Follow Fido's Nose: Pet Food A Great Investment

Includes: CL, NSRGY, PETM, PG
by: Tony Daltorio

Most people see their pets as part of the family, so they will do anything they can for them.

This includes buying what they perceive to be the very best pet food.

A poll earlier this year, cited by Bloomberg and conducted by market research firm Mintel, found that 79 percent of pet owners consider the quality of pet food to be as important as the quality of food given to the rest of the members of the family.

This fondness of people for their pets should tell alert investors there may be an investment opportunity here.

Pet Food Market

The global market for dog and cat food is massive. . .about $67 billion annually.

In the United States, the market is four times the size of that for baby food and about twice the size of the coffee market.

Bernstein Research found that the compound annual growth rate in the pet food market in the developed markets is twice the rate of growth of human personal care items, at 3-4%.

The two main makers of dog and cat food are privately-held Mars (best known for its chocolates) with its Pedigree and Whiskas brands and Swiss food giant Nestle SA ADR (OTCPK:NSRGY) with its numerous Purina brands (Purina, Alpo, Beneful, etc.). Both have about a 20 percent share of the market.

Two other well known players in the industry are Colgate-Palmolive (NYSE:CL) with its Hills brand and Procter & Gamble (NYSE:PG) with its Iams brand. Each brand controls roughly 4 percent of the dog and cat food market.

Nestle's Success

A closer look at Nestle's pet food business shows that it is quite successful.

It is the company's second most profitable business, behind only coffee. And like the company's Nespresso coffee pods business, dog and cat food often is sold in one meal servings.

Morgan Stanley analyst Eileen Khoo told the Financial Times she believes that 20 percent of Nestle's growth in earnings the next few years will come from the pet food business. She said, "It's one of the hidden jewels in Nestle [and] has the highest return on capital at over 25 percent."

Khoo expects the division to grow at a compound annual growth rate of 6.5 percent through 2015. She also expects margin improvement of about 80 basis points per year.

This may prove to be a conservative estimate based on Nestle's otherwise weak first-quarter 2013. Pet food grew the most of all categories, rising 7.9 percent year-on-year. Nestle's did particularly well in selling pet food in the emerging markets.

Speaking of the emerging markets, pet ownership in China has exploded as capitalism spreads. The country's pet food market seems to be moving into high gear as the population becomes more wealthy.

According to Euromonitor, pet care spending will nearly double by 2017 in current prices. This will bring spending on pets to $2.1 billion by that date.

This still relatively small number should expand rapidly in the years ahead, benefiting Nestle and others with a large presence in China.

Spinoffs Coming?

But what about the other two players in the market, Colgate and P&G?

Many observers believe that eventually their pet foods business will be spun off to shareholders. With both Hills and Iams having turnover in the $2 billion range, any spinoffs will likely have a price tag of $2.5-$3 billion each.

Pet food accounts for some 13 percent of Colgate's revenues though. So it may not want to part with Hills just yet, hoping to revive the no growth brand with a move toward a focus on being consumer friendly through the introduction of more natural products.

P&G did strengthen the Iams brand somewhat in 2010 with the acquisition of the Natura brand. But the patience of the company's management may be running thin on this division.

Pet Store Chains

The lure of profits from dog and cat food has also lured in the major pet store chains, closely-held Petco and PetSmart (NASDAQ:PETM), with its more than 1,200 locations.

Petsmart is especially keen on premium and organic pet foods. The company sells grain-free Innova Prime dog food made from chicken, turkey and peas for a pricey $52.99 for a 25-pound bag. It also sells 33-pound bags of Blue Buffalo Life Protection foods for $51.99. Regular dog foods sell for less than half that price for a similar bag.

These high-priced premium brand pet foods no doubt have played a major role in the company's success over the past several years. Petsmart's stock more than tripled from 2008 through 2012 and has held its own this year.

The takeaway for investors is that the pet food business is growing and is a profitable one.

Nestle and Petsmart look like good investments. And any spinoff of Hills or Iams could turn out to be a 'tasty' investment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.