Freshpet, Inc.

Greetings and welcome to Fresh Pet Inc. Third Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during a conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Jeff Sonick with ICR. Thank you. You may begin.

Thank you. Good afternoon and welcome to Fresh Pets Third Quarter 2020 Earnings Call and Webcast. On today's call are Billy Cyr, Chief Executive Officer, and Heather Pomerantz, Chief Financial Officer. Scott Morris, Chief Operating Officer, will 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 Securities and Exchange Commission and the company's press release issued today for a detailed discussion of the risks that could cause actual results to differ materially from those expressed or implied in any forward-looking statements made today. Please note that on today's call, management will refer to certain non-GAAP financial measures such as EBITDA and adjusted EBITDA, among others. While the company believes these non-GAAP financial measures provide useful information for investors, the presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP. Please refer to today's press release for a reconciliation of the non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP. Finally, The company has produced a presentation that contains many of the key metrics that will be discussed on this call. The presentation can be found on the company's investor website. Management's commentary will not specifically walk through the presentation on the call. Rather, it's a summary of the results that they will discuss today. Now, I'd like to turn the call over to Billy Sear, Chief Executive Officer.

Thank you, Jeff, and good afternoon, everyone. I'm speaking with you from Bethlehem, Pennsylvania, and Scott and Heather are in our offices in Secaucus. We will do our best to not trip over each other on the call. And as always, please excuse any barking in the background and any other technical issues we might encounter. Let me start by saying that it feels really good to have Kitchens 2.0 up, running, and producing saleable product because we need the capacity to catch up with the demand. But it also feels good because Kitchens 2.0 is more than just incremental capacity. It is an indication of the capability of our manufacturing and engineering team, completing such a large and complex project under some of the most difficult conditions we've experienced in a long time. Our team managed through shelter-in-place orders that brought construction to a halt, challenges getting fully staffed construction crews during the pandemic, state mandated shutdowns at equipment suppliers across the country and the challenges of keeping workers safe from the coronavirus. In addition to the usual safety, weather and technical challenges on a construction site. Despite all that adversity, they completed and started up our biggest capital project to date, and we now have a longer runway to support our growth. I'm incredibly proud of what our team accomplished. Completing this project was no small feat and a major milestone for our organization. This capacity is critical to the future growth of Fresh Pet. During the third quarter, our Nielsen megachannel consumption growth, driven by continuous media since May, exceeded 40% and made it very difficult to keep up with demand, particularly on our premium fresh from the kitchen line. Our manufacturing team performed very well, delivering record total output and a strong adjusted gross margin, but that was not enough to keep up with the demand. As a result, we drew down trade inventories during the quarter and had much higher out-of-stocks than we, our customers, and our consumers would like. With Kitchens 2.0 up and running, we are now able to start rebuilding that trade inventory and expect that we will be fully caught up within a few months. The capacity challenges that we have faced all year and that many of you worried about are now behind us, which feels really good. We now have the capabilities and capacity to do what we love most, convincing more pet parents to change the way they feed their pets forever. I think it is also worth noting that we manage this complex capacity expansion while delivering highly reliable top-line performance, solid and steady adjusted gross margin, and an adjusted EBITDA growth rate that is well in excess of our top-line growth rate, which demonstrates the operating leverage inherent in our operating model. And we kept our teams safe. with no evidence that anyone contracted the coronavirus in our facilities or transmitted it to anyone there after more than 500,000 man-hours of operation under the current COVID conditions. That is probably the achievement that means the most to us. With a notable exception of the COVID-19 issues, though, these are the challenges and the kind of results that both you and we expect from a high-growth company like Fresh Pet. As impressive as it is that we've added so much capacity and delivered strong top and bottom line results, we are prepared to demonstrate this sound execution over and over again on a larger and larger scale each time for many years to come in order to achieve our goals. The mountain we just climbed has given us a clearer view of the next mountain ahead of us, which is taller but not necessarily imposing. We are rapidly building the capability to scale that next mountain. Nowhere is that clearer than in Ennis, Texas, where we have broken ground on our next fresh pet kitchen on almost 70 acres of land. We now have seven engineers in Ennis and a large array of construction and engineering partners, most of whom have been with us through multiple expansion projects. That site, when fully built, will be almost double the size of our Bethlehem operations and add more than 700 million of capacity. It will employ technologies and operating practices that represent third and fourth generation manufacturing know-how that we've developed at Fresh Pet. It will also be an incredibly environmentally friendly site, employing state-of-the-art practices designed to reduce our environmental footprint. We are very excited about what is happening in Ennis and look forward to opening that facility in mid-2022. Now, on to the results. We feel very good about what we accomplished in the quarter. We shipped everything we could make, delivering $84.2 million of net sales for 29% growth versus a year ago. Recall that the year-ago quarter included about three points of trade inventory refill. So, on an apples-to-apples basis, our growth was closer to 32%. Further, we short-shipped customers quite a bit in this quarter, and we'll begin to catch up on that in Q4 and Q1 of 2021. That, and an improvement in spoils, accounts for the roughly eight-point gap between our 40% Nielsen megachannel growth rate and the 32% apples-to-apples growth metric I just mentioned. A full reconciliation is in the accompanying presentation. This growth was a result of the post-COVID pivot we made, rescheduling our media to run continuously from May until October for the first time, taking advantage of higher viewership and lower media rates. That plan worked even better than we had anticipated and drove Nielsen megachannel consumption growth above 40% by the end of July, and it stayed there until out-of-stocks began to impact our growth in late September. Our growth rate is still running in the high 30s today, despite those out-of-stocks. The consumption growth was incredibly broad-based, with grocery up 40%, mass up 46%, and big box pet specialty up an impressive 32%. In each class of trade, Fresh Pets' growth was at least 35 points better than the category as a whole. Driving this growth were the strongest velocity gains, measured as dollars per million ACV we've ever experienced, up 29% versus a year ago in the quarter. It is that kind of performance that convinces our customers that Fresh Pet is a good investment of space and inspires them to find ways to add more and bigger fridges to more stores. By the end of the quarter, seven of our top 10 customers had significant tests or expansions of multi-fridge sets underway. Household penetration gains were the major driver of our growth. Total household penetration was up 23% versus a year ago. Core dog household penetration was up even more at 27% growth. Over the last 12 months, we've added 725,000 incremental households. This puts us slightly ahead of the pace we expected on our quest to add 5 million more households by 2025. It is our expectation that we will add households faster in the early years of our 5 by 2025 program. and that the buying rate will come along faster in the later years as our installed base of users gets bigger. We took a deeper look at who the new users were who joined the Fresh Pet franchise in the post-COVID period and were encouraged to see that they were younger, skewing towards millennials and Gen Z, ethnic, unmarried, and urban. This is very good for the longevity of the franchise we are building and is also indicative of the role Fresh Pet and pets play in our lives. Pets are highly valued for their companionship, particularly in times of stress, and the highest quality food becomes even more important when you spend so much time with a pet you love. That is the perfect recipe for success at Fresh Pet. Our buying rate was up 5%, which is strong growth despite the large number of new users we acquired. As we've indicated before, when we look at an undiluted cohort of established users, we typically see 6% to 7% buying rate gains That includes consumers who are moving from our lower price per pound items to our higher price per pound items and increased usage on a daily basis. Everything we are seeing in our data suggests that that is still happening, but they are being diluted by the large number of new users who are just beginning their Fresh Pet journey. As expected, new store additions were modest, reflecting retailers' intense focus on keeping their stores clean and safe for employees and patrons, as well as their need to manage labor amid the growth of their e-commerce options. We added 251 net new stores in the quarter and have now added 801 net new stores so far this year. We believe we are on track for the thousand net new stores we projected for the year. More importantly, though, we upgraded 417 more stores to larger fridges and installed double fridges in 565 more stores in the quarter. Year to date, we've upgraded 635 stores and have installed 1,344 second fridges, both of which are in excess of our original guidance for the year and the revised guidance we issued in May. Those placements are clearly paying dividends as our velocity in stores with upgrades typically increases by 25% to 35%, and double fridges typically grow velocity by 35% to 45%. Further, Upgrades in second fridges are increasingly becoming a significant enabler of our growth through their ability to carrier a wider assortment of products appealing to incremental consumer and pet demographics and a broader range of needs. ACV growth reflects the same trends, up 11% to 55.3%, reflecting retailers' focus on protecting shoppers and employees versus making planogram changes. Total distribution points, TDPs, are a bit more complicated because we experienced a very significant gain behind the large number of upgrades and second fridges, but TDPs began to slip in late August when we began to short-ship customers. That can be seen on the chart in the accompanying presentation. As a result, TDPs peaked at plus 21% versus a year ago. and then dropped, still ending the quarter 12% ahead a year ago, but well below the peak and the 17% average TDP growth in the quarter. Once we rebuild supply, we expect to regain those TDPs. Our e-commerce business was up 188% versus a year ago and now accounts for 5.1% of our business. On a sequential basis, our e-commerce business realized a small increase versus Q2 in when consumers were under shelter-in-place orders and online ordering became a necessity for many people. Within the overall trends, we are seeing particularly strong performance with Instacart and the curbside programs, including those in pet specialty. And over 85% of our e-commerce business went through our in-store fridge network. Our manufacturing team performed very well in the quarter. Heather will give you more detail on the adjusted gross margin performance But I want to comment on the overall level of productivity. The Bethlehem Kitchens produced almost 3% more dollar volume than they did in Q2, despite no incremental capacity or staffing coming online in the quarter. Kitchen South produced almost 11% more in Q3 than they did in Q2, thanks to the addition of a second shift in the middle of Q2. By the end of the quarter, kitchen staff was producing almost 25% more per month than they were in June and still accelerating, producing almost twice as many pounds in October as they did in June. Absenteeism dropped from its peak of 15% in mid-June to a steady state of around 5% to 6% today. It is, however, still above our long-term average of 2% and reflects continuing challenges our employees' families are facing with young kids at home, family members with underlying health conditions that make them more vulnerable to COVID-19, and the abundance of caution that we all employ in trying to keep the virus out of our facilities. I will also add that, despite the publicly reported national unemployment rate of 8%, We, and most of our suppliers, are facing a very tight labor market. The number of highly skilled workers looking for jobs is nearly as robust as that national rate would suggest. In early August, we announced the hiring of a new head of HR, Kendi Makaba, who is developing strategies for us to address those near-term issues, but more importantly, developing a long-term plan that will support our rapid growth. including staffing our NS facility, continuing to expand our technical bench strength, and rebuilding the necessary depth needed to support a larger and more complex business, while still delivering the SG&A leverage we have committed to. Finally, adjusted EBITDA was up 42% versus a year ago at $17.0 million in the core, and it's now 113% ahead of a year ago for the year to date. Recall, we increased our media investment in Q3, moving a portion of it out of Q2 and into Q3, resulting in the advertising investment in the quarter being up 30% versus a year ago. We had planned for it to be even higher, but when the rapid growth began to exceed our capacity in August, we pushed some of the advertising back to Q4 to better match our available capacity. That advertising begins this week. Now the Kitchens 2.0 is up and running. We've also made an incremental investment in UK media in Q4 to begin to recapture the growth that were obscured by the COVID crisis there. That advertising ran in October and it produced exactly the results we hoped to see and positions us well for 2021. As I look ahead to the year end and into next year, I want to make a few points. Number one, we are well on track to deliver the revised guidance we issued at the end of Q2. That guidance called for greater than $320 million in net sales and greater than $46 million in adjusted EBITDA. Both numbers are heavily dependent on our ability to produce meaningful quantities of saleable product from Kitchens 2.0 and Q4, and we believe we were on track to do just that. In fact, we had a very good start to Q4 in October. We grossed sales up more than 40% versus a year ago for the month, catching up on some of the trade inventory that we depleted, but there's still much more to go. In November and December, we will be lapping last year's unusually strong performance, but with the added capacity of Kitchens 2.0 and strong demand, we believe we are well on track to deliver the revised guidance. Two, our capacity additions are on track and will position us very well to drive growth in 2021. Our startup plan for Kitchens 2.0 began with staffing to run the new bag line 50% of the time while we iron out all the kinks with the new equipment. We'll take that to 100% staffing, i.e., 24-7, once we are comfortable that we are operating efficiently. We're adding staffing for the roll line in Q4 and expect that to be producing saleable product by January. We don't need that line to run a 24-7 schedule until later in the year. It may take advantage of its capacity and the greater efficiency and throughput of the new bag line to do some upgrades in our existing facility in early to mid-2021. Further, our Ennis, Texas project is on track to come online in 2022. If all goes as planned, we will have all the capacity we need to drive strong growth in 2021 and have the ability to sustain that growth into 2022 and beyond. We will make a final assessment of the readiness of our incremental capacity at the end of this year and use that in determining how much we will invest in media in 2021. That will dictate how fast we will grow. Our marketing and sales teams are preparing a variety of scenarios, and we are quite confident that we have the necessary marketing and innovation tools to support strong growth well into the future. As we have said many times, our goal is to fill capacity when it is available, as long as we can do it efficiently and with quality product. So our bias is to keep our foot on the gas in 2021. We will provide more clarity on this when we issue our guidance for 2021 in late February. Number three. We believe that the long-term trends that have been driving Fresh Pets' growth have been amplified and accelerated this year, giving us increased confidence in our long-term goals. Despite all the economic and social uncertainty this year, ultra-premium pet foods have accelerated their growth, while the lower-priced, value-oriented brands have struggled. That is very consistent with what happened during the Great Recession and is one of the reasons why many view the pet category as relatively recession-resistant. There's also a lot of discussion about whether there have been increased pet adoptions that are driving the pet food category during the challenging circumstances we've experienced this year. We believe the data on that is very murky, as we have seen evidence both supporting that notion and evidence that suggests there was only a temporary increase in pet adoptions. In the end, we are treating any increase in adoptions as a pull forward of demand for pets and believe that it doesn't really matter for a brand as small as Fresh Pet whether there are 63 million households with a dog or 65 million when we're only in 3.8 million households. The untapped opportunity is enormous either way. More importantly, we believe that consumers' increased awareness of the role pets play in their lives and the benefits of feeding them the best that they can provide scale-force tailwinds for fresh pet. As we said at our Investor Day, pets are replacing kids and many families. It is now very clear that dogs are no longer just a member of the family. They have become our favorite child. My kids have jealously pointed that out to my wife and me numerous times. That is very good for Fresh Pet, as we provide the quality of foods that a favorite child would merit. Separately, I want to thank our shareholders for their support of the five-year governance transition plan we announced in August as part of our proxy. At our shareholder meeting in September, each of the initiatives on the proxy received overwhelming support, so we are moving into implementation on each of the steps that we committed to deliver. Finally, before I turn it over to Heather, I want to note one other milestone that we achieved in the quarter. We donated our 10 millionth meal to shelters and rescues. This year alone, we've donated 1.3 million meals, and through a variety of other efforts under our Pets, People, Planet mantra, we saved 450 dogs and cats, contributed $137,000 to shelters, and distributed over 7,000 plus fresh pet coupons through adoption and community outreach programs. We are proud of our team members who volunteer their time to lead these efforts and are thrilled to support them. Now, let me turn it over to Heather, who officially became our CFO on October 1.