"After more than 100 pitches, in which he argued Amazon could never provide the intimate customer service and expertise of Chewy, someone did. Boston-based Volition Capital LLC put $15 million into the company in 2013. The volume of Chewy’s repeat business was what convinced the firm to invest, according to Larry Cheng, a managing partner at Volition who served on Chewy’s board."
How PetSmart Swallowed Chewy—and Proved the Doubters Wrong
The market poo-pooed PetSmart’s $3.35 billion purchase of Chewy—a fast-growing online retailer that was sucking away customers from the bricks-and-mortar chain
WALL STREET JOURNAL
By Miriam Gottfried
Executives at BC Partners, which had bought PetSmart in an $8 billion leveraged buyout in 2015, were scratching their heads. Operational improvements they made during their first year of ownership were so successful they had paid themselves a dividend. Why had same-store sales suddenly fallen over a period of only three weeks from flat to down almost 5%?
Anyone buying a retailer in 2015 knew Amazon.com Inc. tends to suck the air out of every category it enters. But the culprit turned out to be another fast-growing e-commerce company. Chewy Inc., CHWY -3.83% founded in 2011, was offering premium brands and effectively replicating the specialty pet store experience online. It had started running TV ads in June of 2016, and the resulting surge in its growth was biting into PetSmart’s sales.
BC Partners quickly realized it would never be able to beat the online star. Instead, the buyout firm settled on a high-stakes strategy for a debt-laden retailer: It bought the very e-commerce upstart that was undermining its business.
In April 2017, PetSmart paid $3.35 billion for Chewy in what was then the largest e-commerce deal ever. The purchase was criticized by PetSmart’s lenders and the wider market as a bet-the-company move that would force PetSmart to add $2 billion in debt to the $6 billion it already had, all to buy an unprofitable rival. Some likened Chewy to Pets.com, a notorious failure of the dot-com era, and predicted it would ultimately fall victim to competition from Amazon.
For months, sales at PetSmart, which is profitable, continued to sag, and losses at Chewy mounted, even though its revenue skyrocketed.
PetSmart bonds began to fall, eventually going below 50 cents on the dollar. Lenders were signaling that PetSmart could be the next old-line retailer heading for bankruptcy.
These days, Chewy is worth about $11 billion, and PetSmart is shaping up to be one of the most successful private-equity turnarounds in history.
Chewy went public in June, and its shares have climbed nearly 20% since then in what has been a busy year for initial public offerings and despite the recent tumult in the IPO market. PetSmart’s roughly $10 billion paper gain on Chewy’s first day of trading is one of the largest ever from a private-equity-backed IPO. Its bonds are back near par thanks in part to $826 million of debt reduction fueled by proceeds from the share sale.
Though not a household name, BC Partners is known in private-equity circles for bets on companies including regional cable-TV provider Suddenlink Communications (now part of Altice USA ) and satellite operator Intelsat SA . With offices around Europe and in New York, it manages more than $25 billion.
Raymond Svider, an affable 56-year-old Frenchman, serves as the firm’s chairman. A 27-year veteran of BC Partners, he joined after stints in consulting and investment banking.
The investors saw PetSmart as poorly managed, but as a market leader in a strong category, with a healthy portfolio of retail outlets. They set out to fix the company’s pricing strategy and improve its inventory management.
When PetSmart’s business started to decline, Mr. Svider knew he needed to act fast. Given the parlous state of traditional retail and the risky nature of leveraged buyouts, PetSmart’s woes could quickly turn into a death spiral, as they did at Toys “R” Us and other once-formidable, indebted chains that lost customers to online retailers.
BC Partners had also been struggling to meet a target for a new buyout fund it was raising due to the performance of some of its prior investments. Mr. Svider could ill afford a black eye with PetSmart.
Building up PetSmart’s small online presence had been part of BC Partners’ original plan, but the firm was already spending money on its other priorities and couldn’t quickly divert its focus to building an e-commerce business. Mr. Svider also doubted the company would be able to attract the Silicon Valley-type talent necessary to succeed.
“It was effectively a make or buy” decision, he says. “What became evident to me was that the ‘make’ would never work; Chewy was already on a path to being 10-to-15 times the size of PetSmart’s online business, and the gap was accelerating every day that went by.”
Mr. Svider sent an email to Ryan Cohen, Chewy’s co-founder and chief executive, whom he had met the previous year. He inquired whether Mr. Cohen would be interested in a sale. Mr. Svider had been impressed by then closely held Chewy’s ability to expand rapidly without eating up a significant amount of cash. He figured that acquiring the fastest-growing online-pet business would immediately help recapture lost sales and gain market share.
“It was both offensive and defensive,” Mr. Svider says of the strategy. “It was defensive because all of a sudden customers are moving online, and we would be buying the leader. It was also offensive because if this thing succeeded, there 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, besuited Mr. Svider, who has two engineering degrees, an M.B.A. and a pair of Siberian cats named Cashmere and Pearl. Mr. Cohen, raised in Montreal, was living in South Florida when Mr. Svider contacted him. He had co-founded Chewy at age 25 after visiting his neighborhood pet store to buy products for his teacup poodle Tylee, and he set out to replicate the warm, knowledgeable customer service online. Chewy was his first real job.
When Mr. Cohen initially sought backers, he was met with skepticism, he recalls. Most venture-capital firms he approached 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. Cohen says, referring to the address of many venture-capital firms in Silicon Valley. “Nobody wanted to give me money.”
After more than 100 pitches, in which he argued Amazon could never provide the intimate customer service and expertise of Chewy, someone did. Boston-based Volition Capital LLC put $15 million into the company in 2013. The volume of Chewy’s repeat business was what convinced the firm to invest, according to Larry Cheng, a managing partner at Volition who served on Chewy’s board.
The customer-retention rates were “some of the highest we had ever seen,” he says.
Customers who had signed up for automatic recurring shipments made up 66% of Chewy’s sales in 2018, according to a securities filing. That’s the result of Mr. Cohen’s fanatical devotion to customer service, Mr. Cheng says.
Customer-service representatives were pet lovers who sat near executives at the company’s Dania Beach, Fla., headquarters and were empowered to do almost anything to assist callers, often helping them select the right food for their pet’s sensitive skin, weight loss program or allergies.
Chewy sent handwritten cards to new customers, surprising some, selected at random, with portraits painted in oils of their pets.
Mr. Cheng recalls witnessing some representatives who stayed on the phone with a customer for as long as two hours. “We knew if we won the customer, we would have them for life,” he says.
By the time Mr. Svider emailed Mr. Cohen, Chewy had raised just over $350 million in outside capital and was on the path to an IPO. But the road ahead looked potentially hazardous: Shares of publicly traded e-commerce peers Wayfair Inc. and Etsy Inc. were having a rough time as investors worried they would be unable to cope with competition from Amazon.
It was also a period of personal emotional upheaval for Mr. Cohen. A couple of weeks after his wife gave birth to their son, Mr. Cohen’s father suffered a major heart attack, making the prospect of an IPO seem even more overwhelming.
Selling Chewy to a specialty retailer would give it more leverage with suppliers and help the company reach profitability more quickly, Mr. Cohen reckoned. Still, he and his investors were determined to hold out for a big price. They also wanted Chewy to remain a completely separate business to preserve its startup culture and its value as an unencumbered 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 stock, and Mr. Cohen wasn’t keen on owning shares in a highly indebted bricks-and-mortar retailer. PetSmart surprised him by stepping forward with an all-cash bid as a deadline for offers loomed.
“He was able to do it, last-minute,” Mr. Cohen says of Mr. 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 buyout firms hold on to their investments.
“I was building a customer-focused business over the long run,” he says. “Chewy didn’t make sense in the short-term.”
As prices on PetSmart’s bonds began to sag further, it became clear that lenders and the broader market didn’t get the Chewy deal—saying it loaded too much debt on PetSmart and put it in competition with the seemingly unbeatable Amazon.
“Everyone thought it was stupid,” Mr. Svider says. “It was not an easy decision putting $3 billion into a company that was losing money.”
He says the market didn’t understand that Chewy was reinvesting all of the cash generated from existing customers into acquiring new ones, who were expensive at the beginning because the company lured them with big discounts on their first orders.
As long as Chewy’s newly acquired customer base was bigger than its existing one, its losses would continue to mount. The company believed that eventually revenue from existing customers would overtake the costs of growth, and it would register profits.
The comparison to Pets.com was particularly irksome to Messrs. Svider and Cohen. Incorporated in 1999, Pets.com aimed to capture what its founders thought would be a flood of consumers shopping online. But e-commerce was still new, and the company was never able to amass the customer base necessary to cover its high fixed costs, namely shipping and warehouse infrastructure. In the end it overspent in a scramble for customers.
At PetSmart, same-store sales continued to decline. In August 2017, its CEO resigned, and Mr. Svider stepped into the role himself. He began a grueling 10-month stint, leaving his wife and three children in New York each week to spend two-to-four days at PetSmart’s headquarters in Phoenix to work on a strategy to stabilize PetSmart and take Chewy public.
In March 2018, Toys “R” Us, which had filed for chapter 11 bankruptcy protection the previous fall, said it would sell or close all of its more than 700 remaining U.S. stores. PetSmart bonds fell below 50 cents on the dollar, signaling investors were worried it might face a similar fate.
That June, PetSmart announced an aggressive move to restructure Chewy ownership, putting a large chunk of its shares out of the reach of bondholders. It mirrored a tactic employed by other private-equity-backed retailers such as J.Crew Group Inc. and Neiman Marcus Group Ltd. to preserve value for their shareholders.
Lenders saw it as a desperate attempt to keep the most valuable piece of the company away from them in the event of a bankruptcy, and geared up for a legal fight.
After months of negotiations, PetSmart managed to scrape together the votes required to resolve the dispute, paving the way for an IPO of Chewy in June 2019.
Mr. Svider and his team also managed to stem declines at PetSmart’s stores, in part by culling 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, which yield higher margins, and revamped PetSmart’s marketing to emphasize in-store services such as veterinary clinics, grooming, doggy day care and pet hotels—things online retailers, including Chewy, can’t offer.
PetSmart same-store sales were only slightly negative in the first two quarters of this year, investor communications show. The company’s most closely watched measure of earnings came in at $1.1 billion in 2018, higher than what PetSmart had posted in the last year before its buyout.
PetSmart still owns about 87% of Chewy and its ultimate return will depend on whether it manages to sell down the stake profitably. Chewy made its second quarterly report as a public company Sept. 17, posting revenue that grew 43% from the previous year’s quarter to $1.15 billion and raising its sales expectations for the full year. But the company reported a wider net loss, driven by higher costs related to paying employees with stock.
More difficult for BC Partners may be selling or taking PetSmart public at a time when financial markets and private-equity firms have largely shunned bricks-and-mortar retailers.
One possibility could involve combining PetSmart with Petco, which would likely afford ample opportunities to shave overlapping costs, according to people familiar with the matter. Regulators who could otherwise oppose a deal combining the No. 1 and 2 physical players might allow such a move given the heft of Chewy and Amazon in the business and the sale of pet food and supplies through big-box stores such as Walmart Inc. The business could then be sold or taken public.
Mr. Svider says he isn’t ruling out anything but that now isn’t the time to sell. His primary focus is to get PetSmart to a consistently flat or slightly positive same-store sales by the second half of next year or earlier.
For Mr. Cohen, Chewy’s success is bittersweet. The buyout and IPO have validated his vision, 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 paralyzed outside the New York Stock Exchange the night before. I was crying the whole time.”
Write to Miriam Gottfried at Miriam.Gottfried@wsj.com