Freshpet, Inc. (FRPT) Q1 2017 Earnings Report, Transcript and Summary

Greetings, and welcome to the Freshpet Inc.’s First Quarter 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Ms. Katie Turner. Thank you, you may begin.

Thank you. Good afternoon, and welcome to Freshpet’s first quarter 2017 earnings conference call and webcast. On the call today are Billy Cyr, Chief Executive Officer; Dick Kassar, Chief Financial Officer; and Scott Morris, Chief Operating Officer; who will 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 involves 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-K 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 on today’s call management will refer to certain non-GAAP financial measures, such as EBITDA and adjusted EBITDA. And 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 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. Now, I’d like to turn the call over to Billy Cyr, Chief Executive Officer.

Thank you, Katie, and good afternoon, everyone. To begin, I will provide a brief overview of our financial highlights and recent business performance. Then Dick will review our financial results in more detail. Finally, Dick, Scott and I will be available to answer your questions. We feel very good about what we accomplished in first quarter, and we are well on track to achieve our annual outlook. As a reminder, our Feed the Growth strategy is built on the simple premise that pet parents and their pets find the Freshpet product and promise highly appealing, resulting in very high repeat rates when they try the brand. We believe that gives us license to invest our marketing dollars in recruiting new users to grow household penetration, rather than having to invest to maintain the existing user base. This effort to attract new users, combined with our opportunity to leverage the recently completed kitchen expansion and existing organizational infrastructure, provides us with the ability and the incentive to rapidly scale this business. We expect to drive significantly higher revenue and ultimately stronger profitability, as we absorb the fixed cost. We remain committed to the 3 strategies to rapidly scale the Freshpet brand. First, investing in increased marketing to drive household penetration. Second, embracing a new selling approach to expand distribution. And third, driving adjusted gross margin expansion to support our increased advertising investment. These strategies form a virtuous cycle. We expect increased advertising to drive higher store velocity, which should drive retail distribution expansion, enabling us to spread our fixed costs and drive greater cost savings. As a result, we expect higher margins over time that will help, in part, to fuel our strategic investments to accelerate growth. We believe this Feed the Growth Plan has the potential to more than double our business and create a $300 million brand as soon as 2020, with EBITDA margins of 20-plus percent and continued growth of 15% to 20%. We told you that this plan will deliver an accelerating growth rate throughout this year. With a 20% growth rate in the fourth quarter and an adjusted gross margin run rate at the end of the year, that is 1.5 points ahead of where we were at the end of 2016. Based on what we achieved in Q1, we believe our strategy is working, and we are on track to deliver our fiscal 2017 guidance of 15% net sales growth and $16 million in adjusted EBITDA. Our objective in Q1 was to set the table for more rapid growth as we progress throughout the year and begin laying the groundwork for gross margin expansion. Most importantly, in Q1, we were able to show via the IRI scanner data that our increased investment in advertising is turning into an accelerated rate of consumption growth. The IRI data through April 2, 2017, showed that our multi-outlet consumption was up 23% versus year ago and provides a strong run rate as we head into Q2. However, as we expected and communicated on our earnings call last quarter, revenue was up low-double digits or approximately 10% for Q1 due to the anticipated delay between consumption and shipment growth, higher marketing investments in the year ago period and our efforts to smooth the supply chain to deliver fresher product and better match our production with the very stable rate of consumption we see in the market. To help you bridge the gap between the reported IRI growth rate of 23% and our reported revenue growth rate of 10%, the following variables need to be taken into consideration. First, pet specialty. This channel is not included in the IRI data. In Q1 last year, we had a very large pipeline fill behind some new products and distributors. As a result, our business was down approximately 10% in pet specialty in Q1 of 2017, which reduced our overall growth rate for Q1 by 7 points. On a consumption basis, we believe our business outperformed the category in the pet specialty channel for Q1 and that consumption was flat versus year ago. Sales trends improved throughout the quarter and for Q2 to date, we are now experiencing low-single digit growth. Second, baked. As we communicated on our fourth quarter earnings call, our primary focus for investment is on our fresh refrigerated products. Thus, we expected our baked product to be a modest drag on our sales growth. In Q1, baked drove a 1 point reduction in our growth rate. Third, supply chain. Freshpet has the unique advantage of having incredibly smooth and stable consumption patterns with virtually no seasonality and no promotionally driven consumption surges. Despite that, in previous years, we had significant surges in orders and shipments and fluctuating customer inventories that resulted in supply chain inefficiencies and older products in the hands of our customers and consumers. So we deliberately smoothed the supply chain, which reduced trade inventories in the quarter by about $1.6 million. This reduced our reported sales growth rate by 4.5 points versus the reported consumption rate. We are now shipping to consumption and that smoother supply chain is helping deliver the manufacturing savings we anticipated as we begin Q2. Our plant throughput improved significantly in the quarter and we are well on our way to delivering the gross margin progress we promised. The sum total of these 3 issues is a reduction to growth rate in the quarter of about 13 points from what has been reported in IRI. Two of those items, the pet specialty pipeline fill in the year ago period and the supply chain smoothing, are temporary phenomena and won’t be repeated in the coming quarters. From this point forward, we believe you will see much more direct flow-through of the reported IRI growth to our reported top line growth, with a notable exception of the non-measured pet specialty channel. We began to see the direct flow-through late in Q1 and it has continued into Q2. Separately, we also made good progress on our gross margin improvement objectives. Our reported gross margin improved on a sequential basis by a little more than 1 point from 44.7% in Q4 to 45.8% in Q1, and our adjusted gross margin was flat versus Q4 at 49.9%, despite the inventory adjustments we took which cost us 40 basis points. Q1 adjusted EBITDA was $1.9 million, down $600,000 versus a year ago due to our planned increased investment in marketing. Finally, we added 422 new stores in the quarter, taking us up to 17,031. As we told you in March, we don’t expect to see an acceleration in our rate of new store growth until early 2018, when our new selling approach begins to yield results. In addition, we’re pleased to have announced the appointment of a new sales leader, Eddie Young, in early April. Eddie worked with me at Sunny D for 11 years, and I believe his strategic selling skills, in conjunction with the strong team we have, will result in a more rapid rate in new store growth. In summary, we are on track and where we thought we would be to start the year. We are seeing strong consumption growth in response to the advertising investment and our costs are coming down. And we expect to accelerate that progress in the coming quarters. With that overview, I would now like to turn the call over to Dick.

Thank you, Billy, and good afternoon, everyone. I’ll review our first quarter 2017 financial results. For the first quarter, net sales increased 9.7% to $34.5 million over the prior year first quarter. Our fresh offering grew 12.2% during the same period. This growth resulted from both distribution and velocity gains, including a 10.4% year-over-year increase in Freshpet Fridges. Gross profit for the quarter was $15.8 million compared to $14.9 million during the same period last year. Gross margin was 45.8% for the first quarter of 2017 compared to 47.3% in the first quarter last year. Adjusted gross margin was 49.9% compared to 50.2% in the prior year period, which excludes depreciation and nonrecurring costs associated with our new plant start-up. Adjusted SG&A expense for the first quarter of 2017 was 51.5% of net compared to 49.4% in the first quarter of 2016, excluding stock-based compensation expenses as well as a true-up of leadership transition expenses in the first quarter of 2017. The percentage increase was due to the increase in media spend in the quarter as part of our Feed the Growth Plan. Looking ahead, we expect SG&A to decrease, excluding any increase in TV and digital advertising 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 $1.9 million for the first quarter of 2017, a decrease of $600,000 from the prior year first quarter. The decrease is primarily due to the increased marketing spend for Feed the Growth Plan. Focusing on our balance sheet, on March 31, 2017, the company had cash and cash equivalents of $2 billion, compared to $3.9 million at December 31, 2016. The decrease in cash was primarily due to the paydown of $1.3 million of our credit line during the first quarter of 2017 and the purchase of additional Freshpet Fridges during that quarter. At March 31, 2017, we had $5.8 million outstanding, with $30 million remaining from our credit line. For each quarter of 2015, 2016 and 2017, we have generated positive cash flow from operations and expect this trend to continue in 2017. As Billy mentioned and noted in today’s press release, we are reiterating our 2017 annual guidance. We expect to exceed net sales of $153 million, to exceed adjusted EBITDA of $16 million and to have distribution in over 18,200 store locations. From a seasonality perspective, we expect our net sales growth to be more weighted to the second half of the year as we realize full benefit from our increased media spend, along with increased distribution. We expect adjusted EBITDA to more heavily weigh toward the fourth quarter when our expenditures lighten considerably due to the timing of our planned media program, which we will front load to gain the maximum learning quickly. As a reminder, our adjusted EBITDA represents EBITDA plus loss on disposal of equipment, new plant start-up expenses, share-based compensation, launch expenses, leadership transition expense, secondary costs and warrant expense. We see strong growth for our products across our distribution network. And we will continue to maintain a strong balance sheet and liquidity to beat that demand. That concludes our financial overview. Operator?

Ladies and gentlemen at this time, we will be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Bill Chappell with SunTrust Robinson Humphrey. Please state your question.

Thanks, good afternoon.

Oh there.

Hey, Bill.

I guess first question, just kind of understanding the multichannel of the Nielsen’s, looking forward, I mean would you expect – are we fully kind of caught up where it would more match your sales going forward? And then also, when I look at the pet specialty channel, I know you’ve said your consumption’s better than the category. But overall, what we’ve heard is the pet specialty category has been pretty weak. Are you seeing any signs of improvement there? And will that be more of a drag on numbers versus kind of the Nielsen’s we look at, going forward?

Thanks, Bill. Obviously, this is an important question as we look at the results we had. And we feel very good about where we are. I think as everybody knows, the fundamental premise of the marketing plan we put in place is that we would increase the advertising and we’d see an accelerating growth rate. So what you saw in the first quarter is, and what we told you back in March, that in the first quarter, you’d see a little bit of a delay between the consumption of shipments, you’d see the impact of baked and you’d see some streamlining that we had. The good news is that we did see the acceleration in the consumption. And so if you start early in the quarter, I’ll give you a little bit more perspective, what I told you – what I said on the call was that our IRI measured consumption in multi-outlet in the first quarter was up 23%. If you break that down into the 4-week periods as we were going through the quarter, it was – the first 4 weeks was up 79%, then it was up 23.3%, then it was up 25.5%. And in the period that extends beyond the end of the quarter through April 16, it’s up 26.8%. So we feel very good that the advertising is delivering the accelerating growth rate that we had talked about and that we were shooting for. But to reconcile that, then, with what we delivered in terms of the growth, the 10% growth. The 3 major offsetting factors were, first, the pet specialty, as you acknowledged. We had some significant pipeline for both the new product and some distributors in the year ago. So that was down 10% versus a year ago on a revenue basis. But the important part is that we feel like we exceeded the rate of growth of the category and we saw an accelerating growth rate. And to your questions specifically, what we saw is at the end of the quarter, we were starting to run with low-single digit growth rates and that’s continued into April. So at this point, we’re feeling good about the trend line and, at this point, it’s significantly less of a drag on the overall growth rate. The second one was the impact on baked – of baked. Obviously, it’s not our prime focus, and so that was a 1 point drag. And the third part was the inventory or the trade supply chain smoothing, where we took $1.6 million out-of-trade inventory in the quarter and that hit us for about 4.5 points. So now you – to your question about where we are going forward, so we have the accelerating growth rate. Now we’re showing numbers in the, call it, 26%, 27% growth rate over the last 4 weeks. And we have those 2 phenomena in the first quarter that will not repeat. So the supply chain smoothing of 4.5 points and the pet specialty drag from the new product launches in the distributor part, which was a 7 point drag. So what we end up with is, if you start doing the math, we’re going to run much closer to what the IRI multi-outlet reported growth rate is going forward. Or at least, that’s what we’re seeing so far heading into Q2. And we feel pretty good about where we are. Baked will continue to be a small and increasingly insignificant impact on the growth rate, and so it’ll be much closer to what you’re seeing in the IRI. So I think that the key piece for us is we got done what we wanted to get done in the first quarter. The supply chain is smooth, it’s helping us on our production and on our gross margin. We feel good about having put the issues that we needed to put behind us. And the advertising is working as we had intended it to work, and the growth rate is accelerated and it’s now running at a very, very good level. Does that address the question?

Yes, definitely. Definitely, that helps. And one piece of that maybe that would help to understand my other question. Gross margin, and maybe even – kind of, gross margin for fridge was down, and I didn’t think you were doing a whole lot more trade promotion. I think most of your support was more on advertising and marketing. So was there something going on there? Or was that $1.7 million in kind of taking back inventory reflected in that?

No. In the quarter, we – as I said in our last call, we finished last year at 49.6%, so we said we would grow about 1.5% by year-end to 51.5%. The quarter’s going to take a full depreciation in 2017. And since the revenues didn’t increase as much as – the depreciation stayed flat, it had a negative impact on margin. But the good news is the margin from year-end at 49.6%, adjusted gross margin increased to 49.9%. So we made up 0.30% – 0.3% towards our 1.5% goal by year-end.

Got it. And then just the last one for me. In terms of new product launches in specialty kind of cat, is that, Billy, as much of a focus as we started this year? Or is it really just trying to focus advertising and marketing on the core?

As we said, fresh refrigerated is what we define as the core. We have our strongest offering right now on the dog food side, and so that’s where we’re seeing the biggest benefit. But we clearly believe we have a right to play in the cat segment. And we’re actually seeing pretty nice growth on it, but it’s a very small part of our business today and it’s also a key development focus for us going forward. But right now, the advertising is running. It’s having its biggest impact on the dog food side, which is the dominant part of our business.

Got it. I’ll turn it over. Thanks so much.

Thank you.

Thank you. And our next question comes from the line of Rupesh Parikh with Oppenheimer. Please state your question.

Yes, thanks for taking my question. So I wanted to ask a little bit more about your media programs. Is there a way to give us more color in terms of the phasing of the media spend throughout the year?

Certainly. So if – hey Rupesh, it’s Scott. So if you kind of look at the phasing, so Q1 and Q2 will be our heaviest periods in media spend. Then there’ll be about a 20% decrease in Q3 and then in Q4, it’ll go down to a very low level, which is pretty typical kind of phasing for us. This year, we’re going to spend a lot more in Q2 than we have in prior Q2s. Q1 is actually a similar level and we got really strong performance in Q1 versus prior year.

Okay, great. And then from your advertising efforts so far, what channels do you think have benefited most from a velocity perspective?

So typically, when we look at the response from the advertising, basically, think of it as amplifying the way a channel’s going. So if you think about mass, mass is doing fairly well from a category standpoint and we’ve been able to like multiply that and really see terrific growth in mass, very good growth in grocery. But we’ve actually started to see nice response even in pet specialty. But it’s not at the level that we’re seeing in kind of – the more kind of mainstream channels, grocery and mass.

Okay. My last question, the IRI data, what percent of your sales does that cover?

Right about 80%...

79% was what we – I think is right. 79%, something like that.

Okay.

More than 80% range, yes.

80%, okay.

Yes.

Okay, that’s helpful. Thank you.

Yes, thank you.

Thank you. Our next question comes from the line of Robert Moskow with Credit Suisse. Please state your question.

Yes. Hi guys, this is Matt Sussis on for Rob. So our question was, I know last quarter you guys had said gross margin expansion could happen in the back half of the year. The visibility there could be clouded if there’s some incremental staffing needs just to keep up with the demand. It looks like the demand is pretty good, so do you anticipate higher levels of staffing? And if so, what kind of margin impact would that have?

It’s a really good question. I’ll take a first shot at it and we’ll have Dick finish the financial part of it. But obviously, it’s something that we’re going to watch because, as we’re seeing, the very good demand is helpful. But we’re also seeing very good improvements in our throughput in the plant. And so as we head throughout the year, we’re going to drive the demand and drive it as well as we can but also improve the throughput. So our throughput in the first quarter was up – total throughput was up 14% and our efficiency level was up 7%. And so we feel pretty good about the performance of our manufacturing operation. And as they perform better, it allows us to push back the date that we need to hire any incremental crewing. But if we continue at a very high level of growth, there will be a point somewhere down the road, whether it’s late this year or early into next year where we will add additional crewing. And Dick can quantify what the impact of that is going to be.

Yes, we’re looking at about potentially 20 employees for an additional shift. And that number would be, on an annualized basis, it’s somewhere around $800,000 to $900,000. But what Billy said, basically, tells it all. If in fact, our velocity continues to move as it has been through the IRI data that we’ve seen in the last 3 months and it continues throughout the year like that, then we will be potentially facing those issues in the fourth quarter of 2017.

Great. That’s very helpful. Thanks, guys.

Thank you. Our next question comes from the line of Brian Holland with Consumer Edge Research. Please state your question.

Thanks, good afternoon. So you may have addressed this in your prepared remarks, so forgive me if I’m being repetitive here, but what did category sales look like in the pet superstore channel, just kind of high level? Are those year-over-year declines stable, improving, worsening? I’ll let that lead into another question here.

So everything from what we can see in the channel is that it is – we’re still seeing some decline but the decline is definitely slowing. And I’m talking at a category level first. For us, we’re actually seeing consumption at basically very flat and we anticipate in the back of the year that we’ll kind of come up into the early single digits. As Billy was mentioning, we’re starting to kind of get a hint of that and see that now. So we think those declines are slowing from everything we’ve been able to see, Brian.

Thanks, Scott. So what does – we’re thinking about the channel shift that’s going on at a high level in the category, and we’ve got PetSmart’s recent acquisition of Chewy, maybe giving you some indication of the state of brick-and-mortars in the category. But how does that channel shift and folks moving online and PetSmart making a big bet here with Chewy, how do we think about the impact of all this with respect to your relationship with retailers? Does that make you guys more valuable to the retailers because you’re only available – you don’t sell online at this point? Can you help us think about that and how maybe you think the retailers are thinking about it?

So it’s a good question. We do think about that a lot. We’re really focused on watching the changes in the category. I mean, you guys see them across all the categories that you’re covering. They’re pretty pronounced in pet food. We’re hearing numbers where kind of mid-single digits, kind of 5%, 6%, 7% are now online. For us, it’s a pretty interesting situation. I mean, for us, 90 – call it, 93% of sales are still done in brick-and-mortar, and we’re only halfway there from a penetration standpoint in brick-and-mortar. So we see a tremendous road in front of us just on the brick-and-mortar piece. But in addition to that, any place that someone is doing online and refrigerated distribution, we’re definitely doing testing and we’re being really diligent about making sure we’re kind of most up-to-date and on – kind of involved with any tests that are going on. So that’s AmazonFresh, that’s Jet, any place that anyone is doing click and pick, too from a brick-and-mortar standpoint. So we’re making sure we’re kind of evaluating every opportunity out there. But we think that there’s a lot of opportunity in brick-and-mortar, especially with click and pick. And we also know that as there’s lower traffic and less frequency in brick-and-mortar, we do become a more important part of the category for retailers, as you mentioned.

Thanks. That’s helpful. Last question from me. Thinking about the accelerated consumption, any learnings on how your media spend is working to bring in new pet parents? Any reads with respect to household penetration growth – I appreciate it’s early, but assuming that it isn’t attracting new parents, what are you hearing from them about their experience at this point? Any color you can give there?

Let me just frame it and then Scott will give you some more context to it. But first of all, one of the things I find most amazing about the advertising campaign that we have and the media investment behind it is how unbelievably reliable and predictable the results are becoming as we’ve kind of gone into 15 months into the year. We put advertising on under the media plan that we’ve got. We looked at the measured consumptions that we’re showing and the predictability of the results is incredibly strong. And so we feel very good about it and it’s running at a level that is meeting or slightly exceeding what we had expected from the campaign. So we feel very, very good about it. We don’t have the ability to measure the household penetration on improvements that we might get over a short period of time, but we get an awful lot of qualitative feedback. But I’ll let Scott give you a little bit more context on that.

Yes, so I think like what Billy was saying, we don’t necessarily have the data in on how the Q1 media has impacted new pet owners. What we have seen historically for the past 4 years in this model is as we advertise, we drive consistently new consumers into the brand and we’ve also been able to increase the buying rate. So we really like those dynamics. And based on the growth that we’re seeing from a consumption standpoint, we anticipate we’re seeing the same impact from the media where new consumers are coming into the brand. And we’ll be able to see on a more frequent basis that panel data throughout this year and how it’s working. But all signs point to that it is working. The thing we are continuing to hear is that people are having great experiences, they’re enjoying the product. We’re getting kind of rave reviews as we typically have gotten in the past from consumers as they come into the brand. So I mean, everything seems to be kind of working as planned. And we like how everything is working in that kind of advertising and driving consumers into the brand model that we’ve seen in the past and – but we like how it’s working today.

And I would go on to add to that, which is – and the retailers are definitely noticing it. When you sit in front of retailers and you’re exceeding the category performance by some reasonably good measure and then in food and mass customers, your numbers are looking like the IRI numbers. Obviously, there’s a lot of variability, but there are customers who are up in the teens and there are customers who are up in the 20s and 30s, and those are really good meetings to have with customers. So customers are definitely noticing.

Thanks. That’s helpful. Thanks a lot.

Thanks, Brian.

Thank you. [Operator Instructions] Our next question comes from the line of Peter Benedict with Robert W. Baird. Please state your question.

Hi guys, two questions. First, just around in-stocks, I mean, how are you guys doing keeping the fridges in stock, when you’ve got the response here? I mean, you had the trade inventory being pulled down, but the sell-through is going higher. So just give us a sense of what’s going on with in-stocks. And then the second question is around – just around the 2Q EBITDA, Scott, you had mentioned a big step-up in marketing in the second quarter, particularly heavy there. Should we expecting 2Q EBITDA dollars to be lower than where they were in the first quarter and then ramp as we get towards the later part of the year? I just want to clarify that. Thank you.

Yes, sure. So I’ll answer the front end of the question. So what we’ve done, when you see – when we’re talking about inventory level, it’s primarily at the warehouse or the distributor level where we’ve taken those up. It really hasn’t been at the retail level. We’re operating within the same band at the retail level, so it shouldn’t be impacting out-of-stock conditions. Even though we’re seeing increased velocity at retail, our out-of-stock level, although it is not where we would like it to be, is similar to where it has been in the past. And there’s a lot of work being put against that in order to kind of improve that situation as much as possible. But the tightening of inventory was at a warehouse or a level. Our main problem is going from the back of the store and into the fridges, it’s not kind of warehouse or distributor level.

Yes, Peter, it’s Dick. Our marketing spend in the second quarter is approximately the same as what it was in the first quarter. So you should see a nice jump in adjusted EBITDA based on revenue growth.

And just to be clear, so when Scott said earlier the gap was bigger because the gap – the spending last year in the second quarter was relatively lower than what it was in the first quarter. So while spending this year in the first quarter and the second quarter is comparable, it’s the year ago that wasn’t what – the second quarter was lower.

Okay, good. That’s helps. Thanks, guys.

Thank you. There are no further questions. That does conclude our question-and-answer session. At this time, I’ll turn it back to Mr. Billy Cyr for closing comments.

Thank you, everybody. As we said at the beginning, we’re very pleased with where we are. We feel like we’ve accomplished quite a bit. And we look forward to reporting the progress that we’re making in the second quarter, but we feel very good about where we are. And thank you for taking the time with us today. Thank you.

This concludes today’s conference. Thank you for your participation. You may disconnect your lines at this time.