debt freeOne of the most frustrating aspects of following the pet industry is the lack of transparency we have into the operational results of bellwether companies that comprise the market.  With only a handful of pure-play public companies, and even fewer with meaningful analyst coverage, we are left to rely on publicly available market studies, which are often dated and/or at a cursory level, expensive third party research, or, more often than not, rumors and conjecture.  As evidence, approximately 25% of search terms that led people to this blog are related to market rumors (e.g. “Blue Buffalo acquired”) or data searches on private pet company performance (e.g. “Petco 2012 EBITDA”). However, the availability of cheap leverage to fund organic and acquired growth is providing us a rare opportunity to understand how some of these large private pet names are performing.

In October 2012, Moody’s Investor Services assigned a B3 rating (speculative) to a $250 million private bond issuance from Radio Systems Corporation, the privately held market leader in pet containment products and training systems.  The proceeds from the issuance went to replace existing balance sheet debt and purchase a putable equity stake valued at roughly $90 million.  According to Moody’s, the transaction would leave Radio Systems with a debt-to-EBITDA ratio of 4.7x.   The report also states that the company generated sales of $270 million for the twelve month period ended June 30, 2012.  So what can we glean from this disclosure?

  • Based on the company’s debt-to-EBITDA of 4.7x, this would imply Radio Systems had somewhere in the neighborhood of $50 million – $55 million in trailing EBITDA as of June 30, 2012.  Based on $270 million in sales for the coinciding period, this would imply an EBITDA margin of 18.5% – 20.0%, a good metric for a company of this size in this segment of the industry but certainly with room for expansion.
  • If we valued Radio Systems at an EBITDA multiple similar to the Sergeant’s Pet Care Products / Perrigo transaction or based on the public trading multiples of Garmin or Spectrum Brands, this would produce an implied enterprise value for Radio Systems of $500 – $550 million.
  • Finally, it appears safe to assume that TSG Consumer Partners, whose equity put is being acquired, will make a 3.0x return on its investment of $30 million made in 2006.  This returns Randy Boyd to full ownership of the company.

Moody’s rating of Blue Buffalo’s $470 million financing (rating B1) also provides us some salient insight into the company and its capital structure.  According to Moody’s, the proceeds of the transaction will go to fund a special dividend for the owners, including equity partner Invus Group.  While Moody’s did not peg a debt-to-EBITDA multiple for Blue Buffalo at the time of the transaction, it does state that “Moody’s expects that the company will be able to generate sufficient free cash flow to de-leverage rapidly, such that debt-to-EBITDA will be below five times in the next 12 months.”  The report also states that the company generated sales of $400 million for the twelve month period ended March 31, 2012.   So what can we glean from this disclosure?

  • If we assume the debt financing reflects the total leverage of Blue Buffalo, it is safe to assume that the company generated somewhere in the neighborhood of $80 – $90 million of EBITDA for the twelve month period ended March 31, 2012.  Based on $400 million in sales of the coinciding period, this would imply an EBITDA margin of 20.0% – 22.5%, a very good metric for a company of this size in this segment of the industry, especially one who is funding a national television advertising campaign.
  • Setting aside whether they were true or not, the rumors that were swirling around earlier this year that Blue Buffalo was entertaining sale dialogs with a starting price of $800 million, denotes an implied revenue multiple of 2.0x and an implied EBITDA multiple of +/- 10.0x, which do not appear out of line, maybe even light on the profitability side of the equation.
  • This confirms, what many people speculated, that Bill Bishop had sold a meaningful portion of the firm to a third party equity firm sometime within the last three years.  Invus, which has an evergreen fund structure, and therefore can hold positions for long periods, is a sensible partner.  Invus is also well credentialed in food, with historical investments in Keebler, Harry’s and Weight Watchers.

Finally, Petco Animal Supplies is again tapping the debt markets for $550 million in senior notes.  You might recall the company refinanced its balance sheet to the tune of $1.7 billion back in 2010, in part to finance a $700 million dividend to its owners, enabling them to repatriate 90% of their invested capital.  This time around, the notes along with balance sheet cash will be used to fund a $603 million distribution to shareholders.   I hashed out the Petco situation here before, but the most salient point that can be gleaned from Moody’s disclosure is that the company grew revenue from $3.0 billion to $3.3 billion from 2011 to 2012, a rate consistent with Petsmart for the same period, reflecting a greater equilibrium in the balance of power.

Net net, while much of the above might have been pieced together by an informed observer these conclusions were often difficult to corroborate because we lacked factual information.  One benefit of low interest rates, is we have gained some transparency in the process and therefore can substantiate some of the speculation rampant in the industry.

/bryan

happy-puppehAgainst a backdrop of macroeconomic uncertainty, the pet industry continues to thrive.   While the prevailing theory that the industry is “recession proof” is being sternly tested, market fundamentals of pet ownership remain strong and consumers are skimping on themselves as opposed to their pets and/or children.  Further, the premium demographic continues to have a voracious appetite for efficacious products that are good for their pets as well as the environment.

That being said, the recession has set in motion a number of trends that will, in my view, forever change the pet industry landscape.  While several of these trends are in the “early innings” so to speak, the momentum behind them is significant.  The companies that stand to win during the next phase are those that recognize the seachange and position themselves to take advantage of the wave.  This period will separate the leaders from the pack, to steal a phrase.

Recession Not Found Here?

Pure play equities of pet related companies fell precipitously with the market during the second half of 2008.  However, unlike the general market, these equity began to experience their recovery in November 2008.   The primary driver of equity price contraction was based on fundamentals — earnings for these core names fell 30% from the prior quarter, which spooked the market (in truth some of this could be chalked up to seasonality).

In reality 3Q2008 was up year-over-year from an earning perspective, albeit only slightly.  In a world where flat is the new “up”, this should have been investors first signal that the market was overreacting in this category and  pet related equities were becoming oversold.  Notably, earnings rebounded strongly in 4Q2008 posting year-over-year growth of ~ 4% (weighted by market capitalization), driving a correction with respect to public company valuations.   Thus, the prospects for a technical recession in the pet industry are in fact quite low.

pet-industry-3-30-09

Notably, the macro economic environment did not constrain equity deals in the pet space.  Key deals including Hammond Kennedy Whitney/FURminator, TSG Consumer Partners/Dogswell and Tyson/Freshpet were all announced against a declining or, even abysmal backdrop.   Appetite for pet related concepts has never been higher among growth equity funds due to the prevailing dynamics and long term fundamentals.

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Key Trends for 2009

So what are the seismic shifts of which I speak?

First, I believe we are in the early innings of a major shift in the pet retail landscape. PetSmart and Petco are facing significant competition from Wal Mart as they battle to be the one-stop-shop for the mid-tier pet buyer. Wal Mart’s merchandising acumen coupled with their reach and financial strength make them daunting opponents. Large pet specialty will take share among the most attractive demographic and thrive amidst the chaos among big box players. Their ability to educate buyers and offer patrons a favorable service experience situates them to be long term partners of both customers and the most compelling pet related brands. They will also take share from contracting boutiques hit be financial hardship.

Second, in bad times value trumps luxury.  The downturn in the U.S. economy has eroded the balance sheets of mainstream consumers. While companion animals will continue to a growing part of our society, consumers will become more fickle as it relates to spending on their pets. Product (excluding consumables) and service providers must give pet owners a compelling value proposition if they expect to experience continued growth. This change is expected to be lasting.

Third, consumers want to know what they are paying for.  In the food arena, efficacy is going to become important, a concept which many have taken at face value.  The market has become saturated with better-for-you pet food brands whose differentiation has become hard to appreciate. Supply chain control and organic are no longer differentiators. As distribution opportunities contract, due to contraction in the boutique market, and funding dries up, solutions that can demonstrate high degrees of efficacy will prevail. Customers will begin to demand results for their incremental dollar.

Finally, pet health will come in to focus as owners make difficult choices with their limited free cash flow.  Pet related health care is even more inefficient than its human corollary. Relations between veterinarians and their customers is strained by the high cost of service and medications and the limited proliferation of pet insurance. Further, compliance rates on even basic pet medications are sub-standard. Solutions will arrive that deliver compelling value throughout the pet health care supply chain, driving operating and cost savings at the clinic level, compliance rates among drug applications and ultimately satisfaction for pets and their owners.

Net net, I expect the balance of 2009 to be challenging but good for pet related industries.   Notably, I believe we will see additional pet related equity deals as investors seek to put capital to work in sectors that continue to grow.  As the debt market improves, leveraged buyouts of some of growing bell weathers of the industry (a la FURminator) begin to come in to play, assuming valuation expectations have come down due to market realities.   One would also expect public pet companies to seek to buy growth in a effort to fuel their lagging equity prices.  This could kick of a consolidation phase in the middle market, but I’m not overly optimistic.

As always, you can contact me for a complete version of our market presentation.

/bryan

In April 2003, TSG Consumer Partners (which, at the time, was known as The Shansby Group) invested $40 million for a 30% stake in a company named Energy Brands, Inc. Energy Brands was the parent company of Glaceau, the maker and marketer of vitamin and herb infused waters.  At the time of the investment, flavored water, as a drink category was in its infancy, but TSG was on to something.   On August 23, 2006 TSG sold its stake in Energy Brands to Tata Group for a reported $677 million, or ~ 6.4x Trailing Twelve Months (TTM) Revenue.   TSG’s return amounted to over 17x after dividends.  Not bad for a lifetimes work, let alone three years.

The chapter has a second verse,  between August 2006 and May 2007, the value of Tata Group’s stake nearly doubled from $677 million to $1.2 billion, when Coca-Cola purchased the company for $4.1 billion.  The deal valued Glaceau at 11.9x TTM Revenue, an unprecedented multiple for a beverage company.  Despite the astronomical price Coca-Cola paid, it was hailed by industry analysts as a paradigm shifting move in the battle with Pepsico.

It turns out the Pepsico was not the only one listening to Coca-Cola.  Since that fateful date there have been hundreds of alternative beverage companies launched.  Most were thrust into the market in hopes of being bought by one of the big beverage conglomerates, who had been prolific acquirers over the past three years. Strategies have ranged from ready-to-drink beverages with super fruits, to tea based beverages, to energy drinks to affinity concepts.   At a 2007 beverage trade show I attended, there were literally hundreds of energy drinks being launched in hopes of being the next Red Bull, the homegrown parallel to Energy Brands.

Fast forward to today, I’m sitting in an office with an “A-list” consumer investor and a strong private beverage company.   Beverage company is interested in taking growth equity to launch a handful of new products and a moderate amount of recapitalization.  Very solid operating company meets very solid investor.  As I am watching the back and forth, it dawns upon me, beverage investing is dead, at least as we know it.

I came to this conclusion, not necessarily from the above meeting, but rather over the last 60 days as I have met with a number of beverage companies seeking capital.  What I have seen during my meetings can be summarized as follows — revenue ramps are not being met, marketing spend to realize those ramps has been 2x – 3x budget amounts, expensive packaging is a serious drag on profitability and value relative to invested capital is under water.  Long short, the beverage case at Whole Foods and other natural markets has become increasingly crowded.  Marketing spend to rise above the chafe has been much more costly than originally anticipated.  Grocery store cut-ins have exacerbating the problem, and will continue to do so.

The unstated reality, is also that Coca-Cola and Pepsico have slowed their pace of acquisition (see chart below).  The reality is a number of the bets these companies have made over the past 24-months are just not panning out at the expected rate.  As an example, Coca-Cola’s investment in Bassa Nova is often referred to as a “dog”.  As a corollary, deals that should have gotten done in relatively short order remain in the balance.  Sambazon, a leader in the acai based beverage category, has been actively raising money for more than six months, despite a threshold level of financial traction ($20+ million in revenue), a solid position in the marketplace, an asset goldmine locked up (they control much of the acai that flows from the Amazon rain forest) and what appeared to be well thought out valuation expectations.  The last major equity private placement into a beverage company was Oak Investment Partners minority investment in FRS on June 2007 (see chart below).

I’m not worried about financial investors, they are smart people they are paid to put money to work and benefit from the upside.  I fear for the angel investor who does not see the down stream reality, funding money into a company that faces increasingly dim near term prospects for capturing a threshold institutional equity investment.   As an example, the recent winner of an angel event I attended was a better-for-you beverage company.

Have a drink, but put it on ice, beverage investing is going into a period of deep freeze.  Smart investors will wait out the inevitable market rationalization.

/bryan