Blue Buffalo's a Natural Buy

As pets are increasingly seen as members of the family by millennials choosing to delay parenthood and by older households where children have left the home, owners are seeking premium pet foods that mirror trends in human categories, particularly those favoring natural, clean-label, high-protein, and snack items.

Blue Buffalo Pet Products BUFF has benefited, with an all-natural lineup that contributes about one third of subcategory sales.

The premium subcategory is far more conducive to developing durable brand intangible assets, which we believe have given Blue Buffalo a competitive advantage. Because owners hesitate to switch from a tolerated food and are reluctant to cut pet spending in times of economic stress--no significant trade-down occurred during the 2008-09 recession--Blue Buffalo's broad product set has delivered strong returns on invested capital, averaging 59% the past three years.

We anticipate that efforts to build a therapeutic lineup, consisting of products that require a veterinarian's prescription, will add to Blue Buffalo's competitive position. As part of the rollout, the firm has targeted veterinarians with sales, advertising, and promotions to improve its standing with the professionals who are the top influencers of pet owners' buying behavior. While we expect this initiative along with international expansion will require incremental spending, we believe it will add cost leverage while building brand strength.

The growth in wholesome, natural products has not escaped the attention of large conventional pet food makers and upstarts, creating competitive pressure focused especially on puppies and kittens, since owners are unlikely to switch brands over the life of the animal. Blue Buffalo has favored pet superstores (63% of 2016 sales came via PetSmart and Petco) while forgoing the food, drug, and mass merchandise channels. Though it is diversifying its channel mix via e-commerce and farm and feed stores, Blue Buffalo could find itself pressured if shoppers increasingly look to buy differentiated pet foods from conventional grocers as availability improves and natural human foods proliferate in the channel.

Brand Intangible Assets Result in a Narrow Moat
Blue Buffalo is a leading natural pet food producer with a product lineup that competes exclusively in the premium segment, as opposed to the lower-margin and less-differentiated mainstream division. It holds a mid-30s share of the wholesome natural market (about 4 times the size of the next-largest brand), a subcategory that constitutes about 18% of overall pet food sales. Its strong gross and operating margins reflect its pricing power, as the firm has been able to remain solidly profitable despite competing in a lucrative category. Blue Buffalo has averaged a 42% gross margin and 21% operating margin over the past three years, with an uptick to 46% and 24%, respectively, expected in fiscal 2017 as the firm benefits from a new plant investment that should allow it to move much of its manufacturing in-house. These results outpace Big Heart's (owned by J.M. Smucker SJM ) mid-30s gross margins and midteens operating margins, though they trail Colgate-Palmolive's CL mid- to high 20s pet operating margins (we suspect this is due to the consumer products giant's sourcing and distribution leverage with the remainder of its businesses). Blue Buffalo's recent returns on invested capital are also consistent with our assessment, most recently 67% in 2016 (59% three-year historical average) and well above our 7% estimate of the weighted average cost of capital. That said, we do not believe Blue Buffalo has a sustainable cost advantage over peers that can replicate best practices in production to achieve comparable profitability, ultimately leading us to conclude the company has a narrow, rather than wide, economic moat.

The pet food category's attractive dynamics are driven by increased pet ownership and humanization of animals in households that have chosen to delay parenthood (millennials, who are generally starting families later than their forebears and view pets as a form of training for parenthood) or among people whose children have left the home. Given the tendency to view pets as members of the family (95% of pet owners responded as such in a 2015 Harris poll, up from 88% in 2007), consumers are hesitant to trade down to a lower-quality product or away from their dog's or cat's favored food. The loyalty dynamic and demographic trends have combined to limit private-label penetration in pet food to about 10% (versus around 20% private-label penetration for U.S. food and beverage in the aggregate; the share is even lower in the premium segment in which Blue Buffalo's products lie) and have made consumers receptive to innovative products. The pet food industry mirrors trends in the consumer food sector, with an increasing focus on natural and health-oriented products and a move toward more frequent snacking. However, the industry is bifurcated, with product offerings differing significantly between conventional mass retail (which Blue Buffalo has forgone) and specialty stores including pet superstores, smaller regional sellers, and farm and feed shops. While the food, drug, and mass merchandise channels still account for two thirds of pet food volume sold, they only account for about half of the $28 billion spent on the category in 2016, given their focus on undifferentiated, lower-margin products that turn more quickly than the less commoditylike counterparts in premium subcategories.

Animal appetites are price-inelastic and contained within a narrow range of palatable foods. Combined with pet owners' hesitance to switch away from a product their dog or cat tolerates, this insulates the category from much of the intense competition seen in center-of-store human consumable segments, which has compressed margins and diminished competitive advantages in several aisles. However, the humanization trend has led customers toward pet snacks and premium wet food products (often in Blue Buffalo's wholesome natural subsegment), leaving significant opportunities for premiumization beyond traditional mainstream bagged brands. The company has responded well to the trend, adding product lines above its already premium-priced Life Protection Formula that are consistent with dynamics occurring in human food. For example, its Wilderness, Basics, and Freedom lines correspond to consumer desires for protein-rich, clean-ingredient, and grain-free diets.

Category undercurrents have led to the pet food industry's relative durability even in times of economic stress, which lead us to believe the premium subcategory (and Blue Buffalo) should be less sensitive to trade-down effects in the event of a recession. While Blue Buffalo was not a public company during the 2008-09 recession, competing firms indicated that customers avoided cutting expenditures on their pets, choosing to economize elsewhere. Even within the category, little trade-down from premium to mainstream categories was cited despite premium subsegment price increases meant to compensate for rising input costs; this is consistent with more recent price discounting efforts, which have had a limited impact on sales. This was borne out in industry margins through the downturn. Colgate-Palmolive's pet unit has held operating margins at 25%-29% since 2004 (with a 100-basis-point dip in 2008 followed by an 80-basis-point uptick in 2009, despite three commodity-linked price hikes over 15 months). Big Heart saw a meaningful operating margin decline in 2009 (to 13.1% from 16.2% in 2008 and 17.2% in 2007), but the dip corresponded with a spike in input costs that came ahead of price increases that led to a 20.3% mark in 2010. Industry performance during the recession raises our confidence that Blue Buffalo should be able to maintain solid top- and bottom-line results even if economic conditions deteriorate meaningfully.

Blue Buffalo has eschewed the food, drug, and mass merchandise channels in favor of pet superstores, regional specialty retailers, farm and field shops, and e-commerce. We believe this has been a prudent decision, allowing Blue Buffalo to focus its resources on channels more likely to attract the affluent, variety-seeking customer it targets with a full range of products, as opposed to more confined shelf space in traditional channels. However, increasing natural food options in food, drug, and mass merchandise retailers may require Blue Buffalo to re-evaluate its strategy, particularly given that the firm's largest competitors are part of established branded packaged food enterprises that carry considerable clout with traditional grocers as they are able to capitalize on a sizable portfolio of human products that are proven store traffic drivers (for example, Colgate-Palmolive, Smucker, Nestle NSRGY , and Mars). Should buyers look to conventional channels for convenient access to comparable products, despite fewer available stock-keeping units and large-scale firms' limited success in the wholesome natural segment to date, Blue Buffalo could see its competitive standing diminish, particularly if such a change coincided with increased competitive penetration into pet superstores, similar to Smucker's 2015 launch of its Natural Balance lineup into PetSmart, though that introduction has not had a meaningful impact on Blue Buffalo's sales through the chain to date. Smucker's recent launch of its Nature's Recipe lineup into the grocery and mass market channels is indicative of traditional pet food peers' efforts in the space.

While Blue Buffalo has strong share in the wholesome natural segment, we do not believe its positioning has resulted in a durable cost advantage. Production best practices can be duplicated, and the company's scope is insufficient to allow cost leverage over several categories, unlike broader packaged food firms. Along with the long-term competitive environment in the industry, this lack of a cost advantage is a factor leading us to conclude that the company has only a narrow economic moat.

Competition Could Take a Bite
Segment growth has drawn attention from large traditional pet food firms and upstarts. In addition to growing penetration from large firms' natural offerings, competition is rising among premium treats and wet foods. This could leave Blue Buffalo's brands behind if the firm fails to innovate (or give the firm an edge if it stays ahead of the competition).

Blue Buffalo's standing could erode if conventional grocers' increasing natural food offerings lead to shoppers buying natural pet foods available in the conventional channel (where Blue Buffalo does not have a presence) rather than specialty stores. If grocers attract premium customers and use scale and limited shelf space to extract better pricing, industry margins could suffer. Pet superstores could also try to capture a larger part of the profits in premium pet food, using their high share of Blue Buffalo's distribution to pressure margins.

Pet owners' desires are changing rapidly, and while the category was durable through the 2008-09 recession, it is unclear whether new buyers entering the market since then will behave similarly. Millennials are driving much of the trend toward pet ownership, humanization, and premiumization, and as this cohort is on shakier economic footing than others, owners may sacrifice high-end pet products in a sharp recession. Similarly, owners who have only recently moved up market may be more likely to trade down, particularly if they see natural foods as a part of a healthy diet rather than as a lifestyle decision.

The therapeutic initiative exposes Blue Buffalo to the need to prove clinical efficacy as well as regulatory scrutiny. This risk should grow with the segment's sales. International expansion adds foreign currency exposure.

We assume U.S. corporate tax reform will benefit Blue Buffalo starting in 2018; deviation from our targets (calling for a mid-single-digit-point reduction in the firm's effective rate) could lead performance astray.

We do not foresee the company commencing a regular dividend payout because opportunities for profitable reinvestment should be abundant as Blue Buffalo grows. Instead, we expect the firm will explore acquisitions to add brands, pet-care products, or international capabilities, with debt and equity issuances as needed to augment organically generated funds. Rather than speculate on the timing and nature of purchases, our analysis assumes Blue Buffalo purchases its stock with excess funds (its likely second choice for deployment of surplus capital) such that it remains net debt neutral.