Greetings, and welcome to Freshpet Second Quarter 2021 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 this conference over to your host, Mr. Jeff Sonnek at ICR. Thank you, sir. You may begin your presentation.

Thank you. Good afternoon, and welcome to Freshpet's second quarter 2021 earnings call and webcast. On today's call are Billy Cyr, Chief Executive Officer; and Heather Pomerantz, Chief Financial Officer. Scott Morris, Chief Operating 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 cause actual results to differ materially from those described in these forward-looking statements. Please refer to the company's annual report on Form 10-K filed with the SEC 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. Please note that on today's call, management will refer to certain non-GAAP financial measures such as EBITDA and adjusted EBITDA, among others. 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 how management defines such non-GAAP measures, reconciliation of the non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP, and limitations associated with such non-GAAP measures. Finally, the company has produced a supplemental presentation that contains many of the key metrics that will be discussed on this call. That presentation can be found on the company's investor website. Management's commentary will not specifically walk through the presentation on the call, rather, is a summary of the results and guidance they will discuss today. Now, I'd like to turn the call over to Billy Cyr, Chief Executive Officer.

Thank you, Jeff, and good afternoon everyone. I want to start by giving you the punch line upfront. Our net sales continue to grow strongly, up 36% in the quarter, so we are raising our net sales guidance for the year. We are now projecting that we will end the year with greater than $445 million in net sales, resulting in the growth rate of 40% for the year and a second half growth rate of 44%. We are not, however, raising our adjusted EBITDA guidance for the year as we will use the incremental contribution produced by the higher net sales to offset some inflation and temporary operating inefficiencies we've experienced. We've announced that we will take pricing to cover those incremental costs later this year, but it won't have much impact until next year. We believe this is a balanced and reasonable approach to creating the greatest long-term value for our shareholders. We are able to raise our net sales guidance because we've been very successful at ramping up our production, producing 44% more pounds in the quarter than we did a year ago. This enabled us to generate 36% more in net sales than the year ago quarter, while also beginning to restore our in-house inventory, adding approximately $5 million of net sales value of finished product inventory to our quarter end inventory versus where we began the quarter. In the challenging labor market in which we are operating, that is a significant achievement for our manufacturing and HR teams. And as you will hear in a few minutes, we are taking an even more aggressive approach to our labor strategy, with a goal of creating a strong stable workforce with a distinctive career offering for our employees that will enable them to build more skills, add more value and share the benefits of that added value. Our strong production performance is enabling us to refill the trade inventory that we had drawn down during the back half of 2020 and satisfy our customers and consumers with much better in-stock conditions, but we are still not done refilling the trade inventory. Frankly, the depth of the trade inventory hole we had dug during the back half of 2020 was deeper than we had expected. And our efforts were compounded by additional obstacles downstream from our manufacturing operations in the third-party warehouse and logistics network we use. We and our logistics partners have moved quickly to resolve those issues, but in today's tight labor market, the changes they are making will take a bit of time to fully resolve the issues. Despite all those challenges, most consumers can find a wide variety of Freshpet items in most stores at this point, but we still have work to do on filling out the complete assortment of SKUs. We are on our way, however, and our strong production performance is enabling us to rebuild our internal inventories, so that we can better service our customers. As we look forward, we will post sizable gains in net sales each quarter for the balance of the year. We anticipate that Q3 and Q4 reported growth will be in excess of the consumption growth rate as consumers will be able to find the items they're looking for more readily than they did a year ago. And we have a much heavier marketing investment plan for the back half of this year. That will allow us to deliver net sales growth in excess of 40% during the back half of the year and also set us up for a fast start next year. Our capacity expansion plans to support that growth are on track. We are now running the bag line in Kitchens 2.0 24/7, and we'll take the rolls line in that facility to 24/7 in August. We will be moving staffing from Kitchens 1.0 to Kitchens 2.0 for the ramp-up of the rolls line as the higher throughput on the lines in Kitchens 2.0 makes it a better use of our staffing than to have them work in Kitchens 1.0. In September, we'll be starting up our second line at Kitchen South with a two-shift operation. And in January, we'll start up a third line at Kitchen South. That line will also be our first test of the new cooking technology that, if successful, could allow us to produce twice as much product in a significantly smaller footprint. If that plays out the way we expect it to, it will form the foundation for Ennis phase 2 and for the second building at Kitchen South. Finally, our construction project in Ennis, Texas remains on track and we anticipate starting up our first line there in Q2 of 2022. We hope to be under roof next month, which is an important milestone as it will substantially mitigate weather risk through the completion of the project. It has been a very rainy first half of the year in Ennis, but our team has still managed to get quite a bit done. Additionally, we’ve already begun hiring team members for the Ennis facility and are quite pleased with our ability to attract the talent we need. The first 10 Ennis employees arrived in Bethlehem in late June to begin training on our lines and we’ll spend several months here getting operating experience. We have at least two more waves of employees who will arrive in Bethlehem in the coming months. By the time we start up the Ennis Kitchen, we expect to have approximately 50 experienced employees to lead the startup between those who choose to transfer from PA to Texas, and those who did several months of training in PA; that will greatly reduce our startup risk. We expect to bring on all three lines in Ennis by the end of 2022, and we’ll have our first line in Kitchen South Building 2 ready to go in Q1 of 2023. In total, we’ll be starting up at least one new line per quarter until Q4 of 2023. That will be eight consecutive quarters with a new line. We’ll make a decision on the construction of the second phase of Ennis sometime in the next six to nine months, but have already done some site preparation work there, so that we are ready once the decision is made of when to build it, and what technology we will install there. We believe there’s ample demand to support this planned capacity expansion, despite our out-of-stocks and delayed start to marketing this year. We still grew household penetration by 19% in the second quarter and the buying rate grew at a very high rate of 12%. As we have said many times, there is strong underlying growth in the buying rate for Freshpet when it is not being diluted by so many new users. Because of our delayed start to the marketing this year and the out-of-stocks, the household penetration growth was below our long-term growth rate in the quarter, but that simply exposed the underlying strength in the buying rate. We expect household penetration gains to reaccelerate in the coming months, as we ramp up our marketing investment. The consumption growth was broad-based; it was particularly strong in pet specialty, where it was up 57%. Our e-commerce business grew strongly again this quarter of 46% versus a very strong quarter a year ago, and accounting for 5.6% of our total sales in the quarter. The launch on Chewy.com occurred in early July, so that is not reflected in these numbers. It is still too early to make any meaningful comments on the impact that Chewy might have on our business; we are encouraged by the potential. Store count grew by 265 in the quarter, and we remain on track for our projected 1,000 store increase this year. We also saw meaningful increases in second fridges and upgrades despite our supply limitations and have now exceeded our guidance for the year in both categories. Second fridges grew by 510 stores to 3,108, and we upgraded 324 more stores and have now completed 3,003 upgrades cumulatively since we started the program. We are also anticipating significant increases in stores and second fridges next year, based on our increased supply and rapid growth. Our international business grew 48% in the quarter with strong growth in both the U.K. and Canada and has real momentum. Clearly the Freshpet model is working outside the U.S. I want to briefly comment on the cost environment and Heather will provide more color on it in her comments. Overall, we are seeing broad-scale inflation. That is no different than what you’re hearing in reports from other CPG companies. Some of the increased costs are clearly permanent and others may be more cyclical; in either case they will have an impact on our profitability this year and that is why we are not raising our adjusted EBITDA in line with our net sales growth. Last week, we announced to our customers that we’d be taking price increases late this year. Those increases are designed to cover the inflation that we’re seeing today and that we expect to see when our fixed-price contracts end later this year; it is also intended to cover the significant increase in labor costs we are seeing in the market. Our price increases will be very noticeable to consumers, because we don’t do any merchandising and thus we can’t reduce that. And we believe that downsizing our packages will be disruptive to consumers who expect a bag or roll to feed their pet for a set number of days. As such, we are being very thoughtful about the price increases we are taking, considering the strategic role of each item in our line, the underlying profitability and the anticipated cost increases we are seeing. We have a successful track record of doing this before and are comfortable doing it again. I also want to comment on one important aspect of the inflation we are seeing: labor costs. Many of our suppliers are having to pay higher costs for their labor and are passing those costs on to us under the terms of our agreements with them. We also raised our wage rates earlier this year in line with our normal annual practice. But in light of the environment we are operating in, it is clearly not enough. So, we will be raising wages a second time later this year. In doing that, we are mindful of the competitive market for labor and seek to be competitive with other employers. But our new wage program is driven by a different philosophy. We are driven by the idea that our dedicated team members deserve to have the opportunity to earn a wage that will enable them to support their families comfortably while also providing them with long-term career growth opportunities. But it must also deliver a good return for Freshpet. We are not seeking the minimum wage we can pay to get the job done. We want to create a win-win for our team members and our shareholders. That is why we treat our team members as owners and partners with us in the development of the Freshpet business. That is the people part of our Pets, People and Planet philosophy. The key to creating that win-win is for us to invest in the training and skill development of our team members, enabling them to add greater value to our business and thus justifying the higher wages that we pay. While many employers and much of the public communication is focused on the entry-level wage, our focus is on the wage we pay to those employees who are contributing at a higher level. The heavily advertised and promoted wage rates are only what you pay to get someone into your lobby for an interview. If that is where our employee’s career and wage progress ends, we will have failed and they will leave. Our goal is to quickly advance their skills and ability to contribute so that we can provide them with a much higher wage. In fact, our typical production employee will see their hourly wage go up by about $3 per hour within the first six months as they progress through our Freshpet Academy training program and up by another $3.50 per hour within nine months after that. At that level, the typical employee who has a working spouse and up to three kids at home will be earning a wage that comfortably supports their family and significantly more than the advertised wage rates you see from many other employers. We believe that approach delivers a significantly better return for Freshpet. A highly skilled worker is dramatically more productive than an entry-level employee, justifying both the investment in their training and the wages we pay them. We also know that it is not enough to pay good wages and have good benefits. We have to treat our employees well every day; those of you who have been to our Freshpet Kitchens have seen many of the things we do to make working in a cold, wet environment more comfortable. We also grant stock to every employee each year after they've been with us for at least one year that drives the ownership mindset we seek to create. All of this is not easy to accomplish, particularly in the current environment: challenges with childcare, perceived health risks, government stimulus, and an overall competitive environment for entry-level talent is particularly challenging for a company that is growing as fast as we are. We constantly need to hire and train more new employees, and the kind of work we do is not for everyone. So we've invested heavily in our recruiting team and in our training department over the past year, and we'll continue to do more. And we are starting early with our recruiting and training of the team who will start up our facility in Ennis. In total, we believe this is the right approach for Freshpet and will differentiate us as an employer. Finally, we will be releasing our inaugural sustainability report in about one week. We are a young company, but sustainability has been embedded in our culture since our founding. What we haven't done in the past is document our progress nor set explicit targets for our efforts. We just did what seemed like the right thing for Pets, People and Planet. We realized that our investors are expecting more from us and our sustainability report is designed to address that interest. Now, let me turn it over to Heather for a more detailed look at our results.

Thank you, Billy, and good afternoon, everyone. As Billy indicated, net sales for Q2 of 2021 were $108.6 million, up 36% versus year ago. Actual Nielsen Mega-Channel consumption was up 37% versus the depressed year-ago period, which was the post-COVID trough. The year-ago period also included significant trade inventory build behind the Q1 2020 COVID surge. So the base year net sales were significantly in excess of consumption. We did the same thing this year, refilling about $8 million of trade inventory thanks to the very strong production performance. We also built our own inventory a bit during the quarter, which has helped us improve customer service on some lower-volume SKUs that are produced less frequently and where our service had been particularly poor. The reconciliation of the Nielsen consumption to this quarter's net sales can be found in the accompanying presentation on our investor relations website. The growth in the quarter continued to be led by strong performance in the pet specialty channel with Nielsen-measured big box pet specialty consumption up 57% in the quarter. Our e-commerce business also performed well, growing 46% in the quarter, and now accounts for 5.6% of sales. As Billy indicated, that does not include any sales through Chewy.com as that service did not begin until July. Additionally, our international business grew 48% in the quarter, and we continue to see strong momentum in those markets behind the advertising investments we have been making. Adjusted EBITDA for Q2 was $10.9 million, down 2.9% versus the year ago. The underperformance on adjusted EBITDA traces to both inflation and some temporary inefficiencies that we have described previously, largely in freight. Freight costs were 11% of net sales for the second quarter versus 7.8% in the year ago. A portion of this is due to freight inflation, but a larger portion is due to the system issue that we spoke to in the first quarter, which prevents us from being able to consolidate loads when we are shipping less than 100% of a customer's order. That issue is created by both our relatively low inventory, and also by the inability of our current system to allocate inventory to shipment prior to scheduling the transportation. I have included a chart in the accompanying presentation to remind you of the impact this has on our costs. Both increasing our available inventory and implementing our new ERP system will eliminate this issue. The available inventory will gradually improve during Q3 and the new system will be implemented in Q4. The freight inflation portion will be covered via other realized efficiencies as we scale and via pricing. It is also important to note that in July, we opened our new Dallas DC. We are shipping a small quantity of product from Bethlehem to the Dallas DC to do the necessary testing and preparation for the opening of Ennis next year. We're only shipping to a very small number of customers in nearby markets during this test phase, but longer term that DC will not only enable us to have lower freight costs in a large part of the U.S., but it will provide some insulation from the labor and weather issues we have experienced in our Pennsylvania DC. Again, there won't be near-term benefits from this, but I want you to appreciate our foresight to improve our logistics capabilities as we plan to gain significant efficiencies going forward. The other cost issues came in cost of goods sold where our gross margin was negatively impacted by inflation, mainly due to beef and corrugate and some of the temporary operating inefficiencies we had as we scaled up production. As we add shifts, there was a learning curve for our team that results in lower shippable production per hour of operation until we get up to speed. This includes higher labor costs and excess disposals of product. We added significant production in the quarter and are still adding production hours, so we expect a portion of this issue to continue, but it becomes a smaller portion of our total operation as we scale. Adjusted gross margin in the quarter was 46.1%, down from 49.1% in the year-ago quarter for these reasons. As we look forward, we expect to see more inflation as suppliers pass on their higher labor costs, and as we increase wages again to ensure we are able to adequately staff our operations. Our announced price increase will cover those costs; however, the impact will not be felt until next year. Media investment in the quarter was slightly above our long-term rate at 12.9% of net sales, in line with a year ago. This year's media was skewed towards the back half of the quarter, so we did not get the full benefit of the investment in the quarter. Excluding the higher freight and lower media costs in the quarter, adjusted SG&A was down 200 basis points versus a year ago, giving us the confidence that our long-term roadmap towards 1,000 basis points of SG&A leverage by 2025, excluding media spend, is on track. We incurred $700,000 in COVID-related expenses in the quarter and then added those backs. We expect to complete our COVID add-backs in Q3 as we roll back our COVID incentives at the beginning of July, and vaccines are broadly available. Our net cash from operations was $2.9 million in the year-to-date period ended Q2. Our cash from operations was impacted by accounts receivable and inventory working capital needs due to the strong net sales growth and production in the last month of the quarter. Our cash on hand at the end of the quarter was $280 million. We spent $68.3 million in CapEx in the quarter. The Ennis facility is entering some of its highest investment quarters as all the site preparation is complete. Foundations have been poured and steel has been going up for four months now. You can see a picture of the current state of the Ennis construction in our supplemental presentation. Additionally, the second line at Kitchen South is on track to produce product by the end of Q3. And the third line there will come online at the beginning of 2022. We're also taking advantage of the incremental capacity that is coming online to make some upgrades in our existing Kitchens 1.0 and expect to have that work completed by the end of the year. That work will improve quality and reduce some of our labor costs on one of the existing lines. To accomplish that, we have delayed our ERP implementation by one month to November 1. This will allow us to synchronize the shutdown of the Kitchen to both install new equipment and transition our systems at the same time, reducing the total downtime for our operations. Turning to our guidance for 2021, as Billy indicated, we are raising our net sales guidance by $15 million to an updated target of greater than $445 million to reflect the strong underlying trends in the business. This guidance implies that 2021 will be our strongest year of growth since we went public in 2014. And also implies that our back half growth will be in excess of 44% setting us up with considerable momentum as we transition into 2022. The growth during the back half of this year will be in excess of the Nielsen-measured consumption growth as a year ago included a significant drawdown of trade inventory due to COVID-related production shortfall. We do not expect to have those issues this year. The second half growth will accelerate as we move towards the end of the year, with Q4 growth and net sales greater than Q3 behind increased production capacity, strong Q4 marketing and a soft year-ago comparison. We are not raising the adjusted EBITDA guidance due to the inflationary pressures, and temporary operating inefficiencies we discussed on this call. Once we have increased pricing in place to address those issues at the end of this year, we expect to once again see the leverage we get from scale show up in accelerating adjusted EBITDA margins. In particular, as we look to the back half, please take into account the following. In Q3, we expect Nielsen Mega-Channel consumption growth to slow until early September and then accelerate due to increased supply, driving better in-store conditions and higher media investment than in a year ago. We expect gross margins to decline versus a year ago as inflation and temporary operating inefficiencies exceed the underlying process improvements we are gaining from Kitchens 2.0 and our increased pricing will not meaningfully impact this year. We will continue to experience higher freight costs, due to our depleted inventory level for most of Q3. This will diminish our leverage gains in adjusted SG&A excluding media this year, but we expect those increased costs to start declining beginning in November. We will have a large advertising investment plan for Q3 and Q4 as a match for the increased production capacity we have created. In closing, our guidance for 2021 calls for net sales greater than $445 million, up 40% versus year ago, and an unchanged adjusted EBITDA of greater than $61 million, up 30% versus year ago. We believe we are well positioned to continue accelerating our growth. We now have production capacity to support approximately $600 million in run rate sales and are adding one new production line per quarter for the next eight quarters with a balance sheet to support the capacity additions, a proven business model that can drive increased household penetration and a product that drives increased buying rates. More than 25,000 Freshpet Fridges across multiple classes of trade and in three countries with a reliable service network that supports them, plus a strong presence with a leading player in the pet food e-commerce space. Significant scale in the pet category and category-leading growth that encourages our customers to put more fridges in more stores, and to upgrade to larger and second fridges. And a deep innovation pipeline with the team and resources to further accelerate our growth. We believe that positions us to win as the Freshpet food segment becomes a sizable portion of the growing pet food category. That will also enable us to accelerate our growth towards our 2025 goals of 11 million households, $1.25 billion in net sales and a 25% adjusted EBITDA margin. That concludes our overview. We will now be glad to take your questions. Operator?

(Operator instructions.) At this time, we’ll be conducting a question-and-answer session. (Operator instructions.) Our first question comes from the line of Rupesh Parikh with Oppenheimer. You may proceed with your question.

Good afternoon and thanks for taking my question. So, I guess, Billy, Heather, just starting out on the pricing front. At this point, any sense of whether there’s any retailer resistance to the price increases you guys anticipate taking? And then secondly, how do you think your projected price increases compare to maybe some of the other pet companies out there?

We’ll let Scott take that one.

Hi, Rupesh. So we sent out a letter at the end of last week. We carefully went over this with our sales team. We had some conversations with a handful of customers even right as we were developing the price increase. We also looked around at what we’re seeing in the market. We have not heard resistance. From our understanding a lot of people are taking pricing at this point. So I think it’s something that a lot of people anticipate and expected. The thing I want to say about the way we did it is we pushed it off as far as we possibly could. We want to take a consumer-centric approach like we do to every single thing we do. We want to make sure that everyone wins in every single thing we do too. So we wanted to really avoid any pricing impact until our availability and our inventory issues were better and the increase would be less visible to consumers. So we really pushed it off as far as we possibly could. And again, we wanted to think about what is the best way to do this for the consumer, for our customers, and for Freshpet. It's a pretty wide array in the pricing meaning there were some items that will move maybe not at all and there were some items that will move significantly. And we’ve done this several times before. And I think at this point we really understand the best practice in how to do this, how to minimize the impact and how to implement it, where we’ll realize the greatest benefit and the least impact possible.

Okay, great. And then maybe just one follow-up question. Just on out-of-stocks for retail, I’m just curious the latest thinking in terms of when you guys think the out-of-stocks will be at a level that you guys are happy with.

Rupesh, you will see in the deck that we published, it shows the TDPs, which while it’s not the best measure of in-stocks is a reasonable measure. And the TDP data that’s in there shows that the last measure was at like 7.78. If you take our ACD that we have today, and you multiply it by the average number of SKUs we had in distribution at our peak last summer, we’d have to be at like 8.0 to 8.5 to be at the same place. And you can see the line, the slope of the line is moving up at a fairly consistent rate. So I’d expect you could take a look at that and make your own projection. The thing that’s tough is the tail end is always the hardest part to get when you’re getting into smaller SKUs that are only in specific channels. Those are always going to be the toughest parts of it, but it will happen sometime in this quarter.

Great. Thank you. I’ll pass it along.

Our next question comes from the line of Bill Chappell with Truist Securities. You may proceed with your question.

Thanks. Good afternoon.

Hello, Bill.

Hi, Billy and Scott. I’m just going to follow up on Rupesh’s question. I don’t fully understand why not be more aggressive with pricing? All your competitors are stepping up pricing. Every CPG company is passing on pricing. Do you have a potential where the price gaps go away with some of the premium dry dog food players? And there hasn’t been any real elasticity? So I understand protecting the consumer and being good to consumers and all that. But why not—this is a window that’s open—why not be more aggressive right now?

So, Bill, as you know, we have very, very aggressive penetration growth goals. And that is really fundamental to us achieving our objectives in the next several years. So the single best thing that you can make sure you’re doing—and again I’m looking across the portfolio—there are items we will not touch because they’re the most price sensitive, and there are some items where we have the opportunity to take significant price. We will be aggressive on those items, but over time what we want to do is build a really strong consumer franchise with many consumers coming into our brand and portfolio. We want to make sure that there are items with features and benefits that people are comfortable and willing to pay for. And we want to go over time from a business of know-how and capital investments early on to a business of scale and a really large consumer portfolio. We feel that we’re going to—our letter will be the most aggressive price increase we’ve taken potentially ever across the entire line, but it will not be—for our goal is not to take every single dollar we could get. Our goal is to make sure we get what we need and to keep us as available as possible for as many consumers as possible.

Yes. Bill, let me just add to that that I don’t think we’ve disclosed yet what the magnitude of the price increases are. So in terms of your question about, are we being aggressive enough, there’s two sides. One is the size of it and the second is the timing. On the size part we haven’t disclosed that number. The second part is timing. Many of our customers require a 90-day advance notice on a price increase. And so practically speaking, you won't see it until 90 days down the road. We also disclosed that we’re doing an ERP conversion on November 1st, which always can create some disruptions in the business. So we wanted to get that behind us before we got in a position where we were doing the pricing. But the reality is the price increases— we’ll get the full benefit of the price increases in next year.

And just to be clear, you don’t see nearing a price ceiling at this point?

We don’t see nearing a price ceiling, no.

No, not at all.

And then just one other question to you Heather to help. Has there been a meaningful change in terms of the Ennis or even Kitchens I/O pause to completion or labor or potential that can add—construction costs have skyrocketed over the past few months, but also with labor and just trying to find labor, have your calculations changed meaningfully over the past few months?

No change, Bill, to our plans. The team was very proactive in terms of being able to secure materials ahead; had good foresight there. So no risk in terms of Ennis phase 1 timeline at all with respect to materials or construction. And in terms of labor same thing. Actually, the labor market in Ennis is a little bit better than what we see in Pennsylvania. And so, as they start thinking ahead about having the right labor in place for the commissioning— as you heard Billy talk about in our comments, we’re well ahead already hiring staff to start training. So, in good shape there as well.

Yes. And Bill, the biggest piece on labor's change is the second wage increase that we’re taking in our facilities here in Bethlehem, which will be effective on 9/1. We did one in May. We’re doing a second one here. That’s the big cost increase that we’re seeing.

Got it. Thanks for the color. Thank you.

Our next question comes from the line of Mark Astrachan with Stifel. You may proceed with your question.

Thanks and good afternoon everyone. I have a couple questions. One just for clarification: anything in the guidance to greater than $445 million that is related to inventory fills that would be different than what you were expecting last quarter? I’m trying to figure out how to think about apples-to-apples sales growth. So any change there in terms of what’s embedded? And second, maybe a broader question: you’ve had some time to reflect on out-of-stocks at this point. Obviously, still not completely resolved, but more than it’s been. Any impact on the business as best you can tell from a retailer perspective, from a consumer perspective? One of the things I’ve heard from some concerned folks is, are we seeing any impact on demand because scanner data is slowing? Obviously the comparisons are what they are, but anything you can do to discuss that would be helpful.

Let me take the first part and then I’ll ask Scott to talk about the impact on customers. As I said in the scripted comments at the beginning, the size of the trade inventory hole has turned out to be larger than what we thought. And while we don’t have a precise number that we are putting in there versus what we’ve been saying before, I would suspect that the number that you’re seeing is probably at least $5 million bigger than what we had previously outlined. So when we gave our prior guidance we did reflect on that. But the reality is that the slope of the line that we’re seeing on the Nielsen data is pretty much right on where we thought it would be. In fact, we have a chart in the deck that kind of shows you where that’s falling at this point. So to people who have been talking about slowing growth, I remind them that I’ve been telling them that this was what it would look like for quite some time just because of what happened a year ago and the odd dynamics of that period, but the line is falling exactly where we thought it would be and that’s why we feel very comfortable raising guidance. The trade inventory hole is a little bit larger. From a consumer perspective, you’ll also see that the household penetration gain slowed in the quarter versus what our long-term run rate is. We do think that out-of-stocks played a significant role in that. We're now about a year of consumers struggling to find the item they wanted. So, clearly, we’re not getting the conversion from the advertising to household penetration because of it, but it also revealed again that when you aren’t diluting your household penetration gains with significant numbers of new users the buying rate goes through the roof. So we had the strongest buying rate growth we’ve had in the time I’ve been here. So I think at the end of the day, we have seen this before that when you do have shortages like this, the penetration gains bounce back and so we’re not concerned by it. The mix of buying rate and penetration will probably swing back to penetration beginning in the fourth quarter of this year and continuing throughout next year. I’ll ask Scott to talk about the customer impact of the out-of-stocks. Scott?

The customers are obviously as frustrated as we are by the shortages. And at this point we have communicated very aggressively with them about our plans. We expect that they are all waiting to see improvements in our inventory position before they start putting in more fridges. But they know this is the segment to be in, and they know this is where the category is going.

Great. Thank you.

Our next question comes from the line of Ken Goldman with JPMorgan. You may proceed with your question.

Hi. Thank you. Two from me. Heather, did you mention, and perhaps I missed it, how much trade inventory you're modeling in the back half of the year and what the timing of that might be between the two quarters?

No, we touched on the Q2 refill being $8 million. We didn't touch on the full magnitude of the number for the back half because we don't yet know the full magnitude. But we do anticipate some continued trade refills in the back half.

Okay. But in terms of modeling, are you conservative or aggressive in the numbers you put in? I'm trying to get a sense because you did raise your guidance. How much of that was due to pipeline fill?

When we gave the guidance at greater than $445 million, we had a pretty good handle on where the consumption line was headed. And we also had a sense for how much trade refill happened in Q2 and what we think will happen in Q3. We expect trade refill to be skewed more to Q3 than Q4 because we're still refilling as we speak and we expect it to be largely done by the end of Q3. At the same time, we also said Q4 will be bigger than Q3 because of the heavier marketing investment we have this year and the available supply since we'll be bringing on a second line in Kitchen South in September in addition to capacity already online. So when we gave the guidance, we were comfortable with the guide being the sum of those elements and we'll be in excess of $445 million.

Okay. Thank you. And then quickly, you've raised your outlook for sales and for capacity in the back half of the year. Is it fair to say these factors are unrelated? I'm assuming so because your second half shipments will still be well above theoretical capacity. I just wanted to make sure this is more demand and pull-driven and not push.

Yes, without a doubt it's not driven by a push. It's being driven by our efforts to secure the maximum supply. We've been frustrated by our ability to get caught up and our customers have reason to be frustrated as well. This update was about what we actually think those pieces of equipment can get and what our staffing will get. The staffing environment is dynamic and we've found ways to move and attract staffing that give us higher confidence in our ability to produce the revenues we included in our guidance. Kitchens 2 is turning out to be more productive than we had expected; the capacity on that operation is remarkably good.

And to extend that a tiny bit further, capacity has been and will probably be the single biggest limiter that we have for a very long period of time.

Understood. Thank you.

Our next question comes from the line of Peter Benedict with Baird. You may proceed with your question.

All right guys. Thanks. First, on the revenue plan increase for this year, did the addition of Chewy play a role there, or was Chewy always in the initial guidance?

We always had it in there.

Okay. Understood. And then on wages, can you give us a sense for how much wages have gone up versus 2020 for this year?

I’ll talk in terms of hourly wages. I don't want to go into specifics of the total at this point. Our regular wage increase in May was a typical increase, about 3%. We realized that was not going to get us where we needed to be. So the increase we’re taking in September is much more sizable than that. It varies by level in the organization, but a headline number would be a 20% increase.

Peter, another way to think about that is we’re going back to principles on how we operate and think about the business. We believe this is a significant investment in our company because we want the best quality and the most efficiency. Growth requires us to get more out of our lines and to retain people. If you had high turnover, you keep restarting training and that strains the rest of the team. So we're trying to create a different approach and really invest in the vision for where we're going.

That makes sense. Last question: among the households being added, Millennials and Gen Z, what topics are they gravitating to differently than legacy customers and how does that influence your innovation plans?

That's an important question. More pets were acquired last year than in many prior years, with the biggest group acquiring pets being Millennials and Gen Z. That group is willing to spend more on pet products and are more thoughtful about product choices. We over-index with Millennials and Gen Z and think we're a key piece of how pet foods are shaped into the future. We're taking a brand called Nature's Fresh, which had been in the natural channel, and positioning it to win with Millennial and Gen Z: gap-rated meats, carbon-neutral credentials and more focused packaging and communication. Also, we're launching a product called Spring & Sprout that is plant-based and addresses both ethics and environmental concerns around proteins. It ships in the next couple weeks. We're excited about it and think it's an important addition to the portfolio focused on younger consumers.

Okay, great. Thanks so much for that.

Our next question comes from the line of Steph Wissink with Jefferies. You may proceed with your question.

Thank you. Good afternoon, everyone. Two questions. Heather, can you help us think through the stair-step of how much revenue each new line could add as we think about the next six to eight quarters?

Yes. There's a chart in the company presentation that shows the continued ramp. By the end of this year, adding one additional line in Kitchen South brings installed revenue capacity to about $760 million. The additional line in Kitchen South coming online in Q1 will add about $50 million of revenue capacity. Ennis starts to ramp in Q2 and each Ennis line coming on will add capacity; Ennis totals about $400 million by the end of 2022. Kitchen South Building 2 plans to install three lines over the course of 2023 with revenue potential of about $300 million. There are variables: new technology we're testing could impact the revenue potential for Kitchen South Phase 2 and Ennis Phase 2 depending on outcomes.

That's helpful. On pricing: decompose labor inflation versus shipping inefficiencies. Are you taking price to cover both, and once inefficiencies roll off, will you see margin benefit or do you expect pricing to just cover ongoing shipping inefficiencies?

There are two elements of inefficiencies: one impacts gross margin (temporary operating inefficiencies as we ramp new lines) and one impacts logistics costs in SG&A. The production inefficiencies from ramping Plant 2—learning curves and training—should self-resolve by the end of this year. The freight inefficiency where our systems don’t allow allocation of inventory to orders before scheduling transport is caused by low fill rates and system limitations. That will improve as inventory improves and it will be resolved by our new ERP implementation in November. Our pricing plans are focused on covering expected inflation into next year. The big variable will be commodity pricing, particularly chicken, when we lock pricing at the end of this year.

To add: we are not pricing for temporary inefficiencies that will go away. We are pricing for inflation we expect to be persistent—particularly labor-related inflation, both in our facilities and in suppliers' labor costs, which we are already seeing. We expect to realize operational efficiency gains over time from scale, Kitchens 2.0, and logistics improvements which will help margins as pricing takes effect next year.

Very helpful. Thank you.

Our next question comes from the line of Jon Andersen with William Blair. You may proceed with your question.

Hi. Excuse me, good afternoon, everybody.

Hello there.

My first question: how will Chewy accelerate your e-commerce business and where do you think e-commerce goes as a percentage of sales over the next couple years? Where will the biggest benefit be—household acquisition, buy-rate enhancer, or combination?

Jon, we think Chewy makes a lot of sense for both companies. Over time, we expect it to serve consumers who want convenience and a consistent cadence, which can expand buying rate over time. It’s early—launch was a few weeks ago—so it’s too soon to quantify impacts. Research suggests it can both open up penetration and increase buying rate. We’ve structured product offering and pricing to be channel-appropriate and to try to ensure everyone wins. Different channels bring different benefits; we’re developing a portfolio to meet the needs of different consumers and customers.

Okay. Regarding stores and second fridges: you mentioned expecting more next year with better supply and in-store merchandising. Can you add color on that? You were up low to mid-single digits in store count in the first half—do you see acceleration in 2022?

Keep in mind the vast majority of our growth comes from penetration driven by marketing. Store footprint is important; wider availability makes marketing more effective. Second coolers are highly productive, but we've needed to keep them full. Our customers have been cautious adding coolers while supply was constrained. Looking ahead, as we have more product next year and continue to invest in advertising, we expect to see a good year in store count and second coolers, although we’re not providing specific numbers today.

Thanks so much.

Our next question comes from the line of Robert Moskow with Credit Suisse. You may proceed with your question.

Scott, I’m glad that you’ve devised a win-win system for customers. I had a question on Slide 17 where you provide fill rates going back. It looks like it doesn’t get much past 65%. What was your fill rate in the quarter and is there something intrinsic making it difficult to keep fridges full given multiple steps to get product into them?

Rob, that slide was used last quarter to demonstrate the correlation between inventory and fill rates; it’s not the most recent data. Historically we operated fill rates in the 90% plus for quite a long time until COVID. There’s nothing intrinsic about the business model that prevents full trucks and full fridges. With the new ERP we’ll be able to allocate orders to inventory and get to full trucks. Also, higher velocity stores have better fridge conditions because stores have more incentive to keep them stocked. Low-volume situations are harder to keep full, but as we grow velocity and importance in the store, the fridges look better.

What do those dots represent—are they quarterly or monthly?

They show the correlation of fill rate with inventory levels; it’s the relationship, not a time-series. The chart on the right shows the correlation where cost per pound goes down as fill rate improves. The points represent instances rather than a continuous time-series.

Okay. On ERP transition in November, how much inventory do you need to build up to give you cushion during the transition? Inventory is still not where you want it to be.

When we do the conversion, we'll have to shut down operations for a couple of days to implement the system, do testing and training. We're taking advantage of that downtime to upgrade some equipment on one of our lines. Ideally you'd want a position where you could continue to ship orders during that time with a high fill rate. We think full inventory on our business is somewhere between four and five weeks of inventory because of the range of brands and SKUs across the portfolio. Today, depending on the day you're looking, we probably have about two to two-and-a-half weeks of inventory. But we are producing well in excess of consumption every week and are building both our internal and trade inventories.

And Rob, we’ve always had a lot going on. The team has experience scaling rapidly. We brought in people with experience and are focused on execution.

Okay. Thank you.

Our final question comes from the line of Ryan Bell with Consumer Edge Research. You may proceed with your question.

Hi. Regarding household dynamics, you mentioned a slowing in household penetration and a higher buy rate. Is the primary driver that increased buy rate is coming from more long-term users and fewer new buyers coming in, which would dilute buy rate, or is there something else where new users are also buying at higher rates?

When you aren’t diluting with many new users, the buying rate of existing buyers goes up. If next year we post significant penetration increases, you'd expect buying rate to moderate. There's also a longer-term phenomenon where each cohort entering the franchise in recent years has started at a higher level of purchasing than the prior cohort—they buy higher-priced items, more frequently. We also see some consumer hoarding due to scarcity, which can temporarily increase buying rates for those who find product. That’s a small effect but real.

Helpful. About the specialty channel: do you expect it to continue delivering outsized growth? And regarding the Chewy relationship, have you found anything in terms of how it's impacting your existing e-commerce user base?

We expect pet specialty to continue strong growth. There’s a secular trend with Millennials and Gen Z driving natural and premium purchases, and we've also added many second coolers in specialty which helps assortment. The Chewy partnership is very early, so we won't comment specifically on dynamics between customers, but we think there's a lot of potential.

Last one: on freight cost impact—how much of the increase is due to the system issue versus general inflation?

Freight as a percent of net sales was 11% for the quarter versus 7.8% last year. We estimate about 100 basis points of the increase in the first half was freight inflation and the balance was due to the fill-rate and system issues. Depending on the quarter, the fill-rate/system inefficiency has an impact of somewhere between 150 to 200 basis points.

Thanks. That’s very helpful. That was it for me.

Ladies and gentlemen, we have reached the end of today’s question and answer session. I would like to turn this call back over to Mr. Billy Cyr for closing remarks.

Thank you. I’m going to close with a quote from Anne Tyler, the author of Accidental Tourist: 'Ever consider what our dogs must think of us. I mean, here we come back from the grocery store with the most amazing haul—chicken, pork, half a cow. They must think we’re the greatest hunters on earth.' And I would add to that: include Freshpet and they’ll think you are a god. Thanks, everybody, for your interest and your attention.

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