Jana Partners, the activist hedge fund, spearheaded by Barry Rosenstein, sent a letter to PetSmart, Inc. (NASDAQ:PETM) (H/T MarketFolly) urging its board of directors to conduct a full review of all strategic alternatives including a sale. The activist hedge fund owns 9.8% stake in the company.

According to the activist hedge fund, a sale “very likely offers the highest risk-adjusted return for shareholders” given the chronic underperformance of PetSmart, Inc. (NASDAQ:PETM), and significant private equity interest in the company.

Jana Partners emphasized that PetSmart, Inc. (NASDAQ:PETM) trailed most of its peers in shareholder value creation, and its shareholders lost their confidence in its ability to reverse its situation.

PetSmart PETM
PetSmart PETM

Jana Partners warns regarding PetSmart’s leveraged recapitalization

Jana Partners said it was surprised by the recent reports indicating that the board of directors of PetSmart, Inc. (NASDAQ:PETM) is considering “short-circuiting” a fulsome review of its strategic alternatives by simply proceeding with a leveraged recapitalization.

The activist hedge fund warned that pursuing a leveraged recapitalization without first evaluating whether a sale that delivers a risk-adjusted return can be accomplished would be condemned by shareholders.

A leveraged recapitalization is appropriate only where a company can credibly say that it will drive future value higher by addressing the underlying causes of its share price underperformance. Given the chronic underperformance of this board for shareholders, it is clear that it has no such credibility,” according to Jana Partners.

The activist hedge fund also emphasized that such added leverage would only increase the risk to its current risky situation for shareholders. Therefore, a” recapitalization is very likely to be inferior to a sale in magnitude and certainty of value creation.”

PetSmart failed to innovate and capitalize on its leading position

Jana Partners also pointed out that PetSmart, Inc. (NASDAQ:PETM) benefitted from positive industry trends in the past such as humanization of pets and consumers’ shift to premium products and organic pet foods, but it failed to innovate and capitalize on its leading position at present.

The activist hedge fund said the leadership of PetSmart continued to rely on store openings and product resets for growth while its peers went ahead in terms of innovation and performance.

Jana Partners identified some of the failures, including its weak e-commerce presence, suboptimal pricing structure and inadequate cost management. The activist hedge fund also stated that the company failed to develop new store formats, and its products lack innovation.

According to Jana Partners, the board of directors were responsible for the company’s failures. The activist hedge fund noted the comments from shareholders that the board micromanaged the company’s operations instead of recruiting and retaining skilled executives.

In its second quarter letter to investors JANA partners stated the following regarding Petsmart:

PetSmart, Inc. (PETM) – PetSmart is the leading specialty pet retailer in North America with a 23%  share of the $30 billion industry. Pet retailing is an attractive market. The category has grown at a 3.8%  CAGR from 2003 to 2013, and industry sales have increased in every one of the last ten years, unimpeded  by the global financial crisis and the concomitant reduction in the U.S. pet population. PetSmart was the  second largest commitment we made in the second quarter. We are currently PETM’s largest owner. We  filed a 13D on July 3rd and are actively engaged in discussions with management and the board.

Following years of underperformance for shareholders, we believe shareholders are overwhelmingly  supportive of change. Subsequent to our filing, Longview Asset Management, the second largest PETM  owner, released a public letter in support of our efforts. Recent press reports also indicate that there is  likely to be significant private equity interest in the company.

The full letter which JANA sent to the BOD of PETM today can be viewed below

235377596-JANA-PetSmart-Letter (1)

JANA PetSmart Letter (1)