Yielding 21% in Bond Market, the No. 1 Retail LBO Is in Trouble

(Bloomberg) -- PetSmart’s owners thought embracing e-commerce would keep it competitive in the age of Amazon.

Two chief executives and $3 billion later, they’re discovering it takes a lot more than web smarts to outrun an avalanche of debt.

The nation’s leading pet supplier has to figure out how to pay $8.1 billion in bond and loan maturities even as its sales and margins are shrinking. Half that debt traces back to a 2015 buyout led by private equity firm BC Partners, whose bidding was so aggressive that it actually topped its own offer to seal the deal, leaving veteran rivals agog at the final price.

The rest it took on to buy what was intended as an Amazon-beater -- the $3.4 billion acquisition last year of online pet merchant Chewy.com. It was the biggest e-commerce acquisition to date, topping even the $3.3 billion that retail giant Walmart shelled out for its takeover of Jet.com the year before.

Some of PetSmart’s securities are now trading at about half of face value and yielding 21.2 percent, reflecting creditors’ concern that they won’t be fully repaid.

PetSmart is one of the starkest examples yet of the troubles afflicting all of those big-box chains that specialize in one type of goods. Many retailers, such as Sports Authority and Toys “R” Us, were bought by private equity shops and loaded with leveraged buyout debt.

But the big-box model was designed before the encroachment of online shopping and predicated on large sales volumes. When Amazon came along and cut into revenue, the companies flailed under the debt payments. Bookseller Borders Group and electronics chain Circuit City shut down during the recession. Sports Authority closed in 2016, while Toys "R" Us is now liquidating its U.S. business.

“Big-box LBO’d concepts are having a hard time surviving,” said Derek Pitts, head of restructuring at investment bank PJ Solomon.

Perhaps most disconcerting about PetSmart’s struggles is they are coming even as Americans spend more on buying and taking care of their pets -- $70 billion in 2017, compared to $41 billion in 2007, according to the American Pet Products Association. Its first quarter with Chewy on board last year saw earnings fall almost 40 percent under the weight of debt.

CEO Departures

After that, its post-buyout CEO Michael Massey abruptly resigned, and has yet to be replaced eight months later. This year, Chewy’s founder and CEO Ryan Cohen quit too.

BC Partners and PetSmart declined to comment.

PetSmart’s debt load can be traced back to a single financial quarter. In June 2014, the Phoenix-based company reported negative comparable sales for the first time ever, and activist shareholders pounced. Barry Rosenstein’s Jana Partners snapped up a stake in the company and demanded it consider a sale, launching a proxy fight to get fellow shareholders on board. Jana declined to comment.

The campaign attracted major buyout firms such as Apollo Global Management, Ares and KKR & Co. London-based BC Partners won the bidding war with an $8.7 billion offer, including debt. PetSmart was a giant in the pet supply industry. The 28-year-old company had 1,400 stores and $7 billion in annual revenues.

Expensive Takeover

But BC Partners’ purchase price amounted to retail’s most expensive takeover to date. It valued PetSmart shares 11 percent higher than analysts’ consensus, and at a 40 percent premium to their price before the sale process began.

BC was so keen to prevail that it even bid against itself in the auction, raising its own final offer by 50 cents -- to $83 per share -- before any opponent had matched the lower price, according to court records from a subsequent lawsuit. Apollo, the next highest bidder with an offer of $81.50, or about $150 million less, later told PetSmart’s investment bank, JPMorgan Chase & Co., that it "never would have paid” what BC Partners did, a filing shows. JPMorgan declined to comment.

BC Partners managed to pocket an immediate $800 million dividend, but it had a long road ahead. The acquisition marked its first-ever foray into the U.S. retail sector. And the new management team had no experience with the pet industry.

Raymond Svider named Michael Massey as CEO, a colleague from his time on the board of Office Depot. Massey, in turn, brought on former colleagues from his CEO stint at Payless Shoesource parent Collective Brands Inc.

Amazon Defense

One of Massey’s tasks was making a big e-commerce acquisition to retain customers moving online. He zeroed in on Chewy.com, an online supplier with loyal customers and workers it called ‘Chewtopians.’

Massey reasoned that Chewy would establish a defensive line against Amazon and shore up earnings that had sagged since the takeover. But the plan backfired. PetSmart’s financials deteriorated even more sharply as Chewy, which has yet to turn a profit, dragged on earnings. In the third quarter of 2017, the latest available, the combined companies lost $56 million.

“On the one hand, they can now say they’re a leader in the online pet space,” said former CEO David Lenhardt. “On the other hand, they have a lot more debt.”

To contact the reporters on this story: Eliza Ronalds-Hannon in New York at eronaldshann@bloomberg.net, Lauren Coleman-Lochner in New York at llochner@bloomberg.net.

To contact the editors responsible for this story: Rick Green at rgreen18@bloomberg.net, Larry Reibstein

©2018 Bloomberg L.P.