Why a Nestle Purina Lawsuit Could Be Bad News for PetSmart

A popular, high-end brand of pet food has boosted PetSmart's performance, but now Nestle's Purina has challenged the brand's health claims.

May 13, 2014 at 9:30AM

While the health trend has affected many companies that sell food to people, it has also become prominent in the pet food industry. Some shoppers have moved away from traditional pet-food brands toward premium brands, such as those made by Blue Buffalo. Like other health-food companies, Blue Buffalo has marketed its brand by claiming that its products don't contain certain ingredients that are present in major food companies' products. This allows Blue Buffalo to charge higher prices for its pet food, which also results in higher margins for companies that sell its products, such as PetSmart (NASDAQ:PETM).

The Nestle Purina complaint
If shoppers switch to Blue Buffalo because of its health claims, other pet food companies may lose customers. One of these companies, Nestle (NASDAQOTH:NSRGY) Purina, responded by running its own tests on Blue Buffalo's pet food. Purina claims that its tests found chicken byproducts in several varieties of pet food that Blue Buffalo had marketed as chicken-free. These include products for both cats and dogs.

In addition, Purina argues that the Better Business Bureau's National Advertising Division had made Blue Buffalo change its advertising claims about competitors' products back in March. The decision from this industry body came on the back of a complaint from Hill's Pet Nutrition, which is owned by Colgate-Palmolive (NYSE:CL).

Colgate-Palmolive's pet food
Past results from Colgate-Palmolive show that natural pet food brands have been taking market share from other popular brands. Colgate-Palmolive's market share in pet food had been falling. While the company had promoted Hill's Science Diet as a premium brand, it still contained ingredients that shoppers considered artificial. In response, Colgate-Palmolive adjusted the formula for Science Diet; according to AllAboutFeed.com, this included taking chicken by-products out of this product.

Colgate-Palmolive's first-quarter 2014 results show that these adjustments may have worked. Its Hill's Pet Nutrition segment posted 3.5% sales growth; while foreign currency effects counteracted the effect of a price hike, the report also showed that Colgate-Palmolive was able to raise prices on pet food. The segment provided 13% of the company's revenue for the quarter, and it has presences in several major international markets. If the switch to a more natural product formulation did drive this sales growth, it provides even more confirmation of the trend and could also indicate its strength in international markets. 

Why this matters for PetSmart
This table shows the trend in PetSmart's profit margin over the last five years:

PETM Profit Margin (Quarterly) Chart

PETM Profit Margin (Quarterly) data by YCharts.

PetSmart's profit margin has been rising and natural pet food has contributed to this. However, as a result PetSmart has become more dependent on the Blue Buffalo brand; the Fool's Brian Pacampara pointed this out, saying that an analyst from Bank of America had downgraded the stock partly for this reason. This means that if Purina wins its lawsuit and Blue Buffalo has to change its advertising practices, this could result in lower sales and lower margins for PetSmart.

The lawsuit has not gone to court yet. Blue Buffalo Chairman Bill Bishop responded to the complaint by saying that Purina had made false allegations and accused Purina of using "voodoo science." Blue Buffalo went on to promote the benefits of natural products such as its own pet food over those sold by Purina.

Foolish takeaway
The Purina lawsuit, the complaint from Hill's Nutrition, and Colgate-Palmolive's first-quarter 2014 results all provide evidence that consumers have been seeking out more natural pet food brands and this has had an impact on other pet food brands' sales. While a win by Purina could have negative effects on PetSmart and this adds some risk, in general the health trend still looks like it's working in favor of PetSmart and this supports the bull case for the stock.

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Eric Novinson owns shares of PetSmart. The Motley Fool recommends Bank of America and PetSmart. The Motley Fool owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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