Freshpet, Inc.

Good afternoon, ladies and gentlemen, and thank you for standing by. Welcome to the Fresh Pet Third Quarter 2021 earnings conference call. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. Should you require operator assistance during the conference, please press star zero to signal an operator. Please note this conference is being recorded. I'll now turn the conference over to your host, Jeff Sonick, Investor Relations for ICR. Thank you. You may begin.

Thank you. Good afternoon and welcome to Fresh Pet's third quarter 2021 earnings call and webcast. On today's call are Billy Cyr, Chief Executive Officer, and Heather Pomeranz, 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 that involve risks and uncertainties that could cause actual results to differ materially from those described in these forward-looking statements. Please refer to the company's annual report on Form 10-K filed with the SEC and the company's press release issued today for a detailed discussion of the risks that could cause actual results to differ materially from those expressed or implied in any forward-looking statements made today. Please note that on today's call, management will refer to certain non-GAAP financial measures, such as EBITDA, and adjusted EBITDA, among others. While the company believes these non-GAAP financial measures provide useful information for investors, the presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP. Please refer to today's press release for how management defines such non-GAAP measures, a reconciliation of 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. Rather, it's a summary of the results and guidance that we'll discuss today. Now I'd like to turn the call over to Billy Sear, Chief Executive Officer.

Thank you, Jeff. and good afternoon, everyone. While may not be obvious from the results we reported today, Fresh Pets' consumption growth in the quarter was exactly where we expected it to be when we raised our guidance in August and would easily support delivering greater than $445 million in net sales this year. However, supply chain challenges that impacted our equipment suppliers will constrain our Q4 capacity, and that is causing us to change our guidance from greater than $445 million to approximately $445 million. Please don't mistake that for reduced demand, because the demand was very strong, and we ended the quarter with significant unfilled orders. But we lost more than a month of production in September and October on the second line at Kitchen South due to delays getting equipment through the ports. So we are not as confident in our ability to produce enough fresh pet to meaningfully exceed $445 million. That second line is up and running now, but we can't make up for the lost time. Thus, we are making the small change in our guidance. That challenge is typical of the environment we are operating in today. So our Q3 results reflect some tough choices that we've had to make. In each case, the choices were driven by our goal of maximizing the long-term value of the fresh pet opportunity, and we were willing to make some near-term sacrifices to accomplish that. We believe that the pet food market has made a significant shift towards fresh and that it is in our best interest to capture as much of the emerging opportunity as we can and build a large, highly loyal consumer franchise, even if we have to absorb some of the short-term costs and manage through the resulting consequences. This quarter, some of those consequences were more significant than we anticipated and more significant than we budgeted in our guidance. But that does not change how we feel about our focus on maximizing the long-term growth opportunity. Let me highlight a few of those choices and the consequences we felt in Q3. First, while we continued to generate strong net sales growth in the quarter of 28% versus a year ago, We could have generated even more if we had not made the decision to invest in manufacturing upgrades, automation, and much overdue maintenance that will enable us to deliver the quality and supply reliability that we will need to sustain our growth. We estimate that we could have generated up to an additional 10 million of net sales, adding 12 points to our growth rate if we had not made those long-term investments in our manufacturing capability. To be clear, we fully anticipated making those choices when we gave our guidance at the end of Q2 and still believe we are on track to deliver approximately $445 million for the year. Additionally, we optimized our production planning schedule to restore customer service, resulting in longer production runs and higher inventory levels. We believed it was very important for our customers to do everything we could do to restore customer service as fast as we could. The result of that was an increase in our inventory on hand at the end of Q3 of about $8 million of net sales value, with the equivalent of six days, versus where we ended Q2. That has helped us significantly improve our customer service in October, but it also reduced our net sales potential in Q3 by about $8 million. There was no lack of demand that drove that inventory build. In fact, it is quite the opposite. We did it because we had such strong demand that our fill rates in September were in the low to mid-50s, and they needed to improve. Fortunately, it is working, and we now have fill rates in the mid-60s, and our fill rate on our rolls is in the 90s. Judging by the consensus net sales estimate for the quarter, we could have made those choices clearer. We fully anticipated the loss of production from the maintenance and upgrades and called those out in our presentations and Q2 earnings call. However, our estimate of the timing of when we would restore our inventory levels turned out to be incorrect, as we built that inventory in Q3 rather than in Q4. Hopefully, the materials we are providing today give you more clarity on our capacity going forward. Similarly, we made a tough choice that negatively impacted our adjusted EBITDA in the quarter. We delayed taking a price increase until we had restored customer service to acceptable levels. We believed that our cost increases would be manageable until then, but that turned out to not be the case. Our costs escalated much more quickly than we had anticipated and more quickly than we had budgeted in our guidance. Simply put, we absorbed rapidly escalating costs without any pricing relief, which we estimate costs us about $5 million of adjusted EBITDA in the quarter versus the results we would have had if we had taken pricing on the same timing as our competitors. As a result, adjusted EBITDA was $14.6 million, down 14% versus a year ago, instead of being up 15% versus a year ago. In total, choices like that made this a rocky quarter. But even if we had anticipated the incremental costs more accurately, I think it is fair to say that we would have made the same choices, i.e., investing for long-term growth rather than optimizing the near term. Each of our decisions were part of our determined effort to build a solid, long-term foundation for growth so that we could achieve our mission of changing the way people feed their pets forever. To provide greater clarity on the results, Heather and I will focus the bulk of our comments on addressing the two most likely questions on many of your minds related to the results we are posting today. First, why wasn't the net sales growth greater than 28%? And second, what drove the reduction in adjusted gross margin in the quarter and when will it improve? I will address the first question and Heather will address the second. So why wasn't the net sales growth greater than 28% in the quarter? The answer is quite simple. As I alluded to already, that is all a manufacturing plan could support. We had more than enough demand to sell more, but between building inventory to improve our customer service and investing in maintenance and upgrade projects, our net sales continued to be limited by our capacity. To help you understand our capacity limits in the quarter, the accompanying presentation includes a bridge from the $490 million annualized capacity we had at the end of June expressed as $122.5 million in quarterly net sales and $107.6 million in net sales we actually delivered in Q3. As you will see, our capacity was constrained by a planned three-day shutdown of all of our lines in early July for significant maintenance that had been deferred due to staffing shortages during the COVID crisis. We'd included our decision to do that in our Q2 earnings presentation. Additionally, we took one of our bag lines out of commission in two steps, the first phase in late August, followed by the second phase of a full shutdown in early September so that we could upgrade and automate the line. That line will restart later this month with new, more efficient equipment and the ability to deliver higher quality more consistently. Heather mentioned this on our Q2 earnings call, but we were not specific on the timing, only indicating that we would do it before the end of the year. We rebuilt our internal inventory by about $8 million of net sales value in the quarter, While we would prefer to have shipped everything we made, we focused on maximizing the number of pounds we could produce to restore our internal inventories and improve customer service by doing large runs of key items. That means that we produced enough of an item to support several days of shipments before moving on to the next item, increasing our days of inventory on hand of each item by about six days and a quarter, particularly on our rolls. The result is that our fill rates have improved by 20 points since July, but we had $8 million less in net sales than we might have had. As I alluded to earlier, the timing of the inventory build was different than our expectations as we'd expected this to occur in Q4 instead of Q3. It is for this reason that we remain confident in our full year 2021 net sales estimate of approximately $445 million. Finally, our treat supplier had significant capacity constraints due to labor shortages, and that cost us about $1 million in net sales in the quarter. While small, we expect this issue to continue for at least the balance of this year. We are looking for some longer-term solutions to this problem. Despite these limitations on our production, we still produced 45% more in Q3 this year than we did last year. That enabled us to satisfy current retail sales refill about $8.5 million of trade inventory, and rebuild some of our inventories. The result of that was 28% net sales growth versus a year ago. You will find a reconciliation of our net sales growth versus consumption and another reconciliation versus our production in the accompanying presentation. Demand was strong in the quarter and in line with our expectations. the Nielsen measured consumption growth rate accelerated in mid-August, as we had predicted it would, going from a low point with 13% growth versus a year ago in early August to its most recent week of 22% growth, an average improvement of about one point per week. And it is on track to be more than 30% ahead a year ago by the end of December, nine Nielsen weeks from now. The two-year stacked growth rate stayed consistently in the upper 50s throughout the quarter, as we had anticipated it would, and it is now consistently exceeding 60% and may potentially break 70% by the end of the quarter. The consumption growth in the quarter was broad-based, but was again particularly strong in pet specialty, where it was up 36% versus a year ago. Our e-commerce business grew strongly again this quarter, up 57% versus a very strong quarter last year, and accounted for 6.4% of our total sales mix in the quarter. Store count grew by 226 in the quarter to 23,381. It will take quite a finishing push to get to our 2021 target of 1,000 net new stores as customers remain hesitant to put in new coolers until we are fully stocking the existing coolers. So we'll be close, but there's a chance we'll get there. We're already well ahead of our annual targets for this year on upgrades and second fridges, but still added 48 upgrades and 51 second fridges in the quarter. While this rate of additions has slowed, we are anticipating significant increases in new stores and second fridges next year based on our increased supply and rapid growth. Household penetration gains were modest due to the out-of-stocks and advertising delays over the past year. Total household penetration was up 9%. Conversely, buying rate benefited from the reduced increase in households and was up well above our long-term target at 17%. We expect those to reverse by the end of the first half of 2022. Our UK business grew 57% in the quarter and has real momentum. We intend to increase our investment in that market next year to capitalize on that momentum. Our Canadian business was constrained by supply and only grew 9% in the quarter. Consumption, on the other hand, continued to be very strong, with our leading customer-producing sales growth of 39% versus a year ago in the quarter. Our full year 2021 net sales outlook implies that Q4 will be significantly larger than Q3, both in absolute terms and in comparison to the year ago. There are four reasons for that. First, we have significant incremental capacity coming online in Q4 at Kitchen South that will provide a meaningful production increase versus Q3. That is a high-capacity bag line with a two-shift operation. It did get off to a slow start due to delays on getting pieces of equipment through the ports in September and early October, but it is running now. I will provide more commentary on that and the impact it will have on our year in a few minutes. But based on what we know today, we estimate that we will have approximately $135 million of net sales capacity in Q4. A reconciliation for that versus Q3's net sales is included in the accompanying presentations. This more detailed look at our capacity for the quarter incorporates all the known factors that can influence the conversion of our estimated annual run rate capacity into an actual operating plan for the fourth quarter. Second, a year ago, Q4 provides a very soft comparison because last December's production and shipments were severely limited by winter storms and COVID-related absenteeism. For perspective, the Q4 net sales growth rate in the year ago was nine points below the Nielsen consumption growth rate, indicating that we're drawing down trade inventory heavily in the quarter. While weather could present the same risk this year, last year's storms were unusually impactful in the Lehigh Valley, and we are hoping that we don't face the same severity this year. Additionally, COVID appears to be much less of a threat this year than it was last year. Third, we will record meaningful revenue from trade inventory refill in the quarter. As I indicated earlier, we largely completed refilling trade inventory on our rolls in October, and that refill will contribute to our fourth quarter net sales. If our bag lines come online as expected, we will finish refilling the trade inventory on our roasted meals in November and December, also delivering net sales above consumption. We do not expect to finish refilling the trade inventory on fresh from the kitchen until early February, but we'll also record net sales above consumption in both Q4 and part of Q1 2022 on that item. And fourth, we have our strongest quarter of marketing support for the year in Q4, reflecting our improved in stocks and our desire to invest to support the rapid capacity expansions we have over the next eight quarters. Historically, we have not supported the business with much marketing support in Q4, so this will be a step change in our growth rate and a bit of a change in cadence versus our past practice. To be clear, we still have risks in Q4. Everything from the potential for winter weather that can disrupt either production or shipping, to labor and transportation challenges that are plaguing the entire industry, to typical production startup issues that could impact new lines and new facilities, and the ongoing threat from COVID, including increased absenteeism due to positive test results in our facilities for those of our suppliers, logistics partners, or customers. We are like everyone else who produces and sells goods in America today, i.e., constantly incurring supply interruptions that require interventions by our team to keep our lines running and enabling us to meet consumer demand. As I mentioned earlier, one issue that we were already aware of that could impact our final results for the year has been the delay in getting equipment to start up the second line at Kitchen South. That delay caused us to revise our net sales guidance from greater than $445 million to the $445 million we now see as a good approximation of reality. While over the long haul these minor delays will mean very little, they are frustrating for all of us as we are diligently working to improve retail availability while simultaneously ramping up much needed capacity to support future growth. While not impacting this year, that delay on line two at Kitchen South will push back the timing of the third line at that site by about one month. It had been scheduled to start up at the end of December. but the installation timetable and some of the construction work will now move the startup date to early February of 2022. This is reflected in the capacity projects chart in the accompanying presentation. Similarly, we are experiencing shortages or being put on allocation for basic construction materials that are typically widely available, such as insulation and steel studs, and that has pushed our startup in NS back by about a month. but we still believe it will fall in Q2 of 2022. Despite those potential short-term risks, we remain very bullish on our prospects, both in the near term and the long term. That is because we are successfully putting in place the critical building blocks to achieve our long-term goal of changing the way people feed their pets forever. In the last few months, we have increased production to the point that in October, we produced almost 60% more pounds than we did last year. We did that in the face of some of the most significant labor and supply chain challenges I've seen in my 36 years in the CPG industry. Over the past six months, we've produced significantly more than was sold at retail, rebuilding retail conditions and providing ample capacity to support strong growth going forward. Our customers are beginning to notice those improvements, and we hope it gives them the confidence to install more fridges next year. We also have projects under construction that will more than double that capacity in the next 18 months. We reaccelerated our growth rate through our investment in media with the inflection point occurring in mid-August and expect to exit this year with consumption growth in excess of 30%. We are investing in significant Q4 media for the first time because we are squarely focused on fulfilling our long-term growth goals and now have the capacity to deliver that. That Q4 media will get us off to a fast start in 2022, and we have favorable year-on-year comparisons during the first half of 2022 that could accelerate our measured consumption growth rate even further. We also announced a 4.8% price increase designed to offset a meaningful portion of the significant inflation we are seeing and position us for improvement in our adjusted gross margin, the EBITDA margin, next year. that price increase will go into effect with orders received on 11-29-21. We delayed taking this pricing until we could improve our customer service. For the purposes of providing you with some added context and sensitivity around the impact of pricing, if we'd implemented our price increase in the time that our competitors had taken their price increases, our adjusted gross margin would have been 240 basis points better, and adjusted EBITDA would have been $5 million better than our reported Q3 results. And we implemented a new labor strategy built around our Fresh Pet Academy that is stabilizing our staffing and positioning us for the significant growth we have ahead. We are not out of the woods yet, as it takes time for that strategy to deliver the results we need. But we are on more solid footing today than we were six months ago. Our team members are getting the training they need and deserve, and we are seeing early signs of the productivity increases that come with that. Each of these efforts will contribute to building a strong foundation for Fresh Pet's continued growth. Unfortunately, the fruits of most of these efforts will not be felt until 2022 and beyond, when they will deliver accelerating growth with better margins. Until then, we are absorbing the many pains common to the CPG industry right now, and also some of those associated with rapid growth. We do know that our shareholders expect us to continually demonstrate that, at scale, Fresh Pet will produce meaningful profit and cash flows. We try to provide the evidence of that by continually updating you on the key drivers of our efficiency improvements, including increased absorption of our G&A expense and the benefits of our more efficient manufacturing. Many of those are obscured by the near-term issues, so we'll do our best to clear the debris so that you can see the underlying performance improvements. These are not meant as excuses, but are simply an effort to provide greater clarity. I will now turn it over to Heather so that she can provide that clarity and give you more detail on our results.