piggyAs has often been discussed, the post recession rise of the pet industry is often linked to the ongoing upgrade cycle in pet food. Pet owners, fueled by a combination of love for their companion animals, human food trends, and supply chain concerns associated with foreign sourced product, began to spend more on what they were putting into their pets bowl on a daily basis, focusing on solutions with higher quality ingredients, known sourcing, and production integrity. The result was a proliferation of brands targeting consumers with premium and super premium offering that met these emerging needs. Premium solutions now make up 42% of total consumables sales according to Packaged Facts. The net result was that the pet food upgrade cycle fueled a disproportionate percentage of industry growth.

From 2008 to 2014 estimated year end, according to the American Pet Products Association, sales of pet food increased from $16.8 billion to $22.6 billion, over 35% or nearly 5.1% annually. What is less often discussed is that this period of time coincided with de minimus growth in the pet population, especially large dogs who are the primary driver of pet food volume. If consumers of pet food were not growing, and therefore volume was flat to down, the resulting rise in pet food sales had to be price driven. In fact, during this period annual pet food inflation averaged over 3.0% annually according to Federal Reserve Economic Data.

screen shot 2015-02-14 at 8.26.25 amWhile rising pet food prices have been a boon for the industry, a lack of real wage growth has meant that these premium solutions are increasingly cutting into the discretionary spend of pet owners. While on the surface this may not be a problem for the industry — sales afterall continue to be robust — over the long term it is and will be. Our belief is that cost inhibits ownership, and for the industry to continue to grow the population must expand. Further, the increasing presence of higher cost solutions can serve to undermine the trust relationship between the retailer and the pet owner given that most of the benefits of these premium solutions are not easily observable.

When I walked the aisles of my local pet store, I noted that approximately 15% – 20% of the dog food SKUs would result in an after tax price of over $100.  A few other stores I sampled had SKU counts that comprised between 10% – 30% of their dog food merchandising mix at, or above, this price point.  This highlights a further concern of the pet food upgrade cycle for independent pet specialty stores. As conventional and natural grocery introduce more emotive brands with similar product characteristics, in an effort to capture their share of the pet food pie, the risk of consumers defecting the channel increases. Why would one pay $100 for a 40 lb bag of dog food when they could get a solution with a high percentage of the same attributes for 60% – 75% of the cost? According to Packaged Facts, 69% of pet product shoppers look for lower prices when they shop for pet products; further, 74% of pet owners believe that many pet products are becoming too expensive; finally, 52% of dog and cat owners are actively channel shopping. Given that premium and super premium solutions command a higher profit margin profile for both the pet specialty retailers who carry the products and the manufacturers/marketers who supply the channel, a pet food “downgrade cycle” could be devastating.  Absent a change in the personal economic fortunes of pet owners, we see the potential in this thesis.

The net of this is that the pet industry needs to become more acutely focused on product transparency and value. Manufactures/marketers of pet food and the retailers who sell their products need to be doing more to help consumers understand what they are getting for their premium price and why it is justified or they risk losing customers to lower priced solutions would in turn slow industry growth. Companies that cater to the value oriented wellness segment of the market stand to benefit from these changes in pet consumer behavior.

/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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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.

I’m not an economist. Nor do I play one on television. Further, I haven’t stayed at a Holiday Inn Express in recent memory. As such, I encourage you to proceed with caution, because I am going to talk economic data.

Generally speaking, economic releases, especially those related to retail sales, are pretty straight forward. Every month, around the 13th of each month, the U.S. Census Bureau releases Advanced Monthly Sales for Retail Trade and Food Services. The data provides macro monthly change information, as well as detailed breakouts by sub-segments (see August report here). Advanced numbers are later revised and termed “preliminary” and then later revised and termed “actual”. This process takes approximately 90 days. Eight times a year the Federal Reserve Board publishes a Summary of Commentary on Current Economic Conditions by Reserve District, or the Beige Book, for short. The Beige Book gathers anecdotal information by District and sector, through interviews with business leaders, economists, etc. and provides anecdotal information on the current economic climate. Given the generally high correlation between economic health and the current economic climate, people generally believe the Beige Book is a good leading indicator of forward retail sales estimates. Collectively these factors are used to predict the earnings of retails who report on a quarterly basis. Wasn’t that simple?

Now that we have our reporting pattern down. Let’s look at some data.

The chart above is more or less typical of the retail sales cycle. Sales fall preciptiously in January, post holidays, rebound through the spring, seek to find direction through the summer, rebound for the back to school sales, only to fall again before building through the holidays. What appears concerning about the chart above is the precipitous fall between June and July 2008, over a 10% drop. However, when we consider that the economic stmiulas package of 2008 held retail sales up for May and June, the drop is reasonably out of context. While one might be fooled if they relied on a linear trend line (the straight line in the above chart), a polynomial trendline (the curved line in the above chart) would have forecasted the fall, albeit maybe not as precipitiously.

So fast forward to today, Wal-Mart Stores Inc., the world’s largest retailer, reported a solid gain that beat Wall Street forecasts. However, mall-based apparel stores, appeared to remain in the doldrums. High-end retailers posted weaker results as their affluent customers start to feel the impact of the economic slowdown. This is all no surprise to anyone despite the fact that gas prices have abated somewhat. What does baffle me is that nearly every market analyst missed in their forecast. Combined with weak labor data, the Dow Jones Industrial Average was down 344 points.

So now I will play arm chair analyst on why I think the pundits over shot (yes, I understand hindsight is 20/20):

1) My first answer lies in an incomplete understanding of recent GDP growth. In early 2008, despite not being in a technical recession there were many articles that communicated the belief that, numbers notwithstanding, we are in a contracting economic climate. This turned out to be true. Then on August 28, the Department of Commerce revised second quarter GDP growth to 3.3%, up from 1.9%. A significant increase from the 0.9% growth in the first quarter. We generally do not equate such growth rates with a recession, and as such maybe analysts believed that that the good times would soon be back and that things were not as bad as reported. Too bad quarterly growth was due almost entirely to exports. I would have loved to have known the GDP growth figure ex-stimulus checks, but not sure that would be possible. (side note: Intrade.com, where you can bet on nearly anything saw a marked increase in the price associated with the U.S. economy going into a technical recession in 2008 to 10.8%).

2) A second theory is the analysts got away from the Beige Book which has, for the last two releases, been stating that the economy was weakening and consumer spending trends were deteriorating in most parts of the country. Granted the second instance of this came just yesterday and therefore reaction opportunity was lost by then.

3) Third, I suspect that analysts underestimated the financial condition that many of these firms are currently in. While debt is not a substantive problem for these companies, inventory factoring is not free and has become more costly. Many retailers entered the quarter with historically low inventories and therefore lacked clearance merchandise to bargain hunting consumers.

4) Lastly, the reason might have been completely unrelated to the any of the above, but rather the Republican National Convention. Maybe the market wanted more data on the McCain/Pallin economic plan. Just a thought.

I’m thankful that we have economists, that way I don’t have to be because I would surly never make a living. However, I expect more critical thinking from the lot. Maybe I am being too critical, but my view is all the signs were there and most people just flat out missed them in sequence.

/bryan