Freshpet, Inc. (FRPT) Q3 2014 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Freshpet Third Quarter 2014 Earnings Conference Call. [Operator Instructions] As a reminder, today's conference is being recorded. I would now like to turn the call over to Katie Turner.

Thank you. Good afternoon, and welcome to Freshpet's Third Quarter Fiscal 2014 Earnings Conference Call and webcast. On today's call are Richard Thompson, Chief Executive Officer; and Dick Kassar, Chief Financial Officer. Scott Morris, Chief Marketing Officer, will also be available for Q&A. Before we begin, please remember that during the course of this call, management may make forward-looking statements within the meaning of the federal securities laws. These statements are based on management's current expectations and beliefs and involve risks and uncertainties that could differ material from actual events and those described in these forward-looking statements. Please refer to the company's prospectus filed with the Securities and Exchange Commission on November 10, 2014 and the company's press release issued today for a detailed discussion of the risks that could cause actual results to differ materially from those expressed or implied in any forward-looking statements made today. Finally, please note that on today's call, management will refer to certain non-GAAP financial measures. While the company believes these non-GAAP financial measures will provide useful information for investors, the presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP. Please refer to today's press release for a reconciliation of the non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP. Management will also refer to EBITDA and adjusted EBITDA on today's call. For a calculation of these measures, please refer to the company's press release. Now I would like to turn the call over to Richard Thompson, Chief Executive Officer.

Thank you, Katie. Good afternoon, everyone, and thanks for joining us on the first conference call as a public company. We're glad to be here today, and we're glad you're here with us. We enjoyed speaking with many of you while out on the road last month, and we look forward to meeting more of you when we attend investor conferences in the near future. Our recent IPO was a significant milestone for Freshpet and has positioned us well for increased long-term success as we build and scale our business. We want to thank our team for all their dedication and hard work, for without them, our growth would not be possible. We believe we are well positioned for the future as we bring the power of fresh food to more pet parents. We are pleased to report strong results for the third quarter of 2014. In Q3, we saw the net sales growth of approximately 35%, which was driven by 26% increase in Freshpet fridges and increase velocity per fridge. In other words, our robust net sales growth outpaced the growth of our Freshpet fridges. Therefore, we are growing sales faster than fridges. We believe this demonstrates pet parents' increasing desire for fresh, natural pet food and our team's ability to expand our Freshpet products across many retail sales channels. This includes grocery, mass, club, pet specialty and the natural channel. In fact, in addition to growing distribution, we are seeing strong consumer fundamentals, expanding consumer penetration at the same time as increasing consumer loyalty rates. For those of you that didn't have the pleasure of meeting during our road show, on today's call, I would like to share a little bit more about Freshpet including a little history, mission and strategic value proposition. Freshpet started in 2006 as our cofounders, who are pet lovers, noticed a shift in how people care and provide for their pets. The number of people owning pets is increasing in the U.S. Furthermore, people are treating their pets better. Just like any other family member, pet parents want their pets to live longer, healthier lives and we believe that the best way to do this is by feeding them natural, less processed foods, just like we strive to feed ourselves. This is why we believe Freshpet is truly positioned in the right place at the right time with the right products. The pet category is a growing $60 billion industry in North America, of which pet food represents more than $20 billion. This tremendous market opportunity has helped Freshpet become one of the fastest-growing pet food companies in North America. Recent health and wellness trends indicate that people buy food products based on what is the most beneficial for their overall health. Today, consumers are more knowledgeable about their food purchases than ever before. They routinely scrutinize nutritional labels to see exactly what they're putting into their and their families' bodies. Buying food for one's pet is no exception. We believe it is an emotional process in which pet parents make decisions based on the overall well-being of their beloved pets. We are proud to be a company that is committed to serving fresh, natural food to dogs and cats, and it all starts in our manufacturing facility, which we refer to as our Freshpet Kitchens in Bethlehem, Pennsylvania. Here, we gather locally sourced fresh meats and fresh vegetables. Freshpet's recipes are developed with veterinarian nutritionists helping us formulate great tasting and healthy foods. Our next step is to generally cook the food, cool it down and serve it to our consumers in a unique proprietary packaging. Because our product is so fresh and doesn't use preservatives, it needs to be kept in cool, refrigerated locations, just like perishable human food. We operate our Freshpet Kitchens utilizing human food standards where quality and safety are the cornerstone of our cooking process. Before Freshpet, there were no existing refrigerated distribution networks designed specifically for dogs and cats in the U.S. So we created custom-designed Freshpet fridges and placed them now in over 13,000 store locations across North America. Freshpet has brought the most significant innovation to the pet food category in more than 70 [ph] years. We are the first mover in revolutionizing the pet food aisle. Our Freshpet fridges allow us to control critical real estate while truly differentiating our products at the point of purchase. As we own and maintain them, our Freshpet fridges and fridge distribution network is a key barrier to entry. This provides us with a unique Freshpet brand ambassador in every location. Most of the investment into the development and design of our Freshpet fridges has already been completed, and we look forward to further leveraging our existing network. We believe Freshpet delivers category-leading retailer margins compared to the average pet food brand. We have proven time and time again when introduced to a new store, we actually grow the pet food category in that retail location. We believe we do this by attracting new shoppers that previously would not buy pet food at a particular store and by increasing average number of visits per consumer. Our mutually beneficial retailer relationships have significantly contributed to our success across all sales channels. While we have had success and growth to date, looking forward, we believe we have a considerable opportunity to expand our distribution footprint, increase brand awareness and grow our market share. The fact is when walking through a retailer, Freshpet is kind of hard to miss. Our competitors' products are placed on a standard store shelf undifferentiated, SKU after SKU, while Freshpet is displayed in a colorful, clean, brightly lit fridge. Furthermore, we are committed to keeping our prices competitive to remain accessible to the average consumer. Freshpet's opportunity is underscored by our less than 1% of the pet food category versus a 6% share in stores with a Freshpet fridge. We believe the keys to growth are increasing brand awareness and access to our products. We hope this gives you a helpful background on how Freshpet started and our unique approach to pet food. We're extremely proud of the success we've had in the last 7 years, but we're even more excited about what lies ahead. I'd like to talk to you about our long-term growth strategies. Today, we believe we are at an inflection point where we can begin to leverage our organization, our kitchens, our sales team and our marketing departments for accelerated profitability. We intend to focus on efforts on the following fronts. Number one, increased distribution. We own and maintain over 13,000 Freshpet fridges across North America and see significant whitespace opportunities for expansion. We believe we have potential to expand in more than 35,000 store locations in North America. We expect to install over 6,000 Freshpet fridges in new store locations over the next 3 years. Within our existing retail partners alone, we have the opportunity to double our store count. Second, growing brand awareness. Less than 20% of U.S. pet food consumers today have ever heard of Freshpet. We're committed to increasing the awareness of our brand and influencing new potential consumers to try our products. We have a strategic plan in place to achieve this through strategic marketing campaigns, such as national TV advertising, targeted guerrilla marketing and creative digital and social media initiatives. Third, continued product innovation. We have a very impressive history of introducing and pioneering new products. We have many exciting new products in development. We have developed an innovative shredded product that looks and smells more like human food and is designed to look like it just came off the dinner table. Next is our fresh raw product that we have developed specifically for the pet specialty channel to appeal to raw pet food consumers. We are really excited about the potential behind both of these new products. Our team is always thinking of fresh ideas and ways we can bring more fresh and healthy foods to our pets. Further innovation remains a top priority for the company and will be critical cornerstone of continued growth. We believe the Freshpet brand is perceived by consumers as delivering the best quality pet food in the industry, thus giving us a strong platform for new product development. We are in the process of assessing opportunities to expand our portfolio and bring innovation to the pet category in many ways. We believe some of the most significant opportunities are to expand our product offerings and develop a deeper portfolio of products in cat food and Freshpet treats, 2 categories where we are currently underdeveloped. And lastly, the ability to leverage our scalable infrastructure. Our team is focused on driving net sales growth, which we believe will allow us to increase our current capacity utilization and fuel future gross margin expansion. Our corporate infrastructure is well established, and we continue to focus on improving our operating efficiencies. With that overview, I would like to turn the call over to Dick, our CFO, who will review our financial results in more detail. Dick?

Thank you, Richard, and good afternoon, everyone. I'll review our third quarter and fiscal year-to-date financial summary. I will also provide our full year outlook for 2014. Before I get into the Q3 results, I want to review our successful IPO which closed on November 13. Upon closing, there are approximately 33.5 million shares of common stock outstanding, which includes full exercise of the underwriters' option to purchase additional shares. The company received net proceeds from the offering of approximately $164.1 million after deducting underwriting discounts and estimated offering expenses. We have used the net proceeds from the offering to repay existing indebtedness and to support our future growth and development of our business and including commencing Phase 1 of our Freshpet Kitchen expansion, which we believe will substantially increase our manufacturing capabilities. Now focusing on the third quarter. Consolidated net sales increased 35% to $22.5 million. This growth was driven by a 26% increase in Freshpet fridges, which resulted in distribution gains across retail sales channels. Gross profit for the quarter increased to $10.9 million, up $7.3 million last year, an increase of 49%. Our third quarter gross margin was up 470 basis points to 48.3% versus 43.6% in quarter 3 of 2013. The increase in our third quarter 2014 gross profit reflects higher net sales and lower manufacturing costs per pound or products produced, partially offset by higher depreciation from the use of our new Freshpet Kitchens. SG&A expenses as a percentage of net sales was 54.2%, down from 68.6% of net sales in the same quarter last year. Looking ahead, we expect to generate further leverage of SG&A as a percentage of net sales as we increasingly scale our operating efficiencies and better utilize our existing infrastructure. EBITDA increased $3.1 million to $0.2 million, and adjusted EBITDA increased $1.8 million to $1.1 million. Third quarter 2014 adjusted EBITDA as a percentage of net sales was 4.9%. As a reminder, EBITDA and adjusted EBITDA are non-GAAP financial measures. Turning now to year-to-date results. Net sales for the first 9 months of 2014 were up 37% to $62.3 million compared to $45.4 million in the first 9 months of last year, and our gross margin increased to 48.6% from 45.7% the same period last year. EBITDA improved $4.9 million to a loss of $2.4 million, and adjusted EBITDA increased $4 million to $1.5 million. Adjusted EBITDA as a percentage of net sales for the first 9 months of 2014 was 2.4%. Turning now to the balance sheet. At the end of the third quarter, the company had cash and cash equivalents of $1.8 million. Total debt was $86 million, and total redeemable preferred Series B shares was 34.3 million. The September 30, 2014 pro forma cash balance was $61.6 million, and the debt balance was $18 million. Pro forma cash gives effect to the net proceeds received from the IPO, the pay down of outstanding debt, the redemption of preferred Series B shares, the payment of accrued interest on outstanding debt and cash received from the new credit facility. Immediately prior to the IPO, the preferred Series C shares and accrued fees on debt guarantee were converted into shares of common stock. Upon conversion of the fees on debt guarantee, 1.8 million shares were fair valued at $27 million, of which $9 million will be recorded as a noncash expense in quarter 4 2014. A total of $20 million noncash expense will be recorded for the full year 2014. I would now like to review our full year outlook for fiscal 2014. We expect full year 2014 Freshpet fridges of approximately 13,350, representing an increase of approximately 23% compared to the prior year; net sales of $85.7 million to $86.7 million, an increase of approximately 35.7% to 37.8% compared to last year. Adjusted EBITDA is expected to be in the range of $4.8 million to $5.2 million or an increase of $5 million to $5.4 million compared to a loss of $0.2 million in 2013. As a reminder, our adjusted EBITDA represents EBITDA plus loss on disposal of equipment, new plant start-up expenses, share-based compensation and launch expenses. We will continue to provide net sales, Freshpet fridges and adjusted EBITDA guidance on an annual basis. While net sales growth may be lumpy quarter-to-quarter based on timing of Freshpet fridge expansion, we expect to provide directional guidance on how the quarter is progressing and also update our annual guidance each quarter. We plan to provide our full year 2015 outlook when we report our fourth quarter and full year 2014 results in March 2015. That concludes our financial overview. I will now turn the call back to Richard for closing remarks. Richard?

Thanks, Dick. We remain committed to our core values. Freshpet will continue to work to revolutionize the pet food industry through our innovative products and our hard work. We will always challenge the accepted wisdom about what's best for our pets. We work to be transparent and honest in every facet of our business. And finally, we strive to do what's right for pets, people and the planet. Every day we challenge ourselves to find new and better ways of delivering the benefits of fresh real food to our pets. We are very pleased with our growth and success thus far and are very optimistic about our long-term growth opportunities. Our journey has just only begun, and we expect to be even more successful on the road ahead. We would like to now open up the call and take some of your questions.

[Operator Instructions] The first question comes from Jason English from Goldman Sachs.

Congrats again on the IPO and your first conference call as a public company.

Thank you.

You gave some good detail in terms of distribution growth. You highlighted it's obviously a top priority for growth on the foreword, including 6,000 new stores the next 2 years and quite a bit in the fourth quarter. Can you give us a better line of sight of where you see the opportunity for -- as specific as possible kind of what you have locked in to get us more comfortable with your ability to deliver on those in the near term?

Sure, Jason. Thanks for calling in. We really appreciate it. I'm going to let Scott take that question. Scott?

So basically, if you look at the way that we've discussed the guidance, we feel really comfortable with the way next year is shaping up. And we do have insight and we feel very comfortable with the guidance that we have given that it's consistent and that we should be on pace or potentially slightly exceed that. But we're very comfortable with the numbers that we've given thus far.

Okay. And turning to the other side of revenue driver, the sales per unit. This year, we've seen some deceleration, albeit still pretty healthy growth. What are you guys expecting on a sales per unit going forward? And is there any reason to believe that we could actually see some acceleration as we -- some of the new innovation rolls through into next year?

Yes, on the -- it's Dick. Basically, a store is not a store as we've discussed on the road show. We're planning on doing 6,000 stores over the next several years -- or next 3 years. And basically, if we pick up a major club store, that will be 1 velocity movement. If we pick up an independent pet store, that will be another velocity mover. If we pick up a mass account, that would be a different velocity mover. So it depends on the mix and how it's going. But from a guidance -- from a view going forward, we're expecting to get towards $150 to $155 by year end on dollars per store per week.

The next question comes from Robert Moskow from Crédit Suisse.

I had one number that was a little different from what we'd expected. It was launch expense. It looks like you were $600,000 in the quarter, and we had a lower number. I just want to know if that came in higher than your expectations internally. And if so, was there anything behind it?

No, basically as we said, our launch expense is $1,000 per store for every new store plus noncapitalized expenses associated with chiller movement, and that's basically where we -- we're very comfortable where we finished and we think we're on pace.

Okay. And what do you think about launch expenses for next year, Dick? Do you think it will be lower?

No, the -- we're going to continue to utilize launch expenses. We're looking at if we do 2,000 stores next year, it'll be somewhere around $1,000 a store and then on top of that, about $500,000 to $600,000 for noncapitalized chiller expense. That's basically moving chillers in and out of stores.

Okay. So -- all right. I'll follow up offline. Maybe my definitions are a little different. I had something a little different. Just in terms of your -- when you're making your adjustments to get to adjusted EBITDA, I have kind of a fading of that expense that you've -- that you're adjusting out. But it sounds like from your tone that it's kind of -- it's actually going to be kind of in line with how this year plans out. Maybe it's just definitions that we have that are different.

Absolutely. It is definitions and we discussed it and basically said, "Why don't we just be consistent with what we've been saying kind of on the road show and on presentations?" At some point in time in the future, maybe in 2016 or so, we'll discontinue doing that. But the relationship we have with our banks currently, they allow us to do it and it helps us with our covenant calculation.

The next question comes from Peter Benedict from Robert W. Baird.

Guys, so first question is around the cash. Obviously, the IPO raised more than, I think, what you're initially anticipating. So just give us a sense for what the plan is for the cash and where we should think cash may end the year at.

We're negotiating now to pay back the loan that we took out upon the IPO, so that $18 million return. We don't expect any interest expense in 2015, and we're projecting -- we went during the road show and the presentations, we've discussed what our capital outlay would be based on plant expansions and chiller expansion. We're projecting to finish the year around $19 million -- $18 million, $19 million in cash -- finish 2015 at $18 million, $19 million in cash.

And then just circling back to kind of the velocity growth question, I mean, the one way that we tend to look at weekly average sales per store. And it looks like if you take your guidance for the fourth -- or the full year, it implies an acceleration in that growth rate into the fourth quarter that you had mentioned $150, $155. Is that kind of an exit run rate you're thinking about for the end of this year? Or is that something for 2016? Just wanted to clarify that.

That would be exiting 2015.

Got it.

What occurs [ph] if you recall, we had heavy installation in the second quarter of 2014 and where we put in over 1,000 stores. As a store starts up, it takes about 6 months for a store to get to a -- 80% of its current levels. And in the fourth quarter, it's not a big quarter for -- normally for store growth. So we get to realize that benefit much greater in the fourth quarter, and the fourth quarter is looking somewhere between $137, $143.

The next question comes from Bill Chappell from SunTrust.

Richard, a little disappointed we didn't start off with the Freshpet cheer, but I'll hold off for that on the year-end conference call.

Yes, hey, we're not done yet, Bill.

Sorry, sorry, sorry. I guess the first question just on the raw launch. I'm starting to see it in the stores and didn't know if you had any more color on kind of what kind of customer feedbacks been, what kind of market share you're thinking. Did you have anything -- any early learnings you've had since it's been out in the market?

Scott, why don't you take that?

Yes, basically what we're seeing so far is it's, I would say, meeting expectations at this point. We had a rollout with one of our pet specialty accounts, and then we're doing a test in a different form in another account sometime in next year. We expect it to be kind of in full distribution in pet specialty. But I would say expectations are very similar to the initial read that we saw early on in the test markets, and we're very encouraged. We -- the original execution, and this is kind of just more logistics and execution of go-to-market, wasn't quite as smooth as we would have liked, but that happens many times at these launches. But now we're on track and things seem to be going well with it. So -- and it is very innovative and very different than the rest of the raw products. Those are all frozen, obviously, in the market. So we just -- we're now starting to let people know about it and do a little bit marketing behind it, but the initial results are kind of on par.

Got it. And then Dick, maybe as I look towards next quarter, next year, I think -- I realize that oil is not a huge part of your cost and resin prices haven't come down. But I mean, how are you looking at kind of the commodity complex with the recent changes we've seen? Would freight get a lift? Would other things get a lift where you may get some profitability on the gross margin a little bit faster than expected?

Yes, we will be getting new pricing come January from our logistics supplier, and we'll know -- have a better feel for that at that point in time. But obviously, in our plant, our energy costs are going down. So we expect to pick up certainly benefit associated with that.

And how long before you start to actually see that?

I would hope to see it by the end of the first quarter.

Got it. And just last one. Back to the new products, is there a time frame for shredded and when we will start seeing that?

Scott?

Shredded is now being distributed in a handful of kind of early bird accounts. It just started in distribution, and it should be in kind of getting some much more significant distribution across our retailers in Q1 and really in full distribution by kind of mid to end of Q2 next year.

And full means like a wide range of retail formats?

Yes. Full for us, yes, full across our fridge network.

The next question comes from Scott Van Winkle from Canaccord.

It's Mark Sigal for Scott. I wanted to just ask a question on gross margin. Can you kind of parse out the drivers on the gross margin deceleration quarter-over-quarter, raw inputs versus kind of your Kitchen expenses? And then if we can kind of extrapolate that forward looking towards Q4, if you can kind of talk about the drivers in those 2 buckets.

Yes, we certainly -- as we said on the road show, chicken prices are about 60% of our raw material costs. We've seen some increases in beef prices like the rest of the country. We're reacting to them. In this quarter, we see -- also see us picking up and seeing more velocity going through our Freshpet Kitchens, and that's basically what we projected. We feel very comfortable about our Kitchens continuing to optimize their labor and overhead rates. All the other costs are basically as we've discussed in the past.

Okay. And then on the road show, you talked a bit -- I know you don't want to go into detail on '15 yet, but can you talk a bit about visibility on fridge adds? Are you trending into the first or second quarter into '15 where you have line of sight? Are there particular channels where line of sight is stronger than others?

Scott?

At this point, we can't get too far into the details around '15. But I think that we are comfortable in saying that we are very comfortable with the numbers that we have projected out for '15. '15 is shaping up very well. If you look at kind of where we are this deep into Q4 and where we usually see kind of into the Q1 and Q2 projections, we're definitely -- we feel very comfortable that the guidance that we've given is very accurate. And we're hoping that other things develop and we can potentially do better than that.

[Operator Instructions] The next question comes from Mark Astrachan from Stifel.

Wanted to follow up on an earlier question and then ask a follow-up for my question. So just trying to figure out what percent of fridge growth is from new and what is from existing retailers. And sort of more broadly, how do you think about -- or how should we think about the push and pull of fridge placement? How does it work if you want to expand distribution, for example, in existing retailers? Do you go to, name the retailer, Wal-Mart, Target, et cetera, and just say, "Hey, here are the growth rates that we see in the stores we're in. We've got another 2,000 or 3,000 doors to go. We can get you in there in 6 months," and the retailer says what?

Usually, we sit down and kind of do a joint business planning with them, and we're really talking about the performance to date and where the next kind of tranche of stores is that we're looking to go into. And then we just start talking about the different fridge models that might be appropriate for that retailer and what the timing is and obviously, we have to -- we have a production cycle on refrigerators and we're just going to get them into the planning cycle. But usually, it's a very productive conversation. It's really kind of a joint -- it's the result of a joint business planning. And so I think we -- there's a lot of opportunity when we talk to these retailers about really where the appropriate locations are and where to place them in the stores and kind of at the different timings. So -- and then they also have specific timing that they like to do major category changes to, so we're having to kind of align our joint business plans. Does that answer your question pretty well or...

Yes, directionally, yes. I guess maybe just a follow-up on that. The 6,000 doors roughly that we're talking about over the next 3 years, how many come from existing roughly versus new retailers?

The way we had originally looked at it and when we had put all the materials together for the S-1 is the vast majority of them will come from existing retailers, and we are continuing to add some new customers in each quarter. But the vast majority of them come from existing retailers, and there's some significant new retailers out there and opportunities for us. I don't know if you remember the specific number, but we can actually double our current distribution in our existing retailer base. So we have really a lot of runway, a lot of greenfield.

At this time, I am showing no further questions. I would now like to turn the call back over to management for closing remarks.

Thank you, everyone. Again, thank you for your time today. I'd like to thank our entire Freshpet team here for all the hard work and dedication they put into making this work. And I'd like to thank our investors for their support and confidence going forward, and I want to wish everybody a happy and safe holiday season, to all the pet parents out there especially. And please, while you're out there shopping on the holidays, don't forget to pick up some Freshpet not only for you and your pet, but pick some up for a friend or a neighbor because we want you all to be in the brand and all to be our salesmen to help us grow Freshpet. Happy holidays, everyone.

Ladies and gentlemen, that does conclude the conference for today. Again, thank you for your participation. You may all disconnect. Have a good day.

Thank you.