This article first appeared on LinkedIn
In the world of pet care mergers and acquisitions (M&A) there has been at least 14 so far in 2018. It is a smorgasbord: companies are (re)entering the space (General Mills), expanding within the category (JM Smucker), strengthening their services (Central Garden), going "upstream" with suppliers (CJ Foods), "downstream" with brands (Cargill) and delving deeper into health care (Mars). Channels and borders are blurred and the funding dollars available for companies in the pet space are significant (Wag, a dog walking and care app raised $300 MILLION from The SoftBank Vision Fund). Why? Well, like most things, if you follow the money, the answers are clear. The numbers and data in the following article have been aggregated and are from public sources and general industry knowledge. Any similarities to actual companies (both living and dead), is purely coincidental! Ready? Let's take a deep breath and dive in!
Let's start with consumer demand and price points. APPA reports that 68% of US households own a dog or cat, and many (particularly with cats) are multi-pet homes. It is estimated that there are 94.2 million cats and 89.7 million dogs. The APPA report goes on to say that the average dog owner makes 7.5 dog-specific shopping trips whereas cat owners average 7.9 trips. The population of pet food consumers (all 184 million of them) is enormous and touches an estimated 84.6 million US HHs. Simple math tells you that each HH spends almost $350/year on food and an average of $58/year on treats. Pet owners are currently spending an average of $2.55/pound at retail (up 46% since just 2011). We have to assume that with the continued humanization of pets (e.g. pets are part of the family) and desire for "human-grade" ingredients that this average expenditure will only increase. So is the pet food category "attractive" to investors? YES!
What about profitability of the category? I mean, if companies are willing to pay 6-8x against sales (or 22-25x of EBITDA), the return on investment has to be pretty good, right? Lets take a quick look at some industry averages for a "big bag" of dog food.
The manufacturer costs are those directly attributed to the sourcing, production, storage and transportation of the finished product. In the markup (from $19.07 to $36.00) is where you will find things like TPF, MDF, PFME, SG&A as well as other financials, including profit. A few things probably jump out at you right away like the idea of paying $79.99 for a product that costs less than $20 to make. Well, based on industry metrics, the manufacturer ends up making 18% profit ($6.48), the distributor 4% ($1.82) and the retailer is making around 3% profit ($2.39) - remember, these are examples for illustrative purposes only. Right now you should be saying, "What? You only get $10.69 profit from nearly $61 of gross margin?" Yup! But think of the sheer volume! In a world of fast nickels or slow dimes, pet food is a pretty quick nickel (and four pennies)! If you think the profit numbers sound low, you have to remember that there are a lot of costs, many which were borne years ago in CapEx and market development. There is also the expense of employing people. We like to call them "Full Time Equivalents" or FTEs because its easier to eliminate an FTE than it is Fred or Mary, with their spouse, 2.1 kids, car payment and home mortgage (probably a pet or two as well)! When asked to explain the cost structure of the industry, I often compare it to a tube of toothpaste. The industry spends a lot (A LOT) of time squeezing and pushing on the tube, forcing the toothpaste to one end or the other. Retailers try to increase the top line by making the shopping experience more engaging and offering "margin additive" services. Manufacturers try to reduce their bottom lines by finding less expensive ingredients and improvements on the manufacturing lines. They also spend a disproportionate amount of time (and money) marketing. And the distributors...they're stuck in the middle! On one side they're asked to improve manufacturer sales (but lower operating expenses) while the other side is asking for them to lower prices and provide more (higher cost) services. My solution, while overly simplified here, is to remove the cap on the tube and force costs out of the "system". Before I move on to that, lets recap; all participants are trying to maximize profits. This isn't any surprise because its why people and companies are in business. In order to grow sales, manufacturers and retailers cut costs, add services and, in a cruel twist, charge the shopper more so that they are able to get even more from them in aisle!
The pet food market is big AND profitable and, based on financial projections for the industry, growing. The CAGR through 2022 has been estimated between 3.9% and 5.6%. All of these factors make the category very (VERY) attractive for M&As. The biggest question that remains is return on investment (ROI). In one recent acquisition, a pet food company had $800 million in sales and a 9% EBITDA. The acquiring company had an EBITDA of 21%. If the acquired company's base of the $800 million is raised to 21%, it would generate $96 million of increased profitability. Add in a decrease in ingredient costs, shared tech, manufacturing efficiencies, reduced logistics and administrative costs plus the new distribution opportunities (on top of their run rate) and you can justify the kind of dollars being paid. Well, you can get close to justifying it!
The industry "as is" has plenty to like from sales and profits to growth and market size. The biggest thing missing that should play a role in M&A valuation is innovation. Product innovation, use innovation and delivery innovation; all of it. The time to look at doing things differently is when you have the profit to do so. If we start from the end user and move backwards through the value chain, we may find ourselves not only solving old problems but also creating more value than we ever thought possible. It is time to remove the cap on the industry, improve the health and well being of pets and “Raise the Bar”!
Jim Galovski is a 25 year veteran of the pet care industry and works as a consultant for both start-ups and well established companies in the pet industry. Jim sits on several Advisory Boards and is also the co-founder of Guardian Pet Food Company (www.guardianbars.com) which produces MoRE Canine Food Bars and WHoLE Prey Treats for Dogs.