Phoenix-Based PetSmart Being Cornered Into Possible Sale

July 21, 2014

Amazon, Walmart, grocery stores, mom-and-pops and even gas stations.

If it seems like everyone is selling dog food, chew toys and kitty litter these days, they are.

The pet products industry should reach more than $58 billion this year in the United States, which is 70 percent larger than it was a decade ago, according to the American Pet Products Association.

That means pet owners like Mike Carson of Phoenix aren’t so concerned about store loyalty.

"It’s convenience for me. If I’m in Costco and he needs food, I’ll pick it up. If I’m in the neighborhood, I’ll come here. It just really, I mean that’s as much as I can say. It just comes down to convenience," said Carson, standing in the parking lot of a PetSmart store in central Phoenix.

Convenience is the specialty of PetSmart Inc. With more than 1,300 stores nationwide, the Phoenix-based company is the largest and most recognizable in its industry. It's big-box stores are also one-stop-shops for food, toys, obedience training, grooming, kenneling and even veterinary services.

Still, industry competition and shoppers like Carson are why PetSmart is starting to lose its grip on the market. Earlier this month it was called out by a multi-billion dollar hedge fund called Jana Partners LLC in New York.

In a July 3 statement filed with the U.S. Securities and Exchange Commission, Jana said PetSmart shareholders could be getting way more bang for their buck. The two companies are now discussing some major potential overhauls, among them is the possibility of PetSmart putting itself up for sale.

But what is Jana Partners, and why is it nipping at PetSmart’s heels?

Jana is part of a powerful group on Wall Street called activist investors, which include mutual funds, private equity firms, wealthy individuals and hedge funds.

“Activists get involved when they think there is some element of mismanagement that is happening," said Brad Thomas, an analyst with KeyBanc Capital Markets Inc. who tracks PetSmart.

Activists are more common than ever today, and Thomas said they actually have a pretty decent track record of affecting change and unlocking shareholder value. For example, activists took crafts store chain Michael's private in 2006 and then back to the public stock market this year, and they were also behind last year's merger of Office Depot and Office Max.

So far, PetSmart shareholders have been pretty welcoming of Jana. One of PetSmart's largest shareholders, Longview Asset Management, submitted a letter to the retailer's board of directors saying it supported Jana's involvement.

But activists aren’t doing this out of the goodness of their hearts. Their goal is to make money. Lots of it. And sometimes, they bully other companies into fixing things that aren’t broken, said Robert Mittelstaedt, the retired dean of Arizona State University's W.P. Carey School of Business.

“I think that that’s a disservice when they go after a company that is fundamentally a sound company that may have some minor glitch but they think it gives them an opportunity to get in on it. I think PetSmart’s in that category," Mittelstaedt said.

Mittelstaedt said he’s skeptical of Jana and its motives. Although PetSmart didn’t have the greatest first quarter, he noted that it’s still a $7 billion company with strong cash flow and hardly any debt. Mittelstaedt says that exactly what makes it vulnerable to activists like Jana.

“That’s the chance you take when you become a publicly held company," Mittelstaedt said.

So how do activist investors have this kind of power? They start by buying up huge amounts of a company’s stock. Since May, Jana has spent about $700 million on PetSmart shares. It’s now the largest shareholder — owning almost 10 percent of the company's stock — which gives Jana the power to influence company decisions and pressure PetSmart into doing things such as selling itself.

Middlestaedt said Jana would really score if it were one of the buyers.

“They’re looked at in a way by people with a vulture mentality that say, ‘Gee we could take, buy that company, load it up with debt, pay ourselves huge fees, grow it a little bit then sell it back to the public on the public markets at a higher price,'" he said.

But Thomas, the PetSmart analyst, said he thinks a merger with a competitor such as Petco is also a possibility, and actually makes the most sense.

“With these synergies, PetSmart would be in a better position to invest in e-commerce, to invest in lower prices and to be more competitive," Thomas said.

Thomas also said last year’s Office Max/Office Depot merger is key for PetSmart. Years ago, a Petco/PetSmart merger would’ve been hard to get past the Federal Trade Commission. In 1997, for instance, the FTC blocked the merger between Staples and Office Depot over fears of a monopoly.

But because Amazon and others have made the marketplace far more competitive today, the FTC allowed Office Depot and Office Max to merge last fall.   

"Frankly I think that this is a landmark ruling that can open the door for more consolidation in other subcategories of specialty retailing, like the pet category," Thomas said.

Given all the competition, Thomas, Mittelstaedt and other experts are doubtful shoppers would see much of a difference if PetSmart were sold. But it’s still possible some stores could be consolidated and some prices could go up.

The latter is OK with Michael Hruby, who was at a downtown Phoenix dog park one recent morning with his pit bull mix, Buddy.

“The amount of money that would actually be raised would be minimal. It wouldn’t affect my need for convenience," Hruby said.

PetSmart didn’t respond to multiple requests for comment. Petco and Jana Partners declined to comment.