happy faceThe pet industry, for all its interest and fanfare, is a data starved segment of the consumer landscape.  The industry lacks for data solutions that would provide a dynamic understanding of industry, channel, and company level performance.  Instead, operators and investors are left to rely on summary level government reporting, annual data releases from industry associations, specialized proprietary data reporting from industry participants, and select data points from publicly traded companies, that when put together provide a general understanding of industry growth and direction.  As the pet industry further expands into the food, drug, and mass channel data should improve, but this will take time.

As we wait for APPA data to be released at Global Pet Expo in March, we thought it might be useful to use the other available data sources to paint an industry picture ahead of the tradeshow season.

  • Growth:  The pet industry continues to grow at levels in excess GDP (2.3% in 2017).  Pet related Personal Consumption Expenditures, measured by the Bureau of Labor Statistics posted 6.5% growth in 2017, driven by 9.7% growth in Services PCE.  Product PCE growth was more muted at 4.2%.  The industry experienced a deflationary trend in pet food of 1%. Services inflation continued at just short of 2%.  The variance in PCE versus APPA growth figures has been expanding, meaning the data sets are getting less correlated, for reasons that are unclear. However, based on the underlying PCE data it is safe to assume that growth was steady in 2017, but it is unlikely that we returned to 4%+ growth.  Continued deflationary pressure in pet food is a long-term headwind, which services inflation could constrain pet population growth for cash starved Millennial pet owners.
  • Economic Tail/Head Winds: Growth in the pet industry is, in our experience, tied to three economic factors.  First is employment.  People who are employed are more likely to have income to afford a companion animal and a living situation that would allow for pet ownership.  Currently, unemployment is at a structural barrier, which has been good for pet ownership growth over the past 12 – 18 months.  However, it seems the industry is getting as much benefit from the employment situation as one can expect. Unemployment has also declined due to people leaving the workforce, meaning the benefits of full employment on the pet industry in recent years is somewhat overstated.  Second, is disposable income.  The cost of owning a pet continues to increase. According to the APPA Pet Ownership Survey 2017 – 2018, the annual cost of owning a dog is greater than $1,500.  Some surveys put the lifetime cost at over $25,000.  To afford these costs, pet owners need disposable income. Yet growth in disposable income has been tepid over the past over the past 24-months. The recently passed tax reform should benefit income trends, but potentially at the expense of inflation. Psychologically income trends should be healthy for pet ownership as consumers tend to overlook cost inflation in the near term. Third, is home formation.  When a family unit purchases a home, it is often a catalyst for purchasing a companion animal.  Low interest rates and sustained economic growth have led to a strong demand for housing, despite concerns about affordability given current home prices.  Home formation trends should continue to benefit the industry, though rising interest rates may cause home formation trends to taper.
  • FDM Growth: The launch of Blue Buffalo in the mass and grocery channel is a game changer for the industry.  A myriad of other brands are launching outside the pet specialty channel, such as Nutro in Walmart, and we expect PetSmart and Petco will be offering a competitive response in their next reset.  The issue is that PetSmart and Petco cannot offer brands the same growth trajectory they have enjoyed in the post-recession period.  Quite simply, consumables availability has become ubiquitous; consumers are simply choosing a transaction venue based on convenience weighted cost.  The consumer relationship is with the brand, not the retailer.  Even with only six months of Blue Buffalo exposure, which has slightly underperformed and been aided by significant discounting and promotional spend, in 2017 pet consumables growth in FDM is estimated to have exceeded that in pet specialty — 2% compared to 1.5%.  This bodes well for growth among brands with existing FDM shelf space, though the ability to hold that space going forward is going to become increasingly competitive.
  • Ecommerce Growth Continues:  In 2016, industry analysts, based on very limited information, estimated that ecommerce penetration in the pet industry would eventually grow to 20%.  At the time penetration was estimated to be +/- 5%.  According to Amazon, they estimate ecommerce penetration in the pet space will reach 18% in 2018, meaning the industry will almost certainly breach 20% and do so in 2020.  Amazon recently stated that they viewed the industry as a “unique and highly valuable category” and they intend to make growing their online sales of pet products a 2018 business priority.  Additionally, the proliferation of direct-to-consumer pet food brands (Ollie, JustFoodForDogs, etc.) and sales platforms (Petnet, PetCube), many of whom are now venture backed, will give the broader sales channel additional tailwinds. We also see aging pet parents as a further opportunity to grow pet ecommerce. As consumers get mobility constrained they are increasingly turning to online venues for product acquisition. We believe they will do so with their pet spend, especially pet medications. The unanswered question is how MAP pricing might impact online channel sales.  Ecommerce has grown substantially based on its pricing advantage.  As that narrows, it would logically impact purchase intent unless it offers convenience benefits that outweigh the alternatives.

For the past two years, we have talked about an industry in flux.  While we believe the industry continues in a state of transformation, we think we are through the most volatile phase of the change cycle.  The truth is there is some stable thematics — steady growth aided by modest tailwinds, customer first retail, and dissolving incumbent paradigms.  Companies that can build a salient customer value proposition and innovate stand to do just fine against this continually evolving backdrop.  Those that rely on historical paradigms as a means of competitive advantage seem more likely to get run 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.

 

 

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spinoffI enjoy the holidays as much as the next person.  Every year I seem to make some new friends during the party circuit that accompanies each Yuletide.  This year was no exception.  However, who those friends were was a departure from historical norms. All my new pals had one thing in common — they were PetSmart bondholders.

My firm does not engage in sales or trading of public equity or debt securities, nor do we provide any research products tied to specific companies or offerings, so for a critical mass of hedge fund managers to end up at my doorstep was a bit of a surprise.  All of them wanted to know if I thought PetSmart would spinoff Chewy.com.  To better understand why that was such a pressing question some context is required.

When PetSmart acquired Chewy in April 2017, they financed the purchase with a combination of debt ($3.25 billion) and equity. The debt component include two tranches of publicly traded notes (first and second lien).  The price of the debt began to slide within one month of the close, and picked-up steam when Blue Buffalo jumped the channel in August followed closely by the departure of PetSmart’s CEO. A third quarter earnings miss added fuel to the fire (EBITDA down 34% year-over-year).  The company’s second lien notes have traded as low as the mid-50s, while the first lien note have traded as low as the mid-70s, a healthy discount to par.  The notes were among the worst performing junk debt issuances of 2017.  However, what caused PetSmart bondholders to worry most was the fact that the covenant package tied to the debt would allow the private equity syndicate to separate Chewy from PetSmart for its own benefit, and to the detriment of creditors.

The primary motivation of private equity investors is first and foremost financial gain.  That is not to say they do not provide a direct or indirect public good, but rather I would never put it past this class of investors to pursue what was in their own best interest.  While separating Chewy from PetSmart might be theoretically viable under the terms of the bonds, we think the carve-out has more risk than reward.

While Chewy remains the market leading ecommerce property in the pet space, its value proposition is eroding.  Post-closing of the transaction, a small number of notable brands exited the platform, dealing the company a topline financial hit. The transaction also accelerated a movement within the retail community for the implementation of MAP pricing policies.  While MAP can be hard for smaller brands to enforce, it appears that most companies are making reasonable efforts to communicate and enforce these policies.  Of greater significance is the fact that Chewy was losing money at the time of the sale, meaning it would need more cash to sustain its growth.  Separating from PetSmart would result in the loss of significant purchasing leverage, meaning even further losses.  Absent a major cash infusion, Chewy would need a public float to perpetuate the business model.  Public comps with this business model trade at 1.0x – 2.0x revenue, much lower than the multiples paid for the banner.

The net of all this is that I do not see a full separation as a likely outcome.  At the very least it would lead to years of expensive litigation. Rather, I believe the private equity syndicate will use the threat of a spinoff to renegotiate with bondholders if and when needed.  If a spinoff does occur, expect it to involve less then 50% of Chewy, such that the entity can continue to be consolidated for financial reporting purposes and enjoy the benefit of PetSmart’s purchasing power to offset losses.

/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.

 

 

 

 

 

The evolutionary cycle that is currently gripping the pet industry is now on full display, impacting all segments and all market participant. The market is no longer benefiting from historical growth drivers as new influences overrun incumbent paradigm. Notably, pet food prices have experienced deflation throughout 2017, and this pattern is projected to continue.

The differentiation and uniqueness in the pet industry’s operational model is rapidly eroding.  The industry is beginning to parallel its human corollary, changing the nature of competition and anointing new winners.  Barriers to product availability have eroded and the consumer behavior patterns resident in the human food and healthcare markets are increasingly exhibiting themselves within the pet industry

The challenge for market participants is that the current phase of competition is not programmatic in nature. The strategies that parties have historically relied upon to compete are unlikely to serve as effective guideposts for future strategic decision-making.  Market participants should brace for higher levels of volatility

This fact pattern will present the best-positioned companies with an opportunity to create outsized value. Capital will flow into companies best-positioned to take advantage of new ownership paradigm and evolving channel preferences of pet owners at pre-money valuations that better resemble technology multiples. Acquisition multiples for market leaders will expand as companies will be “bought” more often than sold. Buyers are more likely to view assets differently, due to the tendency for strategies to diverge in periods of uncertainty, reducing potential competition for deals

However, increased risk associated with the current operational paradigm will also drive a flight to quality and elongate deal cycles due to increased scrutiny. When multiples are elevated, marginals deals are more likely to fail due to associated risk discounts.  We expect buyers to search for companies with meaningful barriers to replication – brand, intellectual property, access to alternative sales channels, or proprietary products.

Against this backdrop there were four theme that caught our attention in 2017 (click through to view content):

  1. Services are increasingly driving the growth of the pet industry.

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2. As anticipated, Blue Buffalo launched into FDM.

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3. Digital distribution is accelerating and changing the competitive landscape.

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4. Supply chain integrity/sourcing are becoming a meaningful form of differentiation.

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In short, we are living in interesting time.

For a full copy of the report contact 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.

 

dylan“The times they are a-changin” – Bob Dylan

Industry analysis is easy when everything is moving up and to the right.  When market conditions are such that a rising tide does not float all boats, it is harder to draw conclusions that are applicable to a broad set of market participants.  The pet industry now finds itself in an operating environment where company execution will most likely determine the winners in this phase of the cycle.

The  pet industry has hit a transformative moment.  The humanization movement, though it continues to be cited regularly, has achieved its point of arrival — pets are treated like members of the family.  Kids today only know of pets as their equal.  As a result, there are no longer large cohorts of pet owners who are available to upgrade.  At the same time, younger generations now represent the largest segment of pet owners, and they think and act differently than their parents generations.  However, they also lack the same disposable financial resources, meaning they have to make tradeoffs today.

These realities are changing the power paradigm in the category.  The pet consumer is in the ascendancy at the expense of all others who participate in the supply chain.  Today the pet owner is able to choose among channels and brands based in their personal values.  Effectively product access has been commoditized. Consumers are now able to dictate to manufacturers what attributes they seek, not vice-versa.  In the future this paradigm will move across the sub-categories within in pets to redefine who wins and who gets left behind.

When market dynamics shift with significant force, it usually leads to elevated levels of industry consolidation. The 2015 – 2016 period was the greatest period of consolidation the industry has witnessed, and we expect that will continue.  With that as a backdrop, we present our pet industry capital market themes for the Spring of 2017:

  • Major Pet Specialty Franchises Struggling. It was not long ago that PetSmart and Petco could do no wrong. The major pet specialty chains were posting SSS comps that were the envy of retail analysts; the gap between the two biggest pet retailers and the balance of the industry seemed vast and unbridgeable. How quickly things can change. Over the past three years, major pet specialty has watched its franchise erode. Independent pet retailers out-serviced them; FDM retailers poached manufacturers and offered customers a better cost value proposition; and ecommerce providers out-priced and out-“convenienced” them. In 2016, we estimate that PetSmart comped down 3% – 4% (mature stores) and that Petco comps were flat to down 2% (mature stores). With their loan packages trading below par, both companies are under pressure to innovate. Petco’s turnaround strategy appears focused on private label and house brands.  PetSmart is focusing on ecommerce, as evidenced by its acquisition of Chewy. What is clear is that there is no silver bullet for what ails them. Expect things to get worse, before they get better as brands begin to feel pressure to find other sources of growth and as Petco and PetSmart refine their respective strategies.
  • Treat Acquisitions are Focused on Sustainable Competitive Advantage. The treat space has been actively consolidating as manufacturers compete for the discretionary portion of the pet owner’s shopping basket. However, what is rapidly changing is the attributes these consolidators are seeking in their acquisition targets. Deep customer relationships built through an emotive brand are now the table stakes.  Buyers want some form of competitive advantage that has greater barriers to justify prevailing multiples. The acquisition of Salix Animal Health (Spectrum Brands) and Whimzees (WellPet) are examples of this in practice. Other major pet treat IP players, including Petmatrix, are most likely to get snapped up by the large industry players. This will in turn create an opportunity for private equity to acquire mid-stage brands and invest in building these attributes.  The phrase “innovate or perish” has never been truer than in the treat space today.
  • Digital Pet Age Has Arrived. Historically, pet industry incumbents have been dismissive of the potential for category disruption through technology innovation. Major pet retailers were not well situated to sell the solution set; legacy pet ownership generations, the Baby Boomers, did not understand it; market leaders were not organized to innovate into the category. As a result, Chewy, A Place for Rover, Bark Box, Whistle, and their peers rose up to fill the market void, creating substantial shareholder value as pet ownership dynamics shifted to favor the digital generations. In 2016, $154 million dollars was invested in 46 pet-tech deals, a pace that has been increasing since 2012. Even in its nascency the pet tech movement is showing signs of making a lasting impact. As Millennials further outpace Baby Boomers in terms of pet ownership, digital will gain more momentum in the pet category. This realization will leave strategic buyers who have not made a tech play scrambling to play catch-up.  This trend augers well for acquisition valuations in this sector of the market.
  • Expect M&A Transaction Velocity to Remain High. Since 2014, transaction bias in the pet industry has been towards M&A. 2015 – 2016 was the greatest period of industry consolidation as measured by transaction volume. As company’s reposition themselves to compete in a rapidly changing landscape, we expect elevated M&A activity to continue in 2017. Market leaders will seek to plug remaining portfolio gaps while small and midsized players will be looking to exit at the tail end of the cycle. While acquisitions may be plentiful, there will also be a flight to quality with differentiated assets – brand, scale, channel (direct or proprietary) – garnering premium valuations, while those lacking it face commodity multiples. If the U.S. implements tax reform, volume should spike across asset classes providing private equity a unique opportunity to buy into the category.  Financial buyers will be banking on these assets to carry them through the next recession.

As always, our full pet industry report is available by request.

/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.

sbmIf you have not seen the digital age in pet coming, it’s arrival has now been fully announced.  In the past year, a remarkable number of meaningful events have happened to punctuate it’s arrival.  Many of those events were likely to have gone unnoticed at the time, but in aggregate its hard to ignore.  Notably the past last year was book-ended on one end by Mars acquisition of Whistle Labs (March 31, 2016) and the merger of A Place for Rover and Dog Vacay (March 29, 2017) on the other end.  In between we have witnessed the rise of Chewy.com at the expense of Petco, PetSmart, and even Amazon; Phillips Feed Services acquisition of Petflow for the purpose of arming independent retailers for the digital pet race; and a total $154 million dollars invested in 46 pet-tech deals.

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Historically, it has been easy to dismiss the digital pet movement as a novelty act, confined to products whose addressable market was small and whose value proposition was narrow.  It’s true that many of the first generation products were poorly designed or over engineered, and generally expensive.  Further, the arrival of pet tech was slowed by the inability of core pet retailers to sell the solution set.  Simply stated, Petco and PetSmart were not well set up to educate consumers on why they needed to own a $200 smart feeder or a $150 remote treating system.  Further, technology retailers, such as Best Buy, knew very little about the category and were therefore unable to effectively merchandise a pet technology set.

Despite these impediments, it’s hard to argue with the results of the market leaders.  Whistle Labs was acquired by Mars for $117 million, representing a high single digit multiple of revenue.  As we detailed in our last post, Chewy.com has achieved over 50% market share in online sales and anticipates 2017 sales of $1.5 billion. Finally, A Place for Rover (Rover.com) was valued at more then $308 million its $40 million Series E financing closed in October 2016.  Rover also announced that it acquired its primary domestic competitor Dog Vacay in a stock-for-stock transaction. In our discussion with other pet technology companies many of them appear poised to deliver strong growth and financial results in 2017.

The collective impact of these digital pet companies and their ascendancy in terms of industry importance can no longer be ignored.  While the negative comps produced by both Petco and PetSmart in 2016, and the recent deterioration of their leveraged loan valuations, can be attributed to a variety of factors, it’s hard to argue that the rise of Chewy.com and the lack of traffic drivers attractive to the Millennials, and subsequent generations, such as pet technology products, has been a key contributor.  The fact that the vast majority of pet food brands are available online, making their availability more commoditized, and not an influencer of store visits, is exacerbating the problem.  Further, Rover and DogVacay have served to disrupt the discretionary services segment of the market, for whom Petco and PetSmart (both boarding and grooming), along with VCA Antech (boarding) and Banfield Animal Health (boarding),  are the most established players.  Prior to the take private, PetSmart generated $750+ million in services revenue annually, accounting for ~ 12% of revenues.

The ability of incumbent players to catch-up digitally is limited.  Earnings based companies are hesitant to acquire companies without an established track record of profitability given their valuation paradigms consist of multiples of EBITDA or contribution margin.  Mars benefited from its private nature when considering the acquisition of Whistle.   A subset of major players we have spoken to are waiting around for these companies to stumble in hopes of acquiring them at bargain prices.  While companies like Chewy.com have “scraped paint” in the past, we see this strategy as unlikely to succeed in the near to medium term.  Those who are called to action, but partially paralyzed by their valuation paradigms will seek to partner.  Whether creating these bridges will be enough to move the needle or insulate them from risk remains to be seen.

/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.

 

happy-puppehAgainst a backdrop of macroeconomic uncertainty, the pet industry continues to thrive.   While the prevailing theory that the industry is “recession proof” is being sternly tested, market fundamentals of pet ownership remain strong and consumers are skimping on themselves as opposed to their pets and/or children.  Further, the premium demographic continues to have a voracious appetite for efficacious products that are good for their pets as well as the environment.

That being said, the recession has set in motion a number of trends that will, in my view, forever change the pet industry landscape.  While several of these trends are in the “early innings” so to speak, the momentum behind them is significant.  The companies that stand to win during the next phase are those that recognize the seachange and position themselves to take advantage of the wave.  This period will separate the leaders from the pack, to steal a phrase.

Recession Not Found Here?

Pure play equities of pet related companies fell precipitously with the market during the second half of 2008.  However, unlike the general market, these equity began to experience their recovery in November 2008.   The primary driver of equity price contraction was based on fundamentals — earnings for these core names fell 30% from the prior quarter, which spooked the market (in truth some of this could be chalked up to seasonality).

In reality 3Q2008 was up year-over-year from an earning perspective, albeit only slightly.  In a world where flat is the new “up”, this should have been investors first signal that the market was overreacting in this category and  pet related equities were becoming oversold.  Notably, earnings rebounded strongly in 4Q2008 posting year-over-year growth of ~ 4% (weighted by market capitalization), driving a correction with respect to public company valuations.   Thus, the prospects for a technical recession in the pet industry are in fact quite low.

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Notably, the macro economic environment did not constrain equity deals in the pet space.  Key deals including Hammond Kennedy Whitney/FURminator, TSG Consumer Partners/Dogswell and Tyson/Freshpet were all announced against a declining or, even abysmal backdrop.   Appetite for pet related concepts has never been higher among growth equity funds due to the prevailing dynamics and long term fundamentals.

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Key Trends for 2009

So what are the seismic shifts of which I speak?

First, I believe we are in the early innings of a major shift in the pet retail landscape. PetSmart and Petco are facing significant competition from Wal Mart as they battle to be the one-stop-shop for the mid-tier pet buyer. Wal Mart’s merchandising acumen coupled with their reach and financial strength make them daunting opponents. Large pet specialty will take share among the most attractive demographic and thrive amidst the chaos among big box players. Their ability to educate buyers and offer patrons a favorable service experience situates them to be long term partners of both customers and the most compelling pet related brands. They will also take share from contracting boutiques hit be financial hardship.

Second, in bad times value trumps luxury.  The downturn in the U.S. economy has eroded the balance sheets of mainstream consumers. While companion animals will continue to a growing part of our society, consumers will become more fickle as it relates to spending on their pets. Product (excluding consumables) and service providers must give pet owners a compelling value proposition if they expect to experience continued growth. This change is expected to be lasting.

Third, consumers want to know what they are paying for.  In the food arena, efficacy is going to become important, a concept which many have taken at face value.  The market has become saturated with better-for-you pet food brands whose differentiation has become hard to appreciate. Supply chain control and organic are no longer differentiators. As distribution opportunities contract, due to contraction in the boutique market, and funding dries up, solutions that can demonstrate high degrees of efficacy will prevail. Customers will begin to demand results for their incremental dollar.

Finally, pet health will come in to focus as owners make difficult choices with their limited free cash flow.  Pet related health care is even more inefficient than its human corollary. Relations between veterinarians and their customers is strained by the high cost of service and medications and the limited proliferation of pet insurance. Further, compliance rates on even basic pet medications are sub-standard. Solutions will arrive that deliver compelling value throughout the pet health care supply chain, driving operating and cost savings at the clinic level, compliance rates among drug applications and ultimately satisfaction for pets and their owners.

Net net, I expect the balance of 2009 to be challenging but good for pet related industries.   Notably, I believe we will see additional pet related equity deals as investors seek to put capital to work in sectors that continue to grow.  As the debt market improves, leveraged buyouts of some of growing bell weathers of the industry (a la FURminator) begin to come in to play, assuming valuation expectations have come down due to market realities.   One would also expect public pet companies to seek to buy growth in a effort to fuel their lagging equity prices.  This could kick of a consolidation phase in the middle market, but I’m not overly optimistic.

As always, you can contact me for a complete version of our market presentation.

/bryan