And we are back…

The pet industry continues to evolve towards its new normal.  However, while it appears the volatility within the industry has decreased, tremors continue and several events could catalyze a second wave of transformational change.  Central going forward is that the industry now finds itself facing some new pain points with no clear path to resolution.

Of increasing significance, latency between consumer trends and pet trends has compressed from years to months, which will put immense pressure on the industry’s antiquated regulatory framework. Consumer demand for pet products that incorporate CBD, human diet concepts such as Keto and Paleo, and protein alternatives is significant but lacks regulatory and, in some cases, legal clarity. That has not stopped manufacturers or retailers from bringing these products to market in order to satisfy demand. If AAFCO cannot evolve to become more nimble and responsive, the industry will become more risky to all involved.

Also of significance, is that the risk associated with the repositioning of Petco and PetSmart could result in major downstream implications. As Petco forges ahead with its new wellness enabled vision, PetSmart has largely stood still lacking financial flexibility.  The success of Petco’s strategy could put pressure on PetSmart to sell or IPO Chewy, it’s most valuable liquid asset. Notably, a Chew S-1 was filed on April 29th (see here). Tepid operational results for Petco or from investors during a Chewy IPO roadshow, could place these two organizations on a merger path in order to remain relevant.

Slower industry growth is driving consolidation, a theme that will continue for the foreseeable future. The cost of doing business in the pet industry has increased as physical and online retailers monetize their market positions, making it more difficult for midsized and emerging brands to compete. Given the pace of change, strategics are under more pressure to acquire assets that enable them to meet emerging customer needs, or risk losing out on the ability to monetize faster growing market opportunities. Private equity is leading the consolidation charge due to broader business malaise prevalent among large strategics, which will enhance focus on profitability as the key criteria underlying acquisitions and put downward pressure on valuations

Notwithstanding slower growth and more turbulent competitive dynamics, we believe the current environment offers a market opportunity that may not manifest itself again for some time.  The other key trends we are keeping our eye include:

  • Blue Buffalo Banks Further on FDM. General Mills announced that they intend to double Blue Buffalo’s retail availability by April 2019. Central to this strategy will be launching Wilderness in FDM. When Blue transitioned Life Protection Formula in August 2017, it communicated its intention to protect the pet specialty channel by preserving exclusive access to its others brands. The quest for growth and profits rendered that commitment fleeting. By the end of April, according to General Mills earnings presentation Blue will have a retail ACV of 65%, up from 32% in October 2018.  Retail sales declines in pet specialty necessitated the move according to General Mills executive leadership. Notably, Blue also posted 24% ecommerce growth for the nine months ending February 2019.  If there is anything left in the relationship between Blue and pet specialty we will soon find out.
  • Amazon Accelerates but Housebrands Not a Category Killer. According to Packaged Facts, Amazon generated pet category sales of $3.3 billion in 2018, giving it a 6% share of the market. Amazon pet food sales exceeded $1 billion in 2018, up over 20%.  However, Amazon’s own housebrand Wag, launched in mid-2018, only accounted for $2 million of these sales. While Amazon housebrand sales will invariably increase over time and benefit from the launch of complementary brands, such as Solimo, owning the buy box is not yet translating into changing consumer behavior. Most Wag and Solimo product ratings are 3.5 to 4 stars, evidence of mix sentiment, and the launch has been plagued by production issues. A study by Marketplace Pulse suggested that Amazon housebrands across categories were having limited impact on brand sales online. With estimates for online penetration of pet food sales reaching as high as 50% over time, Amazon stands to benefit anyway you look at it.
  • Petco Launches Repositioning Strategy. Petco is ushering in a comprehensive new strategy firmly rooted in the health and wellness driver of industry growth. Petco’s approach involves eliminating products whose formulations feature artificial ingredients. As part of this process, Petco will seek to transition customers in many leading national brands to its housebrands and other channel dedicated brands. Criticism has ensued as Petco’s housebrand formulations may not fully comply with their own standards and many brands they are removing appear to be for financial or competitive reasons. Additionally, Petco launched its PetCoach store which “offers the highest quality suite of personalized pet services, products and experiences – all designed through a veterinary lens – to address total pet health and wellness.” While its competitor runs in place, we applaud Petco for its efforts to reframe its appeal and relevancy to pet owners. However, if traffic and transactions don’t materialize, Petco may lack the flexibility for a further pivot. Get your magic 8-ball ready.
  • Follow the Funds to See the Industry’s Future. 2018 was a record year for industry consolidation, but it also outperformed in terms of private placements, as equity flowed into the category at record levels. Over $1 billion of equity capital was invested in pet related enterprises since 2017. Notably, the year was punctuated by larger deals, with the median deal size of $45 million among transactions whose proceeds yielded more than $5 million. Investments in dog-walking apps accounted for 40% of deal value, but 23% went into ingredient manufacturing companies, with an additional 7% flowing to direct-to-consumer dog food brands. Institutional equity is flocking to these opportunities because they are not well served by existing market participants. The deals of today will fuel the exits three to five years down the road, which will only serve to extend the consolidation cycle. However, the subsectors attracting capital speak to a much broader market opportunity within the industry.

As always, if you are interested in accessing our full report you can reach out to 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.

 

 

roller coasterLike other consumer industries, the pet sector is discovering that today change in constant.  While this seems obvious, in the five years following the recession, the prevailing status quo enabled the pet industry to enjoy substantial and consistent growth.  The period that follows stability is often best characterized as turmoil, regardless of the amplitude or velocity of change.  Even modest changes after a long period of calm can appear daunting.  Over time disorder then turns into a new paradigm; the pet industry appears to be moving into its new status quo.  However, there is little rest for the weary as new challenges, such as trade policy and house brands, that pose new treats to incumbents.  And when those threats dissipate, new ones will rise in their place.  Industry evolution is now characterized by persistent change.

As we keep our eye on industry change drivers, the four themes we are focused on this fall, include the following:

  • Independents’ Conundrum Multiplexes. In our Spring report, we commented on the potential impact of Blue Buffalo’s move into FDM and subsequent acquisition would have on independents, many of which have historically “divested” brands that jumped the channel or were acquired by large CPG firms. In our store visits since the acquisition closed, we have certainly seen a deemphasizing of the Blue brand in specialty, though it remains widely available in the channel. The brand that has historically benefited most from independents scaling back on Blue has been Champion, a process that began when several prominent chains reduced or excluded Blue in wake of the 2015 labeling scandal. If, in fact, Champion is acquired by Nestle Purina, this would further complicate the merchandising strategies for independents. Many of the brands poised to fill the potential shelf space void lack the name recognition to drive traffic, the ability to rapidly expand production, or the marketing dollars to drive trade spend. Independents have survived upheaval before, but this time things may be more challenging and it leaves them more vulnerable to ecommerce.
  • Trade Policy Could Impact Growth. In September, the US expanded the tariffs imposed on Chinese goods to $250 billion worth of products. Of greater significance, the tariffs applied will increase from 10% to 25% on January 1, 2019. While the pet consumables supply chain has meaningfully shifted to US-sourced products, a broad range of pet products will be impacted, with hard and softgoods having the greatest exposure. What is unknown is how these tariffs will impact retail traffic, purchase intent, and transactions. Given that real wage growth has been muted for some time, there is potential that pet population growth could be impacted, which will have a trickle down effect on all industry categories. While there was once a widely held belief that China trade tensions would blow over quickly, we find market participants are preparing for a longer game, which includes seeking alternative sourcing in Vietnam, South America, and Mexico given favorable labor rates. Only time will tell.
  • House Brands and Private Label Growing. Consumer industries, broadly speaking, are experiencing a dramatic proliferation of house brands and private label offerings, as retailers seek to cash in on growth trends and the ability to control real and virtual shelf space. In the last two years, Target has introduced 20 brands, Walmart 18 brands, and Amazon 72 brands across different categories. Amazon’s owned brands are on pace to generate $7.5 billion of revenue in 2018, and grow to $25 billion in 2022. With manufacturer margins of 2x – 3x retailer margins, house brands make strategic sense. With consumers increasingly looking for value, private label could redirect $64 billion of purchases. Within pet, Amazon has launched house brand premium (Wag) and value (Solimo) kibble and wet (Simply Perfection) for dogs, as well as a supplies line (Pet Craft Supply). While these brands, and others that follow (dehydrated, freeze dried, super premium, etc.), will create competitive tension among marketers, it provides a segment of the industry that service these brands with a meaningful growth driver.
  • Private Equity Becoming Buyer of Lower Middle Market Pet. 2018 is on pace to be a record year for pet industry consolidation. Shifting consumer demographics, channel dynamics, and, now, trade policy are the key drivers of acquisitions. What is most notable, is not the volume or velocity, but who is doing the buying. Historically, when strategic buyers wanted something, their “ability-to-pay” priced financial buyers out of the market.  Today, the large strategic consolidators are hyper-focused on specific assets that address business model deficiencies and portfolio challenges, leaving a larger population of acquisition targets for the likes of private equity and private equity-backed strategics. This includes the food category, where the pricing advantage of strategics is magnified. Expect more deal announcement from financial motivated players, and invariably the valuation compression that comes from selling to a profitability motivated buyer.

Transformation in the pet industry continues to progress at a rapid pace, with market participants homogenizing around a common set of growth strategies. Major competitive moves continue to unfold, changing the strategic and operational landscape, with more dominoes to fall.  For market participants we suggest you hold on. While this roller coaster we are now on may have lost amplitude, the ride is far from over.

/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.

 

“In my 25 plus years in the industry, this is the first time I can say, I don’t know what is going to happen;  I don’t have a good answer.”

run to the lightGiven the proximity to Interzoo and Global Pet Expo, this year’s SuperZoo trade show allowed for more shop talk than in prior years. Given the heat nobody wanted to move anyway, so the conversations were fulsome, as opposed to being fleeting in nature. The topic du jour, so to speak, was the future of PetSmart, and to a lesser extent Petco.  Adding fuel to the fire was recent data indicating pet food sales in major pet specialty had been down over 10% in the past four weeks, a trend that was accelerating as opposed to contracting. The italiziced statement above was made in that context, and its concerning given that it came from a very smart, very seasoned, pragmatic industry executive whose predictive capabilities over the years have proven to quite accurate.

The pet industry needs a healthy national retail ecosystem and its major retailers are, well, reeling. The cure for what ails them is not obvious. That said, both Petco and PetSmart are not standing still, with both organizations appointing new CEOs in the past 45 days. More changes are likely on their way, whether they be structural (Chewy.com spinoff?), strategic, or modestly tactical.

Below are some summary thoughts on my conversations in Las Vegas:

Petco Animal Supplies

With respect to Petco, most people I talked to put a lot of stock in the hiring of Ron Coughlin, the former President of HP’s personal computer business.  When you read the narratives of those who have written, most with excitement, about his hiring, they put considerable weight behind his ability to develop strategies that connect with emerging consumer cohorts, such as Millennials.  While Ron is new to me, his real value appears to be in driving sales and differentiation against a backdrop of product commoditization. Connecting with Millennials, and subsequent generations, is a strength of Apple, not HP.  That said, Ron’s experience at PepsiCo, should be valuable assuming Petco continues to double down on its private label strategy, as his marketing credentials are meaningful.  He seems like a great hire.

The other strategy that received some attention at the bar, was related to the fate of Unleashed. Once a key differentiator, and a darling for emerging brands that were seeking to bridge the gap from independent pet specialty to major pet specialty, it appears that Unleashed has become a drag, at least to manufacturers. Many brands indicated allocating funds to support online efforts were yielding much greater results than promo spend and exclusives in Petco’s smaller boxes. Essentially, the professionalized box chains (Chuck & Don, Kriser’s, Pet Food Express, etc.) have siphoned off the customer Unleashed was meant to target, and Petco has not maintained the strategic differentiation between its core box and its smaller cousin.  Some suggested spinning off the box chain a la Petsense.

Finally, there was the natural discussion about the private label brands, and their future.  Most people I spoke to did not expect a tactical departure from the current strategy, but likened it to a secondary line of business – i.e., pick up some kibble after your dog is done at the groomer. What this says is that Petco has more work to do to make its brands traffic drivers and find a balance between house brands and third-party brands.  Petco is currently banking on its investments in engagement and services to drive brand attachment and store/online traffic. It certainly has a technology advantage, but it needs to translate that into traffic and transactions, and not let it languish as “potential”.

PetSmart

While most liken the Petco rehabilitation process to a home remodeling project, when people talk about PetSmart’s road back, the narrative is more akin to taking things down to the studs. Maybe it is the drama and intrigue that continues to be associated with the retailer, but more likely it is a function that people cannot clearly see the path out of the predicament the chain currently finds itself mired in. That is not a surprise, given the high stakes poker that has begun between PetSmart’s private equity owners and the company’s debt holders. After spinning off 36.5% of Chewy, PetSmart’s debt prices improved (see recent charts here), seeing the move as more benign than anticipated. However, the other lens through which it can be viewed is the asset stripping provides more fuel for a public listing of Chewy, the proceeds of which could be used to repurchase debt at a steep discount. The more salient question is whether the financial engineering machinations gets in the way of forging ahead with a new operational strategy. My assumption is that J.K. Symancyk would not have joined unless he felt he could begin effectively addressing PetSmart’s challenges against this backdrop.

With respect to that new operational strategy, the same general principles are commonly cited among third parties. First is the need to integrate Chewy on both the back and front end, enabling PetSmart to fully leverage the assets it acquired over a year ago. My long held assumption was that the only way to wring the benefits out of the transaction was to fully integrate the two businesses, but that any contingent consideration owed to Chewy stakeholders was going to inhibit that effort in the near term. With Ryan Cohen having now departed and likely any earnout potential lost, work can now begin in earnest. This includes both warehouse and inventory rationalizations, but also the technology work to enable Chewy to leverage PetSmart’s infrastructure to offer pick-up in store and delivery from store for added convenience. Additionally, PetSmart needs to implement technology strategies that enables them to have a complete picture of their customers across all their sales platforms, leveraging this knowledge to drive customers to the transaction venue that offers the most desirable outcome, whether that is tied to revenue, profitability, or retention.  A continual race to the bottom through escalating customer acquisition seems pointless to most.

The second most commonly discussed action is to change the mental paradigm as it relates to both suppliers and end customers. Historically, major pet specialty has viewed themselves as the customers advocate and educator, despite having a transient workforce. When costs were cut post take private this included spend on training these resources. As the primary retailer of pet food and supplies, major pet specialty retailers controlled access to product and the promotion of the product to pet owners. In this role, they leveraged their position to extract value from the brands to support their financial profile. While brands consistently complained the cost of doing business in these channels was onerous, it what was necessary. That is no longer the case, brands can find alternative sources of growth online and through professionalized chains. Therefore succeeding going forward for PetSmart requires a change to this paradigm. Pet food and supplies are now widely available and owners pursue product discovery in a variety of ways, not necessarily tied to the physical sale location.  This means finding a way to embrace emerging brands and offering them a financial paradigm that enables a win-win scenario, as opposed to offering them a loss of 10% – 15% of margin in addition to seeking meaningful promotional dollars.  This would likely involve trusting that these brands undertake the necessary effort to build a customer following and driving them to PetSmart’s sales venues, crediting them for marketing spend that drives awareness and transactions.  This trust is going to be necessary if there is going to be success in driving ROI for brands that might bring traffic and loyalty.

Finally, several people commented on the need for greater transparency — in everything they do for everyone they touch. This goes right down to the mission and speaks to culture. PetSmart has been historically insular, and that was successful until the access paradigm flattened and the knowledge paradigm multiplexed.  PetSmart need to seek to create relationships as opposed to adversaries.  Easier said than done, but trying will help mend fences.

The net of all of this is that there is work to be done.  Failure may lead to a consolidation of these boxes, while success will elevate the entire industry.  Mr. Symancyk and Mr. Coughlin, we wish you both well.  We all need you right now.  However, we should not fear that brighter days are ahead.  The industry has successfully navigated challenging periods and companies including Walmart and Target found their way against a similar backdrop, though they both had more levers to pull.  Collectively, we have to have faith.

/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.