Freshpet, Inc. Q3 FY2023 Earnings Call

Greetings and welcome to the Freshpet Third Quarter 2023 Earnings Call. At this time all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. I would now like to turn the call over to your host, Mr. Jeff Sonnek, Investor Relations at ICR. Thank you. You may begin.

Thank you. Good morning and welcome to Freshpet's third quarter 2023 earnings call and webcast. On today's call are Billy Cyr, Chief Executive Officer; and Todd Cunfer, 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, 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 on 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 limitations associated with such non-GAAP measures. Finally, the company has produced a presentation that contains many of the key metrics that will be discussed on this call. That presentation can be found on the company's investor website. Management's commentary will not specifically walk through the presentation on the call, but rather it's a summary of the results and guidance they will discuss today. With that I'd now like to turn the call over to Billy Cyr, Chief Executive Officer. Billy?

Thank you, Jeff, and good morning, everyone. The message I would like you to take away from today's call is that the third quarter results show that the Freshpet business is delivering on its promises and potential. As a result, we are off to a fast start towards our 2027 goals. At the beginning of the year, we laid out our new long-term plan that called for 25% annual top line growth, resulting in $1.8 billion in net sales in 2027 and strong margin improvement with the ultimate goal of delivering 18% adjusted EBITDA margins in 2027. For 2023, the first year of that plan, we committed to continuing our strong track record of net sales growth while simultaneously fixing the operating issues that were preventing us from generating the margins that we know are attainable in this business. We are delivering on that commitment and exceeding many of the targets we set, putting us ahead of the pace required to deliver our 2027 goals. This increases our confidence in the capability we are building, the strategies we are employing, and our ability to deliver our long-term goals. In Q3, we delivered both top line and bottom line growth ahead of expectations for the quarter. We delivered 33% net sales growth, bringing our year-to-date net sales growth to 28%. We also delivered a step change in our profitability due to strong operational improvements. As a result of that progress, we are raising both our net sales and adjusted EBITDA guidance for the year. We believe our fast start towards our 2027 goals is largely due to the strengthened organization capability we have built and the strength of the Freshpet Consumer Proposition. The team we have built is delivering improvements in our key focus areas of quality, logistics, and input costs at a rate that has exceeded our projections, which enabled us to deliver a 40.2% adjusted gross margin in the quarter. Our progress in logistics has been even more significant and impressive. This is a true testament to the quality and depth of our team that is spearheading these projects, and we couldn’t be more proud of this measurable progress. Our net sales growth has also been impressive and is a good demonstration of how resilient the Freshpet brand is, even in the face of higher pricing. Q3 was our fourth consecutive quarter of accelerating volume growth, and our 23% volume growth in the quarter in combination with our typical mix improvement provides added confidence that we can continue to deliver the mid-20s net sales growth CAGR needed to support our long-term target, even without the benefit of pricing. Even more encouraging is the increasing rate of household penetration growth that we have seen. While it will take some time for the 52-week household penetration measure to show the low-20s household penetration growth we have seen previously, the 13-week measure is already approaching that rate of growth. It is just a matter of time for the long-term measures to catch up. We think that will happen by mid-year next year. While we're off to a great start, we are also mindful that we still have a lot of work to do to achieve our 2027 goals, particularly our margin goals. Our adjusted gross margin is still 500 basis points below our long-term goal, and our adjusted EBITDA margin is also well below where it needs to be. We need to stay focused on improving our operational performance while simultaneously adding capacity to keep up with the strong growth we expect to deliver. I want to provide a few additional highlights from the quarter and then we'll turn it over to Todd to provide the key details and our updated outlook for the balance of the year. First, net sales growth. The net sales growth in the quarter was particularly strong and ahead of our expectations. It was largely due to strong 23% volume growth that, in combination with typical mix improvements, is equal to our long-term 25% growth target. This growth was due to continued household penetration growth and even stronger growth in the number of heavy and super heavy users, what we call HIPPOs. Those HIPPOs account for 88% of our volume today. The number of HIPPOs in the Freshpet franchise grew 25% in the past year and their buying rate grew 6%, demonstrating the disproportional impact that these targeted consumers have on our growth. We also saw particularly strong growth in the unmeasured channels, such as club, with net sales up more than 100% in that unmeasured portion. What is particularly exciting is that 65% of the households that buy Freshpet in that channel are completely new to Freshpet, and they buy in large quantities. The strong growth in the unmeasured channels more than offsets the slower growth even experienced in the pet specialty channel. Second, fridge placements; we've placed 4,464 new upgraded, and second or third fridges year-to-date, a record for us by a large margin. 20% of all of our 26,385 stores now have multiple fridges. We are on a pace that is well ahead of our initial commitment to place 5,000 fridges this year and already have the 1.7 million cubic feet at retail that we projected for the year. This is a testament to retailers' belief in Freshpet as a scalable and innovative category leader and that we represent a significant growth opportunity for them. Third, e-commerce. We continue to see strong growth in the e-commerce channel, which we define as curbside pickup, delivery, and DTC. E-commerce now accounts for 9.5% of our total volume, and 88% of that volume goes through our fridge network either via curbside pickup or a store-based delivery option like Instacart, which grew 48% versus a year ago. E-commerce sales are up 62% versus a year ago, and we continue to believe this will grow as consumers increasingly adopt new and convenient grocery pickup and delivery services. Fourth, innovation. We launched our large dog offering in a limited number of stores earlier this year, and it is off to a fast start with its dollar velocity within our top 10 items where it is in distribution. Based on these strong results and the ability of this item to expand our reach into larger dogs, we expect to expand distribution of this product next year. Additionally, we launched Freshpet Complete Nutrition rolls in October. Complete Nutrition offers the Freshpet experience at a good entry point value. We expect it to be in more than 9,500 stores by the end of the year. We believe this will make Freshpet more accessible to interested but more value-conscious consumers. Fifth, quality logistics, and input costs. As we told you at the beginning of the year, these costs would be our key focus areas as we sought to improve our operations, and we are making good progress. In the quarter, we improved the collective total of these costs by 780 basis points versus a year ago. Within that, our quality costs were 190 basis points better than the year-ago. Our progress in logistics has been exceptional, improving by 540 basis points versus year ago. While we are benefiting from the macro environment, which has created less demand for trucking capacity and lower fuel costs than last year, we believe that only about one-third of our improvement is due to those factors, whereas the remaining two-thirds is due to actions we have directly taken. For perspective, despite shipping 23% more pounds of product in Q3 of this year than in Q3 last year, the total number of miles of freight we paid for was down by 28%. This was due to higher fill rates, larger order sizes after our June implementation of bracket pricing, and the ramp-up of our second distribution center. We have leveraged our increasing scale to get lower lane rates relative to the market than we have gotten previously. This is a clear demonstration of the incremental capability we've built in logistics over the past year. Six, capacity. We've successfully added incremental staffing at all three production sites over the past 90 days, and this is delivering the necessary capacity to support our current rate of growth and positioning us well to meet the demand we anticipate in Q1 of 2024. Furthermore, the second bag line in Ennis has begun commissioning and is on track to begin producing available product by the end of the year. Construction of Phase II in Ennis is on track or slightly ahead of schedule, which will enable us to begin producing rolls in the first line in Phase 2 by the end of Q3 next year. In total, we believe we will have adequate capacity to support our near-term growth that underpins our 2027 algorithm and will be well-positioned to support growth going forward. In summary, we believe we are making very good progress and remain very bullish for the year and our long-term prospects. I would like to end my comments with some thoughts on the overall pet food category. There's been a lot of discussion lately about the impact on household budgets and the influence on category volumes given higher category pricing and a variety of macroeconomic factors, such as the resumption of student loan payments, interest rates, and inflation. Clearly, the results we presented today suggest that an increasing number of consumers are still willing to pay for high-quality pet foods and the demand for those types of products is growing. We are seeing strong growth across all age groups and income cohorts, and we believe that the most important variables in determining what kind of pet food you feed your dog is not income or age, but how important your dog is to you and how much you focus on their health and wellbeing? The cost to feed Freshpet is only about $2 per day for the average 30-pound dog. That expense for a high-quality pet food has shown over time to be amongst the last things that someone cuts from their household budget when times are tight. When you contrast our performance with a wider CPG narrative about consumer trade down that is occurring, this suggests that there is a bifurcation in the category with high-end thriving and downward pressure on less differentiated brands. It is true that our volume is becoming increasingly concentrated amongst our heaviest users, HIPPOs, who also happen to be our fastest-growing group of users. We view that trend to be favorable, demonstrating high levels of satisfaction and making our business increasingly a main meal instead of a topping or mixer. We now have almost 4 million HIPPOs in our franchise, double the number we had three years ago, and they are consuming an average of $235 per Freshpet per year. That group has grown 25% over the past year and they now account for 88% of our business. Within the heavy user HIPPO group, we have a subset of about 250,000 users the size of some of the DTC brand franchises, who buy more than $1,000 per year and that accounts for about 25% of our total volume. That group has grown more than 50% over the past year. We describe the consumer behavior we are seeing as Freshpet is becoming increasingly mainstream and main meal. We are growing our total franchise across all ages and income cohorts, thus we are becoming more mainstream. And we are increasingly driving higher buying rates, thus becoming more of a main meal. This creates a strong, loyal, and very valuable consumer franchise. This behavior is consistent with a long-term trend towards the humanization of pets and consumer interest in feeding their pets the highest quality food, which has driven the premiumization of the pet food market for the last two decades. Nothing in the data we see suggests that this trend is slowing and in fact, we believe that the next generation of users is even more interested in providing high-quality care for their pets and concerned about the quality of food they feed every member of their family. This is a fundamental trend that we've discussed over the years, but is being tested amid this period of economic uncertainty and the resiliency that we see is extremely encouraging for the future of Freshpet. With this backdrop, we believe that Freshpet has the potential to become a very large brand and a very large and growing category, and we are taking the necessary steps to ensure that we realize that potential. Now let me turn it over to Todd for the details on the Q3 results.

Thank you, Billy. And good morning, everyone. As Billy said, in Q3, we continued the strong performance we saw earlier this year and have raised our net sales and adjusted EBITDA guidance to reflect that strength. Let me break it down a further. Net sales came in at $226 million, up 33% versus the year ago. Our net price mix was up more than 9.5% versus a year ago in the quarter, and the volume measured in pounds grew 23%. The price mix was positively impacted by the two price increases we took in February and last September, totaling 7.5%. The mix benefit, which we have consistently seen over time as consumers migrate to higher-priced items in our lineup, was slightly more than 2 points. Total Nielsen measured dollar growth was 28% versus a year ago in the quarter, but our growth in non-measured channels was much stronger and added almost 4 points to our measured channel growth, which also has been a consistent trend as of late. The growth was broad-based across channels, ranging from a low of 12% in the Pet Specialty channel to 30% in XAOC and greater than 100% in the unmeasured channels. Adjusted gross margin was 40.2% in Q3, 570 basis points better than the year-ago, and well above our base expectation. This improved performance was due to a variety of factors, including improvements in input costs and quality, the benefits of the pricing we took in February and increasing fixed cost leverage in Ennis. All aspects of our operational improvement plan that our team is focused on. We expect these elements will continue to improve as we move forward, driving continued margin enhancement, particularly as we grow into the scale of the Ennis operation. Total SG&A was 28.6% of net sales, down from 32.2% in the year-ago quarter. The biggest improvement was in logistics, where we gained 540 basis points. We spent 9.5% of net sales on media in the quarter, which represents an increase of $5 million versus last year. We did have some unfavorability in SG&A as we trued up our bonus accrual to reflect this year's improved performance, increasing our bonus expense versus the year ago by 170 basis points. Adjusted EBITDA was $23.2 million in Q3. That is considerably better than the expectation we had initially provided and was primarily due to the strong operating performance in COGS and logistics and better-than-planned net sales. Over the year, we have delivered $35.2 million in adjusted EBITDA to date, well ahead of the initial expectations we set at the outset of the year. Capital spending in the quarter was $60 million. There's no change in our outlook for capital spending this year, which remains at $240 million. We generated around $39 million in operating cash flow year-to-date, an improvement of almost $93 million versus a year ago. As a result, our cash position is very strong, with $338 million in cash on hand at the end of the quarter. For the remainder of the year, we expect interest income and interest expense to largely offset each other. We believe that we have adequate cash to fully fund our growth through 2024, and we will be free cash flow positive in 2026. We also believe that we will have access to traditional non-dilutive forms of capital to bridge a gap in 2025, if it occurs. As we look ahead to closing out 2023, we expect to continue the strong consumption growth we demonstrated in Q3, but the net sales growth will be impacted by the large trade inventory refill we completed in Q4 of last year. We believe that the trade inventory refill totaled around $10 million to $15 million in Q4 of 2022, and we will not have any trade inventory refill in Q4 of this year. Thus, we are expecting net sales growth to be in the low-20s while consumption growth will remain in the high-20s. We will continue to see an increasing rate of growth coming from unmeasured channels as the club business is doing extremely well. We will be losing the year-on-year benefit of a 2.7% price increase we took last September, so we will only have 5 points of benefit from pricing versus a year ago in the fourth quarter. Thus, volume and continued mix improvements will be the primary drivers of our net sales growth. The trends we are seeing now are all rate supportive of the volume and mix growth we need to deliver our net sales goal for the year and start next year strongly. We expect to see continuing improvement in our operating costs in Q4 as we build scale in Ennis and continue the strong delivery we have already seen in logistics and quality. However, we have added manufacturing staff in anticipation of meeting the demand we will experience in Q1 of 2024, and that will impact the adjusted gross margin in Q4. We will also incur some start-up costs for the second backline in Ennis. As a result, we expect the fourth-quarter adjusted gross margin will be slightly below Q3, but well above the year-ago margin of 33%. In the fourth quarter, we will have a sizable media dollar investment versus a de minimis investment in the year ago. This reinvestment will help us get off to a fast start in 2024. However, the rate of media spend in Q4 will be below the level we had in the first half of the year, providing some incremental margin benefit. Now let me turn to our guidance for the balance of the year. Given the strong performance to date and what we have seen of Q4 so far, we believe it is appropriate to raise our guidance to reflect the higher net sales and better-than-anticipated performance on adjusted gross margin and logistics. Thus, we are raising our adjusted EBITDA guidance to around $62 million from at least $55 million, and we are raising our net sales guidance by $5 million to around $755 million. We are not ready to give formal guidance for 2024 yet, but you should expect us to continue to focus our strategic planning on delivering against our 2027 targets, which call for 25% compound growth and an increasing rate of margin and profit growth. We will have fewer start-up costs next year and will continue to capture scale benefits and quality improvements in our manufacturing facilities, resulting in further improvement in our adjusted gross margin next year. We will also continue to capture scale and efficiency benefits in SG&A. It is important to note that our priority will remain on restoring the profitability of the business while continuing to deliver the outsized growth that investors have come to expect from us. However, at the scale we have now achieved, over-delivery of our growth rate has consequences that we must avoid to achieve our margin targets. It can significantly impact our ability to meet demand, stretch our ability to design, construct, and start up new lines, and stretch our balance sheet. In this regard, we are being very thoughtful in managing our growth at levels that are consistent with our long-term target. Our goal is to always have adequate capacity to meet our anticipated demand and not much more than that, so that we can live within our existing resources. Our planning process for adding new capacity has multiple checkpoints before we are fully committed to the cost of new capacity. We are constantly updating our demand forecast and only commit to new increments of capacity when it becomes apparent that we will need them. Because of the infrastructure we have already built in Ennis, Kitchen South, and Pennsylvania, all of our current projects are within the scope of the buildings and sites that we have already developed and the Ennis Phase 2 building that will be completed by mid-next year. We can add four lines in that space, two more lines in the existing space at Kitchen South, and we are developing a plan to install another line in storage space in Kitchens 2 in Pennsylvania. Effectively, that means that we are only making capital commitments 18 months out from when we need the capacity at this point and we will not have to invest in new building or site infrastructure beyond Ennis Phase 2 for the next year or two. We are only adding staffing 90 days out from when we need it. We believe that gives us flexibility to scale our capacity while simultaneously managing our cash very closely for the next few years. Our fast start towards our 2027 goals will also provide some added strength and flexibility on our balance sheet. With good capital spending discipline, improved margins, and better operating cash flow, we remain convinced that we will have ample liquidity to meet our needs for 2023 and 2024. We expect to require a small amount of traditional debt financing in 2025 and we will have more than enough earnings power to support that. We continue to believe we will be cash flow positive in 2026. In closing, we are very happy with the way the year is turning out. The management changes that we made in September 2022 and the increased focus on our operational improvement are apparent. They have put us ahead of the glide path that we need to deliver our 2027 goals, giving us both some added optimism that we can meet or beat those goals and also some cushion to absorb any short-term issues along the way. As we end 2023 and head into 2024, we are in a much stronger position than we were one year ago. Ennis is up and running, including the chicken processing operation, our operating efficiency has improved dramatically, and we see solid evidence of continuing improvement almost every day. Our customers have added a record number of new fridges that are amplifying our advertising investment. Household penetration is growing nicely, and our HIPPOs are growing even faster. Freshpet is becoming more mainstream and more main meal. All of that, plus the additions we have made to our team is the recipe for our long-term success. We are very bullish about our future and our ability to deliver our long-term goals. That concludes our overview. We will now be glad to answer your questions. And as a reminder, please focus your questions on the quarter and the company's operations.

Thank you. We will now be conducting a question-and-answer session. Our first question is from Ken Goldman with JPMorgan. Please proceed with your question.

Good morning. Thank you. I know you're not talking specifically about 2024 yet, but you did bring up the idea that I think you're generally aiming for 25% CAGR over the next few years. I just wanted to make sure, is the messaging for next year, if there is messaging at all, you're on target for that 25%-ish CAGR in general, but you're going to do if things come in as expected, above 25% in 2023. So maybe you can still do below 25% in '24 and still get to that number? I'm just trying to get a sense if there's any kind of underlying messaging in there or if I'm reading too much into that.

I think you're reading a little too much into that, Ken. The message is that our current run rate of volume and mix would support 25% growth. Our long-term algorithm calls for 25% growth. So we fully would expect to deliver 25% growth next year based on what we can see today. We feel very good about the momentum of the business. We're seeing good consumption. There's no reason for us to think that's not going to be part of the plan.

Thank you. And then just a quick follow-up. And if you said this on the call, I missed it, but Todd, now you're into November. Presumably, some discussions with vendors have been underway. What's your updated estimate for COGS inflation next year? I think you were roughly thinking on an early basis about low single digit last quarter.

Yes, I mean it is too early to tell. Chicken pricing is the biggest component. We will know that in about the next month. I mentioned on the call, we're very confident we will have gross margin expansion next year. Don't know exactly what that looks like. Obviously, we'll give you more color when we report Q4. But look, I think it's going to be flattish. Right now, things are looking pretty good. I think we'll have some nice leverage from fixed cost. We think the quality cost will continue to decline, feel great about logistics. So very confident about some level of gross margin expansion next year. It's really going to be dependent on what those final input costs are.

Thank you so much.

Thanks, Ken.

Thank you. Our next question is from Mark Astrachan with Stifel. Please proceed with your question.

Yes. Thanks, and good morning, everybody. I guess maybe just to start. So on track and on the mix breakout, can you maybe talk a bit about how much line of sight you have on each of those? And you talked about mix being a similar sort of contributor historically. I don't recall specific breakout previously, sort of curious why and how we think about it and how much ability do you have to manipulate that higher with innovation. And on the untracked piece, at 4 points or so contribution was a little bit more than in the first-half. How do you think about that on a go-forward basis? Is there an opportunity for that to sustain into '24? Thank you.

Hi Mark, it's Scott. Historically, we've observed that mix has typically contributed around 3 to 4 points per year. When you add that to our volume, it accounts for most of what we're experiencing, which has been consistent over time. We're beginning to notice this trend again this year. Additionally, we're seeing significant expansion in non-measured channels, which includes club sales as well as online sales.

Let me just add to it. One of the reasons why it hasn't been as much of a discussion over the last couple of years is because our mix has often been dictated by capacity. This year, we have much more of the consumer available to choose on their own. Historically, our Fresh From the Kitchen product has been our fastest-growing part of our lineup, and it's the most premium part of our lineup. We finally have good in-stocks and good supply of that. So the consumer is able to naturally migrate up through the platform or through the brand franchise as they have historically.

And then I'll add one more piece to it. As Billy mentioned in the call, we introduced some innovation called complete nutrition. And that's, we think, a great opportunity to bring additional people in. We think that, that's going to help us with overall buy rate over time. We're also starting to kind of introduce mixed or bulk cases into the portfolio. So as we see that, we'll see probably buy rate expansion with that. I think that's going to help us with kind of overall consumption, expansion of mix, and in addition actually to penetration.

Got it. And maybe related to the last piece on just the incrementality and sort of building on what you talked about on the HIPPOs. How do you think about the recruitment? And how many non-users are there out there to continue driving growth? And what do you know about them in terms of competition or composition of income and generations in terms of users?

Yes. Firstly, you'll notice in the presentation that the growth has been quite widespread. The demographic with the highest interest in Freshpet tends to be younger. Specifically, millennials and Gen Zs are where we are seeing the most progress. Currently, millennials and Gen Zs represent about 50% of dog ownership in the U.S., and this is where our future growth is coming from. Our proposition strongly resonates with this group. Notably, Gen Z is twice as likely to choose Freshpet compared to baby boomers. Therefore, we believe there is a significant demographic advantage that will support our growth over the long term. We anticipate that this group will expand at a much faster rate.

Thank you.

Thank you. Our next question is from Rupesh Parikh with Oppenheimer. Please proceed with your question.

Good morning and thanks for taking my question. So in regards to your marketing efforts, just curious how the responses to your marketing. And then as you look towards next year, just any initial thoughts on the plan for spend, whether you plan to be consistent to 11%? Or just any thoughts there as well?

So I'll answer the response to the marketing piece, and I'll turn it over to Todd on the kind of the planned spend. So basically, I think we've been able to consistently refresh the advertising over time and the marketing and the communication. We really have been able to see incredible responses to the marketing that we put in place. We see penetration really kind of pushing penetration, really nice, consistent growth over time, and expansion of the portfolio and bringing it, as Billy mentioned in the call, to this really mainstreaming the brand and mainstreaming the idea of Freshpet food and continuing to kind of deliver on that concept. And Todd, I'll let you talk a little bit about the planned spend?

It's still a bit early in the planning cycle for next year. I expect it to mainly grow in line with the sales budget for the year, which will take our media spend over $100 million for 2024. We're very excited about this. At that point, we'll be able to reduce that number as a percentage of sales over the next few years. Our target is to decrease from 11% to around 9%. I'm confident we will have sufficient funds in our media budget to achieve that in the future, but for now, it's about growth with sales.

Great. And then maybe just one follow-up question. So your operating cash flows are very strong year-to-date. I think you guys at one point thought you could do 30 to 35, and you're already about that. Just any updated expectations on how to think about that line for the balance of the year?

Yes, I think it will depend on the final working capital. We had very strong working capital in Q3. While some of that was due to timing, we are making significant improvements. I anticipate we can achieve at least $50 million for the year. This is one of our strong points, along with net sales and adjusted EBITDA. The operating cash flow and the discipline the team has demonstrated over the past year have been really impressive. So far, we've had a great start.

Great, thank you. I’ll pass it along.

Thank you.

Thank you. Our next question is from Peter Benedict with Baird. Please proceed with your question.

Hi, guys. Good morning. So first question, just on the fridge placement momentum. Obviously, a big year here in 2023. Just how you're thinking about that as we move maybe into 2024, not just kind of the new placements, but also the second and third fridge placements. Just how are you thinking about that?

Well, we've made incredible progress this year. I mean, it's a banner year, really a record year for fridge placements. It's not just first fridges we're doing well with; it's second and in some cases even third fridges. We continue to see that as being a really big piece of our overall construct in the future where we're adding second fridges into many of the high-volume stores. When we do that, we expand out on some of the current portfolio on things that we have kind of lower stock and lower inventory on, sometimes in holding power over the weekend, but it also allows us to bring some innovation into the market. So really kind of think that's a really important and fundamental piece. Going forward, we're not ready to put up any numbers for 2024 on fridges, but I would expect a return to more historical levels. And I think over the next kind of year and maybe even two to three years, we'll have the benefit of what we were able to do in 2023 and kind of give us an incredible platform to build out the business and the entire company and brand.

No, that makes sense. A follow-up to that, Scott, is that not all new stores are the same, and you have significant momentum with the club channel. I'm curious about the sustainability of that momentum and the duration of your expanded presence in the club space, as well as any additional insights you can provide regarding partners or channels that you haven't fully penetrated yet.

This is the first year we've seen significant growth in our club presence, and we've made great strides that will benefit us for several years. My ongoing joke over the past decade has been that the best time to embrace a Freshpet vision was yesterday, as we consistently see increases in same-store sales and overall growth. I believe we'll reap the benefits from the club channel, which may exceed expectations. For instance, if same-store sales increase by 15% after a year, we can expect that to align with the higher sales rate typical of clubs. Additionally, it's clear that we currently have no presence in Sam's Clubs, but we believe there is a tremendous long-term opportunity to establish a partnership with them that caters to their customers and facilitates significant expansion over time.

Terrific. Thanks so much.

Thank you. Our next question is from Jason English with Goldman Sachs. Please proceed with your question.

Hey, folks. Thanks for slotting me in. I'm going to take us back to the top with the first two lines of questions, which I think we're all about trying to get confidence in the consensus estimate for 25% growth next year. You mentioned that you're confident based on everything you see. It's a little harder for us to get confidence because we don't see the measured contribution or the mix we used to see the Nielsen data, which is tracking below, and we know the big box pet is not particularly strong. So coming back on two points that have already been addressed, but I want to make sure we come back and hit them again because I think they're really important. The mix component, obviously, a nice contributor. You're launching a lower price per pound product. Shouldn't we expect some of your consumers to opt in for that and mix, therefore, to turn into a headwind, question one. And then question two. I'm sorry, I was distracted. There's other news on the tape. And I know Mark asked this, but the 400 basis points, the Costco contribution. You are going to start to cycle the build-out next year and getting the same number of stores as you got this year, just net neutralizes that. It doesn't continue to add incremental growth over and above. So what's the source of the incremental growth? Like how do we keep that incremental 400 basis points coming?

Let me take a shot at this. So first of all, on the Costco part, we're still not in the full Costco collection of stores. I think at the end of the quarter, we were in something like 370 of the Costcos, there's like 550. So we still have a long runway of new stores. Each of the stores that we're in grows at a very rapid rate, and they're relatively early in their life. I would expect that trend with Costco to continue for quite some time. As Scott just mentioned, we are not yet in Sam’s, but that certainly becomes another opportunity for us when they decide that that's a play that they like to make. On the mix part, yes, we do expect to see that some number of consumers will migrate to the new complete nutrition product. But what we've seen so far is that that is more than offset by the migration of the franchise, especially as we've gotten complete distribution on our Fresh From the Kitchen product and some of the other more premium products we've added to the lineup. So on balance, we believe that there's continued mix gains rather than a mix headwind. Our data, we obviously showed you the data through the end of September. We've had the complete nutrition product in the market in October. We've seen what the sales look like, and we still feel very comfortable that it is not dilutive.

That's good stuff. I appreciate that. And by the way, congrats on all the operational improvement, I should open with that because obviously making great strides, and I want to make sure those are recognized. And it's great to see the driving margins, sticking on the new more value-oriented product. Is that margin neutral, margin dilutive, or penny profit neutral, penny profit dilutive?

It is margin neutral.

We think that's going to open up a lot more penetration, bringing people into the portfolio and then keeping some people using it on a more consistent basis. Performance has been extraordinary. It's very new and performance has been extraordinary already. From where we're able to watch it so far, the results have been excellent. Again, I think that across the portfolio, there's lots of mix and trade-up opportunity. Those items are more available. We're adding things on the other end of the entire spectrum on our portfolio on the higher end of the spectrum. We're seeing great growth with those items. Large dog is a great example that was called out too. We've got all that, and then eventually, going to, as I mentioned earlier, we're going to start adding these cases in and like these bulk packs. It's going to change the dynamics of the business, bringing it more and more mainstream and main meal.

I hear you. It makes sense to me. Cool, thank you. I'll pass it on.

Thank you.

Thank you. Our next question is from Michael Lavery with Piper Sandler. Please proceed with your question.

Thank you. Good morning.

Good morning.

Just looking at the household penetration growth by income bucket. In the last 52 weeks before this complete nutrition launch, you already have that lowest income consumer household penetration up 17%. And so I guess what's driving that? And with this launch, how much higher do you think that should go? If there's already that good momentum, is that really where you see a kick up to some much faster pace? And how do we think about the magnitude of that?

So look, as part of our strategy over time, we want to make sure we have an incredibly wide portfolio of products that really spans different price points, different offerings, and also different benefits to consumers and what they're looking for in products. We want to make sure we have everything out there. One of the things that we have the opportunity to do now is as we get more and more scale, we have the opportunity to bring products that are even more value-oriented and build that piece out. What we know is that sometimes, the initial price point is a little bit of a shock for some consumers. So the goal is to bring them into the franchise let them kind of migrate through and then migrate up over time and use more of our products every single day.

Okay. That's helpful. Just for the consumers' understanding, I'm looking at your slide with complete nutrition package. And obviously, it doesn't say nearly as good or almost as good as some of these others, but how do they understand the differentiation between this and the rest of the portfolio? Obviously, the price point conveys a bit of that message. But what's the right way for them to understand how they're different and what the value proposition distinctions would be?

People often make assumptions about products based on their price points, which is likely the primary indicator. Having a competitive price is important, but we've also enhanced this product by incorporating more whole grains and complete carbohydrates. We've highlighted this feature, even though it's subtle. This product upholds Freshpet's high standards and surpasses them. I will be incorporating it into my dogs' diets regularly. It's an outstanding product that we are very proud of, and it also provides a value that may attract consumers to the Freshpet brand.

Okay, thanks so much.

Thank you. Our next question is from Bryan Spillane with Bank of America. Please proceed with your question.

Hey, thanks, operator. Good morning, everyone. I have just two quick questions. First, I want to clarify something that seems inferred in the earlier comments. Given your current situation regarding cost inflation and productivity, it appears that another price increase is not planned. I want to confirm that I understood that correctly.

Yes. I mean, obviously, until we price our chicken, we can't say for sure. But our read of the tea leaves would suggest that we will not be taking pricing at least not in the first part of next year. So we feel comfortable about where we sit from a commodities perspective based on the markets and the small portion of our commodity costs that we've already locked.

Okay. And then the second question, in the prepared remarks, Bill, you talked about there was a discussion about, kind of, balancing demand stimulation with not overheating the supply chain basically, right? So can you talk a little bit more about that? Just how do you, I don't know, like what does the dial look like? How do you turn the dials to make sure you're not overstimulating demand? And I guess, what are the bandwidth, right, in terms of just how much you could actually exceed the 25%. Just trying to get an understanding of kind of how you approach that?

Yes. I mean, one of the benefits of this business is it's probably one of the most reliable and predictable businesses that I've seen in my 30-some plus years of CPG. We don't do any trade promotion, no discounting. The single biggest driver, and by far the vast majority of the growth comes from advertising investment. So our dial is advertising investment. It's not literally you turn it on and tomorrow, you see it; but if you turn it on, you start adding the users that will contribute meaningful volume over the coming months. So that's the way we can control the demand going forward. That's where we spend the bulk of our time, laying in advertising spending against what we think our capacity needs are going to be. The reason we made the comment in the prepared remarks about dialing it in fairly closely is three or four years ago, we would put a line in, and it would give us capacity that would last us a year or two years, and you're fine on it. Now, at the scale that we've achieved, when you put a line in, you can pretty quickly burn through the capacity of a line in less than a year. We can't afford to have this thing planned for 25% and deliver 33% on an ongoing basis, because you just won't have the infrastructure in place. You just won't have the equipment installed. Lead times on equipment are long; construction takes a long time. Staffing is quick. We can staff up in 90 days. But if we're going to suddenly outperform our expectations by 5 or 10 points as we might have done over the last couple of years, we could find ourselves short shipping again, we don't want to do that. At this point, we're very comfortable planning for 25% growth. There is a little bit of headroom on top of that, and we plan for a little bit of headroom on top of that, but we certainly don't want to be pushing over 30%.

Alright. Thanks, Billy.

Thank you.

Thank you. Our next question is from Bill Chappell with Truist Securities. Please proceed with your question.

Thanks. Good morning.

Good morning.

Just a little bit more on pricing, especially moving to next year. One, do you think you get back to a normal cadence of just doing some pricing every year going forward? Or is there some pushback on the pricing you've taken so far? And then two, and probably more importantly, I know you have a different product than the dry goods. But I mean, do you see some increased promotions in kind of the competitive landscape that may change your pricing attitude? Or do you think everybody is going to kind of hold the line even at the premium, super-premium side as we move into '24?

Hey, Bill. Let me discuss the category first. As volume has softened, we are monitoring it. Yes, the category volume has weakened. We are closely observing and waiting for someone to begin adjusting prices. We haven't seen that happen yet, nor have we noticed increased promotions. Growth in this area has been minimal. At some point, I think we may see some movement, but nothing has materialized so far. Historically, I expect some players to gradually introduce changes, but it won't be extensive. From our perspective, we aim to make pricing adjustments when necessary, and we approach this strategically and selectively in all our efforts. So, will we implement a few price changes here and there? Yes, that will likely be a continuous consideration. However, most of our price adjustments have stemmed from modifications and enhancements to our portfolio and the new products we've introduced. It hasn’t merely been a blanket increase of 2% or 3%. We've launched new items at higher price points and seized various opportunities over time to make slight pricing adjustments.

Bill, I would add to that, we also expect that there are fairly sizable opportunities for us to improve the gross margins from throughput and yield. We have built organizational capability over the last, call it, year that is really focused on increasing throughput, driving efficiencies in the manufacturing operation, and driving efficiencies in the supply chain, much more competitive bidding on some of the key components that we buy or used to just have to take whatever you could get, whatever was available. Now there's a much more ability to do strategic sourcing. So all of those elements will help us and could mitigate the need for further pricing. It doesn’t mean we won’t try to take some pricing at some point, but the need for it won’t be as great.

Got it. And then switching back to some of the questions on the club channel. I mean at the store level, we've seen a lot of changes over the past few months. I mean, I know you've got a benefit, but can you maybe give us an idea of where we are? I think Costco has 11 regions. I'm not sure if you're in every store. And it seems like there's more opportunity in front of you than behind you, but I just want to make sure I'm looking at it the right way.

No, we believe that there is a significant amount of opportunity ahead of us. Firstly, this has been an incredible year with substantial expansion. We will benefit from this throughout next year. Additionally, we are about two-thirds through our engagement with Costco as of the third quarter, meaning there are still more Costcos to come, not only in the U.S., but also in Canada, Mexico, and even the U.K. There are many more Costcos available. The most important aspect is that we have not yet entered any Sam's Clubs. We believe that over time, entering Sam's with the right approach could be very beneficial and give us exposure to another group of consumers who shop for pet food at Sam's.

Great, thanks so much.

Thank you.

Thank you. Our next question is from Rob Moskow with TD Cowen. Please proceed with your question.

Hi, everyone. This is Jacob Akin for Rob. Congrats on the quarter.

Thank you.

I just have two quick clarifying questions and then a broader question. So first, for media spend, last quarter, you said that it would be up $15 million in the second half. Is that still true? Or it was today an update to that? And then for like freight and logistics costs, does your guidance assume that the fuel costs and stuff will stay where they currently are or go back to more normalized levels?

Your question on media first. So yes, we were up about $5 million in Q3 year-over-year. We'll be up approximately $10 million in Q4 spend, only a couple of million dollars last year. So we'll be kind of in the plus or minus $13 million range of spending for Q4, which we're really excited about. I think it will give us a little bit of a help in Q4, but more importantly, get us off to a strong start as we go into 2024. Logistics have been holding steady. We don't see a big change sequentially between Q3 and Q4. We've had a little bit of an uptick in diesel cost, not significant, but we've seen some favorability in some other areas. So we're feeling very good about the logistics expense right now.

Awesome. And then just more broadly back to media. You said that next year, you kind of expect it to grow close to sales, maybe above $100 million rough math. But then going forward, you'll expect it to leverage with sales growth. But it's my understanding that your media and sales are kind of like 1:1 when you try on, meaning you get sales. So how do you expect to generate this 25% sales growth in the later years with a lower media as percentage of sales?

There are certainly some scale benefits as we get further and further out. One of the things that we've seen is the more you build out your fridge network, you get the visibility amplifying the advertising. Stores with two and three fridges amplify the advertising. We think that part of the reason that our advertising has gotten so effective and driven growth in excess of what we had planned for was because of the increased retail visibility. That doesn't go away. Yes, net new fridges is a good thing, but the installed base of fridges, lighted fridge sitting in a store, double or triple fridges, continues to amplify the value of the advertising every successive year. We think that's frankly where we're going to get some of the benefit, but also scale in the media. We'll get some benefit there as well.

Yes. Just for perspective, and I've said this before, if we reached the $1.8 billion goal in 2027 and get the media spend down around 9% of sales, which we expect on both, that's $160 million of media spend, one brand, basically one country. We think that's a powerful resource to drive 25% CAGR.

Awesome. I appreciate it. Congrats again.

Thank you.

Thank you. Our next question is from Jim Salera with Stephens. Please proceed with your question.

Hi, guys. Thanks for squeezing us in. I wanted to ask about the expanded distribution of the large dog offering as well as the complete nutrition. What does that look like in the fridges in store? Which SKUs get taken out in replacement those? Or is that kind of a way to dangle that offer in front of retailers to motivate them to put in that second fridge?

Yes. As we build out new products, we typically will really have a very deep discussion with the retailers about adding a second fridge. It takes up a fair amount of space. You're typically dedicating at least a full two feet to it in a fridge, on a shelf in order to get packed out. So it takes up a fair amount of space. You never want to kind of take out existing items that are performing extremely well. So it is a really, really big push to go into our second fridges and even some of our third fridges over time.

Okay, that's helpful. Todd, I have a follow-up. I know others have discussed the logistics aspect, but you all achieved impressive results in that area. Should we consider the current logistics expense, which is below 7%, as sustainable going forward? Additionally, did you exceed the 2027 target in that area on a continuous basis?

Yes, I mean we laid out, to your point, we laid out a goal of 7.5% logistics back in February. Obviously, one of the bright spots is we've already beat that target. Yes, we think we will long-term be below the 7.5%. Obviously, if there's a big spike in diesel or lane rates from time to time, that could drive it periodically higher. But long-term, we're very confident at this point with reasonable diesel costs that we will be sub-7%. From what we can see right now, obviously, something has changed, but we feel good about being 7% or below for next year as well.

That's helpful. And then if I could maybe sneak in one last question. On the breakdown of the household growth rate by income, I was honestly surprised to see low income up as much as it's been. Can you just give us an idea of maybe what SKUs are driving that? And then from a consumer perspective, is kind of the value proposition that you guys offer that a consumer that has a little bit tighter of a budget would still be buying premium pet feed?

Yes. One of the challenges I face in sharing data by income is that it assumes all income supports the same size household. In reality, many consumers in the lower-income category live in smaller households; they may be single with a dog, or their children may have moved out, leaving just them and their pet. This means their available discretionary income is much higher, even though their total income is relatively low. Since we cater to a younger demographic, we have a notable number of millennial and Gen Z consumers in this group for whom their dog is the most significant part of their lives. They often do not have a car or a spouse, which means their expenses are quite limited.

Thank you. Our next question is from Jon Anderson with William Blair. Please proceed with your question.

Hey, good morning, everybody. Thanks. Just two quick ones. On the productivity work, congrats on the benefits that you're delivering there. As you look to the Fresh Future goal of getting to 18% EBITDA margin by 2027. It looks like this year will come in closer to 8% from an EBITDA margin perspective. So you've got about 10 percentage points over the next four years. Can you talk a little bit about the path you expect during that time frame? Is it a straight line? Does the improvement ramp in the out years and what some of the drivers are there? And then the follow-up to that is, Todd, I think you mentioned gross margin you expect it to be sequentially lower in the fourth quarter than the third quarter. When do you think you hit an inflection point where we did see kind of sustained gross margin improvement sequentially going forward? Thanks.

Regarding your first question about EBITDA margin, we expect to see around 500 basis points of improvement this year, which is great. However, we won't achieve that amount every year, nor is it necessary. As for the additional 10 points you mentioned, 5 of those will need to be generated from gross margin. We anticipate a gross margin of approximately 39.5% for this year, leaving us needing about 550 basis points more. We have discussed how our media expenses will decrease as a percentage of sales by a couple of hundred basis points. There might be some room for growth in logistics, but it's not significant since we've already made substantial progress there. The remainder will come from SG&A leverage; with a growth rate of 25%, we don't need to grow our headcount or other costs more than in the high single digits, providing us with considerable leverage in SG&A. We have strong visibility on this. Gross margins are the most challenging aspect, and we must execute exceptionally well, but we are confident in our ability to be more productive and efficient, which will help us achieve this. As for the cadence, it's difficult to forecast precisely. I believe we'll see nice improvements in both gross margin and EBITDA margin next year, although it's too early to set a specific target. Our goal is to gain 10 points over the next four years, averaging 250 basis points of EBITDA margin growth per year. I'm very confident we'll achieve that, but the exact timeline for that growth is uncertain. Nonetheless, I expect to see a significant improvement next year.

Thank you.

Thank you. There are no further questions at this time. I would like to hand the floor back over to Mr. Billy Cyr for any closing comments.

Great. Thank you, everyone. I'll leave you with this thought. The humorous Jerome K. Jerome said about dogs. They never talk about themselves, but listen to you while you talk about yourself and keep up an appearance of being interested in the conversation, to which I'd add, we reward them for their patience and feed them Freshpet. Thank you very much for your interest.

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