Pet supplies retailers are moving online to bolster sales. Photo: Flickr via Mike Mozart

The kennel is getting smaller as pet industry growth is being fueled by consolidation. Privately held pet supplies retailer Petco just announced it was acquiring the Web-based Drs. Foster and Smith, joining rival PetSmart (UNKNOWN:PETM.DL) in expanding its e-commerce platform.

The big dogs on the block
The pet-care industry is in the midst of a wave of a broad roll-up strategy, often urged on by private equity backing. Over the past two years there has been a significant uptick in the number of companies getting bought out:

  • Phillips Pet Food & Supplies bought Pet Food Limited and PFX Pet Supply, and then was itself sold to P/E firm Thomas H. Lee Partners this year
  • Animal Supply acquired Lone Star Pet Supply
  • Pet Food Experts acquired Zeus
  • Del Monte Foods acquired Natural Balance Pet Foods and then exited the food industry altogether to concentrate on pet food
  • Animal health specialist Zoetis was spun off from Pfizer and just last month announced it was buying Abbott Labs animal health assets
  • PetSmart this past summer said it was buying online retailer Pet360

Now Petco is also buying a pet supplies e-tailer, underscoring the importance this channel represents to the future growth of the industry.

Chowing down on pet food
According to the American Pet Products Association, consumers will spend more than $58.5 billion on their pets this year, up 5% from 2013. The biggest category will be food, where over 38% of the dollars, or $22.6 billion, will flow. Veterinary care includes routine vet care and prescription meds, will come in at $15.3 billion and will be the second largest segment.

Over the past decade there's been a 72% increase in spending on pets. As people continue to humanize their pets -- referring to them as "pet babies" and treating them as such -- it is only going to grow.

But the online channel will cast a larger shadow going forward. In the five years leading up to 2014, the market analysts at IBISWorld estimate revenues increased at an compounded average annual rate of 7.8% to $3.2 billion. That's well ahead of the industry as a whole, and though some pet owners (or "pet parents," as they like to refer to themselves) cut back on spending during the lean recession years, others moved online to find the cheapest deals.

We've also seen a proliferation of niche operators like PetMed Express (NASDAQ:PETS), direct-to-consumer players like Bark & Co. and Dog Vacay, and mass retailers such as Wal-Mart (NYSE:WMT) become an increasingly significant point of sale for pet supplies.

And that doesn't take into account the rise of (NASDAQ:AMZN) as an important player as well with its site. The growth of Amazon's popular Prime membership program, which provides for free shipping on millions of items for an annual $99 fee, represents a big challenge for the big-box pet care companies to overcome.

It was a certain myopia about threat of Internet-based retailers that prevented PetSmart from hiring a dedicated executive to manage its digital platform until this year. Such lapses have made it a target for activist investors who are demanding it put itself up for sale.

An industry being called to heel
Despite the outlook for high industry sales, the overall rate of growth in sales has been slowing over the past decade.

It's been the dog days for pet supplies industry. Data: American Pet Products Association

The wave of consolidation washing over the pet supplies industry may claim yet another company in PetSmart, and Petco's acquisition of Drs. Foster & Smith for an undisclosed sum shows its ability and willingness to participate in the M&A game.

As much bite as bark these days
Although a lot of the stocks gains PetSmart has made over the year can probably be attributed to the strategic moves it has been forced to undertake, its most recent quarterly performance was a reason for investors to purr with delight. Net sales continued improving, rising at low single digit rates, and comparable stores were flat, which for a company experiencing falling comps for much of the year, it was a welcome change.

It still needs to get control over comparable transactions, which continued to fall, but it maintains a trajectory that's beating analyst expectations while producing profit margins that are decent considering the promotional economic environment it's operating in. 

With planned cost reductions totaling $200 million for 2015, comps in the low single digits, and a mid-teen increase in EPS, PetSmart may be strong enough to withstand the challenge hedge fund operator Jana Partners promises will result if it doesn't approve of the strategic alternative analysis that emerges. The P/E firm says it has five candidates it will nominate for the pet supplier's board. 

Chomping at the bit
A PetSmart acquisition could make its acquirer the top dog in the industry. However, there seems to be more risk than reward in its stock at the moment. An offer has been largely priced in, and if a buyout deal doesn't materialize, its stock could deflate. 

With the industry being shaped by the ebb and flow of mergers and acquisitions, and as e-commerce and online shopping continue to alter the landscape further, the major industry retailers will need to devise new strategies to come up with a competitive edge other than simply buying out their rivals if they want to unleash growth.