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.

 

 

 

 

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

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

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

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

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

/bryan

Note: This blog is for informational purposes only. The opinions expressed reflect my view as of the publishing date, which are subject to change.  While this post utilizes data sources I consider reliable, I cannot guarantee the accuracy of any third party cited herein.

 

 

 

 

 

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.

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

playbookIn October, Del Monte Foods announced that they had sold their fruit and vegetable business for $1.68 billion.  While the world will still have Del Monte canned pineapple, whole kernel corn, and Contadina tomatoes to enjoy in perpetuity, the transaction speaks volumes about the attractiveness of the pet food business relative to its human corollary.  Del Monte’s pet products business will now operate under the Big Heart Pet Brands banner.

You may recall that back in 2010, when Del Monte Foods was taken private by a private equity syndicate headed by Kohlberg Kravis & Roberts (http://wp.me/piXtL-dU), I postulated that the deal was not about shelf stable fruits and vegetables but a bet on the macro fundamentals of the pet industry.  The sale of Del Monte’s Consumer Products business validates my thesis, as does the recent acquisition of Natural Balance Pet Food.  The real question is what comes next?

As a general rule, private equity backed companies are not keen to keep cash on their balance sheets.  Excess cash is used to make acquisitions, delever, or ends up as dividends to shareholders.  Given the size of the slimmed down Del Monte post sale (some $1.8 billion in revenue), I don’t see the later two options as being viable alternatives. As such, I expect that Del Monte will be an active player in the pet consolidation market, and with that much cheese at its disposal the target list includes brands others cannot contemplate.  So who will Del Monte buy? We handicap the candidates:

  • Blue Buffalo. The Blue is the biggest and best name on the block. Not a month goes by without a rumor surrounding the prospects of a Blue Buffalo acquisition by a major CPG company, but the reality is that the company has limited options for suitors at the purported price tag — $3.0+ billion.  Could Del Monte take it down?  Yes.  Will they? Unlikely.  First, Del Monte’s pet line-up is very much about a product portfolio and spending all your allowance on one product company runs a bit counter to that premise. Second, private equity backed companies do not have a propensity for being top payors.  When Del Monte acquired Natural Balance for $341 million, they paid between 1.0x – 1.5x Revenue.  I’m not sure what multiple of EBITDA a $3.0 billion deal for Blue implies, but it would be far greater than the 9.0x the private equity syndicated paid for Del Monte.  While Del Monte established the market multiples that pet companies aspire to achieve through their acquisitions of Meow Mix and Milk Bone, I don’t see them doing a highly dilutive deal with Blue Buffalo; the cost benefit tradeoff is misaligned. Odds: Not good.
  • Natura Pet Foods. The fate of Proctor & Gamble’s pet food portfolio has been a source of constant speculation.  P&G was rumored to be considering offloading its pet business when they acquired Natura Pet Foods in 2010 (http://wp.me/piXtL-cJ), which some took as an about face. They never integrated Natura, which would make it the most likely candidate among the P&G portfolio to be acquired.  Natura would provide Del Monte another power house brand in premium natural, but of greater significance is the fact it would be buying a portfolio of products (EVO, Innova, California Natural, Healthwise), not a single brand.  This would also enable Del Monte to keep Natural Balance in pet specialty, as the Natura portfolio would meet the same needs in mass.  This strategy runs into two problems, one from each side of the transaction.  First, Natura was the subject of one of the widest recalls ever in June of this year, when the company voluntarily recalled every product it made with an expiration date before June 10, 2014. It was their fourth Natura recall in as many months.  Would Del Monte buy a dented egg?  For the right price I suspect they would.  Second, a sale of Natura would only generate proceeds of less than $500 million, a rounding error for P&G, and therefore not much motivation to transact.  Odds: Possible not probable.
  • Iams Pet Foods/Eukanuba. In contrast to a Natura transaction, the sale of Iams and Eukanuba would likely fetch between $3.0 – $3.5 billion ($2.5 – $3.0 billion of that being Iams). This would be worthy of some attention for both sides. Merging Iams/Eukanuba with Del Monte’s pet food brands would make it the number two player in the market, with 20% share versus 35% for Nestle Purina Pet Care. Notwithstanding my comment about check size above, this deal would be tempting for Del Monte to consider. Iams and Eukaneuba generated approximately $2 billion in revenue in 2012 (allocating the other $300 million of segment revenues to Natura), and therefore would be attractively priced, consistent with the Natural Balance transaction. Notably, in July 2013, Del Monte tabbed Giannella Alvarez as Executive Vice President and General Manager of the Pet Business.  As part of her work history, Ginnaella spent time at P&G, albeit involved in a Latin American paper joint venture, but she may have some relevant connectivity to current leadership. However, a deal of that size would likely require the private equity owners of Del Monte to invest more equity, something private equity firms can be loathe to do.  The transaction timeline would also be elongated by anti-trust concerns.  While this deal makes a lot of sense, there are clear barriers to a transaction.  Odds: Possible.
  • Champion Pet Foods. The brand that few talk about in this conversation is Champion Pet Foods, which manufacturers and markets the Orijen and Acana brands of super premium pet food.  Champion was acquired by Bedford Capital Management in 2012, and the business has grown rapidly since the transition, benefiting from Natura’s channel exit and growing distribution offset by production complications related to a plant fire in December 2012. Champion’s regional formulations may not create production economies of scale (yet), but they garner a premium price among consumers who value a limited ingredient solution with a known sourcing pedigree.  While Del Monte wants scale in the brands it acquires, Champion is growing quickly and will become a target of major pet CPG companies over the next 12 – 24 months.  An acquisition would provide Del Monte a very compelling product stack in pet specialty.  Odds: Long, but logical.

Net net, post sale transaction Del Monte finds itself in an enviable position — with both cash and intent.  I do not expect that the company will rush into any transaction, but they have to buy and given the limited competition for premium assets in the space, look for them to strike while the iron is hot, or at least warm.

/bryan

elvisIt’s hot in Las Vegas in July.  I mean, uncomfortably hot if you ask me.  Maybe 10 years of living in the Pacific Northwest has made me a warm weather wimp, but facts don’t lie — Las Vegas averages over 100 degrees in July.   So when the SuperZoo tradeshow date was moved for 2013, the only thing I could think of was the possibility I would melt while wearing my show badge.  In reality, repositioning the show time to mid-summer makes a lot of sense, but still Las Vegas in July?

When the numbers of are tallied for this years show, I’m sure it will be a record, both in terms of number of attendees and exhibitors.  It felt like the number of companies renting booth space doubled either as a result of industry growth or the repositioning of the shows timing.  I had the opportunity to spend a few days both on and off the floor and below is a summary of my observations:

  • Performance is Solid, Expect Consolidation.  Overall, industry sentiment remains strong.  Existing companies are reporting solid growth driven by consistent consumer demand and new companies reported strong interest from both domestic and foreign retailers. Both operators and large strategic players I spoke with predicted the pace of consolidation would accelerate. Consolidators are looking for brands they can convert to mass as well as opportunities to develop relationships at independent pet specialty.  The later strategy is no longer lip service, as the dedicated pet channel continues to take share from mass.
  • Large Players are Trying to Peg the Customer. Grain-free, limited ingredient, organic, natural, regional formulations, raw/freeze dried/frozen, made in U.S. There are so many concepts that are currently in play in the pet industry.  However, there is lack of fundamental research as it relates to what is actually motivating consumers to transact.  As major pet food companies contemplate their next deal, the proof points inherent in any strategy need to be as developed as possible in order to motivate an acquisition.
  • Small Companies are Innovating We met with a number of small companies who were engaged in dialog at the show by the major pet specialty retailers.  This is a sign that retailers perceive that their offerings are innovative enough to draw traffic and do meaningful turns.  While I don’t think companies with limited SKUs are going to be able to compete with large product providers long term, we do see moment in time opportunities and for some that time is now.
  • Competition for Petco and PetSmart Continues to Mount. When we look at the growth in independent chains such as Petsense and Pet Food Express, it is clear to us that these concepts are resonating with consumers in a meaningful way.  You simply don’t get that sort of box growth without consumer demand. These retailers had a more open presence at the show and a number of product providers were discussing their positive experiences with them.  I continue to believe the proliferation of these concepts is good for the industry.

If you have been reading my blogs, you know I entered this year a skeptic, maybe even a pessimist, albeit a relative pessimist.  Based on the financial results we are seeing from core public companies, the economic data we are seeing related to the industry and the sentiment we experienced at the show, I am officially off the couch and on the bus with the bulls, maybe just in the back seat.

/bryan

DVPYesterday, Del Monte Foods announced that they had entered into a merger agreement with Dick Van Patten’s Natural Balance Pet Foods.  The deal is expected to close in June, no financial information was disclosed. The fact that a transaction involving Natural Balance occurred is no surprise, the form of the transaction, well that is another story.

Some five years ago San Francisco consumer growth equity fund VMG Partners made an investment in Natural Balance, taking a minority position for an undisclosed amount at an undisclosed valuation (you might see a trend here).  The investment made a lot of sense for both sides at the time.  VMG had recently closed their first fund and was quickly able to get their brand associated with one of the leading independent players in the pet industry, a fact that would help them win the the Waggin’ Train deal later that same year.  Natural Balance was seeking to fuel growth and was able to attract the money at a valuation based on future financial performance. On paper, it was a win-win.

Generally speaking, minority investments from institutional equity funds come with a redemption right often set five years from the date of the investment (we see them range from five to seven years, but more heavily weighted towards the lower end of that range).  These rights require the company to repurchase the shares of the investor for the greater of a floor valuation (usually a multiple of invested capital) or fair market value. As a result, a minority investment often is the precursor to a larger financing or sale transaction.

With VMG’s mandatory redemption right looming, Natural Balance began to evaluate the potential for a transaction early in 2013.  While the company had grown nicely during VMG’s tenure as in investor, the San Francisco firm was a small player and had limited influence over strategy and operations.  Since 2007, revenue seemed to move up and to the right (exceeding $200 million), but profitability was elusive.  In contrast to Blue Buffalo, which is twice the size of Natural Balance, and boasts “high teens” operating income margins, Natural Balance was not thought to be highly profitable.  This would become a problem when the company went to market.   To raise sufficient capital to take out VMG (which generally invests +/- $20 million per deal) the company would need to raise a significant chunk of change. Assuming a redemption right at three times invested capital, Natural Balance would have had to raise in excess of $60 million, and likely much more. Equity funds do not write checks of that size in to companies with low levels of profitability at attractive valuations; enter Del Monte.

Del Monte was responsible for establishing the modern valuation paradigm for leading pet food and consumable companies through its acquisitions of Meow Mix and Milk Bone in 2006.  Today, when pet companies talk about being valued at 2.0x – 3.0x revenue, these are the transactions that set that precedent.  However, since that time Del Monte had undergone a transaction of its own, having been purchased by buyout giant KKR in 2010.  Notably, KKR would go on to purchase Pets-At-Home later that same year. While I have no insider knowledge of the purchase price, the acquisition of Natural Balance was unlikely to have taken place at those levels given the lack of profitability and limited competition for the transaction.  Natural Balance did not hire an agent or run an auction.  One of the driving factors for the deal was likely that Del Monte could rapidly expand Natural Balance’s distribution footprint through its Pets-At-Home franchise.

Net net, this appears to be a good pick-up for Del Monte making them an instant player in the natural category and in super premium.   It was able to achieve those objectives without shelling out the $1.5 billion Blue Buffalo has reportedly sought from strategic acquirors.  Opportunity knocked and Del Monte answered.  Expect them to keep the product in the pet specialty channel, as opposed to migrating it to mass a la Natura. VMG wins as well, likely making more than their mandatory redemption due to the valuation that would be associated with Natural Balance in a 100% sale transaction as opposed to another minority financing.

/bryan