Recently, Mars Inc. announced its acquisition of VCA at $93 per share, with a total value of $9.1 billion including debt. VCA is a U.S. company providing pet care services, with its main revenue coming from its chain of pet hospitals. In the 12 months ending September 2016, the company took $2.4 billion from the pockets of pet owners.

This made me realize that while I diligently scoop poop behind my dog "Piaoyu," there are people quietly scooping gold behind me. In the industry, they are known as "gold scoopers"...

In the highly developed U.S. pet market, pet spending in 2016 is projected to reach $62.8 billion, with a compound annual growth rate of about 5.0% over the past decade.

U.S. households with dogs and cats are the most numerous, and unsurprisingly, they are also the most heavily harvested group in the poop-scooping world.

Their annual spending on dogs and cats is as follows:

Medical care and food account for the largest share. Let's see who the gold scoopers are in these areas.

Pet Hospitals

VCA's 2015 revenue: $2.1 billion (approximately 15 billion RMB)

Gold-scooping capability: ★★★

As of September 2016, VCA (ticker: WOOF) operated 776 pet hospitals across 43 U.S. states, with its reach even extending into 5 provinces in neighboring Canada.

As the data above shows, pet owners across the Pacific spend an average of $786 annually on veterinary care for their dogs, accounting for 48% of total spending. However, due to high specialization and strict regulation, the pet hospital sector is actually the slowest-growing in the industry.

Before looking at VCA's financials, I assumed, based on the stereotype of hospital profiteering, that VCA's profit margins were very high. In reality, VCA's average profit margin over the past 10 years has been around 9%, not as high as pet food companies.

This is because the bargaining power that comes with specialization is firmly held by the 4,700 doctors VCA employs. This is evident from the company's low gross margin; as a service-oriented company, most labor costs are included in the gross margin calculation.

So to some extent, pet hospitals have become providers of space and equipment, and their gold-scooping capability is not the most advanced.

Pet Retail Chains

PetSmart's 2015 revenue: $7.1 billion (approximately 50 billion RMB)

Gold-scooping capability: ★★★★

PetSmart (ticker: PETM), founded in 1986, is the largest pet retail chain in the U.S. and the company most imitated by Chinese pet chains.

As of September 2016, PetSmart had 1,477 stores.

As early as the 1990s, the company was already the industry leader, mainly because the two best-selling pet foods at the time - Hill's and Iams - were sold only in pet stores. However, this good fortune did not last. Hill's began test sales in supermarkets, and Iams was acquired by Procter & Gamble, which had strong supermarket channels. Pet owners found they no longer needed to make special trips to PetSmart for their offerings, and the company's market share began to erode.

In response, PetSmart decided to offer services that ordinary stores could not, such as pet grooming, pet boarding, and pet medical care. The company's subsequent sustained growth proved this move was correct.

But no business strategy is perfect; there are always drawbacks: more services mean more expenses, and more expenses often mean higher debt.

As long as the contradiction between expansion and debt is resolved, capital will naturally favor the company. In 2014, PetSmart was acquired by a consortium of private equity firms for a total of $8.6 billion including debt.

Pet Food

Mars Petcare's 2015 revenue: $17.2 billion (approximately 120 billion RMB)

Gold-scooping capability: ★★★★★

The benefactor mentioned at the beginning of this article, Mars, is the seventh-largest private company in the U.S. in 2016 and one of the world's largest candy and chocolate manufacturers. Well-known brands like Dove, M&M'S, and Snickers are all under its umbrella.

But low-key Mars is also the world's largest pet food company. It began selling canned dog food as early as 1954, and its current revenue from pets is $17.2 billion.

Similar to infant formula, pet food has strong safety attributes, high brand-switching costs, and a longer product life cycle compared to infant formula. Once a brand barrier is formed, it creates a very wide moat.

The result is that when the industry reaches its later stages, growth can only be achieved through continuous mergers and acquisitions, leading to very high industry concentration. For example, Mars alone accounts for 44% of the total revenue of the top 10 global pet food companies, making it the undisputed king of gold scooping.

Is There an Opportunity?

After a series of mergers and acquisitions, there are not many pet-related stocks left in the U.S. Are the remaining ones potential acquisition targets?

Using PetSmart as a benchmark, the ratio of transaction value to EBITDA at the time of acquisition was 9.2 times. Now look at Blue Buffalo Pet Products (ticker: BUFF), listed in the U.S., which is the sixth-largest pet food company globally. Without considering debt, Blue Buffalo's transaction value to EBITDA ratio has already reached 18 times, and its P/E ratio is as high as 33 times.

As for why PetSmart was willing to sell a business that was still growing, I think it's because the proportion of U.S. households with pets has reached 65%, leaving limited room for growth.

In China, the proportion of households with pets is less than 10%, indicating huge potential. However, it's important to note the differences between China and the U.S. For example, companies that have imitated PetSmart over the years are still in trouble, and none have succeeded. I consulted Li Yuru, CEO of the WeChat public account "Dahua Chashi," about this phenomenon. She pointed out that their failure is due to not recognizing that PetSmart was a product of its era, and copying it mechanically won't work.

Speaking of "era," PetSmart started in the 1990s, when the U.S. was not as e-commerce-dominated as China is today, with abundant channels. This makes it much harder for pet chains that started in recent years to enter the market compared to their American predecessors. However, pet chains are not a dead end; they are just more difficult, because offline services like pet grooming, pet boarding, and pet medical care, along with the experience, are things ordinary e-commerce cannot provide.

As for whether the pet industry itself is a good industry, if you look closely, you'll see that even during the 2008-2009 financial crisis, people did not reduce their spending on pets. Investors all hope to find good companies that can ride through cycles, and the best time to judge is often after a major external shock. As Buffett said, only when the tide goes out do you discover who's been swimming naked. This indicator may cause you to miss some opportunities, but at least it ensures you won't choose wrong.

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