Pet Industry Overview - Cascadia Capital

Pet Industry Overview

Spring 2019 v 13.1

Disclaimer

This report was produced for the benefit of all parties interested and involved in the pet industry but its contents are for informational purposes only. The opinions expressed reflect our analysis as of March 29, 2019, unless noted otherwise, and is subject to change. While the information is from sources we consider reliable, we make no warranty of its accuracy. I offer this report to anyone free of charge. However, its contents are property the of Cascadia Capital, LLC except where third party data has been cited, and should not be reproduced without my expressed written permission. I appreciate your adherence to this policy. Bryan Jaffe Managing Director Cascadia Capital, LLC bjaffe@

Executive Summary

As industry participants position themselves to succeed in a consumer centric paradigm, new complexities have emerged with long term implications Latency between consumer trends and pet trends has compressed from years to months, which will put immense pressure on the industry's regulatory framework Consumer demand for pet products that incorporate CBD, human diet concepts such as Keto and Paleo, and protein alternatives is significant but lacks regulatory and, in some cases, legal clarity That has not stopped manufacturers or retailers from bringing these products to market in order to satisfy demand If AAFCO cannot evolve to become more nimble and responsive, the industry will become more risky to all involved As Petco forges ahead with its new wellness enabled vision, PetSmart has largely stood still lacking financial flexibility The success of Petco's strategy could put pressure on PetSmart to sell or IPO Chewy, it's most valuable liquid asset Tepid results for Petco, could place these two organizations on a merger path in order to remain relevant

Slower industry growth is driving consolidation, a theme that will continue for the foreseeable future The cost of doing business in the pet industry has increased as physical and online retailers monetize their market positions, making it more difficult for midsized and emerging brands to compete Given the pace of change, strategics are under more pressure to acquire assets that enable them to meet emerging customer needs, or risk losing out on the ability to monetize faster growing market opportunities Private equity is leading the consolidation charge due to broader business malaise prevalent among large strategics, which will enhance focus on profitability as the key criteria underlying acquisitions and put downward pressure on valuations

Notwithstanding slower growth and more turbulent competitive dynamics, we believe the current environment offers a market opportunity that may not manifest itself again for some time The continued transition of Blue Buffalo to mass, including Wal Mart, and the Champion transition to major pet specialty will open unprecedented shelf space in the independent channel for emerging and channel dedicated family brands in the consumables category Retail consolidation will allow strong independent concepts the ability to enhance reach and accelerate growth, organically and through acquisition The forthcoming tension among the human and pet food supply chains will offer ingredient companies significant M&A and capital formation opportunities Company's across the industry that can offer acquirers a defensible moat ? as defined through brand, operational capabilities, and intellectual property ? will grant a subset of players category leading valuations in financial and M&A transactions

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SECTION I

Market Growth Assessment

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Industry Growth Analysis

According to data provided by the APPA, the pet industry grew 4.4% in 2018, exceeding estimates by 0.7% Food category growth accelerated to 4.3%, exceeding estimates by 1.6% ? Growth acceleration is attributed to increased availability of specialized diets, Millennial willingness to pay, and manufactures taking price, as evidenced by faster growth among APPA figures versus PCE measurements o Millennials are spending almost 44% more a month than Baby Boomers on their dogs ? Food category benefitted from 0.7% inflation in 2018, reversing a three year deflationary trend Veterinary category growth decelerated to 6.1% in 2018, missing estimates by 0.8% ? Veterinary Care benefitted from inflation of 2.5% in 2018 ? Declining growth rate reflects falling prices and increased utilization of preventative care among new pet owners

Pet related PCE grew at 4.3% in 2018, the slowest observed growth rate since the recession Product-related PCE grew at 4.2% in 2018, an acceleration from 3.5% in 2017 Veterinary Care-related PCE grew at 4.4% in 2017, a deceleration from 9.7% in 2017

APPA industry growth for 2019 is forecasted at 3.9%, representing a deceleration versus 2018 actual growth Food category growth is anticipated to slightly accelerate to 4.5% in 2019 Veterinary Care category growth anticipated decelerate to 4.8% in 2019

$ Billions

$ billions Category

Food % growth Supplies/OTC Med % growth Veterinary Care % growth Live Animal Purchases % growth Other Services % growth Total % growth

2011 19.85 5.8% 11.77 7.6% 13.41 3.1% 2.14 0.5% 3.79 8.0% 50.96 5.4%

2012 20.64 4.0% 12.65 7.5% 13.67 1.9% 2.21 3.3% 4.16 9.8% 53.33 4.7%

Actual

2013

2014

21.57 22.26

4.5%

3.2%

13.14 13.75

3.9%

4.6%

14.37 15.04

5.1%

4.7%

2.23

2.35

0.9%

5.4%

4.41

4.84

6.0%

9.8%

55.72 58.24

4.5%

4.5%

2015 23.05 3.5% 14.28 3.9% 15.42 2.5% 2.32 (1.3%) 5.41 11.8% 60.48 3.8%

2016 28.23 22.5% 14.71 3.0% 15.95 3.4% 2.10 (9.5%) 5.76 6.5% 66.75 10.4%

2017 29.07 2.9% 15.11 2.7% 17.07 7.0% 2.10 0.0% 6.16 6.9% 69.51 4.1%

2018 30.32 4.3% 16.01 6.0% 18.11 6.1% 2.01 (4.3%) 6.11 (0.8%) 72.13 4.4%

2019E 31.68 4.5% 16.44 2.7% 18.98 4.8% 1.97 (2.0%) 6.31 3.3% 75.38 3.9%

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Note: 2016 reflects methodology changes for APPA calculations that when normalized result in ~ 4% total industry growth Source: APPA, St. Louis Fed, TD Ameritrade, U.S. Labor Bureau

Analysis of Industry Growth Drivers

Jan-03 Oct-03 Jul-04 Apr-05 Jan-06 Oct-06 Jul-07 Apr-08 Jan-09 Oct-09 Jul-10 Apr-11 Jan-12 Oct-12 Jul-13 Apr-14 Jan-15 Oct-15 Jul-16 Apr-17 Jan-18 Oct-18

Sep-10 Feb-11 Jul-11 Dec-11 May-12 Oct-12 Mar-13 Aug-13 Jan-14 Jun-14 Nov-14 Apr-15 Sep-15 Feb-16 Jul-16 Dec-16 May-17 Oct-17 Mar-18 Aug-18 Jan-19

12.0% 10.0%

8.0% 6.0% 4.0% 2.0% 0.0%

1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5%

U.S. UNEMPLOYMENT RATE

Unemployment volatility ticked up in 2018 Unemployment Rate

Change

0.6% 0.4% 0.2% 0.0% -0.2% -0.4% -0.6%

REAL WAGE GROWTH

Real wages effectively decline in 2018

PET ADOPTION RATES

Feline adoptions grew 2.3% while canine adoptions declined 2.0% in 2018

Canine Adoptions YoY Change Feline Adoptions YoY Change 13%

8%

3%

-3%

-8%

PET RELATED PERSONAL CONSUMPTION EXPENDITURES ($B)

$140,000 $120,000 $100,000

$80,000 $60,000 $40,000 $20,000

$-

Pet related PCE growth continued to decelerate

Product

Service

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 Jul-18 Jan-19

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Sources: Pethealth, Inc., U.S. Bureau of Economic Analysis, U.S. Labor Bureau

Public Company Performance

Industry revenue and earnings, as measured by public company performance, was favorable in 2018(1)(2)(3) Earnings for publicly traded pet companies in our index grew 36.6% in 2018, benefitting from weaker comps posted in the 2H2017 ? Health care equities drove the majority of earnings growth in 2018 led by Zoetis, IDEXX, Virbac and Neogen ? Other favorable performers include Oil-Dri and PetMed Express Revenue for publicly traded pet companies grew 9.4% in 2018, driven again by health care spend ? Revenue growth excluding Zoetis, which accounts for between 40% - 45% of our comp group revenue in any quarter, was 9.2%

Notably, emerging growth stocks Freshpet, PetIQ and Trupanion posted at least one positive earnings quarter in 2018, with PetIQ and Trupanion narrowing losses across the full calendar year while Freshpet was essentially flat

PET INDUSTRY REVENUES

PET INDUSTRY NORMALIZED EPS

Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014 Q1 2015 Q2 2015 Q3 2015 Q4 2015 Q1 2016 Q2 2016 CQ3 2016 CQ4 2016 Q1 2017 Q2 2017 Q3 2017 Q4 2017 Q1 2018 Q2 2018 Q3 2018 Q4 2018

$2,500 (in $ millions) $2,000 $1,500 $1,000

$500 $0

Revenue Adjusted

Adjusted YoY Change

16%

$6.00

140%

14% $5.00

12%

10%

$4.00

120% 100% 80% 60%

8% $3.00

6%

4%

$2.00

40% 20% 0% -20%

2%

$1.00

-40%

0%

-60%

$0.00

-80%

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 2013 2013 2014 2014 2015 2015 2016 2016 2017 2017 2018 2018

Adjusted EPS

Adjusted YoY Change

(1) Data set includes Central Garden & Pet Company, Freshpet, Inc., IDEXX Laboratories, Inc., Neogen Corp., Oil-Dri Corp of America, PetMed Express, Inc., Pets At Home Group, PLC, PetIQ, Inc., Trupanion, Inc., Virbac SA and Zoetis, Inc.

(2) Companies that did not report two positive EPS quarter for each of the past four quarters are excluded from any EPS based calculations which has a meaningful impact of volatility calculations and results in changes to year-over-year comparisons Source: CapitalIQ

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(3) Publicly available data

Deal Flow Analysis

BROADER M&A ACTIVITY

B2C M&A and PE deal volumes have fallen, driven by market and political uncertainty

$174 $221 $188 $256 $157 $152 $200 $136 $135 $235 $151 $200 $39 $19 $28 $21 $16 $31 $39 $21 $26 $33 $48 $23 $17

B2C M&A Deal Volume and Values

1,575

$300 $250 $200

1,328 1,269

1,331

1,119

1,137 1,105 1,126

964 924

783

1,600 1,400 1,200 1,000

$150

800 572

600 $100

400

$50 200

$0

0

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

2016 2016 2016 2016 2017 2017 2017 2017 2018 2018 2018 2018

Deal Value ($B)

Deal Volume

B2C PE Deal Volume and Values

$60 $50

219 192 190 185 192 180 191 201 211 184 191 182

250 200

$40 150

113 $30

100 $20

$10

50

$0

0

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1

2016 2016 2016 2016 2017 2017 2017 2017 2018 2018 2018 2018 2019

Capital Invested ($B)

Deal Volume

12.0x 10.0x

8.0x 6.0x 4.0x 2.0x 0.0x

Debt/Equity Invested in PE Deals

10.8x

11.7x

11.5x

9.8x

5.7x

5.7x

5.4x

4.3x

11.5x 5.7x

5.4x

5.4x

6.0x

5.7x

5.8x

2015

2016

Debt/EBITDA

2017

2018

Q1 2019

Equity/EBITDA

EV/EBITDA

PET SECTOR DEAL VOLUME

Industry consolidation continued within the pet sector in 2018

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Source: CapitalIQ, Pitchbook

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