willieWillie Nelson once said, the early bird may get the worm, but the second mouse gets the cheese.  In this case, I’m not sure which mouse I was.  Just days after I published my fall pet report a number of news worthy items came into focus that would have merited a mention in my industry report.  However, several of the items provide direct validation of the trends I have been discussing here over the past year.

Of greatest significance was the headlines coming out of PetSmart’s Analyst Day presentation.  Just prior to their Analyst Day presentation on October 17th, management announced that they expected third quarter same-store-sales (“SSS”) comps to come in below the anticipated range. Management believes 3Q13 SSS will come in at 2.0% – 2.5% versus prior guidance of 3.0% – 4.0%. PetSmart has not seen comps this slow since 2009. Notwithstanding the company’s issues with driving traffic, management is sticking by its full year EPS guidance.

Notably, as part of their presentation, PetSmart finally addressed its web strategy in some detail.  CEO David Lenhardt noted that how to remain relevant to consumers across channels was one of his biggest concerns and that the company would be investing more of its marketing budget and CRM resources online. He went on to detail several new ecommerce initiatives include in-store inventory look-up online, improved mobile experience online, in-store pick-up, and opening of a new West Coast distribution center which will reduce shipping times. Lenhardt continues to believe that PetSmart’s position as a destination retailer and its services platform will continue to enable it to compete effectively against other online players.

Over the past year, I have been highlighting the risk of the internet to PetSmart.  I’ve not been alone in ringing this bell.  While I believe PetSmart is uniquely situated to perform well online long term, my concern has been that they have not had a coherent strategy. In light of recent financial performance, including 3Q13 guidance, I have to believe that other online players are succeeding at eroding some of the premium customer base of PetSmart’s and Petco, especially among a younger demographic.  The company’s willingness to detail their plan, after years of side stepping the question, tells me there is some truth to this theorem. While online will result in erosion of hardgoods share, because of the wide availability of these products online, the concern will not reach its apex unless and until pet specialty sees consumables share erosion to online.

Second, the long running narrative linking imported pet jerky story product to numerous pet deaths finally hit the headlines. News about pet death related to foreign jerky products have appeared in nearly every major online publication during the past week. My historical conversations with domestic manufacturers has been that regulatory bodies are not doing enough to protect consumers from imported product and instead have been myopically focused at cracking down on domestic producers.  While it is terrible that so many pets had to fall ill before we got to this point, it now seems we have arrive at the moment where the paradigm shifts. When the dust settles the winners will be consumers and branded treat companies with domestic sourcing and production pedigrees.

Third, Whole Foods announced that they are launching a house brand of premium value oriented pet products. Whole Paws will consist of 24 SKUs addressing both dogs and cats cutting across multiple categories ranging from grain-free food and treats to cat litter.  The attempts of traditional grocery to cut into pet specialty sales are, like the jerky story, old hat for those that follow the industry closely, but the within the natural segment pet remains an under monetized opportunity. Grocery continues to leak share to both mass and pet specialty, due to price and assortment respectively.  However, natural has a real market opportunity in my opinion because it can provide grocery consumers more of a one-stop-shop.  While space limitations will ultimately cap the potential of the natural channel within pet, this product line launch is a clear demonstration that store managers are starting to understand the potential of pets within their channel.  Natural could become a nice bed for incubation of emerging brands with a wellness oriented theme much the way it was in natural beverage, healthy snacks, and gluten free foods.

Finally, the relative pull of the pet industry on owners was again affirmed to me when I became aware that pet owners will purchase nearly $330 million of costumes for their pet this year. This amounts to approximate 22 million consumers spending, on average $15 annually.  What consumer pressures on pet?



Despite its size, the pet industry, as a whole, is under analyzed.  That is not to say there is a lack of analysis, but rather a lack of diverse perspectives.  The reason for the homogenous set of  “points of view” is largely structural.   There are a handful of very big companies that drive the pet industry from the product side — Mars, Nestle SA, Procter & Gamble, Del Monte, etc.  However, we have limited transparency into the granular performance of their pet brands because they either have no reporting obligation (Mars) or their pet business is quite small relative to their overall income statement or balance sheet.  Notably Nestle, who controls some 30% of the pet food business, does not report  its pet food segment separately.  The same can be said about pet retail — Petco, Petsmart, Wal Mart.   The primary industry reporters — Packaged Facts, Mintel, IBIS — rely, largely, on the same survey methodology.

Given the above, you can understand why I was excited to get my hands on Todd Hale’s “State of the [Pet] Industry 2011”.   Todd is SVP, Consumer Shopper Insights for The Nielsen Company.  Simply put, I think Todd brings a different and unique perspective to the table.  Because his firm has access to unprecedented amounts of transaction data, he is best situated to look at the industry from a consumer standpoint, as opposed to from a product or individual retailer standpoint, and of equal significance, put pet consumer behavior in the context of consumer behavior in other retail environments.

With that as my long winded set up, here are some key takeaways from his presentation (all data credits to The Nielsen Company):

  • The Polarized Consumer.  We often talk about consumers in terms of median household income.   One can then analyze consumer behavior across stratified income bands.  This is really nothing new.  But what Nielsen scan data (actual product movement and basket purchases) provides is the opportunity to, on a rolling 52-week basis, analyze purchasing behavior within these income bands and compare the results to prior year periods.   This data does not need a +/- 4% confidence interval because it relies on actual transactions, as opposed to sentiment.  What Hale’s data shows is that the consumer population is very polarized.  While the wealthiest 20% of the consumer population have exited the recession, as evidenced by growth in shopping trips and shopping dollars, all other income bands have contracted.   This demonstrates the fragility of the retail industry and validates how important the premium demographic is to the health of all retail, not just pet.   Using the same methodology, Hale shows that that the affluent (those with household incomes in excess of $70,000) purchase 40% of the pet food and consume 42% of the pet services, despite making up less than a third of the consumer population.   As a result, it is easy to conclude that the pet industry remains as vulnerable as other retail categories.
  • Pet is En Fuego.  If you look across U.S. retail formats, as measured by store counts, value and convenience are winning.   The number of warehouse clubs, supercenters, dollar stores, supermarkets and convenience stores have all increased since 2005.  Only drug and mass merch have contracted.   However, when you dig into the specialty retail category, home improvement and pet have shown meaningful store count growth during this same period, with pet doors increasing 43% and home improvement moving 10.5% to the positive.  Further, pet is the only store category that has shown positive household penetration over the past 10 years, increasing from 30% to 32%.   In short, pet specialty industry has been star performer in the retail landscape over the past six years.
  • PetSmart is More En Fuego.  We have covered the performance of PetSmart on this blog in some depth.  Our historical analysis demonstrated that once PetSmart stopped focusing on topline growth and embraced a balanced scorecard (same store sales, product level gross margin, earnings per share) it quickly became the premier retailer in the pet industry.   Hale puts PetSmart’s performance in perspective across all retailers, noting that PetSmart has produce a 14 quarter “winning streak” of positive comp store sales.   Nordstrom came in second in the discretionary spending category at six quarters.  Among all other retailers (discretionary, value, club), only Sam’s Club and the “dollar” stores (Dollar Tree, Family Dollar, Dollar General) have comparable winning streaks, with only Family Dollar and Dollar General having higher average comp store sales since 2008 than PetSmart.  While the bar for domination of the pet specialty channel is in fact low, Hale’s data proves how impressive the company’s performance has been relative to all retailers.
  • Inflation is Hurting/Helping Pet.  Based on Nielsen scan data for the past two years, prices have risen across the board, with the exception of alcoholic beverages and pet food, though pet food prices increased over 4%  in 2011.  Pet care and pet treats also experienced inflation of 2% and 3% respectively in 2011.   While inflation is hitting consumers at times when incomes are down, price increases have helped the pet industry grow to new heights (sort of perverse).  Notably, Hale’s data shows more pet industry inflation than PetSmart has reported, meaning price increases at grocery and mass have been more substantial than in pet specialty.
  • Brands Hang Tough.   The recession kicked off a new chapter in the branded versus private label tug-of-war across consumer categories.   As Hale points out, private label brands hovered at 19% – 21.5% of unit volume from 2005 to the middle of 2008.  During the recession, store brand volume shot up and has remained at 21.5% – 23.5% post-recession.   Since 2007, store brands have grown 21% in dollar volume versus 3% for branded items.  Notably within pet, all major categories have a lower penetration of store brands than the product average, and private label penetration has fallen in pet care, food and treat over the past year.   This is logical given that store brand attachment falls as income rises, and the pet industry is driven (per above) by the higher income demographics.

In summary, Hale’s data provides us a different lens through which to view the pet industry.   The dominant perspective, to date, has been that of the product provider, and we are led to believe that the manufacturer dictates to the customer what he/she wants and consumes.  Hale helps us understand that the tail may in fact be wagging the dog — consumer behavior, and the ability of pet retailers to incent that behavior, may have been the more powerful force in driving the growth of the industry over the past five years.


I’m very passionate about food and local agriculture.   As such, I was very pleased to be part of the article below written by Seattle Times reporter, Melissa Allison.


Full Circle Farm expands grocery home-delivery service area

Full Circle becomes part of a still-evolving market divided between the very large (Safeway.com and Amazon Fresh) and the very local (New Roots Organics, Terra Organics and Nature’s Last Stand).

Andrew Stout, co-owner and founder of Full Circle Farm in Carnation, shows off one of the prepared deliveries. Stout has an office inside this red barn.


Andrew Stout, co-owner and founder of Full Circle Farm in Carnation, shows off one of the prepared deliveries. Stout has an office inside this red barn.

Lemon thyme is one of the crops grown at Full Circle Farms.


Lemon thyme is one of the crops grown at Full Circle Farms.

Freshly out-of-the-ground parsnips at Full Circle Farm in Carnation.


Freshly out-of-the-ground parsnips at Full Circle Farm in Carnation.

Full Circle Farm is not the only organic farm within an hour of Seattle that sells directly to consumers, but it is among the first to bring boxes of its own produce — along with bread and tea and chocolate — directly to their doorsteps.

A few months ago, Full Circle in Carnation began offering a home-delivery option to its 8,000 members, who for years have picked up their weekly boxes of food at the farm or at centralized locations such as schools, churches and offices.

“We’re typically 24 to 36 hours from harvest to delivery on most of our products, so you get a fresher-tasting experience,” said Andrew Stout, a landscaper from Minnesota who started the farm with his wife, Wendy Munroe, in 1996. Their business partner went on to found Nature’s Last Stand, another Carnation farm that offers home delivery.

“We looked at food as the perfect intersection of being able to take care of both people and the environment,” Stout said. “Plus, the challenge of it and the romance of it, and the opportunity to be involved with something that had a noble sense to it.”

By moving into home delivery, Full Circle becomes part of a still-evolving market divided between the very large (Safeway.com and Amazon Fresh) and the very local (New Roots Organics, Terra Organics and Nature’s Last Stand). One player, Spud of Vancouver, B.C., has bridged the gap by acquiring lots of smaller companies, including Seattle’s Pioneer Organics.

The smaller delivery services tend to offer organic, mostly local food, a market whose growth is self-limiting.

“You can only grow so much and move so far before you’re losing the authentic aspect of your business model,” said Bryan Jaffe, senior vice president of Cascadia Capital, a financial advisory firm in Seattle that has evaluated the industry but does not currently have clients in it.

Staying small is a relative term. Locally oriented services will not reach the proportions of Webvan, a multicity grocery-delivery business that burned through $830 million in five years before filing for bankruptcy in 2001.

But Jaffe estimates that Full Circle’s sales could reach $100 million a year in King County alone. Last year, the farm’s sales topped $10 million.

“We like to say we didn’t hit our projections last year. We just grew by 33 percent,” Stout said.

He and Munroe started Full Circle on five acres of rented land near Mount Si. Now they farm 400 acres and employ 125 people.

“Every time we’ve been presented with an opportunity to grow more food, we’ve said yes,” Stout said. “It’s not that we want to get bigger, but there’s opportunity and we feel like we need to fill it.”

The farm has been profitable for the past seven or eight years, he said.

Adding home delivery has meant hiring a couple extra truck drivers to run at night, so that deliveries are on customers’ doorsteps by 6 a.m. During the day, the trucks deliver Full Circle produce to restaurants, farmers markets, traditional pickup locations and retailers like PCC Natural Markets and Whole Foods.

Full Circle also sells produce from more than a dozen other farms to round out its offerings, along with other grocery items, including coffee from Grounds for Change, hot cereal from Bluebird Grain Farms and eggs from Stiebrs Farms.

Home delivery costs $4, on top of the price of groceries. A standard box, which is $30, recently contained salad mix, carrots, snap beans, greens, tomatoes, cabbage, corn, beets, pears, nectarines, melons and pluots.

Many organic home-delivery services say their prices are below grocery stores’, because their overhead is lower. Unlike traditional community-supported agricultural operations, called CSAs), most of the services allow customers to add or delete items from their orders and to start or end service at any time.

Carolyn Boyle, the owner of New Roots Organics, which has been delivering organic groceries to people’s homes in this area since 1999, stopped carrying Full Circle produce years ago, when she realized they were also competitors.

“They had drop sites in some of the areas where we were delivering,” Boyle said, adding that “there’s plenty of room for everyone.”

A decade ago, she said, her only competitor for organic home delivery was Pioneer Organics.

“I moved here from Vancouver (B.C.), and there were tons starting there,” Boyle said. Eventually many of them, like Pioneer, were bought by Spud.

Other grocery-delivery services have launched locally, including Safeway.com six years ago and a test by Amazon.com called Amazon Fresh that began in 2007 and is still limited to the Seattle area.

Smaller players include Nature’s Last Stand, which has a farm in Carnation, and Terra Organics, which is the sister company of Tahoma Farms in Orting. Some services — including Full Circle — offer products that are decidedly not local, like bananas.

“A rounded diet is essential, and there are great people doing great things across the planet,” Stout explained. He points to a mango farm in Ecuador that takes good care of its workers and invests in health and sanitary conditions in its town.

“That’s a business that needs support,” Stout said.

It is hard to isolate one value — for example, local — to the exclusion of others, he said.

“Is it better to buy a local piece of lettuce that was grown using harsh pesticides and fertilizers from a grower that has less-than-ideal work conditions, or something grown in a different region but with great intention and integrity?” he said.

And then there’s the taste factor.

“There are wonderful American wines and wonderful French wines,” Stout said. “Just because they’re from France doesn’t mean you shouldn’t drink them.”

— Melissa Allison

superzThe fall trade show season for the retail segment of the pet industry has come and gone.  From a macro perspective, the industry continues to thrive.   Not only is innovation accelerating, but the core themes around humanization, health and wellness and convenience remain relevant.   That said, things are not all sweetness and light.   Of greatest significance is the reality that the economic contraction is having an impact on the industry, maybe not in the most obvious ways.  Additionally, the H.H. Backer Pet Industry Trade Show was flat relative to SuperZoo, just two weeks prior.   In the balance of this post, I discuss the key observations from walking the floor in Las Vegas and my interpretation of front line accounts from those attending H.H. Backer.

Recession Resistant, But Not Proof

Anyone who pays attention to pet media has been inundated with articles touting the industry as a safe haven from the downturn in the economy.  While, technically speaking, the industry continues to grow, it is by no means moving along unscathed.   The show season provided ample evidence that the industry is feeling the pinch.   Notably in this regard, paid attendance was down across the two shows both in terms of buyers and exhibitors.   Many who normally exhibit at both shows chose one or the other, but not both.  Second, growth rates for most of the industry has slowed, in  the majority of cases significantly, though outliers still remain and in a world where “flat is the new up” any movement up and to the right should be commended.  Third, buyers (in the retailing sense as opposed to the M&A transaction sense) were clearly more cautious, many were there to browse and keep updated on the evolution of the merchandising mix,  but we saw a lot of “wait and see” from people in independent pet specialty who normally travel with their checkbook.

When one factors in that access to capital is currently quite limited, especially for small companies, these signs point towards consolidation in the industry.  Or at the very least a bifurcation of the market into leaders and laggards.  Cash flow generating businesses who can attract capital will drive growth through marketing spend, while those who cannot access funds will be challenged to allocation their limited resource base.

I’ll Take a Treat As Opposed to a Meal

While subtle it is notable; I felt the “presence” of the treat companies exceeded that of food companies at SuperZoo.  That is not to say there was an absence of food folks on the floor of the show.  In fact they were there in force, as always.   However, their participation was much less extravagant and a number of up-and-coming brands were absent.   Part of my conclusion is that there has been limited innovation among the major independent players, they are too busy duking it out  for shelf space.

The most notable innovator in my mind has been Merrick, which launched Whole Earth Farms.   Whole Earth is a premium natural line of dog food targeted to the value oriented consumer.  On one hand this makes complete sense to me, as consumers are forced to trade down, this product offers product attributes that are very appealing at an attractive price per pound.   Possibly of greater significance it may be attractive enough to pull up consumers who generally buy mass, but would prefer to feed their dogs natural.   With Pet Promise going away a healthy percentage of these customers are looking for a new home.  At the same time, I wonder if these two groups can live harmoniously.  Value orientated natural has not been highly successful in the human realm.  I offer Whole Foods 365 Everyday Value as Exhibit A.

I give runner up accolades on the food side to Mulligan Stew’s launch of their baked soft kibble and Honest Kitchen with their display of feathers signifying their move to free range chicken in their chicken based diets.  For the later, it made the point nicely.

At the same time we were more impressed with the evolution and innovation in treats, not only in terms of ingredients but also in terms or blurring the line between reward and core wellness.   At the show we saw an increasing number  (relative to the prior year) of treat companies promoting their offerings (or an offering) as “source verified”.    Further, numerous treat companies are marketing formulations with an ingredient count that only requires a few fingers.  Fruit and vegetable based treats are also on the rise.  Finally, many treat companies now have offerings that  promote general wellness or help alleviate specific issues experienced by companion animals — joint health, dental wellness, skin and coat support, digestive health.  Kudos to the likes of Zukes, Fruitables, Pegetables, Terrabone,  Petit Four Legs  (shameless plug) and a host of others.

LOHAS Movement A Foot in Pet

The lifestyle of health and sustainability movement continues to gain momentum within the pet industry.   Nearly every company I visited with that offered bedding and toys has a product incorporating some form of recycled material.   Sustainability has become more prominent in marketing, especially for companies where the link is less obvious.

Of greater significance is the proliferation of health related offerings.  Not only is the supplement space gaining in competitors, but sophistication from a product formulation and branding standpoint has also evolved.  New comers such as 3M and The Brampton Companies (which purchased Vet’s + Best) were just two of the more notable booths, coupled with industry incumbents Nutri-Vet, NaturVet, Ark Naturals, PetAg, and a handful of others.  Of the condition specific issues being addressed most prominently, dental health and weight management have joined hip and joint as the most commonly addressed.

Finally, there were a host of other target specific health solutions ranging from pet first aid kits to electronic emergency pet reference manuals to ear thermometers to therapeutic treadmills.   Most notable was Anti-Lick Strips from Nurtured Pets.  These all natural peel and stick bandages deter unwanted behavior and prevent small problems from becoming big problems.

Better Branding

A final note, packaging and associated branding in the pet industry has come a long way in the past 2 years.  This is consistent with my thesis that more companies have entered the market with traditional consumer packaged goods experience and who are looking at the industry as a business (the professional trumps the enthusiast).   It used to be that packaging was a source of competitive advantage.  Now, in some segments, sophisticated presentation is the bar for entry.  Anyone who knows Vets + Best pre-Brampton, can attest to what a makeover can do.   Other notable packaging came from the Get Naked line of health supplement from NPIC, Zupreem, Flexi, and Nutramax.  I expect more innovation next year as others refresh their image to keep up with their competitors.


jack-lambertIt is Super Bowl week for the National Football League.  It is also Super Bowl week for the market in my opinion.   In addition to a slew of earnings releases from market bellwethers in the pipeline, we will get economic news providing us some indication of just how bad 4Q08 was.   We know it was bad.   Retail data has been revealed, write downs have been announced and expectations have been slashed.   However, if it turns out to be worse than expected it will roil the markets and provide the television pundits plenty of fodder in which to claim that we are all going to go personally bankrupt, at least financially.  If we some how find a way to meet or exceed consensus estimates and market psychology does not pull us down much below the November 2008 lows, AND we end the week at 8000+, I expect that we will have established a bottom.  Small consolation, but you have to take what you can get right now.

Now to tie up a few loose ends:


Why are banks not lending?  This is the question my mother asks me on a weekly basis.  The good news, for me, is that she is not alone in asking me this question.  The bad news is that people don’t like my answer.   The reason, in my view, is that while TARP did neutralize the balance sheets of a handful of banks, it did nothing to remove the associated plutonium.   As such, when then portfolio companies of these lenders go Southern Hemisphere on their covenants, it sends the balance sheets back out of the alignment.  Further, as more companies are expected to experience financial distress, lending ratios will get further sideways.

In order to remedy this situation, the system is going to need a lot more money or a mechanism to move these bad assets of the balance sheets or to nationalize the banking industry.   This is probably the most difficult decisions to make, because there is no good answer.  Nationalizing the banking industry would basically put an end to the free market economy and market based capitalism as we know it.   Creating a liquidating asset management company like a Resolution Trust Corporation seems to make more sense on its face.  However, it creates a litany of questions that are vexing regarding pricing (face value, market to market) and who keeps gains and absorbs after the fact losses.  Clearly this would become a political issue resulting in the realization of the lowest cost denominator solution.  When is doubt print more money right?

That is FAScinating

Not really, unless you dig accounting issues, but I wanted to stick with the theme.

In November 2007, the Financial Accounting Standards (“FAS”) Board (“FASB”) issued Rule 157 (“FAS 157”).   FAS 157 dealt with the fair value measurement standard for assets whose value was, wait for it, hard to measure.  In developing FAS 157, FASB said it considered the need for increased consistency and comparability in fair-value measurements and for expanded disclosures about such measurements.  FAS 157 defines “fair value” as the price that the asset or liability would achieve in an orderly market transaction between informed participants at the measurement date.   I’ll spare you the rest of the accounting detail.

When FAS 157 was issued there was a litany of articles about how it was going to “rock the financial services industry to the core” or some such other derivative statement (most these “gloom and doomers” failed to recognize Goldman Sachs had been using mark-to-market accounting for years).   That didn’t quite happen, at least not at the time.  However, in light of the financial crisis many people are pointing at FAS 157 as the cause of unnecessary pain, as it has forced banks to market their assets to market in very troubling financial conditions.  Many of those who are complaining the loudest are private equity personalities, people who don’t like FAS 157 to begin with.  Historically, private equity firms would hold their investments at cost for at least a year unless a subsequent transaction justified marking it up or down.  They were negatively impacted, in their view, by FAS 157 as it would expose to the rest of the world, or at least to limited partners, their missteps.  Woe is me.

Well it turns out woe will be quite large.  This morning we learned that Thomas H. Lee partners wrote down $524 million worth of assets in order to comply with FAS 157.   With $8.1 billion under management, this is a healthy sum for a firm that is considered one of the oldest and most successful in the business.   I expect we are going to learn of significant write-downs across the industry.   On the plus side, this will give outsiders some insight into their valuation assumptions and view of the future, which will help inform companies as they consider their options for funding operations and achieving liquidity.


Okay, so I could not keep the streak going.

As expected, New Seasons Markets lost in their bid to not comply with the subpoena they received pursuant to the Federal Trade Commissions antitrust exploration regarding Whole Foods and Wild Oats.   However, New Seasons was able to come to an agreement with Whole Foods to limit its disclosure in certain areas so as to reduce the cost of compliance and limit the risk the company was taking in turning over sensitive information.   Through this process it also came to light that another company also sought a legal solution, but it is unclear who it was and what outcome their case has met.


wholeI’ve had a love hate relationship with Whole Foods Markets, Inc.  I love what they provide for me, but I hate the crowds and the customer experience.   In my household we refer to it as “Whole Paycheck”.   I was lucky, in a sense, when I lived in New York, the first Whole Foods  went in just a few blocks from my apartment, providing a working guy an oasis of healthy food options, that stood in marked contrast to everything I could procure within a 10 block radius of my doorstep.   I moved to Seattle and, thankfully, Whole Foods was just a few exits up the freeway, and I was able to conveniently procure my produce, protein and staples that served as the basis of our healthy lifestyle.

I first learned about Whole Foods when I was a traveling management consultant at Price Waterhouse (pre-merger with Coopers & Lybrand).   Back in the early days of Fast Company (circa 1996), the magazine featured an article on the company (article here) calling it the future of democratic capitalism — decentralized team based work environment, financial transparency, and consensus hiring.  At the time, I thought it was interesting model (multi-functional teams were all the rage in the reeingeering world), completely counter cultural within the grocery industry, but I was fairly out of tune with the natural foods movement at the time.

As I graduated from consulting to investment banking, my proximity to Whole Foods became closer,  and not only as a consumer.   Perry Odak, who was a Gordian Group, LLC (my previous employer) relationship, from the Ben & Jerry’s deal, had been brought in to turnaround Wild Oats Markets, Inc., the second largest organic market chain in the country.  While we were never engaged, to my knowledge, we were routinely bouncing ideas off of Perry and providing him valuation insights.  It was clear that an M&A exit was in their future.  I spent more time understanding the industry and business model and walking the isles of Whole Foods.  By then I was pretty much living in the prepared foods section.

While Whole Foods enjoyed a healthy run, driven by expansion of the store footprint, accelerating consumer sentiment around natural and organic foods, and the strong economic environment, the run began to lose steam in late 2006.   With the stock trading at $65/share in November 2006, the company announced results which included a projected slowing of their growth rate.   Comps were off, margin compression was evident, and square footage ramp was below expectations.  The era of 20%+ annual growth for Whole Foods had sunseted many believed.  Applying more conservation price-to-earnings assumptions yielded implied stock prices nearly 50% the prevailing share price.  By January, the stock was trading at $43/share, or better than expected according to analysts.

In February 2007, the inevitable happened, Whole Foods offered to purchase Wild Oats via a tender offer for would turn out to be approximately $752 million ($586 million if you net out the stores sold to Smart & Final post close).  If you can’t build it any more, than buy it.  Given Wild Oats historical operating challenges and Whole Foods  execution acumen, it was thought that considerable value enhancement could and would occur.  Whole Foods has a strong track record of turning around under performing natural foods retailers, and  it appeared there were significant opportunity for both overhead cost savings and store-level productivity gains to be had at Wild Oats owned stores.   The analyst community believed the merger will be a significant earnings driver for Whole Foods over the next several years.

A funny thing happened on the way to the alter however — the Federal Trade Commission  (FTC) filed a lawsuit to block the proposed acquisition, taking a very narrow view of the antitrust market, given that nearly every grocery store now sells organic and natural products.  This had negative implications for the stock, as uncertainty now was a compounding factor on top of eroding performance in the core business caused by cannibalization, competition and price reductions.   At the very least management would be distracted and integration delayed.

Whole Foods did not sit on its hands and wait for the FTC to mess with its future.  Instead they took their case to court and received a preliminary injunction against the FTC, setting the stage for an imminent closing.  In the background, it came to light that Whole Foods CEO John Mackey had been posting negative comments  under an anagram of his wife’s name (Rahodeb, when unscrambled would be Deborah) about Wild Oats and glowing comments about his own organization on the Yahoo! Finance message board for seven years, referring to himself in the third person.  Additionally emails from Whole Foods executives expressing their disdain for Wild Oats and their desires to “crush them at any cost” came to light.   That notwithstanding, on August 27, 2007 the deal was finalized and the merger effected.

Case closed? Not so fast.

After closing the deal with Wild Oats, Whole Foods stock price continued to erode.  Earnings misses followed by failed integration milestones blurred in to an economic crisis where consumers were trading down and, ultimately, suspension of the dividend.   Facing both a confidence crisis and a liquidity crunch, Whole Foods took a $425 million investment from Leonard Green & Partners (LGP) through their Green Equity Partners Fund.   While very successful, LGP is not known for paying peak market multiples.

Then things started to get very strange…

On July 29th,  a three-judge panel ruled that a district court judge had erred when he refused to grant an FTC request for an injunction to block the merger of Whole Foods and Wild Oats.  On November 21st, Whole Foods lost a decision to have that ruling reviewed by a larger panel of judges.   Despite the fact that most Wild Oats stores have been closed or absorbed, the FTC is now moving to have the merger invalidated.  A hearing on the merger is scheduled for February 2009.  Whole Foods has launched a new suit, claiming their right to due process has been violated.

In an effort to make a compelling case that Whole Foods is not a monopoly they have subpoenaed the records of 93 competitors in the natural food space (note: the number quoted in the popular press is 96, but in a recent court motion, the number was stated as 93).  Their inquiry focuses on 29 markets in what is terms are the “premium organic retailing space”.   Parties were given until November 4th, 2008 to respond. Financial records, weekly sales figures, marketing plans, store opening schedule, inventory reports, and more.  Most of these entities are in fact private, making these records proprietary.  Amazingly, 50 of 93 entities have complied in whole or in part without a peep.  The squeaky wheel in the machine is New Seasons Markets, a nine store chain of natural markets located in Portland, Oregon.

New Seasons CEO Brian Rhoter naturally took issue with the subpoena and is taking his case to court.  In his blog Rhoter points out not only the burden complying with the order is having on his business financially, but also, aptly,  that the FTC motion does not, in his mind, provide for adequate protection of its information or remedies upon breach.  Basically, Rhoter is saying we don’t have a dog in this fight, so why are we unnecessarily being burdened and our business information being put at risk.   The fact that Whole Foods had fronted the argument that none of their employees would see the data, and then went to court to get it sent to their Austin headquarters, raises eyebrows.

While I feel for New Seasons and side with Rhoter on this issue, my sense is that Whole Foods will prevail in court.   Antitrust does not work without competitive information and Whole Foods is following the common protocol, at least at a high level.  What boggles my mind is that others being impacted by this legal morass are not lining up behind Rhoter, at least in an attempt to greatly narrow the scope.   And what of the 42 odd companies (sans New Seasons) who have made no production in this case?  What action is Whole Foods going to take against them?  It is possible if New Seasons would have quietly ignored the subpoena that they might be better off in the short run.  After all I don’t think Whole Foods has the necessary runway to successful compel “groupo 42” to produce and then internalize that response and incorporate it by February.

I can’t also help but let my mind wander, to the actions of Mackey and the emails of key employees that painted a win at all costs culture within the corporate center, and wonder if secretly Whole Foods is loving this part of the process.  Essentially this is antitrust as a business strategy.  I’m not saying that anything Whole Foods is not above board or that they have any intention of misusing anyone’s information, but the reality is you can’t see this information and then wipe the slate clean of it when making decisions.  Sure, pursuant to the protective order, key executives would never see this data but there are a cadre of individuals who will and invariably there will be data leakage, there always is.  Further, this case is central to the future of Whole Foods, its executives and board have to be exposed to  some of the information in order to make decisions on legal strategy.  Even if data reaches them in summary form, or at a high level, it is information they would otherwise not  have had access to in absence of this case.  This only leads me to be more sympathetic to Rhoter, as it points to a lack or organization among independent organic retailers.  If only they had known they would need their own lobby.

The last great example of a company that used antitrust as a business strategy was Gemstar-TV Guide International.   The fate of that entity and its executives was not so favorable.  That said, I value Whole Foods role in the market and I hope it prevails in its case against the FTC.  A break-up of the company would do more harm than good.   Organic food retail is a highly competitive market place once you consider how much of the product can be obtained in  mainstream supermarkets and club warehouses.  However, I wish Whole Foods approach to business was more indicative of its role as senior statesmen for the industry and consistent with what we might view as its mission.