Freshpet, Inc. (FRPT) Q3 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and thank you for your patience. You have joined Freshpet's Third Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions] As a reminder, this conference maybe recorded. I would now like to turn the conference over to your host Ms Katie Turner. Ma'am, you may begin.

Thank you. Good afternoon and welcome to Freshpet’s third quarter 2016 earnings conference call and webcast. On today’s call are Billy Cyr, Chief Executive Officer; Scott Morris, President and Chief Operating Officer; and Dick Kassar, Chief Financial Officer. 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 cause actual results to differ materially from those described in these forward-looking statements. Please refer to the company’s quarterly report on Form 10-Q, expected to be filed with the Securities and Exchange Commission 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, such as non-GAAP profit margin, non-GAAP SG&A, EBITDA and adjusted EBITDA, while the company believes these non-GAAP financial measures provide useful information for investors, the presentation of this information is not intended to be considered in or isolation or as a substitute for the financial information presented in accordance with GAAP. Please refer today’s press release for a reconciliation of the non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP. Now, I’d like to turn the call over to Billy Cyr, Chief Executive Officer.

Thank you, Katie and good afternoon everyone. I am pleased to be hosting my first earnings call with Freshpet. I have been with the company eight weeks and I am happy to say that the company has the potential that I anticipated based on the extensive diligence I performed prior to joining the business this past summer. I joined Freshpet because I think it’s one of the few CPG companies that has the potential to change the industry it is in. The pet is unique, strongly preferred by its users and on trend. And the company has built a very strong platform that can exploit and defend that position. And to be brutally honest about it, when I saw the reaction of my dog Coco at Freshpet, I know who is the winner. She now sits in front of the refrigerator and barks until I feed her. I also thought that I could add value to the business. I have 31 years of experience working with many the same customers, managing our refrigerated supply chain in North America and Europe, resulting market leading brands that are driven by strong marketing and developing an organization capable of successfully running a mid-sized CPG business. I am now about half way through my review of the company's strategic initiative and operation. I have done extensive review to the company's products, manufacturing operations, marketing program, the fridge program, core financials, product development plans, organization capability, and the U.K. test. I have also begun engaging with our key customers and sales partners to better understand how they see our business and its opportunity. I can tell you that the opportunity remains very compelling. Unlike many other CPG companies, our challenge is not where to find growth, but which opportunities to pursue first. We have unique brand with great potential. Our team knows we have a lot of work to do, but I am confident that the future is very bright. I expect to be able to provide a more detailed report on the business and our plans going forward sometime in the first quarter. Now, I would like to turn your attention to review of our third quarter results. I will provide a brief overview of our financial highlights and recent business performance, then Dick will review our third quarter 2017 financial results in more detail. Finally, Dick, Scott and I will open the line for question. We are pleased with our progress in 2016. As we execute on our mission to bring the power of fresh real food to dogs and cats. We strive every day to pet parents' products that their dogs and cats love and have a positive impact on their pet life. We see the results of our work in the thousands of happy letters we received from pet parents which you can view on freshpet.com. In the third quarter, we continue to improve upon key metrics as compared to the prior year and quarter. For our third quarter 2016, net sales increased 13% to $34.5 million, driven by increased velocity per fridge, increased store count. Excluding our baked dry sales, Freshpet refrigerated net sales grew 17.1% during the period. Freshpet fridge store count increased to 16,261 as of September 30, 2016, up from 14,670 in the third quarter of the prior year. We are very encouraged by the sales growth on our fresh business, and IRI is further demonstrating the positive rebound with recent trend showing total growth in excess of 19%. The growth is driven by solid innovation in advertising that are generating increased velocity in addition to steady distribution gain. Despite this solid performance, we anticipate that we will not realize the total planned growth this year due to softer bake sales and lower than expected sales in the pet specialty channel. Now let's say Kitchens are complete, we have been able to expand distribution of our shredded product in addition to placing other innovations into market. The transition out of some heritage into the newer innovation has not gone quickly -- as quickly as anticipated, but the early response of these products has been positive. As I said earlier one of the many reasons I decided to join the company was my personal experience with Freshpet. My experience is not unique. After using Freshpet the response from pet parents is overwhelmingly positive and our new TV advertising campaign launched during Q3 captures the feedback we received describing a significant positive changes experienced in the pet physical appearance and vitality. These messages are resonating based on the recent response we have seen through POS and IRI data. We are planning continuing this theme during 2107. We also made progress on our planned product distribution test in the U.K. At the end of the Q3, our Freshpet Fridges were approximately 63 stores across two retailers. Early results of these tests are encouraging and we believe that over time U.K. and other parts of Europe to represent strong market for incremental growth. From a manufacturing perspective, our Freshpet Kitchens expansion was complete as of mid-October and on budget. We continue to train our plant personnel in the new line. We now have significant capacity available to meet anticipated demand for the next several years and can turn our focus fulfilling that capacity. Going forward, we expect that our annual capital needs will be significantly over the next several years to primarily support fridge growth and maintenance CapEx. We remain focused on the execution of our strategic initiative which has enabled us to generate increased adjusted EBITDA and positive operating cash flow during the past eight quarters, while growing net sales and store count at double-digit rate. We appreciate the hard work and dedication of our entire team. We expect our efforts to drive greater leverage across our business model, improve profitability and enhance long term shareholder value as we finish the year and enter 2017. With that overview, I would like now to turn the call to our CFO, Dick Kassar, to review our financial results in more detail. Dick?

Thank you, Billy and good afternoon everyone. I will now review our third quarter 2017 financial results. For the third quarter overall net sales increased 13% to $34.5 million. During the period our fresh sales were 17.1%. This growth resulted from both distribution and velocity gains, including a 10.8% year-over-year increase in Freshpet Fridges. Gross profit for the quarter was $15.4 million compared to $14 million during the same period last year. Gross margin was 44.4% for the third quarter of 2016 compared to 45.9% in the third quarter last year. After adjusting for depreciation and one-time startup planned costs, non-GAAP gross margin for the third quarter 2016 was 49.6% versus 48.1% prior year. After adjusting for stock-based compensation, fair value of warrant expense and leadership transition expense, non-GAAP SG&A decrease as a percentage of net sales to 40.8% from 46.8% in the same quarter last year. Looking ahead, we expect to continue to decrease SG&A as a percentage of net sales as we increasingly scale our operations and better utilize our existing infrastructure while growing net sales. Adjusted EBITDA was $5.3 million for the third quarter compared to $2.3 million in the third quarter of 2015. On a year-to-date basis, net sales for the nine months ended September 30, 2016 increased 15.1% to $99 million compared to $86 million for the same period in 2015. Adjusted EBITDA improved $4.2 million to $11.3 million. Adjusted EBITDA as a percentage of net sales for the first nine months was 11.4% compared to 9.5% in the same period last year. Turning now to the balance sheet. At September 30, 2016, the company had cash and cash equivalents of $3.5 million. The decrease in cash from the prior year is primarily due to expenses related to the expansion of our Freshpet Kitchens. Each quarter for the fourth quarter of 2016 to this quarter, we generated positive cash flow from operations. As many of you know, with the conjunction with our initial public offering we entered into a $40 million credit facility. As we have communicated part of our 2016 plan was to borrow approximately $8 million to $10 million from our credit facility by third quarter 2016. As of September 30, 2016, we borrowed $10 million and have repaid $1 million. We continue to expect to repay this balance by June 30, 2017. Finally, I would like to review our annual guidance. We expect Freshpet Fridges of over 16,600, an increase of approximately 10%. Net sales of $133 million, an increase of approximately 14% versus guidance of $137 million. Adjusted EBITDA of over $17 million, an increase of approximately 58% versus initial guidance of $18.5 million. Based on the year-to-date results and outlook for the remainder of the year, we are lowering net sales and adjusted EBITDA guidance due to the lower bake sales that projected lower unexpected growth in Freshpet while maintaining our Freshpet guidance. This guidance includes our expectation for continued adjusted gross margin expansion and leverage of our SG&A expenses. From a seasonality perspective, our adjusted EBITDA will be increase more heavily in the fourth quarter as our expenditures lightened considerably due to the timing of our planned media program. As a reminder, our adjusted EBITDA represents EBITDA plus loss on disposable equipment, new plant start-up expenses, share based compensation, launch expenses, leadership transition expenses and warrant expense. We expect strong growth for our products across our distribution network and we will continue to maintain a strong balance sheet and liquidity to meet demand and further grow our distribution network. That concludes our financial overview. Billy, Scott and I are now available to take your questions. Operator?

[Operator Instructions] Our first question comes from the line of Jon Andersen of William Blair. Your line is open.

Good afternoon, everybody.

Good afternoon.

Hi, Jon.

Hey, can I ask, first of all, on the guidance update on the top line. If you can talk a little bit about what's happening with bake, I am assuming you had anticipated some decline in that business. I know you kind of reorganic around the Fresh refrigerated offering. And then if you can add a little bit more color to what you just seen in the pet specialty channel, if that's a channel -- overall channel dynamic or if you are seeing something more specific with your business. Thanks.

Jon, let me take a stab at that and then I will pass it up to Scott. But as you commented the refrigerated business has done very well and you saw that in the data that we posted. That the core refrigerated products business had a very good quarter, showing up in the IRI data. The trends are very good and our advertising is driving it quite well. The [indiscernible] taking the guidance down was the softness that we saw in the bake business. What we were seeing in the pet specialty channel. And we feel pretty good about where we have got the guidance going forward. But it is less than what we had anticipated when we built the plan at the beginning of year. The business, so as we looking at it and the core of the business is really -- is in the refrigerated product business. We have got more to do to figure out how the bake part is going to fit in. But I will pass it to Scott to give a little bit more detail on that.

So as Billy was saying obviously the core refrigerated business is doing quite well. We are really actually very enthusiastic about how it responded to advertising innovation. Throughout the year the last two quarters we have seen nice gains there. And the two areas of softness are really around the pet specialty business that you mentioned and the bake. In the pet specialty business, there are -- it is slightly softening from what we have seen kind of as an industry. But the key piece is for us or the core component to that softening really centre around some transition that we have where we are going out of some products and into a couple of other. The transition was not as smooth as we would like. And secondarily, in order to put that business in a better position long term, we have actually changed distributor. So there is a fair amount of disruption going on in pet specialty and we think that the lion share of the impact in that channel. So those are the two major components that we are seeing, so really impact the business. And we are looking from now to the end of the year and seeing how the business we are going to pacing. Our advertising is off air at this point. Our innovation for the year somewhat in, and that's why we wanted to kind of update the numbers for the back.

Okay. Thanks. That's really helpful. Just one another one for me. On the advertising, the new campaign, could you talk a little bit about, number one, how much you spent in the quarter or planning to spend for the year on advertising? And how that may evolve in 2017? And then just some of the kind of initial results you are seeing from that program. Thank you.

So, we did put the new campaign on air. And we were very excited about how the business responded to that, which is really what drove the numbers in that core. So combination of innovation and the TV. The TV was just on for three week, so it’s almost a sampling. Not really a lot of advertising in that quarter at all. So it gives us a little bit of feel for the response rate and the impact it has on the business. And it leads us feeling very encouraged about when we go on air next year, the response that this should have or the impact should have on the business. So we like the new campaign. We like the impact of it. And we think it’s kind of positions us really well next year once we kind of establish exactly the rates that we will be investing in behind the advertising.

Let me add a little bit of commentary to that. Coming from first P&G background and the last 11 years at Sunny De, one of the things that impressed me when I got here was the -- when you look at the advertising how quick we can see a reaction from the advertising in a market. I am used to seeing advertising built over a long period of time. But the organization here a really nice capability to first see the impact the advertising on our internet interaction, the social media interaction and connections we have with the consumer. And so even though the advertising was only on the air for three weeks, we started seeing early diagnostics that was having the impact fairly quickly. The second piece of it is that the advertising have been on the air for only three weeks, give me a lot of confidence that it has a lot of life left in it. We think we can run it to campaign and broaden it out to the campaign. But even the initial execution have a lot of life left in because they have only been on air for three-week. So the third part is the quick response we saw in the market. I mean, most of you see the IRI data and the uptick that we saw in the measured channel is really a strong testament to how effective this campaign was reengaging the consumer against the benefit that Freshpet offers. So it gives me awful lot of confidence that we have a winning marketing model. We haven’t figured out how much we want to run that in next year, that's the work that I am doing as part of our strategy work and we will share with our board later this year. But it does give you a really strong foundation to start with as we look for building blocks to build the plan going forward.

Thanks. If I could just squeeze one more. Billy, you mentioned in your prepared comments that you began the work of engaging with a number of key customers. Is there anything that you can share there in terms of feedback from key customers in terms of their overall view of the business and your confidence in -- your ability continue kind of drive the store count higher and drive velocity, but some timings from those initial discussions if you are willing to share any of that would be helpful.

Well, we are only in the middle of that part now which in fact we have not seen other one tomorrow. But what I would say that I have learnt so far is first when you have composition that is growing as quickly as we are with Freshpet, customers inherently interested. There is not a lot of things that they are seeing in the store today that have of growth that we are talking about and as growth come basically for retail price. So this is very attractive for the retailers and that is seen. So the second part of it is that I would highlight is most of these customers look at this is a slightly more complicated execution to get into this. It’s not just put it on the shelf and watch it fly. We have to put the chillers in. And so the level sophistication in the sales presentation, we have to make the customers. It’s a little bit more typical than little bit more challenging than what you would normally expect to see for new item. It builds a heck of a barrier to entry once you get it put in, but it does mean it’s a little bit more sophisticated to sell and it take a little bit longer and my challenge is to find ways to get that to go more quickly. You would logically think that when customers have put the chillers in, 40%, 45% of their stores it would be way to stay -- to have 75% or 80% of their stores. And that hasn’t happen yet. And so my focus is to figure out what it will take to unlock that. And we have got a couple of good ideas, but we are not ready to share those at this point. I would say that I feel pretty confident that the customers will want to realize the opportunity that we have, the growth rate that we have in more of their stores and our challenge is to just find a way to make that happen faster.

Thanks. I will get back in the queue.

Okay.

Thank you. Our next question comes from Bill Chappell of SunTrust. Your question, please.

Hi, this is actually Stephanie on for Bill. My question is kind of going off what was said before SG&A, it looks came in kind of well below our expectations, is this more or less had the new base you expect going forward, or do you plan more of a meaningful step-up to the media and advertising spend. Some just color on what you are expecting from SG&A going forward, would be helpful.

Sure. In our SG&A we have both fixed and variable cost. Our variable costs are marketing spend. But the marketing spend for the third quarter was basically similar to the first two quarters of the year. It will come down somewhat in the fourth quarter. The other variable expenses, major player expenses logistics. And logistics is tied to our revenues, but we did have a new supplier coming in, in June and we realize a nice savings. When you see the details, when the Q comes out, you will be able to uncover that. So we are looking at SG&A for the year around $62.5 million. And we feel good about how it’s been leveraged.

Great. That's very helpful. And then my second question is, clearly looking at the 17% growth on the fresh product, very strong and above what we are expecting. Is there anything we need to consider from kind of year-over-year comparability standpoint, can they drive that or is this just kind of good proxy for going forward and what to come?

So, our comparables last were a little softer in this period. But the other that we are seeing is we are seeing period on period growth which is what really like. So we have been able to kind a see a nice -- we have had kind of flattening in the middle of the year. And then over the past two quarters we have started to see growth reaccelerate, so we have been able to see that. So year-over-year you will definitely see some -- you see a nice increase, but also period-over-period or quarter-over-quarter, even four week data we have seen a nice numbers coming around. So, it really will kind of correlates back to what we are spending on the business next year from an advertising standpoint. And where we go from an innovation standpoint and how the stores layer in. And those are basically the three building blocks for the business, obviously. So it will -- I think it’s going to be very variable depending on how we invest and structure the business plan next year.

Got it. That's it for me. Thanks.

Thank you.

Thank you. Our next question comes from Rupesh Parikh of Oppenheimer. Your line is open.

Thanks for taking my question. I also wanted to go back to the guidance changes for the full year. First on the pet specialty channel, how quickly do you think you can move pass some of the issues you had on the product side?

We this is primarily going to be something that we saw little of an impact in late Q3 and then into Q4. We think this will be balanced out by -- beginning of next year. But I think that we will have a really strong perspective and update for everyone early in Q1 on exactly what we are seeing and how things have kind of balanced out.

Okay. Great. And then on the bake side, I just wanted to get a sense of what's in the guidance for the -- I guess for the full year on baked. As you guys look forward to next year, where does bake fall in terms of your priority?

Well, let me start with. We haven’t figured out what the priorities are for next year yet, that's one of the things that we are working on. We -- the guidance that we gave does reflect the softening on the bake business, Scott give you a little bit more detail on that. But we are clearly watching and learning on the bake business to figure out what will play in our portfolio.

One of the thing I will build on too from a bake standpoint is, this is a really unique proposition that is quite timely with consumers and really the softness that we are seeing is -- and I think we had mentioned there is going to be kind of puts and takes from a distribution standpoint. Most of what we are seeing is some kind of distribution where it has gone away on the bake business. So -- but we do expect a little bit of a softening in velocity for the balance of the year. But there is a nice opportunity and it kind of balance out in the portfolio. Right now, it looks like it was about -- we originally budget around $6.2 million in bake and it looks like it’s going to end up being closer to a little bit over $4 million for the year.

Okay. Great. Thanks for all the color.

Thank you.

Thank you. Our next question comes from Peter Benedict of Robert Baird. Your line is open.

Hi, guys. Just back to the marketing, just curious the 2016 marketing spend that you guys are coming with, how does that set up versus your initial plan. I mean, is it -- are you spending what you thought you would? Are you spending a little less, just trying to understand that and the plans for the fourth quarter marketing. I think Dick may have said it was going to be down versus the prior few quarters. Trying to understand why? I know historically you guys pull back in the fourth quarter, but with the capacity now in place why would you guys pushed the marketing right now?

We are basically going to spend from marketing standpoint almost exactly how we had planned for the year. And when we planned initial part of the year, we had planned to kind of pull back in the Q4 period. We do have a tremendous capacity at the Kitchens now. And that something that we want kind of pull together in overall strategic plan for next year establish with the level of spending and the level of investment in the business, and the response we anticipate getting. So I think we have got really good feel for the new campaign as I mentioned earlier. And it puts us we are in a position to be very well educated around, how we invest in the business and really what the results should be for next year.

All right. Scott, and -- so this historically -- I guess what's been the -- I guess the timing of the demand response. You turned on some advertising. How long is it takes show up in the sales numbers? Is the recent three-week test to that show any changes in terms of that, assuming that the demand response could be that quick, maybe it takes longer than that, so just curious about that one.

We saw almost -- within kind of two weeks we saw an acceleration in the business behind the advertising and that coupled with the innovation that we layered in, give us that nice in the past that we have been able to see in IRI and also in POS. And so -- but it was planned, I guess it was planned on how we budget the year and that we were coming off in Q4. Typically we will come off in Q4. This year is fairly complicated Q4 whether elections and holidays et cetera. But that was really planned out in the beginning of the year.

And Peter, I would emphasize the comment I made earlier which is that we get pretty good indications very quickly about whether the advertising having an impact based on the commentary we get in social media. And then from there you start seeing it in the IRI data. So it gives me a lot of confidence that we have the right advertising, the right message. There is the fact of light that when you put advertising on air, you can get an immediate impact. It’s not necessarily going to be an immediate payout, payout takes a longer period of time. And so running a media skewing it more towards the front end into the years, obviously been a smart choice for this business that would build demand throughout the year and we would expect to see that going forward. So absolute levels the media spend thing we got to really work on. So, right now spending as it was planned for this year. And the spending that we had this year was relatively consistent with prior year. Question is, is that the right level for this business.

Yeah, I know that make sense, Billy. And just as you think about that for next year, you know, with the prospects for that spending to probably to go up, it sounds like, are there areas of the business where you see some ways to kind of fund that increased investment, whether it would be efficiencies in certain areas, cost outs in other areas or is that just kind of thing you start to take some P&L pain in order to get the long term gain?

You sound like you are asking the same question, I am asking. I am doing my strategic review. But clearly you have to think about this business as the business that is growing very quickly. It’s relatively young in a lot of way. The company is 10 years old, a lot of their capabilities that the company has built relatively recently. And so the challenge for us is to figure out which are them we need to focus on and emphasize, which are the opportunities we want to pursue because if more opportunities here then most companies see across a much larger portfolio. And then also where the opportunities to do things more efficiently, because as you basically build an organization to meet demand, you don’t spend a lot of time focusing on doing things efficiently early on. You just want get them done. Now we have the time and the resources to focus on doing things more efficiently. I would tell just like there are lot of opportunities for growth, there are also lot of opportunities for efficiency. The challenge is to figure out which ones we want to resource and prioritize first.

Okay. Thanks. Just the last question around CapEx. Can you give a sense of what the CapEx was in the third quarter and kind of the plan for the year, where do you think that comes in? And just remind us the maintenance CapEx needs maybe on per fridge basis, how we should think about that as we model going forward? Thank you.

Sure. CapEx year-to-date was $26 million. And we will be somewhere in the $28 million by year-end. We have about $1 million left for completion of our manufacturing facility because it was holdback from the construction management team. CapEx on maintenance, looking at for the year about $1.5 million. We probably have $200,000 or $300,000 left. Going forward, as I -- we might have mentioned in the past CapEx going forward is just basically chillers. We have capacity as we told you before in the $350 million to $400 million range in our existing facility. In addition -- so there is no capital planned other than maintenance CapEx which we're estimating about $2.5 million. CapEx for fridges will be about $3,500 a store for 2017, and we will be letting you know what we perceive our store count gain to be in the early part of 2017.

Okay. That's helpful. Thanks guys.

Yeah. Thank you.

Thank you. Our next question comes from Jason English of Goldman Sachs. Question, please.

Good morning, folks or good afternoon I guess now. Real quick on dry, if refrigerated was up 17%, it looks like the dry was down around 50% this quarter. Is that math sound about right?

Yeah, last quarter it was about -- last year it was $1.8 million and this quarter is around $900,000.

There is pipeline in the year ago. The pipeline for some significant new customers in the year ago period.

Okay. Is there any returns sort of dampening the number this year or is this sort of real base line to operate off right now, the 900?

Well, we are projecting, you know, as Scott said earlier about $4.3 million for 2016 versus what we planned to $6.2 million.

Okay. And so it looks like -- I think that implies even sequential deceleration sales in the fourth quarter, is that right.

Yes. And Jason, I think I just touched on it. But a lot of that was around and we knew that there are some puts and takes from a distribution standpoint. So it was actually -- there has been some distribution that's gone out and there is actually some distribution that we anticipate coming in over next few months too.

Okay. So it’s too early to zero this out as we think into next year then if you are picking up new distribution, is that fair?

Yeah, that's right.

Okay. And then can you help me on the math on how -- we leak out, let see, $4 million of sales with $2 million is pretty much on the dry which doesn't make any money. So you're kind of losing $2 million on refrigerated and it drops all the way through to $1 million reduction at EBITDA. It sounds like expense-wise, there's no surprise is there is. So is it just a variable contribution on the sales as they leaked out, so leaking out of 50%, rate for refrigerated?

Yeah, we have a gross margin of approximately for the quarter when you take refrigerated out of the picture someway around 45%. We certainly have depreciation in there. We will be experiencing some additional depreciation in the fourth quarter as we put on -- we deploy our chub line. The chub line is ready, but we just didn't need it. We will start to need it in November. So it's about -- we kind of generate to the bottom line about 40% of -- 40% goes to adjusted EBITDA for every dollar of sales. So we're going to be down, you know, $2 million in sales and I agree with you this not much of a contribution coming up on the bake side. That's why we kind of took it down our EBITDA from 85 to 75.

Got it. Okay. Thanks a lot guys. It’s helpful.

Thanks Jason.

Thank you. Our next question comes from Eric Gottlieb of D.A. Davidson. The question, please.

Yes. Touching on the change in distributors, one, what prompted the change and two, how much savings, you know, you explain this quarter there's some leakage. But going forward, how much savings you anticipate?

From a specific around savings, that's something that I think we need to kind of get into when we kind of discuss our full business plan for next year. We do anticipate some savings, but a lot of it was centered around service levels also and alignment with a handful of other things around the business. So that's something we will probably need to touch on in more detail in the future.

Okay. So was a -- it was a servicing decision and not a financial decision for the most part.

There are some savings, but it's also a service related and aligning with a couple other things that we're trying to do on those businesses also.

Okay. Can we talk about some of the other channels, I mean we talked about pet specialty a lot. But how is the grocery, mass -- natural stores how they perform?

For Freshpet or for the category?

Both actually.

Okay. So for the category, I think that what you'll hear across the industry is it's been a slight slowing overall in pet, but the people that have a lot of a typical traffic in their stores, grocery and mass in most of the mass accounts that where they have a lot of people coming in on a more frequent basis, they've been able to weather the storm quite well and most of them are putting out modest growth not as quite as high as, you know, 2%, 3%, 4% like you've seen in the past, but they're definitely showing and posting growth. From Freshpet standpoint, our growth has really kind of mirror that we're in grocery and mass, those has been the channels that have really accelerated and also natural. And the place that we've seen some softness on the pet specialty piece. But as I mentioned there's a couple of other factors that are contributing on the pet specialty component.

When we you step back and you think about the way the shopper or way the consumer buys this product in the -- you have to recognize that because we have relatively short shelf-life product the consumer pushes in the refrigerator where they don't have a lot of space. We get people shop more frequently for this, so they obviously skew the business to the channels that they visit more frequently. We sit listen to consumers and research tell us how it's so much more convenient to buy this product, they don't have to go to necessarily to a pet specialty store they can buy it in a lot of different outlets including in the grocery stores as part of the regular shopping trip. And so there's a lot of value for it in the breadth of the distribution that we offer. And it also is good for the retailers. The retailers like it because we end up bringing consumers into the aisle, shopping more frequently. So going back to the advertising piece to you, also means you can see a more rapid impact of the advertising because consumers are purchasing this brand more quickly. When you put advertising on the air, you can see reaction much more quickly rather than waiting for a 30 or 60-day purchase cycle, we can be on at seven or 10 or 14-day purchase cycle. So some real benefits there, and we start seeing that in the channels like mass and grocery. And it's a really great asset of the business.

Got it. Thank you for the color. One last one on the store count guidance being unchanged. I am curious if this quarter met your internal productions, meaning did you have some cushion built in there on the full year 2016, 600, or we right where we thought we'd be?

No, we've been tracking really tight on store count for growth for the year. And -- but I think what we have tried to do based on past years is make sure that we're budgeting as appropriately as possible for store account.

Okay. Very good. With that I will pass it on. Thank you.

Thank you.

Thank you. Our next question comes from Rob Moskow of Credit Suisse. Your line is open.

Hi, there. Billy, just a couple questions. So the first is, we had a chance to meet with you recently and I think your commentary was, you know, you done a preliminary overview of the business, no big surprises. I just want to make sure that that, you know, that the guidance reduction here wasn't like an end of quarter kind of surprise, or if it was just kind of like -- it makes sense depended based on where the business was headed? And then I'll just have a follow-up.

So I tell you no surprises, my focus was a very much of a sort of broad strategic level, are there any big boogey man in the closet, somewhere that tells me that this business isn't going to have the potential -- the long-term potential that I anticipated it would have. And as I said when I met with you the long-term potential of this business is very clear. In fact if I was going to say there was a surprise and they're really haven't been any significant surprises. But the surprises would be the number of opportunities are probably a little bit greater than what I expected and that's going to put us -- the burden on us to be a little bit more choice full about which opportunity to pursue. The magnitude of the reduction that we gave you in the guidance is relatively small reduction. And so when I met with folks and if you look at it across the quarter, and you kind of trend across the balance of the year, it's not a huge change, and so really it's not out one thing happened at the end of the quarter that's going to have an impact. It is just sort of a glide path reflected in the baked business, reflected in the pet specialty business, that cumulatively adds up to over the second half of the year the numbers that we've given you for the guidance. It was a huge change I think you'd be fair and poking at, really where is the surprise, but it's not a huge change. It's just reflecting the reality that we're seeing sort of glide path in those two parts of the business.

Okay. Just want to make sure from your perspective…

That's a good question.

And secondly, just some of the logistics thing, I guess I'm still a little confused what kind of services was that distributor providing. Where they in the stores, resetting shelves, was it vans going to pet specialty and how is the new provider different? is it the same type of service that they're providing?

So these are folks that deliver to pet specialty. You look for a handful of options everything from overall -- the overall agreement on kind of what the charges are for delivery. But you look at frequency, you look at fill rate and service levels. You are going to look at minimum drop levels which can start obviously affecting your frequency. So I'm every one of those have the ability to impact the business in a positive way, both on kind of been in stock rate but also from a cost standpoint. So after kind of looking at this for a pretty extensive period of time, we evaluated it, thought about, it did some testing around it and thought it was a really smart move for kind of a long-term piece of business. So we hope it positions fresh or pet specialty in -- you know put us in a better position in pet specialty over the next several years.

And so Scott, I just want to make sure like when you say that the transition to heritage products in the stores had gone as quickly if you'd hope, is that a function of that distributor not executing well, or is it just the retailer just not willing to make that transition?

No. The retailers are willing to make it. It's just a combination of -- we had just because of timing that the retailers have to actually change out products, so the specific timing as you're well aware there are certain times of the year. So we had certain products kind of going in and out, at the same time we had a distributor transition. So you kind of add those things together and we knew that there were potential downside to it, but typically we've been able to do manage them pretty well. In this case if things did not go quite as smoothly as you can imagine transitioning piece of business like that and making sure one distributor is kind of moving out, another distributors coming in and maintaining the service levels -- even the prior several levels that we had in the store can be fairly tricky, and that's we got caught up. And couple that with some product transitions and those two pieces together created, you know, some softness in the business.

Okay. Thanks. And last question, Dick, you might have said it. But did you give a new gross margin -- adjusted gross margin target for the year? Is it something around the lines of like 45% or something?

Well, as you know, we came in the quarter we have -- first time we got hit with a new appreciation for the expansion. This quarter has $500,000 additional in the quarter. And in the fourth quarter when we bring up the chub line we're expecting another $250,000. So the depreciation for all the new equipment for the upgrade of the facility will be at -- about $3 million incremental to where it was. Previously we're in the $2.2 million range. So we're looking at now $5.2 million. And so during that quarter we also had about $500,000 of plants startup expense. For the year what we're trying to do now what we get on the press release we wanted to show you what's happening without this depreciation and without the startup expenses and we displayed for the quarter 49.6% versus 48.1% in the prior year. That gives the reader a sense that, when you look at the margin going down as a result of non-cash items, you kind of think we're being inefficient. But what's really occurring is we're starting to leverage some of that. And obviously as time goes by as we increase our productivity on our lines that we just purchased we had advised earlier that those lines could produce potentially 30% more currently over time, but it's going to take time. For the year we're -- on an adjusted basis, I don't have a problem with 49%, when you add back the depreciation and the startup expenses. But if I am going to take a $250,000 hit in the fourth quarter above and beyond, the current appreciation our numbers of probably in the 44% range after depreciation for the fourth quarter.

Okay. So Dick, before you said it was 465% last quarter. So -- and that was all in with all the depreciation charges, right?

Yeah.

I am just basing it off of that. So you're are down versus…

Probably come in the -- will probably come in around 45%

45%. Thank you.

The depreciation charges were higher than I anticipated.

Okay. Thank you.

[Operator Instructions] Our next question comes from the line of Mark Astrachan of Stifel. Your line is open.

Yeah, thanks and afternoon everyone. On the third quarter, the 17% growth in the core product, how much that came from innovation, how much that came from the U.K. launch?

Our U.K. is really small or a little over 60 stores there. So it's almost a rounding error. Since of our U.K. I mean what we see and Billy mentioned there are several opportunities on the business. We like overseeing in U.K. We're moving forward. We're now into the majors -- the velocity trends looks strong up front, so we're encouraged by that, but that's another thing. We're going to have to be really thoughtful about the resources that we put against that. But overall U.K, launch very, very small contribution for this quarter.

What about for the year?

Even for the year. I mean, you're dealing with 60 stores out of 16 -- 16,000 -- over 16,000. So it's a really, really small piece of business that. It's incredibly small. I mean we're talking in the hundreds of thousands kind of number. But on a per square basis, that's what we're looking at. From an innovation standpoint, really if you look at the back of the year here we look at same-store sales, you know, you're seeing kind of a low double-digit number in the quarter, and of that it's broken out almost 50-50 between innovation and TV.

I think it's also important to know when you think about the company's track record with innovation, success the company's had, it's important to take a step back and realize where we are on the product which is way ahead of our competitors. The product differentiation and the superiority of the product versus all the alternatives is quite impressive. And so we've had a history here of driving innovation as a key driver of velocity, at some point you have to look at it and say how much more we get out the innovation that we've already done, and that's one of the questions that we're looking at. I don't have a conclusion to that. But as you look at the success that we've had of late and where some of our greatest performance has been, it's on some of the products that have been launched recently, but they have a lot of life left and they have a lot of room to grow, household penetration, distribution, there's a long runway for the products that we already have.

Got it. Okay. And then for the fourth quarter, what is guidance implying about pet specialty sales given the deceleration it seems at least our numbers for the two-year sales CAGR based on what you've given. And obviously we can see -- what the standard is doing in the drug and mass channel to sort of get you the same thing. So I guess the question is what is the number that you're expecting or sort of broader strokes how are you expecting pet specialty to perform in your guidance in the quarter? And is there also inventory out there in wherever it is channels whether food drug mass or pet specialty, that needs to be drawn down?

So from pet specialty standpoint, we don't -- the rest of business we continue to see some growth around, but in pet specialty specifically we see it being very flat through this next quarter. So basically pet specialty and bake are going to be basically almost directly flat and potentially down a little further than what we saw in Q3. And from -- and I'm sorry, what was it?

Inventory?

From an inventory standpoint, there's always kind of some ebb and flow in that. We don't anticipate anything significant from an inventory standpoint, inventory adjustment standpoint.

Got it. Okay. And then just lastly back to Rob's question, so Billy, I understand it's been eight weeks since you've been there. If you want to sort of read -- probably too much into what you said in terms of taking a good look at the business, are we -- am I wrong in thinking that there's a probability of a larger reset coming in 2017 given all that you've outlined, you've talked about -- the comment that Scott just made about resources in the U.K., the comments about advertising spend in terms of what it is you want to support. So as you sort of looking at revenues from a trajectory standpoint, call it mid-teens this year, are we talking about numbers that on a revenue basis are going to be worse than they are this year as you are sort of selectively looking at businesses that you want to be in? And then is the cost to grow those businesses decently greater than sort of run rate that we are at today and -- that you're not going -- know the answer putting up for those out there they're trying to think about whether there's more to come here, what can you do to either allay those fears or say look it may be that case?

Well, you're right. I am not going to be in a position that I'm ready to talk about it we haven't shared it with our Board. We haven’t aligned what the plan will be yet. But I would tell you that the overarching comment is that there are more growth opportunities here then I probably expected. And the question is how we are going to pick between them? So I am not expecting us to come back with any plan that would talk about decelerating growth. I think that the focus and what the mandate that I've got is to find a way to accelerate the growth. How we do that and what resources we have available to do that, that's the question that we're wrestling with. But this is a growth oriented company. We are striving for faster revenue growth and that's what we're going to be driving for.

Great. Thank you.

Thank you. At this time, I'd like to turn the call back over to management for any closing remarks.

Thanks everybody. We appreciate you joining us for the call and look forward to finishing up the year and letting you know how that turns out. So thank you very much everybody.