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

[indiscernible] cans.

Yes, yes, yes. But we've got -- I forget how much capacity is -- $5 billion worth of capacity coming in and a lot of it's coming on wet. So the Senate could say you benefited in the last couple of years because the substitute product for Freshpet, which is wet can, was not available. And as availability comes back to market, this is clearly going to be a headwind for your growth.

The hypothesis assumes the people that you're talking about and the consumption you're talking about is that last 13% of our volume, where it's used in that fashion. When we're talking about the other -- the 34% of our people account for 85% of our business, who are using us as the main meal can is not the alternative. The alternative there is dry. And our price relationship versus dry is not changing much. It's relatively the same. So I look at that and go, yes, we might have a little bit of can availability affecting that last 15% of the business or something like that. That's a small part of the total franchise.

Okay. And media spend, where is it today in terms of absolute quantum dollars?

Yes, we're going to spend probably $80 million, $85 million this year. We spent $62 million last year. It's going to be front-half loaded, almost 2/3 of it will occur in the first half of the year. We spent about $26 million in Q1, a little bit more in Q2, and then it will trail off. Most importantly, we will spend a decent chunk in Q4, we were largely off air this past year in Q4, and I think that kind of hurt some of our business trends a little bit. You don't want to be dark for that long, but we will be on air for most of Q4 as well. So as Billy pointed out, it continues to return nicely. It's a really important part of our model, and we'll continue to lean in. We just put some new advertising on, which is fabulous. And so we're very bullish on it.

Todd, that's a huge spend for a single brand in a single market, at which -- what point -- like why would it double? Aren't you at a point where you're going to get massive diminishing returns?

So we track it very closely. Do I think that's part of our margin gain over the next 5 years is, it will become a smaller percentage of net sales over time. So it's been 11%, 12%. And we'll get that probably down to 9-ish over the next 5 years, but it will still be very healthy. If you do that math on where our projection of [indiscernible], we're going to spend about [ $167 ] million in media in 4 years. And to your point, it's one brand in one country. It's a very healthy spend that we're super pumped about. We think it's going to really generate some nice returns for us.

Okay. You took us to margins. So let's stay on margins. Margins have been the sore spot. We've seen what this business could do. I mean it's sort of ironic. When you're running small-scale business out of an old dairy plant that have been retrofitted, you were able to generate high 40s gross margins. We scale with things that are supposed to be taking you down the cost curve and your margins went down with it. So they went the wrong way. And now we've gone from high 40s to high 20s at least with D&A included -- massive, massive degradation on packet for us and give us the path forward, like why haven't -- these new state-of-the-art facilities you brought on, why haven't they brought us down a cost curve? Why hasn't pricing been enough to offset inflation as it has been for other CPG businesses? And why should we have confidence that you can get back to where you were before? A lot there.

Yes. There's a lot there. So first of all, to your point, we've been there before. So that -- we're not -- when I say we're going to be at 45% or above by end of 2027, it's not a crazy number. We were at 48%, 49% a couple of years ago. So that -- one could say that's a conservative number. A couple -- obviously, trying to build out 2 facilities in the middle of pandemic with lots of labor issues. It was incredibly challenging. But let's put it down into its components. So just the start-up costs, the unabsorbed overhead of these new facilities last year cost us about 400 basis points. So that's a huge hit for us. The quality issues, again, labor issues, just trying to run so quickly, case fill rates have cost us 300 or 400 basis points over the last 2 years. We think we'll get 200 -- at least 200 basis points of that back, and we've had 2 quarters in a row where that's gotten better. You mentioned the commodities. We had a huge commodity mismatch over the last couple of years. Commodity prices were -- the inflation was very high. We were behind the curve on pricing. That cost us a couple of hundred basis points. We're going to get a good chunk of that back and you already saw it happen in Q1 where we got a nice chunk of that back as inflation has moderated and we got about 12% -- from a shipment perspective, 12% pricing on mid-single-digit inflation in Q1. So that really helped us. And then below the line, not in our definition of gross margin, but logistics went up several hundred basis points over the last couple of years as well. Some of that is macro diesel cost and lane rates and all that kind of stuff. We're seeing that, those macro issues come back. And at the same time, internally, our case fill rates have come from 60s and 70s to now mid to upper 90s. We have a new team managing our logistics process, and they're bidding out lanes really effectively and doing a lot of smart things. And so we're already seeing significant reductions in logistics, and we still got a ways to go here. And I think it's going to happen pretty quickly.

Okay. Okay. On the commodity side, any line of sight to absolute deflation?

I think in certain pieces, there's some deflation out there in total. Again, really early to tell again, again, kind of mid-single digits this year and about 80% of -- we're fixed for about 80% of our commodities. As we go into next year, it's early, but I'm probably -- if I pick right now, some pluses and minus, it's probably going to be low single digit would be my guess right now. So I don't see deflation, it could because we tend to buy all our chicken at one time of the year in December. So that's a big time depending on where chicken prices and turkey is at that point in time, which in eggs come back significantly. So that should be very deflationary as we go into '24. But there'll always be some offsets. But maybe we'll catch a break, and we'll see deflation across the board. But it's probably going to be flat to slightly up is my best guess right now.

Chicken and turkey prices soared, and they've come crashing down. [ Tyson's ] not having a great go, right now. You got hit on the way up, why aren't you benefiting on the way down?

So I guess the way to think about it is, we did get hit on the way up. Remember, we didn't go up as much as the publicly reported chicken prices are, whether you're talking about chicken wings, chicken breast and whatnot. We didn't go up nearly as much as them. So we're not going down as much as they are. And one of the things that we're seeing in the market right now is that all the chicken processors, they're still seeing their cost, labor and some of their input costs of grain and feed are still up on an elevated level, and that has a significant impact on us. So we believe there's an opportunity to trace back on chicken a little bit from where we are, but we don't think we're going back to the world that we had before because their labor costs are still up and they still have some feed costs. So we don't think we're going to go back there. I do think there are some things, Todd mentioned, turkey. Turkey has been clobbered by the avian flu. That will trace back. Eggs, egg same thing, avian flu, wiped out eggs. We're priced out for eggs for this year because we had to get supply. As we head into next year, you'd expect to see some egg improvement. Will the egg improvement be offset by some cost increase on and else corrugate or plastic or whatever it is, maybe, but overall, the picture is much more favorable. Because from our perspective, we really don't -- we want to get to a stable pricing environment with the consumer because our model works really well. If we're having to take pricing, it's disruptive. We'll do it, and we will take pricing to protect the margin, but we'd rather have the commodities, ups and downs net out to you're in a pretty good place.

Okay. Okay. I'm going to come back to Ennis in a minute. But let's stick on price for a second. Let's imagine, let's fast forward. You've got some commodity relief. You know that when you get trial, your repeat rates are great. Is there a time and place where you start to lean in with a bit more of a high-low pricing strategy?

People asked it a lot. And there's 2 really big fundamental reasons why a high-low strategy doesn't work particularly well in our business. One of them is because the reality is the amount of consumption you're going to get is kind of fixed. I mean if the dog eats something around every day, people don't change their dog food. So if you go to a high-low strategy, all you're doing is forcing the consumer to buy the fixed quantity at a lower price at some point in time. And people don't readily switch their dog food just because other dog food is a little bit cheaper. They make a decision about the health of their dog and what the values are they have for the dog. So that's not going to change. The second thing is doing merchandising when you have a fixed amount of shelf space, that has to be restocked once a day is a little bit pointless because you just basically blow out the out of stocks. If we -- if all of a sudden, our 6-pound chicken rolls were at a discounted price, the consumer walk in the store, they won't to be able to keep it on the shelf because there's only so much shelf space that's available. So it really doesn't work for us. We'd much rather keep the model where we get very high capacity utilization from very steady demand that is driven by advertising. It brings in a predictable number of consumers who feed the same amount every day, who buy the same amount every week or 2 weeks or whatever it is, and then that ultimately delivers the highest value for the consumer and for our shareholders.

Okay. I'd probably still can come back to Ennis. We'll come back to Ennis. Another key driver of not just unlocking or fueling the growth of capacity, but bring you back down the cost curve, right, and getting margins back. Where do we stand on Ennis in terms of progress of the build-out, the start-up? Where are we at in terms of capacity utilization, overhead absorption? And what do the next couple of quarters look like on that journey?

Yes. So second line, Ennis, just came online last month. It's the bag lines. We have a roll line that went live at the end of last year. The first bag line just came on last month. There will be ultimately 10 lines in that total facility, and we're building that out in phases, plus a chicken processing facility, someone that's running for us right on that property. So it's going to -- look, we're incredibly bullish on Ennis. We think it's going to be a huge step forward for us, not just from a capacity standpoint. But ultimately, we'll get some margin benefit as well from lower wage rates, less labor because there's more technology there and just the scale of the facility plus the chicken processing. And as we've said before, we haven't baked any of those assumptions into our model. We've assumed Ennis basically has the same margins as Pennsylvania does, okay? So we're being very conservative in that assumption. But it's going to be a little bit clunky. As these lines come on, there's unabsorbed costs that hit every quarter or every 2 quarters. So everything was flowing really nicely in Q1, Q2 as that second line comes on, all those fixed costs of that second line start to hit our P&L, and we're still not nearly at any kind of high level of capacity on that bag line. You got some unabsorbed costs, not huge, but there's some unabsorbed costs that hit in Q2. That will subside as we get into the second half of the year. When we bring on the third line, and it's probably Q1 or Q2 of next year, all of that same phenomenon where there's a little bit of fixed cost, unabsorbed costs hit us. Now as you get bigger and bigger and bigger at the time you bring the line on, the math is less impactful because it's just off a much larger base. But look, we've got a long way to go, but we're really excited about the facility.

Okay. So we've got we're going to be living with stranded costs for a few years. So we're not going to see the clean profitability of that business for a while. Your Pennsylvania margins aren't good. Like relative to history, relative to where you want, like relative to anything, relative to your [indiscernible], why would we be planning for this very expensive facility to be operating with comparably poor margins?

Well, so I mean, when I say it will have the same margins, it will have -- we're assuming Bethlehem's margins over the next few years will get back to where it was or close to where it was. So we're going to see that pricing and commodity mismatch, that's starting to go away, okay? And that will largely go away by next year. The quality issues that we've been facing in Bethlehem, they're starting to get better. We're assuming they're going to get much better over the next couple of years. So I -- so when I say it's not going to be any better than Ennis, it's not going to be any better than Bethlehem. It won't be any better than where Bethlehem will be in a few years and where it has been.

I want to point out that I think that the single biggest hurt for us on the margins is that an underlying root cause was labor and stability. The reality is during the pandemic, growing at our rate, that we are growing in a manufacturing facility that was very labor dependent because that facility is not particularly automated. What you ended up with is quality problems, which turned to disposals and secondary processing, you ended up with throughputs that weren't what you wanted. And we made a major intervention to try to improve against our labor stability back in August of 2021. And I can't tell you the difference that, that has made. Our retention of our labor has been dramatically better. We're now down to a place where a vast majority of our people have been here over a year and that they have also advanced up our learning curve because we've invested in their training. And that's what's really driving the improvements in the quality and the throughput and the yields that we're getting in Bethlehem. You may not have seen them yet enough in the P&L. What I can tell you is we see it on a daily basis when we look at our metrics, and there's some noise because of all the stuff at Ennis that kind of obscures it, you're bringing on all the Ennis stuff. But if we just look at what's going on at Bethlehem and now that we have labor stability and we've got the training coming up, we're very encouraged by the trends that we're seeing. And again, part the pandemic ending, but part the intervention that we made to stabilize our workforce and it's made a huge difference.

Any questions from the audience? We've got about 3 minutes left. So we're running up against the clock here soon. Okay. We've talked capital intensity. Todd, coming back to you, you put together some plans out to 2027 at CAGNY. You just showed us where you want your revenue to be, where you want your EBITDA margins to be, implicitly, we can calculate EBITDA, and what your CapEx burn is going to remain, I mean, beyond that. And it doesn't look great. Like this fridges to free cash flow, let's say, you have $200 million CapEx. It's like in working capital. Okay. I get $74 million of free cash flow is my calculation on like your implicit EBITDA, assuming working capital as a growing company, continues to kind of burn out. I've got interest expenses, assuming no tax, but you're still burning off your NOL. I get the $74 million of free cash flow at a healthy run rate profitability level. It's just so small. It's so small. Is that really the right level? Or is it -- is there conservatism about margins? Is there conservatism on your assumed CapEx? Like why can't this business be generating more cash at that point?

So look, we're being conservative, right? We wanted throughout targets that we can meet for certainty and exceed. So we believe there is some margin conservatism in those numbers. And obviously, we're working on some technologies that will reduce the amount of capital that we need to employ when we're growing this fast. Still TBD on that, we're very encouraged. But we're not ready to announce that or we're not ready for prime time on that, but that's another facet of how free cash flow can increase over time. But look, when you're growing at the rate that we're growing at, and if you're growing 25% out in '26 and '27, you're adding $300 million of revenue a year to this business. And that does cost -- that does require a fair amount of capital. That's probably 2 to 3 lines every year. I got incremental lines I got to put in a facility. The reality is we're not going to grow 25% forever. I think we can grow 25% for a long, long time. But once that growth rate starts to be and slowed down to the high single digits, and I don't have to put $200 million of capital in each year, and maybe it's 75 instead, you're going to generate a lot more free cash flow. So it's technologies, it's margins being a little bit conservative. It's a business that, at some point in time, won't require as much incremental capital. All those will help free cash flow in the out years.

I think it's also important to think what are you getting for that capital spend. And I don't think people have fully appreciated the strategic value or the strategic advantage that manufacturing assets give us. A lot of food businesses or even beverage businesses grow up off of a co-pack model where the capital spend is on the shoulders of somebody else. But that also means they can be easily duplicated or replicated and part of what makes Freshpet such a good long-term opportunity is the fact that it's really hard to do many aspects of it. Manufacturing is probably the hardest thing to do. And so we're investing in what we think is probably the single biggest strategic barrier to entry that we can have. The existing assets have to generate cash, though. As you're spending to put new assets in place, the existing assets have to produce cash, and we believe that they are. We just sort of -- right at this point, they're getting obscured by the massive investments we're making to build out the future capacity.

Yes. Yes. And I think what's happened in the competitive playing field in the last 24 months has offered real proof points.

Yes. I mean it's just hard to do what we do. It's really hard. And it's also -- I mean, if you're -- if somebody wants to enter this space, you have to master something you've never done before and then you have to deal with fridges and stores. And then you have to figure out how to manufacture it and then you have to manufacture to scale and create efficiency in it and a technology you've never done before. It's hard. And the hardest part of that is the manufacturing part because it's new technology, it's scale, it's cost, it's time. It's not easy.

Yes. Yes. No doubt. Gentlemen, we're out of time. Thank you so much. Thank you. Really appreciate it.

Thank you Jason. All right. Thank you.