Freshpet, Inc. (NASDAQ:FRPT) Q3 2023 Earnings Call Transcript

Freshpet, Inc. (NASDAQ:FRPT) Q3 2023 Earnings Call Transcript November 6, 2023

Freshpet, Inc. beats earnings expectations. Reported EPS is $-0.15, expectations were $-0.2.

Operator: Greetings and welcome to the Freshpet Third Quarter 2023 Earnings Call. At this time all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the call over to your host, Mr. Jeff Sonnek, Investor Relations at ICR. Thank you. You may begin.

Jeff Sonnek: Thank you. Good morning and welcome to Freshpet’s third quarter 2023 earnings call and webcast. On today’s call are Billy Cyr, Chief Executive Officer; and Todd Cunfer, Chief Financial Officer; Scott Morris, Chief Operating Officer, will also be available for Q&A. Before we begin, please remember that during the course of this call, management may make forward-looking statements within the meaning of the federal securities laws. These statements are based on management’s current expectations and beliefs and involve risks and uncertainties that could cause actual results to differ materially from those described in these forward-looking statements. Please refer to the company’s annual report on Form 10-K filed with the SEC and the company’s press release issued today for a detailed discussion of the risks that could cause actual results to differ materially from those expressed or implied in any forward-looking statements made today.

Please note that on today’s call, management will refer to certain non-GAAP financial measures such as EBITDA and adjusted EBITDA among others. While the company believes these non-GAAP financial measures provide useful information for investors, presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP. Please refer to today’s press release on how management defines such non-GAAP measures, a reconciliation of the non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP and limitations associated with such non-GAAP measures. Finally, the company has produced a presentation that contains many of the key metrics that will be discussed on this call, that presentation can be found on the company’s investor website.

Management’s commentary will not specifically walk through the presentation on the call, but rather it’s a summary of the results and guidance they will discuss today. With that I’d now like to turn the call over to Billy Cyr, Chief Executive Officer. Billy?

Billy Cyr: Thank you, Jeff, And good morning, everyone. The message I would like you to take away from today’s call is that the third quarter results show that the Freshpet business is delivering on its promises and potential. And as a result, we are off to a fast start towards our 2027 goals. At the beginning of the year, we laid out our new fresh future long-term plan that called for 25% annual top line growth, resulting in $1.8 billion in net sales in 2027 and strong margin improvement with the ultimate goal of delivering 18% adjusted EBITDA margins in 2027. For 2023, the first year of that plan, we committed to continuing our strong track record of net sales growth, while simultaneously fixing the operating issues that were preventing us from generating the margins that we know are attainable in this business.

We are delivering on that commitment and exceeding many of the targets we set, putting us ahead of the pace required to deliver our 2027 goals. This increases our confidence in the capability we are building, the strategies we are employing, and our ability to deliver our long-term goals. In Q3, we delivered both top line and bottom line growth ahead of expectations for the quarter. We delivered 33% net sales growth, bringing our year-to-date net sales growth 28%. While we also delivered a step change in our profitability due to strong operational improvements. As a result of that progress, we are raising both our net sales and adjusted EBITDA guidance for the year. We believe our fast start towards our 2027 goals is largely due to the strengthened organization capability we have built and the strength of the Freshpet Consumer Proposition.

The team we have built is delivering improvements in our key focus areas of quality, logistics, and input cost at a rate that has exceeded our projections and which enabled us to deliver a 40.2% adjusted gross margin in the quarter. Our progress in logistics has been even more significant and impressive. This is a true testament to the quality and depth of our team that is spearheading these projects and we couldn’t be more proud of this measurable progress. Our net sales growth has also been impressive and is a good demonstration of how resilient the Freshpet brand is, even in the face of higher pricing. Q3 was our fourth consecutive quarter of accelerating volume growth and our 23% volume growth in the quarter in combination with our typical mixed improvement provides added confidence that we can continue to deliver the mid-20s net sales growth CAGR needed to support our long-term algorithm, even without the benefit of pricing.

Even more encouraging is the increasing rate of household penetration growth that we have seen. While it will take some time for the 52-week household penetration measure to show the low-20s household penetration growth we have seen previously, the 13-week measure is already approaching that rate of growth. It is just a matter of time for the long-term measures to catch up. We think that will happen by mid-year next year. While we’re off to a great start, we are also mindful that we still have a lot of work to do to achieve our 2027 goals, particularly our margin goals. Our adjusted gross margin is still 500 basis points below our long-term goal and our adjusted EBITDA margin is also well below where it needs to be. We need to stay focused on improving our operational performance, while simultaneously adding capacity to keep up with the strong growth we expect to deliver.

I want to provide a few additional highlights from the quarter and then we’ll turn it over to Todd to provide the key details and our updated outlook for the balance of the year. First, net sales growth. The net sales growth in the quarter was particularly strong and ahead of our expectations. It was largely due to strong 23% volume growth that in combination with typical mix improvements is equal to our long-term 25% growth target. This growth was due to continued household penetration growth and even stronger growth in the number of heavy and super heavy users, what we call HIPPOs. Those HIPPOs account for 88% of our volume today. The number of HIPPOs in the Freshpet franchise grew 25% in the past year and their buying rate grew 6% demonstrating the disproportional impact that these targeted consumers have on our growth.

We also saw particularly strong growth in the unmeasured channels, such as club. The net sales up more than 100% in the unmeasured portion of that channel. What is particularly exciting is that 65% of the households, who buy Freshpet in that channel are completely new to Freshpet and they buy in large quantities. The strong growth in the unmeasured channels more than offsets the slower growth even experiencing in the pet specialty channel. Second, fridge placements, we’ve placed 4,464 new upgraded, and second or third fridges year-to-date, a record for us by a large margin. 20% of all of our 26,385 stores now have multiple fridges. We are on a pace that is well ahead of our initial commitment to place 5,000 fridges this year and already have the 1.7 million cubic feet at retail that we projected for the year.

This is a testament to retailers’ belief in Freshpet as a scalable and innovative category leader and that we represent a significant growth opportunity for them. Third, e-commerce. We continue to see strong growth in the e-commerce channel, which we define as curbside pickup, delivery and DTC. E-commerce now accounts for 9.5% of our total volume and 88% of that volume goes through our fridge network either via curbside pickup or a store-based delivery option like Instacard, which grew 48% versus year ago. E-commerce sales are up 62% versus year ago, and we continue to believe this will grow as consumers increasingly adopt new and convenient grocery pickup and delivery services. Fourth, innovation. We launched our large dog offering in a limited number of stores earlier this year and it is off to a fast start with its dollar velocity within our top 10 items where it is in distribution.

Based on these strong results and the ability of this item to expand our reach into larger dogs, we expect to expand distribution of this product next year. Additionally, we launch Freshpet Complete Nutrition roles in October. Complete Nutrition offers the Freshpet experience at a good entry point value. We expect it to be in more than 9,500 stores by the end of the year. We think this will make Freshpet more accessible to interested, but more value conscious consumers. Fifth, quality logistics and input costs. As we told you at the beginning of the year, these costs would be our key focus areas as we sought to improve our operations and we were making good progress. In the quarter, we improved the collective total of these costs by 780 basis points versus year ago.

Within that, our quality costs were 190 basis points better than the year ago. Our progress in logistics has been exceptional, improving by 540 basis points versus year ago. While we are benefiting from the macro environment, which has created less demand for trucking capacity and lower fuel costs than last year, we believe that only about one-third of our improvement is due to those factors, whereas the remaining two-thirds is due to actions we have directly taken. Her perspective, despite shipping 23% more pounds of product in Q3 of this year than in Q3 last year, the total number of miles of freight we paid for was down by 28%. This was due to higher fill rates, larger order size after our June implementation of bracket pricing, and the ramp up of our second DC.

And we have leveraged our increasing scale to get lower lane rates relative to the market than we have gotten previously. This is a clear demonstration of the incremental capability we’ve built in logistics over the past year. And six, capacity. We’ve successfully added incremental staffing at all three production sites over the past 90-days. And that is delivering the necessary capacity to support our current rate of growth and is positioning us well to meet the demand we anticipate in Q1 of 2024. Further, the second bag line in Ennis has begun commissioning and is on track to begin producing available product by the end of the year. Instruction of Phase II in Ennis is on track or slightly ahead of schedule, and that will enable us to begin producing roles in the first line in Phase 2 by the end of Q3 of next year.

In total, we believe we will have adequate capacity to support our near-term growth that underpins our 2027 algorithm and will be well positioned to support growth going forward. In summary, we believe we are making very good progress and remain very bullish for the year and our long-term prospects. I would like to end my comments with some thoughts on the overall pet food category. There’s been lots of discussion lately about the impact on household budgets and the influence on category volumes given higher category pricing and a wide variety of macroeconomic factors, such as the resumption of student loan payments, interest rates, and inflation. Clearly, the results we presented today suggest that an increasing number of consumers are still willing to pay for high quality pet foods and demand for those types of products is growing.

We are seeing strong growth across all age groups and income cohorts and we believe that the most important variables in determining what kind of pet food you feed your dog or not income or age, but how important your dog is to you and how much you focus on their health and wellbeing? The cost to feed Freshpet is only about $2 per day for the average 30-pound dog. That expense for a high-quality pet food has shown over time to be amongst the last things that someone cuts from their household budget when times are tight. When you contrast our performance with a wider CPG narrative about consumer trade down that is occurring, this suggests that there is a bifurcation in the category with a high-end thriving and downward pressure and less differentiated brands.

It is true that our volume is becoming increasingly concentrated amongst our heaviest users, HIPPOs, who also happen to be our fastest growing group of users. We view that trend to be favorable, demonstrating high levels of satisfaction and making our business increasingly main meal instead of a topping or mixer. We now have almost 4 million HIPPOs in our franchise, double the number we had three years ago, and they are consuming an average of $235 a Freshpet per year. That group has grown 25% over the past year and they now account for 88% of our business. Within the heavy user hippo group we have a subset of about 250,000 users of the size of some of the DTC brand franchises, who buy more than a $1,000 per year that count for about 25% of our total volume.

That group has grown more than 50% over the past year. We describe the consumer behavior we are seeing as Freshpet is becoming increasingly mainstream and main meal. We are growing our total franchise across all ages and income cohorts, thus we are becoming more mainstream. And we are increasingly driving higher and higher buying rates, thus becoming more main meal. This creates a strong, loyal, and very valuable consumer franchise. This behavior is consistent with a long-term trend towards the humanization of pets and consumer interest in feeding their pets the highest quality food that has driven the premiumization of the pet food market for the last two decades. Nothing in the data that we see suggests that this trend is slowing and in fact, we believe that the next generation of users is even more interested in providing the highest quality of care for their pets and concerned about the quality of food they feed every member of their family.

This is a fundamental trend that we’ve discussed over the years, but is being tested amid this period of economic uncertainty and the resiliency that we see is extremely encouraging for the future of Freshpet. With this backdrop we believe that Freshpet has the potential to become a very large brand and a very large and growing category, and we are taking the necessary steps to ensure that we realize that potential. Now let me turn it over to Todd for the details on the Q3 results. Todd?

Todd Cunfer: Thank you, Billy. And good morning, everyone. As Billy said, in Q3, we continued the strong performance we saw earlier this year and have raised our net sales and adjusted EBITDA guidance to reflect that strength. Let me break it down a bit further. Net sales came in at $226 million, up 33% versus year ago. Our net price mix was up more than 9.5% versus a year ago in the quarter, and volume measured in pounds grew 23%. The price mix was positively impacted by the two price increases we took in February and last September, totaling 7.5%. The mixed benefit, which we have consistently seen over time as consumers migrate to higher priced items in our lineup, was slightly more than 2 points. Total Nielsen measured dollar growth was 28% versus a year ago in the quarter, but our growth in non-measured channels was much stronger and added almost 4 points to our measured channel growth, which also has been a consistent trend as of late.

The growth was broad-based across channels, ranging from a low of 12% in the Pet Specialty channel to 30% in XAOC and greater than 100% in the unmeasured channels. Adjusted gross margin was 40.2% in Q3, 570 basis points better than the year ago, and well above our base expectation. This improved performance was due to a variety of factors, including improvements in the input cost and quality, the benefits of the pricing we took in February, and increasing fixed cost leverage in Ennis. All aspects of our operational improvement plan that our teams is focused on. We expect these elements will continue to improve as we move forward and drive continued margin enhancement, particularly as we grow into the scale of the Ennis operation. Total SG&A was 28.6% of net sales, down from 32.2% in the year-ago quarter.

The biggest improvement was in logistics, where we gained 540 basis points. We spent 9.5% of net sales on median in the quarter, which represents an increase of $5 million versus year ago. We did have some unfavorability in SG&A as we trued up our bonus accrual to reflect this year’s improved performance, increasing our bonus expense versus year ago by 170 basis points. Adjusted EBITDA was $23.2 million in Q3. That is considerably better than the expectation we had initially provided and was primarily due to the strong operating performance in COGS and logistics and the better than planned net sales. Over the year, we have delivered $35.2 million and adjusted EBITDA to-date well ahead of the initial expectations we set at the outset of the year.

Capital spending in the quarter was $60 million. There’s no change in our outlook for capital spending this year, which remains at $240 million. We generate around $39 million in operating cash flow year-to-date, an improvement of almost $93 million versus year ago. As a result, our cash position is very strong with $338 million in cash on hand at the end of the quarter. For the remainder of the year, we expect interest income and interest expense to largely offset each other. We believe that we have adequate cash to fully fund our growth through 2024, and we will be free cash flow positive in 2026. We also believe that we will have access to traditional non-dilutive forms of capital to bridge a gap in 2025, if it occurs. As we look ahead to closing out 2023, we expect to continue the strong consumption growth we demonstrated in Q3, but the net sales growth will be impacted by the large trade inventory refill we completed in Q4 of last year.

We believe that trade inventory refill totaled around $10 million to $15 million in Q4 of 2022, and we will not have any trade inventory refill in Q4 of this year. Thus, we are expecting net sales growth to be in the low-20s, while consumption growth will remain in the high-20s. We will continue to see an increasing rate of growth coming from unmeasured channels as the club business is doing extremely well. We will be losing the year-on-year benefit of a 2.7% price increase we took last September. So we will only have 5 points of benefit from pricing versus a year ago in the fourth quarter. Thus, volume and continued mix improvements will be the primary drivers of our net sales growth. The trends we are seeing now are all rate supportive of the volume and mix growth we need to deliver our net sales goal for the year and start next year strongly.

We expect to see continuing improvement in our operating cost in Q4 as we build scale in Ennis and continue the strong delivery we have already seen in logistics and quality. However, we have added manufacturing staff in anticipation of meeting the demand we will experience in Q1 of 2024, and that will impact the adjusted gross margin in Q4. We will also incur some start-up costs for the second backline in Ennis. As a result, we expect the fourth quarter adjusted gross margin will be slightly below Q3, but well above the year ago margin of 33%. In the fourth quarter, we will have a sizable media dollar investment versus a de minimis investment in the year ago. And that reinvestment will help us get off to a fast start in 2024. However, the rate of media spend in Q4 will be below the level we had in the first-half of the year, providing some incremental margin benefit.

Now let me turn to our guidance for the balance of the year. Given the strong performance to-date and what we have seen of Q4 so far, we believe it is appropriate to raise our guidance to reflect the higher net sales and better-than-anticipated performance on adjusted gross margin and logistics. Now let me turn to our guidance for the balance of the year. Given the strong performance to-date and what we have seen of Q4 so far, we believe it is appropriate to raise our guidance to reflect the higher net sales and better-than-anticipated performance on adjusted gross margin and logistics. Thus, we are raising our adjusted EBITDA guidance to around $62 million from at least $55 million, and we are raising our net sales guidance by $5 million to around $755 million.

We are not ready to give formal guidance for 2024 yet, but you should expect us to continue to focus our strategic planning on delivering against our 2027 targets I call for 25% compound growth and an increasing rate of margin and profit growth. We will have fewer start-up costs next year, and we’ll continue to capture scale benefits and quality improvements in our manufacturing facilities, resulting in further improvement in our adjusted gross margin next year. And we will continue to capture scale and efficiency benefits in SG&A. It is important to note that our priority will remain on restoring the profitability of the business, while continuing to deliver the outsize growth that investors have come to expect from us. However, at the scale we have now achieved over delivery of our growth rate as consequences that we must avoid to achieve our margin targets.

It can significantly impact our ability to meet demand, stretch our ability to design, construct and start up new lines and stretch our balance sheet. In this regard, we are being very thoughtful in managing our growth at levels that are consistent with our long-term target. Our goal is to always have adequate capacity to meet our anticipated demand and not much more than that, so that we can live within our existing resources. Our planning process for adding new capacity has multiple checkpoints before we are fully committed to the cost of new capacity. We are constantly updating our demand forecast and only commit to new increments of capacity when it becomes apparent that we will need them. Because of the infrastructure, we have already built in Ennis, Kitchen South and Pennsylvania.

All of our current projects are within the scope of the buildings and sites that we have already developed and the Ennis Phase 2 building that will be completed by mid-next year. We can add four lines in that space, two more lines in the existing space at Kitchen South and are developing a plan to install another line in storage space in Kitchens 2 in Pennsylvania. Effectively, that means that we are only making capital commitments 18-months out from when we need the capacity at this point and we’ll not have to invest in new building or site infrastructure beyond Ennis Phase 2 for the next year or two. And we are only adding staffing 90-days out from when we need it. We believe that gives us flexibility to scale our capacity while simultaneously managing our cash very closely for the next few years.

Our fast start towards our 2027 goals will also provide some added strength and flexibility on our balance sheet. With good capital spending discipline, improved margins and better operating cash flow, we remain convinced that we will have ample liquidity to commit our needs for ‘23 and ‘24. We expect to require a small amount of traditional debt financing in 2025 and we will have more than enough earnings power to support that. We continue to believe we will be cash flow positive in 2026. In closing, we are very happy with the way the year is turning out. The management changes that we made in September 2022 and the increased focus on our operational improvement are our parents. They have put us ahead of the glide path that we need to deliver our 2027 goals giving us both some added optimism that we can meet or beat those goals and also some cushion to absorb any short-term issues along the way.

As we end 2023 and head into 2024, we are in a much stronger position than we were one year ago. Ennis is up and running, including the chicken processing operation, our operating efficiency has improved dramatically, and we see solid evidence of continuing improvement almost every day. Our customers have added a record number of new fridges that are amplifying our advertising investment. Household penetration is growing nicely, and our HIPPOs are growing even faster. And Freshpet is becoming more mainstream and more main meal. All of that, plus the additions we have made to our team is the recipe for our long-term success. We are very bullish about our future and our ability to deliver our long-term goals. That concludes our overview. We will now be glad to answer your questions.

And as a reminder, please focus your questions on the quarter and the company’s operations. Operator?

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Q&A Session

Operator: Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Our first question is from Ken Goldman with JPMorgan. Please proceed with your question.

Ken Goldman: Good morning. Thank you. I know you’re not talking specifically about 2024 yet, but you did bring up the idea that I think you’re generally aiming for 25% CAGR over the next few years. I just wanted to make sure, is the messaging for next year, if there is messaging at all, you’re on target for that 25%-ish CAGR in general, but you’re going to do if things come in as expected, above 25% in 2023. So maybe you can still do below 25% in ’24 and still get to that number? I’m just trying to get a sense if there’s any kind of underlying messaging in there or if I’m reading too much into that.

Billy Cyr: I think you’re reading a little much into that, Ken. The message is that our current run rate of volume and mix would support 25% growth. Our long-term algorithm calls for 25% growth. And so we fully would expect to deliver 25% growth next year based on what we can see today. We feel very good about the momentum of the business. We’re seeing good consumption. There’s no reason for us to think that’s not going to be part of the plan.

Ken Goldman: Thank you. And then just a quick follow-up. And if you said this on the call, I missed it, but Todd, now you’re into November, presumably some discussions with vendors have been underway. What’s your updated estimate for COGS inflation next year? I think you were roughly thinking on an early basis about low single digit last quarter.

Todd Cunfer: Yes. I mean it is too early to tell. Chicken pricing is the biggest component. We will know that in about the next month. I mentioned on the call, we’re very confident we will have gross margin expansion next year. Don’t know exactly what that looks like. Obviously, we’ll give you more color when we report Q4. But look, I think it’s going to be flattish. Right now, things are looking pretty good. I think we’ll have some nice leverage from fixed cost. We think the quality cost will continue to decline, feel great about logistics. So very confident about some level of gross margin expansion next year. It’s really going to be dependent on what those final input costs are.

Ken Goldman: Thank you so much.

Todd Cunfer: Thanks, Ken.

Operator: Thank you. Our next question is from Mark Astrachan with Stifel. Please proceed with your question.

Mark Astrachan: Yes. Thanks, and good morning, everybody. I guess maybe just to start. So on track and on the mix breakout, can you maybe talk a bit about how much line of sight you have on each of those? And you talked about mix being a similar sort of contributor historically. I don’t recall specific breakout previously, sort of curious why and how we think about it and how much ability do you have to manipulate that higher with innovation. And on the untracked piece, at 4 points or so contribution was a little bit more than in the first-half. How do you think about that on a go-forward basis? Is there opportunity for that to sustain into ’24? Thank you.

Scott Morris: Hy, Mark, it’s Scott. So historically, what we’ve seen is mix has definitely been a contributor of typically around 3 to maybe 4 points per year. So you kind of add that to our volume, and that’s the majority of what we’re seeing. And that’s kind of been historical. We’re starting to see it again this year. And then the other thing that we’re kind of starting to obviously see a ton of expansion in is — all the non-measured channels. And part of that’s club, but part of that is also the online piece, too.

Billy Cyr: Let me just add to it. One of the reasons why it hasn’t been as much of a discussion over the last couple of years is because our mix is oftentimes been dictated by capacity. And this year, our mix — we have much more of the consumer available to choose on their own. Historically, our Fresh From the Kitchen product has been our fastest-growing part of our lineup, and it’s the most premium part of our lineup. And we, frankly, finally have good in-stocks and good supply of that. And so the consumer is able to naturally migrate up through the platform or through the brand franchise as they have historically.

Scott Morris: And then I’ll add one more piece to it is we’ve — as Billy mentioned in the call, we introduced some innovation called complete nutrition. And that’s, we think, a great opportunity to bring additional people in. We think that, that’s going to help us with overall buy rate over time. And then we’re also starting to kind of introduce mixed or bulk cases into the portfolio. So as we see that, we’ll see probably buy rate expansion with that. And I think that’s going to help us with kind of overall consumption, expansion of mix and in addition actually to penetration.

Mark Astrachan: Got it. And maybe related to the last piece on just the incrementality and sort of building on what you talked about on the HIPPOHs. How do you think about the recruitment? And how many nonusers are there out there to continue driving growth. And what do you know about them in terms of competition or composition of income and generations in terms of users?

Billy Cyr: Yes. I mean, first of all, you’ll see in the presentation we attached that the growth has been fairly broad-based. Obviously, the group that is the highest likelihood of being interested in Freshpet skews younger. So the millennials and the Gen Zs and that’s where we’re making the most progress. And I think millennials and Gen Zs today account for about 50% of the dog ownership in the U.S. and it’s obviously where the growth is coming from going forward. And that’s where our proposition really resonates. I think the number I would call is that Gen Z is twice as likely to choose Freshpet as a baby boomer is. So we think that fundamentally over the long haul, there’s a very good demographic tailwind that’s going to help us with this. And we expect to see — so we’d expect to see that cohort grow much more quickly.

Mark Astrachan: Thank you.

Operator: Thank you. Our next question is from Rupesh Parikh with Oppenheimer. Please proceed with your question.

Rupesh Parikh: Good morning and thanks for taking my question. So in regards to your marketing efforts, just curious how the responses to your marketing. And then as you look towards next year, just any initial thoughts on the plan for spend, whether you plan to be consistent to 11%? Or just any thoughts there as well?

Scott Morris: So I’ll answer the response to the marketing piece, and I’ll turn it over to Todd on the kind of the planned spend. So basically, I think we’ve been able to consistently refresh the advertising over time and the marketing and the communication. And we really have been able to see incredible responses to the marketing that we put in place. We see penetration really kind of pushing penetration, really nice, consistent growth over time, and expansion of the portfolio and bringing it, as Billy mentioned in the call, to this really mainstreaming the brand and mainstreaming the idea of Freshpet food and continuing to kind of deliver on that concept. And Todd, I’ll let you talk a little bit about plan spend?