petcoOn November 23rd, CVC Capital Partners Limited and Canada Pension Plan Investment Board (the “Buyout Group”) signed a definitive agreement to acquire PETCO Animal Supplies, Inc. (“Petco”) from TPG Capital, L.P., Leonard Green & Partners, L.P., and friends for $4.6 billion. The deal values Petco at approximately 10.0x my pro-forma TTM Adjusted EBITDA for Petco as of October 31, 2015. This contrasts with the 9.0x TTM Adjusted EBITDA for the acquisition of PetSmart by BC Partners.  It is rumored that the Buyout Group was able to arrange approximately $3 billion of debt financing to support the deal.  Notably, both Petco and PetSmart will be owned by foreign investors assuming the deal closes.

It should come as no surprise that Petco opted for a private equity sale. Too much time had passed since the September 18th media leaks to believe a Petco / PetSmart combination would come together.  The case for public equity offering also faced numerous headwinds — a) broader stock market volatility driven by macro-political risk (Syria, ISIS, China), b) weaker than anticipated earnings among publicly traded retailers (as of November 20th over 40% of the retailers in the S&P 500 had posted earnings misses for 3Q2015), c) weak October retail sales (0.1% increase versus 0.3% consensus) and d) falling consumer confidence (lowest levels this year and a steep drop from October).  Against this backdrop, a trade sale was the most attractive option, even if debt market support for the deal had been choppy.  We generally consider 10.0X the break-point for specialty retailer M&A, above which history has not looked kindly on the buyer from a shareholder value creation standpoint.

The most pressing question now is who will lead the acquired organization going forward.  Jim Meyers, who has been in the CEO role since March 2004 (he was named Chairman earlier this year), and his team has lead Pecto back to a position of prominence.  Based on the S-1, Petco was posting stronger growth and better unit economics than its larger rival.  However, if history is a guide, large private equity deals seldom result in a staying of the course. In a small amount of irony, it is possible, though unlikely, that David Lenhardt could be running Petco a year after being ousted from PetSmart. Stranger things have happened.

If the Buyout Group is smart, they will purse incremental changes at Petco as opposed to a holistic approach to transformation. While there are certainly cost inefficiencies to be rung out of the system, Petco’s value is in how well it is currently situated from a growth standpoint with its greater emphasis on wellness, its multi-box positioning, its omnichannel reach and its under penetration in private label.  Further, with PetSmart deeply invested in its cost containment program, now is the time for Petco to press on the growth accelerator.  Someone is going to grab the brass ring and if not Petco, the chase will be led by Pet Supplies Plus, Pet Valu or a series of financially supported independent chains.

The next year should be an interesting one is large box pet retail land.  Regrettably we won’t be getting much transparency into either business any time soon.

/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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puzzleLast week, it became public knowledge that PetSmart and Petco Animal Supplies were engaged in “merger” discussions.  Back when PetSmart was under pressure from activist shareholders, we discounted the potential for a deal that would bring together the two leading pet specialty retailers. Our analysis was based on the notion that if these two companies were ever to combine, PetSmart would be the more natural acquirer given its relative size, strong balance sheet, and cleaner ownership dynamic. However, companies in play don’t tend to be net buyers of assets. As expected the deal did not come to pass.

Since that time, much has changed.  Most notably, the two companies are both private entities, which makes a deal more likely in our estimation.  Bringing these two assets together will be a messy process given the high levels of overlap between the two businesses — retail locations, warehouses, systems, people, processes.  For a merger integration process of that complexity to play out within the purview of the public markets would be problematic at best.  Additionally, the information playing field has been leveled with the filing of Petco’s S-1.  Previously, dialog between these two companies was hampered by the fact that PetSmart did not want to further educate its primary competitor on the details of its business without some transparency into the condition of Petco as a buyer. With the filing of the S-1 we now have insight into Petco’s historical and current business performance and that data should be sufficient for PetSmart to form a preliminary view as to the attractiveness of a combination. Of greatest significance, it will enable them to ascertain whether a deal could be financed solely with debt. If so, the probability of PetSmart making a strong play for Petco would increase. Third, we now have some clear transaction motivation at Petco — go public or be acquired.  A year ago, such impetus was lacking. Given that the recent volatility in the equity markets has made a public offering less likely, a sale to the party who can underwrite the most synergies makes more sense than ever.

While the fact pattern above is compelling, a combination will likely come down to the perception that the transaction can clear antitrust.  Recall that PetSmart had numerous discussions with what appeared to be Petco during its exploration of alternatives and came to the conclusion that the deal would not clear antitrust (article here).  It appears Petco was more concerned about the potential for an antitrust review to have an unfavorable outcome. A review of the transaction by the Federal Trade Commission (FTC) will hinge upon traditional benchmarks such as market share and price competitiveness, but also market concentration, which is also a consideration with horizontal mergers. While we are not antitrust experts, we believe the deal would undergo considerable scrutiny as follows:

  • Market Definition. How the FTC defines the competitive market for the sale of pet products will be the central risk to a transaction.  The FTC has previously scuppered deals (Whole Foods – Wild Oats, Staples – Office Depot) where it defined the sales market for the product narrowly. If the FTC views PetSmart’s and Petco’s competitive position to include all FDM retailers as well the veterinary supply channel, it’s market share hovers around 20% for both pet products broadly as well as pet food sales. However, if the competitive landscape is viewed as other pet specialty retailers, including independents, that market share rises to unacceptable levels from an antitrust perspective, and would likely result in strong resistance to a deal.  While a more broad market definition has some inherent logic, the channel tied nature of the product mix, especially as it relates to consumables, undermines that logic.
  • Pricing. Pricing is a paramount consideration for the FTC when evaluating a business combination.  Ultimately, the government seeks to protect consumers from being disadvantaged at the cash register when choice contracts. Of interest to the FTC in these circumstances is how pricing might react in defined geographies.  While we do not have access to, or know of for that matter, any comprehensive pricing studies for the pet specialty market, we do not believe that, on its face, pricing related risk is elevated here. However, if there is an Achilles heel in this analysis it is that PetSmart and Petco collectively control in excess of 50% of the sale of channel exclusive pet foods. That said, both PetSmart and Petco experience pricing pressure from both independent retailers and the online channel as it relates to the consumables category, the later being important given the shifting demographics of pet ownership away from Baby Boomers and towards Millennials, who are more prone to using online venues to procure products. Additionally, we have seen a proliferation of premium food in FDM. Further, numerous substitutes for these products are available in the independent channel. Ultimately, the FTC may choose to evaluate the sale of premium pet food as its own market and assess the potential antitrust risk accordingly.
  • Concentration. The FTC also considers the potential for market concentration from horizontal mergers. There is significant overlap in retail footprints of Petco and PetSmart. Over 70% of PetSmart stores are within five miles of a Petco location. The FTC analyzes market concentration according to the Herfindahl-Hirschman Index (HHI).  Where HHI levels are elevated, meaning increased concentration, there is more scrutiny applied to the transaction. HHI is influenced by the number and size of competitors in a given MSA. Therefore if the market is defined more broadly per the above, the potential for HHI risk being exacerbated declines.  We believe that a narrowly defined market definition would likely result if considerable HHI driven scrutiny, which may result in required levels of store divestitures in order to obtain antitrust clearance.

The potential for a PetSmart / Petco combinations really comes down to two factors.  First, if the private equity owners of PetSmart are willing to take the merger integration risk of a Petco combination this early in their ownership lifecycle. Second, is whether you believe the FTC will take a broad view when defining the market for the sale of pet products.  We see support for arguments on both sides.

/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.

petcoOn Monday, Petco Animal Supplies filed for a public offering. Goldman Sachs, Bank of America and J.P. Morgan are the lead underwriters on the offering. If-as-and-when successful, this will be the third time the company has tapped the public markets. A brief synopsis of Petco’s ownership/liquidity history can be summarized as follows:

  • 1994 IPO. Largest pet specialty retailer in the country.  Owned by private equity firm Thomas H. Lee Partners (currently the owner of Phillips Feed Service). For the fiscal year ended January 31, 1994, Petco’s 208 stores generated approximately $180 million in sales at less than $3 million of operating income (EBITDA figure was not available). Trading on NASDAQ under the ticker symbol PETC.
  • 2000 Take Private. $600 million transaction (6.1x LTM EBITDA) led by Leonard Green Partners (LGP) and Texas Pacific Group (TPG).
  • 2002 IPO. $275 million IPO, again on the NASDAQ.  For the fiscal year ended February 2, 2002, Petco’s 548 stores generated $1.3 billion of revenue and $109 million of EBITDA.
  • 2006 Take Private. $1.85 billion transaction (8.5x LTM EBITDA) by LGP and TPG using an abundance of cheap debt financing to underwrite the purchase price.  LGP and TPG contributed approximately $765 million in equity (total equity check was $775 million).
  • 2010 and 2012 Leverage Dividends. Company financed approximately $1.2 billion in distributions through two leveraged dividends (1.5x Invested Equity).

In short, Petco has been the pet industry’s transaction bellwether, and that is before you take into account the acquisitions and strategic investments the business has made historically. However, this trajectory is more a function of the company’s economic fortunes overlaid against the broader capital markets backdrop. After being the clear market leader in pet specialty in the early 1990s, the company found its position usurped by PetSmart later that decade. A relative comparison of the two leading pet specialty players looks as follows (Fiscal Year, Revenue/EBITDA, $million):

  • 2000. Petco, $990/$88; PetSmart, $2,110, $128
  • 2006. Petco, $1,996/$209; PetSmart, $4,234, $440
  • 2015. Petco, $3,995/$411; PetSmart, $7,070, $944

In 2011, I wrote this piece suggesting that maybe Petco had been done and dusted by PetSmart, a fact that was supported by the data at the time.  While PetSmart remains the dominant player from a financial perspective, Petco has certainly made up ground, producing slightly better same-store-sales than PetSmart over the latest twelve month reported period. That said, it could be argued that Petco is poised for a better near term run for the following reasons:

  • Store Format.  Petco currently operates 130 Unleashed stores in addition to their 1,279 Petco locations.  Unleashed units are 5,000 square feet and currently located in 14 major urban markets. They target a premium customer who values a small box specialty experience. These stores also appeal to a Millennial customer who often lives in an urban center.  Based on our experience, leading small box pet concepts are experiencing growth rates in excess of 15% percent (many of them are producing 20%+ growth), providing Petco exposure to a higher growth segment of the market. Further, Millennials are the fastest growing category within pet ownership. Unleashed units also provide Petco an opportunity to have a specialized merchandise mix, which allows them to embrace emerging brands earlier in the lifecycle. Notably, as part of its go-public preparations, Brad Weston, who was previously President of Unleashed, was made President of the company.
  • Digital Assets. Petco’s .com properties generated $185 million in Net Sales in the first half of fiscal 2015.  While it is hard to validate the company’s claim that they have the largest integrated ecommerce offering in pet specialty, we also have no reason to dispute the assertion.  Of greater significance is the fact that throughout the growth of pet food supplies online, Petco has maintained control over its digital assets and made significant investments in technology to enhance both customer engagement and omnichannel capabilities.  Petco is currently implementing technology that will facilitate cross-selling across physical and online properties as well as enable same-day delivery.  Additionally, the company is making investments in store resident technology to offer endless aisle support.  Finally, Petco has partnerships with major online properties such as Instacart and Rover.com that augments its digital footprint and offerings.  As online grows in pet, Petco is well situated to benefit.
  • Operational Upside. Based on the substance of Petco’s regulatory filing, there is clear upside to be harvested through operational improvements.  As an example, Petco currently generates 15% of sales from private label/owned brand products versus 27.5%+ for PetSmart.  Given the ability of house brands to drive traffic and take margin, a greater emphasis by Petco on this initiative should provide meaningful earnings growth.  The acquisition of Drs. Foster & Smith, which has significant private label capabilities, offers one direct point of leverage in both consumables and wellness solutions.  A second example is the potential for greater sales in higher margin product categories. Notably, Petco generates ~ 38% of sales from consumables and ~ 8% of sales from services versus ~ 50% and ~ 11% respectively for PetSmart. While these categories remain competitive, and are subject to pricing pressure, the potential to drive greater sales through these higher margin verticals would drive earnings growth.

Based on market chatter, a publicly traded Petco could be valued at $4 – $4.5 billion, or +/- 8.5x – 9.5x Adjusted EBITDA.  This compares to 9.0x EBITDA for the PetSmart take private, and the low end of the range is in-line with the historical take private, about where I would expect it to land. The question is whether there remains pent up demand for public pet industry equity in light of the first day run-up in Blue Buffalo’s equity valuation.  While public investors are sure to view Petco’s operational upside favorably, PetSmart’s experience provides a cautionary note.

/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.

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.

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

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

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

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

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

/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.

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

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

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

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

/bryan

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

accross the pongI often talk about PetSmart and VCA Antech being proxies for the direction and health of the domestic pet market because of the transparency it provides us into consumer pet product and healthcare spend through quarterly earnings reports and third party equity research.  However, the U.S. market should not be viewed as a proxy for the global pet industry.  Absent the transparency we enjoy through publicly traded U.S. pet companies our view of global pet markets is tied to a reliance on third party data firms (Euromonitor, Mintel, etc.). While these firms produce excellent research, there is an inherent latency to their content, making it hard to measure real time performance.  A partial solution to that problem looks to be coming in the form of a public listing for the UKs largest pet retailer, Pets At Home, Ltd. (“PAH”).

Earlier this week PAH filed for an initial public offering on the London Stock Exchange.  The company plans to raise £275 million, giving PAH a valuation of around £1.5 billion. Thew company operates 369 retail stores, 246 small animal veterinary centers and 116 in-store grooming salons across Britain.  Estimates puts the company’s share of its home pet retail market at around 12%. The British market is highly fragmented, with PAH’s five largest competitors totaling just 225 stores combined. The company should have ample opportunity to grow both its retail base and veterinary services concept given these market dynamics. PAH plans to open an additional 131 stores, 400 veterinary clinics, and 200 grooming salons.  The company would be the only listed pet retailer in Europe.

PAH was acquired by a private equity consortium led by U.S. based Kohlberg Kravis Roberts & Co (“KKR”), which also owns Big Heart Brands, the Del Monte Foods pet products division, in January 2010 for £960 million.  At the time, the company had trailing twelve month revenues of £402 million and EBITDA of £70 million, resulting in an implied valuation of 2.4x Revenue and 13.6x EBITDA.  Bridgeport Equity, the seller, had acquired the business for £230 million in July 2004. Assuming a £1.5 billion enterprise value for PAH, it would imply that the value of the business has increased over 55% since being taken over by KKR and friends.

According to the recently announced listing, PAH had sales of £598 million for its year ending on March 28, 2013. The company said its revenue increased 11.7% for 40-week period ending on January 2, 2104.  Extrapolating this growth for the full year yields revenue of approximately £700 million, resulting in an implied valuation at listing of 2.14x Revenue. At the time of its listing PAH expects EBITDA of £110 million, resulting in an implied valuation of 13.6x EBITDA.  This would value PAH at multiples nearly two times those prevailing for U.S. leader PetSmart (1.0x Revenue and 7.3x EBITDA) despite the two companies having similar same-store-sales for the prior 12 month period.  While PAH has produced better topline growth over the past year versus PetSmart and enjoys a better profit margin profile due to its services revenue, this still amounts to a very healthy premium even after you account for the 17% decline in PetSmart’s stock since October 2013.

Whether PAH is overvalued or correctly valued is likely a debate with no end, the truth likely lies somewhere in the middle.  Either way, KKR has made a handsome return in a short period, even after you consider the company has reinvested over £100 million in growth initiatives.  However, the real value for those that follow the industry, will be increased data and transparency.  While PAH’s market capitalization will be approximately 37% of PetSmart’s, it should receive solid coverage from equity analysts with strong UK sales and trading networks.  That coverage will help us better pinpoint how the British pet market is performing, and ultimately enable us to draw parallels between a key foreign market and our own as well as the leading retailers in both geographies.

/bryan