Freshpet, Inc. Q2 FY2022 Earnings Call

Greetings, and welcome to Freshpet’s Second Quarter 2022 Earnings Call and Webcast. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Jeff Sonnek, Investor Relations at ICR. Thank you. You may begin.

Thank you. Good afternoon, and welcome to Freshpet’s Second Quarter 2022 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 the non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP and the limitations associated with such non-GAAP measures will also be available. 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, but rather it’s a summary of the results and guidance that we’ll discuss today. With that, I’d now like to turn the call over to Billy Cyr, Chief Executive Officer.

Thank you, Jeff, and good afternoon, everyone. The message I would like you to take away from today’s call is that the dual challenges of inflation and economic slowdown, which have resulted in unwelcome volatility in our results, have not derailed our ability to deliver our long-term goals, including significant margin expansion. During this call, you will learn that, first, net sales are strong and growing in line with our expectations, price sensitivity is modest and also in line with our expectations, and household penetration growth has accelerated and is more consistent with our long-term goals. In fact, our net sales growth is outpacing our long-term plan, which only requires a 28% compound annual growth rate to achieve our 2025 goal. Second, adjusted EBITDA was below expectations in the quarter due to media investment timing, inflation, logistical challenges, and the quality issue we had in June. We have already taken the necessary actions to adjust for the critical issues, including announcing a third price increase. However, the cost of the quality issue and the new timing gap on inflation versus our pricing requires us to lower our adjusted EBITDA guidance for the year to $48 million from $55 million. Third, we are updating our CapEx expectations to reflect our current best estimate of the actual timing we will experience with our various capacity addition and fridge expansion projects. Our initial estimates were very conservative and designed to give us significant flexibility. But now that we are more than halfway through the year, we have much greater visibility and expect that we will spend approximately $80 million less this year than the $400 million previously projected. The impact on our available capacity will be minimal and still leave ample room to grow at or above the rates we had projected. Fourth, the underlying health of the business, both its growth potential and the underlying margin structure, remains sound. Despite the litany of new obstacles and our own admitted missteps, we deeply believe that Freshpet remains one of the best growth opportunities in the CPG space, if not the broader consumer sector. We have consistently demonstrated an ability to grow the business at very strong rates and have now done it at higher prices, improving the pricing power of the brand. Importantly, our growth is the result of very solid and sustainable consumer fundamentals, including strong increases in the size of our consumer franchise at steadily increasing buying rates. This combination is only made possible by strong satisfaction and high customer retention. Retailers are responding to that strong consumer interest and now realize that Freshpet is the future of pet food. So they are increasing their placements of Freshpet fridges, and the number of stores with double and triple fridges is expected to grow dramatically in the next year. We already have more than 27,000 fridges in stores, and retailer interest is growing, not shrinking. The strength of our competitive moat goes beyond our retail presence, as we are now building increasingly efficient manufacturing facilities that are unlike any others in the world. Our existing Freshpet Kitchen in Bethlehem is operating at full capacity and producing strong cash flow, and we are about to open an even larger and more efficient facility in Ennis, Texas. We have consistently demonstrated an ability to capture the benefits of increasing scale in our G&A costs, and we aim to demonstrate our ability to deliver consistent gross margins as well, regardless of the operating environment. Finally, with a strong balance sheet, in combination with the cash generation of the business and our credit agreement, we can support our long-term growth ambitions without the need for additional capital. There are very few businesses that can say all that. While the past 2 years have presented some very unusual and difficult challenges, we have worked diligently to ensure that Freshpet can achieve its potential and change the way people nourish their pets forever. For much of that time, we did not have enough capacity to meet demand. We outgrew our ERP system and labor shortages plagued the business regularly, but we’ve solved those problems. Today, we have enough capacity to meet demand, with more coming online soon. The stores are in much better shape with steady improvement in fill rates and better in-stock conditions. We have implemented a new ERP system to enable greater efficiencies, and our proactive Freshpet academy approach to labor has turned a weakness into a strength. It goes without saying that the backdrop we are facing today is very different from what we have experienced over the past several years, making it hard to see and appreciate those accomplishments and the potential of the business. We have replaced a pandemic with inflation, yet we’ve unfortunately kept the supply chain problems that came with the pandemic. And now we are facing a potential recession. We recognize the desire and need to stay aligned with, if not ahead of, the shifting macroeconomic forces. The ramp in inflation and higher interest rates necessitate strengthening our focus on the cash-generating capability of the business while simultaneously delivering the long-term 11 million household prize. While the recent challenges have caused inconsistency in our margin delivery performance, we are in a much stronger position today than we have been over the past 2 years with a more formidable organization that provides greater control and confidence in the long-term opportunity that Freshpet presents. The new capacity plan that we outlined in May provided some early hints of how we might make better use of our cash, including a realignment of where we build various incremental capacity, the use of leases for non-strategic assets, and a focus on more space-efficient technology, but the current environment requires that we go further. There are 3 areas in particular that we need to focus on: capital spending, start-up expenses, and working capital. Each of these is the necessary use of cash to support our rapid growth, but we have significant opportunities to improve our capital efficiency and prove to investors that Freshpet can, at scale and as we scale, generate significant operating cash flow and ultimately, free cash flow. Key to accomplishing that will be to continue strengthening our organizational capability and processes. For example, our new ERP system is operating and supporting our day-to-day operations, but we are not getting full value for its expanded functionality. That has led to inventories that are larger than we need, less efficient use of freight, and higher accounts receivable balances. We’ve put in place a highly focused team designed to capture those benefits as soon as possible. Encouragingly, since the quarter ended, we have implemented a more timely billing process, which will dramatically reduce our accounts receivable by the end of this month. Additionally, we have focused on getting new capacity online as fast as possible, and that has come at a cost. That was necessary because we are so far behind on customer orders, but stores are in much better shape today, thanks to our significant inventory improvements. As a result, we are finally in a position where we could be more prudent with our planned start-up expenses. The same could be said for capital expenses. The intense focus on getting plants built and lines installed quickly often came at the expense of efficiency. We are adding an intense focus on adding capacity in the most efficient manner while maintaining our commitment to speed and quality. Those efforts will not compromise our ability to grow; rather, they will provide added focus on the cost of that growth, ensuring that we get full value for every dollar we spend and that we time our investments to maximize the impact they can have. As part of this renewed focus on capital efficiency, you will see us change how we report adjusted EBITDA. Beginning with Q3, we will no longer add back plant start-up expenses for the new store marketing investment. That will provide greater clarity on our path toward generating positive net income as the business scales further following our planned capacity additions. We will provide updated guidance using this new definition at that time, and we’ll also provide historical data that shows both approaches. This will create a seamless transition from the old measure to the new measure. To be clear, there are no new disclosures, and our transparency will remain intact. This is simply providing greater visibility on the cash usage and generation of the business to meet the shifting needs of the marketplace, while we fully realize this approach will create lumpier adjusted gross margin and EBITDA results. We also believe that it will allow us to demonstrate the emerging profitability of the business with greater clarity and make it easier to compare it to other high-growth businesses. Looking ahead, we are keenly aware that our net sales are running well ahead of the pace needed to deliver our 2025 goal and that the price increases are driving up the buying rate, making that goal much easier to achieve. We intend to revise our long-term goals by year-end to capture the impacts of the price inflation, including any impact on our ability to attract new users, any loss of users due to higher pricing, and the full benefit of higher buying rates. We will also need to adjust for the updated methodology that Nielsen is using to determine household penetration. That new methodology is now in place, and it indicates that we have even more users than we previously reported, about 500,000 more users. The new method also indicates that we’ve been adding users over the past 2 years at a faster rate than Nielsen previously projected, adding an incremental 220,000 users over the past 2 years, with more balanced growth over time. I’ve included a comparison of the old and new data sources in the investor presentation so that you can see those changes. Before I turn the call over to Heather to discuss the Q2 results and our guidance for the year, I also want to make a comment on the planned start-up of the Ennis facility and how we think Freshpet will perform in a recession. We are in the final countdown to lift off in Ennis. We remain on track to start up our roll line there next month and produce saleable products by the end of the month. That will not turn into meaningful shipments until October, but it’s very exciting to reach this milestone for such a pivotal project. We have begun sending the highly trained production staff back to Texas from Pennsylvania, and they are ready to go. All the roll line equipment is installed, and we are going through our start-up checklist. Additionally, much of the equipment for the first guideline has already been installed, and we remain very confident that we will be able to start that line up in Q4. Once that start-up happens, it will unlock significant potential for Freshpet. In addition to the significant increase in production capacity, it is designed to be our most cost-efficient, most sustainable, highest quality facility, with room to grow and support an even larger business. With the first phase of that facility opened next year, we will have more than $1.1 billion in capacity available to us, enough to support almost double the volume we have guided to this year, thus ensuring our ability to continue our rapid growth next year and beyond. We’ve already spent the cash to create most of that capability, and we will finally be able to generate returns on those investments. Turning to the impact of a potential recession on the business. I think it is safe to say that pet food is a category and Freshpet as a brand should perform very well in a recession. History has shown that pet food is one of the most recession-resistant businesses, as consumers are unlikely to stop feeding their pets, and the number of dogs in households has grown consistently through each of the recessions of the past 20 years. While Freshpet was in its infancy during many of those recessions, our track record of growth has been extremely consistent, doubling the business every 3 years since its founding in 2006. Furthermore, as we have studied the household penetration and buying rate data for Freshpet versus the entire pet food category during the recent period of rapid price increases, we’ve seen that the Freshpet user base has been more committed to maintaining the Freshpet habit than the pet food category overall. While this is not the same as weathering a recession, it does speak volumes about the overall loyalty of the Freshpet franchise even under economic duress. That leaves us confident that we will be able to continue our rapid rate of growth even if we experience a recession. There’s also a positive side to a recession. We believe that a short and not very deep recession could better align supply and demand for the various ingredients and equipment we buy, lowering costs, shortening lead times, and improving availability of the materials we depend on. That could lead to greater capital efficiency and better margins. In summary, the underlying health of the business is strong, and we are more focused than ever on ensuring that the business will generate the margins, cash, and profitability that you would expect of a company that is leading and defining the future of pet food. We are navigating through difficult times with the ramp in inflation that the entire industry is facing, but we are engaged, we are reacting, and we are improving. Once we find equilibrium with cost and price, we will deliver the gross margin that we know this business is capable of delivering. In combination with the leverage from scale that we get on our G&A costs, we believe we are on track to deliver our 25% adjusted EBITDA goal by 2025. Now let me turn it over to Heather to take you through the highlights of the quarter.

Thank you, Billy, and good afternoon, everyone. We had strong net sales in the quarter, in line with our guidance, but the adjusted EBITDA was below our expectations. A meaningful portion of this shortfall was the timing of marketing spend and will correct itself by year-end. Some of it was due to the cost of the quality issue we had in the quarter. Some of it was due to some logistical challenges we had in June, which we think we can overcome in the back half of the year. Some of it was due to incremental inflation that exceeded our plan, for which we are taking pricing. Let me take you through each element one piece at a time. Net sales were $146 million in the quarter, up 34.4% versus a year ago. Nielsen-measured consumption in the quarter was up 41%. The difference between Nielsen-measured growth rate and the net sales growth rate is the size of the trade inventory refill that occurred in the year-ago period versus what we did this year. The consumption growth rate consisted of approximately 21% unit growth and 20 points of pricing growth. While we still only have about 4 months of data with full pricing in effect, this balance between pricing growth and unit growth is in line with our expectations and represents very modest price sensitivity compared to other CPG businesses. For perspective, our unit growth of 21% in the quarter can be compared to unit growth in Q4 of 19%, which was prior to the price increases, and 28% in Q1 when we had strong distribution and advertising and the smaller of our two price increases was in effect. You should expect that we will always have price growth due to innovation and consumers moving into our higher-value items over time. So our total Nielsen-measured sales growth should always be a few points higher than our unit growth. Driving the net sales growth was a return to household penetration gains closer to what we would expect over the long haul. Over the past 12 weeks, our household penetration has increased by 19% versus a year ago. As Billy indicated, Nielsen is now reporting that the size of our consumer franchise is larger than we had previously reported, and it is growing more quickly. Our consumer data and the feedback we get from retailers support that. We did see both a downturn in retail foot traffic and household penetration gains in June, when gas prices hit a national average of $5, but we are seeing a strong bounce back as gas prices are dropping again. That did have a modest impact on the net sales in Q2 as consumers seemed to consolidate or defer trips in June, but our shipments in July have been strong, as have consumption and household penetration gains. It is also interesting to note that the seasonal consumption patterns we are seeing this year are in line with those we saw in the pre-pandemic era, with consumption going flat during the summer months due to established seasonal feeding patterns and then growth resuming in late August. We expect to see that again this year. This suggests that consumers have returned to a more normalized pre-pandemic lifestyle. You can see this on the 3-year stacked growth rate chart in the accompanying presentation, which helps smooth the volatility of the last 2 years and compares our performance to the pre-pandemic period. That shows our growth rate by week when compared to 2019 is extremely consistent, reinforcing the strong and steady growth of the Freshpet business. We continue to get strong interest from retailers in placing additional Freshpet fridges. Our focus, and the focus of many retailers, has turned towards multi-fridge placement in the highest volume stores so that we can both expand the assortment and improve holding power. Many retailers have been waiting for us to increase our supply before they replace those fridges. That is now happening, but many retailers are running into either labor issues or budget issues that will prevent some of the more major renovations of their pet food sections that are necessary to accommodate the significant increase in space that they are planning for Freshpet. That will push some of the bigger launches of multi-fridge sets into next year, so we will likely come in light on the number of upgrades and second and third fridges this year, but will overdeliver by quite a bit on net new stores because those installations require less labor and can be managed within existing retailer budgets. Those deferred upgrades and second fridges will likely result in a very strong first half of the year next year. All of this has us feeling very bullish about our prospects at retail over the next 12 months or so. The adjusted EBITDA was $3.9 million in the quarter, below our expectations. Part of this shortfall was timing with the marketing investment in the quarter coming in at almost $24 million. This spending was not incremental to the year; it simply reflected a timing adjustment. We made this investment to help sell through the 12% price increase that went into effect in mid-March, which is when consumers were most sensitive to the price increase. Based on the unit movement and household penetration gains that follow, we are pleased with the strategy and the limited price sensitivity that we encountered. Adjusted gross margin was 42.4% for the quarter and was 42.1% for the year-to-date. This is up sequentially from the 41.9% we generated in Q1, but does not reflect the magnitude of the improvement we had expected our price increase to produce due to our quality issues. However, when you exclude those costs, the adjusted gross margin would have been approximately 43.8% or about 140 basis points higher. The amount of affected products that got into the market and had to be retrieved was very small. But the cost of the product disposals related to the underlying production issue, some additional lab work and testing, and some supplemental processing was much bigger than anticipated. We experienced increased inflation in some input costs, mainly due to labor and energy, as well as transportation cost increases at our suppliers, and expect them to continue for the balance of the year. Further, our cost for diesel and natural gas is well in excess of the cost we estimated when we gave our initial guidance. This is why our third price increase, which will be 2.6% and goes into effect in late September, is designed to protect our margins in the face of those higher costs, and we expect to end the year with much stronger margins and position ourselves with a much more balanced set of costs and pricing as we enter 2023. However, the timing of the increase will create another mismatch between our cost increases and our pricing in the third quarter. In simple terms, the cost increases we have seen since we set our budget are in the range of approximately $10 million to $11 million or about $15 million on an annualized basis, and our price increase will cover less than half of that this year, primarily because it won’t be effective until the beginning of Q4. We promised you that we would plan more conservatively this year, and we did. While we are absorbing some of the incremental costs, we cannot absorb all of them, so we are lowering our adjusted EBITDA guidance to reflect that mismatch. We are encouraged by some emerging cost trends that suggest that inflation in the materials that most impact us may be moderating. This may be the result of the economic slowdown we have been hearing about and an early indication of the potential cost benefits we might get if we have a mild recession. Spot freight rates have declined over the past 3 months, and we have gotten a rate reduction that begins in the third quarter. Diesel costs have dropped significantly since peaking in mid-June. While many of our key ingredients and their key inputs continue to move up, the cost of our proteins has stabilized, and there is some suggestion that they might actually provide some relief next year versus the cost we are paying this year. The underlying cost of the materials used in construction and equipment, such as steel, nickel, zinc, and copper, have also dropped considerably. While none of these declines will help us in the short term, they are positive indications that much of the inflation that has plagued us for the past 18 months may have peaked, allowing us to restore our margins and complete our capacity projects with less pain. I think it is important to be cautious on this because it only takes one Gulf hurricane to drive up energy and diesel costs further or another outbreak of disease to impact the bird block, offsetting the otherwise positive momentum we are seeing. However, the underlying supply and demand characteristics are improving, so I am optimistic that we will finally be able to reap the margin benefits of our price increases, or at least narrow the gap. Our production performance in the quarter was strong, with increasing throughput during the quarter, which puts us in a much better position on retail availability. We achieved the highest number of total distribution points in our history during the quarter and have maintained them. As Billy indicated, labor has become a strength for us. We have successfully increased the talent of our recruits, invested in their training, and are now seeing significant reductions in turnover and much higher productivity. Logistics costs, including warehousing, diesel, and lane rates, drove approximately $2.4 million of incremental cost in the quarter. This was most pronounced in June when diesel soared to $5.81, and we also incurred higher warehousing costs, including those needed to segregate the products affected by the quality issue and the cost of starting up our new warehouse in Dallas. Diesel prices and lane rates had dropped considerably since then, and we should return to more normal logistics costs in Q3. Additionally, our inability to start up our inventory allocation tool prevented us from filling trucks as we had intended. While our natural order fill rate continued to improve, our inability to fill trucks completely cost us about $1 million. We expect to continue improving our fill rate and hope to have our inventory allocation tool turned on later this year, but we will get the bulk of the benefit as our fill rates continue to improve naturally. For perspective, our most recent week fill rate was over 80% and growing. We are continuing to deliver the leverage benefits in SG&A that our plan requires. Year-to-date, our SG&A as a percent of net sales has dropped by 150 basis points, and we believe it will continue to improve as the year goes along. Capital spending in the quarter totaled $39 million. As Billy noted, we are expecting this year’s total CapEx spending to be approximately $320 million instead of the $400 million we previously projected. The delay in the multi-fridge expansion, less maintenance CapEx and both efficiencies and timing adjustments on our larger capacity projects will free up about $80 million in cash. We also expect the same delays to push back some of the CapEx previously planned for next year, so we will not increase next year’s CapEx but will instead push the spending back into 2024 or later. We can do this while still delivering our capacity and fridge expansion plans without the need for additional equity. Operating cash flow used in the first two quarters was $62.4 million, which was driven by inflated receivables and inventory levels, resulting from delays in invoicing and some inventory reporting challenges in our new ERP system. I’m pleased to say that we have worked through those issues since the second quarter ended. We are also addressing the inventory issues, which were caused in part by the need to hold onto a large number of products due to the quality issue, and we expect to see a significant improvement in Q3. That is offset in part by the start-up of our second distribution center in Dallas. We drew $27 million on our borrowing facilities in the quarter. At the end of the quarter, we had gross availability of $272 million on our credit line, subject to various conditions. Looking forward, we continue to believe we are on track for our net sales guidance for the year. Our net sales are up 38% to date. Q2 was our toughest year-on-year comparison, but we feel comfortable that we can achieve our net sales guidance for the year. We are also lowering our adjusted EBITDA guidance to account for the cost of the quality issue and the incremental inflation we are incurring prior to our increased pricing going into effect. Thus, we are lowering our adjusted EBITDA guidance to greater than $48 million from greater than $55 million. In closing, as you have undoubtedly heard from us and others, this is a turbulent time, but the infrastructure and organizational capability we have built and the underlying strength of the Freshpet brand have enabled us to continue our rapid growth, and we are very optimistic about the future. While we continue to experience short-term hiccups, we learn from each of them, and they become less significant, and this makes us stronger as we pursue our long-term goals. We are motivated by our mission to change the way people nourish their pets forever, and we believe we are on track to delivering that goal. That concludes our overview. We will now be glad to take your questions.

Our first question comes from Steph Wissink with Jefferies.

I would like to spend a little bit more time on the EBITDA revision for the year. And maybe Heather and Billy, if you could both talk about this, but how much of the burden occurred already in the second quarter versus what do you expect that timing mismatch to account for in the balance of the year? If I just look at that, I think it’s on Slide 8, that EBITDA bridge, just help us break down what’s already been resolved and what’s still to come? And then also related to the CapEx to settle along the same lines, how much of the deferral has already occurred versus how much is yet to come in terms of the overall revision.

Heather, do you want to take that?

So I’ll start with, of course, the EBITDA guide. So the reduction is approximately $7 million. The quality issue is $2.2 million. So of course, that has already occurred in June. The balance of the change coming from the mismatched inflation versus price, about $1 million of that has occurred in the first half, with the expectation that the balance of that comes in the second half. Steph, can you just state one more time the CapEx question?

Yes. Just the revision lower in CapEx. I’m wondering how much of that has already occurred versus how much is yet to occur. So the CapEx for the quarter, did it come in below, meaning what’s left to be realized is also below? Or is all of the deferral in the revision of the year in the back half?

Got it. Yes. Yes. So about a quarter of it occurred already in the first half, and then the balance is reductions in the second half. The main driver of the second half shift is around the phasing of spend that we’ll have around the innovation kitchen. That’s the biggest driver of the shift in the second half.

Okay. So that innovation kitchen is now going to be a 2023 event?

Most of it. Yes, there’ll be a small spend in the second half, but the majority will be in 2023. That’s correct.

Our next question comes from the line of Peter Benedict with Robert W. Baird.

First question, just can you give us a sense of what we should expect plan start-up costs and the launch expenses could be for the full year? I think there were around $11 million in the first half. What should we think about for the full year? And maybe just a sense for what it should look like next year?

Sure. Peter, first of all, we will provide clear clarity when we issue the revised view for Q3. But for now, the best assumption is that the second half will largely align with the first half, so you can essentially double it. Regarding the Ennis start-up, there will be an increase in costs as we ramp up. However, during the start-up phase, we will stop adding costs largely in Q4. The increased costs will be offset by those that would have entered the cost structure anyway. For next year, there will be less start-up activity. We will be finishing the last line in Phase 1 of Ennis next year, and we will provide a revised timeline for when we plan to start that up. This will be the main start-up for next year, resulting in a much less significant impact since Ennis will be mostly operational, just adding one final line.

Got it. Okay. That’s helpful. Can you share your thoughts on the EBITDA margin and how incremental margins on sales growth will work with this new method? Also, how can we look past the current noise affecting the business? What does your model indicate regarding the incremental margins as we continue to grow sales over the next several years?

Yes, Peter. We mentioned in the prepared remarks that there will still be some variability. For instance, this year we have significant startup costs, like the $20 million from the first half, which greatly affects plant startup. Looking to next year, we expect a substantial improvement in gross margin as operations stabilize. This facility is our most efficient and profitable, and we anticipate a nice benefit. However, the following year will see the startup of projects like the innovation kitchen, which may bring more volatility. We will provide as much clarity and insight as possible as we progress and will remain transparent. The long-term plan and flow-through remain unchanged. The expectations for Ennis, particularly with Phase 1 and Phase II focusing on greater efficiency, will continue to be a vital factor for margin improvement. Additionally, we expect ongoing advantages from SG&A leverage related to logistics and general administration, which should contribute consistently to our flow-through.

Okay. As a follow-up regarding pricing, you've mentioned that some of the cost pressures may be reaching a peak. Assuming that's accurate, how do you perceive pricing in a situation where costs begin to stabilize and decrease? Do you anticipate that prices will remain steady in this category, or do you think there might be a reduction? How are you currently approaching this matter?

Scott, do you want to take that one?

Yes, hi, Peter. We have been carefully considering our pricing strategy as we move forward. This has caused some delays in our actions over the past couple of quarters, where we've taken about 30 to 60 days longer to implement some pricing changes. Our goal is to position ourselves well once everything stabilizes. We expect that many competitors in the dry and wet food categories will utilize substantial promotional budgets to adjust their prices in both the short and long term. Since we do not engage in promotions, we want to be very cautious about how our pricing strategy unfolds and ensure we offer a range of products appealing to over 11 million consumers. This is the mindset we've maintained throughout this process.

Our next question comes from the line of Bill Chappell with Truist.

Billy, Scott, I know you are deeply involved with analytics and customer insights. The main concern I hear is not about your loyal existing customers trading down, as they are committed to their pets' food. The worry is about new customers trading up and how the pace might slow due to higher prices at the super premium level, especially with an impending recession. Are you noticing any slowdown from new consumers, aside from minor fluctuations? Or do you believe your products will remain resilient? You've mentioned growth through previous recessions, but your base was significantly smaller then. Any insights or data you could share would be appreciated.

Yes, Bill, this is a topic we’ve been spending a lot of time thinking about and watching the data very closely. We included in the presentation today a few slides that give you a glimpse of what we’re seeing. We did see a little bit of a slowdown in June when gasoline hit $5, as Heather said in the prepared remarks. But since then, we’ve seen it bounce back up. The number that we saw in the last 12 weeks, the household penetration gains have been up 19% versus a year ago. When we look at it across a variety of demographics, we look at it, small dog households, large dog households, both up, we look at it by generation. We’ve seen virtually all the generations are moving up. The millennials, actually, we’re moving up the most. We’re getting the most traction in that group, and we look at it across income groups. And across income groups, we are not seeing any significant differences in their willingness to buy Freshpet or join the Freshpet franchise. There were little bits and dips in June. I don’t want to gloss over that June was a little bit lumpier than we would like, but it came right back in July. So we’re feeling pretty good about the ability to attract new users to the franchise because the proposition is pretty darn attractive. But that’s what our data is saying so far, and it’s in line with where we’d expect to be or would hope to be.

Okay. And then just kind of a minor question. I guess I’m a little surprised that diesel prices kind of impacted you intra-quarter. I thought you had done some diesel hedges or maybe just educate me on what is hedged and what is not hedged?

We do not hedge diesel, but we have some hedges on natural gas for part of our production facility. However, those will expire by the end of November, presenting a challenge as we approach the end of the year. We currently do not hedge any of our diesel exposure. As our distribution scales up, we should consider it, but so far we have not.

Our next question comes from the line of Anoori Naughton with JP Morgan.

Thanks for the question. A quick clarification and apologies if you said this on the call, but how does your new household penetration target or your metric of $4.9 million compare versus the first quarter of this year? And then my question is, what does the shape of the trajectory look like for Freshpet to get that back on track with its longer-term household penetration goal of 11 million households? I believe the additional plan when you set it out was closer to 7.6% in ‘23, which is still a sizable 50% jump from where you are today. So I guess the cost of the question is, will Freshpet need to spend more than 12% on ad spending for the next couple of years to catch up, so to speak?

Yes. We compared the June data from the old method to the new method, and you can see the difference. I don’t have the new method data for the end of Q1, so it’s hard to say. Overall, there are about 186,000 more users in the new method compared to the old one. Additionally, our growth over the last couple of years has exceeded the old method by 200,000 users. It's interesting that the data indicates our growth rate has been more consistent over the last two years than previously projected, which is also supported by data from Numerator. To address your question about reaching 11 million households, we need to increase household penetration back to the mid-20s, a level we have achieved in the past. In the last 12 weeks, we were at 19%, including a slight dip in June. I expect that as we approach the end of the year, this number will continue to rise into the 20s. Numerator, which uses a larger panel, is already indicating we are approaching the low 20s with their recent data. I feel optimistic that we are moving back toward a growth rate exceeding 20%, and it's crucial that we maintain that momentum.

As the business continues to grow, the significance of the 12% becomes apparent, leading to substantial dollar amounts that enable us to attract more consumers. If we can maintain our customer acquisition cost in a similar range, we should be able to reach that 11 million target quite easily.

Understood. And just to clarify though, you’ve accelerated some of your ad spending into the second quarter. So presumably, there would be very little incremental spending as we move into the back half. So I guess I’m just trying to square how we’ll see your household penetration start to accelerate from here if you’re going to be spending less incremental dollars as we move through the back half.

Yes, it's important to keep in mind the comparison. Last year in this area was relatively weak.

Yes. We have a very healthy Q3 advertising-wise. And then, as Billy was mentioning, we typically have a very soft Q4 in advertising. Look, the big thing is there is a tremendous amount of disruption in the marketplace with whether it’s gas prices, fear of recession, that I think the fear may be as bad as the actual recession itself. We can see consumers stabilizing in their behavior and their traffic into stores. It looks like this next period, our prices are now stable, consumers are kind of calmed down, and we’re going to see them go back into stores with fuller fridges than we’ve ever had, and we anticipate making some progress in this quarter.

Our next question comes from the line of Brian Holland with Cowen and Company.

So if I could ask first about maintaining the net sales guidance. Given prior year track volume compares get tougher in the second half, Pet Specialty appears to be a drag. I appreciate that part of that is comp-driven. But I’m just curious how we get comfortable, because it would seem that one or both of track volume will need to sequentially get better from here, assuming price takes hold, why you get another little bump there in the fourth quarter. But that and/or Pet Specialties got to get better. So can you help us understand the volume path over the balance of the year and next?

I believe we will be in a stable period until the end of August. Due to our media investments, improved stock levels, and strategic placements, I anticipate an increase in consumption as we move into the fourth quarter. Last year was particularly challenging due to a significant warehouse issue that affected July, but we managed to perform well this July. Additionally, in the fourth quarter last year, we faced a parts shortage that hindered our shipping capabilities in late November and December. While we expect strong consumption numbers moving forward, it's important to consider last year’s anomalies, as they suggest we can achieve our guidance for growth in net sales and consumption, which gives us some flexibility.

And then just as a follow-on to that, obviously, trade inventory, I think it was maybe like a 700 bps headwind or whatever it was in the quarter, forgive me for not looking at that slide at this moment. But I’m curious if you can help remind us what that looks like in the second half of the year and what you’re lapping as far as impact there? And then also on the elasticity side, I appreciate the data that you gave us, but you’ve also called out some nice distribution growth in the first half. So I’m wondering how you discern between unit growth that’s sort of apples-to-apples and what the distribution benefit is? Because if you had some distribution benefit in the first half, the logic would be you might have to keep that up to make the math look the same, but maybe you can walk us through that.

Yes. I’m probably going to get lost in some of your questions there. But the best way to neutralize, Brian, what you’re talking about is velocity, measuring the velocity on the business. The velocity on the business has continued to do quite nicely even though we’ve been in this period where we had $5 gas and whatnot. So I don’t know if you’ve seen that. We didn’t include it in the deck this time, but velocity in the business of dollars per point of distribution has been fairly healthy. We think we’ve gotten distribution where we have more distribution coming in the back half of the year, and we’re going to have velocity gains behind the advertising. So I think that all gets us to where we want to get to. I don’t know if that addresses the question or not though.

No, that’s helpful and exactly what I was getting at. I was trying to be confusing, but you got it. Trade inventory was the other one there. Just help us understand what...

Yes, there was trade inventory. There’s a fairly significant amount of trade inventory refill in the year-ago. It was more skewed to the fourth quarter than the third quarter, but even in the end of the fourth quarter we had some drawdown when we had our supply problem. It’s going to be lumpy throughout the back half of the year. So we do need to have consumption in excess of our net sales growth to compensate for it. There’s going to have to be some over-delivery, but it’s not exactly clear how big that number is going to be because the trade inventory needs to grow year-on-year as well as we get more distribution and a bigger business. The customers hold 3 weeks of inventory, and that 3 weeks of inventory is a bigger number on the 35% larger business than it was a year ago. So there will be some trade inventory build that happens this year as well.

Our next question comes from the line of Rupesh Parikh with Oppenheimer.

I wanted to revisit the topic of operating cash flow. Year-to-date, your cash burn has exceeded $60 million, primarily driven by accounts receivable and inventory. I'm interested in your perspective on how you anticipate this cash burn will trend by the end of the year at the operating cash flow level.

Sure. The first point is about receivables, which have been significantly impacted by the challenges from our new ERP system. Our delays in invoicing have hindered our cash collection process. However, as mentioned earlier, we now have a solution that enables us to invoice customers in real-time as shipments occur, similar to what we did before. As we continue to collect past due amounts and invoice clients, we anticipate returning to our usual Days Sales Outstanding of around 25 days based on customer payment terms. Regarding working capital, our finished goods inventory is currently aligned with our goal of maintaining 4 to 5 weeks of inventory on hand, which we had to increase to enhance customer service. We are also holding excess raw materials and packaging inventory, which impacted us by about $5 million in the second quarter. This situation is also related to ERP issues, as we needed to retain extra inventory for planning purposes. We have a dedicated team working to resolve the necessary post-implementation challenges, and we expect improvement soon. Future movements in working capital will primarily be driven by business growth, not by ERP-related issues.

Okay, great. And then maybe just one additional question. Just on the guide. I’m just curious what you guys see now as a bigger risk for the guide for the remainder of the year.

We believe we have identified all the inflation factors that concern us. We're factoring in some of the conservatism we established earlier this year, but we cannot absorb all of it. We have accounted for the inflation we expect to experience, but certain variables like diesel and natural gas pose potential risks since we do not have hedge positions for those. If prices surge unexpectedly, that could present challenges, although they are not overwhelming. Additionally, we continue to focus on avoiding supply interruptions, whether from our suppliers or our own production capabilities. The timely start of our Ennis facility is essential, and we are prepared to launch it. We need that roll line operational to fulfill our sales targets for the year. While we acknowledge there are risks we must manage, they are primarily related to supply and inflation, rather than demand. Scott or Heather, do you have a different perspective on this?

Our next question comes from the line of Mark Astrachan with Stifel.

I wanted to ask about volumes. So they seem a little bit slower than at least I would have thought, inclusive of more ad spend that you said earlier in the second quarter. If we take a look at just the scanner data of the two-year volume CAGR, it has sequentially decelerated, I think each period since, call it, late March, early April. So I guess I’m curious how that has stacked up versus your expectations. You touched on elasticity on the prepared remarks, but I don’t think updated the actual elasticity. So if you could perhaps talk to that? And then how do you think about it if not potentially getting worse with the incremental pricing that you talked about today?

Yes. We expected, I think, as we said in the prepared remarks, to go flat during the summer because it looks like 2019; and that’s why we provided the 3-year stack. You could see from 2017 to 2019, we saw very consistently in the summer, consumption goes flat, whether it’s people on vacation or dogs eating less. But you went flat and then came back up again late August into early September. We expect to see that continue. We did see in June, we saw some softness. As I said, it was about $5 gas, but we also saw it come back in July and had very strong shipments in July. We saw household penetration bouncing back up. So we feel pretty good about the trajectory for the balance of the year. I mean, we’re all in uncharted waters, and we don’t know whether there’s a recession or if the next price increase is going to be something that is the straw that breaks the camel’s back. But the data we included in the deck and data that we have beyond that shows that pricing is pretty stable at this point. The sensitivity we have is about where it’s going to be, which is what you’d expect. After about 4 or 5 months, you’d expect to get to a fairly stable place. So we think we know what it looks like, and we think we know what the trends look like going forward. Our shipments and order rates match up pretty well with the projections and the guidance we’re giving.

Okay. And maybe just sticking with that, thinking about just broader strokes on affordability. So with the new price increase, I think you’ll be up something, call it, high teens versus where you were 12 months ago, I guess that’s roughly consistent with what we’re seeing across the pet food, dog/cat category. But to earlier points about potential for increased promotions coming out of this period of heightened inflation or potentially deflation at some point. You don’t promote; you’re not going to do that. But if others are doing it and they promote back half of it, how do you think about the relative affordability for the product going forward at that point?

Scott, do you want to take that?

Yes. One of the things we were very mindful of, as I briefly mentioned to Peter, is that with the recent price increase, we ensured that we had several items that remained affordable for everyone. We were really careful about this. We approached it with various sizes and different product forms. Regardless of how the situation evolves, those products will remain accessible, and while they have seen some modest price increases, they haven't experienced the largest hikes. Overall, we made a conscious effort to ensure this.

Our next question comes from the line of Robert Moskow with Credit Suisse.

I guess I cover a lot of food companies, and I don’t recall hearing any of them talk about a slowdown in consumption from $5 gas, except for maybe Impulse. So can you be a little more specific as to what type of products within your portfolio felt that impact? Are there some items that are more discretionary in your portfolio. That would make more sense to me than saying that people look at the price of gas and then reduce their volume of consumption for their pets.

Yes, what we observed was a decline in foot traffic, and customers were consolidating their trips. They were shopping less frequently and opting for larger sizes. I believe this was a temporary situation because our business in July saw a rebound. In fact, it appears to be compensating for any downturn that might have occurred in June. I can't pinpoint exactly why this happened, but the data indicates that people are consolidating their trips and purchasing larger quantities during those trips. There was a slight reduction in pantry inventory, which they seem to have replenished in July. Again, I'm not sure about the underlying psychology behind this behavior, but that’s what the data reveals.

Okay. And then maybe one more follow-up. You mentioned that you increased your media spending to support the price increases. Is that meant to benefit the trade, helping them with the price increase, or is it aimed at the consumer? I'm unsure who the media spending is intended to assist in selling through.

It’s to make sure that as you’re seeing your prices rise, you’re making sure that you’re keeping your growth rate intact, right? One of the things that we looked at when we consider growth rate is we’re looking at units, we’re looking at pounds, et cetera, because dollars are a little bit hard to get a handle around right now. We’ve been able to see units stay in the high teens, even in same-store sales, high teens into the early 20s, similar with volume. So if you look at it that way, through this period of taking a net 17% price increase, we’ve been able to keep our overall velocity growth strong. I look at it and say that’s pretty encouraging, especially with what we saw in the category. If you look at units across the category, everyone’s kind of high-fiving across the type-2 category, celebrating that they’re having growth. But if you remove the price increase growth that they have in place, units look pretty bad or volume looks pretty bad for the majority of the category. I think that we’ve come out of this in pretty good shape.

Okay. I don’t know if you’re making me more optimistic or less by saying that the pet food category is getting hurt, but okay, Scott. But here’s the follow-up. Like you’re raising pricing in the back half, so why is this just a pull forward in media? Would you have to do it again in the back half?

We are indeed implementing a price increase of 2.6%. For example, if we're at $5.79, we're going to $5.99 for certain items. This change is significant.

One of the lessons I’ve learned from this experience is that we implemented one modest price increase, followed by a significant price increase, and then another modest one. Consumers seemed to manage smaller price increases better than the much larger second increase, which could lead to sticker shock and cause them to rethink whether they really need the product. In contrast, more frequent but smaller increases seem to be more acceptable. I believe the next increase won't raise many eyebrows, but the second one certainly got their attention.

Our next question comes from the line of Jon Andersen with William Blair.

Yes, thanks for the question. First question is, Billy, I think you referred to providing an update at some point in the future with respect to addressable households and the underlying algorithm of household penetration and buy rate. Were you referring to that as being just kind of a mechanical exercise given the change in approach or methodology by Nielsen or something more fundamental based on price changes, a different kind of consumer behavior, or both?

It’s somewhere in between. I don’t think we’re going to go back and revisit the addressable market, at least we haven’t committed to doing that yet, but we are looking at the driver. For example, as Scott mentioned earlier, what is the customer acquisition cost with our current pricing in the market? Does that change in any appreciable way? What does the buying rate look like once consumers are digesting the pricing we’ve got? Just reconstruct the model that gets us from where we are to the 11 million households and the $1.25 billion in net sales, because as I think I said when I framed it up, we know we’re running at a rate that’s well in excess of what you need to get to the target. The question now is, with the higher pricing and the higher buying rate, what is the composition of that going to look like? Do you make any changes because the CAC is higher or lower, the buying rate is higher or lower, and the households are easier or harder to get? That’s the algorithm we need to put together, and we wanted to see the pricing stabilize before we made that decision.

Okay. So no change to your level of confidence in the $1.25 billion or the 25% EBITDA margin. It’s just kind of maybe the algorithm underneath that is what you’re saying?

Yes. That’s probably the right way to think about it, Jon.

Okay. And then I guess, just a follow-up. I just have a broad question on direct-to-consumer. You didn’t really mention at least in the prepared comments, e-commerce growth this quarter. If you could give us an update on that? And then do you have broader plans for a direct-to-consumer offering? When might we hear about that? If so, I just want to get your perspective on that from a competitive standpoint, too.

We have seen significant growth, particularly in e-commerce, which includes any method where customers can order our product online. A portion of these orders is directly delivered while others are available for click and collect. The figures indicate a 45% to 46% increase, as mentioned in the presentation, and we have numerous materials available for review. We plan to keep collaborating and investing with some retailers who are excelling in this area. We believe that focusing solely on direct-to-consumer is not the right strategy for us; instead, we think it's better to adjust our product offerings and enhance our relationships with existing partners. We have developed a new and unique model that should help us penetrate this segment of the market, and we expect to launch a new product line by the end of this year or in the first quarter.

Our next question comes from the line of Ben Bienvenu with Stephens.

Jim Salera on for Ben. I wanted to circle back to the CapEx guidance reduction. If we look at pushing the investment in the innovation center more into 2023, just given the overall inflation in building materials and things that go into setting up a new facility, does that $80 million add into the CapEx? I would assume that if you shifted some of that goes into the new year, but it looks like the CapEx cadence outside of this year is still the same $300 million, $200 million, $100 million.

So with that innovation center, it literally is we can’t get as much done as we would like to from a timing perspective. We actually think that can work to our advantage. We touched on whether it’s stainless steel, building materials, etc., the amount of strength that we use in our equipment is pretty extraordinary. As we look at planning that out, we may have to put deposits down at similar timing, but we anticipate that as the markets on some of those commodities, stainless steel, for example, or some of the other building materials cool down a little bit, we think there may be advantage in that innovation center. We’re hoping there’s additional savings through that, too.

So to be clear, that’s in the $80 million. Is the assumption that some of those core commodities come down?

The $80 million reflects a combination of timing and some efficiency measures. We initially took a conservative approach, but as we progress, our assumptions regarding timing and actual costs are becoming more realistic. We've also postponed some projects. It's important to understand that there is a cascading effect where one project influences the next. While we presented our capital expenditure plans extending through 2025, some elements will likely shift to 2026. The $80 million represents a total reduction in our projections. Part of this reduction is due to efficiency, some is related to timing, and some projects have been deferred to later years.

The capital spending we have outlined in this revision provides us with ample room to grow and achieve our objectives.

I understand there are many questions about ad spending. Given the strong ad support in the first half of the year, if the economy continues to decline in the latter half, would you be comfortable increasing ad spending to support volumes? Or would you prefer to prioritize margins and accept a drop in volume, waiting for recovery in the first quarter of next year?

I believe we are fully committed to ensuring we continue to achieve growth in our top line. We are confident in our plan. However, there are lead times associated with media commitments that could hinder efficient execution. We are dedicated to meeting the net sales targets we discussed, as well as the EBITDA commitments we made. I want to clarify that we are not looking to compromise profitability. As mentioned during the call, we are concentrating on generating cash and maintaining cash efficiency as we expand. We are also being cautious about the timing and nature of our investments.

There are no further questions in the queue. I’d like to hand the call back over to Mr. Cyr for closing remarks.

Great. Well, thank you very much for your interest and your attention. I’d like to close with a statement in honor of Olivia Newton-John, who passed away earlier today. She said, 'The only weight I left from my dogs,' to which I would add if she fed them Freshpet, they would be lean and live easier.' Rest in Peace. Thank you very much.

Ladies and gentlemen, this does conclude today’s teleconference. Thank you for your participation. You may disconnect your lines at this time and have a wonderful day.