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.

Pet-Tech-Annualnew

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.

 

blue dog 2Over the past five years, interest in the potential and performance of the online channel for pet products has become an increasingly hot topic.  The narrative around pet ecommerce has been fueled, in part, by a change in ownership demographics, but more significantly by the lack of transparent data regarding the size of and growth rate in the channel.  Quite simply, no one knows how much pet food is sold online or how fast the channel is actually growing, and therefore everyone is free to speculate.  The loss of PetSmart as a public reporting entity only further exacerbated this reality.

What we have known for some time is that online is taking share and its growth is a key driver of malaise within major pet specialty.  Whether you source your information from Packaged Facts, IBISWorld, or Euromonitor, all three entities have online pet products sales in the U.S. growing at between 10% – 15%.  Further, according to Packaged Facts 2016 National Pet Owner Survey, 46% of pet owners buy products online, an increase of 5% from 2015. Thus, the intent from a consumer perspective continues to rise.  Additionally, Blue Buffalo, widely believed to be the top selling pet food brand online, CEO Billy Bishop commented, in the company’s most recent earnings call, that the shift to online is occurring much faster than anyone at Blue Buffalo anticipated.  Couple this with the fact that during FY16, Blue Buffalo’s share of sales outside of major pet specialty increased from 33% in Q1 to 41% by Q4 primarily behind the sharp increase in ecommerce.

No entity has been more responsible for shaking up the pet retail world than Chewy.com.  In November 2016, we got our first real glimpse into the organization when a Bloomberg article detailed that the company anticipated that it would generate $880 million in sales for the calendar year.  Further, it projected 70% growth in 2017, bringing the company’s topline to $1.5 billion.  A recent Miami Herald article pushed that number to $2 billion. According to a recent survey by 1010data, Chewy.com has approximately 51% share of the online pet products market including autoship revenues.  This contrasts with Amazon at 35%, also inclusive of autoship.  Chewy also leads in subscription pet food sales at 10.2% versus 7.6% for Amazon.  PetSmart garners 7.9% of the market when you consolidate its own banner (2.2%) with sales of its Pet360 (5.7%) acquisition.  Petco clocks in at 3.1%, while Wal Mart (< 1%) barely registers. Finally, Chewy employs 200 full time portrait artists who churn out 700 oil paintings a week for unsuspecting customers.

Chewy, which has never turned a profit and has been funded by $261 million of equity, raised over five rounds, and $90 million of debt, is in the process of upping the table stakes.  The company recently launched its American Journey house brand of dry kibble.  American Journey, which comes in seven flavors, currently costs $39.99 for a 25-lb. bag before autoship discount.  This is $8 – $10 less than a comparable sized bag of Blue Buffalo on the site.  Notably, American Journey is made by one of Blue Buffalo’s co-packers. Additionally, Chewy launched Tylee’s, their human grade fresh/frozen pet food brand aimed squarely at the increasing band of upstarts seeking to deliver human meal equivalents for your pet. The company is also said to be working on a public offering slated for 2018.

The question of whether Chewy.com can be stopped has been answered. It’s most recent financings ($75 million of equity from BlackRock and $90 million in debt from Wells Fargo) suggest that investors are looking past the profitability profile and instead focusing on the growth history and the potential IPO valuation.  Mutual funds targeting a pre-IPO stake are likely accessible should the company need additional funding. The more intriguing question is whether there is a transaction alternative that might be more attractive to Chewy shareholders than a public offering.  As Chewy.com Chairman Mark Vadon, who co-founded Zulily, can attest, being a public company without earnings is not all that it is cracked up to be.  We rule out an Amazon combination for a myriad of reasons.  This leads us to Petco or PetSmart as the most logical destination.  While somewhat counter-intuitive on the surface, if Chewy.com could extract more value in a combination than an IPO, why not consider it?  Given the weak comps we have been hearing coming out of Petco and PetSmart, a combination with Chewy.com would solve a myriad of problems.  Chewy would gain access to cash flow and hundreds of local warehouses, while Petco or PetSmart would be able to rationalize its store base and gain the pole position in pet omni-channel.  It might not be as far-fetched as we think.

/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.

 

 

thAnxiety about ecommerce in the pet industry is not a new phenomenon.  I’ve had it for a while; it seems to come in waves.  Often the “worry” is overcome through the most limited acceptable response from a market participant, just sufficient enough to satisfy my concerns. Most recently, my unease related to the future of Chewy.com, the leading independent ecommerce player in the industry.  My fear was that should Chewy be cut off from the capital markets, it could lead to a meltdown given its operating profile and cash burn, setting the online component of the industry back for a decade, from which it may not recover.  Thankfully, for the moment, my concern has been assuaged with the announcement of the company’s most recent funding, a $75 million investment from investment management firm Blackrock.

Pet ecommerce is a bit of an enigma, wrapped inside a riddle, wrapped inside a conundrum.  The conundrum — the perceived potential for cannibalization of four wall retail revenue — started it all in my opinion (others will quibble here, but to do so would merely be a digression).  For years, Petco and PetSmart buried their head in the sand about the potential for ecommerce in the pet industry. As the dominant retailers in the category, their view was akin to “why promote it, if you don’t want it to happen?”. The number three and four retail players possess a limited to non-existent ecommerce capability set as well.  The riddle was how to get a 25 – 40 lb. bag of dog food to a customer’s door without going broke in the process.  The failures of those who tried to solve the riddle, before the needs of customers were sufficient to want it or the infrastructure was available to make it happen, only served to reinforce the conundrum.  The cost problem has been addressed in a variety of ways ranging from infrastructure partnerships, to rising consumer demand, to subscription services, to more effective cross selling of higher margin products to online consumers.  The enigma remains how much ecommerce is influencing the pet industry and the trajectory of its largest retail players.

Depending on what you believe, online sales of pet products accounts for 6% – 10% of industry sales, or $4 – $6 billion.  Again, depending on your source, online sales for pet products is growing at 12% – 20% and enjoys the highest sales penetration of any home care category in the U.S.  However, the U.S. trails both the UK and China in terms of sales penetration of pet food online.  Of these estimated sales, we now know Chewy.com makes up $880 million of them, according to a Bloomberg article where the notoriously secret company disclosed details of it’s most recent funding, a $75 million equity financing from Blackrock.

To date, Chewy.com has raised $236 million (or $248 million depending on your source) in equity from a variety of institutional investors.  There is no complete data source that can reconcile that number — mapping the who, the when, and the how much.  However, we do know investors have migrated from traditional venture capitalist (Volition Capital and Greenspring Associates) to mutual funds whose investments often are a precursor to an IPO (T. Rowe Price and Blackrock). These fund have been necessary to fuel the company’s hyper growth, which has been driven by aggressive customer acquisition and rock bottom pricing for customers.  You don’t go from $0 to $880 million in online revenue in five years without a significant war chest and a willingness to buy customers at essentially whatever cost is required

However, on the way to becoming a pet industry unicorn, Chewy.com’s world began to morph.  First, Jet.com added the category and began to compete aggressively for customers driving up acquisition costs for all the major players and driving down profits for price matching entities as Jet sought to undercut the market when possible. With Jet’s acquisition by Wal-Mart, this issue may abate over time in the name of its parent company’s earnings and ROI requirements. Second, the major physical retailers began to quietly fight back, threatening punitive action for brands that would not enforce MAP online.  While MAP would be a net positive of Chewy’s margin profile, it would likely have come at the cost of growth, a necessity to access the capital markets.  Finally, was the issue of the most recent election cycle.  As Chewy sought to fund its business it was likely going to be pushed towards foreign markets or an IPO, as a trade sale at an attractive price appears unlikely unless you view the business as a capability acquisition and not a category play. Based on the trade and capital markets forecasts for the incoming political regime, there are concerns about slowing foreign investment in U.S. companies against a back drop of changing trade policies and the potential for the IPO window to close as a result of a market contraction.  While neither of these may come to pass, the concerns are real.  This makes the most recent announcement by Chewy to be welcome news, in my opinion, for all independent pet ecommerce players.

Should the public capital markets continue to be inviting, expect an S-1 sometime in 2017 for Chewy.com.  Further, cross off another of our anticipated transitional events for the pet industry in 2016 – 2017 (see here).

/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.

 

dog-bowlBeing early, wrong, or both is no fun, at least not in the case of making industry predictions (traders will also say early is also wrong).  And when it comes to our views on the waning of the pet food upgrade cycle many people have made us aware that we were either early or wrong (or both!).  However, when you make market predictions based on limited information you are going to be wrong, sometimes with regularity (see my view on the inability for private equity to acquire PetSmart here, as just one notable example where I have missed the mark, but at least I correctly predicted that they would not combine with Petco, see here), and we are okay with that.  That said, here I am not sure we were either wrong or even that early in this case.

In 2013, we began to beat the drum about the deceleration of the pet food upgrade cycle (for those of you scoring at home you can see comments here and here).  Our view was that basic economic realities were fundamental headwinds — stagnant wage growth, slowing pet replacement, growth in small dog ownership, and continued food price inflation.  We then pointed to PetSmart comps going flat to negative, and fully negative ex-inflation, for most of 2014, had to be a sign this cycle was on life support.  However, all of these factors were explained away by other data — accelerating pet product Personal Consumption Expenditures in 2015 (Bureau of Economic Analysis), recovering pet adoptions in 2015 (PetPoint), accelerating pet food spend in 2015 (APPA), growth in alternative form factor pet food (GfK), mismanagement at PetSmart (pick your favorite equity analyst), and the successful Blue Buffalo IPO.  In short, for every fundamental premise we had on the offer, there was a data set that one could point to bolster their thesis.  The issue was that the evidence used to perpetuate the myth that the upgrade cycle was alive and well was easy to debunk, but nobody want to hear it, and they still don’t.

Fast forward to today, and we now see increasing direct evidence that supports our thesis.  First, last month The J.M. Smucker Company trimmed its full year earnings forecast on the basis of declining sales of pet food for the quarter, down 6%. While there was a positive spin around the narrative (difficult comps due to prior year sell-in, strong new brand sales prior year), it is concerning.  The company expects weakness to persist throughout the balance of the year.  Second, our survey of private mid-market pet food marketers ($100+ million in revenue) indicates that the malaise Smucker’s is experiencing is not isolated, though the magnitude is greater.  Most of the company’s we surveyed offered full year views of 0% – 2% growth domestically. Finally, Tractor Supply, which does a significant percentage of its business in livestock and pet supplies (44%), trimmed its quarterly earnings forecast and full year outlook for the second time this year.  The company now expects same-store-sales for the quarter to be flat to down 1% after being up 2.9% in the prior year period. While we may not think of Tractor Supply as the prime destination for the premium pet food consumer, they do sell a considerable number of premium brands – Blue Buffalo, Merrick, Natural Balance, and Wellness, among others.  The company pointed to slowing growth in the C.U.E. (consumables, usables, edibles) business. Translating the semantic hieroglyphics, this means their pet and animal products business, including pet food.  We suspect Tractor Supply is not alone.

What is more important here than being right or wrong as it relates to the state of pet food, is what will the implications be for the capital markets of the death of the cycle.  We do not believe that slowing pet food sales, premium or otherwise, is going to hamper capital formation. There remain multiple heuristics of emerging brands garnering footholds to grow their business rapidly to $25 – $50 million in sales with limited capital investment.  The scarcity of these businesses, coupled with the amount of institutional capital chasing these opportunities, means that growth equity investments in pet food, distinct from treats, will remain robust.  Of greater significance is whether this will jump start a new M&A cycle.  While large strategic acquirers tend to have a negative M&A bias during period of weak financial performance, it might just be such that they will uses these events to recognize the need to buy into niches that represent the future of the industry.  This could push multiples, which have been waning, albeit, at the margins over the past three years to begin to trend up.  Further, the fact that broader M&A statistics indicate we are almost certainly at the end of this M&A cycle, might cause more sellers to come to the table.  Watch closely for M&A volume in this segment to tick up over the coming year.

/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.

 

 

 

 

mockingjayEarlier this month, Petco Animal Supplies and PetSmart stores in Topeka, Kansas, and adjacent Lawrence, Kansas, removed from their shelves Hill’s Science Diet and Ideal Balance products.  Store managers have been telling customers that the brands is not coming back on shelf.  Notably, Hill’s Pet Nutrition, a subsidiary of Colgate Palmolive, is headquartered in Topeka.

Consider the above action a shot across the bow in the dynamically evolving landscape of pet food retail.  To better understand the future, and what this gambit might mean, one must begin with a look at the past.

Hill’s Pet Nutrition was founded in 1907. The company started in the rendering business.  By 1930, the company had evolved into packing company, producing animal feed, dog food, and horsemeat for human consumption in Norway, Finland, and Sweden.  In 1948, Dr. Mark Morris contacted Hill’s seeking a producer for Canine k/d, his brand of healthy scientifically engineered pet food.  In 1968, Canine k/d was made available to veterinarians as Hill’s Science Diet.  The brand evolved into a broad line of prescription and breed specific solutions available through veterinarians and pet specialty retailers.  In 1978, Hill’s became part of the Colgate family through a merger of Hill’s parent company.  In 1999, Hill’s sales reached $1 billion.

What is particularly significant was the fact that Hill’s was at the forefront of the healthy pet food revolution, albeit with a scientific approach. Further, long before there was Blue Buffalo, Hill’s, along with Nutro, was one of the biggest drivers of customer traffic to pet specialty retailers on the market.  Thus, for Petco and PetSmart to declare war on Hill’s is, for lack of a better term, A BIG DEAL.

The makings of this feud can be traced back five years.  Beginning in 2011, Hill’s pet food sales began to stagnate.  The company, whose products evoked images of white lab coats and engineers, found itself on the wrong side of a change in consumer preference, and therefore purchase intent.  Instead of favoring science based nutrition solutions, pet owners began to favor products whose ingredient panels best mirrored their own diet.  White lab coats were replaced by images of roasted turkey, market vegetables, and whole grains.  Natural triumphed over engineered.

Hill’s, being part of a large consumer packaged goods firm, was not content to let its franchise slip away. The company tried to change with the market, launching Science Diet Nature’s Best, a naming convention approaching the absurd.  Not surprisingly the disconnect remained.  Hill’s responded with the launch of Ideal Balance, its “natural” solution, but was slow to win back customers. While Hill’s revenues had grown to $2.2 billion in 2015, this number represented essentially flat growth between 2011 – 2015.  To maintain sales, Hill’s embraced the internet as a channel.  In 2015, Hill’s represented 7.5% of online pet food sales, taking the third position behind Blue Buffalo (12.3%) and Wellness (9.0%).  It attained that position by turning a blind eye to the price discount pet food retailers where charging for its solution set, thereby drawing the ire of Petco and PetSmart.  And you understand why we-are-where-we-are.

One has to surmise that Hill’s knows quite well what it is doing and the consequences of its actions. My understanding is they have recently put pressure on major online retail sites to enforce their MAP policy based, in turn, on pressure from Petco and PetSmart. However, if Hill’s cannot get back in the good graces of its top premise based retailers, prepare to find Science Diet and Ideal Balance at big box store near you.  The likes of Target and Wal Mart would welcome Hill’s and its customer base with open arms. Whether this is a brilliant move by Colgate or the straw that breaks the brands back remains to be seen.

Of greater interest is what this means for Blue Buffalo.  A big box Hill’s is not going to be a welcome site for the veterinary community who drives the disproportionate sales of prescription diets and is a big influencer of Science Diet sales.  Blue Buffalo has staked the next leg of its growth stool on its veterinary line of products.  If Hill’s defects, that will create a fracture in the relationship between the company and the veterinary community that Blue Buffalo could be poised to exploit.  That’s not to say it won’t have fierce competition for that mind share from the likes of Royal Canin and Purina, but thirty days ago that market looked much tougher to crack.

Let the games begin.

/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.

 

 

 

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.

/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.