Freshpet, Inc. (FRPT) Earnings Call Transcript & Summary

Good afternoon, everyone. I'm Andrew Lazar, Packaged Food analyst here at Barclays, and we're thrilled to hear today from Freshpet. Company's continued to show impressive growth in household penetration, velocity and buy rate, and frankly, has only been held back a bit lately by capacity constraints. With this new capacity set to come online in the second half of 2020 as well as the advertising push that will accompany this, the company should be set up to come out of this in a stronger position than it went in and be poised for continued solid trends moving into 2021. Here with us today to chat about some of these recent trends and the outlook are CEO, Billy Cyr; and EVP of Finance, Heather Pomerantz. Billy, I'll turn it over to you, and thanks to you both for being with us today.

Thank you, Andrew. It's actually a pleasure to be here at the Barclays Global Consumer Conference. We very much appreciate the opportunity to tell the Freshpet story. As always, we have to begin with our safe harbor statement, forward-looking statements and non-GAAP measures. Then I would like to always -- as I always like to begin, start with who I work for. This is Appa. She's a nearly 2-year-old Samoyed. She is the fourth Samoyed that my wife and I have had since we got married 33 years ago. The first Samoyed, Nuki, was a surrogate for the children we did not yet have. The next two, Tundra and Cocoa, were companions for the children as we were raising them. And now Appa is the surrogate or the replacement for the children now that the children have left the nest. Of course, that was pre-COVID because the children have now come back to the nest due to shelter in place, and do online schooling. But that's -- I always like to start there and remind people that's who I'm working for because our mission as a company is to awaken the world to a better way of feeding our pets. That's what we do. And how we do it is incredibly unique as well. We operate differently. We're focused on a healthier, happier world where pets, people and the planet thrive. And each of the elements of our business plan and every 1 of the decisions we make is informed by each of these elements. I'll give you a hint and a few of those as we go along today, but I can go into much greater depth if you have an interest in our ESG program. We live at the intersection of 2 of the most significant trends in CPG today, the humanization of pets and the desire for fresh and all-natural wholesome foods. Until Freshpet came along, the dogs' choices were really limited. They can have dry kibble or mystery meat in a can. In a lot of ways, this was an industry, a $30 billion industry, that was stuck in 1950. I grew up in the '60s. And in the 60s, most of the food that was available was canned or dry, dehydrated, came in a box with artificially flavored, artificially colored, had some vitamins sprinkled on it. And that's what food looked like. Unfortunately, that's what food looks like for our pets today. In essence, pet food is stuck in 1950. But as you all know, dogs had a very different place in our -- role in our families in the 1950s. Most dogs slept in a doghouse in the back yard. They had a chain around their neck, collar around their neck. They might have had a chain link fence around them as well. That's very different than the role that dogs are playing in our lives today. Today, dogs are part of our family. They don't sleep in the doghouse, they don't slip in the garage, they don't sleep in the living room. They sleep in our bedrooms. And if they don't sleep in our bed, they're sleeping in a bed that's personally made for them with their name embroidered on it. Dogs are part of our family. So it makes sense that the food should start to catch up with the changing role of the pets in the family. So Freshpet came along in 2006, and it's really the first major innovation since dry kibble came along in 1956. Freshpet came out in rolls then, and these are chunks of those rolls. And you can tell it's a significant step forward versus the foods that existed from the 1950s. In 2015, Freshpet made another advance and came out with Fresh From the Kitchen, which is a shredded meat product sold in a bag, and this product is a huge step forward versus the other alternative, which is canned dog food, which has been around since 1922. Today, we sell bags and rolls as well as chicken and beef patties, all sold refrigerated, shipped refrigerated, manufactured refrigerated, stored refrigerated at home. All of this delivers exceptional palatability. Freshpet products tested using industry standard testing methodologies, produces significant taste test winners versus virtually all other dog foods. It also provides some significant benefits in nutrition. If you take the way Freshpet is made, which is it's lightly cooked, basically pasteurized, and then it's cooled very quickly. And you compare that to other ways in which you could prepare proteins like chicken, which might be retorting or turning it into meal, which is cooking it so much, it's turned into a powder. And you take a look at what is the essential amino acid bioavailability as shown in this chart, you can see there's a significant advantage for preparing your proteins the way we prepare ours. But it's not just how we make them, it's also what we start with. Freshpet starts with a higher percentage of the calories coming from protein than your typical dry dog food as shown in this chart. About 54% of the calories in Freshpet come from proteins as well as compared to dry dog foods, where it's about 27%. All of that results in noticeable differences for the consumer. The consumer who feeds their dog Freshpet, after a while begin noticing -- 82% of them will notice some change in the physical appearance of their pet, whether it's an increased energy level or shinier coat, or fewer upset stomach episodes, or healthier skin, they all feedback to us that they notice a difference after they've been feeding their pet Freshpet. And with all this great quality, though, the product comes at prices that are comparable to other super premium pet foods. This chart shows the cost to feed a 30-pound dog of pet food that if you fed that pet, pet food exclusively for a day, how much it would cost you to feed the dog. And so on the chart, you'll see our Freshpet 6-pound chicken roll would cost you $1.61 to feed a 30-pound dog per day. At our more premium end, our Fresh From the Kitchen product, the shredded product I showed you earlier, bought in a 4.5-pound bag would cost you about $3.38 a day to feed a 30-pound dog. Obviously, that's a meaningful number, but it's comparable to what you'd spend on other super premium pet foods that you'd feed as a full-time replacement. The result of that exceptional quality and that reasonable price is that Freshpet delivers exceptional consumer satisfaction, both overall product satisfaction as well as value rating. You can find Freshpet in more than 22,000 stores in our company-owned Freshpet fridges. We have about 55% ACV distribution in the United States, and we have over -- more than 1 fridge in more than 1,500 stores. They might have 2 or in some cases, they'll have 3 Freshpet fridges. And you can find these in mass outlets like Walmart and Kroger or Walmart and Target, grocery outlets like Kroger, Albertsons and Safeway, pet specialty outlets like PetSmart and Petco, Whole Foods in the natural channel and in the club channel, BJ's in Costco. And we're also in the very early stages of our international expansion, where in Canada, we're in about 1,000 stores, about 23% ACV and really just getting going with the Freshpet business model. And in the U.K., we're even on another year or two behind that, but we're in about 400 stores with about 7% ACV. But we see a bright future for the business following a very similar model to what we're using in the U.S. The model we're using in the U.S., we call it Feed the Growth, and we first launched it in 2017. We updated it earlier this year with what we call our 5 by 2025 program under Feed The Growth. And this is a virtuous cycle with traditional productivity loop that you would see a lot of people use and it starts at the very top, where we focus on advertising and innovation as a way of driving expanded household penetration. From that, we expect to see increased velocity at various retail outlets. That would allow us to expand the visibility and availability of the brand, meaning bigger fridges or more fridges in more stores. We'd expand our capacity, which will give us leverage and scale and COGS and SG&A. It will allow us to drive efficiencies in our costs and allow us to then reinvest in advertising and innovation. We've been at this, as I said, since 2017. And what you can see is, not only have we grown at a rapid rate, where we're up 25% on a compound annual growth rate, but we are accelerating. Our rate of growth has accelerated to where we're guiding to 30% growth this year, which is greater than $320 million in net sales, up from growth last year of 27% and 14% in the year just before we began our Feed The Growth program. This growth is largely driven by our ability to add households quickly. We're in about 2.96% of U.S. households today, up 24% from a year ago. And our main meal items, what we call our core dog items, so our rolls and our bags, not our treats or canned food, are about 2.31% of households or up 27% versus a year ago. This household penetration expansion is the prime focus of our efforts. All of this results in us creating scale as that productivity loop I showed you indicated. And what you can see is we're bringing that scale benefits to the bottom line. This year, we've guided to greater than $46 million in adjusted EBITDA, up 58% versus where we were a year ago. A year ago, we were growing 43% and the year before that, up 15%. So clearly, we're bringing the benefits of scale to the bottom line at an accelerating rate and a rate in excess of our net sales growth. But we think the opportunity is much bigger. As I said, we're focused on penetration. But we're only in 3.7 million households today. There's another 59.3 million dog-owning households in the U.S. that are our opportunity going forward. And it's all part of this very large and growing pet food market. The pet food market is about a $30 billion business today, growing about 7% a year, and the population of pets is growing as well. We have demographic trends that are working in our favor. Today, dog households, as I said, there's 63 million of them. About 45% of those are Millennials and Gen Z, which is an audience that finds Freshpet to be incredibly interesting. By 2025, though, the dog owning household will be 58% millennials and Gen Z, and it speaks to the opportunity for us to continue to build the size of our business. We think the addressable market is greater than 20 million households. Recall, I said we're in 3.7 million households today. We got to that 20 million households using 2 different methodologies. The 1 methodology, the one on the left, exposes consumers to a concept that explains what Freshpet is, and asks them whether or not they would definitely would buy, probably might -- probably would buy, might or might not buy, probably not buy or definitely not buy. And in 2016, if you did it, the combination of the top 2 boxes was about 10 million households. In 2019, when we did the same question with the same concept, the number was 28 million households. There's another method, which is taking a look at consumers, and this is the method on the right, consumers who are buying Freshpet today and using it today, there were about 7.5 million of those households in 2016. Households looked just like that who were not yet buying Freshpet. Today, there are 20 million households, who look just like our existing Freshpet users. So we define the opportunity as greater than 20 million households. But frankly, we think that number will be bigger by the time we get to 2020. And while penetration is our big focus, we also know that we get a significant gain from increasing buying rate. That's dollars per household per year. As you see in the chart on the left, today, we have about $110 per household per year for an average user. And that's a little bit diluted because we're bringing so many new users each year, who come in partway through the year or might be only trying the product rather than buying it on a regular basis. But the opportunity is to be $630 a year if you're feeding your 30-pound dog Freshpet exclusively. And so our focus is on having the product performance allow consumers to move up that curve. And the charts on the right show you how when consumers first enter the franchise, they're spending about $9 per household, and they're buying about 1.2 units per time and over time, what you can see is the dollar per household, the units per household, the pounds per household and the price per unit, all go up until you get to the most recent purchase. So we see buying rate going up in addition to our penetration. We are in the very early stages, though, of this accelerating consumer adoption. If you think about major innovations that have come along over time, the data that you're seeing here, this is a representation of what those would look like if you aggregated them. So the arrival of the dishwasher or the television or the cell phone or now even the electric car, there's always a group of people who fall in the innovators or the early adopters, the early majority category. And at some point, as they move up that curve, as the new innovation moves up that adoption curve, they get to the point that people call takeoff, where there's this critical mass that causes an acceleration. And what you see is a lot of focus and attention from people who aren't even related to your business, who start taking actions that help you. So retailers put you in more stores and more prominently feature you in their stores, or people do product reviews, write product reviews about you because there are audiences interested in your brand, and there's social currency that people get from talking about your brand. We think Freshpet is at that point of take off. And that's what's going to result in accelerating growth. Take off typically occurs when you're at about 12% of your ultimate end audience. So it's very encouraging for our long-term potential. So our goal is to go from the 3 million households we had at the end of 2019 and get to 8 million by 2025. We call that our 5 by 2025 program as the extension of Feed the Growth. If we got those 5 million new households, in addition to the buying rate growth, we'll end up with $1 billion in net sales by 2025, up from the just over $300 million that we expect to deliver this year. And along the way, we'll get the scale and leverage that I referenced earlier in that productivity loop, where we'll go from the 14.4% adjusted EBITDA margin that we have this year to a 25% adjusted EBITDA margin in fiscal 2025 with the bulk of it being gains that we get in leverage in adjusted SG&A, a place where we've already demonstrated our ability to pull out over 600 basis points of improvement. And with that scale comes increasingly strong fortress that we're building around the business or a moat that we like to talk about. Our business model will be very difficult for someone to replicate and certainly not simple to replicate at the scale. So we have manufacturing facilities. We have the only manufacturing facilities that can make fresh pet food in any significant quantities. We have 1 kitchen today. We're opening a second shortly, and we're beginning the construction of a third. We have a refrigerated supply chain that we're increasingly building scale in, which lowers our freight costs, and we have an exclusive distribution channel for refrigerated freight into the pet specialty channel. We have the top retail partners, where we're in 9 of the top 10 pet food retailers, and we have over 1 million square feet of space occupied by our Freshpet fridges. We're developing strong brand loyalty behind a significant investment in advertising and also the preference that people have and the satisfaction they have with our products. And we continually expand and differentiate our brands, creating more products that are perfectly tailored to the varying needs of pet parents across the U.S., Canada and the U.K. So what kind of progress have we made this year against this plan? Obviously, this year has been an unusual year. We had to make a pivot at the end of the surge that came behind COVID and the trough that came behind it. But unlike many people who just hunkered down and kind of tried to weather the storm, we decided to pivot and tried to accelerate our growth coming out of the post-COVID surge. And we did that by keeping our teams safe as the a, #1 most important priority, and we think they've done that incredibly well. That allowed us to rebuild our supply, which was basically emptied as a result of the surge. It allowed us to fix the stores, get in and get extra people into the stores, to reset the shelves, to make sure product was pulled out of the back room and that our presentation looked good. That allowed us to create new e-commerce options. The new e-commerce options allowed consumers who were afraid to go into stores to access Freshpet in other ways at an accelerating rate, and then get back on the air with advertising at a time when advertising costs are lower because the advertising space is cheaper and also higher viewership. And so we've done that, and we've succeeded in accelerating our growth. This chart shows you what our growth rate is. It's not consumption. It's our actual growth rate. So you can see on the left is that our growth rate in the first 2 months this year before the COVID surge was about 28.8% versus a year ago. We went through the surge in the trough, and we've come acceleratingly growing out of that. And what you can see is that we are now, latest week, our growth was 44% in the Nielsen Mega-Channel Consumption Data. Our guidance for the back half of the year is for us to be at over 30%. So obviously, we're off to a very, very fast start. And we're bouncing back much faster than the category. The green line in this is Freshpet and the yellow line in this is the category. It shouldn't be a surprise because we're a refrigerated product. So consumers were less able to stock up on Freshpet. But it's also -- less consumers tend to buy it via chewy.com or Amazon online, and retailers now know that about 10% of their business in drying -- in dog food has left their stores and may not be coming back. We're also seeing significant gains in our household penetration behind the return to advertising. Our advertising went back on the air at the beginning of May when the stores have been restocked. And you can see we've had the most significant period of household penetration growth that we've had in quite some time. And that's a testament to the effectiveness of the advertising as well as the efficiency that we're getting. All this has allowed us to build meaningful share in the dog food category. This chart shows you our shares by channel with the green bars being grocery, where we have a 10.5% share in the most recent 4 weeks, and we have a 5.9% share in the Nielsen-measured xAOC, which adds mass and club to the measures. So it's not just that we're growing fast, we're also growing to a size and a scale that's meaningful to the customer. All of this has allowed us to deliver very strong fundamental financials this year. So for the first 6 months of this year, our net sales growth is up 31%, and we brought that scale and leverage to the bottom line where our EBITDA is up 326%. So the model is working. As we look forward to the second half of the year, I want to remind you though that we are capacity constrained, and Andrew referenced this in his comments at the beginning. We will be opening our second Freshpet kitchen at the end of this month and producing salable product for the first time there in October. But until then, we are extremely tight on capacity on certain items. In -- our max Q3 capacity is $87.5 million of product, and that assumes that we have perfect mix, no significant production issues and minimal absenteeism, and obviously, you never get everything perfect, so you should expect that we don't have quite that much capacity in the third quarter. But by the time the fourth quarter comes around, and our Kitchens 2.0 opens, we'll be producing salable product in October, and we will have meaningful quantities in November and December. So what are the key growth drivers for Freshpet as we go forward? And how are we doing on that? So the key growth drivers for us in this business model are very simple. The top half of this slide, the white background part, are those things that we use to expand household penetration, the key driver of the growth of this business. The bottom part, the green part, is the product's performance and how it drives repeat and buying rate. And we have such a strong story there. We don't have to spend any of our marketing money trying to drive the repeat or buying rate because the product is so good, the feedback the parent gets from their pet on the satisfaction with the taste as well as the visible differences they see means that we can spend every 1 of our dollars out finding new consumers and introducing them Freshpet. Advertising on the left is the biggest driver of our growth. It accounts for about 80% of our growth. Visibility and availability from our Freshpet fridges is the next biggest piece, followed by our innovation, and the innovation is designed to create new items that bring in new household penetration. So how are we doing with advertising? Well, first of all, our awareness is low at only 46% aided awareness. So we have a significant opportunity to go beyond that. And our advertising program includes television, about 70% of our investment is in television. Believe it or not, television still works very, very well for us. And we also have a very aggressive digital and social campaign. And the campaign and the television on the left is very much a heartwarming message that tells people about the differences they can expect in their pet and how that changes their relationship with their pet and the relationship the pet has with the family. The campaign on the right is much more of a logical product pointed difference story, but told in a very humorous way. Both of those campaigns run and are doing phenomenally well for us. How do we know that? Well, if you look at the results we've gotten, when you compare our advertising investment, cumulative advertising investments since 2016 against the household penetration that we've had over that time, you get an astounding R-squared of 0.989 so basically, we run advertising, we bring new people into the franchise and they stay. What I also point you to at the far end of this at the very end, you can see that the yellow line starts deviating from the green line because, yes, we're spending at a higher rate, but even at a higher rate, we're getting greater efficiency in this post-COVID period, and we're seeing significant gains. But it's not just a household penetration. We hang onto them and it turns into consumption over a long period of time. And you can see the R-squared here is 0.986 between the Nielsen Mega-Channel Consumption and our media spending over time. The deviations that you see at the far end are obviously the COVID surge and the trough, but then you see the same uptick that happened in the post-COVID period where we're getting significant efficiency gains and significant consumption as reported in the Nielsens. Innovation, second big driver for us. The new items that we've launched over the last 5 years now account for 28% of our volume. So it tells you that innovation is a very important part of our business, and it's part of the way in which we satisfy increasingly large number of consumers. And what that shows in the data that I show you here on the left, which shows how we add new households with innovation. It's not like we're expanding variety to just keep the same people in the fold. This is creating innovation that brings new people into the fold, and then we retain them as shown on the chart on the right. This year's innovations are off to a delayed but good start. Many of them didn't get shelved during the COVID crisis and they only got on the shelves in the last couple of months. So there's a delayed start, but they seem to be doing well. And we launched a sensitive stomach and skin product. We also launched a small dog product, and we have some new sizes of our Homestyle Creations patties. I want to emphasize 1 particular form of innovation we've done that gives you an example of the significant gains that we can get over a long period of time. We launched Freshpet small dog roasted meals product in 2018. So it's now in its third year. In its third year, its last 4-week growth rate was 71% in Nielsen Mega-Channel Consumption versus 41% for the overall total Freshpet brand, significant growth. What's really amazing about it, though, is when you think about, we've also got other items that are catering to that same small dog audience, where we launched a small dog roll this year, which, as you can see at the yellow on the top of the chart is incremental to the green part, which is the small dog roasted meals at the bottom. And then there are some consumers who are buying our 6-pound chicken roll, which they would slice up into pieces and serve their small dogs. The sum total of that is our small dog portfolio is up 60.4% in consumption since January behind product innovation and sustained growth on our small dog item. Today, we're also announcing our next innovation, which is our Homestyle Creation meals. Homestyle Creations is a lineup that is targeted against the people who are using -- who are home cooking for their pet. So we have patties, chicken and beef patties that we launched previously, and they're small, but growing nicely. Now we're launching meals. And these are outstanding meals from both an aesthetic, nutritional and palatability perspective. The first 1 is our chicken and turkey. It's a 1 pound bag, selling for about $8, and it's ground chicken, turkey, shredded chicken, eggs, sweet potatoes, cranberries, green beans and spinach. Your dog will love it. The other version is beef, chicken and turkey, and this will sell for about $9. And it's beef, chicken, turkey, eggs, brown rice, carrots, pumpkin, green beans and spinach. We're very proud of this innovation. We think it's another step beyond our Fresh in the Kitchen and it brings in a new audience, those people who home cook for their pet. We're also announcing that our Nature's Fresh brand, which is sold in the natural channel, is going to be our first carbon neutral pet food brand. In a partnership with Conservation International, where we are purchasing carbon offset credits to offset any of the carbon footprint created by the Nature's Fresh brand. Again, part of our innovation and part of our Pets People Planet program. From a visibility and availability growth driver, you can see we're at 55% ACV, and we've grown very consistently over time, with the growth slowing a little bit during COVID as retailers were hesitant to adjust their planograms in the store. But we have a long runway for growth if we're only at 55% ACV. But one of the other bigger growth -- big drivers of growth for us is expanding the mix of large and multi-fridge stores. So today, about 60% of our stores, as shown in the chart on the right, have a large fridge and 10% have 2 or more fridges. So 70% are large or multi-fridge stores. But the percentage of our stores that are becoming large and multi-store -- multi-fridge stores is growing as shown in the chart on the right, where in 2020, almost 90% of our installations were either a large fridge, 30%, or a multi-fridge store, 60%, and we expect that to continue to grow. Multi-fridge stores also have a consumer benefit, not just a broader holding power, but what we show is that as we expand the assortment that we can offer its consumer in a store by going to larger fridges or second fridges, what ends up happening is they make more trips, they spend more per trip, and the total dollars that are spent go up fairly significantly. That's in addition to the incremental consumers we bring into the store. And also consistent with our Pets People Planet as in 2020 and Beyond, our chillers are now powered by wind energy. We're buying energy -- wind energy credits to provide electricity for our fridges. We're also investing in technology that will help us understand how to stock, where there's a camera that's mounted on the fridge door. This is in test in -- on some of our fridges today. You send the image up to the cloud, it identifies the outages, matches them up against the planogram, checks whether there's product available in the back room, and if so, deploys someone to fix the out-of-stock in the store. This is in it's test phase, but it gives you a sense for how having electricity in the aisle can enable us to have all kinds of information that we can use to service the consumer better. Part of our visibility and availability also is a growing suite of e-commerce options. As you can see on this chart, about 90% of our e-commerce sales today go through our Freshpet fridges. That means they're a last-mile delivery program like Instacart, Shipt or they're a curbside program like Kroger's Clicklist or Walmart's curbside. Our e-commerce business was up 201% in the second quarter, not a surprise during the COVID period, and it accounted for about 5% of our sales. We also increased the emphasis on the e-commerce options on our website and we are available through some direct e-commerce players like Amazon, FreshDirect, and Peapod. And we think that could be a growing opportunity for us. To keep up with all this growth, though, we need to build capacity. Our Freshpet Kitchens 2.0 will start-up at the end of this month. We're targeted to begin running test product on the lines in the last week of this month and produce salable product in October, and November and December, we'll get to meaningful quantities. In August, we also broke ground on Freshpet Kitchens 3.0 in Ennis, Texas, with a target to start that up in Q3 of 2022. Our CapEx plan is designed to support a $1 billion business by 2025, and that plan is on track. So in summary, we think there's significant opportunities for Freshpet to continue to grow. Our awareness is low, where we have a lot of households who currently are not aware of and aren't buying Freshpet. We're only in 3.7 million households today. Our buying rate has a significant opportunity for growth. And our ACV distribution can be expanded significantly from its 55%. Our primary goal between now and 2025 is to get to 8 million households. And we believe if we get there, and deliver the product satisfaction that we've been delivering, that, that will result in an increased buying rate, and the combination of the buying rate and the penetration will deliver $1 billion in net sales. As lofty as that sounds, to basically triple our business between now and 2020, this is something that has been done before. Blue Buffalo, which all of you are familiar with, this chart shows their household penetration gains over similar periods in their life cycle. And you can see that the gains that we're talking about between 2022 and 2025 are even less significant than Blue Buffalo actually deliver. And the net sales is less than what they actually delivered. And the reason for this is because they could use co-packers to expand their capacity more quickly, but whereas we have to design, construct, start-up, and then hire and train employees to build capacity because our product is so unique, so differentiated and nobody else does it. But that's the only limiter to our growth because the consumer interest and demand is incredibly strong and the power that we have and the ability that we have to drive the demand with our growth drivers is very significant. So we're very comfortable and very confident in our ability to deliver our long-term growth goal. And with that, Appa says thank you for your interest and attention, and just remind you that Freshpet's 5 by 2025 Feed the Growth program is well on track. Thank you for your interest and attention.