PetSmart Bonds Sink As Most Expensive LBO In Retail History Hurtles Toward Bankruptcy

With Sears' hedge-fund owner stepping in the backstop the flailing retail giant as it shambles toward bankruptcy, and what's left of Toys R' Us is struggling through the indignity of liquidation after the company failed to find a buyer in bankruptcy, 2018 is shaping up to be just as bad - if not worse - of a year for American retailers as 2017 was. Already, retail defaults reached an all-time high during the first quarter, Moody's Investors Service revealed. And the fallout is far from over.

And in what's shaping up to be the next big private-equity backed retailer to crumble under a stupefying pile of debt, Bloomberg reported today that investors in pet supply retailer PetSmart are panicking as the $8.1 billion in bond and loan maturities that are soon coming due might force it too into bankruptcy, even as the market for pet supplies in the US is in the midst of an unprecedented boom.

Americans spent $70 billion on pet supplies in 2017, compared with $41 billion in 2007, according to data provided to Bloomberg by the American Pet Products Association. 


The company's troubles have caused the value of its bonds trading on the secondary market to plummet, with some of these bonds are now trading at half of face value and a yield of 21.2%, according to Bloomberg. What's worse, the adjustable-rate bonds carry a coupon of 300 basis points above Libor, with a floor of 1%. This is hugely problematic, given 3M USD Libor recently touched its highest level in 13 years.

In retrospect, BC Partner's offer seems almost ridiculously high.

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.

Of course, this is hardly news to anybody who has been following the troubled world of American retail. In what sounds to us like a recipe for instant business success, private equity firm BC Partners led a leveraged buyout of the company in 2015, topping its own highest bid to lock in the winning offer at $8.7 billion, or $83 a share, despite having no retail experience. That makes the PetSmart buyout the most expensive takeover in retail history.

One rival, Apollo Management, which had submitted a bid for $81.50 as a handful of firms weighed a buyout later confided in PetSmart's investment bank, JP Morgan, that Apollo would never have paid anything close to the $83 per share that BC and its partners did. Yet, it was already too late. The deal was done.

And as one might expect given their lack of experience in the industry, the store's private equity managers quickly realized that running a giant big-box chain isn't a particularly good business strategy unless you have a massive e-commerce presence to compliment it.

So last year, BC returned to the debt markets and - true to the firm's MO - massively overpaid for, a buzzy e-commerce startup, in what is still the largest e-commerce acquisition ever. The final price tag? $3.4 billion, beating out Wal-Mart's acquisition of online retailer

Barely four months after leading the company through the acquisition, PetSmart CEO Michael Massey decided to step down. Board member Raymond Svider stepped in to take the reins while the board conducted a search for a new CEO. Nine months later, no successor has been found.

Now, one of PetSmart's biggest problems - at least as far as its bondholders are concerned - is that it closely fits an unflattering profile: The specialty retailer taken private in an LBO that suddenly couldn't manage its pile of debt. The biggest difference between PetSmart and other failures of the genre like Toys R' Us and Sports Authority is that the PetSmart LBO happened after the financial crisis.

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.

And so far, every hint at the company's earnings confirms this narrative. Reuters managed to get its hands on the company's third-quarter earnings late last year (since PetSmart is privately held, this information isn't public). The third quarter was the company's first full quarter after the Chewy deal, and the results weren't encouraging, to say the least, and they also drew some undesirable comparisons to Amazon (a company PetSmart had sought to emulate but...not like this).

However, the combined company’s Ebitda sank 34% to US$189m, from US$288m a year earlier, driven by negative Ebitda at Chewy that has been exacerbated by ongoing costs related to growth initiatives and customer acquisition. Petsmart’s standalone Ebitda fell 15%.

"The company is draining cash out of existing Petsmart to fund Chewy," one of the sources said. "It’s the Amazon model – Amazon takes money from the cloud business to fund the retail business."

The company’s debt includes the term loan, a US$1.35bn secured note used to fund the Chewy purchase and US$2.55bn of unsecured notes, US$650m of which was also used to fund the Chewy deal.

But while most of PetSmart's problems are common in the retail space (too much debt, squeezed margins etc.), the company is presently grappling with a scandal that threatens to alienate its most loyal customers: A rash of dog deaths during grooming appointments at its locations has elicited protests and calls for the company to improve its oversight.

PetSmart has yet to announce the rash of store closures that typically precedes a retailers' final lurch into bankruptcy. But one thing's for sure: Hell hath no fury like a dog owner who must suddenly come to grips with the loss of a pet.