PetSmart Activists Wave Cash Flow at LBO Firms: Real M&A

Activists are trying to sell PetSmart Inc. before it gets to the point where it needs reviving.

Same-store sales at the $6.8 billion pet-care company fell last quarter for the first time in at least a decade as competition with Inc. and other retailers intensified. Those results, combined with a declining share price, can look like early warning signs to activist investors, who target undervalued companies they believe need a shakeup. Now, Jana Partners LLC and Longview Asset Management LLC together own almost 20 percent of PetSmart and are calling for a sale.

“PetSmart has gone from a retail darling to where we are now,” said John Tomlinson, a New York-based analyst at ITG Investment Research. “This company is far from being in any sort of dire straits, but it’s just that the change happened relatively quickly and people are worried that if they don’t get more aggressive, the business could deteriorate further. There’s probably a lot of discussions going on about what the best alternatives for the company would be.”

PetSmart’s high free-cash-flow yield and low debt relative to earnings open up several ways to boost returns, according to shareholder Olstein Funds, which said the company should be valued at 31 percent more than yesterday’s $68.75 closing price. PetSmart could take on debt to buy back shares, according to Wedbush Inc. However, a bigger payout could come from a merger with Petco Animal Supplies Inc. or a buyout by a private-equity firm., says Credit Suisse Group AG.

Sale Discussions

PetSmart said in a statement last week that it “welcomes open communications with its shareholders and values constructive input toward the goal of enhancing shareholder value.” A representative for the Phoenix-based retailer declined to comment further.

Representatives for New York-based Jana and Chicago-based Longview declined to comment beyond their firm’s regulatory filings.

Jana, run by founder Barry Rosenstein, said in its July 3 filing that it intends to have discussions with PetSmart regarding a review of strategic alternatives, including a sale. On July 7, Longview also called for the company to weigh a sale and said it would consider contributing some or all of its stock to a deal.

In Vogue

In the month leading up to the activism, PetSmart’s free-cash-flow yield -- a measure of how much cash from operations the business generates relative to its share price -- was almost 8 percent. That’s more than double the median for U.S. retailers valued at more than $1 billion, according to data compiled by Bloomberg.

“Free cash flow is in vogue right now,” Eric Heyman, co-manager of the Olstein Funds in Purchase, New York, said in a phone interview. “That’s the opportunity.”

Heyman, whose firm oversees about $800 million and owns PetSmart shares, cited companies such as Express Inc. and URS Corp. that have recently been targeted by buyout firms or activists in part because of their attractive free cash flow. His firm owns shares of both.

Potential Gains

There are three main options for PetSmart: a leveraged buyout, a merger with Petco or returning cash to shareholders through more stock repurchases, said Daniel Johnson, of River Road Asset Management LLC, which oversees about $10 billion and owns PetSmart shares. A merger with closely held Petco, either as the buyer or seller could boost the stock into the $80 range, while a leveraged buyout could take place in the mid to high $70s, he said. The stock closed at $68.75 yesterday.

“All three are going to result in a higher stock price,” Johnson, a Louisville, Kentucky-based money manager at River Road, said in a phone interview. “We would, of course, be thrilled if we got a strategic acquisition here and the stock went to what we think it’s worth or above that.”

PetSmart shares climbed 2.6 percent to $70.55 today.

Seth Sigman, a New York-based analyst at Credit Suisse, agrees that PetSmart shareholders have the most to gain from a merger with its largest competitor. An LBO may be less likely with the stock up 15 percent since Jana’s involvement, Sigman wrote in a report yesterday.

With an enterprise value of $7.1 billion, PetSmart would rank as at least the fourth-biggest U.S. retail buyout by a private-equity firm and the largest since 2007, according to data compiled by Bloomberg.

Low Leverage

PetSmart’s earnings before interest, taxes, depreciation and amortization outstrip its debt, leaving it with a low leverage ratio of 0.6, a quality financial suitors look for. The average U.S. retailer has 1.7 times more debt than Ebitda, data compiled by Bloomberg show. Petco’s ratio was about 0.7 in 2006, before it was taken private later that year by Texas Pacific Group -- now TPG Capital -- and Leonard Green & Partners LP, the data show.

PetSmart’s low leverage also leaves room to do debt-funded share repurchases, Seth Basham, a New York-based analyst at Wedbush, wrote in a July 7 report, noting that he sees an LBO as unlikely and a low probability of a deal with Petco.

Buying back more stock isn’t “the right strategic move,” Brian Nagel, a New York-based analyst at Oppenheimer Holdings Inc., said in a phone interview. Instead, PetSmart “needs to hunker down and prove their business. Taking on debt is not the smartest thing to do when you have a transformation to undertake.”

Short Interest

Bearish traders have also been piling into PetSmart this year. About 15 percent of the shares outstanding have been sold short, up from about 7 percent at the end of 2013, according to Markit data. Companies in the Standard & Poor’s 500 Index have an average short interest ratio of 2.2 percent. In a short sale, traders sell borrowed stock in a bet the price will fall, allowing them to buy back the shares more cheaply and pocket the difference.

Whether the activism leads to an LBO, merger or buybacks, as long as it boosts PetSmart’s valuation it may be all the same to shareholders.

“We think the stock’s worth about $85 to $90,” Heyman of Olstein Funds said. “Any way that I get to my $85 to $90, I’ll be happy with.”

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