The Pet Food Bombogenesis

"Bombogenesis" occurs when a midlatitude cyclone rapidly intensifies, dropping 24 millibars (atmospheric pressure) within 24 hours. The changes in weather are quick, big and, at times, devastating. I couldn't think of anything that better describes what is happening right now in the pet industry. Last week's acquisition of Ainsworth by J.M. Smucker (SJM) came right on the heels of General Mills purchase of the Blue Buffalo Company and is, I fear, a harbinger of things to come. I've already given my views on the General Mills deal so I'll dedicate this space to my thoughts on the SJM purchase and what it may mean to the industry.

When the initial news broke, I thought the 12x EBITDA was "interesting" because 15x had been a pretty good historical marker on these types of acquisitions. I thought it was interesting because Ainsworth, in my humble opinion, is one of the best manufacturers in pet food today and 12x seemed to be undervalued. Just as a reminder, General Mills paid 25x EBITDA (6.3x Sales) for Blue Buffalo. Fortunately for me, Bryan Jaffe of Cascadia Capital explained that the "proper math" put it closer to 22x (2.4x Sales). Just to be clear, I believe this is a fantastic purchase for SJM. As for the industry at large and for the consumers themselves, it makes me a little nervous. With the acquisition of Ainsworth (~90% of which is the Rachael Ray (RR) line), SJM has doubled their share in the dry dog category to 17% putting it in 3rd position (in the USA) behind Nestle's 40% and Mars' 24% share. In doing so, it also firmly cements SJM in the "natural/premium" segment with offerings spanning the entire spectrum of price points. With their recent entry into PetsMart, the RR lines are poised for potentially significant share growth as they have lowered the entry price in to the "natural" segment. As part of the sale, the Frontenac, Kansas (acquired when Ainsworth purchased Triple T) and Meadville, Pennsylvania manufacturing facilities are part of the sale to SJM but NOT the other two Ainsworth production facilities which are "primarily" used for co-manufacturing of other brands. In separating the plants, SJM has picked up significant capacity and production capabilities while not having to take on the margin dilutive co-manufacturing responsibilities.

So what's not to like about the deal? The multiple!! Don't get me wrong, I'm not blaming companies for selling at 22x and 25x...hell, I hope to do the same someday. The problem is that the financial pressures (and associated courses of action) that both the staging and selling creates while pursuing these multiples are problematic for the long term health of the industry. In 2017, Blue Buffalo reported a sales growth of 10.9% but a net income increase of 48.6%. All signs lead me to believe that the growth of their net income came at the expense of innovation and R&D. The old adage of "Innovate or Die" still holds true. While profits soared and multiples climbed, Blue discontinued significantly more SKUs than they introduced, leaving the acquisition of new customers at risk. How long will it take, and at what cost, before General Mills reinvests in to the Blue innovation pipeline?

SJM's EBIT was estimated at 22% whereas Ainsworth was estimated at 9%. The Ainsworth financials will improve after the co-man is shed but even if it were to double against the roughly $750 million in sales, their profit position improves by $65 million. With the $1.8 billion purchase price, that is a long road to ROI. To find "synergies," they will find production and sourcing savings but the gap is large enough that headcount has to be "in play" in order to make it work. There were about 700 Ainsworth employees at the time of the acquisition and I would guess that at least 80 won't make it through the full transition. Innovation and other "investment" expenditures suffer when a company prepares to sell and after the sale is completed. Ingredients, advertising, people and R&D all take the hit. Often times the higher the multiple, the deeper the cuts that are needed.

The pet food industry has had incredible growth and is projected to have a 4% CAGR through 2022. The final numbers for 2017 showed a GROWTH of $3 billion; almost reaching $67 billion in sales across all categories. The industry has often been called "recession proof" and "highly profitable" but there are a few storm clouds on the horizon. If we aren't careful, we could be creating our very own Bomb Cyclone.

CREATING THE PERFECT STORM

Large CPG companies are buying into pet, NOT necessarily to improve the lives of pets so much as to improve their own profitability. Pet is a big industry with significant profit margins. When "crazy" money multiples come in to the market, the new owners have to find (or create) balance to justify the expenditure. In pet, this often leads to 1) higher prices 2) smaller package weights and 3) lower cost ingredients. Customers and the pets themselves are the ones that lose when this happens.

As the pet, and pet owner, demographics change we as an industry will be faced with new challenges. How we respond to the wants and needs of our costumers and consumers (pets) will determine the longevity and "self rule" of our industry. I've said many times that the world of pet food marketing is running rampant with a "wild west" mentality. Between fear mongering and error filled packaging and marketing claims, customers are getting confused...and angry. When prices go up and clarity evaporates, oversight and intervention is usually right around the corner.

Today, four pet food manufacturers in the US account for more than 70% of sales. While they have over 100 brands to offer at varying price points, they dominate the industry and create the general "rules of engagement" for all participants. When I hear pet owners decry the "Big Pet" brands and then tell me what they feed, I laugh when I get to tell them that they are owned by the same company. As ownership of pet companies becomes more and more consolidated (look at the full Mars pet portfolio as an example), risk and fear grows.

SUMMARY

I love this industry! I have been in it for 25 years; I have left it, returned to it and cursed its very existence more than once. The impact of General Mills and SJM's recent acquisitions won't be known for some time. The impact of PetsMart's Chewy acquisition is starting to play out and the storm cloud that is Amazon is taking shape. If we aren't careful as an industry, we will lose the faith of those that enrich us and, in turn, we will no longer be able to effectively enrich the lives of pets. In an even more pessimistic opinion, if we don't self-regulate our industry, a governing body will. I'm not asking for pet care to experiment in Socialism, just for us to be more cognizant of the future reactions that our decisions today will create. Early in my career Al Bates succinctly explained market pricing with this statement, "Pricing is determined by the stupidest person in the room!" I can see the t-shirt now...