Freshpet Q3 2024 Earnings Call Transcript

Quartr
Provided by Quartr
November 4, 2024

There are 13 speakers on the call.

Operator

Greetings. Welcome to Freshpet's Third Quarter 2024 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.

Operator

It's now my pleasure to introduce Jeff Sonek with ICR. Thank you. You may begin.

Speaker 1

Thank you. Good morning, and welcome to Freshpet's Q3 2024 Earnings Call and Webcast. On today's call are Billy Cyr, Chief Executive Officer and Todd Kunfer, Chief Financial Officer. Scott Morris, President and Co Founder will also be available for Q and A. Before we begin, please remember that during the course of this call, management may make forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Speaker 1

These include statements related to our long term strategy, 2027 goals and pace in achieving these goals, prospects for growth, timing of capacity expansion, new products and new technology and 2024 guidance. Words such as anticipate, believe, could, estimate, expect, guidance, intend, may, project, will or similar conditional expressions are intended to identify forward looking statements. 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, including those associated with such statements. Please refer to the company's annual report on Form 10 ks filed with the SEC and the company's press release issued today for detailed discussion of 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.

Speaker 1

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 for how management defines such non GAAP measures, why management believes such non GAAP measures are useful, 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.

Speaker 1

So with that, I'd like to turn the call over to Billy Cyr, Chief Executive Officer. Billy?

Speaker 2

Thank you, Jeff, and good morning, everyone. For those of you who are wondering, Jeff was gracious enough to fill in for our VP of Investor Relations, Rachel, while she is on maternity leave. Now to the business. The message I would like you to take away is that we are beginning to establish the kind of consistency and reliability in our manufacturing operations that we've been delivering on the top line for some time. That has enabled us to rapidly increase our margins while simultaneously generating the kind of growth you've come to expect from us.

Speaker 2

As you know, our objective this year was to continue our strong top line growth, but do it at a rate that would enable us to live within our capacity limits while strengthening our operating performance and cash generation. The result would be category leading growth, outsized improvement in profitability and more effective cash management. We described that as disciplined growth. If we do that well, consumers will win, customers will win and our shareholders will win. And that is what we are delivering.

Speaker 2

In Q3, we delivered our 25th consecutive quarter of 25% year on year growth, a significant expansion on adjusted gross margin and adjusted EBITDA margin and sizable operating cash flow. In fact, this is the 3rd quarter in a row where our adjusted gross margin exceeded our 20 27 target and our 6th consecutive quarter where our logistics cost was better than our long term target. And we've generated more than $100,000,000 in operating cash flow so far this year. I suspect that many of you are now wondering if or when we are going to adjust our long term targets to reflect the early achievement of so many of our long term financial goals. While we are very encouraged by our progress, we don't want to get ahead of ourselves.

Speaker 2

We want to see sustained improvement across the full year before we conclude that we can deliver more than what we have already committed. We are also very mindful that we are operating in a dynamic environment and would like a bit more time to see where the current trends, particularly on inflation, settle out. So this is something we are giving a great deal of thought to in consultation with our Board, but we aren't yet ready to update our long term targets. I would now like to call out a few key highlights from the quarter and then Todd will provide a bit more detail on the financial results and we'll update you on our thinking on guidance. First, I am very encouraged by the net sales growth we saw in the quarter.

Speaker 2

We grew 26% and virtually all of it was due to volume growth. This volume growth was driven by strong household penetration growth, particularly amongst our HIPPOs. Overall, household penetration growth was up 17% despite lapping a sizable gain in households in the year ago period and the HIPAA growth rate was 24%. Recall, our media investment is more backloaded this year than it was last year. So you should expect that household penetration, which is a 52 week measure, will lag our long term growth rate in the back half of this year due to the change in the media timing.

Speaker 2

However, it should reaccelerate in the first half of next year, we are getting the benefit of this year's second half media investment in the 52 week measure. We continue to believe that we are well on track to deliver our 20 27 target of 20,000,000 households and are increasingly focusing our attention on the 5,000,000 HIPPOs who now represent approximately 90% of our revenues. 2nd, our team did an outstanding job managing the balance between capacity and demand, allowing us to simultaneously drive strong growth rates and strong operating performance. Recall that we chose to limit our first half media investment to a rate that was below our rate of sales growth so that we could reliably meet demand until our new role line in Ennis was up and operating at the end of Q3. That plan worked.

Speaker 2

We were able to grow 26% in the quarter, but did it with a customer order fill rate of 99% for the quarter. As I've said before, a strong fill rate is a very good indicator of overall operating performance for us and that was definitely true in Q3. We were able to deliver this strong performance because the reliability of our media model provided a very accurate forecast demand and our operations team generated strong throughput on our existing production lines and started up the new role line 1 week early. In essence, we were able to thread the needle, I. E.

Speaker 2

Generate strong growth without exceeding our capacity limits and while maintaining exceptional customer service. We expect to apply that same type of robust planning as we bring on new lines over the next few years, carefully managing our media investment and capacity to ensure good customer service, strong net sales growth and healthy margins. 3rd, the production, quality and logistics teams in the Freshpet Kitchens continue to drive improved performance, including yield, throughput and quality costs, while also delivering exceptional customer service at our lowest logistics cost as a percent of net sales ever. On a year over year basis, the sum total of our input costs, logistics and quality improved by 7.90 basis points and that contributed to a 6 30 basis point improvement in our adjusted gross margin. We believe this is the result of the investment we've made in our hourly production workforce and their training, I.

Speaker 2

E, the Freshpet Academy, the Freshpet Performance Excellence program we began about 2 years ago and a more stable external environment. Finally, our customers continue to believe that Freshpet is the future of pet food and continue committing additional retail space to Freshpet. At the end of the quarter, we had 22% more total distribution points, TDPs, due to the addition of more than 1,000 new stores year to date, more than 750 additional stores with 2nd and third fridges year to date and a sizable increase in shelf space and retailer owned fridges. We continue to also see a strong connection between the increased retail visibility and the efficiency of our media investment, as our retail presence amplifies the media investment. This is visible in our customer acquisition cost, CAC, which continues to be in line with our long term targets and is helping us drive a strong return on our advertising investment.

Speaker 2

Now I'll provide an update on KPIs we track for our main and more plans, mainstream, main meal, more profitable plans. Focusing on the idea of mainstream, Freshpet is becoming increasingly mainstream, but still has a long runway for growth. According to Nielsen on the channel data, which includes e commerce and direct to consumer, as of September 28, 2024, total U. S. Pet food is a $54,000,000,000 category.

Speaker 2

We only have a 3.2% market share within the $37,000,000,000 dog food segment, which is the majority of our business today. Within the fresh frozen subcategory in measured channels, Freshpet has a 96% market share. Fresh continues to outperform the broader pet food category and many retailers believe it is the future of pet food. As a result, Freshpet now commands 66% ACV in Nielsen ex AOC and we continue to add distribution breadth and depth with 2nd and third fridges. Our household penetration gains also demonstrate that we are well on our way to making Freshpet more mainstream.

Speaker 2

As I mentioned earlier, household penetration is on track to meet our target of 20,000,000 households by 2027. But more importantly, the complexion of the households underpinning our growth continues to improve. Our HIPPOs are growing 24% versus the prior year period, surpassing our broader household growth of 17%. We think the combination of retail support and our ability to drive household penetration is a clear indication that Freshpet is leading the way towards making fresh pet food a mainstream idea. Our Hippo penetration also extends to the main meal part of the strategy.

Speaker 2

Currently, 39% of Freshpet users are Hippos and they represented 90% of our sales in the Q3. Of those users, about 325,000 or less than 3% of our total users buy more than $1,000 of Freshpet per year and this group grew 23% over the past year. They now represent approximately 27% of our business. We are increasingly focusing our attention on this audience and trying to create a much larger cohort of users who look like they do. Part of our strategy for making Freshpet into a more of a main meal item is to offer a range of items that meet the broadest range of consumer needs.

Speaker 2

This year, we've launched several new items to do that and they are doing very well. In particular, our large dog product, while still in limited distribution has grown quite nicely and is becoming a very successful item for us as it broadens the appeal of Freshpet into larger dogs. Similarly, our multi packs have done very well. Early next year, we'll be launching a product for seniors, further broadening Freshpet's appeal. Adding second and third fridges enables greater distribution of our wider assortment.

Speaker 2

Based on total U. S. Pet retail plus data from Nielsen, we currently have an average of 20.5 SKUs per point of distribution, up from 18.0 SKUs 1 year ago. Now to the more part of Maine and More, more profitable. We had another strong quarter of margin improvement.

Speaker 2

Adjusted gross margin improved 60 basis points versus the strong results we posted in Q2 to 46.5 percent and we ended the 3rd quarter with an adjusted EBITDA margin of 17.2%. As I mentioned earlier, the margin improvement came in our key focus areas of quality, input costs and logistics. It is becoming increasingly apparent that the improved organizational capability, improved analytics systems and intense focus on those drivers of profit improvement are not only working, but generating better results than we had expected and sooner than we had anticipated. We are very pleased with this progress, but also believe there is significant upside that we can deliver over time. I would also like to give you an update on our efforts to expand our capacity.

Speaker 2

As a reminder, we continue to focus our capacity expansion plans on 3 key drivers of improved capital efficiency. They are: 1, maximizing the throughput of our existing lines 2, maximizing the capacity of our 3 existing sites and 3, developing and implementing new technologies that generate more throughput per line. We are making good progress against all three parts of that strategy. In Q3, we achieved another milestone with the start up of the 4th line in Ennis, a roll line, giving us 2 bag lines and 2 roll lines at that site. That 4th line started up 1 week early, under budget and ramped up faster than we had projected.

Speaker 2

We have also largely completed the installation of the 5th line, which will be our 3rd roll line in Ennis because it was more efficient to install 2 roll lines at the same time in the new space. That 5th line will be commissioned in Q4 and between those two new roll lines, we'll have enough rolls capacity to last well into 2026 once we have fully staffed those lines. We are in the final stages of installing our next bag line in Kitchen South and expect that to start up in late Q1 of next year. We've also added staffing in Kitchen South on the existing lines, so that we will have adequate bag capacity for the balance of 2024 and into 2025. In Bethlehem, the team is focused on increasing capacity utilization or OEE on our existing lines.

Speaker 2

Our Freshpet Performance Excellence program has driven sizable gains in throughput, yield and quality since it was launched almost 2 years ago and we believe that investment has unlocked a sizable amount of free capacity. We believe there is significant upside remaining and are increasing the resources we devote to that effort and reapplying the program to Ennis. The Bethlehem team is also in the process of remodeling some dry storage space in Kitchens 2 to accommodate a production line that uses the new technology for our bag products. That line is on track for start up in the second half of twenty twenty five. In summary, I think we are making good progress at proving that we can reliably deliver improved operating performance and strong growth simultaneously.

Speaker 2

This disciplined growth is the result of our strengthened organizational capability, improved analytics systems and intense focus that has enabled us to generate outsized gains in productivity and profitability. We are increasingly confident that we can sustain this type of performance and deliver the levels of shareholder returns that we believe the proprietary Freshpet business model is capable of generating. Now let me turn it over to Todd to walk through the details of

Speaker 3

the Q3 results and our updated guidance. Todd? Thank you, Billy, and good morning, everyone. As Billy mentioned, we are very pleased with the Q3 results, particularly our ability to deliver on profit improvement. Now I'll give you some more color on our financials and updated guidance for the year.

Speaker 3

3rd quarter net sales were $253,400,000 up 26 percent year over year. Nielsen measured dollar growth was 23% versus the prior year period with broad based consumption growth across channels. We saw 24% growth in ex AOC, 22% in U. S. Food, 11% growth in Pet Specialty and over 70% growth in the unmeasured channel.

Speaker 3

3rd quarter adjusted gross margin was 46.5%, up 630 basis points year over year. This was driven by improvements in input costs, yield, throughput and quality costs. Specifically, input costs as a percent of net sales improved 4.50 basis points versus a year ago due to better yields and lower commodity costs and quality of costs improved by 2 20 basis points versus year ago. We did have a timing benefit in our quality costs that will reverse in Q4, but it was a strong quarter nonetheless. 3rd quarter adjusted SG and A was 29.3 percent of net sales compared to 28.6 percent in the prior year period.

Speaker 3

We spent 10.8% of net sales on media in the quarter, up from 9.5% of net sales in the prior year period. Total media investment was up 43% year over year. Recall, our media plan was less front loaded this year than in years past so that we can manage our growth to live within our capacity limits. As a result, our media investment in the back half of twenty twenty four will grow significantly faster than our sales will grow and that will position us for a faster start in 2025. Logistics costs continued to improve and were 5.6 percent of net sales in the 2nd quarter, a decrease of 120 basis points compared to the prior year period.

Speaker 3

The majority of the improvement was due to strategic actions we have taken to increase fill rates, reduce miles driven by increasing the number of states served by our 2nd distribution center and negotiations with various carriers with the remainder being more macro driven with more favorable lane rates and lower diesel costs. Other SG and A, which was 13% of net sales, increased 60 basis points driven by higher incentive compensation. 3rd quarter adjusted EBITDA was $43,500,000 or 17.2 percent of net sales compared to $23,200,000 or 11.6 percent of net sales in the prior year period. This improvement was primarily driven by higher gross margin as well as improved logistics cost, partially offset by higher media investment and incentive comp. Capital spending in the Q3 was $34,000,000 This was lower than expected due to the timing of projects and payments.

Speaker 3

We expect a much higher rate of spending in the Q4. However, we are lowering the estimate of capital spending this year due to the timing of projects. We now expect CapEx this year to be approximately $180,000,000 versus the previous guidance of $200,000,000 Operating cash flow in the 3rd quarter was $56,100,000 and we had cash on hand of $274,600,000 at the end of the quarter. We continue to believe that we have adequate cash to fully fund our growth through 2025 and we will be free cash flow positive in 2026. Our strong improvement in adjusted EBITDA this year also makes it unlikely we will need any additional capital.

Speaker 3

We generated $11,900,000 in net income in the 3rd quarter, bringing our year to date net income to $28,800,000 Now turning to guidance for 2024. We are updating our outlook to reflect our outperformance in the 3rd quarter as well as our conviction and our ability to execute in the final quarter of the year. We are raising our net sales guidance from at least $965,000,000 to approximately $975,000,000 or growth of around 27%. We are able to do this because of the significant improvements in our operating efficiency and the strong start up of the new rolled line in Ennis. Collectively, these efforts will allow us to sell a bit more this year than we had originally projected and still maintain strong customer service.

Speaker 3

We are also keeping in mind the capacity needed to support next year's growth and do not want to get too far ahead of our original plans. As far as cadence, we continue to expect net sales to have sequentially lower percentage growth in the Q4 of 2024 as the lower first half media spending will result in slower growth in the second half, something that we deliberately did to manage our growth to live within our capacity limits. In our business, the first half media investment really dictates the demand we will have in the second half of the year and the second half media investment will drive the demand we experienced in the first half of next year. For this reason, our second half media investment will be significantly larger than the investment we made in the previous year. We are expecting second half twenty twenty four media investment to be more than 50% larger than in the comparable prior year period.

Speaker 3

For adjusted EBITDA, we are raising guidance from at least $140,000,000 to at least $155,000,000 to reflect the over delivery in Q3. We now expect the gross adjusted gross margin to expand by approximately 600 basis points for the full year compared to 500 basis points previously. Capital expenditures are now projected to be approximately $180,000,000 compared to approximately $200,000,000 previously to support the installation of capacity to meet demand in 2025. The reduction is due to the timing of certain expansion projects. Some of that reduction will push spending into 2025.

Speaker 3

In summary, the Q3 results have continued to build our confidence in our ability to deliver our long term financial goals. We are operating more effectively and more efficiently and you can see that up and down the P and L and in the way we show up to our customers and consumers. We believe that is the result of our investments capacity and organizational capabilities as they are now delivering the scale benefits we believe are possible in the Freshpet business model. That concludes our overview. We will now be glad to answer your questions.

Speaker 3

Operator?

Operator

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

Speaker 4

Yes. Thanks and good morning everybody. Obviously, really good results here in the quarter and the guidance. So maybe taking a bit of a different tact, I wanted to ask about expansion of the business from a top line standpoint in kind of the less focused areas. So I've seen some things about looking at expanding the U.

Speaker 4

S. B2C business beyond a test. It looks like there could be some incremental news potential at some point there. So maybe talk a bit about kind of effort in that space, what you see as the opportunity path to success, kind of what you've learned so far. And then, looking outside the U.

Speaker 4

S, in particular Europe, also it seems like there's some efforts there around accelerating or refocusing on that business. I think there's been some kind of start and stocks and focus there. So maybe talk a bit about those efforts. Thank you.

Speaker 2

Yes. Mark, this is Billy. I'll take the second part of your question and Scott will take the first part of your question. Recall the beginning of this year, we said to folks that we felt really good about the European business and the business model that was there, but we didn't feel very good about the reliability of the supply chain. So we endeavor to work on ways to create a more reliable supply chain in Europe before we make any decision about investing any further in that market.

Speaker 2

Those tests are underway. We feel very good about the progress we're making, but there's no conclusion yet, no definitive plan to do anything more than what we're already doing today. We like the consumer dynamics there. We think the Freshpet business has long term potential there, but we want to make sure we get it right when we actually do it. So at this point, we're still in the testing and validation phase, particularly on the supply chain side of it.

Speaker 2

Turning to

Speaker 5

Scott to tell you a

Speaker 2

little bit about the DTC side of things.

Speaker 6

Hey, Mark. So look, the way we think about e commerce, I think you know it pretty well. But basically, the majority of what we consider e commerce is click and collect for us. It's about that's like around 60% of our total. And the vast majority of what we're seeing is about 87% is coming from our fridge network.

Speaker 6

So that's really where the majority of it is. Now we are always doing a lot of we know there's a lot of opportunity for us to open up and make sure that we're giving people other opportunities to purchase from us in different ways. So we're always continuing to test. We have opened up our D2C just a little bit, to test a little bit of expansion, understand how it's working. But right now, this is something that I think it's in a test and learn phase, a test and learn mode, similar to what Billy was talking about as in Europe especially.

Speaker 6

We have all these places where we're kind of planting seeds and understanding how those models work, how we would invest in them, the returns that we're getting on them. But right now, these are very small pieces of our business at this point. And what we're doing is, as we learn enough and we feel confident, those are places that we potentially invest in and see if we can drive well above our kind of standard growth rate of, call it, around 25%.

Operator

Our next question is from Ken Goldman with JPMorgan. Please proceed.

Speaker 7

Hi, good morning and thank you. I wanted to ask on gross margin, the commentary is now being focused on consistent performance after the obviously excellent improvement in that gross margin rate. How do we think of the comment about consistent performance, which I think some people might interpret sort of as, say, it will be kind of flattish from here. In light of the prior comments that you're looking at new technology to help with throughput and efficiency, maybe you have that new technology coming in later next year, it sounds like. So just kind of wanted to balance those comments and kind of get a general sense of how you see the gross margin path ahead?

Speaker 7

Thank you.

Speaker 3

Yes. Hey, Ken, it's Todd. So look, we're obviously thrilled with performance this year, hitting year to date almost 46% and that's our guide for the year. So we think we'll have another solid quarter in Q4. Clearly, we do not anticipate that's the end.

Speaker 3

We're obviously ahead of our long term target of 45%. So that's fantastic that we're 3 years ahead of schedule. But we still think we have tons and tons of opportunities. What that path exactly looks like over the next couple of years, I think we'll talk more at year end. We'll be at CAGNY, so we can kind of explain that in a little more a little bit more depth.

Speaker 3

But obviously, as we talk about all the time, there's 3 areas of focus here where we think each of them still has upside. One is getting more efficiency out of the lines that we have. We made great progress, particularly in Bethlehem, but we got a lot more work in Ennis to go. And when we've seen some positive signs in the last couple of months in Ennis and feel good about the future there. It's getting more capacity out of all the facilities that we have.

Speaker 3

So we're going to get we're going to use every square inch to make sure we have the right capital efficiency there. And then as you mentioned, new technologies. The line should come up at the end of next year. So it's going to be early days and we won't know exactly kind of where we are till the end of next year. We're optimistic.

Speaker 3

We think we have something that could be very, very interesting, but that's going to take a couple of years to play out. So in summary, look, we're going to hit around 46% for the year, which again is terrific. We're not stopping there. We think there's significant more upside to come.

Speaker 7

Thank you. And then for a follow-up, thinking about next year, I realize it's too early for specific numbers. You have talked a little bit about the cadence just in terms of how you expect the second half of twenty twenty four's media to kind of influence the first half of twenty twenty five. And just trying to get a sense, are there any other kind of tailwinds, headwinds we should be thinking about right now? You did talk about inflation a little bit or at least mentioned the word, wanted to get a little bit of color there if you could at this time.

Speaker 7

Any kind of insight that you're ready to provide them, I'm sure would be appreciated.

Speaker 3

Yes. So look, we're still early days for 2025 planning. Everything we're seeing right now in the commodity bucket, again, it's still too early, but I'll just say it's looking kind of flattish right now. So, as you know, we kind of lock in a lot of our commodities kind of in the December time period, particularly our proteins. So we're getting closer to that period.

Speaker 3

We're obviously talking with people every week on that. Again, it feels kind of flattish, but that could change a lot in the next month or 2. So no other big updates, but we're not seeing any surprises right now.

Operator

Our next question is from Rupesh Parikh with Oppenheimer and Company. Please proceed.

Speaker 8

Good morning. Thanks for taking my question. So maybe 2 macro questions for me. So just want to get your latest thoughts on the pet category, what you're seeing on the pet adoption side. And then your business continues to see tremendous momentum.

Speaker 8

So just curious if you're seeing any shifts in consumer behavior?

Speaker 6

Hey, Ritesh, Scott. So on the pet category, basically what we're seeing is, look in traditional brick and mortar is not doing as well from a growth standpoint as they have historically. There's definitely a little bit of softness there, but it's in the kind of couple of points down versus prior periods, etcetera. But remember, there was a ton of expansion for a while. Where we are seeing a lot of that growth is definitely some more and more of it's coming from online.

Speaker 6

So if you look at kind of any type of omni channel piece, you're seeing like still a couple of points of growth. The long, long term algorithm that I've always used for the categories, you're seeing kind of 2% to 4% overall pet category growth. You might not see it within 6 months or a year, but that's typically what you see. And that's what we're seeing right now. We're seeing around like a 3% growth if you look at everything like omni channel.

Speaker 6

From an adoption standpoint, look, these things kind of go up and down and in waves. We think from everything we're seeing, it's come back and it's at a more consistent pace. There is definitely some trends that are starting to develop around dog size again. Again, they come and go. We're starting to see a little bit more towards smaller and medium sized dogs again.

Speaker 6

Again, it's just slightly. We're seeing more and more of those dogs kind of adopted in consumers' homes a bit more. That's actually a good thing for us. If you look at where we typically over index, it's typically with people with smaller and medium sized dogs. We don't do quite as well with large dogs, although we're making a lot of progress with our large new large dog product to continue to kind of come out of the gate and do really, really well.

Operator

Our next question is from Robert Moskow with TD Cowen. Please proceed.

Speaker 9

Hi. Congrats again and a couple of questions. I think the target for sales is like close to $2,000,000,000 is less than that, but for 2027. And as you're evaluating, revising your long term guide, are you evaluating like introducing another time series like beyond 2027? Is that part of the decision making that you're doing?

Speaker 9

And would that also entail spending to expand your footprint beyond Ennis and beyond what you have in Pennsylvania? Then a follow-up, please.

Speaker 2

Yes, Rob. We haven't made a decision on what we'll look at for updating guidance if we do that sometime next year. There's everything has got to be taken a look at. One of the things that we do spend a lot of time thinking about is capacity planning, which is embedded in how we think about the long term guidance and also part of your question. But I would remind you that within our existing footprint of the 3 sites that we have today, we have capacity to get us to the $2,000,000,000 in net sales.

Speaker 2

Our guide is for $1,800,000,000 We need to have a run rate that's ahead of that when you get there. We can get well north of $2,000,000,000 by with the existing footprint. So any decision on expanding the footprint beyond where we are would influence periods that would go well beyond 2027. We won't need any capacity beyond that footprint till probably 29 or 30 depending on how our new technology plays out, what our efficiencies do and whatnot. So at this point, there's really no conclusion or decision where we've got all the variables.

Speaker 2

We'll look at all of them. We'll make the right decision based on the best inputs and the best visibility that we have.

Operator

Our next question is from Brian Holland with D. A. Davidson. Please proceed.

Speaker 10

Thanks. Good morning. I believe guidance implies 24% net sales growth against relative media spend of 9% in the back half of twenty twenty four. I obviously realize that's a bit of a condensed window as opposed to looking at it more annualized. But just curious whether that dynamic is indicative at all of how you see 25 shaping up at this point, particularly on the media side?

Speaker 2

Yes. Brian, I would characterize it as the media in the back half of the year would indicate the momentum and the household penetration gains we get as we head into the first half of next year. So looking at the spending in the back half and the growth rate in the back half, you're sort of looking at 2 things that are not time aligned. The growth rate in the back half of this year is related to the spending we had in the first half this year. The spending in the second half of this year is what will drive the growth rate in the first half of next year.

Speaker 2

So we do know that as we get the significant media spending that we're making in the back half of this year relative to what we've done in previous years, we expect that to be the thing that starts driving the household penetration growth back up again and you'll start seeing that in the first half of next year. And then that obviously will turn into volume growth that begins in the first half of next year and continues through the back half of the year.

Operator

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

Speaker 11

Thanks, operator. Good morning, everyone. Given the, I guess some of the comments and things you've teased out in terms of updating long term targets and objectives, I guess bigger question I was thinking about is, it's very rare in consumer packaged goods for a category to develop and gain substantial shelf space with really just one player in the category. Retailers tend to like multiple options, multiple price points. And if we think about fresh as a sub segment of total pet food category, just how does that factor into your thinking about expansion, the gaining share of fresh gaining share of the pet food category?

Speaker 11

Like can that happen with what is effectively at least in brick and mortar retail effectively like one horse in the race?

Speaker 2

Yes. Brian, this is the thing that we've been spending a lot of time thinking about since we launched EBITDA Growth in 2017, which is the reality is that this is a very scale driven business and there are enormous advantages to somebody who built scale in it, whether that's in manufacturing, whether that's the fridge placements at retail, whether that's distribution and logistics that go with it. And our goal was to get ourselves in a position where we had an enormous head start and a significant scale advantage against somebody who came behind us. Clearly, anybody else can enter this category. We've seen that from Mars and from General Mills, and we'd expect to see others come along as well.

Speaker 2

Whether they'd be able to compete effectively against what we've built is remains to be seen. But in terms of you look back over time, your observation is a fairly good one, but the reality is the category creator, the guy who creates the category, if they do a really good job, which is what we're shooting to do, ends up with the lion's share of the market share, whether you think about Gatorade at 75 share, whether you think about Keurig, Green Mountain, any of these guys who really created a big category, they own the lion's share of the category and the bulk of the profits, if not more than 100% of the category profits. And so that's really where we expect ourselves to go. We do expect to have competition at some point. Question is how good they'll be.

Operator

Our next question is from Jon Andersen with William Blair. Please proceed.

Speaker 12

Hey, good morning everybody and congrats on the quarter. Quick two parter on distribution. In the presentation, it shows a 9% increase in cubic feet, but a 22% increase in TDPs. Just wondering how you kind of square the 2. And I think there was a comment in the prepared remarks around absorbing some shelf space from retailer owned fridges.

Speaker 12

If you could talk a little bit about that dynamic. And then the second part is, I think 22% now of your locations have 2nd fridges. How would you expect that to develop over time based on your conversations with retailers? And where is the white space for 2nd, 3rd fridges in terms of channel? Thanks.

Speaker 6

Hey, John, Scott. So, yes, so we look, we've tried to move over time really start thinking about the space that we're picking up from a cubic foot standpoint. The reality is that, one fridge is interesting, but we like the reality is for us that 2nd and third fridges is really where the greatest opportunities lie for us. So we're continuing to see a lot of second and third fridges being added. Not only were they added this year, we think there's going to be a lot added over the course of the next couple of years as retailers are looking around the category.

Speaker 6

And if you look, most retailers, they look up and down the category and they're going, what's going on across these brands and what's going on across these segments? And then recognizing that fresh is really where the growth is coming from. And as they do that, they go, wow, I have 1 fridge. Do I need a second and potentially a third? And we're even having conversations with a few people maybe even a 4th.

Speaker 6

And that's a little bit premature, but we see consistent growth coming from fridge expansion. What we are starting to see is there are a couple of retailers and I would say literally just literally a handful that are kind of tinkering and trying a couple of different fridge layouts and formats with some of their own models and some of their own fridges. The only one who has really substantial number of their own fridges is Walmart. They had made an investment in it. That investment was originally intended to help Blue and honestly, I believe Caesar rollout and in addition to some of their private label products.

Speaker 6

And what's happened over time is they made that investment was I think a really interesting decision for them. It is a heavy lift not only from a capital standpoint, but from a maintenance standpoint. And those products really didn't play out to what I think anyone had imagined on any side of the fence. I think Walmart was somewhat disappointed with it. And now what started to happen is we're actually going into many of those bridges.

Speaker 6

You start to see our products into some of those bridges. And now we'll have a substantial share of that fridge and our products are performing incredibly well. Like we are pleasantly, pleasantly surprised that being able to put the set of new products into those bridges and see the performance that they're delivering. And they continue to kind of grow on a consistent basis. So we love that.

Speaker 6

We're really behind in space at Walmart and we love that we're able to now kind of grab that additional space in those fridges and see that happen. Other than Walmart, as I was touching on a minute ago, there really isn't anyone that has any kind of scale around owning their own fridges. And I think most retailers have gotten really comfortable with we're bringing something that's incredibly value added, very unique, incredibly well managed. And I can get into like why it's well managed, but they don't have to touch a thing. We can repair a fridge, a broken fridge within hours, not days weeks that you'll have many times.

Speaker 6

It's because we've built this into another one of these kind of assets and capabilities as the organization. So and hats off to the fridge team. We have less than 1% of fridges down all the time and we have 33,000 fridges out there. It's a small group that does great work for us. So we think this is an asset that we're developing for the future and a benefit that we're bringing to retailers and most of them aren't anticipating buying their own fridges.

Operator

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

Speaker 8

Hey, good morning guys. Thanks for taking my question.

Speaker 7

Wondering if you could talk a little bit about

Speaker 8

the hiring of Nikki as Chief Operating Officer a couple of months ago. Just kind of curious what she's bringing, what are maybe initial observations are? I know she's somewhat restricted what she could do initially, but just kind of help us understand what you think her impact can be on the organization as you guys look to continue to grow over the next few years?

Speaker 2

Yes. Thanks, Peter. We're thrilled to have Nicky join us. She's bringing a fresh set of eyes to our business and a different set of capabilities than some of our management has or our team has collectively. And so that's been a real breath of fresh air.

Speaker 2

As you alluded to, she does have some limitations in what she can do until May of next year. And those limitations restrict her ability to work only in the grocery drug mass club channels until then. So we'll be a little bit limited in the total impact that she can have until that time. But between now and then, she's digging into our existing business, bringing fresh eyes to it, and we think that's going to be purely additive and adds to our bench strength. We have really big ambitions as a company.

Speaker 2

We want to be a much bigger player in the pet category and getting a talent that as of Nikki's caliber is a huge win for us. And we think frankly it gives us the ability to project further a much bigger business, probably much more expansive business than we have today.

Operator

Our next question is from Tom Palmer with Citi. Please proceed.

Speaker 8

Good morning and thanks for the question. I just wanted to ask on some timing items you kind of noted this year. You noted this quarter that there was a timing benefit for quality costs in the Q3 that's expected to reverse. Just any quantification and detail on what drove that? And then secondarily, in the Q1 of this year, you'd noted around 100 basis points of operating leverage on the gross margin line.

Speaker 8

Has that kind of fully reversed at this point? Thanks.

Speaker 3

Yes, it's Todd. So on the quality issue, we had a fantastic quarter. Disposals were super low, which really helped. We did see experience some higher quality costs in September, the secondary processing piece of the quality component that did not flow through the P and L in September. It will it did flow through the P and L in October.

Speaker 3

That was about a 50 basis point benefit in Q3 that we'll see in Q4. So that number still will be higher, the quality cost number in Q4, but we still feel very, very good about where we are for the year. Regarding the 100 basis points, the benefit we saw in Q1 as we built inventory. We've seen only a very small portion of that reverse. Some of it's still a little bit of a wild card.

Speaker 3

We might see a little bit of it reverse in Q4, but I'm not anticipating much of it. So most of that inventory benefit will hold. It's really just a derivative of how fast we're growing and our need to build inventory to supply the business.

Operator

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

Speaker 8

Thank you. Good morning. Can you just touch on, and it's a little bit more now that you've got the 4th line. How much more significant is your flexibility there? And have you been able to push a little bit on more extended runs with like maybe one bag and one roll line that each could do kind of the power SKUs and then the other that could do the rest of the portfolio.

Speaker 8

Is that something you've been able to test yet or get working on? How does that look?

Speaker 2

Yes. Michael, as we've said all along, getting 2 bag lines and 2 roll lines up and going was going to be a big unlock for us and that will be able to have one line specialize in very high velocity, high volume SKUs and have all the complexity be taken by the other line. So when we started up that roll line in September, we saw that benefit that obviously didn't show up in this quarter because those that production will impact Q4. But we started seeing some sizable improvements, particularly on our roll side of the business. On the bag side of the business, we've been getting some of the benefit of that, but we're still scaling that business, trying to work out the Kings as you get the site up and going.

Speaker 2

But without a doubt, having 2 of each, 2 bag lines, 2 roll lines has enabled us to get the longer runs on one of the lines, more efficiency on those lines and have all the complexity borne on the other line. The site in Ennis though, just to be very clear, we'll always be, I'd say running a little bit behind where we are in Bethlehem purely because we're constantly starting up new lines versus the more mature site in Bethlehem where we've been operating for a long time. It's very stable environment. In Ennis, we started up a line in September. We have another line starting up in December.

Speaker 2

The 3rd roll line starts up in December and we have construction going on there. So there's a nonstop process of expansion that makes it a little bit harder to get to the level of performance you get in a more stable operation like Bethlehem. But over the long haul and it looks like it's going to deliver the efficiency advantages that we had hoped for when we designed and built the facility, it just will take a little bit of time till we get there.

Operator

Our next question is from Jim Solera with Stephens Inc. Please proceed.

Speaker 12

Hi, guys. Good morning. Thanks for taking my question. Two part question for me. You guys talked in the deck about the conversion from toppers to main meals helping drive the buy rate.

Speaker 12

I just wanted to drill down on that and see if you could offer some color on what drives that conversion into kind of a main wheel buyer? And if you're able to size up the percentage of your current buyers that are using the product as toppers, just so we can kind of frame up how much conversion opportunity there is as we move forward?

Speaker 9

Hey, Jim.

Speaker 6

So look, I think that a lot of times adoption takes different paths, right? So we know that people some people come in and they start they become a heavy user almost immediately and they kind of go down that path. We do know that there are a lot of users. In fact, it's a very big chunk of people that we consider toppers because they are doing some type of mixing behavior. It's a pretty standard behavior in pet food where people are taking dry food and mixing in wet food.

Speaker 6

What our goal is and what we're doing over time is we're trying to make sure that we're communicating and messaging to people that this is your main meal. And I think that's why you're starting to see more and more growth in that Hippo area. So if you see we talk about basically our penetration growth is this number, our Hippo growth is 24%. So if we can get those Hippo's and get everyone in that mindset to use us as a main meal, and not a topper and get them to understand this is the center of your plate. Just like your food, your meal, the center of your plate should be fresh real food.

Speaker 6

And that's what we're delivering to consumers and bringing to them. And what you're seeing is that's in the way in our advertising and the way we communicate that's in everything we're showing. We're always showing full bowls of fresh pet. We're not showing bowls of people mixing food. So we're demonstrating that and all the imagery that we're doing, everything that we're kind of the way we're communicating consumers from an emotional standpoint, and who they are and what they're all about and how they think about their dog's food.

Speaker 6

And then the next thing that we're doing, you'll see more and more recently and Billy touched on in the script is more and more packs that are multi packs or variety packs, where there's just multiple SKUs in a pack, you're also seeing more

Speaker 3

and more large sizes from us.

Speaker 6

The biggest people that are a mix is a large dog. Well, what do we just come out with? A large bag of a large dog food that tends to be doing really, really well. Like we're thrilled with the results from that. So that's kind of like that's what we're seeing.

Speaker 6

And this is going to take some time because what we're doing is trying to encourage a behavior change. The core of our business again is the $5,000,000 high profit or the hippos, the super heavy, heavy group. We love those guys. They're 90% of our business. That's who we're focusing on.

Speaker 6

That's who we want to cultivate. And that's the behavior we want to encourage.

Operator

Our next question is from Kamil Gharwala with Jefferies. Please proceed.

Speaker 5

Hey, guys. Good morning. One just starting just very quick one confirming that the CapEx change was just entirely timing and pushed into 2025 and not maybe something that you're doing differently or a decision you've made on capacity. And then maybe a bigger question, which is on the marketing and I guess effectiveness of marketing. You alluded to it a little bit at the beginning, but there's many different sort of pieces of calculus in how much to spend, whether it's capacity, capacity of specific forms.

Speaker 5

But also now you're pushing $1,000,000,000 in revenue. So how do you think about advertising in the context or advertising and marketing in the context of the size that you now are beyond just sort of the capacity stuff which you brought up?

Speaker 3

Yes. I'll take the first part. The CapEx is almost all timing, so that will push into 2025.

Speaker 8

That was quick.

Speaker 6

Look, to the effectiveness of the marketing, like is the I think this is the key question that we try and stay on top of like sometimes on a weekly basis, we're looking at this. And the thing that is look, it's very unusual. Someone brought up very unusual for a packaged goods business in order to kind of maintain like a leadership role for a really long period of time. I think it's incredibly unusual for a packaged goods company to have the same level of productivity on their advertising marketing effectiveness as they had for almost the past 10 years. I mean, I don't think I'm like exaggerating too much where I say for literally for a decade, we have had very similar CAC.

Speaker 6

And the thing I'll go to CAC for a second, acquisition costs, because I think it's a good indicator of we're continuing to keep the message fresh, we're continuing to like find new channels to communicate, the CAC stays within a very, very tight band. And I think what that demonstrates is the model is overall intact. And it also I think most importantly demonstrates the TAM potential, which I think is the other thing that people get really concerned about. Usually when you get deeper into your TAM, your CAC starts to go up significantly. We haven't seen that.

Speaker 6

So it gives us incredible confidence in like what we're doing. Now back to like what we're doing for a second. So this is one of these areas where there is a lot of magic that's created from the team and the people associated and that we work with in order to keep the marketing kind of going. And that's first the creative. The creative, it tests incredibly well and then in market performance is honestly it's extraordinary.

Speaker 6

Todd loves when I use that word. Next, the way we have where we place it, we've started off like very, very kind of large broad market advertising and then we've taken into more and more different types of vehicles and mediums and different targets. And even as we've kind of moved into different targets, all our men and sports, you're seeing us more and more in sports, we've been able to stay as productive. And we also know what we're doing not now, but we know what we're doing 6 months and even a year from now as the plans like fold out. So what I mean by that is we will test things that are 6 months plus out and have them ready to go for us to continue to execute on the across the marketing model that we use.

Speaker 6

So that hopefully is helpful. We could spend a lot of time on that one.

Operator

Our next question is from Mark Turrin with Wells Fargo. Please proceed.

Speaker 9

Hey, good morning and thank you

Speaker 8

for the question. Just on the consumer, you continue to see strong buy rate gains. You had also called out a shift to larger pack sizes last quarter. I guess any updated color on what you're seeing out there? How do you expect mix to evolve near term, both in terms of consumer behavior and how that flows through the model?

Speaker 8

Thanks.

Speaker 6

Hey, Mark. So, it's interesting. It's been one of these periods where there are it's a little bit of tale of 2 cities quite honestly. We talked about overall growth rate of the category has really moderated a bit, kind of flattened out around that 3% level. Definitely, there are two ends of the spectrum that seem to be doing well.

Speaker 6

One of them is what's considered almost ultra premium in the category and we'll put ourselves in that bucket for a second. I don't think we'd like to think of ourselves that way, but we're in the higher end of the category. And then there's a handful of products and more in the value area that are still doing pretty well and actually growing. The middle is getting squeezed a little bit. And it tends to have to do a little bit with people's income levels, but it is a conscious choice that people are deciding on what foods they want to buy.

Speaker 6

On the ultra premium end, there's people like us, there's other direct to consumer brands that are very fairly expensive, but people are seeing the value and what we are bringing to the market and willing to spend the extra money on it because of the product that we bring and the value that they see from it. On the other end, maybe people that aren't quite as involved with their pet, they may be in a little bit of a crunch from inflation. They haven't seen salaries go up as much and they're making some different buying decisions. That's not really our consumer group. That's not really who we're focused on and that's not really the group we're after.

Speaker 6

But we are watching this play out for the category. It's been an interesting period. I think it's starting to kind of flatten out and moderate a bit. I think people are getting a little bit more I think salaries have overall kind of grown a bit. I think people are getting more comfortable with pricing is in general across the market.

Speaker 6

And I think that we're in a really fortunate position as we've tapped into a need and interest in the market from a consumer group that seems to be really, really large and growing as they understand the differentiation of the products that we're putting out there.

Operator

Our final question is from John Laurence with The Benchmark Company. Please proceed.

Speaker 8

Great. Thanks. Congrats, guys. Can you talk a little bit about the retailers? You mentioned the 2nd and third fridges.

Speaker 8

We've talked about it over time, the cycle times and the review periods at these retailers when they do their performance reviews. How long does it sometimes take 12 to 18 months to get these planograms and fridges added to the mix?

Speaker 6

Hey, John. Yes, it really in some cases, it can be a very, very long cadence with certain retailers that are in kind of certain mindsets and certain investment ideologies. And a great example and you and I have probably chatted about this at one point. If someone's doing a massive remodel in 2026, they're not going to probably do a big touch in a category in 2025. But look, I mean there's 70 retailers that we work with.

Speaker 6

So it spans the gamut. There are times where we could be having discussions now or in kind of Q1 that can have real impact in 2025 and we have seen that very often. I think the good news for us is that we are having great conversations now about things that will happen in 2025 and if they don't happen in 2025 some of them will happen in 2026. And we feel like we're well positioned to start going into next year with additional fridge expansion, space expansion etcetera as the retailers assess the category. The one thing I will put like the paid advertisement in here, the distribution is terrific.

Speaker 6

The media is what is the vast majority of the driver. It's over 70% of the driver for our growth and that's the growth algorithm. And then what that media does is it drives new consumers, hopefully they're hippos that come into the business and then we do see really, really strong same store sales growth over time. We're always seeing double digit same store sales growth. So that puts us in a really good position.

Speaker 6

And then on top of that, then we'll add innovation and we'll add some additional space and that's really what gets us to the rest of the growth rate that we're always looking for.

Operator

We have reached the end of our question and answer session. I would like to turn the conference back over to Mr. Cyr for closing comments.

Speaker 2

Thank you, everyone. On this day before Election Day, I'm reminded of a quote from Will Rogers. I love a dog. He does nothing for political reasons. So reward that dog with some fresh pet and your dog's affection will make you forget all those campaign ads and fundraising texts you've been drowning in.

Speaker 2

Thank you very much.

Operator

Thank you. This will conclude today's conference. You may disconnect at this time and thank you for your participation.

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Freshpet Q3 2024
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