to. However, these companies are likely to avoid large set-asides from transaction consideration to fund potential litigation in the future.

3) I expect to see multiples for boutique brands who can make substantive claims around country of origin labeling, health and wellness and nutritional content to experience premium multiples to the historical trends. Wet and dry raw foods will benefit from pet owners seeking out brands that are free from stigma. That said, these products are expensive and therefore are unlikely to get true mass appeal and the sales associated with broad distribution and national branding. As such, their valuation ceilings are potentially capped. However, I expect a number of brands in this category to create substantial shareholder wealth over the next five years.

More to follow as data becomes available.

/bryan