cowboyIn prior posts I have lamented about the reality that the pet consumables industry lacks a deep pool of brand consolidators.  Once you get past the “big three” (Nestle Purina, Big Heart Brands (The J.M. Smucker Company), and Mars), the industry possess a limited set of buyers who operate brand portfolios and who have deep pockets to afford the most attractive properties at prevailing transaction multiples.  That is not to say there are no other capable buyers of pet consumables properties, but rather that the current valuation paradigms of the second tier of buyers represents a significant drop from that of market leaders, whom simply can do more strategically and operationally with the assets they acquire.

Conventional wisdom has been that, over time, this reality would work itself out in four ways. First, was that the largest Tier 2 players would become aggressive in their M&A push in an effort to challenge the market leaders. Save for Spectrum Brands, who has been active, acquiring Proctor & Gamble’s European division, which includes the Iams and Eukanuba brands, and Salix Animal Health, a leading pet treat manufacturer, this segment of buyers has been largely stagnant.  Hill’s Pet Nutrition has participated in a few known M&A processes, but never at valuation levels necessary to challenge the companies it is chasing. Second, was that large private players would become more aggressive in acquiring emerging brands before they became of interest to the large industry players, creating a second economy, so to speak, for sellers.  Save for WellPet’s acquisition of Sojos, activity within this class of competitors, at least for consumables companies, has been muted.  Generally speaking, these companies have either opted not to run brand portfolios, or chosen to build rather than buy.  The third leg of this stool was that foreign buyers would enter the market.  Save for Agrolimen SA’s joint venture with Nature’s Variety, we have only heard crickets from the foreign buyer community on notable deals. Finally, the notion was that human food companies would crossover into pet in an effort to capture the growth and margin available to leading industry players. While many have talked-the-talk, they have not been able to close, primarily losing out to industry players on a valuation basis due to operational synergies.

This fact pattern is troubling for many of the emerging authentic brands in the category, who don’t want to be perceived to be selling out a major industry player. For some, the thought of a foreign buyer or a consumer packaged goods or natural food company acquiring them remains seductive.  So why has the industry seen such limited crossover appeal to these constituencies?  The answer has both quantitative and qualitative underpinnings.

The pet industry possesses a myriad of large foreign operators in the consumables sub-segment.  According to petfoodindustry.com, three of the world’s 10 largest pet food players are foreign — Unicharm, Deuerer, and Heristo AG.  Additionally, there are five other foreign market players (mostly Western European) producing between $400 – $600 million in annual revenue. Based on the prevailing margin profile for a pet consumables business, these companies would seem to have sufficient financial wherewithal to acquire a mid-sized U.S. pet food business. However, when you analyze this population, the following common traits emerge — largely private companies with closely held/family ownership (Unicharm being the most notable exception), owned manufacturing assets, and a limited acquisition history.  Where these companies have been acquisitive the targets have been in the buyer’s home market or in direct geographic adjacency. While some of these acquisitions have been of reasonable size, $50 – $150 million, it is clear that most of these companies are most comfortable sticking to what they know or prospecting only as far geographically as required.  Further, when you talk to executives of these companies they tend to cite three primary concerns about U.S. pet consumables M&A — a) a lack of knowledge of the U.S. pet food market, b) a lack of internal M&A capability internally, c) a perception that the market is hyper competitive and therefore of limited attractiveness, and d) the deal prices are high in light of these competitive concerns.  It seems logical to conclude that these dynamics are only likely to change if, and when, these companies experience a slowdown in their core business, if ever, and/or a professionalization movement stimulated by private equity drives them towards these outcomes.  Of note, some of the smartest U.S. private equity funds with a heritage in pet consumables are actively targeting Western Europe for their next pet deal, but I view the possibility of these parties being players for U.S. assets as being a ways off.

Consumer packaged goods companies, as potential buyers of pet businesses have had their own unique limitations.  Most notably, is the challenge these players have had with appreciating the gross margin profiles of the targets.  Companies like Clorox and Church & Dwight, who have actively courted pet companies involved in sale processes, are used to product level gross margins that push 50%.  We have yet to see a lower middle market pet food company that could produce those types of margins.  Scale operators like Blue Buffalo generate 40% gross margins.  Further, this class of buyers is not used to employing meat based inputs and concerns about recalls have led them to prioritize companies with owned production assets, which as a class of sellers have been experiencing the highest market valuation multiples in the most recent M&A cycle.  Finally, we find consumer product companies, who are used to spending considerable dollars on consumer marketing, do not appreciate the role the pet specialty retailer plays in motivating product sales, and therefore they build into their valuation models a level of additional spend that makes them less competitive on price. Absent a notable cross-over success story, we don’t foresee these sentiments changing. In fact we have seen more companies in this class give up the ghost than take us the charge.

Finally, we have the conundrum of the natural food companies.  It would seem logical to assume this class of companies would be interested in the pet space given the current parallels between the human and animal nutrition markets.  With the proliferation of grain-free and natural pet solutions, these two markets have never been more closely aligned.  There have been several instances where natural food businesses have pursued pet food assets where they appeared poised to win, only to go home empty handed. The challenges here have been both quantitative and qualitative.  On the quantitative side, the inability to drive revenue synergies has made them less price competitive, even though deals at prevailing levels for the most attractive properties would have been accretive on an earnings basis (as an example Hain Celestial trades at 16.5x LTM EBITDA). Further, this class of buyers needs a scale property to justify the adjacent market entry to their investor base, which leaves them both limited properties to choose from and puts them in direct competition with the big three.  On the qualitative side, two issues have surfaced consistently.  First, these companies are being actively pursued by large strategic buyers themselves, which means focus is critical to driving shareholder value and remaining independent if that is what is perceived to be in the best interest of shareholders. Second, is the intellectual conundrum of adding meat to the portfolio mix.  Of note, the three largest natural food products companies — General Mills, WhiteWave Foods, and Hain Celestial — orient their market offerings around plant based nutrition.  Adding meat into that marketing narrative makes for a bit of a conundrum, even if they are comfortable with the food handling risk.  My view is the right property will enable these buyers to overcome those concerns.  The attractiveness of the profit margin profile of well managed animal protein based businesses, nearly 2x on an EBITDA margin basis at scale, will be sufficient to motivate a natural products buyer with some vision. I view it as only a matter of time before one of these companies takes this leap of faith, but there is certainly no clarity on when that might happen.  WhiteWave Foods and Boulder Brands, the two natural products companies who have come closest to the finish line now find themselves in very different circumstances.

While the above narrative may lead one to conclude the glass is half empty, as opposed to half full, it is actually an improvement on the historical paradigm. Five years ago we would not be mentioning the other classes of buyers as possibilities, let alone probabilities.  Today, I see it more as a matter of when, not if.

/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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fly in soupOn its way to a date with a public security listing, Blue Buffalo ran into a small problem.  It seems there was a fly in their soup; one which they claim to have been blissfully unaware.  Equally embarrassing was the fact their fiercest rival, Nestle Purina, had been the source of the discovery.  What followed the initial accusation is either evidence of the power the independent premium pet food company wields or the first act in a Greek tragedy. The outcome is likely to have an impact on the pet food industry investment and the pet food M&A landscape.

In March 2014, it was leaked that Blue Buffalo, the $600+ million revenue independent premium pet food marketer, had selected a trio of lead arrangers for its public offering. The company had, for years, been rumored to be on and off the market seeking a buyer at prices between $2 – $3 billion depending on the timing of the speculation. It appeared that the company was now ready to tap the public markets for liquidity, an event that filled the industry with equal parts fear and excitement.

Two months after the leak, Nestle Purina filed a lawsuit in federal court alleging its competitor was lying about the contents of its products. Nestle claimed that independent tests show that Blue Buffalo uses chicken byproducts and corn in some of its food formulations — despite making marketing claims to the contrary.  Nestle would later amend its case to dispute other product claims on kibble, treats, and even cat litter. The fact that the industries top dog would undertake efforts to undermine Blue Buffalo came as a surprise to many.  Many speculated it was a tactic to lower the potential acquisition price for the brand.  Blue Buffalo returned the volley several days later counter-suing Purina for defamation, a summary of which can be seen here.

In a letter to customers, Blue Buffalo Founder and Chairman, Bill Bishop wrote:

“It is an easy thing to make unsubstantiated claims, put them in a lawsuit and then publish them all over the Web to disparage and defame a company. It is quite another thing to prove those allegations… We will prove these and other matters in court with good reliable evidence, and we look forward to disproving the voodoo science that Nestlé Purina relied on to support their outrageous allegations.”

The complete responses from Bishop can be seen here and here. Later, Bishop would go all in on a letter to the editor of Businessweek that can be seen here.  During the process, the National Advertisers Review Board (NARB) recommended that Blue Buffalo modify marketing claims it was making about competing products.  While Blue Buffalo disagreed with the the conclusions of the NARB, they agreed to take into account their recommendations in the future.  Details of the review hearing, recommendation, and associated reaction can be seen here.

Upon reading the first letter of response, I knew Nestle had something.  History has shown that the de facto strategy for the guilty is to attack not the claim but the science of the test and the party administering it. If professional sports is a relevant proxy, sometimes that plan works.  So Blue Buffalo then set out to undermine the validity of the Purina’s independent test going so far as to claim the laboratory involved had “dubious scientific credentials.”  The company’s critique of Windsor Labs and its scientific findings can be seen here.

As it appeared the two sides were heading to court, Blue Buffalo issued a statement that one of its suppliers had mislabeled ingredients sent to their customers, which could (that choice of words is important) have resulted in Blue Buffalo product being made with poultry by-product meal.  That statement can be seen here.  While it is notable that Blue Buffalo is acknowledging some of Nestle’s claims, it is passing the buck to its supplier.  While Wilber-Ellis has a history of recall related issues, the names of other pet food companies who may have received mislabeled ingredients, as Blue Buffalo claims, have not surfaced.  Since the FDA and Wilber are choosing to remain silent on this issue (the FDA views those names, if any, to be confidential information), it would be natural to speculate that there are no other names and in fact, this circumstance was known to Blue Buffalo.  However, that is merely speculative. What is also interesting is that Blue Buffalo has not issued a voluntary recall (the FDA does not mandate a recall in cases where the ingredients involved do not have a reasonable probability of causing serious adverse health consequences), has not disclosed probable lot numbers, or offered to refund customers their money.  So far the strategy seems to be working as they have not wavered from their approach.

What happens next is likely to impact pet food investing and M&A.  If the circumstance above results in Blue Buffalo modifying or pulling its IPO plans, or going public and experiencing diminished value, or selling at a diminished value, it will be yet another cautionary tale of how supply chain issues can quickly erase equity returns hard earned over time in the pet space.  This may lead to investors pursuing pet consumables investments with greater caution and scrutiny.  Further, pet consumables M&A may come with more strings attached — broader seller representations and warranties, higher indemnification caps, etc. — or at lower valuations to account for this risk.  Companies that can demonstrate control over the product they put in the bag should also be ascribed a premium.  Owning your production assets becomes, in fact, more valuable. That written, if Blue Buffalo is able to hold shelf space, avoid a recall, and move forward with its liquidity plans, it will, in fact, validate how powerful the leading independent brand really is.

My view is the marketer is ultimately responsible for ensuring that the product in the bag matches the associated claims.  However, absent consumer lash-back, Blue Buffalo is unlikely to suffer much.  Further, given how much traffic their products drive at retail, pet specialty chains are more likely to accept the “it’s not our fault” explanation.  In the meantime, Blue Buffalo may get to see the results of the Freshpet IPO before confirming its path.  Freshpet is expected to price on November 6th.  At the mid-point of the range, Freshpet would command a fully diluted value of $414 million.  Based on estimated 2014 revenue, that would value the company at 3.5x – 4.0x revenue.  Those multiples would only serve to validate Blue Buffalo purported $3 billion price tag.

/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.

CPO2In prior posts we have explored the notion that pet industry transaction volume is accelerating, and by all available measures in fact it is.  We have also delved into rumors of a public offering by Blue Buffalo later this year, noting the lack of public traded pure play pet companies. On Tuesday, Trupanion, a venture backed provider of health insurance for dogs and cats, announced it intended to file for an IPO on the New York Stock Exchange. We are also aware of at least one other company in the process of filing, and the concept of going public has been increasingly discussed in my industry coverage meetings.  This begs the question, are the public markets the most viable exit opportunity for a variety of midsized pet companies?

What is most notable about the Trupanion filing is the size of the company.  The business, of which I am a customer, disclosed that it was covering 181,634 pets as of March 31, 2014 and generated revenue of $83.8 million for the year ended December 31, 2013. On a quarterly basis, the company said it has posted quarter-over-quarter revenue growth since the first quarter of 2010. In the most recent quarter, ended March 31, the company reported revenue of $25.6 million, a 44% increase from the same period a year earlier.  However, also in the disclosure was the insight that the company lost $8.2 million in 2013 and has never made money.  That said, Trupanion has a huge intangible data asset, having covered a large population of pets for nearly 14 years; data that would be highly valuable to a variety of players in the pet supply chain. That notwithstanding, it is hard to believe that Trupanion, even at the most generous valuations, is going to achieve an offering price that results in a market capitalization that will motivate meaningful analyst coverage, given its size and earnings profile. Trupanion’s primary competitor, the larger Veterinary Pet Insurance Company, remains private. Other pet insurance companies have not met with favorable results in the public markets due, primarily in my estimation, size.

Often public filings are practical way of putting a “For Sale” sign on a business. Whether or not this is Trupanion’s intention, the mere optionality of a public listing would act as another catalyst for industry transaction volume.  Further, if successful it could pave the way for other midsized pet companies to explore the go public alternative.  Certainly companies such as Radio Systems Corp, Hartz Mountain (which is owned by publicly traded Uni-Charm Corporation) and United Pet Products (owned by publicly traded Spectrum Brands) would be well situated to tap the public markets for liquidity or acquisition capital. Further, brands such as Champion Pet Food, Dosckocil Manufacturing, Freshpet, Kong Company, Nature’s Variety and Merrick Pet Care would gain another exit alternative.

The analysis above separates the issues of “could” from “should”. While Trupanion has a clear path to a diversified growth plan through its data asset, the ability to sustain public company momentum for many of the companies listed above is limited. We have already questioned whether the much bigger Blue Buffalo can remain channel tied as a public company and it dwarfs most of the above listed companies in size and brand awareness.  However, more public pet companies would be good for the industry, which generally lacks a broad set of consolidators.

/bryan

 

 

 

 

iamsA theme we have been emphasizing in our missives about the pet industry has been the concept of change. Industries evolve for a variety of reasons — innovation, regulation, exogenic shock, mergers/acquisitions, among others. Our view is that the pet industry is changing for another reason — slower growth. The key drivers of pet industry performance over the past five years — the humanization of pets and the pet food upgrade cycle — appear to have peaked and, as a result, we are seeing divergent performance among industry participants as new core themes take hold; innovators continue to take share from incumbents. A logical reaction to this state of play is an increase in deal velocity — incumbents buy innovators, investors fund innovators to accelerate their existing or potential advantage, and large companies consolidate to drive economies of scale. Notably that is exactly what we are seeing and some of those deals could have far reaching implications. The case of Mars, Inc. buying the Proctor & Gamble pet portfolio is an example of this reality in practice.

When Mars acquired 80% of P&G’s pet food portfolio for $2.9 billion, it should have come as no surprise P&G was largely exiting the pet space. P&G management had been actively seeking to pair its exposure to non-core lines of business and a buyer for their pet brands has been sought for several years. That Mars was on the other side of the transaction, was not a real surprise. After all, only a small handful of companies in the space could have taken a deal of this size down, Mars being one of them. However, Mars has been increasingly active in its food business overseas at the expense of its pet portfolio so many discounted the possibility. On its face, the deal appears to be attractive for Mars. Among the acquired brands, Iams fits nicely into their merchandise matrix, and mitigates the risk they would fall to the number three player in the most important pet market should Big Heart Brands have scooped up the assets. Eukanuba is largely redundant and Natura is a wild card given its recent recalls. What we suspect happened was Mars had sought to buy Iams for some time, and eventually the sides agreed to a deal where P&G threw in more assets (Eukanuba and Natura) and Mars, in turn, agreed to throw in more money. The $1.6 billion portfolio sold for 2.25x revenue after considering the retention of ownership.

While the deal backdrop consists of some mildly compelling drama, more interesting is what it all could mean in terms of change. Of significance, Mars is largely focused on the mass channel, and logic would dictate that they would seek to move Natura into mass at a lower price point. Given the recalls that is where Natura might have some residual value. That scenario could have significant implications for pet specialty assuming a Natura launch is a prelude to other natural brands entering the FDM channel under their flagship brand. The would be a big win for consumers — premium natural pet food at a mass price. This would add additional fuel to the notion that Blue Buffalo, if public, would pursue this very strategy. Further, Big Heart Brands, through its Natural Balance transaction, would be well situated to join this movement despite the promise to keep the brand in channel. The net result is the potential for both share and channel shift but also pet food deflation. Falling food prices would have significant implications for major pet specialty and independents. On a price per pound basis, premium food trades at 2x-3x price premium and a 2x-2.5x profit premium. Price compression would therefore have a significant impact on margin for pet specialty players.

We concede that the scenario above is speculative, but one that increasingly has the potential to be realized in whole or in part. Further, it is one that we would not have given much consideration 12 months ago that everyone should now take seriously.

/bryan

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

noseFor those of you who are consistent followers of my blog, you might recall earlier this year I was rather sanguine (on a relative basis) with respect to the prospects for the pet industry in 2013. My thesis was based upon three factors. First, that a tepid recovery would result in slower pet population growth and the waning of the pet food upgrade cycle. Second, that slowing comp (same-store-sales) growth at PetSmart was in fact a proxy for the industry. Finally, that declining influence of the baby boomers, who have slowed pet replacement, would not be sufficiently supplanted by the necessarily levels of spending growth by Gen X/Y to propel the industry forward at projected levels.

As we round the final turn in the calendar year and head for home, things have not played out quite as I had expected.  The industry has proven itself to again be resilient and more adaptable than even I recognized. The economic recovery has been aided by strong equity returns and rising home prices that have exceeded most pundits expectations. Notably, this has resulted in solid growth in industry related personal consumption expenditures that indicate the industry should deliver projected 2013 results. While PetSmart comps are in fact slowing, management has found ways to adapt — prolonging the pet food upgrade cycle through expanding offerings and more square footage dedicated to the premium aisle, resetting key categories such as canine hardgoods, and evolving service offerings to be more compelling.  Management also reported their belief that the company’s online strategy is producing above market returns. Finally, pet adoption rates, a key driver of spend, have accelerated in 1H2013 adding additional reason for optimism. While there may be clouds on the horizon, rain does not appear imminent. As such, we expect the industry to hit its annual growth projections.

In addition to strong growth, we are also predicting that 2013 be a good year for industry related transactions, both M&A and private placements. One of the best predictors of future M&A volume is trailing private placement volume. Generally speaking, private and growth equity firms have three to five year hold periods. From 2010 – 2012 private placement volume met or exceeded M&A volume in the pet industry. Investments made in 2010 are now starting to come into season. Given the number of companies that will enter their exit window over the next two years we expect transaction velocity to continue to grow. Consumables, distribution, and hardgoods are expected to lead the way. Based on 2013 private placement volume we expect this to become a long-term trend.

The year has also produced a number of trends that we expect will have long term implications. Among these, we are seeing acquisition rationales of large strategic acquirers focus on the value of acquired brands in the pet specialty channel. As an example, when Del Monte Foods acquired Natural Balance Pet Foods, it was the latest in a long line of wellness oriented pet properties snapped up by a large strategic acquirer. Historically, these acquired brands have migrated out of pet specialty and into mass where the market opportunity is perceived to be greater. Our understanding is that Del Monte intends to keep Natural Balance in its current channel. Sure we have heard this before from other buyers, but if you consider that mass is losing sales to pet specialty and currently there is a lack of large brands in independent pet specialty with traffic pull, we may be reaching the tipping point where taking share in broader pet specialty is the more attractive opportunity. Increasingly, we see large strategics seeking ways to connect with a premium consumer in pet specialty and believe that acquisition rationales will increasingly rely on this inherent logic.

Additionally, we are seeing a proliferation of direct-to-consumer models in the pet industry. While ecommerce is the most well known business model for direct sales to consumers, a number of alternative models (flash sales, curated retail, marketplace) have emerged post-recession. During the past twenty-four months, companies promoting these models have begun targeting the pet space.  Notably, Bark & Co. (curated retail), Dog Vacay (marketplace), and A Place for Rover (marketplace), have all raised significant amounts of capital. What these companies, and their backers, are betting on is that as Gen X/Y, demographics that have grown up transacting online, ascend in purchasing power these models will see increasing adoption.

As always, a more complete exploration of these topics and the broader industry are available in my report (post here or email me to request a copy).

/bryan