Freshpet, Inc. Q3 FY2022 Earnings Call

Ladies and gentlemen, greetings, and welcome to the Freshpet, Inc. Third Quarter 2022 Earnings Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder this conference is being recorded. It is now my pleasure to introduce your host, Jeff Sonnek from ICR. Please go ahead.

Thank you. Good afternoon and welcome to Freshpet's third quarter 2022 earnings call and webcast. On today's call are Billy Cyr, Chief Executive Officer; and Dick Kassar, Interim 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 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, as previously disclosed during the second quarter call beginning with this third quarter of 2022, the company is no longer adding back planned start-up and launch expenses in this definition of adjusted EBITDA. The company has provided those costs in the table at the end of its press release to assist in your analysis of the results under both methodologies. Additionally, 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 is a summary of the results and guidance they will discuss today. Additionally, we'd ask that your questions remain focused on the performance of the business and the results in the quarter. Management will not discuss or speculate on other topics beyond what is being reported here today. With that, I would like to turn the call over to Billy Cyr, Chief Executive Officer. Billy?

Thank you Jeff, and good afternoon everyone. The message I would like you to take away from today's call is that we had a solid on-plan quarter and that we are taking concrete steps to deliver on the enormous potential of Freshpet by addressing the most critical issues we outlined in our September organization change announcements. Those actions include: one, continuing to drive the strong and consistent top line growth that Freshpet has demonstrated for the past six years. We delivered 41% growth in the latest quarter and are on track for our sixth consecutive year of accelerating growth. We are also well ahead of the pace needed to achieve our 2025 net sales goal of $1.25 billion. Second, executing on our operational improvement plan to drive margin expansion in particular the quality, logistics and commodity cost management issues. I will provide more detail on our actions and progress on those in a few minutes. Third, aligning long-term growth with prudent capital expenditures. Our goal is to build a very large and comfortable cash buffer in order to optimize our liquidity and financial flexibility. We've made good progress on this so far and we are fully confident that we have adequate resources to meet our growth goals with the cash we have on hand, available credit and the cash flow from operations. I will touch on that in more detail in a few minutes as well, but the headline is that we are now projecting that our CapEx spending over the two-year period of 2022, 2023 will be reduced by $100 million versus our last projection with no change to our near-term growth or our 2025 net sales targets. Additionally, I want to highlight that we are rapidly building the organizational capability needed to deliver the results we need. Today, we announced two important additions to our team. First, Todd Cunfer will be joining Freshpet on December 1 as our new CFO. Todd is a proven public company CFO with experience in a high-growth food business. He has been the CFO of Simply Good Foods for the past five years and delivered exceptional performance there. Prior to that, he worked in a wide variety of finance roles at Hershey for more than 20 years. We are thrilled to welcome him to our team. We are also welcoming Dirk Martin to our team as VP of Customer Service and Logistics. Dirk is coming to us from Lamb Weston, where he managed a large network of third-party distribution centers and a complex supply network of both brokered and direct freight in the US and abroad. In total, he has spent more than 20 years in supply chain, inventory management and logistics roles in a variety of industries and brings much needed expertise to our team. Dirk will begin at Freshpet this coming Monday. Now, let me turn to the results for the quarter. I will start with a few key highlights of our strong top line performance. As I said, our net sales growth was 41% in the quarter. This was driven by 37% growth in Nielsen-measured consumption and approximately 4% growth from our efforts to replenish trade inventory. We built market share in all classes of trade and are now the number four brand of dog food in the Nielsen mega channel and closing in on number three and number two. We are also the number one brand of dog food in grocery, despite having only 70% ACV distribution in that channel. Freshpet velocity, i.e., dollars per point of distribution in grocery, is now 50% greater than the second highest velocity dog food brand. That makes Freshpet an incredibly valuable brand to retailers. According to scanner data, unit growth in the quarter was approximately 18% with the remaining 19 points of consumption growth coming from price increases. Price sensitivity has stabilized behind the large price increase in February at levels that are considered very attractive in the world of packaged goods. We've just begun to see the third, much smaller 2.6% September price increase show up at retail, but have not seen any indications of significant price sensitivity behind that increase and don't expect to see much. As anticipated, household penetration continued to grow now that we are back in stock and media is on the air. In the most recent 52-week period of Nielsen household panel data, Freshpet household penetration was up 14% and buying rate was up 19%. It will take some time for the rolling 52-week measure to reflect our improved growth rates, but we are well on our way. It is also interesting to note that the rate of growth amongst heavy and super heavy users is even stronger, suggesting that we are succeeding at converting more households to using Freshpet as the main meal item. Going forward, we will be transitioning our reporting to data provided by Numerator as it provides a larger panel with more in-depth demographic information and provides better coverage of all channels. We will reconcile the old reporting and the new reporting when we make that transition. Now I'd like to turn to the operational plan to drive margin expansion that we've outlined previously with particular focus on logistics, commodity cost management and quality. Let me start with our commodity cost management. As a reminder, this issue has been the result of a mismatch between the timing of when we incur increased input costs as compared to when we can pass on those higher costs to our customers. In 2022, we estimate that lag cost us approximately $19 million. Given the magnitude of this headwind, our entire organization is focused on this and it is an area that we have already taken some action on. In the near-term, we've gotten closer to our suppliers so that we can better understand the variables driving their costs so we can better anticipate cost increases. Additionally, we put in place a more rigorous system of tracking underlying cost drivers, adjusting the frequency and duration of our supply commitments and are working with our suppliers to find ways to create greater cost certainty that works for them and for us. We are already in discussion with some potential partners about hedging a wider range of our commodity costs and have locked 75% of our natural gas exposure for next year and are looking at other items such as diesel. In total, we have contracted for inputs totaling 25% of our costs already and expect to have significantly more committed prior to the beginning of the year. The point is that we are seeing headwinds sooner and using that information to take more timely price increases. As a result, we have now taken a hard look at our anticipated cost for 2023 roughly two months sooner than we have in previous years and have concluded that the basket of input costs will go up in the near-term. And in response to that work we've already announced a 5% price increase to go into effect in early February. That increase is designed to protect our margins and to greatly reduce the impact of any timing mismatch. On logistics, as I mentioned previously, we've just announced the hiring of a new VP of Logistics who has extensive experience with the cold supply chain in the US and abroad from his time with Lamb Weston. His focus will be to help us more efficiently grow into our expanded distribution network and drive out the elevated costs we have absorbed over the past year. Additionally, we are making good progress with the start-up of our second DC, but do not expect to see the benefits of that until sometime in late Q1 of 2023 or early Q2. In the area of quality I don't want to go into too much detail because we view the improvements we make in this area to be highly proprietary and a source of long-term competitive advantage. But I can say we are already rolling out one new technology we developed over the past three years that we believe can make a sizable impact and have two more under development. Improvements in this area will take time but will also provide a meaningful extension of our formidable long-term competitive moat. In addition, we have very strong candidates under consideration for the new leadership roles in this area. In Q3, our quality costs, i.e., disposals and secondary processing costs both declined versus Q2; the disposals cut in half and we're off to a good start in Q4. We see this as a big opportunity for both cost improvement and proprietary advantage and are resourcing it as such. The accompanying presentation contains details on these efforts and a few additional efforts we are undertaking to enhance margins. In summary, we have a deep appreciation for the importance of rebuilding credibility with you and our team's ability to execute on our operational plan to drive margin expansion will be a primary proof point. I want to impress upon you the focus and determination we have. We have made good progress on each of these efforts since we identified them early in Q3. We have lots of work left to do. The path is clear and we are doing that work. Now, I'd like to discuss how we are aligning our net sales growth goals with prudent capital spending to grow capacity. Let me start by providing some context. Our primary motivation over the past several years was to build as large of a consumer franchise as possible before competition arrived. We described this as a land grab and we were determined to get as big as we could as fast as we could. And while this is no easy task in a normal operating environment, it was made doubly difficult by the pandemic and the related supply chain and labor issues for the past three years. Over the past year, however, that situation has begun to change. While we have continued to increase our scale, the latest competitive entry from a leading competitor and with the support of a very large retailer has made little progress. We're outselling that competitor 7-8:1 in the stores where both our brand and theirs is distributed. This provides another proof point for how significant our competitive advantage is and how much of a head start we have. Executing a Freshpet food program is extremely difficult. We've learned that the hard way at times, but our potential competitors also have to contend with a complex moat that we have created over the past 16 years, which covers the formidable combination of manufacturing know-how, fridge placement and management, fresh food distribution and more. In that context and with the successful completion of the Ennis facility, we are well positioned to balance growth and margins with our increased scale and do so within a prudent financial and investment framework. As a result, we are revising our expansion plans and can smooth our CapEx spend to enhance liquidity and financial flexibility while achieving our robust growth expectations. We have already shifted a few projects that we believe we won't need until further down the road. We aren't ready to provide the full impact of those decisions yet, but we can say that our expected CapEx spending this year and in 2023 will be approximately $100 million less than we previously anticipated with a $30 million CapEx reduction in 2022 and $70 million next year. As noted importantly, we remain confident in our 2025 net sales target. We have the resources and capacity to achieve that target and we believe we are well on track to deliver it. For perspective with Ennis up and running, we will have enough installed capacity to support more than $1 billion in net sales before any of the technology improvements previously mentioned were added investments in capacity. Finally, before I turn it over to Dick to provide more detail on the quarter, I want to comment on the start-up of our Ennis, Texas kitchen. We are already producing very high-quality rolls on our first line. We will be able to ship those rolls once we have completed our final validation on the building security and process controls. Our priority there is to produce the widest range of SKUs rather than the maximum volume because that enables us to make full utilization of our Dallas DC. To date, we have qualified 12 SKUs and we will continue our projected ramp-up, which is on track having already shifted to 24/7 production on the roll line. For context that is about six months faster than we were able to hit that milestone in kitchens two. The number of SKUs we have qualified is similarly ahead of the pace we have delivered on previous start-ups. That is largely due to the extensive planning and training we did in advance of this start-up including the significant investment we made to train our production team in PA for up to a full year. The second line in Ennis, a bag line, will begin test runs in January about one to two months later than previously indicated and we expect to begin shipping product about one to two months after that. This added time is designed to ensure that we have completed the optimization of the rolls line start-up where we have a greater need for the capacity. We have adequate bag capacity in our system to meet the current level of demand, so this delay will not impact our growth. However, it will delay the full utilization of the Dallas DC until later in Q1 or early Q2. Once those two lines are operating, we believe that we will have enough capacity to fully support our growth for 2023, enabling us to provide exceptional service to our customers and consumers, and support the aggressive growth plans we are aiming for in 2023. We also believe that at scale, Ennis will be our most efficient plant. The Ennis facility has the capability to have higher throughputs with less labor and longer run times as a result of greater automation, some technology improvements and through enhanced sanitary design. Additionally, the on-site chicken processing will offer improvements in quality and cost versus what we experienced in Bethlehem. In summary, we are seeing evidence that the foundation we have laid, over the past year, is paying dividends and will continue to do so in the coming months and years. We have our largest and most efficient capacity project completed and it will begin shipping product in a week or two. That gives us a long runway for growth and margin expansion. We have started up our second DC, which will ultimately shorten the distance our product travels to customers and reduce our freight costs. We've restored retail conditions, and the household penetration growth is on track to support our long-term net sales goals. We have proven that Freshpet has the pricing power needed to offset rising costs and still deliver strong growth and will ultimately produce attractive margins. We are executing on a multi-faceted operational improvement plan to drive margin expansion over time. We are also taking a more prudent approach to CapEx and have reduced expected CapEx spending substantially. We are tracking the caliber of talent we need to address our challenges and support our growth, and we have strong support from our customers and consumers. We are improving the quality of our execution and look forward to demonstrating the cash generation that this business is capable of delivering. That is what we are focused on. Now let me turn it over to Dick for a more detailed review of our financials, including a discussion of the change in the reporting method. Dick?

Thank you, Billy, and good afternoon, everyone. Let me start by outlining the change in our reporting method before I share the results. As we indicated last quarter, we will no longer add back plant startup or launch expenses in determining our adjusted EBITDA. It is important to note, however, that these changes do not reduce the data that we make available. Our published financial results always quantified all of the elements of the new adjusted EBITDA definition. We are simply changing the definition of adjusted EBITDA to bring greater focus on our cash generation capability. Since it's the first quarter of the new definition, I'll try to bridge the measures for you as we go along. In that context, quarter three was a solid on-plan quarter. Net sales grew 41% and we are now 39% year-over-year for the year-to-date. Under the new definition of adjusted EBITDA, our adjusted EBITDA is $3.5 million since we have not added back the $8 million of plant startup expenses and $1.5 million of launch expense for a total of $9.5 million that we incurred in the quarter. We incurred a total of just $1.2 million of such costs in the year ago period. We added 374 new stores in the quarter and are on track to add 1,400 stores this year. While it does not impact our launch expense, we also added 408 new upgrades and 382 second and third fridges for the year-to-date. Adjusted gross margin for the quarter was 34.5% under the new method, 530 basis points lower than it would have been under the old reporting method. As you know, in quarter three, we had significant preproduction expenses in Ennis, Texas and we will have those again in quarter four, as we ramp up production on multiple lines and multiple items. We experienced significant inflation in cost in the quarter and have now taken pricing to cover those costs. However, we did not take the pricing soon enough to deliver the gross margins we should expect in a more stable market. That mismatch cost us approximately $5 million or 340 basis points of adjusted gross margin in quarter three. As Billy indicated, we have already announced another round of pricing to offset the higher cost we anticipate in 2023. While we anticipate that our chicken prices will be flat to slightly lower next year, other costs including energy, packaging and grain-based inputs are expected to go up in the near-term. So we are proactively taking the pricing now to avoid another significant pricing mismatch. That price increase will average about 5% and will go into effect with orders on February 6, 2023. We continue to drive G&A leverage in the third quarter, generating 220 basis points of adjusted SG&A leverage excluding media and logistics. This is consistent with our long-term trend in our 2025 goals. Our logistics costs in the quarter continued at an elevated level as we've been both starting up a second warehouse, where we incur significant costs to move product between warehouses and have been unwinding some of the warehouse congestion created by the product quality issues we had in quarter two. That situation is now improving quite a bit. Freight rates have dropped and our fill rates are now running in the mid- to high 80s. So we expect to begin seeing improvement in logistics costs going forward beginning immediately in the fourth quarter. However, until Ennis is producing the full range of both bag and roll SKUs, we will incur above average freight costs until we can fully utilize the new Dallas Distribution Center, which is likely to occur in quarter one or early quarter two of 2023. We invested $73 million in capital in the quarter, expecting to spend a combined total of $520 million over full years 2022 and 2023. And year-to-date, we have spent $168 million of that total. The performance of our ERP system continues to improve and that has resulted in a reduction in working capital. While inventory levels are still higher than we would ultimately like them, our receivables improved by $14 million or approximately 10 days of sale. Operating cash flow used in the first three quarters was $54 million. We did not draw on our borrowing facility in the quarter. Looking forward, we continue to believe we are on track to meet or exceed our net sales guidance for the year. Our net sales were up 39% year-to-date through quarter three. We have a much tougher compare in quarter four than we had in quarter three. But overall, we feel very good about where we are in net sales. Similarly, we are reaffirming our previous underlying guidance but adjusting the guidance to reflect our new accounting method for determining adjusted EBITDA, which now includes the impact of $29 million of start-up planned expenses and $4 million of launch expenses. Subtracting this $33 million of expense from the $48 million underlying guide, you arrive at our new adjusted EBITDA guidance, which reflects the new reporting method of greater than $15 million. In closing, we remain very optimistic about Freshpet's future. We have strong demand, significant new capacity, a state-of-the-art facility, intense focus on improving logistics, quality and commodity cost management and strong retailer support. We appreciate the support we have received from our investors and look forward to creating significant shareholder value in the years ahead. That concludes our overview. We will now be glad to take your questions. As a reminder please focus your questions on the quarter and the company's operation. Operator?

Ladies and gentlemen, at this time we will be conducting a question-and-answer session. Our first question comes from the line of Bill Chappell from Truist Securities. Please go ahead.

Hi. Thanks. Good afternoon.

Good afternoon.

Sorry, I'm going to go off of what Dick asked, but just a simple one on the new hires — they certainly seem like solid additions. How do the conversations go when you're attracting management, when there is an active shareholder involved and kind of strategic alternatives thrown out there? How do you give them comfort and attract additional talent from here?

Bill, I provided an overall comment, but I would prefer not to talk about any of the issues related to activist investors. What I would say is, that we're very happy with the quality of the talent we're getting and they would be a very good indicator of our ability to continue to attract very high-quality talent. So, I just — I think the proof is in the talent that we've attracted.

Okay. I'll leave it at that. The second, just a follow-up. On the price increase next year, what we've been hearing is retailers have been reluctant, but okay with most pricing taken in 2022, but there's been more and more pushback about pricing in 2023. So have you seen any of that, or has this been harder to get through than prior ones? Any color there would be great.

Scott, you want to take that?

Yes. Hi, Bill. We have been very open with all the retailers as we've done all the pricing over time. We've explained to them our strategy and how we're trying to make sure that we're making a handful of SKUs accessible and approachable to as many consumers as possible and that we want to continue to drive the growth that they're looking for. And I think they realize and recognize that we have been very constrained in putting pricing through. When we came in with this one and explained exactly where it is, they were incredibly receptive to put honestly. Part of it is they've seen consistent improvement in the business and the velocity growth over the year and the fill rate over the year. I think they're also looking at what we've done in pricing and what the rest of the category has been on pricing. We have been slightly behind what the majority of the category has done. So I think that they felt it was justified. We've had conversations with a majority of the top retailers and I think they've been again very receptive to the conversation. And we don't anticipate it being a challenge.

Great. Thanks for the color.

Thanks, Bill.

Thank you. Our next question comes from the line of Anoori Naughton from JPMorgan. Please go ahead.

Hi, good afternoon. Could you perhaps parse out for us the composition of the $100 million reduction in the CapEx outlook? Which projects have you delayed? And how much of the $100 million now falls into 2025, versus how much reflects capital projects and savings that you found from things like lower construction cost?

Anoori, we're going to come out with a more detailed look at this when we — our current plan is, as soon as we get Todd on board and get his feet on the ground, we'll kind of restate what the long-term targets look like in light of all the inflation and the impact that has had. But what I can tell you is that, we took $30 million out of this year. So the $320 million previous outlook would be more like $290 million and we took $70 million out of next year. Some amount of that would push back into the later years. But because we're relooking at all the different projects, I wouldn't cast anything in stone in the out years, because we're still doing a fair amount of work on what is exactly the right amount of capacity. And we also are working on some new technologies that might have some potential to alter what capacity we actually put in. So I would take the near-term numbers for the next two years, meaning 2022 and 2023, and we'll come back to you probably in early January with the plans for years beyond that.

Okay, great. Thank you. And then for my follow-up could you update us on what the expected timeline is to get to full production at Ennis? And where do you stand today with staffing and equipment for lines two and three?

Yes. So line one, as we said in the call, is running 24/7 at this point. We have the staffing already for line two for a 24/7 operation; that's all been fully qualified and trained. That line is expected, as we said in the call, to begin running product in January and we'll be shipping that product within one to two months after that. All that equipment is installed plus or minus a little piece here or there. The third line: all the equipment exists — meaning it's all in Ennis, Texas — but it has not yet been installed. And we have not hired the staffing for that yet, because we really need to see how the volume unfolds. But knowing we have the equipment, the installation time is obviously a lot less than construction time is. And because we already have staffing on the ground there for two lines at 24/7 operation, it's relatively easy for us to staff up, because what you do is you spread some of the talent you already have around and you hire the new people on to put some of them on your existing lines. So we feel very comfortable. We don't have a specific date for that start-up of that line, but I think of it as being sometime towards the middle part of the year.

Very helpful. Thank you.

Thank you. Our next question comes from the line of Mark Astrachan from Stifel. Please go ahead.

Yes. Thanks and good afternoon everyone. First on the pricing. Regardless of 2023 outlook — in terms of what you've seen so far, you commented in the presentation about heavy and super heavy buyers continuing to increase. Do you see any impact on the recruitment of new households or consumers from the pricing actions? Do you think that what you've done in terms of limiting the lower-priced items has helped trial or has not hurt trial? Maybe that’s a better way to put it. And then I've got a follow-up, please.

Scott, do you want to take that?

Hey, Mark. We track it incredibly closely. Literally, every couple of weeks we're really dissecting it. Where we have seen a modest, modest impact is in, I would say, the lower income groups at this point. But on our average and higher income groups, there has literally been no impact that we've been able to see and they are growing penetration among those groups. The main reason is because the category has risen so significantly. If you look at the value of where we are versus where the category is, we've actually been almost at a slight advantage to some extent. We want to continue to represent that and show that as we're doing these price increases and keeping things as affordable as we can. So we really have not seen any significant impact or slowdown. When we look at the components of the business and the build that we have over the course of the next 12 to 18 months, and we look at all those different things stacked up, we feel really confident to be able to continue to drive penetration.

That's great. I appreciate that. Just a follow-up on the new lines and the thoughts on the lines going forward: how do you think about the ability and opportunity to improve productivity of the lines that you've put in recently, and over the next 12 months from both the ability to produce greater revenues and to do it at a lower cost?

Let me take a shot at that and Scott might want to add something. Each time we put in new lines, we look for improvements versus the previous lines. The facility in Ennis has more automation than the lines in Bethlehem. The move from Kitchens 1.0 to Kitchens 2.0 was a quantum leap forward for us. The leap from Kitchens 2.0 to Ennis is the same magnitude, maybe even slightly bigger, in terms of automation. We're expecting to be able to have higher throughput per line per hour with less labor than what we have in Bethlehem. We've documented that Kitchens 2.0 operates at a significantly higher gross margin than Kitchens 1.0, so we'd expect to see a similar improvement for Ennis. At the same time, we've hired people starting back in 2019 working on process improvements. We've got a couple of things that are starting to pan out. We're not ready to declare victory nor disclose what they are, other than to say that automation isn't the only driver of efficiency gains for us. There are other drivers that can improve efficiency significantly. Those things are in varying stages of testing and scaling up.

Got it. Thank you.

Thank you. Our next question comes from the line of Brian Holland from Cowen and Company. Please go ahead.

Yeah. Thanks. Good afternoon. Forgive me if you addressed this, but those start-up costs that you're no longer adding back appear to be in aggregate about $10 million above what was in my model and I guess $10 million or so above the first half. Can you just explain what's behind that uptick? Perhaps your comfort that you framed it correctly for 4Q and when we can expect that to roll off?

Dick, do you want to take that?

Sure. The increase in plant start-up costs relates to a slight delay in getting Ennis up and running. Early on when we put the plan together we expected a September startup, and now it's pushing into the next couple of weeks. So a lot of people were hired earlier and they trained in Pennsylvania, and they're all part of plant start-up costs. That expense is now behind us for Lines 1 and 2. For Line 3, we stopped hiring. We haven't hired Line 3 yet. We still have more plant start-up costs in quarter four, because Line 2 will be coming up as Bill indicated in some time in the first quarter. At that point in time, two lines were running. The plan is eventually to have ten lines in Ennis and we'll have planned start-up costs behind each line and now we're budgeting for it as part of our GAAP reporting.

Appreciate the color, Dick. And then forgive me for peeking ahead to next year, but my model assumes you're spending less than $2.5 million on media in 4Q. I can appreciate why that might not necessarily have sales in 4Q. But presumably that would weigh on growth at least in 1Q 2023. Is that fair? And help us understand to what extent there might be some impact as we roll into next year?

Scott, do you want to take that?

Yes. Historically, we have not spent anything significant in Q4 from a media standpoint, and we've been able to maintain good momentum not only through Q4 very often but also right into Q1. We will get started in Q1 pretty aggressively right from the beginning. The best time for us to spend media dollars is early on in the year. We get the best return on that, and it helps us carry throughout the year. We also have benefits beyond just media: better fill rates, product innovation, strong distribution in addition to the media spend and strong creative, and improvements on quality. With all those aspects together, we think we're in a good spot going into next year.

Great. I'll leave it there. Thanks.

Thanks, Brian.

Thank you. Our next question comes from the line of Michael Lavery from Piper Sandler. Please go ahead.

Thank you. Good evening. Just curious as you think about Florida and the hurricane impact there, it sounds like it was obviously quite manageable. But was there much impact from the hurricane, obviously having some homes without electricity and different in that? If so how should we think about 4Q and pacing — your guide implies a little bit of a deceleration? Is that reflected, or is it more just conservatism? Maybe just help us think about the fourth quarter top line.

As bad as Hurricane Ian was, it did not seem to have the magnitude of the impact of the hurricanes of 2017. So there was some impact, but it wasn't as significant as 2017. As we look into Q4, Q4 just has a tougher comp than Q3 did. That's what we're looking at. We had a much stronger start of Q4 last year and a little bit of a catch-up versus the Q3 we had a warehouse issue in the beginning of Q3 last year. So Q4 had a little bit of benefit from that. We also took a price increase in September. So we just want to see how everything settles through. We have another price increase coming in February. We just wanted to get a good handle on it, but as Dick said we feel very good about where we sit right now for Q4 and frankly are very bullish on where we're going to start the year next year.

Okay. That's helpful. And just a follow-up on your slide in the presentation about some of the working capital you've got what looks like ERP driven improvement there. It sounds like you've characterized some of it as needing to catch up to kind of get to a normalized level but is there more upside in terms of that improving even further? Just trying to understand how to model some of the working capital piece as we think about the balance sheet.

I'm going to have Dick in a second. But let me just say that we think there's still more room on the receivables. And certainly, there's a fairly significant amount of room we believe on the inventory side as well.

Yes, we're running with $40 million finished goods. That's about 1.5 weeks more than you'd prefer — more like four weeks of inventory versus six weeks. We've also brought a lot of ingredients upfront and our procurement team did a great job trying to get a little bit ahead of rising costs. When you look at our ingredients level and our finished goods level together with packaging materials it's kind of in a $60 million range. Our finished goods probably should be about 1.5 weeks less. As we get Ennis up and running and we have two warehouses and our distribution supports each warehouse, our inventory will come down to about 4.5 weeks of finished goods. The ingredients level is really just dependent on how the market looks and what kind of positions we want to take.

Okay. That’s helpful. Thank you.

Thank you.

Thank you. Our next question comes from the line of Robert Moskow from Credit Suisse. Please go ahead.

Hi. Thanks. Do you have any color for us on what to expect for plant start-up expenses next year? And is it fair to say that it's going to be pretty constant for a while, while you're continuing to build out? And then I had a quick follow-up.

I'll take that. The plant start-up expense this year was related to two lines coming on and also the actual plant being built. Early on we were looking to be finished earlier in the year and it's now coming in as Bill indicated in the next couple of weeks. We already have the two lines staffed. The next line that we haven't hired yet — we do have to hire 90 days in advance so we can train people and get them in-house. But the building and all the expenses associated with the building prior to those first two lines coming up have been charged. You'll pay for all the utilities and everything else associated with the building, the security and everything. As new lines come up that base has been covered by the two lines. As the third line towards the tenth line comes up each line will have less of a hit as you allocate it across the number of lines in place.

Okay. Maybe I'll follow up on that. The second question was in the past you've said that it's been very difficult to get your full selection of products into the fridges and stores and have them be filled on a consistent basis. Where do you think you're at in that journey? I haven't heard about it lately and I want to know — I heard your fill rates but I'm not sure about your getting that full selection in?

You'll see in the deck we attach there's a chart that shows our TDPs, which is not a specific measure of in-stocks but it's the closest measure you can get from the publicly reported data and it shows we're at an all-time high. If you break it down into the ACV and the average SKUs in distribution, it's like 15 SKUs in distribution on a 60.3% ACV, or something like that. So it's good but there are still a couple of holes that are sporadically empty — we just have to get the right product produced at the right time and in the right warehouse and there's a logistical challenge we've got to work through. But we're getting better every week and I would hope that once we get these lines up and running shipping that problem is invisible. Our in-stock position today is better than it's been in years and our fill rates today are on par or better than most of our leading competitors in the pet food space.

Okay. Thank you.

Thank you. Our next question comes from the line of Peter Benedict from Baird. Please go ahead.

Thanks for taking the question. First on the efforts to enhance margins. You talked about fixing some costs for next year. Can you give us a sense, Billy, for the visibility you have into improved profitability next year just simply based on stuff that falls off from this year that you've already locked in?

Think of it this way, Peter. We talked about this year having a roughly $19 million gap at our current scale, which is the timing mismatch. We expect to have a very minimal timing mismatch in 2023 because of the pricing actions and the commodity purchasing management that we're doing today. So you can take a significant portion of that away. Look at logistics: it cost us roughly $20 million at this year's scale. I'm not going to say it's all going to go away all at once. But as Dick said, our fill rates are consistently getting better, we're running in the high 80s and so we're taking away a significant portion of that inefficiency. Once we get that second DC up and running in Dallas with a full line of items produced locally in Texas, we expect to cut miles significantly. So there's a big opportunity there. The cost on the quality side — we've got some things we're rolling out now that we're not ready to describe the benefit of yet — but the opportunity pool is of similar size to the opportunities on logistics and commodity mismatch. We think we can make a meaningful dent in it probably more toward the back half of the year than the first half.

Okay. That's helpful. Thanks. And then I'm just curious it looks like still 1,400 locations that are coming on this year. Just curious your conversations with retail partners, how those are going right now? What you think the momentum is as you look into next year? Is adding a similar amount a good assumption, or what's the view there?

I think we're going to have a strong back half of the year and I think we'll have a very good year next year.

All right. Fair enough. Thanks guys.

Thank you. Our next question comes from the line of Rupesh Parikh from Oppenheimer. Please go ahead.

Good afternoon. Thanks for taking my question. I just had one question on consumption by channel. Big box pet grew pretty significantly sequentially. Can you give more color there in terms of what's happening, and how you think about the recovery or stronger growth going forward in that channel?

We never quite smoothed out the supply chain as much as we would like. We had some additional product shorts in that channel. The channel has been slightly slower from a growth and traffic standpoint. I don't know the exact dynamics, but as gas rose people made fewer trips and that may have had a disproportionate impact on the pet channel. We expect this to normalize over time. Importantly, pet specialty is 14% to 15% of our sales. It's a smaller piece of business but an important one we want to develop.

Okay. Great. And then any update on the UK market given inflation there?

Our business in the UK is still small relative to the US and more exploratory. We're mindful of rapid inflation there and are taking pricing. While we don't have a huge cost base there because our product is produced in the US, we will have wage inflation for the team that we have there. In terms of consumer dynamics, so far they've been holding together pretty well. We haven't seen significant negative impact on our trends, but we are still relatively small scale and ramping up.

Great. Thank you.

Thank you. Our next question comes from the line of Ben Bienvenu from Stephens. Please go ahead.

Hey, guys. Good afternoon. Jim Salera on for Ben. I wanted to ask a question on the in-stock rates. As you get the operations side buttoned up, does that have a noticeable impact on velocity with your retail partners? And as a part two, do your retail partners have a certain velocity threshold they want to hit before they'll put in a second or a third fridge?

Ten years ago, we were below the category average on sales per linear foot, but we've improved dramatically. We're typically in the top 20% of the category and often the leader in velocity. Velocity has not been the primary challenge. We've not had full fridges consistently for almost three years; we're in the 80s for fill rates today. Historically we've been best-in-class in the high 90s and that's what we expect to get back to in Q1. As we get fully in stock, having full fridges will provide a multiplier effect on sales. Regarding second fridges: the single biggest factor has been having full fridges consistently. As we move from the 50s to the 60s to the 70s and now in the 80s and they see new lines come up and operate, it gives retailers confidence to add additional fridges.

I'd add that one of the items most frequently short was the one where we had the quality issue in the end of Q2. When that's out of stock, consumers trade down to our roasted rolls item. When it gets back in stock, they trade back up. So we may see the same unit purchases but higher dollars when we're fully in stock — there's a trade-up phenomenon for us.

Got it. Maybe a quick housekeeping question: what was advertising spend in the quarter?

You can see it in the deck; it's imputed in the SG&A line.

Okay. $14 million?

Yes.

Great. Thank you.

Thank you. Our next question comes from the line of Jon Anderson from William Blair. Please go ahead.

Thanks. Good afternoon, everybody. Billy, you referenced competition in the prepared comments. Could you talk more broadly about competition and what you're seeing on a direct-to-consumer basis? As you bring up new capacity and address capability challenges, should we expect a renewed effort in direct-to-consumer from Freshpet?

Scott?

Jon, there are many entrants across fresh and frozen cooked items and some in fresh. If you add all the competition and activity together, it looks like a lot, but we're still 96% of the sales in fresh and frozen cooked foods and we're by far the largest piece. We've been maintaining share. We know competition will make progress over time but the end state of this category could be in the many billions, $4–$5 billion, and our goal is to have as much share of that as possible. On DTC, there's an interesting small but high-value group of consumers who appreciate customized, convenient meals delivered to their homes. We continue to evaluate that and look at ways to make our product more customized and convenient. We have solutions that utilize our assets and capabilities to give consumers a strong proposition and we'll update over time but we're not ready to share specifics yet.

Okay. And a follow-up. Regarding the 2025 plan, you mentioned confidence in the sales target. I didn't hear any reaffirmation of an EBITDA margin target. Any thoughts on updating that?

John, we recognize because of all the inflation over the past year and impacts on buying rates, potential impacts on household penetration or customer acquisition costs and margin structure, we didn't want to address the net sales and EBITDA margin in 2025 at this time. We'll come back and do that in January and level set. But we wanted to be clear that the change in CapEx spending is not going to impact our ability to get to the $1.25 billion net sales target.

Okay. That's helpful. Thanks a lot.

Thank you. Our next question comes from the line of Cody Ross from UBS. Please go ahead.

Good evening. Thanks for taking our question. I want to focus on gross margin. You called out inflation and quality issues as two leading headwinds to gross margin in the quarter. Can you quantify the impact on the quarter? And when do you expect the quality issue to no longer be a headwind?

Dick, do you want to take a shot at that?

We've never broken out quality before, but we certainly suffered consequences from margin standpoint not only in the quarter but year-to-date. We disclosed in the last quarter $3.5 million for one of our roll issues. We're working on improving quality and feel good about how those initiatives will impact the latter part of 2023. I'm not prepared to break that out further at this time.

I'll add we're comfortable that impacts on quality are manageable. As we scale, issues that are rare at smaller scale can show up; our challenge is to minimize the size of the impact when something unexpected happens. That means reducing time impact and disposals. Our rolls are robust; the focus is on making bag products as robust as they can be.

Thank you. And switching gears to fill rates: you mentioned fill rates are in the high 80s now. What are your biggest challenges today and when do you anticipate fill rates returning to normal levels? I heard Q1 '23 — is that correct?

The immediate impact on fill rates is getting caught up on our fresh kitchen product where we had the quality issue earlier this year. It's taken a while to sort that out and get caught up. We're making significant progress and I see that closing and may close by the end of this year. Rolled capacity has been tight and we needed the Ennis line to come on to keep up with demand for rolls. If Ennis production goes as planned we'll be able to fill holes on rolls. I feel pretty good about our total capacity position heading into Q1 and fill rates should get progressively better from mid- to upper-80s; we expect to be well above 95% in Q1.

Great. Thank you, I'll pass it along.

Thank you. Our next question comes from the line of Peter Galbo from Bank of America. Please go ahead.

Hey guys. Thanks for taking the question. Just to clarify the timeline with Todd and Dirk stepping in later this year: are you thinking of reassessing and presenting something to us in January? Is that enough time to assess or will there be a more extended timeline once they come in to reevaluate?

Our current target is to do it sometime in January, but we won't do it unless we're ready. The work is already well along and the rest of the team has been doing it. We want the new talent to have a chance to get their arms around the work. Dirk starts this coming Monday and he'll get up to speed quickly. Todd starts on December 1. Both hires are ready to go on day one; they know the industry and key players, so they'll hit the ground running. We'll share the plans when they feel comfortable with them.

Okay. That's helpful. Dick, two quick clarifying questions: you mentioned gross margin was roughly $5 million under what you would've thought in the third quarter — is that tied to the price-cost mismatch? And the lower CapEx spend you discussed, is there any impact on cooler placements or is it solely on production side?

Yes, the $5 million headwind was due to pricing timing mismatches and some one-time issues in disposals and quality. The 2.6% price increase that began shipping in the first week of September will pick up for the whole fourth quarter and adds about 130 basis points against fourth quarter sales. We also have some commodity movements helping. On CapEx, the reductions are on production sites, not on coolers.

Got it. Thanks very much.

Thank you. Our next question comes from the line of Connor Rattigan from Consumer Edge Research. Please go ahead.

Hey, good evening guys. Thanks for taking the question. I was hoping to touch on trip consolidation and pack mix that popped up last quarter. From the data we've seen it appears some of that may still be going on despite meaningfully lower gas prices versus last quarter. Have you seen any improvement or a return to normalcy with consumers returning to typical shopping habits and smaller pack sizes?

Scott, do you want to take that?

There are a couple of dynamics: pack size changes and some trade down within brands. We've weathered this quite well. It's given us increased confidence in the portfolio and in doing pricing next year. We haven't seen a category-wide negative impact; when we look at dollars and pounds equivalized units, it gives us confidence going into our planned changes.

Thank you. Our next question comes from the line of John Lawrence from Benchmark. Please go ahead.

Hi, guys. Billy, would you comment on the decision today on the CapEx? As you look at the margin improvement plan toward 2025, does this allow pushing out some projects and allow margins to expand a little earlier, maybe in 2023–2024 without dilution from the projects? Is that fair?

We'll go into more detail when we roll out the long-term plan. Part of what we found is ways to do some innovation projects more efficiently that require less CapEx upfront and that can have a margin benefit. The more volume we can load into Ennis, the more margin improvement you'll see across the business. Our bias is to put as much volume in that facility as possible because it is the advantaged facility from a margin perspective and our capital plans will mirror that.

On a GAAP basis you would have depreciation on that $100 million if completed by the end of 2024 and that would hit 2025; pushing it out helps on GAAP but not on adjusted gross profit basis.

Great. Thanks guys. Good luck.

Thank you. Our next question comes from the line of Corey Grady from Jefferies. Please go ahead.

Hey. Thanks for taking my question. Two quick follow-ups. First on pricing, do you expect to be in line with the industry or taking another round of pricing? And then have you seen any change in the industry in terms of promotionality?

I've been watching promotion and was waiting for it to get more aggressive; it hasn't moved much and may have contracted slightly. When we take our next price increase, we'll still be below what most of the wet category has taken and will be in line or a bit above some of the dry. There's a big range by manufacturer in recent moves; overall we'll be in a good spot.

Got it. That's helpful. And then on heavy and super heavy users: you've talked about 25% of Freshpet customers using fresh as full meal replacement in the past. Can you give an update on what percent use Freshpet as a meal replacement?

I don't have that off the top of my head. It may be in the deck but I don't recall the exact number right now.

On a sales basis, the percent of our sales from consumers using Freshpet as meal replacement is north of 50%. As a percent of the universe of households, it's a smaller percentage.

Got it. Thank you.

Thank you. Ladies and gentlemen, we have reached the end of the question-and-answer session. I would now like to turn the conference over to Mr. Billy Cyr, Chief Executive Officer, for closing comments.

Thank you very much for your interest. We feel very good about what we've delivered and we feel like we have delivered a strong on-plan quarter. We look forward to continuing the strength for the balance of the year. I want to leave you with one thought as I always do. According to Canadian author and historian Charlotte Gray, 'A dog desires affection more than its dinner' — well almost — to which I would add, if you feed them Freshpet, the dinner will win hands down. Thank you very much and we look forward to following up with you later. Thank you.

Thank you. The conference of Freshpet, Inc. has now concluded. Thank you for your participation. You may now disconnect your lines.