Investors seek bigger bite of pet foods

The $67bn market for cat and dog food is attracting more than just pets. Potential disposals also have investors salivating.

The industry once focused on selling standard cans of vaguely meaty concoctions. Now it commands miles of shelf Space, replete with bags of dried food targeted at pets of different ages, as well as gourmet single-serve dinners.

In the US the market is quadruple the size of that for baby food and twice the size of coffee. It boasts fat margins - pet food is the second-most profitable category behind coffee for Nestle, the world's biggest food company - and is growing at a faster clip than the human variety.

Two possible disposals are also tantalising the industry - Colgate-Palmolive's Hill's brand and Procter & Gamble's Iams. Each boasts turnover of about $2bn, on Bernstein Research estimates, implying price tags of $2.6bn-$3bn apiece.

The sector's buoyancy is in sharp contrast to the lacklustre performance of other parts of the consumer goods business. At a compound annual growth rate of 3-4 per cent in developed markets, pet food has been growing at twice the rate of personal care and home care, according to Bernstein Research.

Manufacturers have been borrowing practices more commonly associated with items for human consumption to lift profits. These include introducing ultra-premium and organic varieties as well as "single serve" portions. Mirroring high-margin Nespresso coffee pods, cat and dog food is also sold in one-meal servings.

"It's just like your tin of tuna, but they charge more because it's for your cat," says Morgan Stanley analyst Eileen Khoo.

Some 20 per cent of Nestle's growth in earnings before interest and tax over the next few years will come from pet food, according to Ms Khoo - not least as many dog owners trade up from the fad for Chihuahuas to Great Danes which, helpfully for food manufacturers, eat 12 times as much as their smaller brethren.

"It's one of the hidden jewels in Nestle," Ms Khoo says of the Swiss-based group's Purina petcare business, acquired in late 2001 for $10.3bn. "It has the highest return on capital, at over 25 per cent and plays to the whole humanisation [of animals] trend."

Privately owned Mars, best known for its chocolate bars, also makes the Pedigree and Whiskas brands and has a market share of about 20 per cent. Nestle's share is roughly the same.

Behind them, with about 4 per cent of the market each, are Hill's and Iams. Analysts reckon both are potential disposals. The purchase of a stake in P&G by activist shareholder Bill Ackman of Pershing Square Capital prompted speculation that non-core businesses such as pet food and batteries would be spun off.

For Colgate the problem is that Hill's has "hit a virtual wall, losing share and delivering no growth", according to Ali Dibadj, analyst at Bernstein Research. This is partly due to missing the drive towards "natural" products and limited exposure to emerging markets. Both Hill's and Iams largely target the premium end.

Speaking in July, Ian Cook, Colgate chief executive, said Hill's had not "made enough progress in penetrating the faster growing natural segment".

The company's Science Diet - sold partly through vets - is to be converted and relaunched with more "consumer friendly" ingredients in the second half of the year.

Pet food makes up 13 per cent of Colgate's revenues and Mr Dibadj says its rhetoric suggests it is unlikely to jettison the segment in the near future. Colgate did not respond to a request for comment.

P&G declined to comment on spin-off speculation, but stressed that it strengthened Iams with the acquisition of Natura in 2010 and said the division "mirrors our time-tested model for business growth".

Nestle's example demonstrates the appeal of keeping pet food in the fold. In the first half, profits from pet care - which makes up more than one-tenth of group sales - rose 12.25 per cent year-on-year, virtually double the overall group growth rate.

Adjusted operating margins, at 20.7 per cent, were comfortably ahead of the group's overall 15 per cent. Morgan Stanley is estimating the division will grow at a compound annual growth rate of 6.5 per cent through 2015, with margin improvement of around 80 basis points per annum, versus 30 basis points for the group.

The US will be central to this. Unusually for Nestle, which derives over 40 per cent of sales from emerging markets, it lags behind Mars in much of Asia and Latin America. Reversing that would provide another fillip to earnings.

Like all food industries, there are pitfalls, including spiralling input prices, cash-strapped consumers and a growing private label effort. But for now manufacturers like Nestle - which went so far as to run an ad aimed at dogs rather than their owners - are banking on four-legs remaining good.

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