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How PetSmart swallowed Chewy – and proved the doubters wrong



Nearly the end of 2016, sales in PetSmart Inc. stores began to slide.

Executives at BC Partners, which had purchased PetSmart in a $ 8 billion purchase in 2015, scratched their heads. The operational improvements they made during the first ownership were so successful that they had paid themselves. Why had sales in the same store suddenly dropped over a period of just three weeks from flat to down almost 5%?

Everyone who bought a dealership in 2015 knew

Amazon.com
Inc.

tends to suck the air out of every category it comes in. But the culprit turned out to be another fast-growing e-commerce company.

chewy
Inc.,

was founded in 2011, offering premium brands and effectively recreating the experience of pet stores online. It had started running TV ads in June 201

6, and the resulting increase in growth is biting PetSmart's sales.

BC Partners quickly realized that it would never be able to beat the online star. Instead, the acquisition firm embarked on a high-stakes strategy for a debt-laden retailer: It bought the e-commerce boom itself that undermined the business.

In April 2017, PetSmart paid $ 3.35 billion for Chewy in what was then the largest e-commerce deal ever. The acquisition was criticized by PetSmart's lenders and the broader market as a bet between companies that would force PetSmart to add $ 2 billion in debt to the $ 6 billion it already had, all to buy an unprofitable rival. Some compared Chewy to Pets.com, a notorious failure in the dot-com era, and predicted that it would eventually fall victim to competition from Amazon.

A Chewy distribution center in Dallas.


Photo:

Justin Clemons for The Wall Street Journal

For several months, profitable PetSmart sales continued to decline and losses on Chewy mounted, even as revenue skyrocketed.

PetSmart bonds began to fall, eventually falling below 50 cents on the dollar. Lenders signaled that PetSmart could be the next old retailer on the way to bankruptcy.

These days, Chewy is worth around $ 11 billion, and PetSmart is about to become one of the most successful private equity turning operations in history. [19659004] Chewy went public in June, and its shares have risen almost 20% since that time in what has been a busy year for the first public offerings and despite the recent surge in the IPO market. PetSmart's $ 10 billion paper gain on Chewy's first trading day is one of the largest ever from a publicly traded IPO. The bonds are back at close quarters thanks in part to $ 826 million in debt reduction driven by the proceeds from stock sales.

Obe gets a trim by groomer Samantha Torres at a PetSmart store in New York.


Photo:

Mark Kauzlarich for The Wall Street Journal

Although not a household name, BC Partners is known in private equity circles for betting on companies including regional cable TV provider Suddenlink Communications (now part of

Altice USA

) and satellite operator

Intelsat
SA

. With offices around Europe and New York, it manages more than $ 25 billion.

Raymond Svider,

a loving 56-year-old Frenchman, serves as chairman of the board. He was a 27-year veteran of BC Partners, and became a member of consulting and investment banking.

Investors saw PetSmart as poorly managed, but as a market leader in a strong category, with a healthy portfolio of outlets. They aimed to fix the company's pricing strategy and improve inventory management.

As PetSmart's business began to decline, Svider knew he needed to act fast. Given the overall state of traditional retail and the risky nature of leveraged purchases, PetSmart's evil could quickly turn into a death spiral, as they did at Toys "R" Us and other once formidable, debt-secured chains that lost customers to online stores. [19659004] BC Partners had also struggled to meet a target for a new acquisition fund it raised due to the results of some of the previous investments. Mr. Svider could not afford a black eye on PetSmart.

Building PetSmart's small online presence had been part of BC Partners' original plan, but the company was already spending money on its other priorities and could not quickly divert its focus to building an e-commerce business. Svider also doubted that the company would be able to attract the Silicon Valley talent needed to succeed.

"It was actually a decision to make or buy," he says. "What became clear to me was that the & # 39; brand & # 39; would never work; Chewy was already on its way to being 10 to 15 times the size of PetSmart's online business, and the gap accelerated every day."

Mr. Svider sent an email to

Ryan Cohen,

Chewy's co-founder and CEO, whom he had met the year before. He asked if Mr. Cohen would be interested in a sale. Cheats had been impressed at the time, keeping Chewy's ability to expand quickly without eating up a significant amount of cash. He figured that getting the fast-growing pet online business immediately would help regain lost sales and gain market share.

Raymond Svider, chairman of BC Partners, in his New York office. Below Chewy co-founder Ryan Cohen.


Photo:

Mark Kauzlarich for The Wall Street Journal



Photo:

Mark Abramson for The Wall Street Journal

"It was both offensive and defensive," says Svider about the strategy. “It was defensive because all of a sudden customers move online and we wanted to buy the manager. It was also offensive because if this case succeeded, it was an opportunity to create a lot of value. "

Mr. Cohen, who never went to college, could not have been more different from the polished, obsessed Mr. Svider, who holds two engineering degrees, an M.B.A. and a couple of Siberian cats named Cashmere and Pearl. Cohen, raised in Montreal, lived in South Florida when Mr. Svider contacted him. He had founded Chewy at the age of 25 after visiting the pet store in the neighborhood to buy Tylee teacup products, and he was trying to recreate the warm, knowledgeable customer service online. Chewy was his first real job.

When Mr. Cohen originally sought bakers, he was met with skepticism, he recalls. Most venture capital firms he turned to for his first round of funding thought he was crazy to go head-to-head with Amazon.

"I went door to door on Sand Hill Road, cold calling investors," Mr Sier Cohen, referring to the address of many venture capital firms in Silicon Valley. "Nobody wanted to give me money."

After more than 100 pitches, claiming that Amazon could never offer Chewy's intimate customer service and expertise, some did. Boston-based Volition Capital LLC invested $ 15 million in the company in 2013. The scale of Chewy's repeat business was what convinced the company to invest, according to

Larry Cheng,

a managing partner at Volition who served on Chewy's board of directors.

Chewy telephone agents aim to recreate the warm, knowledgeable customer service of a neighborhood store. Above is the Dallas Distribution Center.


Photo:

Justin Clemons for The Wall Street Journal

Customer inventory rates were "some of the highest we've ever seen," he says.

Customers who had signed up for automatic return shipments accounted for 66% of Chewy's sales in 2018, according to a securities filing. This is the result of Mr. Cohen's fanatical devotion to customer service, says Cheng.

Customer service representatives were pet lovers who sat near executives at the company's Dania Beach, Florida, headquarters and were authorized to do almost anything for Help callers, often helping them choose the right food for the pet's sensitive skin, weight loss program or allergies.

Chewy sent handwritten cards to new customers, surprisingly some, selected at random, with portraits painted in oils by their pets. [19659004] Mr. Cheng recalls witnessing some reps staying on the phone with a customer for as long as two hours. "We knew that if we won the customer, we would have them for life," he says.

By the time Svider e-mailed Cohen, Chewy had raised just over $ 350 million in non-capital and was on the verge of a stock exchange listing. But the road ahead looked potentially dangerous: Shares of listed online retailers Wayfair Inc. and Etsy Inc. were having a hard time as investors worried they wouldn't face competition from Amazon.

It was also a period of personal emotional upheaval for Mr. Cohen. A few weeks after his wife gave birth to his son, Mr. Cohen's father suffered a major heart attack, which made the prospect of an IPO seem even more overwhelming.

Selling Chewy to a specialist retailer would give it more leverage from suppliers. and help the company achieve profitability faster, Mr. Cohen reckoned. Still, he and the investors were determined to endure a great price. They also wanted Chewy to remain a business of its own to preserve its startup culture and value as an effortless e-commerce company.

PetSmart rival Petco Animal Supplies Inc., backed by private equity firm CVC Capital Partners, was also interested in a deal, but wanted to pay in part using shares, and Mr. Cohen was not keen on owning shares in a highly indebted brick and mortar retailer. PetSmart surprised him by coming forward with a cash bid as a deadline for offers broke out.

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"He was able to do it at the last minute," Cohen says of Svider. He gives the executive credit for understanding that Chewy had to be kept separate and evaluated over a different time horizon than the typical five years that buy-outs hold their investments.

"I built a customer-focused business in the long run," he says. "Chewy didn't make sense in the short term."

As the prices of PetSmart's bonds began to fall further, it became clear that lenders and the broader market were not getting the Chewy deal – saying that they were overcharging PetSmart and putting it in competition with the seemingly unbeatable Amazon.

"Everyone thought it was stupid," says Svider. "It was not an easy decision to put $ 3 billion into a company that lost money."

He says that the market did not understand that Chewy reinvested all the cash generated from existing customers to acquire new ones, which were expensive in the beginning because the company lured them with big discounts on the first orders.

As long as Chewy's newly acquired customer base was larger than the existing one, the losses will continue to increase. The company believed that eventually revenues from existing customers would outweigh the costs of growth, and it would record profits.

An order that was filled at Chewy's Dallas Distribution Center, and below, a pallet of dog food.


Photo:

Justin Clemons for The Wall Street Journal



Photo:

Justin Clemons for The Wall Street Journal

The comparison with Pets.com was particularly annoying to Ms. Svider and Cohen. Incorporated in 1999, Pets.com aims to capture what the founders thought would be a flood of consumers shopping online. But e-commerce was still new, and the company never managed to gather the customer base needed to meet the high fixed costs, namely shipping and storage infrastructure. In the end, it exceeded a quarrel for customers.

At PetSmart, sales of the same store continued to decline. In August 2017, the CEO resigned, and Svider stepped into the role himself. He began a fierce 10-month vote, leaving his wife and three children in New York each week to spend two to four days at PetSmart's Phoenix headquarters to work on a strategy to stabilize PetSmart and take Chewy public.

March 2018, Toys "R" Us, which had applied for Chapter 11 bankruptcy protection last fall, said it would sell or close all the more than 700 remaining US stores. PetSmart bonds fell below $ 50 for the dollar, signaling that investors were worried they might face a similar fate.

On June, PetSmart announced an aggressive move to restructure Chewy ownership, placing much of the stock out of reach for bondholders. It mirrored tactics employed by other private equity-backed dealers such as J.Crew Group Inc. and Neiman Marcus Group Ltd. to preserve the value of its shareholders.

Jojo gets a treat at a PetSmart store in New York.


Photo:

Mark Kauzlarich for The Wall Street Journal

Lenders saw it as a desperate attempt to keep the most valuable part of the company away from them in the event of a bankruptcy and lined up for a legal battle.

After months of negotiations, PetSmart managed to scrape together the votes required to resolve the dispute and paved the way for a stock exchange listing by Chewy in June 2019.

Mr. Svider and his team also managed to curb the downturn in PetSmart's stores, partly by canceling the number of individual products sold and making it easier for customers to find them. Executives expanded and improved the company's private label brands, giving higher margins, and revamped PetSmart's marketing to emphasize in-store services such as veterinary clinics, grooming, doggy daycare and pet hotels – things online retailers, including Chewy, can't offer.

Sales of the same store in PetSmart were only slightly negative in the first two quarters of this year, shows investor communication. The company's most accurate earnings target was $ 1.1 billion in 2018, higher than what PetSmart had posted in the last year before the acquisition.

PetSmart still owns around 87% of Chewy and the final return will depend on whether it manages to sell its ownership profitably. Chewy made its second quarterly report as a public company on September 17, bringing revenue up 43% from the previous year's quarter to $ 1.15 billion and raising sales expectations for the full year. But the company reported a larger net loss, driven by higher costs associated with paying employees with shares.

It is more difficult for BC Partners to sell or take PetSmart publicly at a time when financial markets and private equity companies have largely removed brick-and-mortar dealers.

Many Chewy customers sign up for automatic return shipments.


Photo:

Justin Clemons for The Wall Street Journal

An opportunity could involve combining PetSmart with Petco, which is likely to give many opportunities to shave overlapping costs, according to people familiar with the matter. Regulators that could otherwise oppose an agreement combining physical players # 1 and 2 may allow such a move given the booklet to Chewy and Amazon in the business and sale of pet food and supplies through big box stores such as

Walmart
Inc.

The business can then be sold or published.

Mr. Svider says that he does not exclude anything, but that now is not the time to sell. His primary focus is getting PetSmart a consistently flat or slightly positive sale in the same store during the second half of next year or earlier.

For Mr. Cohen, Chewy's success is bittersweet. The buyout and IPO have validated his view, but by selling out for cash he missed the explosive gains in Chewy's shares. He left the company in March 2018.

"It was emotional," he says of the IPO. “I literally sat outside the New York Stock Exchange the night before. I cry all the time. ”

Write to Miriam Gottfried at Miriam.Gottfried@wsj.com

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