Freshpet, Inc. Q3 FY2021 Earnings Call

Good afternoon and welcome to Freshpet's Third 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. A reconciliation of 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 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, it's a summary of the results and guidance that we'll discuss today. Now, I would like to turn the call over to Billy Cyr, Chief Executive Officer.

Thank you, Jeff, and good afternoon, everyone. While it may not be obvious from the results we reported today, Freshpet's consumption growth in the quarter was exactly where we expected it to be when we raised our guidance in August, and would easily support delivering greater than $445 million in net sales this year. However, supply chain challenges that impacted our equipment suppliers will constrain our Q4 capacity, and that is causing us to change our guidance from greater than $445 million to approximately $445 million. Please don't mistake that for reduced demand, because the demand was very strong, and we ended the quarter with significant unfilled orders. But we lost more than a month of production in September and October on the second line at Kitchen South due to delays getting equipment through the ports, so we're not as confident in our ability to produce enough Freshpet to meaningfully exceed $445 million. That second line is up and running now, but we can't make up for the lost time. Thus, we are making the small change in our guidance. That challenge is typical of the environment we're operating in today, so our Q3 results reflect some tough choices that we've had to make. In each case, the choices were driven by our goal of maximizing the long-term value of the Freshpet opportunity, and we were willing to make some short-term sacrifices to accomplish that. We believe that the pet food market has made a significant shift towards fresh, and that it is in our best interest to capture as much of the emerging opportunity as we can and build a large, highly loyal consumer franchise, even if we have to absorb some of the short-term costs and manage through the resulting consequences. This quarter, some of those consequences were more significant than we anticipated and more significant than we budgeted in our guidance. But that does not change how we feel about our focus on maximizing the long-term growth opportunity. Let me highlight a few of those choices and the consequences we felt in Q3. First, while we continue to generate strong net sales growth in the quarter, up 28% versus year ago, we could've generated even more if we had not made the decision to invest in manufacturing upgrades, automation, and much overdue maintenance that will enable us to deliver the quality and supply reliability that we will need to sustain our growth. We estimate that we could've generated up to an additional $10 million of net sales, adding 12 points to our growth rate, if we had not made those long-term investments in our manufacturing capability. To be clear, we fully anticipated making those choices when we gave our guidance at the end of Q2 and still believe we're on track to deliver approximately $445 million for the year. Additionally, we optimized our production planning schedule to restore customer service, resulting in longer production runs and higher inventory levels. We believed it was very important for our customers to do everything we could to restore customer service as fast as we could. The result of that was an increase in our inventory on hand at the end of Q3 of about $8 million in net sales value, with the equivalent of 6 days, versus where we ended Q2. That has helped us significantly improve our customer service in October, but it also reduced our net sales potential in Q3 by about $8 million. There was no lack of demand that drove that inventory build. In fact, it is quite the opposite. We did it because we had such strong demand that our fill rates in September were in the low to mid-50s and they needed to improve. Fortunately, it is working and we now have fill rates in the mid-60s and our fill rate on our rolls is in the 90s. Judging by the consensus net sales estimate for the quarter, we could have made those choices clearer. We fully anticipated the loss of production from the maintenance and upgrades and called those out in our presentations in Q2 earnings call. However, our estimate of the timing of when we would restore our inventory levels turned out to be incorrect, as we built that inventory in Q3, rather than in Q4. Hopefully the materials we're providing today give you more clarity on our capacity going forward. Similarly, we made a tough choice that negatively impacted our adjusted EBITDA in the quarter. We delayed taking a price increase until we restored customer service to acceptable levels. We believed that our cost increases would be manageable until then, but that turned out to not be the case. Our costs escalated much more quickly than we had anticipated and more quickly than we had budgeted in our guidance. Simply put, we absorbed rapidly escalating costs without any pricing relief, which we estimate cost us about $5 million of adjusted EBITDA in the quarter, versus the results we would have had if we'd taken pricing on the same timing as our competitors. As a result, adjusted EBITDA was $14.6 million, down 14% versus year ago, instead of being up 15% versus year ago. In total, choices like that made this a rocky quarter. But even if we had anticipated the incremental costs more accurately, I think it is fair to say that we would have made the same choices, i.e. investing for long-term growth rather than optimizing the near term. Each of our decisions were part of our determined effort to build a solid, long-term foundation for growth, so that we could achieve our mission of changing the way people feed their pets forever. To provide greater clarity on the results, Heather and I will focus the bulk of our comments on addressing the two most likely questions on many of your minds related to the results we are posting today. First, why wasn't the net sales growth greater than 28%? And second, what drove the reduction in adjusted gross margin in the quarter, and when will it improve? I'll address the first question and Heather will address the second.

Thank you, Billy. As Billy indicated, I am going to address the second question that is most likely on your mind about our adjusted gross margin performance in the quarter. And also attempt to help you see through all the noise to understand our underlying performance. Additionally, I'll update you on our formal outlook for the year including our revised adjusted EBITDA expectations. Our Q3 adjusted EBITDA performance came in at $14.6 million, 14% below the year ago. This underperformance was driven by significant cost inflation and a continuation of the temporary operating inefficiencies that we described the last quarter. Adjusted gross margin came in well below our expectation at 44%, down from the 46.1% we generated in Q2 and 49.3% in the year ago. In our case, and given the fluidity of the operating environment, we think it is most useful to look at variances on a sequential basis relative to Q2. Those variances are as follows: 1. 140 basis points of ingredient inflation and higher costs at our Kitchen South partner. We saw inflation on virtually every cost line that was not under fixed price contracts. And even in those cases where the price is fixed, we had numerous instances where we had to go to alternate, higher-cost suppliers to get access to the necessary materials to keep our lines running at times, due to sporadic shortages of some key ingredients and materials. Our planned price increase is designed to offset much of these costs. 2. 120 basis points of higher labor and overhead costs, as a result of our wage increase plan and some investments in staffing ahead of demand. These costs will be offset by increased productivity as our Freshpet Academy training plan takes hold. 3. 35 basis points of higher cost between the gross sales line and net sales line due to customer fines for short shipments. These should go away when we are finally caught up on trade inventory. These increases were partially offset by improved mix and improvement in operating performance related to quality and yields that delivered a total of 85 basis points of improvement. Media investment in the quarter was 6.3% of net sales, which is roughly in line with the year-ago performance. 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. Our net cash used in operations was $3.3 million in the year-to-date period ended Q3. Our cash from operations was impacted by accounts receivable and inventory working capital needs due to strong net sales growth and production in the last month of the quarter. We spent $103.2 million in CapEx in the quarter. Turning to our guidance for 2021, as Billy indicated, we're now expecting full-year net sales of approximately $445 million, which is dependent on available capacity and our success with starting up the second line at Kitchen South. October shipments met our expectations, but we will need the added capacity from the second-line at Kitchen South and the successful restart of the bag blind in Kitchens 1.0 to continue the growth in November and December. This guidance implies that 2021 will be our strongest year of growth since we went public in 2014, and also implies that our Q4 growth rate will be approximately 60%. We are lowering our adjusted EBITDA guidance to reflect a rapid increase in inflation, the lost net sales from the delay in starting line 2 at Kitchen South, and the delay in our ERP conversion, which would have offset some of the freight issues. We believe we are well-positioned to continue accelerating our growth, but we have significant work to do to get Freshpet positioned for a strong 2022.

Over the course of the year we've had to really think about how we're producing and the cadence of what we're producing. There was a period where we had a lot more inventory moving towards some of our pet specialty customers, and that really caused significant acceleration in growth. On the other hand, we've seen a lot of pricing activity in the market, which has moved some consumers in different formats. We are now at a point where, as Billy mentioned, we are getting to a more steady-state from our operations and we're able to fulfill a more even set of our customers across the board.

Hey guys, thank you. First question, not to be shorter-term focused here, but on the fourth quarter, you've laid out a lot of information there. Are we to read that you think the $135 million number in revenue, is that an everything goes right number, or does that have some cushion baked into it?

That is a good question. We laid out the assumptions in the prepared comments. It assumes normal conditions, what we can normally expect. If there are some hiccups in either the weather or supply interruptions that are beyond what we're currently seeing, or if there was a bigger-than-expected delay in the start-up or the ramp-up of the line at Kitchen South, those would be differences versus what we've laid out as guidance. But we've been successfully producing on that second-line at Kitchen South for 2 weeks now, but it's operating, I call it, I would say 20% of its expected run rate.

I got two questions, both regarding gross margin. Just trying to understand for the quarter, but you knew that you weren't going to take price until the fourth quarter and late fourth quarter, 3 or 4 months ago. I would assume you were going to lock in a fair amount of your commodity costs, at least three months out. So, what's the difference that happened within the quarter that surprised you?

The hedging really for us comes around chicken. We did actually see much more accelerated inflation and bigger inflation than anticipated in a number of key areas on animal proteins outside of chicken. We had to tap into some secondary suppliers where we were facing material shortage. The suppliers are facing the same labor issues that everyone is facing. And so there were some instances where we had to go to a higher-cost alternative supplier to ensure that we had the materials to support production. We had anticipated inflation for sure, but it was just a lot bigger.

Thanks. Just a follow-on on the pricing question. Was that a completely proactive move by you or a delay, or did you get pushback from customers?

This is something we did proactively. We have not been in a good spot with fill rates. When you're running at 40%, 50%, and even to the 60% fill rates with your customers, it's really not a discussion that you really want to put forward a price increase. Understandably, everyone wants us to move on those quickly, but it's not really the right time to be doing it. We made that decision strategically, both from a customer and consumer standpoint.

It sounds like profitability under pressure is going to stay that way for a while, at least be lower than what you're initially anticipating. I'm guessing that you're going to burn through your cash even faster than what we thought. Is this changing at all how you're thinking about funding the ongoing CapEx?

It's not, Jason, and when we look at it's a pretty near-term issue that we're facing. We feel we've included a sort of a progression of the initiative that drives the margin improvement in the deck. And when you look at Q1 2022, there's a number of initiatives that really start to take shape to turn that profitability around. So we're pretty confident that it's temporary in nature, and this will not impact the cash flow expectations that we have.

Just to add, we were a little bit hamstrung because we had to delay taking our pricing until we got our house in order on the shipments. We're now in a much better position to keep the gap between any inflation we see and the price increase at a more reasonable level.

Thanks, guys. I thought 3 months ago that you had expected an exit rate in your consumption to be 35% or higher. And I think you're saying it's now 30%. But I would have thought that with your velocity good, your fill rates improving, you've got the big advertising. I would've thought you'd been able to keep the 35% and higher.

The 35 that was out there was predicated on a timeframe that has changed. It reflects how we anticipated consumption, which is intended to be across the year, as opposed to specifically as we move toward the back half. We continue to feel good about our position overall for where consumption growth will be headed.

You mentioned that beyond the short-term noise related to inflation, you have a lot of initiatives underway to stabilize margins. As you look into next year, do you expect the range of outcomes to narrow, or that it remains as wide as what we've seen during 2021?

Consumption is going to match much closer what you're going to see as our reported sales. So to an extent, that variability will be gone. We think we're well positioned at the end of this year to see consumption start to reflect in our sales effectively.

In 2022, the tailwind for improvement starts to outweigh the headwinds as we know them today. The short-term noise is largely from inflation ahead of pricing, which will sort itself out next year, as we're able to introduce needed pricing.

To finish, I’d like to end with a quote. Quote comes from Maurice Maeterlinck, who was a Nobel Prize winner in literature in 1911, from his book Our Friend the Dog. 'We're alone, absolutely alone on this chance planet. And amid all the forms of life that surround us, not one, excepting the dog has made an alliance with us.' To which I would add, feed them Freshpet and they will call it even. Thank you everyone for your interest and attention.

Thank you. This concludes today's conference call. You may disconnect your lines at this time.