SJM - Freshpet: Activist Pressure Might Lead To Company Sale

Summary

• A potentially interesting setup might be brewing at pet food producer Freshpet.
• Activist Jana Partners has built up a sizable stake and is pushing for a company sale.
• Valuation similar to a comparable industry transaction would imply a share price north of $72/share or 40%+ upside.

Freshpet ( FRPT ) is a $2.5bn market cap cat and dog food producer, with a focus on the premium pet food segment. In September '22, reputable activist investor Jana Partners acquired a 10% stake in FRPT. Jana argued the company might be an attractive acquisition target for larger industry players. The activist has also pushed for a review of FRPT's capital allocation as well as management's composition and incentives. Several weeks ago, Jana came out with another 13D, this time noting intentions to nominate its board members in FRPT's annual meeting. Four new directors (out of ten) are set to be elected in June '23. Pressure from Jana comes amid increasing consolidation in the pet food space, with notable M&A activity from large food/beverage manufacturers, such as Mars, General Mills ( GIS ), and J. M. Smucker ( SJM ). Just last month, Mars pet food arm acquired Champion Petfoods in what was reportedly a highly competitive sale process. The transaction left FRPT as the only large independent pet food producer.

While there are no direct publicly-listed competitors, a glance at other industry transactions suggests there would be headroom for an acquisition offer above current FRPT price levels. The company trades at 4.2x TTM revenues. For comparison, in 2018, one of FRPT's closest comps Blue Buffalo was acquired by General Mills at $8bn EV or $6.3x revenues. More recent mergers include General Mills acquiring Tyson Foods' ( TSN ) pet treats business (5x, July '21) and pet supplement producer Zesty Paws bought by H&H Group (8.3x, August '21). It is worth mentioning that FRPT has grown its topline at a 15-34% clip since 2016. This compares to 11-12% sales growth of Blue Buffalo in 2016-2017 prior to the acquisition. At a 6x multiple - similar to that assigned to Blue Buffalo - FRPT would fetch above $72/share or 40%+ upside.

A potential company sale would come at a rather opportunistic time - FRPT stock is down 46% YTD. While this year's revenues have grown a rapid 39%, profitability has been hindered by ongoing cost pressures, with adjusted EBITDA dropping from $27m to $1m. Having said that, the company's earnings power might be only temporarily suppressed. In August '22, FRPT initiated an operational improvement plan. It is expected to generate COGS and SG&A savings through measures such as commodity cost hedging, logistics- and product quality-focused initiatives. Meanwhile, demand for FRPT's products is unlikely to be noticeably impacted even in an economic downturn. Company management has noted that price sensitivity in the premium pet food segment has been low. It's worth noting that FRPT holds a market-leading position in the grocery pet food segment.

What gives added confidence in a favourable outcome for FRPT shareholders is the reputation of the activist. Jana - an activist investment firm - has successfully participated in several high-profile activist campaigns in the food industry. In April '17, Jana amassed a 9% stake in Whole Foods, pushing for a sale. Just a few months later, Amazon ( AMZN ) acquired the company in a $13.4bn transaction. Jana reportedly pocketed $300m in profit on their position in the company. Moreover, in April '18, the activist initiated a 9% ownership stake in Pinnacle Foods and started discussing potential strategic options with the company's management. Shortly after the activist's involvement, in June '18 the company was acquired by Conagra Brands ( CAG ) in a $10.9bn cash and stock transaction. Jana has also been involved in pet supply industry, pushing for a sale of PetSmart in 2014. The company was eventually sold in 2015 to PE firm BC Partners for $8.7bn, with Jana Partners reportedly pocketing $230m in profits. One interesting point to note here is that Jana has recruited a former Blue Buffalo CEO to help with its campaign at FRPT.

Another noteworthy aspect is that FRPT's Co-founder, President and COO co-founded a new pet food-focused company Hive Brands in 2020. The executive has since continued to work full-time at FRPT, indirectly suggesting he might be open for an exit from FRPT. Moreover, the chairman and CEO might both also be open to a sale, given looming opposition during the re-election of the chairman and a potentially significant payday for the CEO in a company sale scenario.

Freshpet

FRPT produces fresh and natural pet food, with most production sold through company-owned refrigerators operated in retail stores. The company has noted that the company's business model - involving production of fresh products with distribution through retail store-located refrigerators - has been one of their competitive advantages - from the company's CEO during the latest conference call :

The refrigerated distribution, the ownership and maintenance of the fridges, all those elements are different enough that it would likely take any one of those existing competitors to have at least one, if not 2 partners to help them, somebody who can manage the fridge network, somebody who can do the manufacturing, somebody who could do the distribution to make it work, and that's not easy to orchestrate. It's pretty tough. Not that it can't be done, but it means that everybody makes lower margins in doing it.

When you look at the rest of the traditional pet-food players, whether it's the canned or dry dog food manufacturers, all of them would love to have a piece of this space, but our analysis would suggest that it's hard for any one of them with their existing assets to compete in this fresh base because the business model is so different. Whether it's the manufacturing technology that needs to be employed, which is completely different.

Management has noted that FRPT retains a dominant position in the fresh and frozen pet food market despite increasing competition, for instance, Mars' brand CESAR launching a competing product in Walmart stores since last year. From FRPT's CEO :

So I think here's the best way for -- there are a lot of folks coming into this space and kind of how you want to define it and look at it. There's been a lot of folks that have entered retail that have frozen cooked items and some people that have come into fresh. So if I add all of that together, and I think, Jon, we've shared a slide once before with you, and I just updated it. If you add all of the competition and all the activity together, it looks like a lot. But we're still 96% of the sales in fresh and frozen cooked foods. So we are -- we're by far like the enormous piece. And we've been maintaining share there. So I think we're really proud of the results there.

The product that they launched is not selling particularly well. We're out selling at 8 or 9:1. The product in those stores, the velocity on it is not sufficient to support the space that's taking up. And so Walmart has begun to plan a gram putting Freshpet products sort of overflow Freshpet into those fridges. So you find Freshpet fridges sitting next to a Walmart fridge, which is the same model fridge with a hetero card on it that looks strangely similar to ours. But it will have both the CESAR roles as well as Freshpet items planogrammed into it.

Operationally, FRPT has grown at a rapid 27%+ clip since 2018. This year, however, the company has been significantly impacted by ongoing cost pressures, recording only $1m in adjusted EBITDA YTD. In light of recent macroeconomic headwinds, in August '22 the company initiated an operational improvement plan and in November '22 hired a new CFO. The cost reduction plan revolves around managing commodity costs, product quality and logistics:

• On the commodity cost side, the company has already begun locking up commodity prices for next year, with inputs making 30% of costs already contracted, including hedging 75% of its natural gas exposure. FRPT also intends to hedge the pricing of chicken, which makes up 40% of total commodity costs. The company has estimated that the lag between the time of incurring commodity costs and the time of transferring them to end customers has cost the company around $19m in 2022.
• FRPT has hired a new VP of logistics with extensive experience in supply chain management.
• In terms of product quality, FRPT has rolled out a new technology, which management expects to boost its competitive moat. Notably, higher product quality and resulting lower disposal rates have been particularly relevant for FPRT given its focus on products which have a limited shelf life.

Additionally, the company recently started running operations in the newly built Ennis manufacturing facility. Management expects to start up new production lines in Q1'23. Generally, it seems that these measures have the potential to uplift the company's earnings going forward, suggesting at current levels FRPT's current operational performance is rather significantly below its true earnings power.

Risks

It must be noted that the company sale thesis has several risks:

• The activist Jana Partners has cut its stake from 10% in September '22 to 9% as of December '22. This, however, seems rather insignificant, particularly given that the activist has noted its intentions to elect its directors in the upcoming shareholder meeting.
• Given the company's capex-heavy and advertising-based business model, the path towards profitability might be prolonged, implying potential equity raises to finance further expansion. Notably, FRPT has already done three equity raises, the latest one ($338m) coming in May '22. Potential shareholder dilution risk, however, seems to be somewhat mitigated by the fact that FRPT has a net cash position of $187m, meanwhile, cash burn stood at $16m in Q3'22.
• Considering FRPT's differentiated pet food products, synergies with strategic buyers might be limited to G&A savings as opposed to manufacturing synergies. Having said that, FRPT's larger CPG-focused peers generally have higher fill rates of 95-100% compared to mid-to-high 80s for FRPT, suggesting a potential large acquirer could nevertheless manage to benefit from optimizing FRPT's supply chain.

Conclusion

Involvement of a reputable activist, coupled with rather opportunistic timing, might point to a company sale brewing up behind the scenes. Given the somewhat low current valuation of FRPT compared to the multiple assigned in the transaction involving a close competitor, I would expect a potential sale to be announced at a material premium to current prices.

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