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A PetSmart-Petco merger might not add up

Just last week came word that the world's top two beer companies, Anheuser Busch InBev (BUD) and SABMiller were considering a blockbuster merger that would create the world's largest brewer. Now this urge to merge has reached the pet world.

PetSmart, which went private earlier this year in a $8.7 billion deal backed by a group of private equity players led by BC Capital Partners, is said to be holding preliminary talks with privately held Petco about a potential merger.

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Petco's owners, TPG Capital and Leonard Green & Partners, had previously filed paperwork with the Securities & Exchange Commission to bring the San Diego-based company public with a valuation of between $5 billion and $6 billion including debt. Before it went private, PetSmart had considered merging with Petco last year but rejected the idea over antitrust issues, Reuters says.

Officials from the parties involved either declined to comment or didn't respond to emails. Deals at this early stage can fall apart, so there's no certainty about this one.

Although Petco operates 1,400 stores in the U.S., topping PetSmart's total of about 1,300, its revenue in the fiscal year ended Jan. 31 was $3.99 billion, well below the $6.9 billion its rival earned in the 52 weeks ended in Feb. 2, 2014, the latest data available.

The combined company would control roughly 30 percent of the U.S. specialty pet retail market, enough of a market dominance that antitrust regulators probably will demand it "close a lot of stores," according Howard Davidowitz, CEO of Davidowitz & Co., a retail investment bank and consulting firm.

"They would never even get to this point without having met with every smart merger lawyer and looked at this 1,000 different ways," Davidowitz told CBS MoneyWatch in an interview, adding he wasn't sure of the exact number of stores that might be shuttered. "When you go forward with this, you are spending tens of millions of dollars just to explore it."

Earlier this summer, Wedbush Securities analyst Seth Basham argued in a note to clients that a PetSmart-Petco merger would increase market concentration in nine markets, a potential red flag for regulators. Even if regulators don't require closures, PetSmart and Petco might eliminate stores anyway. According to Basham, about 50 percent of Petcos are in a three-mile radius of at least one PetSmart, and 72 percent are in a five-mile radius.

Both Davidowitz and Basham have their qualms about merging PetSmart and Petco.

"If you are asking me if things are going to be better after the merger, (the answer is) absolutely not," Davidowitz said, adding that the combined company would have a "gigantic" amount of debt. "What they should be doing is perfecting their businesses, coming up with specialty niches within pets," he said. "I can think of a hundred things they ought to be doing."

Basham said merging PetSmart and Petco is "feasible and very attractive financially," and he believes a deal has a better than 50 percent chance of getting the Federal Trade Commission's approval. Nonetheless, he urged investors to keep their expectations realistic.

"We believe a combination with Petco would buy PetSmart synergies, but would not solve its competitive dilemma, underscored by rapidly shifting shopping behavior and increasing online competition," he wrote in his client note. "In fact, an acquisition of Petco could distract PetSmart from addressing this issue and add increasing pressure. After all, Petco is a smaller and somewhat weaker competitor with generally higher in-store pricing."

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