PetSmart Lenders Are Worried About a Chewy.com Spinoff

  • Notes financing takeover of online site among worst performers
  • Blue Buffalo steps back amid concern about sales concentration

A vehicle drives past a PetSmart Inc. store in LaSalle, Illinois.

Photographer: Daniel Acker/Bloomberg

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.

Within months of the May acquisition, PetSmart lost some of its mojo with a key supplier, and then lost its chief executive. The notes sold by the pet superstore to finance the takeover of Chewy Inc. are among the year’s worst performers for newly issued junk debt, with some of its unsecured bonds having lost around a quarter of their value since being issued.

Investors are so disenchanted that some are speculating PetSmart might undo the acquisition by spinning off Chewy to the private equity firms that own the pet superstore, a group led by BC Partners.

“That would be a terrible thing for bondholders. The company just sold these bonds in order to acquire Chewy,” said Scott Josefsberg, an analyst at independent credit research firm Covenant Review. “Now, investors are worried that this expected driver of future growth might be taken out of the credit for the benefit of the sponsor, and to the detriment of bondholders.”

Because of the terms governing the new bonds, BC Partners would be within its rights to separate Chewy from PetSmart, keeping the promising online merchant’s revenue for itself, according to Josefsberg.

“PetSmart has an extremely loose and aggressive covenant package, so there’s a lot of room for gamesmanship there,” Josefsberg said. “Specifically in relation to Chewy, there’s a loophole that allows the owner to divert value from the credit to enrich itself.”

For the investors who funded its purchase, future value created by Chewy.com would be untouchable.

Representatives for Phoenix-based PetSmart, billed as the largest pet specialty retailer, didn’t respond to requests for comment, and BC Partners declined to comment. BC Partners, based in London, is a private equity firm that acquired PetSmart in 2015 for about $8.7 billion.

Online Onslaught

Retailers in general are girding for an online onslaught by Amazon.com and its peers. What makes PetSmart stand out was that the Chewy acquisition was supposed to be part of its defense, giving the chain one of the premier online outlets for pet supplies.

PetSmart announced in April it was buying Chewy, promising that the online platform would complement its chain of 1,500 stores and help reach a wider customer base. To pay for it, the company sold $1.35 billion in secured bonds and $650 million unsecured notes, in an underwriting led by Citigroup Inc. and Barclays Plc. The reception was warm enough that the interest rates were cut slightly from those initially discussed.

“The acquisition makes strategic sense as it adds online expertise and scale and complements PetSmart’s brick-and-mortar business” with a platform that’s already been built, Moody’s Investors Service analyst Manoj Chadha said in a May 19 report.

Going Offleash

The enthusiasm didn’t last long in the debt markets. The new first-lien notes -- which typically have one of the strongest claims on assets -- dropped below 95 cents on the dollar in four weeks, and have since slid to 87 cents.

The big blow came Aug. 1, when Blue Buffalo Pet Products Inc., which by one estimate accounted for 11 to 12 percent of PetSmart’s sales, decided to start supplying some of its natural, upscale food products to mass-market retailers, including Target, Kroger, Meije and Publix. Just days later, PetSmart Chief Executive Officer Michael Massey stepped down without a replacement being named.

Representatives for Blue Buffalo, based in Wilton, Connecticut, declined to comment on the reasons. Asked about going mass-market during a May 9 earnings call, Blue Buffalo managers told analysts, “we’re focused right now on selling in specialty.” But the company has fretted that sales were highly concentrated at a few retailers, and said in a November filing that the combined PetSmart-Chewy would account for almost half its revenue.

This leaves PetSmart grappling with a management vacuum, the operational indigestion that follows a huge acquisition Chewy and the looming threat of Amazon.com that haunts the grocery sector.

“There are a lot of bogeymen,” said Harini Chundu, a credit analyst at Advent Capital. “Amazon is one -- it forces your distribution channels to be squeezed for value. Blue Buffalo choosing to distribute through mass channels plays to that fear, steps up the competitive intensity.”

Bright Spots

Still, PetSmart’s thriving services business is a bright spot, Chundu said. About 12 percent of revenue comes from grooming, training and day-care services offered on site, and management intends to expand those offerings, she said.

“That drives traffic, so customers are coming to the stores,” Chundu said.

Another ray of hope for PetSmart and peers? Ownership of pets is higher than ever, according to a report on the industry from S&P Global Ratings from June. Americans in their 20’s are pouring money into four-legged companions as they postpone life events like marriage, home ownership, and starting a human family, according to S&P analyst Amanda O’Neill. That, she says, makes the pet-products sector nearly recession-proof.

With the services business going strong, and the company’s shift into online distribution, Advent’s Chundu says she’s optimistic about PetSmart’s future.

“What PetSmart needs to do is take Amazon on right on its home turf,” she said, “so if this Chewy acquisition works, it could be transformative.”

— With assistance by Sridhar Natarajan

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