Bryan Jaffe, managing director of Cascadia Capital, shares his thoughts on the active M&A market for pet-related deals. Cascadia is a Seattle-based investment bank that helps companies seeking to transact in the capital markets. The bank has advised on numerous pet- related businesses, including Petflow (2017), Manna Pro Products (2015), Nutri-Vet (2015), I & Love & You (2014), PetSmart (2014, in the acquisition of Pet360), Only Natural Pet (2014), Zukes (2013) and Canine Hardware (2012). In one sign of the growing importance of pet deals, Mergers & Acquisitions gave the 2016 M&A Mid-Market Award for Dealmaker of the Year to Gregory Sandfort, the CEO of Tractor Supply Co. (Nasdaq: TSCO), which bought Petsense LLC to expand rapidly in the lucrative pet retail market.

What does all the recent deal activity say about the pet industry?

The pet industry began an evolutionary phase in the second half of 2014, and that continues today. Part of this includes the rise of digital within the pet category. As a result, key industry players are buying assets that position them for success in a world where the consumer increasingly has the upper hand. Digital industry leaders are also consolidating in order to position themselves for greater cash efficiency and likely public offerings.

In the last year, we have seen the merger of A Place for Rover and Dog Vacay; the agreement by PetSmart to acquire; and more than $150 million dollars invested in 46 pet-tech deals. Recently, Cascadia Capital acted as the exclusive financial adviser to PetFlow in its acquisition by Phillips Feed Services, which aims to arm independent retailers for the digital pet race. In addition, Petco Animal Supplies acquired PetCoach and hired its founder as the new head of digital experience.

Online retailers, such as Chewy, are increasingly taking market share from established retailers, even though most major pet store chains operate their own online properties. Today, nearly all major pet brands are available online through a variety of retailers. With their availability now commoditized, sales are driven by a better user experience tending to favor early, online-only pioneers like Chewy that are more intuitive to the digital consumer.

Additionally, the success of Rover, which recently acquired DogVacay, demonstrates that the discretionary services side of the market is also under siege.

Fiscally conservative companies are hesitant to acquire companies with no track record of profitability, and some players are waiting for market bargains or reduced valuations. Those who need to act, but are paralyzed by their approach to valuations, may seek to partner with others. Whatever the solution, market incumbents need to act quickly to capture the growing, high-volume spend of digital pet consumers.

Do you expect to see more deals in pet-related products in 2017?

We have seen increased volumes of closed M&A transaction since 2H2014 and expect the trend to further accelerate through 2017. We believe this is being driven by the fact that the pet industry is in a transitionary phase. There has been considerable growth in emerging pet owner segments, particularly from Generation X, Generation Y and millennials, who tend to engage with brands and retailers differently. These cohorts now outnumber baby boomers in terms of pet ownership: 35 percent versus 32 percent, according to the American Pet Products Association National Pet Owners Survey. While the baby boomers became the first generation to treat pets as part of the family – a phenomenon commonly referred to as the “humanization of pets” and still cited by many executives today – these younger generations have grown up only knowing their pet as a “peer.”

Today, the expectations for domestic pets are even higher. A new generation of consumers favors pet products that reflect the same standards for packaged goods they would buy or consume for personal use. Whether that is a hard or soft good, food, or healthcare, the pet industry is now being shaped by this trend that we think transcends humanization and is more akin to personal wellness.

When an industry undergoes changes of this magnitude, M&A velocity tends to increase as the progressive major market participants take advantage of growing trends and acquire innovative new

players. That said, the pet industry, despite its size, has a relatively small number of strategic buyers with deep pockets. If these companies do not maintain an active M&A bias, volume will adjust accordingly.

What kinds of pet-related companies are getting funded?

Private and growth equity continue to have a strong appetite for the pet industry, given the consistent consumer demand. Pet food and treat companies will continue to see capital inflows if they are on trend and of critical mass. We also expect more deals where mid-sized brands partner with private equity funds to achieve partial liquidity and/or buy emerging competitors.

Within retail, operators of small and mid-sized boxes will continue to experience the strongest growth among physical retail formats, and consolidation opportunities will follow as consumers continue to favor their local pet stores. However, the risk of market erosion of these franchises from online players is likely to influence valuations and interest.

Finally, the pet healthcare space will continue to see significant capital inflows into over-the-counter pet healthcare, walk-in veterinary clinics, and those companies that serve this evolving ecosystem in a more personal and cost-effective way.

Why is the timing right for this subsector of consumer goods and retail?

The pet industry is generally viewed as recession-resistant. From a macroeconomic standpoint, we are late in the cycle. This means private equity acquirers want to buy companies they are confident about owning through a market downturn and where multiples are less likely to contract. This is a primary consideration driving their decision-making.

Strategic buyers have a different perspective, as they are preparing for the next phase of growth and industry evolution. Whether that involves acquiring digital assets or buying brands, the traditional pet retailers are keen to offset the exposure of their core franchise, either from disruption or increased competition. For each of the past five years, our pet industry index of publicly traded companies has outperformed the S&P 500, further supporting our premise that industry conditions continue to be favorable.

Are households spending more on pets than in the past and why?

Households increasingly spend more money on their pets. According to GfK Global, which tracks certain segments of the industry, pet food prices increased approximately 40 percent per pound between January 2011 and February 2016. This shift reflects the trend of owners seeking to feed their companion animals higher-quality foods; manufacturers and retailers are capitalizing on this trend and driving up the price per transaction. Additionally, according to the Bureau of Labor Statistics’ Consumer Price Index, veterinary price inflation was 15.4 percent over the same period. However, at some point, consumers’ willingness to spend on their pets will hit a cap. As a result, the industry risks a flattening of the growth curve and, in some categories, a deflationary cycle. We see an increasing number of new product offerings in pet food characterized as value-oriented premium, indicating that manufacturers also recognize these concerns.

What consumer goods and retail trends are being played out in the pet category?

The growth phase of the pet industry was driven by companion animal owners’ increasing willingness to treat pets as family members and, consequently, purchase products or services reflecting this. The behavioral pattern is commonly referred to as the humanization of pets.

Now, consumer behavior has evolved beyond humanization and is increasingly motivated by wellness decisions. Consumers appear to be motivated by the health, happiness and well-being of the companion animal. The results have spurred a shift in spending toward consumables with the cleanest ingredients at the consumers’ desired price point, solutions with a transparent production pedigree, and products that contribute to a pet’s physical and emotional development.