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I recently had the opportunity to speak at the First Annual Pet Food Investor Forum, sponsored by Susquehanna  Financial Group. The conference was primarily geared towards public equity analysts and it was interesting to see this class of market observers collectively hone in on a few key questions that were affecting the public equities in the pet food sector. Among those questions, one that came up with the greatest frequency was the prospects for Blue Buffalo to penetrate the veterinary channel.  The array of speakers were almost universally asked to proffer our views on this issue, as it is central to the next leg of the Blue Buffalo growth story.

Since Blue Buffalo announced its intentions in the professional channel, I’ve held the belief that it was likely going to struggle to gain penetration quickly. My view was grounded on two basic premises, neither of which speaks to the quality of their solution set, of which I have no knowledge.  The first is that this channel has some very strong incumbents, who have a long history with the channel and its practitioners. The vets I have spoken to suggest that is going to be hard to overcome given how hard it is to create access. Second, was that building sales in the veterinary channel takes time and requires fundamental research that Blue Buffalo might have a hard time producing quickly, unless they had started this process long before the commercialization efforts came to light. Blue has obviously overcome significant hurdles in its history to become a near $5 billion market cap company, and there is reason to believe that if you give them a long enough time horizon that they will make inroads. I only see it as a question of magnitude.

However, last week something caused me to begin to rethink my paradigm.  Lawyers in the State of California, on behalf of California, Minnesota, Georgia, and North Carolina filed a class action lawsuit against the major players in prescription pet food (Mars, Nestle, Hills) and a subset of their primary distributors of their prescription products (Banfield, BluePearl Vet, PetSmart).  The lawsuit contends, among other things, the following, (a) there is nothing unique in the ingredient deck of prescription pet food to differentiate it from non-prescription pet food, (b) the marketing, labeling and sale of these products is deceptive, and (c) the defendants are engaged in anti-competitive practices to sell these solutions at above market prices to consumers.  If you want to read the full complaint it is here.

While I am not a lawyer or a Holiday Inn Express customer, at first blush, it would appear this case is good for Blue Buffalo’s potential franchise in the veterinary channel.  If the plaintiffs were to win their case, it would likely open up the channel to competition, giving Blue Buffalo a seat at the table. Further, if successful, the case could erode the brands of incumbent players in channel, driving faster penetration and sales of Blue Buffalo’s prescription solutions through consumer requests. That said, Blue Buffalo would also have to deal with any implications of the lawsuit given it operates in the category. However, when one digs deeper, it becomes apparent that this case is far from a done deal.

Let’s first deal with the issue as to whether prescription diets should be allowed to be labelled as such.  It is correct that prescription pet food diets do not contain controlled substances and are not manufactured under purview of the FDA. However, they are formulated for specific conditions and feeding them to an otherwise healthy pet is likely, over time, to have consequences. This is what allows the manufacturers to call them “prescription”.  This is merely a labeling issue, and if changed would not make feeding them under general conditions advisable. Further, I don’t think this makes them deceptive by definition. The marketing of these solutions generally indicates they were formulated to specifically treat a condition, not that they contain a drug. These products recommend you only feed them under the supervision of a veterinarian, in case they don’t address an issue that needs addressing or there are negative side effects of feeding them. Personally, I don’t see how labeling them prescription harms consumers and in fact the prescription protocol is, in most cases, necessary to protect pets from self-diagnosis by their owner and improper application. That all being said, these products could be labeled differently and if we adhere to a standard that the label prescription only covers controlled substances a change should be made. Whether that impacts anything beyond that does not, on the surface appear to be all that damaging.

The question of whether they are “different” is where things start to get muddy.  What defines a prescription diet is the inclusion of certain vitamins and minerals that are scientifically proven to help address a specific condition — kidney, cancer, obesity, skin, digestive, etc. The claim that these ingredients could be found in other pet food products sold without a prescription does not make them the same. The notion that pet food is pet food because all of the ingredients are generally available does not hold water in my view. If it did, pet food would only be sold in flavors, formulations and brands would not matter. I suspect lawyers from the manufactures cited in the cause of action have parsed these issues for their clients many times. We also know that brands matter in this category, Blue Buffalo’s success being a prime example of that.

Finally, I can’t speak to anti-competitive behavior, as I don’t know what goes on behind the scenes, but the pricing claims make me smile.  The cost of pet food has escalated significantly post-recession (40% on average on a per pound basis since 2011 according to GfK) without much of a peep from lawyers, despite the fact that class action lawsuits in the pet category have escalated significantly.  The prices of of most Hill’s Prescription Diet dry dog food solutions in 25 lb. bags runs between $80 – $85 online, approximately $3.25/lb.  This translates to approximately $2.40 per 1,000 calories, while higher than premium kibble at $1.75 – $2.25, this is significantly less than dehydrated ($5 – $8), premium cans ($7.5 – $10), frozen raw ($10 – $11) and premium freeze dried ($11 – $18).  If there is outrage around the price, it should be kept in context. When combined with the notion that these solutions are in fact different, these claims lose some of their veracity.  For me, you would have to believe that the veterinarians are coercing their clients into buying these solutions because they have no other choice and then providing them no other means of access than to pay the price for which they are selling them. However, these solutions are available online and transactions are facilitated through prescription verification providers such as Vetsource.  This feels much like a contact lens parallel.  Are there drugs in contact lens? Ponder that.

The net of all this is that it will spur dialog about labeling of these solution sets, and consumers who have purchased these products may end up with coupon books or rebates from manufacturers, but I don’t see that as providing a meaningful recasting of the competitive landscape for the prescription pet food.  And while Blue Buffalo should be a beneficiary in the near term, it is unlikely this provides them the runway they need to rapidly penetrate the channel.

/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 bowelTracking growth in the pet industry has historically been a static exercise.  Industry observers have become beholden to annual disclosures from the American Pet Products Association (APPA) or one of the third party research organizations that track the industry’s performance (Packaged Facts, Mintel, GfK, etc.).  Garnering a read in between reporting mileposts has required the application of inference to lagging data.  The take private of PetSmart removed a valuable leg to the data stool on which many inferences relied. However, in the case of pet consumables, recent public offerings and acquisitions of major pet properties by public companies, provides us greater transparency from which to make educated guesses.  Consider the following August 13th reporting disclosures:

  • Nestle Purina disclosed segment level growth data for the first half of 2015 for all of its businesses (note, European public companies report on a half yearly basis).  The Petcare division delivered ~ $5.63 billion in Sales in 1H2015 (reflects conversion of CHF to USD as of the data of publication), up 4.9% over the same period in 2014.  Nestle also disclosed that its Petcare division increased Operating Income margin by 1.1%.  Healthy growth given the size of the numbers involved.
  • Blue Buffalo reported strong second quarter sales and earnings performance.  Sales for the quarter totaled $254 million, or 16% growth versus the same period in 2014. While earnings were up for the period by 14%, Blue Buffalo posted a 2.0% decline in Operating Income margin for 2Q2015.  Volume growth for the quarter was 15%, with dry food posting a 16% gain.  However, the company noted that dry volume growth was more a function of timing, based on sell-in shipment dates. For the full year Blue Buffalo anticipates that wet food and treat growth will outpace the growth of dry food from a percentage standpoint. Gross Margin was 0.4% higher than the same period in 2014, though 0.7% lower than 1Q2015 due to the ramp-up in the companies owned production facility (Heartland).  The balance of the Operating Income compression is explained by IPO related expenses, investments in new product introductions, and brand related expenses.
  • Freshpet also reported strong second quarter sales and earnings performance.  Sales for the quarter totaled $28.4 million, or 39% growth versus the same period in 2014.  Approximately 4.8% of this growth was attributable to new product tests, as the company seeks to enter the kibble sub-segment. Freshpet reported a 9.1% increase on Operating Margin as losses narrowed. However, the company experienced a 1.3% decline in Gross Margin versus the same period in 2014, driven primarily by mix.

While these three data points do not reflect all brands or channels, they do provide us a reasonable cross section from which to extrapolate. If we compare these results to the APPA projections for 2015, it would seem we are on track to meet or exceed projected growth in the largest category of pet spending.  For calendar 2015, the APPA projected total industry growth of 4.4% and 3.5% growth within the consumables.  If the largest industry player is growing 4.9%, albeit globally, and two key emerging but established independents are growing at healthy double digit rates, it would seem to augur for an up year in pet consumables. For further triangulation, we add to this the J.M. Smuckers disclosure that its Big Heart Brand’s acquisition is growing at a 4% – 5% annual rate. In the future, a publicly traded Petco, will only further add to our ability to predict in year category performance.

The above certainly does not represent perfect science, but in the absence of real time data, it does provide me some comfort as it relates to anticipated annual growth for the industry.

/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.

outrageThe false advertising lawsuit between Nestle Purina and Blue Buffalo celebrated its one year anniversary last week.  The milestone date was met, shortly thereafter, with an admission that a “substantial” and “material” portion of Blue Buffalo pet food sold to consumers over the past few years contained poultry by-product meal, which runs directly counter to the claims Blue Buffalo has historically made in an effort to build its franchise.  The admission, according to a Purina press release (see link here), was necessary to enable Blue Buffalo to file an Amended Complaint in the litigation to include its suppliers as a Defendants.  Blue Buffalo’s own press release (see link here) stated that it “requested permission to bring a claim against this former supplier and others involved for intentionally mislabeling ingredients and unjustly enriching themselves.”

What I find most interesting about the latest turn of events in this saga is the clear lack of outrage from, frankly, anyone other than Purina and a handful of class action lawyers.  While Blue Buffalo appears to be acting within the legal guidelines as it relates to product recalls (since the mislabeling poses no health, safety or nutrition issue a recall is not mandated by the FDA) and customer notifications, it is hard to see how their handling of this situation is good business practice. That said, the pet industry seems to be taking this in stride, in direct contrast to past pet food ingredient disclosure scandals.

In 2007, when the pet food industry was rocked by recalls related to contaminated vegetable proteins, imported from China in 2006 and early 2007, used as pet food ingredients, the response from the industry was visceral.  Sadly, thousands of dogs were affected by the associated product contamination, and many died as a result, justifying such a strong reaction. These deaths led to increased governmental oversight of the pet food supply chain as well as widespread recalls from pet food brands of all sizes operating across both geographies and sales channels. Consumers made their voices heard online and in the stores, resulting in a myriad of brands experiencing a decline in shelf space and, in some cases, expulsion from pet retailers.

To be clear, the situation with Blue Buffalo is not 2007 revisited — the ingredient mislabeling has not been linked to the deaths of any companion animals. However, if you have followed the fine print of this situation two things are notable — a) that it appears unlikely that Wilbur Ellis was the only party providing Blue Buffalo by-product meal and b) Blue Buffalo was not the only manufacturer receiving these shipments. The later of these statements we know to be true based on disclosures by both Blue Buffalo (see link here) and the FDA (see link here). I believe the former to be true because Blue Buffalo now states that they intended to bring claims against “this supplier and others”, with the former being Wilbur Ellis. Further, Blue Buffalo previously stated it sourced chicken meal from multiple parties (see link here), so it does not seem logical that a “substantial” and “material” portion of their pet food could contain by-product if Wilbur Ellis was the only one mislabeling these shipments.  I don’t know this to be the case but I would have expected Blue Buffalo to be emphatic about that fact pattern if it was true.

Yet despite these observations and incongruities, we have not seen the level of discord in the market that one might have expected given historical precedent. In fact we have not witnessed any discord. Yes, there are blog posts here and there making hay of Blue Buffalo and their handling of the mislabeling situation, but the vocal minority exists everywhere online.  Notably, retailers we talk to are not intending to remove the product, nor are they seeing any decline in sales. Further, we are not hearing a groundswell of consumers demanding other brands that received the by-product meal disclose the fact they may have mislead their customers as well. I would like to think that consumer advocacy does not require pets to perish in order to gain momentum, especially at a time in society where moral outrage against opaque corporations and public institutions has never seemed more elevated.

What I am left to believe from the fact pattern above is that a broad set of consumers are either unaware or don’t care. Further, I am also of the mind that the benefit the industry’s retailers receive outweighs the cost of taking a stand. I can’t blame them either. Their job is to be responsive to customers, not to think for them. However, the industry has done so (think for them) in the past when the risks outweighed the rewards (China sourced chicken jerky as an example).

Surely this cannot be the last we have seen in this epic. Maybe a definitive judgement will result in more fervor, but I would not wait for outrage, because it is not coming.

/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.