What Happens if Petco and PetSmart Merge?

With rumors swirling of a potential merger between pet retail titans PetSmart and Petco, the pet industry is left to ponder the chances of such a union, and the possible implications for everyone else.


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Imagine the year is 2020. A merger between PetSmart and Petco has been in the rearview mirror for a few years now, and the newly formed big-box retailer, operating under the PetSmart moniker, has finally finished restructuring its unified organization. This vast undertaking included the closing of a few hundred locations, the removal of numerous back-office redundancies, and a major reset of the remaining stores’ product offerings. Now streamlined, the company is gearing up to grow its business, largely by focusing on services and smaller-format stores—two areas in which the combined big-boxes were having the most success prior to the merger.

This picture may not be too far-fetched if the rumors of a possible merger between PetSmart and Petco that emerged this fall actually come to fruition. But what would the rest of the pet specialty retail landscape look like after such a merger, and what would the impact be on the industry’s vendors and distribution network? While that picture is a bit murkier, what is clear is that the effects would reverberate across all levels of the pet care market. After all, even though the big-box retailers do reside in their own stratosphere, they certainly do not operate in a vacuum.

Of course, a merger between PetSmart and Petco is not a forgone conclusion. In fact, many experts in both the pet industry and the world of investment banking have expressed serious doubts about the likelihood of such a deal being realized, at least in the short term. “I put the odds [of a merger taking place right now] as low,” says Bryan Jaffe, managing director at Cascadia Capital, an investment bank headquartered in Seattle. “I see a number of incumbent structural barriers to a deal.

“One is that you have two private-equity firms engaged in this combination, both of which operate at the top of the food chain. The Leonard Greens and TPG Capitals [Petco’s private-equity investors] are not in the business of selling their companies to other private-equity firms; they’re in the business of taking them public or selling them to large strategic acquirers. So, on some level, this would be a comedown for them, and as a result, I think they would be reasonably unyielding with respect to risk sharing around the transaction.”

Another barrier to a potential merger is the fact that PetSmart’s ownership (a consortium led by European private-equity firm BC Partners) is relatively new to the pet retail market, having bought the company earlier this year for a reported $8.3 billion in one of the largest deals it has ever executed. “The prospect of leveraging that asset even further or writing another equity check, I think, has a certain level of unattractiveness, which will make them desirous of limiting their downside risk—especially regarding anti-trust and a breakup fee,” says Jaffe.

By all accounts, the anti-trust wrinkle that Jaffe refers to could prove to be a significant impediment to a potential marriage between the two big-box pet specialty retailers. If the Federal Trade Commission (FTC), which has the authority to regulate such combinations, deems the merger as suppressive to fair competition in the marketplace, it could require major concessions—such as excessive store closings or a post-merger sale of one of the retail brands—that would ultimately make the deal unattractive.

The key here, say the experts, is how the FTC would define the scope of the marketplace in which Petco and PetSmart do business. If regulators use a broader perspective and count food, drug and mass retailers, as well as online outlets, within that scope, intervention seems far less likely than if they were to narrow their view to just the pet specialty channel, where most estimates put the big-boxes’ market share at upwards of 50 percent.

Even the most seasoned observers in the pet industry and investment community can only speculate on which direction the FTC would go in defining Petco and PetSmart’s marketplace, but Jaffe says it may hinge on the pet food brands that are found on the big-boxes’ shelves.

“What is unique about the pet industry is that it has certain channel barriers, in that there are channel-exclusive products,” Jaffe explains. “This is really how Petco and PetSmart have established their market presence and their leadership position. While there certainly are equivalent competing products available in other retail channels, I don’t necessarily believe that they are a direct substitute [for pet specialty-exclusive brands]; the quality of pet food that you can buy in a Petco or PetSmart is superior to that which you can get in a Walmart or supermarket.”

The bottom line is that if the FTC looks at a Petco and PetSmart merger with the belief that premium and super premium pet foods are inherently different from mass-market pet foods, there is a good possibility that it will view the deal as creating an untenable level of market share concentration. As a result, concessions will almost surely be required. Apparently, Petco and PetSmart also believe that there is a good chance that their combination would be viewed through this prism. As of press time, the two companies had reportedly broken off merger discussions due to complications resulting from concerns about FTC intervention.

To Carol Frank, managing director at MHT MidSpan, a Dallas-based investment bank, it is hard to imagine a deal being executed anytime soon with all of the dynamics working against a potential merger. “I’ve had a lot of conversations with folks in the industry, including many of the larger manufacturers, and based on everything I’ve heard, this [merger] is highly unlikely to happen,” she says.

However, even if the big-boxes do not end up back at the negotiating table in the near term, it would be a mistake to believe that this is a dead issue. Given the forces at work both inside and outside the pet industry, it is almost inevitable that the idea of a merger between the pet specialty retail giants will come up again in the not-so-distant future.

“I think there is inherent logic for a combination,” says Jaffe. “The reason that this is even being contemplated is because the independent retailers are growing disproportionately faster than the major specialty players. That is basically driving slower growth and making the shareholders contemplate consolidation. Right now, I think it is just a matter of risk sharing [that is holding up a potential merger].”

While Petco does have alternative options, such as a sale to another private-equity firm or going public, there are factors that could ultimately impede the company from going in either of these directions. “If interest rates go up, it will undermine the potential for a private-equity deal, and if the capital markets remain volatile, the attractiveness of going public dissipates,” says Jaffe. “So, if those two factors [come into play], I think, long term, it ends up putting the two together.”


Deep Impact
Whether it is executed next week, next year or a few years from now, a merger between PetSmart and Petco would surely have implications for everyone in the pet specialty channel. However, whether the combination can ultimately be viewed as a positive or a negative development depends on one’s position in the supply chain. According to many industry experts, the companies most likely to be negatively affected by a merger between PetSmart and Petco are pet product manufacturers.

“I think it would be very bad for the manufacturers in the pet industry,” says Frank. “The golden ring for manufacturers is to sell to Petco or PetSmart, or both. To get to any size or substance in the pet specialty market, you’re going to have to sell to at least one of them. And a merger would bring your chances down significantly.”

According to Frank, a merger between the two big-box pet retailers would also seriously impact manufacturers’ ability to draw interest from an investment community that has, so far, been quite focused to the pet care industry. At play here, she says, are the dynamics between customer concentration and company value. “If you’re a manufacturer that does 25 percent of your business with Petco and 25 percent with PetSmart, and all of a sudden you now have one company representing 50 percent of your business, the value of your business is going to decline because customer concentration drives down the value of companies,” Frank explains.

Jack Drasner, president of sales and marketing firm PRISM Sales, also sees a potential merger of PetSmart and Petco as a losing proposition for most pet product manufacturers, as the combination would be able to wield an overwhelming amount of leverage against vendors. “There will be no one else to go to that has that type of size and scope,” he says.

As a result of this enhanced leverage, manufacturers that want to do business with the combined chain will likely face significant pricing pressure—a development that could also end up having a decidedly negative impact on other retail players in the pet specialty channel. While it is well-known within the industry that both Petco and PetSmart have historically favored high margins that often allowed independent retailers and regional chains to stay price competitive, a combined chain could use its enhanced size to separate itself from the rest of the field.

“What worries me as a distributor servicing the independents is that this could give [the combined Petco/PetSmart] an unfair advantage in pricing,” says Bob Merar, president of General Pet Supply, a pet specialty distributor based in Milwaukee. “They would be so much bigger that they could pool their resources and get manufacturers to give them additional discounts because their volume would go up.”

Retailer Michael DiTullio, however, is not worried about the pricing structure that could result from a merger of the two big-box pet chains. “In fact, I think they would probably raise prices,” says the president of Especially for Pets, a Newton, Mass.-based pet store chain that operates seven locations in Massachusetts. “Petco gets better margins than PetSmart, and the bigger corporation would probably [follow that model].”

If DiTullio is correct, pricing may represent one of several areas in which a merger between the big-boxes could prove beneficial to independent pet retailers and regional pet specialty chains. Another revolves around product selection. Many industry experts predict that some brands currently stocked in the big-boxes will inevitably end up on the outside looking in as the big-box operators aggregate their product selection.

“I think it squeezes out some of the manufacturers on that level,” says Roman Versch, president of Pet Depot, a Glendora, Calif.-headquartered pet store franchise that currently has 42 locations, noting that these manufacturers will find that the rest of the pet specialty channel is fertile ground for the growth of their brands.

Al Puntillo, chief merchandising officer for Mud Bay, the 30-plus pet store chain based in Tumwater, Wash., agrees that as manufacturers end up getting squeezed on pricing or outright pushed off of big-box shelves as a result of a merger, opportunities will arise for independent retailers and regional chains. “I believe it would remind the manufacturing community of just how important it is to keep their business diversified, and we would most likely see additional sales support and funding from manufacturers flowing into the independent channel,” he says.

Drasner agrees, noting that this could be a boon to other pet specialty retailers. “If the brand assortment in the big-boxes goes down, the regional chains and independent retailers will have an opportunity to really differentiate themselves and innovate,” he says. “And this will increase their chances of doing well.”


Core Incompetency
Service is another area in which independent retailers and smaller chains could benefit from a merger between Petco and PetSmart. As many experts point out, neither of the big-box operators can count customer service as a particular strength, and there is no reason to believe that a larger, combined entity would be any better at it. “The big-box experience is heading more toward self-service,” says Versch. “And that gives us, as the mid-level marketers, the opportunity to really focus on the customer experience.”

According to Puntillo, this focus on delivering a high level of service will be key for independents and specialty chains in the face of competing with a bigger, more cumbersome national big-box player. “My best advice to retailers is to stay focused on their customer experience and ensure that when disenfranchised customers come calling, they can absolutely knock their socks off,” he says.

However, it is important to remember that the same dynamics that will favor independent retailers could also open the door to a national reach for some of the channel’s quickly expanding chains, many of which have their own considerable private-equity funding behind them. Pet Valu, Pet Supplies Plus and Pet Sense are among the chains often cited as being the most likely candidates for such a move.

“Long term, the closure of any Petco or PetSmart stores that might result from the merger would create some opportunity for independents, but it could also create opportunity for a new national chain to try and fill that void,” says Puntillo.

To Frank, the potential for a new national player to step into the void created by a big-box merger is clear, and such a development would ultimately be a good thing, at least for manufacturers seeking investors. “It would give a No. 3 or 4 player an opportunity to step up and become that No. 2 player, and hopefully that would level the playing field and spread out the risk of having so much customer concentration,” she says.

Of course, the evolution of a national chain that can balance out a combined Petco/PetSmart would take some time, even with the deepest pockets behind the scenes. So, in the short term at least, the deal looks like a great opportunity for independents, even if it is just a matter of capitalizing on the general confusion that such a deal could create among the pet specialty channel’s customer base. “This merger would initially be good for the independent channel, as there will undoubtedly be chaos and dysfunction surrounding it for both Petco and Petsmart,” says Puntillo.

DiTullio agrees with this assessment and says bring it on. “Petco and PetSmart would be merging two very big companies, which is going to create mass confusion, mass disruption, and that is going to create opportunities for independents,” says DiTullio. “I hope they do it.”

 

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