Why The Smart Money is Betting Billions On PetSmart

Taking PetSmart private in one of the largest LBO's year-to-date may just be a prelude to a larger merger deal.

PetSmart has been called to heel. The pet supplies giant agreed to be taken private by a group of investors led by PE firm BC Partners in a deal valued at $8.7 billion, or around $83 a share.

Ever since activist investor Jana Partners put PetSmart on a leash in July and demanded it put itself up for sale, it became a matter of when, not if, a deal would happen.

Leader of the packSeveral hedge funds were sniffing around the pet supplier, and a number of analysts had put a fair price on PetSmart's stock in the low $70 range. Most notable of potential acquirers was Apollo Global Management, which was expected to offer about $80 per share, so BC's much higher offer representing a 39% premium from when talk of strategic alternatives first began seems to be an effort to keep others from barking up this particular tree.

Prior to Jana agitating for change, PetSmart was on a not-so-slow ride down. It's stock had fallen from a high of $77 a share all the way down to $55, a near-30% slide from peak to trough.

PETM data by YCharts

PetSmart's lackluster resultsSales have been slowing for PetSmart. Revenues that had been growing at mid-single digits in for the past few years slid to just 1% to 2% over the past few quarters. Comparable sales growth also turned negative and only managed to come even with the year ago period in the third quarter.

While analysts had been looking for 2% revenue growth this year and 3.5% growth in 2015, earnings expansion would be muted and PetSmart's expected long-term growth rate of 11% is almost half the rate it had achieved over the previous five years.

The problem for PetSmart has been increased competition. Along with rival pure-play retailer Petco, mass marketers like Wal-Mart and Target have expanded their pet supply offerings challenging the retailer whose prices Jana said often ran 15% to 35% more than the competition in certain markets.

And Amazon.com is perhaps the top dog to watch.

PetSmart lagged behind development of an effective e-commerce platform, belatedly hiring a dedicated executive to manage its digital platform until just this year. That neglect was one of the primary reasons Jana Partners was looking to shake up the pet supplier's sclerotic management team.

Hot on the scentIt's also likely the cause of online-only pet e-tailers gaining traction and attention. According to a study byMillward Brown Digital, therelative ease of entry into the online market has led to a veritable explosion in competition. And shoppers are noticing, as they're cross-shopping both PetSmart's and Petco's online stores with Amazon's and other e-tailers.

Millward Brown found that over the past year consumers doubled the number of times they shopped PetSmart's site then shopped Amazon's.

Tail wagging the dogPetSmart has essentially been besieged from all corners. On the one hand it has a customer base of loyal pet owners (or "pet parents" as they like to refer to themselves) who've humanized their pets and pushed the premiumization of dog foodto its limits. Many industry watchers feel that trend has now reached its apex.

On the other hand though, PetSmart is confronted with a stable, but mature industry. The American Pet Products Association says consumers will spend more than $58.5 billion on their pets this year, a 5% increase from 2013, just slightly above last year's 4% rise but still in line with the overall trend lower.

In PetSmart's favor is a climate pushing for consolidation. Earlier this month I highlighted the rollup continuing in pet supplies that has been running strong for at least the past two years. PetSmart itself bought online retailer Pet360 to fend off further inroads being made by Amazon.

But few deals are bigger than BC Partners' leveraged buyout offer for PetSmart, though the size of the debt-financed portion of the deal remains unknown at the moment.

Last week when Apollo Global appeared poised to win the bid with an $8 billion offer, its financing package valued PetSmart at 6.5 times its earnings before interest, depreciation, and amortization, an amount apparently in excess of Federal Reserve guidelines mandating LBOs no greater than six times EBITDA. Banks backing such a deal could face stricter regulatory oversight, including requiring them to hold more cash or cut their dividends.

Sit, stay ... now rolloverWhile PetSmart's management has agreed to BC Partners offer, investors still need to vote on the buyout and if successful the new owners will need to figure out a way to turn around the pet suppliers' stagnating growth.

The ultimate endgame may be the eventual merger between PetSmart and Petco, which is owned by PE firms Leonard Green & Partners and TPG Capital Management. Out of the public eye, that might be an easier deal to swing.

The article Why The Smart Money is Betting Billions On PetSmart originally appeared on Fool.com.

Follow Rich Duprey's coverage of all the retailing industry's most important news and developments. Heowns shares of Pfizer. The Motley Fool recommends Amazon.com and PetSmart. The Motley Fool owns shares of Amazon.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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