Consumers and pet businesses alike will soon have to figure out what their industry will look like without the world?s largest pet retailer. About two years ago PetSmart bought Chewy, now slowing sales and increased spending are taking their toll as the acquisition looks to be a strategic failure.
While BC Partners $8.7 billion leveraged buyout of PetSmart was the original sin, the addition of $3.35 billion in debt from the Chewy acquisition (which I wrote about here) saddled them with a debt load almost equal to the companies overall value. Any back of the napkin calculation would have clued PetSmart and BC Capital that Chewy would be no more than a drag on margins. Instead hubris and the need to make a flashy purchase ? the largest e-commerce acquisition at the time ? seems to have blinded them.
Most pet industry retailers have physically heavy food make up the majority of their revenue. Food as it turns out makes up the majority of sales throughout the pet industry with an estimated $29.88 billion coming from the segment in 2018. With the majority of PetSmart and Chewy?s sales being food this was bound to be a recipe for disaster. Chewy, which has never turned a profit, has much lower margins than its parent company due to the associated shipping costs with margins on food being especially low due to the disproportionate cost to weight ratio.
At a time when PetSmart needed to increase same store sales and boost margins it went in the opposite direction and purchased an unprofitable rival with lower margins. The result was predictable, the bottom fell out on margins and suddenly they weren?t generating enough sales. Since the acquisition, spending at Chewy has increased while sales have slowed. This points to a lack of direction and the absence of a plan for profitability.
More distressing is the lack of integration between both businesses. PetSmart and Chewy compete with each other for sales and many consumers don?t even know they are part of the same organization. Their cannibalistic competition has both retailers selling the same products at different prices. This results in there being little to no reported cost or structural benefits to either retailer two years later.
Further stressing the situation is the decline in sales at PetSmart. It seems competition from Petco and Amazon have leached potential customers and margins. At the same time Chewy?s marketing and advertising spending is up while sales are down pointing to possible market saturation.
How did this happen?
Most of these issue began in late 2014. BC Partners had no experience in the pet industry or US retail prior to their December, 2014 LBO of Petsmart. About a year and a half later in 2016 Walmart purchased Jet.com, the upstart eCommerce platform founded by Marc Lore. Lore was previously the founder of Quidsi, the company that owned Diapers.com and Soap.com before it was sold to Amazon. Jet?s edge was an algorithm that knew the exact weight and dimensions of each product. Jet was able to cross reference that data with the size and dimensions of their boxes and would be able to lower the per-item-cost per product by telling consumers which additions would be advantageous to the container their order would be shipped in.
Shortly after launch Walmart purchased Jet and made Lore the president and CEO of Walmart eCommerce US. Walmart got two things, an eCommerce platform built for inner city use (and available in NYC, a market they had never been able to open a location in) and one of the only people to ever bloody Jeff Bezos? nose. However, Walmart could not have done it without requiring Lore to sign a contract, something PetSmart and BC Partners overlooked when acquiring Chewy.
Less than a year after purchasing Chewy, Ryan Cohen the founder and CEO of the startup left and with him all the knowledge of how to build and manage an eCommerce operation. When Amazon acquired Quidsi Lore was required to stay on and work for Amazon a number of years. This is common practice in M&A and was recently put on display when Brian Acton and Jan Koum, the co-founders of WhatsApp, left Facebook and their remaining $1.3 billion payout.
All this points to a general lack of understanding at BC Partners and the executive leadership they installed at PetSmart. Shortly after the LBO Michael Massey was named CEO of the retailer. Massey went on to hire many of his colleagues from Payless Shoesource who he worked with while CEO of the now bankrupt and liquidating retailer. Massey has since left but much of the Payless leadership he installed still remains.
What next?
At this point there?s not much that can be done. PetSmart currently has over $8 billion in debt and can barely pay off the interest it incurs. Any attempt to restructure the company would be disruptive to the industry and require store closings, massive layoffs, or more M&A.
It?s important to keep in mind that BC Partners is a private equity firm and their main objective is to create a return for their investors. This leaves them with two options, Sears or Payless. In 2004 Kmart purchased Sears after exiting bankruptcy arguing both retailers had a better chance of surviving as one combined entity. On February 19th, 2019 Payless, which was also owned by a group of PE firms announced they were liquidating their entire North American operation.
BC Partners has a choice. When the debt is due they can ultimately choose to liquidate or merge with Petco. Petco was also purchased by a PE firm less than a year after PetSmart. Ironically, they was purchased after talks of a merger between the two retailers broke down.
Both CVC Capital Partners, which owns Petco along with the Canada Pension Plan Investment Board and BC Partners need an exit. Without a way to turn their investments into liquidity both PE firms will be in trouble. A merger between the two largest pet retail stores in North America might be splashy enough for them to make the case to go public. This would give both firms an easier exit through the public market and on paper make some sense.
Petco thus far has not been able to make e-commerce work in a meaningful way. While it can be argued that PetSmart hasn?t either a merger would allow them to close stores, layoff staff, purchase inventory at lower rates, and potentially share the fulfillment burden. This could create enough short-term positive cash flow to help pay off part of their debt and pave the way to an IPO while they?re on the upswing.
We won?t know anything for a while. Both retailers are private companies and don?t have to release the reports and guidance that?s required from their public counterparts. With time running out and cash in short supply PetSmart must be looking for a path. All we can do is hope they find one.
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