Do Wagging Tails Translate to Value Creation?

The following article is based on the personal views of the author. Mid-Atlantic Partners is not liable for those that make decisions based on the information contained herein. The information contained in the following article was obtained from research and publicly available data and was relied on by Mid-Atlantic Partners without assuming responsibility for independent verification as to the accuracy or completeness of such information. Rather, the purpose of this article is to simply provide a perspective as it relates to market trends and observations. It is our hope that you enjoy the content and continue to read The Northeast Sentinel. Accordingly, this material may not be reproduced, disseminated, quoted or referred to, in whole or in part, or used for any other purpose, without the prior written consent of Mid-Atlantic Partners LLC.

My Dog did My Homework.

The Pet Services industry is currently experiencing significant growth, driven by increasing trends of pet humanization and the rising demand of premium pet care. Following COVID-19, consumers rushed to purchase and adopt dogs and cats – driving the initial demand and overall growth in the services and care markets. Recent data suggests the market should eclipse $50 billion by 2030. Big players such as Chewy, Bark, PetCo, and the Farmer’s Dog have separated themselves as perceived ‘winners’ harnessing these market tailwinds with their superior digital marketplace platforms. For companies of this size, they benefit from something known as network effects, or value uplifts due to a higher volume of users. But while achievements like network effects are a head-start in collecting market share, they do not necessarily translate to the high valuations current industry dynamics might suggest.

In the middle of the 20th century, finance professor Eugene Fama presented the Efficient Market Hypothesis (EMH). What he stated was that capital markets, in this case stock markets, are efficient in reflecting information about companies and industries. From a public market perspective, the post-COVID honeymoon appeared to have ended for names such as Chewy (CHWY), Bark (BARK), Trupanion (TRUP) quite some time ago. To demonstrate, we created a fictitious market index known for the purposes of this article as the ‘Pet Services Index’. The constituents include Chewy (CHWY), Bark (BARK), PetMed Express (PETS), Trupanion (TRUP), and PetCo (WOOF) with an examination period of September 2021 to October 2024. By taking the median change of the share prices of these five holdings and running directly against the S&P500, the picture is far from rosy.

Figure 1

Source: Yahoo Finance

Around the end of 2021, the S&P passed our four-legged index and seems to have never looked back. Figure 1 demonstrates that by using a starting point of $100 and applying the daily change in the last day’s sale price to that $100 there is a large discrepancy between the market and the Pet Services Public Comps.  So, what does this mean? Are the public markets discounting our furry friends too significantly based on the growth potential of these assets and the overall pet services market?

Here at Mid-Atlantic Partners, we aim to present our readers with a strong null hypothesis that is followed by an alternative argument on how to harness the tailwinds of the ever-evolving pet services market while not falling prey to the headwinds faced by public comps. 

It Pays to Be Different.

To make sense of Figure 1 it helps to look at the bigger picture for the models in the Pet Services Index. Almost every constituent possesses the word retail in their business description whether online or specialty. In fact, the only one that doesn’t, Trupanion, the leading pure play pet insurance company, has the best shareholder return of the select five. In 2024, if a company brands itself as a retailer any analyst will always revert to the question of why Amazon wouldn’t offer that. Hence these companies are subjecting themselves to the drudging concept of commoditization. This reduces the value of each company’s service and product to universal commodities that can be offered by any new entrant where the lowest price and easiest transaction will win. Essentially what Amazon does with ‘Winner Take All’ markets. While it is hard to say whether this reality is the primary drag on the low valuations of these companies, it is certainly something to note. And by looking deeper into the numbers there can be some justification for what is driving the market.

The market is undoubtedly growing. While Millennials and Gen Z’ers are not accumulating the assets at the rate the generation before them did, they are making up for it by acquiring four-legged family members. It has been stated that over 70% of households in the United States own a pet, with 50% of all owners owning three pets or more. The utility people get from pets appears to be increasing with more discretionary income going towards better food, service, and goods for their animals. So before telling your friend to stay away from the basket of stocks listed above, remember that they are marketing to a massive market. 

Figure 2

Source: Company 10Ks

Where is the Value?

There are many up-and-coming services where businesses are generating substantial value. Turning to the small business community, service models are presenting themselves in the form of pet grooming, boarding, daycare, training, dentistry, chiropractic, rehabilitation, transportation, babysitting, nutrition coaching, portraiture, waste removal, memorial, bereavement, enrichment, and even vacation planning for sought after pet-friendly destinations. We are still waiting on that blueprint story for a ‘mom and pop’ that grew up, landed institutional capital, and became so big ownership had no choice but take the company public. Early-stage investors of Chewy, Bark, and PetMed are probably spitting out their coffee as they read the previous sentence. Still, we reserve the ability to attribute a lot of the early success stories to first-mover advantage or franchise sprawl where the growth is more so related to a ‘block and tackling’ strategy in a growing market. The success stories out there do exist. Platforms such as Village Pet Care, Best Friends Pet Care, and Rover, have made it without franchising by focusing on delivering consistent customer delight.

The conundrum that exists in the pet services market is that it does not lend itself to traditional ‘buy and build’ acquisition plays. These strategies consist of acquiring additional competitor businesses for efficiencies on the fixed cost line. The problem with this is that for pet services the service models are incredibly sensitive to any changes that may occur in terms of trying to operate more efficiently. In other words, cost cutting. For models such as daycare and boarding, there have been a substantial number of new players and concepts entering the market as of late. This has driven up competition resulting in increased pressure on pricing models and the overall consumers’ willingness-to-pay for premium services. In this scenario, having a wide competitive moat is critical. The ability to do this comes from understanding what makes you different in the market. In retrospect, this type of model requires finding an equilibrium by decreasing the margin for where the business can maximize the lifetime value of current and new customers.  Any lesson taken from the publicly traded players is that commoditized services that do not differentiate run the risk of losing in the long run.  Start by developing a formula for your business that sets you apart from the option down the street. If you charge $10 more per day, that’s ok if it goes towards creating and preserving the value you bring your customers – both two and four legged.

Efficient Markets equal Wagging Tails.

Figure 3

Source: Mid-Atlantic Partners LLC; internal analysis

Figure 3 tells an important story. While fictitious by design, it is intended to demonstrate how to win against bigger players by being small. The three daycare businesses in the figure are Waggying Butts (spelled wrong intentionally), Panting Tongues, and Village Canine. Despite an antiquated facility, limited marketing, and average accessibility, Village Canine outperforms against its two competitors. It does so by focusing on a quality service model that puts the dog first. Economically this may not make a lot of sense, but it focuses on doing its core service and doing it very well. It does not get carried away with flashy imagery or state-of-the-art machine learning technology for categorizing each dog that comes through the door. Rather it focuses on keeping all the dogs happy. Rewinding the lesson on Efficient Markets, one could argue that the value of these businesses is most powerfully demonstrated by the value of wagging tail.

Is the Residential Services Boom Sustainable?

The following article is based on the personal views of the author. Mid-Atlantic Partners is not liable for those that make decisions based on the information contained herein. The information contained in the following article was obtained from research and publicly available data and was relied on by Mid-Atlantic Partners without assuming responsibility for independent verification as to the accuracy or completeness of such information. Rather, the purpose of this article is to simply provide a perspective as it relates to market trends and observations. It is our hope that you enjoy the content and continue to read The Northeast Sentinel. Accordingly, this material may not be reproduced, disseminated, quoted or referred to, in whole or in part, or used for any other purpose, without the prior written consent of Mid-Atlantic Partners LLC.

Callus Hands Rule the Day

German Economist Karl Marx was famous for many things. Mostly his negative view of capitalist systems where his writing often predicted working class labor revolutions taking back the means of production. Unfortunately for Karl he was not around long enough to witness the boom of the US residential services industry. Assuming he was here today, he would be (slightly) vindicated in the fact that today’s plumbers, roofers, exterminators, and landscapers are in high demand based on their specialization and comparative advantage. In fact, the businesses these laborers represent are seeing very high multiples on the earnings for this specialization. Departing from Marxian economics, the real question we aim to address is whether the high valuations associated with residential services companies are here to stay and why.

Market Emergence

`Since the COVID-19 pandemic, services such as residential landscaping, plumbing, HVAC, pest control, and roofing have become fast-growing end markets for consumption. A figurative gold rush has presented itself in the form of homeowner wallet share whose standard of living is dictated by limited patience pertaining to quality service. As a result, consumers have demonstrated a high willingness to pay for home services that they either don’t want to do or flat out cannot do. This new paradigm has begun suggesting these expenses have become less discretionary, and potentially as durable as the weekly grocery store trips.

In 2024, it sounds like a broken record attributing most market dynamics to the Pandemic externality. However, when economists refer to “externalities” it is referring to specific components that constitute spillover effects, in this case the increase of residential service demand. These spillovers can be labeled pecuniary externalities which occur when individuals demonstrate actions that directly affect market supplies or prices. For many, a shortage in home supply created a spillover demand for aging homes with inept labor skills that Mr. Marx once praised. As these new buyers settled for older homes, renovation and home improvement expenditure continued to grow.

Change in Housing Starts vs. Change in Home Improvement Spend

Source: U.S. Census, JCHS, HUD Data, William Blair Equity Research.

The divergence of Housing Starts and Improvement Spend has created a discernible tailwind for the value uplift to regional providers possessing the labor supplies required for these functions. Once considered a very fragmented market, residential service providers are expanding through various means and investments allowing them to go after not only new zip codes and counties, but new states. Winning strategies for these providers present themselves in the way of high marketing budgets, scalable labor models, quality service emphasis, and same-day appointments. A once simple market that’s value was debated based on the do-it-yourself (DIY) consumer, seems to be a cash flow engine as less sophisticated millennials are finally entering the homeowner arena. Nobody possesses a crystal ball. However, drilling into the consumer who underpins these markets is the first step in knowing what the future holds.

Evaluating the Consumer

At Mid-Atlantic, we often find that resorting to basic economic concepts helps ‘humanize’ the target consumer for developing value-based strategies. Consumer wants are limitless but the means to attain these wants are not. This means that for today’s average consumer an inelastic demand has developed forcing them to explore various tradeoffs and opportunity costs necessary to attain an optimal home life. Gone are the days where sleep quality will be sacrificed due to sub-optimal temperature settings on the boiler or HVAC. Gone are the days where the neighbor flaunts their exquisite landscaping across the front yard without a competitive emulation. Tradeoffs are always going to be required, but the good news for the small residential service business owner is that there is a long line of sacrifices to be made before your service enters this discussion. When determining if the lower income zip codes are worth marketing to, remember that opportunity costs imply sunk costs. For sunk costs, this may be larger foundational issues with the selected home where frequent servicing is the only option versus a complete reinvestment. That old Carrier HVAC may simply be too expensive and viewed as a sunk cost to replace any time soon. This opens the recurring ‘floodgate’ for the professionals able to sufficiently and expediently service.

Source: Mid-Atlantic Partners LLC; internal analysis.

In the lower pockets of the market, the term efficiency requires examination. This term is best understood as a relationship between ends and means. The target consumer does not act as efficiently as we may or may not give them credit for. An example would be selecting a more expensive Dave’s Pest Control with lower ratings than Platinum Pest Control (fictitious names) because we like the brand of Dave’s being a cooler and elegant symbol that we choose to associate our home with. Essentially, for our average consumer, choice may or may not be efficient and far too often we observe choosing the cheapest means to bring about that end.

Will we ever Learn to Fix a Toilet?

For those of you who used to mow lawns in the Summertime, don’t quit your day jobs just yet. Consumption trends unfortunately can be unpredictable and unfortunately, in some industries, counterintuitive. But trust that the folks at Mid-Atlantic are not arrogant enough to select an industry where the consumer is understood to be overly complex and/or counterintuitive. The reality is for me to learn how to fix my HVAC requires time. Time that could be allocated to writing more articles like this. And in the event I cannot fix it, there will be unpleasant sleep patterns from all who live under my roof. Post-pandemic trends have presented the Northeast with consumers that are more cognizant with their time. They may not be the most efficient thinkers, but they behave in patterns that optimize their time outside of their day jobs. Simply put, specialization needs have been increasingly more recognized for services that have become increasingly more durable.

On the macro-economic front, consumer spending appears to be holding strong in areas that are far more discretionary than the items discussed in this article. Restaurant food prices remain high and still the volume is there. Meanwhile, residential services required to make an aging home feel more modernized are becoming a vital portion of the average consumer’s budget and expected to be well into the future. Typical with the lower-middle market, the highest valuations have been seen with those able to generate profits of over $5 million supported by mature brands. Since 2020, various investment banks have reported precedent transactions as low as 5x and as high as 20x for select residential service assets. How’s that for growth implications?