Pet Valu Holdings - Dangling the carrot
In October 2023, Pet Valu Holdings (TSX: PET) provided their CEO with a large retention grant. I believe that the company tipped their hand and now investors have the ability to trade alongside this information.
Pet Valu is the top pet retailer in Canada with ~830 stores and an estimated market share of ~18%. The company sells items such as pet food, treats, toys, leashes and carriers, as well as provides washing, grooming and other services for pet owners.
The business is nearing maturity and operates under a franchise model, with ~75% of the stores under franchise agreements. The franchised store count has expanded over time slightly above GDP growth, whereas the corporate-owned store count has remained relatively unchanged.
I won’t delve into the minutiae of the franchise agreements, but here are some pertinent details:
It costs ~$500k to open a new Pet Valu, which includes an initial franchise fee of $40k. The majority of the spend relates to constructing the retail space as well as purchasing inventory.
Average mature franchises generate ~$2MM in sales with a 10% EBITDA margin. Assuming a typical 3% capex to sales ratio would result in mature EBIT of ~$140k, and an estimated after-tax ROIC of ~21%.
Franchise agreements are 10-years in length and franchisees have the option to extend for two additional 5-year periods. A renewal fee of $10k is charged to franchisees should they exercise the extension options.
Franchisees pay a royalty fee of 6% of gross sales, as well as a marketing fee of 2.5% of gross sales.
Franchisees must also sublease their retail space from Pet Valu, and pay the greater of contract rent or 8% of gross sales.
The franchise base is quite fragmented overall, with 85% only owning one or two stores, and none owning more than seven stores. The company sports a 98% renewal rate among franchisees.
A few things make Pet Valu somewhat differentiated from other pet product retailers. They have 2.9MM loyalty members who generate ~80% of overall retail sales. Loyalty members on average visit the store 5-6 times per year and have a ~70% higher ticket size than non-loyalty members. I would also argue there is an experiential draw to the stores because pet owners love to bring their pets shopping with them. From a food-safety perspective, this experience cannot be replicated by the likes of Walmart, Costco, Loblaws, etc. PetSmart is the company’s largest direct competitor with ~15% market share in Canada, and has 140 larger-format stores.
Excluding the pandemic bump, same-store-sales for Pet Valu have been anywhere from 5-14% per year since 2016, which demonstrates the strength of the model with consumers. At the end of the day, retail is still a difficult business, and Pet Valu is likely to become more and more commoditized over time.
While learning about Pet Valu, I was specifically intrigued when they provided a large grant to their CEO on October 4th, 2023. It comprised both time-based and performance-based options, with a total fair value of ~$7MM. For reference, Pet Valu’s CEO typically earns a salary of ~$800k and total compensation of ~$3MM. This ad-hoc retention grant is more than twice what he typically receives in a year, and quite substantial relative to his current stock holdings in the company (~$14MM).
The timing of the grant is also peculiar because it occurred in October. Pet Valu generally provides grants to executives in March each year, which coincides with the release of year-end financial results. Making an off-cycle grant such as this one (in October) is a deliberate decision by the compensation committee and would likely be premeditated.
You only get one chance to make a grant such as this, and the timing is incredibly important. I’ve highlighted in yellow in the stock chart below the exact date when the grant was made. Quite fortuitous timing if you ask me…
This type of behaviour is unfortunately quite common from companies that are controlled by private equity.
Roark, a large private equity company, acquired Pet Valu back in 2009 for ~$140MM, and subsequently IPO’d it in June 2021. Over the 15 years of private ownership, Roark grew the company into a nationally-recognized brand and added significant value through geographic expansion and operational improvements.
As of today, Roark owns 39.2% of the shares outstanding and have three of their directors sitting on the company’s nine person board. So long as Roark has an ownership stake in excess of 30%, they have the right to nominate four directors per the most recent Investor Rights Agreement.
At the end of the day, the question is whether one should bet alongside Pet Valu’s compensation decision or not. The strike price on the granted options is ~$23.92 per share, which is reasonably close to todays price of $26.45.
The CEO’s retention grant is split into two portions:
The first half comprises 464,621 stock options that vest over a three year period.
These vest solely based on the elapsed time since the grant date.
For example, if the CEO stays for three years and the stock price increases to $35, then the options would be worth ~$5.1MM.
The other half of the grant comprises 564,374 stock options that vest only if Pet Valu’s total shareholder return (TSR) meets or exceeds the blended performance of three TSX benchmarks over a period of three years.
For the options to vest 50%, Pet Valu stock must match the blended return of the three TSX indices.
For the options to vest 100%, Pet Valu stock must exceed the total return of the three TSX indices.
For example, if Pet Valu stock outperforms the three TSX indices and the stock price increases to $35, then the CEO’s options would be worth ~$6.2MM.
It is important to note that the grant comprises stock options and not restricted stock units. Not only does the CEO have to stay for three years and outperform the stock indices, the resulting stock price must also be above the strike price of $23.92 to have any value. These criteria are by no means easy hurdles, unless insiders have a much rosier view of the company.
Board and compensation committees, especially ones controlled by private equity, will only provide grants such as these if they believe that there’s a high probability of payout to the CEO. After all, private equity companies rely on having good relationships with CEOs should they need to hire them for new portfolio investments. Having an active and willing roster of executives goes a long way from a reputational standpoint in the private equity industry.
Based on my napkin math, I think Pet Valu currently generates ~$1,100MM in revenue and ~$185MM in EBITDA less maintenance capex. This results in an EV/EBIT ratio of ~14x relative to its current enterprise value of ~$2,590MM, or an unlevered after-tax multiple of ~18.6x.
While not screamingly cheap, one could argue that a high-quality and growing franchise with strong same-store-sales should trade at a premium multiple. Insiders have timed the grant at what they thought was an attractive price of $23.92 per share, so I would back up the truck if it gets near that level again.
PS: The company provided their new CFO with a one-time new hire grant in March 2023 but instead of options, they granted it in RSU’s. Given the stock price at the time neared $40 (and was likely overvalued), I’m not surprised by their decision…