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Pet Food – Analysing the investment opportunity

black and white dalmatian dog eating fruits

  1. Deal activity at an all-time high: There have been more than 44 M&A deals in 2018 so far, with multiples reaching north of 25x EBITDA

  2. Significant Private Equity interest in the sector with boasts 90% recurring sales, high margins and opportunities across the value chain and in adjacencies (e.g. pet tech and pet health)

  3. Corporates are placing large bets on the future of the industry, acquiring premium assets

  4. Trends are changing fast, and increasing competition could pressure returns

  5. What’s the next big thing in pet?


Deal activity is at an all-time high

There have been over 44 M&A deals this year including several private equity investments and several involving human food companies expanding into the pet sector, or pet food brands expanding into veterinary and other adjacencies. Most of the M&A activity has been driven by US mid-market private equity firms acquiring emerging brands with varying USPs ranging from fresh food, organic, added supplements, breed specific and the list goes on.

Typically, single product pet food businesses are founded by pet parents and pet lovers to solve a specific issue, such as their own pet’s dull coat or excessive itching. Once these small enterprises collect a loyal following of customers, they become highly valued assets for private equity investors to professionalise and expand through the addition of new product lines and new sales channels. The outcome is a typically a two-fold expansion in multiple from entry to exit, as the new operators turn a popular niche product into a professional brand and often national or international multi-product business.

On the other end of the spectrum, this year’s $7.8bn acquisition of Blue Buffalo remains the largest pet food deal in history and relatively expensive at 6x revenue and 26x EBITDA. General Mills, the US human-food company acquired an entirely new business segment to build a ‘millennial-focused, authentic 21st-century brand’ and grow sales through its traditional retail distribution network. While this is a transformational acquisition for a human food company, time will only tell if General Mills will be successful in integrating this once niche pet specialist brand into the mainstream segment.

Attractive sector for Private Equity and human-food MNCs

The pet food sector has several attractive features for private equity investment. The industry is a fast-growing and broad global consumer category. The humanisation of pets, which has introduced the notion of pet parents and pet children, continues to drive premiumisation, price inflation and a growing non-discretionary relationship with spending patterns (i.e. recession resistance). Health and wellness trends that mirror human consumption habits are also now pervasive in pet food. Fresh, organic, natural, personalised food is competing in an already crowded marketplace. Perhaps the most valuable feature of the pet food sector lies in the subscription-like purchase pattern of pet parents leading to low-switch and averaging 90% customer loyalty to top brands, combined with growing high margin e-commerce driven ‘direct-to-consumer’ business models.

While like in any industry profit margins vary, a mid-sized brand-only pet food business may generate c.10-20% gross margins with outsourced manufacturing. However, with scale and insourcing, gross margins can elevate to c.30-50%, leading to large uplifts in value for shareholders. Private equity investor can achieve this through increased scale; however, corporates may already have this synergy potential available to them through in-house expertise. The manufacturing process for dry pet food remains relatively simple (although manufacturers would disagree), and utilizes a technique called extrusion, the same manufacturing technique used to dehydrate human cereal. This strategic rationale and industrial process expertise have led to several human food companies acquiring pet food businesses in recent years, including General Mills acquiring Blue Buffalo for $7.8bn (26x EBITDA) and JM Smuckers acquiring Ainsworth for $1.9bn (c.23x EBITDA).

However, growth and synergies are not the only strategic rationale for acquisition. Many corporates are seeking “direct-to-consumer” and “product plus solution” ecosystems for the pet sector. The idea is to replicate a pet parents’ entire needs under one set of brands, for example, vet services, pet technology, and personalised pet food – all connected through one online ecosystem. The complete ecosystem doesn’t exist yet, but Mars’ Connected Solutions is close to ushering in the future of pet care.

Within Asia, the Chinese pet food market remains the golden goose, but like most things in China, it requires a considerable amount of skill and luck to achieve success. Gambol, BridgePet Care, Mars and Nestle all have entrenched positions in the domestic market, and several thousand local start-up brands form a long-tail of competitors. Smaller international brands typically seek distribution partners in China before establishing their own sales offices, but even then there are a host of strict import and labeling regulations to overcome.

For example, dry pet food is classified as a highly regulated agricultural product similar to cattle feed, whereas wet cat food has significantly less regulation. Some nations also have free-trade agreements with China for such products such as New Zealand whereas others are impacted by on-going trade negotiations (e.g. U.S.). However, a number of mid-sized private equity-owned pet food brands have overcome these hurdles including MPM UK (owned by ECI Partners) and PetCurean Canada (owned by 2Story Group), both of which now successfully sell imported product in China.

Fundamental growth drivers remain strong

The global pet food market totals ~$70bn, growing at ~4% p.a. Despite rapid growth in pet adoption in Asia where the market is growing at c.8% p.a., the US pet food market still accounts for around half of the global market. China, like in many other sectors, is a huge prize for any pet food company that can successfully enter, manufacture and capture market share in the $1.3bn market (likely a considerable underestimate) which is currently growing at over 20% p.a. Globally, dog food still dominates c.60% of sales, with dry varieties accounting for c.60-70% of the market although this is slowly changing as more varieties of wet and “better for you” food products enter the market.

Asia (China, Japan, India) remains significantly underrepresented in pet ownership with the dog and cat population only c.3% of the human population, compared to c.50% in North America. There are many drivers for increased pet adoption, several of which correlate to economic growth indicators such as employment and home formation. In China, social attitudes towards pet companions and the recent increase in family sizes is a significant factor in increasing the addressable market for international and domestic brands.

Trends in the Chinese pet food market typically lag the US market by c.5-10 years, with the gap narrowing in recent years. The Chinese consumer has enjoyed a rapid increase in the number of foreign and domestic brands available for purchase, as well as an evolution in sales channel from offline (market, pet specialty) to online and pet specialty stores. Foreign brands still dominate the market with Mars (Royal Canin, Whiskas, Pedigree) holding c.36% market share. Like many other food sectors, Chinese pet parents historically preferred foreign brands for their higher quality, premium branding. This purchasing habit was reinforced after the melanin scandal in 1997, where Chinese manufactured pet food led to the unfortunate death of over a million dogs. However, the recent growth of domestic challenger brands has been driven by improving the perception of local brands, and premiumisation. Two private equity-owned brands, Gambol (KKR) and Bridge PetCare (Hill House) are rapidly gaining market share with each holding c.15% and 10% of the Chinese market respectively. Their success can be attributed to several factors including (i) effective branding, (ii) customer education, (iii) accessing the domestic consumer through online channels (>50% of sales occur online). There are many original local and ‘copy-cat US’ brands which are challenging the status quo. The scale of competition, however, is enormous and can be experienced first-hand at the annual Shanghai Pet Fair, the largest pet forum in Asia.

Trends are changing fast, and increasing competition could pressure returns

All the current key trends to note point to increasing competition and lower returns. These include consumers migrating to the centre of the eco-system, with retailers no longer controlling the brand discovery or consumer education. Distribution channels are shifting from mass retail to online enabling lower prices and increasing competition. Finally, online retailers are now also launching their own brands (e.g. Amazon’s Wag), and manufacturers are growing direct to consumer sales through new product and service models.

The highly competitive nature of the market is evidenced by the increase in acquisition multiples over the last few years. Multinational F&B companies typically trade at public multiples c.12-14x EBITDA; however, pet food M&A in 2018 alone has achieved multiples in excess of 25x EBITDA. There are few listed pet food comparables beyond Fresh Pet in the US which currently trades at 6x revenue; however, Gambol and Bridge PetCare are rumoured to be exploring China A-Share listings next year which would set a key precedent for Chinese branded pet food valuations (the sky is the limit). Beyond the financials, consumers are now highly educated around ingredients and manufacturing processes, increasingly demanding higher quality foods and more advanced processing techniques (e.g. freeze-dried). Both factors are leading to lower margins, and lower returns as price competition remain high. Sales channels are also evolving, with ‘delivery-only’ business models (e.g. competing heavily against traditional and specialty retail. Investors in the pet food space must take note the spotlight is on, and competition is intense.

What’s the next big thing in pet?

The changing nature of competition will continue to drive consolidation in the core pet food and vetmed categories; however, the relatively nascent but rapidly growing adjacencies may provide “hidden in plain sight” opportunities for investment. These adjacencies include other food categories, for example, specialty cat food (currently dominated by traditional Japanese brands), pet technology (a sector in early-stage growth), and pet services (a highly fragmented industry) including training, boarding/hotels, grooming, hydrotherapy, and on-demand vetmed treatments/supplements. While it’s impossible to forecast the future, cat and dogs have been with humans for thousands of years and over time their influence on our lives has only ever increased

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