My first reaction to seeing that Petco (ticker WOOF) was coming public was ‘here we go again.’ This name went public in 1994 and 2002, and then was bought pre-IPO by current owners in 2015. A perennial PE fan-favorite that doesn’t seem to want to go away. I figured that the company was coming public just like Academy (ASO) did – simply bc Covid created a nice headline comp acceleration making it easy to sell stock into. But after doing the work on the name and building a model, I think this time is different. The primary owner of the name is the Canadian Pension Board – not the typical ‘milk for cash’ PE investor that traffics in LBO’d retail names. CPPIB and CVC Capital actually invested in leveraging the store base over the past two years and was well on its way to creating an investable story pre-Covid – with accelerating comps even before the pet category exploded to the upside. The company is now far more tied into the full pet ecosystem – from vet, to services, to the traditional pet food/treats/toys model that it dominated in the past before Chewy started to take over the category. It is actually now a different company with a far greater reach – hence the name change to Petco Health and Wellness Company. The debt level and bloated store base are the elephants in the room. But this model looks investable from where we sit.
- Deal Specs: The company plans to list its 48mm shares at $14-$17 per share, which could result in north of $800mm in proceeds and value the entity in the vicinity of $4bn. Post IPO, the company would still be controlled by the current owners – CVC Capital and the Canadian Pension Plan. Per the filling, most of the proceeds will be used to pay down debt – which is a positive, bc WOOF is currently sitting on $2.7bn in debt – a nearly insurmountable debt burden for any retailer with a mature store base (1478 stores – arguably too many). Pro-forma debt is closer to $1.8bn, with the free cash flow to systematically reduce debt driving ~500+bp in incremental EPS growth above the rate of EBIT growth.
- Favorable Industry Backdrop: The pet category was attractive pre-covid, with 1% growth in the pet population each year, and 4% increase in per capita spending. That got turbocharged with covid, as pet adoptions surged to 4% while people sheltered-in-place. This creates an 8-10 year secular tailwind for the number of pets that need to be fed, groomed, and vaccinated. Go-forward growth is shaking out at ~7% for the $100bn category – at the same time the shift to online consolidated the ‘mom and pop’ end of the industry. Even chains as large as Pet Value (358 stores in the US) recently announced it’s shuttering all operations. There’s likely to be more consolidation at the low end of the pet food and services category.
- One Stop Shop: WOOF is the only major player in the industry that is literally a one-stop shop for everything pet-related. While in many respects it will have a problem competing with CHWY’s cost structure and scale, WOOF has scale in a different regard – and that’s in its 1,478 stores. Does it need closer to 900? Probably – supported by the company’s vet build-out plans. But durations on leases are not egregious, making store attrition a reasonable goal such that it is left with a portfolio of only the highest quality locations. Using stores as fulfillment centers for growing e-comm business – so we’re not sure how aggressive the company will be in closing doors. Sort of stuck between a rock and a hard place in this regard.
- Offering Fully-Integrated Pet Care Ecosystem: Offers premium pet products, services (grooming, training, boarding), the fastest growing vet/clinic/hospital business in the country – all based in existing stores. Also offers tele-vet services and pet insurance. A step ahead of CHWY in many regards, though the fact that CHWY is catching up here in the services arena is a somewhat daunting reality to face for anyone competing in the space.
- E-comm: 20% of the total business today, and growing 30% pre-covid – 100% during the pandemic. Not apples to apples vis/vis the 40% numbers being put up by CHWY and AMZN as WOOF is including BOPIS in its digital numbers. Also, this business will naturally be a gross margin pressure – likely to the tune of 500bps as it will be more competitive with the AMZN and CHWY, which aren’t saddled with WOOF’s expensive legacy infrastructure. But there’s been an 11% improvement in GM on e-comm over the past year, which is a move in the right direction. WOOF has a former leader in WMT’s e-comm business running its digital initiative. Good pedigree there… Like WMT, WOOF also has the benefit of having a huge store base to facilitate same-day delivery. It’s not there yet, as will need more final mile delivery assets. But its closer to same day than CHWY and AMZN are.
- Vet Business: $27bn TAM with 80% of the marketed fragmented by independent practitioners. Currently has ~100 vet locations in its ~1,500 store base. Plan is to add 60-70 per year to get up to 900 in the future. That 900 figure is important – and any location worth keeping is worth having a vet center. But it’s our sense that anyone using a vet center at a Petco store will be extremely loyal to the store for food, supplies and and/all services offered at the ‘one stop shop’. The addition of a vet center at a store has resulted in ~600bp lift to sales in year 1 of the first 100 clinics. This vet build out in the face of outsized industry growth over the next 3-5 years is absolutely critical to the TAIL call here having any teeth.
- The Biggest Risk: If there are 600 stores not targeted to have a vet center, then they’re likely not worth keeping open under the existing model. That’s one of my main concerns. Too many doors with too much debt is not a recipe for big retail multiples – or at least leaves very little tolerance for an unexpected slowdown in growth.
- Stated Financial Model: Targeting MSD-HSD top line growth, HSD EBITDA growth, LDD EBIT, and high teens EPS growth. This assumes no net share gain given the category is growing at 7% per year. Current market share is ~5% of the total pet product/service industry in the US. Simply needs to maintain share to hit financial model, and current offering – especially the growing vet business – should allow the company to offset store closures, pressure from lower-cost-structure online, to hit and potentially exceed those targets.
- Valuation: The $14-17 pricing range suggests about 10-12x EBITDA, and 0.8x-0.9x TTM sales. The biggest thing WOOF has in its corner is CHWY – a fierce competitor – but one that is trading at 10x the pro-forma EV of WOOF and carrying nearly a 4x sales multiple. Huge competitor, huger valuation halo. It’s also been private three times, so there’s definitely a p/e premium we have to bake in. But also then need to net out the discount for current owners to sell more stock over the next few years. We look at other strip-mall based specialty retailers such as DKS BBY that are trading at 6-8x EBITDA. Given the recent positive shift in secular tailwinds – WOOF definitely deserves something well above that. Would we give it an ULTA multiple of 22x EBITDA? No way – ULTA is a more defendable model, and it doesn’t have two major competitors that are successfully consolidating the online portion of its core market (AMZN and CHWY). Netting out all these factors we think something closer to 13-14x FY22 (Jan) EBITDA of $440mm is about right. That’s an EV of about $6bn, or an equity price of $28-$30 per share.
Bottom line: We’re buyers of the deal on the stated range, and even if it trades up on the day, would be buyers into the low-mid $20s.
-- McGough
