Blue Buffalo Products Outline

Blue Buffalo Products (BUFF) is a leading premium pet food manufacturer and marketer with a single-
digit share of the pet food market, and a path to high single-digit organic revenue and mid-teens EPS
growth. At 26x 2017 adjusted earnings, BUFFs valuation is on par with more mature CPG companies. If
the company achieves 16% earnings growth for 5 years, is valued at 20x earnings at the end of 5 years,
and retains 50% of its earnings as cash on the balance sheet, shares will be worth $39, representing 63%
upside, and will grow at a 10.2% CAGR. In a downside scenario with 9% EPS growth and a 15x terminal
multiple in 5 years, shares would be worth $22, 8% downside from current prices, a -1.7% CAGR.

Business Description and History

Blue Buffalo was started in 2002 by the Bishop family, which still owns a large stake in the company, and
received a growth investment from Invus, a NY-based growth-oriented PE firm, in 2006. The Bishop
family started Blue Buffalo because their dog Blue was diagnosed with cancer, which prompted research
into dog food ingredients. The family discovered that pet food includes unhealthy ingredients for
animals. Blue Buffalo was formed to disrupt the pet food industry and offer better food to pet parents.

Amazingly, the business was not significantly profitable until 2012 despite significant sales growth
almost from the beginning. Building a brand that drives its category growth requires energy and money.
There are a lot of lessons in this companys brief history on how to build a business, including how to
build a brand, circumstances in which outside capital adds value, the benefits of in-sourcing production,
and how to expand internationally.

Blue Buffalo is undervalued today because of several factors:

Growth expenditures in the income statement ahead of sales that depress profitability
o Expenses for international and vet expansion
o Advertising expenses as % of sales above long-term average
International expansion opportunity with $42BN TAM
Vet-prescribed therapeutic foods expansion with $1.5BN TAM
o Vets are major influencers in pet food decision-making
 Capital expenditures to in-source production that will increase Gross margins 200-400bps

Industry Characteristics

The Pet food industry is worth about $28 billion in the US and $42 billion internationally, totaling $70
billion. The industry, and Blue Buffalo in particular, has driven the increasing humanization of pets.
Consumers now more carefully scrutinize their pets diets, as well as their own. This premiumization
trend is part of the reason that U.S. pet food sales have tripled over the last 15 years, while only
doubling from 1984 to 2000.

The U.S. pet food market has grown predominantly due to pricing increases, not volume growth. As the
below chart shows, the value of animal purchases has stayed relatively flat while pet food sales (and
other pet-related categories) continue to experience above-inflation growth.
Premium pet foods have increased the average price per pound at a 6.7% CAGR over the roughly 5-year
period shown below. The premiumization trend is still a recent trend in U.S. pet food, so continued
above-inflation increases seem likely over the next 5+ years.

Again, the chart below shows that premium pet food sales have driven an otherwise much slower-
growing category.

Global pet food market share is somewhat concentrated, with four multi-national firms taking 48%
market share in 2016. However, the remaining 52% is extremely fragmented. Fragmentation plus a lack
of innovation in pet foods has provided a significant opportunity to Blue Buffalo to drive premium pet
food penetration.

BUFFs international and therapeutic pet food growth initiatives are both currently money-losing
endeavors with minimal top-line impacts (which depresses reported results) but can drive BUFF growth
for many years. Execution on both fronts remains to be seen, and any hiccups in execution could provide
the impetus for management to consider selling to a company with more established international
operations.
While the natural pet food category is well-developed in the U.S. the rest of the world continues to
demonstrate low penetration of natural pet foods, with very strong growth. The natural pet food
category continues to take share globally, which is a huge tailwind for companies like Blue Buffalo.

Chewy.com holds 50% market share in the online pet food business, edging out Amazons share in the
30% range. Online is an increasingly important channel for Blue Buffalo, as its non-pet superstore
channel (which includes ecommerce, farm and feed, and regional stores) has experienced 30% annual
growth since the company went public. Currently, roughly 60% of BUFFs sales occur at pet superstores,
and 15% of sales occur online. Online can make up 25% of BUFFs sales after about 3 more years of 30%
growth, while pet superstores will command only about 50%.
Blue Buffalo focused on selling dry pet food, but dry dog food purchases account for only 30% of the
market. BUFFs current mix is 80% dry, 20% wet and treats. There is huge embedded opportunity for
Blue Buffalo to sell more wet dog food and treats, which have been driving sales growth, with 15.1%
growth in wet vs. 6.4% in dry in BUFFs first quarter 2017.

Additionally, Blue Buffalo has historically stayed away from the FDM (food, drug, and mass retailers)
channel. They believed they could grow sales faster at specialty pet stores, where pet food sales had
been much stronger than in the FDM channel. Blue Buffalo for many years believed their brand was part
of the pull that had brought customers into specialty pet superstores.

Pet superstores cannot be underestimated for BUFF when viewed in a historical context. Blue Buffalo
products hit PetsSmart in 2003, and went national in 2007; Petco started carrying Blue Buffalo in 2009,
so these companies date back to the very beginning of Blue Buffalos existence. Today, the two largest
pet superstores provide BUFF with nearly 60% of its sales. However, they have recently been adding
competing natural pet food brands to their shelves, increasing the competitive intensity in the category.

In response, Blue Buffalo announced in August that they would begin shipping entry-level food to
Kroger, Publix, Meijer, and Target. FDM retailers represent 40-50% of pet care sales, and Blue Buffalo
has cited that up to 70% of volume is sold in FDM today.
In other words, BUFF has hit $1 billion in sales without ever being in grocery stores where 70% of pet
food purchases occur! There is a huge opportunity to sell into this channel, which is one of the many
levers BUFF can pull to hit 10% annual sales growth.

Competition

Pet food is a very competitive space. The ROIC is very high, demand is recession-resistant, there has
historically been pricing power, customers are loathe to change their pets food source and risk an
adverse reaction.

Mars, Nestle, Big Heart Pet Brands, and Colgate-Palmolive companies (and their predecessor owners)
have likely had large market shares in pet food. More importantly, these legacy brands generate so
much cash flow that they have the ability to acquire most upstarts before they reach scale, as the below
graphic shows.
While Blue Buffalo has faced an uphill climb to becoming a $1 billion brand from the beginning, the
company is winning in e-commerce. With 12% share in e-commerce, according to 1010 data, the
company has a slim lead over its nearest competitors.

It is my baseline expectation that market share in e-Commerce can and will shift around more
drastically because consumers have essentially infinite choice and have the ability to respond to
negative news on any brand by changing their purchasing patterns immediately. Counteracting this
reduced barrier to changing pet foods is the reality that pets may not respond well to new food, so
owners may face difficulty changing their pets food even if the new food is better for the pet.

As another point of comparison that encompasses all of 2016 as opposed to 1Q 2016, Blue Buffalo is in
approximately the same position as in the 1010data table above, at least relative to its primary
competitors.
While Blue Buffalo is the largest online brand, its conversion rate lags other brands somewhat.
Conversion rate conveys how frequently a buyer purchases a brands products after viewing the
product. The root cause of why some products convert at higher rates than others can be debated
endlessly, but this data indicates that Blue Buffalo is not invincible vs. other competing natural pet food
brands, and squares with recent management commentary that the category has been growing roughly
10% while BUFFs growth is expected to only be 8%.

Obviously, the conversion data above does not match with the online market share leaders, which
indicates the potential for Blue Buffalo to lose share.

Growth Strategy

Blue Buffalos stated goal is to grow revenues 10% and grow adjusted EPS ~20% per year for the next
few years. The first question I asked was: how does the bottom line possibly grow twice as fast as the
top line? The partial answer lies in the multitude of opportunities BUFF has, some of which the company
is investing in today but currently seeing minimal top-line benefit. BUFFs opportunities include:

Growth expenditures in the income statement ahead of sales that depress profitability
o Organizational Expenses for international and vet expansion
o Advertising expenses as % of sales above long-term average
International expansion opportunity with $42BN TAM
Vet-prescribed therapeutic foods expansion with $1.5BN TAM
o Vets are major influencers in pet food decision-making
Capital expenditures to in-source production that will increase Gross margins 200-400bps
Expansion into the Food, Drug, and Mass Retailer segment in the U.S., representing 50% of U.S.
sales

It is difficult to assess how much money is being spent on the vet and international segments. These
two initiatives have contributed to some expense growth before revenue growth has really begun. The
international and vet businesses, taken separate from BUFFs U.S. business, likely resembles the early
years of BUFF itself, with revenues growing strongly off a small base and operating profits somewhat
negative as management reinvests in growth. BUFFs early years are shown below as a guide to how I
think about the business.
BUFF plans to further expand gross margins. The cynic would retort that, so does everybody. Blue
Buffalo has a history of expanding margins because they are undergoing a long-term shift from
outsourced manufacturing to in-house manufacturing, which enables gross margin improvements with
the trade-off of a more capital-intensive business. Additionally, BUFF has stated that mix is shifting
towards higher-margin wet foods and treats, which should bolster BUFFs margins. BUFF is currently
undertaking a $200 million capital investment program designed to build out manufacturing capacity,
which should provide a step-change improvement in margins when complete, similar to what occurred
in 2016 after the Heartland facility was fully operational.

2014 2015 2016

Net sales 100.0% 100.0% 100.0%
Growth % 0.0% 12.0% 11.9%
Cost of sales 60.0% 59.2% 55.1%
Gross profit 40.0% 40.8% 44.9%
SG&A 20.5% 22.1% 22.9%
Operating income 19.5% 15.6% 19.2%
Net income 11.1% 8.7% 11.3%

As previously highlighted, the FDM channel represents a significant portion of pet food sales, roughly
40-50% in dollars and 70% by volume. Blue Buffalo has never entered this market before now because
some people believed the brand would be perceived differently once inside mass market grocers and
retailers. An analyst in a recent conference call express skepticism about BUFFs choice to go into the
FDM channel and the possible loss of distribution at pet specialty stores in response. The company
appears unfazed by that prospect.

Ken Goldman - Billy, that's helpful. But Iams is big too. How do we know that
what you're doing is different than what happened with Iams 15, 20 years ago?

Billy Bishop - Absolutely Ken. We're very familiar with that Iams experience;
believe it was back in 2000 when they decided to increase their distribution, the
result of that was a double of their business within four years.
 While it would be wrong to assume that BUFFs experience will be exactly the same as Iams 15-
20 years ago, this anecdote hints at the potential for BUFFs results to overshoot 10% over the
next few years as they reach greater distribution in the FDM channel.

Overall, BUFF has some high-quality, relatively low uncertainty levers to pull, none of which
requires

Balance Sheet

The biggest question for a company with about $50 million in net debt, or roughly 0.2x net debt/EBIT,
and growing cash flow every year, is what to do with the cash?

Management has committed to invest $200 million in additional manufacturing capacity, which should
increase gross margins 200-400 bps, but that will only absorb under 2 years of free cash flow. In their
2Q2017 earnings release, management announced a $50 million share repurchase program, which is a
welcome sign given the business multiple growth levers. Over a 5 year time frame, the company will
likely generate $1 billion in operating cash flow. Approximately $100-150 million needs to be dedicated
to maintenance capital expenditures, another $200 will go to the growth CapEx for manufacturing
capacity, and then there are no other great options for what to do with the cash. Eventually BUFF may
begin manufacturing pet food overseas to meet international demand, which will require investments in
manufacturing capacity. But for the foreseeable future, the company will be building up significant
excess cash on its balance sheet.

Valuation

Based on the variety of growth drivers laid out above, BUFF can likely hit its 10% growth target over the
next 5 years. However, giving Blue Buffalo full credit for gross margin increases and slight SG&A leverage
only yields 16% EPS growth. In short, 20% EPS growth appears unrealistic in almost all scenarios.
However, a 20x multiple of 2022 earnings gives the company credit for its premium growth profile, so
the business would be worth $40, giving the company credit for $3 per share of excess cash, roughly
67% upside.
2014 2015 2016 2017 2018 2019 2020 2021 2022
Net sales 917,760 1,027,447 1,149,778 1,253,258 1,378,584 1,516,442 1,652,922 1,801,685 1,963,837
Gross profit 366,867 418,831 515,683 576,499 634,149 743,057 809,932 882,826 962,280
SG&A 187,864 226,716 262,761 275,717 296,396 318,453 338,849 360,337 382,948
Operating income 179,003 160,115 220,922 300,782 337,753 424,604 471,083 522,489 579,332
Net income 101,931 89,388 130,241 179,952 206,239 265,646 300,059 338,645 381,892
Diluted EPS 0.52 0.45 0.65 0.90 1.02 1.31 1.48 1.66 1.86
Dilutes Shares Out. 197,852,932 198,047,453 199,348,707 200,345,451 201,347,178 202,353,914 203,365,683 204,382,512 205,404,424

2014 2015 2016 2017 2018 2019 2020 2021 2022

Net sales 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Growth % 0.0% 12.0% 11.9% 9.0% 10.0% 10.0% 9.0% 9.0% 9.0%
Cost of sales 60.0% 59.2% 55.1% 54.0% 54.0% 51.0% 51.0% 51.0% 51.0%
Gross profit 40.0% 40.8% 44.9% 46.0% 46.0% 49.0% 49.0% 49.0% 49.0%
SG&A 20.5% 22.1% 22.9% 22.0% 21.5% 21.0% 20.5% 20.0% 19.5%
Operating income 19.5% 15.6% 19.2% 24.0% 24.5% 28.0% 28.5% 29.0% 29.5%
Net income 11.1% 8.7% 11.3% 14.4% 15.0% 17.5% 18.2% 18.8% 19.4%

Given the number of levers Blue Buffalo has to pull and the fact that the pet food category has grown
above inflation for so long, it is difficult to see revenue growth rates below 5% over the next 5 years. In
this scenario, EPS grows at a 11% CAGR over 5 years out to 2022. Given this growth profile (there are
not many CPG companies growing EPS organically 11% annually), a 15x multiple seems fair to assign the
business in a bear case. In that instance, 5 years from now the business would be worth about $22 per
share, inclusive of $2.50 per share in excess cash, roughly 8% downside.

2017 2018 2019 2020 2021 2022

Net sales 1,253,258 1,315,921 1,381,717 1,450,803 1,523,343 1,599,510
Gross profit 563,966 605,324 663,224 696,385 731,205 767,765
SG&A 275,717 289,503 303,978 319,177 335,135 351,892
Operating income 288,249 315,821 359,246 377,209 396,069 415,873
Net income 172,056 192,213 223,193 238,187 254,113 271,027
Diluted EPS 0.86 0.95 1.10 1.17 1.24 1.32
Dilutes Shares Out. 200,345,451 201,347,178 202,353,914 203,365,683 204,382,512 205,404,424

2017 2018 2019 2020 2021 2022

Net sales 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Growth % 9.0% 5.0% 5.0% 5.0% 5.0% 5.0%
Cost of sales 55.0% 54.0% 52.0% 52.0% 52.0% 52.0%
Gross profit 45.0% 46.0% 48.0% 48.0% 48.0% 48.0%
SG&A 22.0% 22.0% 22.0% 22.0% 22.0% 22.0%
Operating income 23.0% 24.0% 26.0% 26.0% 26.0% 26.0%
Net income 13.7% 14.6% 16.2% 16.4% 16.7% 16.9%

Finally, a worst case scenario is the company is valued at its steady state, i.e. at a price where the
company is merely earning its cost of capital. According to Michael Mauboussin, the steady state
multiple for a firm is about 12.5x and reflects GDP-level growth. In this, scenario, the company would be
worth about $15, indicating approximately 38% downside if the business more or less completely
implodes, wastes all its excess cash, and becomes just another mature pet food brand. The scenario is
unlikely because the company can grow through deeper penetration of the FDM channel.

2017 2018 2019 2020 2021 2022

Net sales 1,253,258 1,290,856 1,329,581 1,369,469 1,410,553 1,452,870
Gross profit 563,966 593,794 638,199 657,345 677,065 697,377
SG&A 275,717 283,988 292,508 301,283 310,322 319,631
Operating income 288,249 309,805 345,691 356,062 366,744 377,746
Net income 172,056 188,363 214,387 224,247 234,501 245,163
Diluted EPS 0.86 0.94 1.06 1.10 1.15 1.19
Dilutes Shares Out. 200,345,451 201,347,178 202,353,914 203,365,683 204,382,512 205,404,424

2017 2018 2019 2020 2021 2022

Net sales 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Growth % 9.0% 3.0% 3.0% 3.0% 3.0% 3.0%
Cost of sales 55.0% 54.0% 52.0% 52.0% 52.0% 52.0%
Gross profit 45.0% 46.0% 48.0% 48.0% 48.0% 48.0%
SG&A 22.0% 22.0% 22.0% 22.0% 22.0% 22.0%
Operating income 23.0% 24.0% 26.0% 26.0% 26.0% 26.0%
Net income 13.7% 14.6% 16.1% 16.4% 16.6% 16.9%

Risks

Billy Bishop recently took over as CEO in what seemed an abrupt exit for experienced CPG veteran Kurt
Schmidt at the end of 2016. Family CEOs have at best a mixed record as managers.
Multinationals have all scooped up premium pet food brands in the last 3-5 years. They will likely put
significant marketing dollars behind their investments to build brands and earn a return, which could
crimp BUFFs profitability and growth.

Analysts seemed concerned on the most recent earnings call in August 2017 that moving into the FDM
channel would cause distribution cuts at pet specialty stores. In reality, the slow growth BUFF is seeing
from pet specialty indicates this has already happened to some extent, so the positive outweigh the
negatives in my opinion.

Blue Buffalo was the subject of a lawsuit by Nestle, claiming one of BUFFs co-manufacturers was
incorrectly including prohibited ingredients in BUFF foods. This claim turned out to be true, and BUFF
settled for nearly $60 million over two years to settle these claims.

Conclusion

Buffalo Pet Products is a leader within its category with enough scale to independently invest in
additional growth opportunities without needing to sell itself to a larger competitor. Ultimately, BUFF
may sell itself, but I feel very comfortable owning the premium pet food brand in the U.S. that has
numerous levers to pull at a slight premium to peers and the market overall. At a time when valuations
are quite rich, BUFF can provide 10% annual returns over multiple years.