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

All right. I think we'll go ahead and lean in a sec or 2 here and get started. But thanks, everyone, for coming. Great to have you here. It's a great pleasure to have Freshpet CFO, Todd Cunfer; and CEO, Billy Cyr.

Maybe just kind of looking at some of the ways the story has progressed. There's been a big focus on margins, and there's been some nice progress there. Can you maybe explain a little bit of how you achieved some of those margin goals and maybe just a sense of kind of what upside might still be ahead?

Yes. So we focused on 3 areas that were an issue for us in '21 and '22, that was input costs, logistics and quality. We've made significant progress on all three. So we ended -- we came out of '22 with a 36% adjusted gross margin, set our goal for '27 to 45%. Gave guidance this year that we'd be at 45%, 3 years earlier, we're absolutely thrilled about that. But look, we're not going to stop there. We think there's potentially some upside. We're working internally right now to figure out what that might look like. We probably come back next year with some updates there. But it's just -- we've built talent across the board. It's paying huge dividends for us. And we're just really excited about where the next few years is going to take us.

And one of the things you focused on more is ROIC and the returns. Obviously, growth had been maybe a primary focus and there's a better balance now. What have you learned about how you can improve that and what are some of the key levers there?

Well, look, the sweet spot for us is growing about 25%. Previously, we were growing from that 30% to 35%. We are very concerned we have a competitor coming along, so we wanted to get a big head start. Now that we're approaching $1 billion in sales, we feel like we got the first mover advantage, and we're in pretty good shape right now. So we've determined 25% is our sweet spot. It's great growth. Right now, it's all volume growth. It allows us to execute really well from a margin perspective. So we guided to approaching 15% EBITDA margin coming off of 3% in '22, and we feel terrific about that. And then the CapEx, we can pace a little bit better. We have time to think through all the alternatives that we have, and it's going to enhance our free cash flow as well. So all that kind of is working really well for us right now.

And I would add to that, we have really 3 distinct focus areas that we are really driving on to get the higher ROIC. Number 1 is get more out of the existing lines. There's capacity available that's already paid for, if we can improve the operating efficiency of the existing lines. So we brought in some outside consultants. We hired some internal people, and they are focused on driving that. The second piece is we want to find ways that we can get more capacity out of the existing fixed infrastructure. So think of it as we have 3 production sites today. Each of them has got some number of lines in different -- for different plants. But the idea here is to spread the cost of receiving docks, labs, training rooms, break rooms, all that fixed cost that takes to build a site get more throughput out of each one of those. So find ways to squeeze more lines in each site. So putting a seventh line and our Bethlehem Kitchens is an example of that. And then the third strategy is find a way to invent new technology that can get much higher throughput and much higher margin of them. So we've talked quite a bit about we have a new technology that we've been working on for several years. We've kind of validated up to the level of the pilot plant level and it works really well. We'll be trying a production line of that beginning in the second half of next year. If that works, it is a breakthrough for us on our bags business in terms of the throughput we get per square foot of facility and also in terms of the margins that it generates, the quality it delivers. And so each of those strategies has a place and each has their own time horizons and time schedules, but those are really big drivers for us.

No, that's great. And so part of that, of course -- part of that whole ecosystem is the Ennis facility and adding lines there as it progresses. What are some of the latest updates there? How is the build-out progressing and what are some of the margin implications we should be aware of, especially in terms of maybe how some of the operating leverage benefits might start to be able to improve?

Yes. I'll take the how it's progressing. Todd can take you through how the margins will progress. But recall, each time we build a new facility, we look to learn from the last time we built a facility and try to advance ourselves. So when we built Kitchens 2, we told people it's going to be very focused on automation and employee safety. We made significant improvements there. We went and built the facility in Ennis, Texas. The really big focus was on hygienic design. And it sounds like basic and simple. But if you're in the food business, hygienics is designed to make the difference between having a good safe product and a product that isn't. And so we did a lot of work to make that facility so that there were barriers between the cooked and the raw, there was different break rooms, different entrances, all these things had allowed us to reduce the food safety risk that exists in the facility. And from where I sit today, I look at it, we're feeling pretty good because we're seeing demonstrably better performance from the micro perspective in that facility. It's still early. We don't know if it's going to sustain over a long period of time, but it's an encouraging piece of progress. What we aren't getting yet, which we will get going forward, is we also are looking for specialization. The more lines we have, the more we can have each line specialized in making specific products. Today or as of a week ago, we were only running 2 bag lines and 1 rolls line. That meant that 2 bag lines could kind of do a mix -- each of them could do a portion of the product lineup. The rolls line, the single rolls line was producing 32 SKUs. So it's producing every single item we had because they had to feed a DC that was nearby. The second roll line started up. It's now up and operating. We're feeling very good about it. Having 2 lines of bags and 2 lines of rolls will give us an efficiency boost that we'd expect going on. But that's just the beginning. Longer term, we'll end up in a position we believe where with 10 lines at that site, maybe more, we'll have multiple lines that are specialized in delivering efficiencies on specific high-volume items. So that's sort of from a conceptual side. We feel very good about where we are, but we still have a lot to prove.

Yes. I mean -- and Ennis is designed to ultimately be the highest margin facility that we have. Currently, just because it's still in start-up mode, it's the lowest-margin facility. So that's the next step from a gross margin lever that I feel really good about is the realization of the fixed cost leverage of the Ennis facility and some of the other plants as well, but there's some big time upside to Ennis coming in the next couple of years.

And what have you learned from some of the design decisions you made there? And is there anything you might change going forward?

Yes. We're really focused right now on space utilization. So one of the things that in Ennis, there's a lot more space per line, and that gives us a lot of flexibility, but it's also expensive. It's an expensive decision. And so one of the things we've concluded is when we lock on a technology and you know what the technology is going to be. So for example, our rolls are a much more mature technology, you should pack more of those lines in as tight a space as you can. On a less mature technology like our bag line, we probably need to leave room so that you can retrofit lines with different pieces of equipment as you advance the technology. So in Ennis, we kind of left ourselves a lot of room in all the lines. In the future, you'll probably see us packing a more rolls lines and spreading out the bag line.

The way that consumers have approached pets with a more humanization mindset and approach has not only been a tailwind for your business but attracted competitors. But it seems like no one has really been able to match kind of your proposition. Why would you say that is? And how can you continue to protect that?

Yes. I mean, making Freshpet food is hard. People always underestimate it. They look at it and go, "It looks kind of like the human food, and these big companies that are in pet foods should know how to do this," but it's not that simple. We basically have to produce a product that is a fresh product, freshly cooked product with a long enough shelf life to go through a warehouse distribution system and into the consumers' pantry or the refrigerator with enough shelf life on it that they can use it well before the expiration date and do that without any preservatives. And that's a very tall order, and the manufacturing expertise that we've developed to do that is very significant. And then to be able to do that at scale is even tougher. And on top of that, you have to have a fridge network and a fridge system. We've perfected that. We know what kind of fridges, how to set them. We know how to maintain them and repair them. We've built brand equity in the space. We understand the practices we use. We do no discounting, no promotion, which is a little bit alien most CPG companies, but it's essential to getting the returns on the capital investment we made. So there's a whole ecosystem of choices that we've made that I think, frankly, are designed to create a winning business system that in many ways or choices that are different than what many CPG companies have made and certainly in this space. So it's very different. I just go back to the previous questions for a second so that it connects into it also, which is one of the things that we're thinking about is the ecosystem that we're operating in and where do we need to develop expertise. And one of the other choices that we made in our Ennis facility is we put chicken processing on site, the only place we do chicken processing. And the reality is we did that for a reason. We think there's value to be gotten by moving upstream in the chicken processing operation. Well, ultimately, we are becoming really good and really expert at that and buyers of large quantities of chicken big enough that we think we can create competitive advantage as we move up into the chicken processing and have a bigger role in the chicken that comes into us, cost and quality. And that's not something that would be typical of anybody who's operating in our space.

So interesting how you characterize that. Would you consider including chicken processing in Pennsylvania or maybe even at Kitchen South?

Yes. So I won't describe Kitchen South because we don't give a lot of detail on that location. But in Pennsylvania, there's -- unfortunately, we're land lock. There's no space there. But it doesn't mean you can't capture many of the same benefits through some form of partnership. Remember, we have a partnership in Ennis, where we only building and the infrastructure around it, but a partner with an expert of chicken processing does the processing. There are similar kinds of relationships we could construct if we wanted to in Pennsylvania, if we got to the point where we had a material difference in the technology.

Switching a little bit to the consumer. Maybe could you give just a little bit of your sense of kind of the finger on the pulse of the consumer. But then also explain sort of who your specific consumer is? I know you call them HIPPOH's, but high...

High-profit pet-owning households.

Yes. And just maybe what you're seeing in their behavior and some of what the upside might look like? And maybe explain a little bit to the kind of the progression from maybe a consumer who starts with the Freshpet food as a topper on to like a heavier user?

Yes. So the economic backdrop that everybody is talking about from our perspective is not really a big driver of our business performance today. First of all, we're a small share of a very large category. So there's a long upside and so even if some number of consumers are constrained, the reality is there's still plenty of consumers out there for us to go after. The second thing is that we're seeing in the market is where there is consumers seeking value. It's -- on our existing users, it's people who are choosing where to buy the product, not whether to buy the product. So they're buying in increasingly value-oriented channels like Walmart. And they're also tending to move into larger sizes because there's a better value for them in a larger size. You know you're going to use up the product, you're going to use it very regularly, you might as well buy the best cost per pound to do that. So we're seeing some of that behavior. For us, the variable strength, where there's a constrained consumer would be on how readily consumers enter the franchise for the first time. And we watch that by watching our customer acquisition costs, or CAC. And right now, it's very good. Right now, our CAC is really, really good because for the last year, we've had a very consistent advertising presence. Pricing has been a very consistent pricing. Product availability is very high. So our customer acquisition cost are very low relative to where they have been and they're back to where they were pre the price increases. So we feel very good about that dynamic. The consumer we're most interested in, as you talked about, is the HIPPOH's, there are about 5 million in our franchise today. They're growing about 30% a year in terms of our penetration of them. There are probably 40 million of them in the country today. And we have a long runway then to get after them. But when they join the franchise, they kind of go through that natural migration or they try a little, they usually buy a 1-pound chicken roll. It's the lowest total outlay, lowest most economical way to buy a product. They buy a little, they try a little. And ultimately, their habit will form over about the first 13 purchases. By the time they finish on average 13 purchases, we'll know whether or not they're going to be -- what level of purchasing they'll have on an ongoing basis. And it's been very consistent and very reliable for a long period of time.

And I just like to add the value means different things to different people. So sometimes value is price, obviously, and we're seeing some trade down in the category. But for a lot of people, value is a new superior product form. So yes, we are seeing trade down somewhat in the category, but the 2 fastest-growing brands in the entire dog food category ourselves and farmer stock, two of the most expensive products you can buy, but people see value in a fresher frozen product that they think is superior to kibble.

It's also just on the backdrop. The 1 thing I always watch is really amazing is that the broader trend here is dogs are replacing children and the birth rate in the U.S. is getting an enormous amount of press lately. It's been a trend that's been going on for some time. People are having fewer children, they're having their children later, and that's nothing but good for dog population.

And so you touched on the 25% growth rate-ish, and you've been a little bit above that. I think you've been more clear 30%, you can work with, too. But I guess to the extent that your consumers seem very responsive to the advertising, you've kind of dialed it back to hold it at about this level as opposed to more -- what -- paint a picture of if it were to slow, I don't know if there's a certain number, but closer to 20%, for example, could you -- how quickly could or would you add more advertising back? What kind of lag -- and partly, if it plays out something like that, how do you kind of hold investors' hands so that there's no reason to panic?

I mean, first of all, the good news is our business is very predictable, reliable. If you look at the Nielsens that come out every week or whatever, you can see that the trend lines are very consistent. And what we told people at the very beginning of this year, going back to your telling investors, we came into this year hot because we had advertising on air in the fourth quarter last year at a heavy level. We deliberately pulled down the amount of advertising we spent in the first half of this year relative to our historic practice. So instead of being really having the front half, we're sort of more balanced across the quarters because we had this capacity gate we had to get through in the middle of the year. In Q2 and Q3, we were going to be short on rolls capacity. We knew that. We've known it for the last 9 months. And so we deliberately held the advertising level down so we can make it through that. And when we started up this new rolls line, which we did, we started up this new rolls line, we then have enough capacity that we can then start ramping back up in our advertising presence in the back half of the year is up dramatically versus where it was a year ago. It's up 45%. And that's part of the way the cadence. So we'll be very transparent about the cadence that we're going to do. To your question, how fast can you ramp it up? The reality is, we don't turn on advertising and see it immediately. What we see as we turn advertising and the household penetration starts to expand and then the buying goes with that. So it's more of a sort of a sign curve going up and down kind of over time. And our goal is to live within our upper and lower capacity limits and just kind of guide the business to fit within that band, and because the business is so predictable and reliable, we should be able to do a decent job of giving guidance in advance about how -- what the trends are you should expect to see.

No, that's helpful. Great stuff. Back to the balance sheet and liquidity. It's been a bigger focus. I think you've done a lot to manage that very well. What are some of your expectations for the next few years?

Yes. Operating cash flow has been a huge positive surprise. In the last 12 months, it's grown much faster than I would have anticipated. We're sitting with over $250 million of cash right now. I know a lot of people are saying they're going to have to come back to the capital markets and potentially dilute shareholders. I'm very confident we have enough cash on our balance sheet right now to get us through 2026, where we believe we will be free cash flow positive. So I feel great about where we are. After that, we will be self-sufficient. We're not going to -- there's no M&A. We're not looking to buy companies. We're probably not going to pay a dividend anytime soon, probably not going to buy any shares back anytime soon. So everything that we -- all the operating cash flow is to add capacity and grow this business, but we're in a much better position than I would have guessed 18 months ago.

No, that's great. And just as far as a recent hire you just brought on, is it Nicki Baty? And can you give a little sense of just where you expect her to have the most impact?

Yes. First of all, in the near term -- so Nicki came to us from Hills is her previous place she worked, where she was at Hills because of the situation there. She is limited to the grocery mass and club channels until May of next year on our business. So we have to live within those constraints. Her primary focus is going to be on the commercial operations of the business in the near term. And so she will come in with fresh eyes and a fresh perspective on that part of the business. And we think that's frankly worth quite a bit because it's been managed by all of our collective team for the last couple of years. With the fresh eyes, we think the real significant impact then will be it frees up Scott, who is probably the single best entrepreneur in the food space, to go work on building out the ecosystem that I described, pushing us further up into the supply chain, particularly the chicken processing world down into our fridge network and making that more strategic, working on cooking technologies that we can change because the belief is that if he can help build a stronger ecosystem that we operate in that will create long-term enduring value for our business and a significant competitive advantage. So that's where he's going to spend his time and Nicki will take over those commercial responsibility. Longer term than that, obviously, Nicki has experience internationally. She is experienced in the vet channel, she is experienced with e-commerce, and those will provide added value, but those will come later. And frankly, beyond that, she's just a really talented leader, a very talented leader. And frankly, we like building bench strength.

Yes. She's super, super smart. She's aggressive in a really positive way. And I mean that in the most positive way, she's all in, and she's got a general manager mindset. She understands the P&L. She takes it very seriously. She's going to be incredible.

Great stuff. We end up just right on time. So thank you for being here. Really appreciate it.

Thank you to be here, great event.

Thank you.

Thank you.