Friday, July 14, 2006

Buyout of Petco and its Impact on PETsMART

Petco (PETC) announced this morning that it was being acquired in a $1.8 billion offer from Leonard Green Partners and Texas Pacific. The $29 all cash offer represents a 49% premium over last night's close.

In a recent post, we had highlighted the superior operating and financial performance of PetSmart (PETM). Please see:

PetSmart versus Petco- The Debate

In this post, we had highlighted how concerns about value pricing strategies of Petco were impacting the valuation of PetSmart.

Interestingly, this is a bit of deja vue...the buyers are the same financial sponsors who had IPO'ed PETC in 2001 having purchased it two years earlier.

In my view, this is positive news for PETM. A major competitor, given its LBO capital structure, will have to be operated primarily for cash flow. Major capital expansion plans at Petco will likely need to be shelved, at least for some time. Typically, an LBO'ed competitor tends not to engage in pricing least not the kind that Wall Street feared.

Based on the metrics of the PETC deal (about 8.2 times EBITDA forecasts for 2006,) PETM would be valued at about $4.1 billion enterprise value, compared to last night's $3.3 billion valuation. On a per share basis, this translates to about $29 per share for PETM.

However, given the superior economics that PETM has demonstrated, the impact of PETM's remodelling program, as well as the expansion of its pets' services businesses, I believe there is substantial upside to PETM's operating margins and consequently, its valuation. Its major competitor has operated with a highly leveraged balance sheet after its first LBO. At that time (2001-2002) debt represented essentially all of invested capital. Interest coverage was essentially equal to operating cash flow. By contrast, PETM's balance sheet is very clean with debt representing only about 28% of capital. Interest coverage is about ten times for PETM.

Disclaimer: I, my family, and some clients have a current position in PETM. Neither I, my family, or clients have a current position in PETC.


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