We'll Discuss Petco on Sunday...
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Midweek Freemium Briefing - 4/18/18
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News of the Week (2 Reads)
DO. NOT. MESS. WITH. DAISY. CHAPTER 1 of 3 (Short Pet Suppliers) 🔫
We have covered a lot of ground since our inception and, for the most part, the path has been trodden with depressing stories of disruption and destruction. The root causes of that run the gamut - from (i) Amazon ($AMZN) and other new-age retail possibilities (e.g., resale and DTC DNVBs) to (ii) busted PE deals to (iii) fraud and mismanagement. Through it all, nothing has really gotten us too fired up — not the hypocrisy surrounding Bank of America’s ($BAC) loan to Remington Outdoor or the hubris around Toys R Us. But, once you start effing with our dogs’ diets, that’s when we have to start getting all-John-Wick up in this mofo.
Enter PFS Holding Corp., otherwise known as Phillips Pet Food & Supplies (“PFS”). PFS is a distributor of pet foods, grooming products and other useless over-priced pet gear. It is private equity-owned (sponsor: Thomas H. Lee Partners) and has $450+ million of LBO-vintage debt spread out across a recently-refinanced $90 million revolving credit facility (pushed to 2024 from January 2019), a cov-lite ‘21 $280 million term loan, and a cov-lite ‘22 $110 million second lien term loan.
The company recently got some breathing room with a freshly refi’d revolver but still has some issues. While quarterly sales increased in Q4 from $293 million to $327 million, gross margins were down — a reflection of price compression. EBITDA was roughly $62 million on a consolidated adjusted basis clocking the company in at right around a 7.4x leverage ratio. The ‘21 and ‘22 term loans both trade at distressed levels, reflecting the market’s view of the company’s ability to pay the loan in full at maturity. Upon information and belief, the new revolver includes a 90-day springing maturity which means that the company is effed if it is unable to refi out the term loan prior to its maturity (which, admittedly, seems lightyears away from now).
All in, S&P Global Ratings appears to think that the Force is weak with this one; it issued a corporate downgrade and a term loan downgrade of the company on April 10, 2018. Why? Well, S&P doesn’t pull any punches:
“The downgrade reflects our view that, absent significantly favorable changes in the company’s circumstances, the company will seek a debt restructuring in the next six to 12 months, particularly given very low trading levels on its second-lien debt, between 30 and 40 cents on the dollar. It also reflects our view that cash flow will not be sufficient to support debt service and maintain sufficient cash interest coverage, resulting in an unsustainable capital structure. We forecast adjusted leverage in the mid-teens. PFS recently lost a substantial portion of business with one of its largest customers, which we believe represented over half of the company’s EBITDA. Management implemented several cost savings initiatives last year, but we do not believe savings achieved will be sufficient to offset this dramatic profit loss. Further, we expect the company will continue to be pressured by a secular decline in the independent pet retail market, which we view as PFS’ core customer base. Independent pet shops continue to lose market share to e-commerce and national pet retailers, as consumer adoption of e-commerce for pet products purchases grows.”
There’s a lot there. But, first, who writes these dry-as-all-hell reports? If any of you has a connection at S&P, consider putting us in touch. We could really spice these reports up.
Here’s our take:
“The downgrade reflects the fact that this business is turning into garbage. The company was hyper-correlated to one buyer, is over-levered and is, in real-time, succumbing to the cascading pressures of e-commerce and Amazon. In the age of the internet, nobody needs a distribution middleman. Particularly at scale. The lost customer reflects that. Godspeed, PFS.”
Just saved like 1,382,222 words.
S&P further predicts a double-digit sales decline and negative free cash flow in 2018 and 2019, “with debt service and operating expenses funded largely with asset-backed loan (ABL) borrowings.” Slap a mid 5s multiple on this sucker and it looks like the first lien term loan holders will eventually be the owners of a shiny not-so-new pet food distributor! Dogs everywhere lament.
DO. NOT. MESS. WITH. DAISY. CHAPTER 2 of 3 (Short Pet Retailers) 🔫🔫
On this day exactly one year ago, Recode first reported that Petsmart acquired Chewy.com for $3.35 billion — the “largest e-commerce acquisition ever.” Venture capitalists — and the founders — of course, rejoiced. This was an a$$-kicking exit — particularly for a company that, at the time, was only six years old. The reported amount of venture funding topped out at $451 million, a massive sum, but sufficiently low enough for the VCs to make a substantial return. Recode wrote,
“The deal is a huge one by any standard — bigger than Walmart’s $3.3 billion deal for Jet.com last year — and especially for a retail company like PetSmart, which was itself valued at only $8.7 billion when private equity investors took it over in 2015.
But Chewy.com has been one of the fastest-growing e-commerce sites on the planet, registering nearly $900 million in revenue last year, in what was only its fifth year in operation. The company had been a potential IPO candidate for this year or next, but was taken out by its brick-and-mortar competitor before that. It was not profitable last year.”
“The deal seems like the type of bet-the-company acquisition by a traditional retailer that commerce-focused venture capitalists have been betting on for some time. While Walmart’s acquisition of Jet.com was a huge deal by e-commerce standards, it represented just a fraction of Walmart’s market value.”
Toss of the dice notwithstanding, most talking heads seemed to think that the acquisition made “strategic sense.” Nevertheless, Recode’s sentiment was more prescient than they likely suspected — mostly due to the havoc it has wreaked to Petsmart’s cap stack.
The company financed the purchase with a two-part debt offering of (a) $1.35 billion of ‘25 8.875% senior secured notes and (b) $650 million of ‘25 5.875% unsecured notes. Rounding out the capital structure is a $750 million ABL, a $4.3 billion cov-lite first-lien term loan and $1.9 billion cov-lite ‘23 senior unsecured notes. Let us help you out here: 1+2+3+4 = $8.2 billion in debt. The equity sponsors, BC Partners, GIC, Longview Asset Management, Caisse de dépôt et placement du Québec and StepStone Group, helped by writing a $1.35 billion new equity check. So, what did all of this financing lead to?
One year later, CEO Michael Massey is gone and hasn’t been replaced. More recently, Ryan Cohen, the CEO and co-founder of Chewy.com has departed. Blue Buffalo Pet Products Inc., which reportedly accounted for 11-12% of PetSmart’s sales, opted to supply its food products to mass-market retailers like Target ($T) and Kroger ($KR). The notes backing the Chewy.com deal are trading (and have basically, since issuance, traded) at distressed levels. Petsmart’s EBITDA showed a 34% YOY decline in Q3. And, worse even (for investors anyway), the bondholders are increasingly concerned about asset stripping to the benefit of the company’s private equity sponsors. S&P Global Ratings downgraded the company in December. It stated,
“The downgrade reflects our view that the capital structure is unsustainable at current levels of EBITDA, although we do not see a default scenario over the next year given liquidity and cash generation. Such underperformance came from the company's rapid e-commerce growth that generated higher losses, and unanticipated negative same-store sales at its physical stores. As Chewy aggressively expands its customer base, we believe operating losses will widen because the company has not yet garnered the size and scale to offset the unprofitable business volume from new customers.”
Financial performance and ratios were a big consideration: margin is compressed, in turn negatively affecting the company’s interest coverage ratio and leverage ratio (approximately 8.5x).
Moody’s Investor Service also issued a downgrade in January. It wrote,
“We still believe the acquisition of Chewy has the potential of being transformative for PetSmart as it will exponentially increase its online penetration which was previously very modest. However, as Chewy continues to grow its topline aggressively and incur increasing customer acquisition costs we expect its operating losses to increase. More importantly, the increasingly competitive business environment particularly from e-commerce and mass retailers has led to increased promotional activity which has negatively impacted PetSmart's top line and margins. We expect this trend to continue in 2018.”
“Buying Chewy.com was supposed to be a coup for PetSmart Inc. For debt investors who funded the deal, it’s been more like a dog.”
See what they did there?
With 1600 stores, the company isn’t light with its footprint and same store sales and pricing power are on the decline. Still, the company’s liquidity profile remains relatively intact and its services businesses apparently still drive foot traffic. Which is not to say that the situation doesn’t continue to bear watching — particularly if Chewy.com’s customer-acquisition-costs continue to skyrocket, overall brick-and-mortar trends continue to move downward, and the likes of Target ($T), Walmart ($WMT) and Amazon ($AMZN) continue to siphon off market share. A failure to stem the decline could add more stress to the situation.
💥We’ll discuss Petco Holdings in “DO. NOT. MESS. WITH. DAISY. CHAPTER 3 of 3 (Short Pet Retailers 2.0) 🔫🔫🔫” in our Members’-only briefing on Sunday.💥
Notice of Appearance
PETITION: What is the best piece of advice that you’ve been given in your career?
“Always be the most prepared. Period. Whether it is a call, meeting or court appearance, be the most prepared person there. This piece of advice is something I do not forget and pass on.”
PETITION: What is the best book you’ve read that’s helped guide you in your career?
“A Civil Action. It was a requirement to read heading into law school and I went back and read it again years later. It teaches that one lawyer can ultimately make a difference. It also speaks to, and without question demonstrates, the high stakes and personal commitment the profession requires and demands. A must read.”
PETITION: What is the one product that helps make you a more efficient or relaxed pro?
“Wireless headphones. Airpods. But it really can be any wireless headphones at all.…”
PETITION: Cool. Anything interesting you’re listening to at the moment?
"Top hits on Spotify!”
PETITION Note: You’re one in (70) million, Josh!
PETITION: What is one notable trend you expect to see in ’18 that not enough people are talking about?
“Restructuring professionals spend lots of time these days talking about the retail, oil & gas and the healthcare sectors, with much less attention being paid to real estate (both commercial and multi family). While there is still a lot of capital in the market place, rising rates and lower rents may pressure this and cause dislocation later in the year.”
PETITION Note: We agree, Josh. We’ve been writing since our inception that the cavalier attitude that many players in the space have taken vis-a-vis the real estate sector is mistaken. If anything, the recent low price offered by Brookfield Capital Partners for General Growth Properties may be the canary in the coal mine for commercial real estate. Note also, this, relating to the liquidation of The Bon-Ton Stores:
A Message From:
For us, it wouldn’t be April unless we are in our nation’s capital meeting up with colleagues, discussing industry trends, and even sharing a few ‘war stories’ with friends at ABI’s 36th Annual Spring Meeting. Over the next few days, when you see us in an ABI ASM session or networking event – please be sure and say hello! Our team of accredited professionals will be there through Sunday, including Ted Gavin, Joe Solmonese, Amy Gavin, Anne Eberhardt, Stan Mastil, Ross Waetzman, Chuck Lewis, Jeremy VanEtten, and Judy Sacher.
Warren Buffett. Ray Dalio. Edward Thorp. Nir Eyal. Jeff Gramm.
It was clear from our survey results that people are hungry for a$$-kicking resources on the topics of finance, restructuring, tech, and disruption. We went ahead and started compiling a "reading list," of sorts for your benefit. You can find it here. This will be a growing list: if there are any resources that you think should be included, please let us know below.
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Vice President with 3-5 years of relevant experience. For requirements and other specifications, please click here.
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Lincoln International, a global investment bank specializing in M&A, restructuring, debt advisory and private capital raising, is seeking a Senior Associate or Vice President for its rapidly growing NY office. Candidates should have 6-10 years of experience. For other requirements and specifications, please visit here.
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