Vital Farms, Inc. (VITL) Earnings Call Transcript & Summary

Good afternoon, I'm Pam Kaufman, Morgan Stanley's U.S. food and tobacco analyst. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative today. So I'd like to introduce Vital Farms for the next presentation. Vital Farms is an ethical food company that offers pasture-raised eggs and butter. The company offers a unique growth profile within the packaged food space and is attractively positioned because it sits in the intersection of shifting consumer preferences towards health and wellness and more protein as well as a focus on Conscious Capitalism and sustainability. The company is a Certified B Corporation and focuses on ethical sourcing practices and a stakeholder business model. As Vital Farms went public earlier this year, we're very excited to have Russell Diez-Canseco, who's CEO; and Jason Dale, CFO, here with us today. And we will jump right into Q&A, but as a reminder, you can submit questions through the online portal for our Q&A.

So thank you, Russell and Jason. So I guess to start, it would be helpful to hear your perspective on the pasture-raised egg category and its growth potential. What do you see as the main tailwinds for growth for the category?

Thanks, Pam. Good to see you today. So yes, all the foods we produce, which are primarily in the egg and butter categories, are what we call pasture-raised and which has some meaning in the industry. And it's basically produced by animals that have meaningful outdoor access year round. That's the easiest way to think about it. And we think we're barely scratching the surface of where that part of the market can go. For example, we're the largest and fastest-growing brand at retail of pasture-raised eggs. But in dollar value, our market share is under 5% in the United States at retail. Interestingly, there are a few ways you might think about, hey, where could this go? If you look at eggs that are produced by birds that have outdoor access, what I would call either free range or pasture-raised birds, in the natural and organic channel, places like Whole Foods and Sprouts, more than 50% of the dollar value of those eggs are outdoor access eggs or ones that are making those claims. And in conventional grocery, it's more like 5%. So if you think about natural and organic as maybe the -- a little bit of the future where the food is trending, then you could imagine that this could be much bigger than our current share of the total egg market. If we look a little further out to the U.K., where I think they've had a few more years of voting with their money for food that's more consciously produced by more sustainable supply chain, those types of eggs are over 70% of the retail value of eggs. So we think there's a lot of room for growth in what we do. And we think, frankly, we continue to find more and more consumers who are looking for brands like ours that they can use to feed their families, that more -- that better align with their own values.

Great. And how do you think about Vital Farms' growth potential within the overall pasture-raised egg category? And what do you see as the main drivers for growth?

Sure. So we operate a little differently than a lot of other companies. And you mentioned at the beginning in your intro, we're a B Corporation. We follow the tenets of conscious capitalism, which means that we work with all of our stakeholders, our suppliers and our customers and our employees and our investment community to make sure that what we're doing is sustainable for the long haul for all of them. And we -- it comes alive in a hundred ways every day, small and large. But we believe that approach to business gets us to better outcomes. So from that perspective, I think that what we do or what we sell is a lot more about who we are than it is the features and benefits of a commodity that we coincidentally produce. So yes, we sell a lot of eggs and we sell a lot of butter today. But the reason that I think people choose us despite the fact that we've got higher prices than others and the reason why our brand in eggs, for example, is growing faster than anybody else's, is that they're buying something more than just our eggs and our butter. They're buying our beliefs and our behaviors. And so from that perspective, I think that continues to be our right to win. That continues to be why we've been able to drive profitable growth. So it all starts with that brand and the investment in telling that story again and again. And then beyond that, I think the velocities that we have at retail, which are strong, give us permission to be in more and more doors over time, be in more and more stores. And so that will be an additional tailwind to our growth as we're -- as we show up in more and more stores across the country. We're in 16,000 of them today, and yet, I think there are thousands more in our future.

And so you have obviously been expanding distribution very quickly, and you mentioned your products are now available in 16,000 stores. Can you talk about the opportunity for further distribution expansion and your strategy to gain sub base and increase store count?

Sure. So in our experience, our focus has always been on building an enduring brand and an enduring company. And so our approach to selling, our approach to retailer relationships is very much about developing a long-term trusted relationship as opposed to a transactional one. And so what does that mean? Well, it means that when we start a relationship with a retailer, and this is what it looked like at Whole Foods in 2009 and what it looked like at Kroger when we started with them around 2013, et cetera, is we often will start with just a single item or 2 and maybe not in all the doors of a particular retailer. So when we first started selling to our first retail customer, Whole Foods, it was for 1 -- in 1 region. And over time, we build credibility. We deliver on our commitments. We show that there's -- the velocity is there, the consumer pull-through is there. We show that the profitability for the retailer's there. And then when we come back the next year to present our items in their normal category review process, they're interested in more because we've earned that right. And so I think that's true for any retailer with which we work. Our general trend is when they do a category review, we tend to get more items as opposed to less. And we tend to have built that relationship not just on the kind of profit potential of our products in their real estate but on our transparent communications, on our consistent focus on executing well, delivering on time and in full and the things that are important to them. So I think the strategy is going to continue to be a long-term focus on building credible relationships. We've just hired a new Chief Sales Officer, Pete Pappas, who's incredible. And I think we'll get even better at being strategic with which retailers we're talking to, with which product, at what cadence over time. But I'm confident that we'll continue to see that expansion going forward.

You talked about the premium that the brand commands relative to other products in the space, just given the positioning, the investments that you're making. Can you talk a little bit more about what types of investments you're making in differentiating the brand and how the brand is positioned relative to other products in the category?

Sure. So I think about a brand identity or a brand being the sum of an awful lot of consumer touch points and impressions. But ultimately, our branding, more than anything else, is education about what we do and, in some cases, what we don't do. And so from that perspective, we're not changing a whole lot our operating practices. We're just investing in getting the story of that out to the right people at the right time. So it's been true since -- in the early days, maybe even before I got to Vital Farms, our founder, Matt O'Hayer, said, "We're not really an egg company, we're an education company because the main driver of our growth was educating consumers that there was a better option for them." And often when we educate the right consumer that there's a better option and we show them what we do, they choose us because we represent what they want. And so that's where the investment is. The investment is in getting the right story out in the right way to the right people at the right time. And when we do that and we get that right, we tend to attract new consumers.

And Vital Farms has increased its household penetration to over 3.5% in the last quarter compared to slightly over 2% at the beginning of the year. Can you talk about how the current environment has accelerated your growth and how you're thinking about customer retention among the customers acquired over the last 6 to 7 months?

Sure. So it's really interesting. I mean, as you can imagine, in the peak kind of pantry-stocking period of mid-March to mid-April this year, there were a lot of empty shelves. And food companies like ours, I think, frankly, saw big upticks in orders for our products. We, like many others, quickly pulled back trade spend and marketing spend because we were just trying to work with our retail partners to help keep them in stock as best we could. So in that time of those sort of the mid-March to mid-April pantry-stocking period, we attracted over 400,000 new consumers to our brands who hadn't bought us previously, or at least hadn't bought us in the prior year. And of those, then we looked and we said, "Well, gosh, what happened to them? Did they buy us again when their regular brand showed back up on the shelf maybe a month later or 2 months later?" Because I think it's reasonable. Our experience was that after mid-April, the shelves kind of filled back up and so there was plenty of variety again. And what we found was that about 30% of those new households that tried us for the first time in mid-March and mid -- to mid-April brought us at least once more in the ensuing 20 weeks. And about 70% of those bought us more than once. So my quick math says about 20% of those people that tried us, probably because we were the only product on the shelf, have now become what looks like early loyal consumers. So -- and we didn't pay anything for that. We didn't market to them. We didn't do trade promotion to attract them because we had a great price at retail. What we do to retain them looks exactly like what we've always done to retain people, which is educate and welcome them to a community. We've got well over 80,000 Instagram followers and we didn't pay for any of those followers. And you can see it in the interaction between our raving fans in our social media community. And so yes, I don't know that we had a COVID retention campaign, but just in the normal course of business, we saw a nice retention.

Great. And then I guess beyond the distribution expansions, I guess, how are you thinking about innovation as a driver of top line growth? What are the plans for expanding into adjacent categories, if you -- and those time lines we should think about?

Sure. So it's very -- it's exciting to see the consumers' sort of faith in our brand. When we ask consumers of our existing product portfolio, what else they would be willing to buy from us or be interested in being offered from us. In every category, we tested, from beef and pork, to ice cream and cottage cheese, we had over 50% top 2 box purchase intent for that item. And so on the 1 hand, you could say, gosh, that's a big universe. We could roll out lots of different foods and see meaningful growth from that. We have a little bit more of a disciplined approach, though. And so first of all, in the -- when we worked with the sell-side analysts, including you, during the IPO process, we were pretty conservative in terms of only putting things into our revenue projections that we had a pretty clear line of sight to. So we didn't include beef and pork and ice cream in those projections. We do have some innovation pipeline that we're constantly working on. We rolled out our first multi-ingredient food this year called Egg Bites, which is like a ready-to-eat or heat-and-eat little egg -- baked egg bite, which is exciting for a lot of reasons. It's our first multi-ingredient item. It's our first kind of on-the-go heat-and-eat item. So when we think about expanding beyond our current focus on eggs and butter, products have to meet a bunch of really important criteria for us. They've got to be on brand. We've got to be fulfilling an unmet consumer need and have a right to win with that launch. That product has to continue to leverage our relationships with small family farms with great animal welfare. It's got to have the potential to create meaningful shareholder value. I mean, we're going to go through all those filters. I think it's safe to say that the area on which we will be primarily focused for the next 1, 2, 3, 4, 5 years will be value-added dairy because it's a huge TAM, $32 billion. It's the part of the store we know. It's the retail buyer we know. It's the farmer we know. It's the supply chain we know. It's the cold chain we know. And so that's how I would think about it.

And then maybe you can talk about the Egg Bites product that you highlighted. How has its early performance been since its launch? And any learnings that you have had since your -- this innovation that you would apply to innovation going forward?

Yes. Both great questions. So in terms of how it's gone so far, met -- and we launched in a few retailers, met or exceeded expectations in each case. It's been really interesting because we are -- what we're seeing is that there are a few other offerings now in that product category that didn't exist a year ago. And in every case that I see, we're taking an early lead in terms of the velocities of our products and our share versus competing products at shelves. And I think -- and we -- and then typically, we've got a higher price point than the competing products. And so again, I think it just goes -- it's consistent with what we've seen in the products that we've sold for longer periods of time, eggs and butter, that our story resonates, people are willing to vote with their dollars for a different supply chain and a different set of values in the food that they buy. In terms of learning, we have, over the years, built internal capabilities as the business has demanded them. And I think -- and we knew this going in that having a multi-ingredient product would require a different procurement muscle. It would require a different level of co-manufacturer management. It would require a different approach to managing the kind of the P&L for a product like that. And the biggest area that I would say we built capabilities in is actually in building a team of really smart people to do those things really well, which I think is a platform that we'll be able to leverage going forward. So we have a director of dairy operations. We have a director of co-manufacturing management and others who collectively create capability that we didn't have 2 years ago.

Great. And then maybe just switching over to the competitive landscape. Can you give us a sense for how the competitive landscape has evolved since COVID began and within the premium and pasture-raised egg segment but also relative to conventional eggs?

Yes. And I don't have hard data in front of me. My -- I believe that our -- not only did we grow households since COVID started but we've grown market share since COVID started, which maybe cuts through all the noise of pricing changes that you might see on the part of others. We took no pricing action at any time this year, frankly, other than during peak sales times, we've pulled back some promotional spend we might have otherwise spent. And so from that perspective, I think maybe our supply chain is more robust. Maybe our story is resonating with consumers who are being even more thoughtful with how they want to spend their money on food. But for whatever reason, I think it's accelerated our growth and our market share and household gains this year versus maybe what we would have seen otherwise.

And how do you think about potential for down-trading within the category and the interaction between your brand and lower-priced alternatives? Is there any concern that there might be down-trading, given the economic backdrop?

Yes. I think that's a great question. We thought a lot about that and done our best to kind of look for analogs that we could use to help foresee what will happen to our premium brand if there's a sustained economic downturn amongst our consumers. What we saw in kind of the '08, '09 recession was that there were 2 countervailing forces. Within retail, there were trends around trading down to lower price points, trading down from premium brands to private label and trading down to smaller pack sizes. But my understanding is that the greater force was the trading out of foodservice and into eating at home. And the net result was actually still a net positive for brands at all levels of price points at grocery retail. And so we think that our business plans assume a relatively minimal impact in either scenario. The other thing that I would look to is when we look back at least to '08, '09 in terms of who was economically impacted, I believe that primary consumers of premium products like ours tend to index more highly around income and education levels, and those tended to be people who were less impacted in the last recession.

And you've mentioned a few times that pricing is not one of your key growth drivers, given the strong volume growth that you've seen and market share gains. But can you remind us what your pricing strategy is and how you think about pricing relative to competitors and how we should think about pricing going forward?

Absolutely. So our pricing is driven by the marketplace as opposed to by internal margin targets, for example. And we believe that we earn a premium relative to other products and other brands that are in the marketplace. And so we work backwards from what's our desired retail, and that might vary by market, some markets have higher prices in general than others. But we generally want to have a certain level of price premium relative to some reference products. But the way we get there is unique to the retailer and our underlying kind of list prices haven't changed in years. So our strategy is we believe we deserve a premium. We haven't seen any impact to our growth from commanding that premium. And we think there's still a lot of room to grow without using price as a lever to drive it.

What have you seen private label in the pasture-raised egg category? Do you see that as a potential for growing more rapidly over the next couple of years, given the attractive growth rate in the category and possibility that retailers would want to compete in it directly?

Sure. So I think that when we started to really hit a national scale in 2012, 2013, 2014, I think many retailers looked at an opportunity to create a private label offering because that's part of their growth and gross margin strategies. And many of our largest customers over those years did create a private label offering. So there are private label pasture-raised egg offerings at places like Whole Foods, Kroger, Sprouts and Natural Grocers, just to name a few of our largest and most valued customers. They and we live very well within an ecosystem of people looking for products with higher standards. We have not seen a substantial impact to our growth trajectory or to our projections when those private label products show up. And it may be that people are trading to them from something else. They don't seem to be trading to them from us. And we don't see them generating the kinds of -- kind of growth rates or overall levels of volume that our branded products do.

Great. And then maybe just switching to the supply side. So there's a question from the audience about if you could talk about how your contracts are structured with your growers? What's a typical target? Who takes the price risk and the commodity risk? That would be helpful.

Perfect. I'm going to ask Jason to chime in here. That's one of his areas of expertise.

Great. Yes, great question. And I think the way that they're structured is we typically do 20,000 birds on 1 contract farm. It typically runs a duration about -- it's for 3 flocks, so a little over 3 years. In terms of the commodity risk, we do protect the farmer from feed input costs and arrears. So basically, every quarter, we'll look at feed input adjustments of any corn and soy tied to a market price and protect them from that price risk. And that's kind of the basic structure of the agreement. I mean, there's a big part of what we do in this process, and the kind of management and agreement with them has to do with a whole team of people we have there and just managing the outcomes on the farm, what the farmer expects within our standards that we expect them to do and also from a compliance perspective. So we have a large team of people who have a direct relationship with all of these farmer partners that we do put a contract in. So it's not -- we're certainly not a brand on one side that just writes a bunch of contracts with farmers and then takes the eggs off there. There's a large support system in there that goes behind the product quality, what we're pulling off there. And again, a lot of that goes into the brand attribute of what we're actually selling.

And how do you navigate your live supply constraints, especially given the growth that you've seen over the past 3 years and this year, in particular? Can you talk about how you add farmers to the network and what the pipeline or lead time looks like of adding farmers?

Sure. Yes. We have a pretty robust demand planning and supply planning process that we go through basically every month looking out. And we plan in the future, and we typically plan to put more supply down relative to the shell egg side of the business than we actually need. So we'll build a little extra in there, and we're always looking further out. So in the time line we view this is somewhere between 8 and 12 months. And so typical this year with what we saw with the spikes in demand during the COVID time, we had already put -- planned to put that supply down and knew we were going to grow into supply in the back end of the year. Some of what we experienced in the second quarter of this year, we just pulled forward. And so now, as we're continuing to look out and we're looking at our base growth business, we're continuing to look into '21 and actually put down supply to manage that base demand and any growth that we'd see on top of that beyond '21 and into '22. So we're always looking pretty far ahead when we're planning for the shell egg side of the business.

And then what is your current processing capacity for eggs and what are your plans to expand it?

Yes. So the current capacity of the Egg Central Station, which is our processing and packing facility in Springfield, Missouri, today, it would support roughly a $300 million shell egg business. We're, call it, roughly at 60% to 65% utilization of that facility today. And then we are actively working to expand that. That completion will be done in the second quarter of 2022, and that would basically, it's a mirror image, it will double -- we'll put another machine in that facility, it will double that capacity, so it will support a $600 million shell egg business. So we fully believe that we have the utilization perspective from a processing and packing capability to support our business for the next 3 or 4 years. We will likely start planning between now and then on an additional facility to support our growth beyond that because it takes roughly a 2- to 3-year time frame to stand up one of these facilities. And the next one will likely be a stand-alone facility separate from this one, which is basically just an addition to the existing facility.

And then can you talk about how you process and manufacture butter? Is that also internally? Or do you outsource your manufacturing for other products?

Sure. Yes. So we're earlier in our journey is very similar to what the shell egg business looked like years and years ago. And as we pulled on more of that supply chain and figured out the things that we wanted to really do great at and improve in terms of the supply chain, we're on that similar journey with butter. Yet today, we do use a co-man to actually churn the butter and take the cream and turn it into butter. We also used to use that same co-man to manage most of the relationship with our farmers. We started the process of now getting more active and involved with working directly with those co-ops and farmers directly on managing that actual raw material cream supply. And so that's the first part of the process. We did some light CapEx help for our co-man to just increase capacity there to support our future growth. But we will likely continue to evolve that process. And again, like I said, where we see places we can really add value and support our growth as well as help potentially expand gross margin, we will take the opportunity.

Great. And can you touch on your outlook for margins? How should we think about your margin progression over the next several years? And what do you see as the key levers for driving markets?

Sure. I think if you break it down into the 3 different groups, so the first one being innovation, I think the way we're looking at that group is when it's relatively small, it will typically tend to be a much smaller gross margin than we would expect once it matures. And so I think a lot of the margin expansion we'll have from early innovation will happen over the course of an 18- to 24-month run, again building towards our target that we've talked about consistently about a mid-30s gross margin for the business. And so we're not far off that today. And then the next one I just mentioned, which was butter. Again, as we continue to look at that supply chain and look to do things there where we could take opportunities, we'll potentially accrete better margins there, too. And then the biggest piece, obviously, the shell egg side, as we continue to focus on just improving outcomes for farmers, a lot of what we're going to do there has to do with the performance of what's happening on the farm, the quality of the product, the quality of that actual farm network and what they're doing there. And as we start to do things there to increase production and performance, to increase the quality of the product, it will allow us to both accrete better outcomes for the farmer, but a lot of that will turn into value and accrete for us over time as well. And so we'll be able to continue to pull some margin opportunities, we think there's drivers there as well.

Great. And can you talk about the promotional environment and how you are thinking about promotional investments that, obviously, you've pulled back earlier this year, given the elevated demand. When should we expect to see the promotional environment begin to normalize?

I wish I had the crystal ball about what happens at retail next year. I think we're all reading the same headlines about vaccines and a potential return to a more normal life. And so we continue to work with our retail partners on promotional plans that make sense for them and for us over time. Nobody wants to promote into a short situation. And it's a question of time when we get back to that place. I would imagine we get back to normal at some point in '21, I hope we do. But in terms of how we think about promotional spend more broadly, we -- it's definitely retail-specific. We certainly want to -- we keep an eye on the competitive scene in a particular retailer. We tend to think about promotional spend, one, as being part of a strategic relationship with a retailer; and two, as a way to drive trial. And one way we think about that is when we run a promotion, as anybody might, we'll typically see a big jump in volume at that retailer. What happens in the following weeks? Do we have a sustained uptick in volume versus do we just go back to our original baseline? And we tend to really try to optimize our promotional spend based on some long-term impact to business at a particular retail. So that's how we'll continue to focus, I believe.

Okay. And then a question from the audience. Just on the topic of gross margin. What is the plan for managing the recent spike in corn and soy prices?

Yes. So today, we don't do any type of hedging of commodities or anything like that. We've looked at -- we've seen what's happened in the market. Again, this has a relatively -- even with the current price that we saw move, was relatively at historic lows prior to this. Even that big of a move doesn't have a huge impact on our specific gross margin. I think that's the takeaway here is that we're not a commodity egg producer, whereas the impact of their gross margin when feed prices move like they have is much more impactful to their overall gross margin. It's a much smaller impact for us. And so today, we don't do anything specifically to hedge or to stabilize those costs. But that doesn't mean that we won't continue to look for ways in the future to help stabilize that. But today, we don't believe it's going to have a meaningful impact on our gross margin.

Great. And then what are you seeing in terms of freight costs? What kind of impact does that have on your margins? And how much is contracted versus spot?

Yes. So today, the carrier, the partner that we work with, roughly 80% of what we do is contracted and the 20% is on a spot rate. We haven't seen a dramatic change. There's some lanes in the Northeast that have been -- have gone up and been more expensive. But it -- our carrier partner and our freight with refrigerated freight has not been impacted as dramatically as what's being reported on the dry van side. So we've not seen a major move there. We are expecting typical kind of inflation to be baked in as we go forward. But again, nothing there that we think is going to move the needle dramatically.

Great. And I guess we're getting close to the end of our session, but just wanted to ask how you're thinking about next year and your positioning going into 2021. Obviously, a lot of tailwinds for the company this year. So how does envision you going forward? And just what do you see as the biggest opportunities for next year?

Sure. Well, I'll take a stab at that and we're far from finalizing and offering guidance on what '21 looks like. But I think we, like any company that saw a big spike in volume in '20, will have interesting time cycling that in '21. I think what we're focused on, because we're always focused on the long term, is we gained, we pulled forward households and we pulled forward doors that might not have happened as quickly without COVID. And the fact that we were able to retain a substantial portion of those, I think, gives us a great tailwind heading into '21. We're starting with more households than we thought we'd be starting '21 with, for example. The year-on-year growth in a percentage terms may look lower than our historic growth rates just because, again, we're cycling having this incredible sales force, which we didn't employ, called COVID, right? So again, we're focused on long-term growth. We're going to support that long-term growth. I'm excited about what '21 holds. Operationally, we weren't challenged in '20, and I think we just proved our ability to operate at the kind of volumes and run rate that we would expect to see in future years. And so it was just a good dry run for what we expect to happen in the coming years.

Great. And what are your priorities for uses of cash over the next several years?

Well, so when we -- the way we thought about the primary raise in the IPO was we looked ahead to our next 5 years of kind of capital requirements. And a lot of that has to do with CapEx that supports our growth plan. So the expansion of Egg Central Station that Jason mentioned and then getting ahead of the next one a few years further out. Some opportunities to continue to look at areas where we might want to invest in or in-source things that may be outsourced today. An example of that -- of something we've already done there was buying our own butter churn to help stabilize capacity for that for our butter business. And then beyond that, there may be other aspects of our existing business where we're currently relying on a co-man or an external supplier but we see the opportunity to drive meaningful returns on invested capital by doing that in-house. Beyond that, it's still a relatively capital-light model if you think about the cost of an Egg Central Station expansion. Jason mentioned that the current plant supports a $300 million run rate egg business, and that was about $20 million. The expansion is about, I don't know, $22 million, $25 million and it adds another $300 million. So it's -- those capital requirements are already built into the model and they're pretty modest.

Great. Well, Russell, Jason, I wanted to thank you for your time and for participating in the conference. We're happy to have you here. And to everyone listening, I hope that everyone has a happy and healthy holiday season, and please feel free to reach out with any follow-ups.

Thanks so much, Pam. Great to be here.

Yes. Thanks so much.

Thanks.