2023-12-20 03:52:05 ET
Summary
- Net sales are expected to keep growing at a very fast pace.
- Recent margin expansion is improving the profitability profile.
- Freshpet has enough resources to fund all investments expected for 2024 but will need funding in 2025.
- If revenue keeps growing as expected and FRPT becomes cash-positive by 2026, potential capital returns could be high.
- This represents a speculative investment that may be interesting for investors with enough risk tolerance.
Investment thesis
In May 2022, I wrote an article about Freshpet ( FRPT ) as the company had experienced impressive sales growth rates in recent years and growth was expected to continue in the foreseeable future as it operates in a fast-growing market. By then, I considered that it represented a very speculative investment because the company was having problems with cash flow generation as supply chain issues and inflationary pressures hit profit margins hard in 2021, and the company has reported negative net income in the past 10 years, so it had to be financed through share issuance, and therefore, the risk of additional share dilution was significant. Also, despite a share price decline of 69% from all-time highs, a PS ratio of 5.332 suggested that the share price was still strongly conditioned by optimistic growth expectations, which seemed to be, in part, covering up the fact that the company had serious profitability issues at least for the short and medium term.
Finally, 2022 closed with revenue growth of 39.92%, and this growth has continued quarter after quarter in 2023 as the year is expected to close with a growth of over 30%. Furthermore, 2024 is expected to deliver a further ~25% increase. Also, despite the trailing twelve months' gross profit margin declining from 36.74% since I wrote the last article to 30.95%, the EBITDA margin expanded from 0.18% to 2.59%, and most of this increase was boosted by exceptional improvements in the past quarter, which has resulted in strong cash from operations. As a consequence of both margin and revenue expansion, the share price increased by 53.86% since then, whereas the S&P experienced a positive 22.14% change, which means Freshpet's shares have widely outperformed the market. Still, there's a lot to do.
The company has been making significant management changes since it launched its operational improvement plan in August 2022, and has made significant use of debt to finance expected investments for the rest of 2023 and 2024 in terms of capacity expansion, marketing efforts, and operational optimization. Also, the total number of shares outstanding increased by 11% since May 2022, and more share dilution should be expected as the company has no resources to fund operations and investments for 2025 whereas the management expects the company to become cash-positive by 2026. In my opinion, the risk/benefit balance at current prices remains very similar to those of May 2022 thanks to significant improvements in operations, so I still think that while it is not a bad idea to invest in Freshpet to achieve potential capital returns once prospects improve, it should only be done if your risk appetite is high, and averaging down should seriously be considered.
A brief overview of the company
Freshpet is a North American manufacturer of premium fresh food products for dogs and cats that is looking to capitalize on the growing pet humanization trends. The company was founded in 2006 and its market cap currently stands at ~$4.13 billion as it employs around 1,000 workers in the United States.
Freshpet logo (Q3 2023 Earnings Call Presentation)
The company has greatly expanded in recent years as net sales have skyrocketed, and this expansion is expected to continue through 2024 and beyond. The company's North American market penetration at the close of 2022 was 4.9 million households, and it has a goal of reaching 11 million households by 2025. Although it is indeed a very ambitious goal, the company is on the right track judging by the results of the last quarters, and it is not necessary to fully achieve the 11 million households mark by 2025 to consider it a more than acceptable expansion.
Still, it is important to note that this growth is happening at a growth stage in which the company has not yet managed to operate in a profitable way, which is why the share price has decreased significantly since 2021, despite a recent surge, as the company has taken on significant debt to finance production capacity expansion, marketing campaigns, and operational optimization projects that, although the management is convinced will lead the company to expand its margins to high levels, are not guaranteed to turn the company into a profitable one.
Currently, shares are trading at $85.65, which represents a 54.19% decline from all-time highs of $186.98 reached in May 2021, and a 53.86% increase from the share price experienced in May 2022 when I wrote my last article. This decline from all-time highs essentially reflects the contraction in profit margins that the company has suffered since inflationary pressures and supply chain issues began to hit the American (and global) economy in 2021 after its reopening, but the situation is beginning to improve as the fruits of margin expansion efforts are becoming evident while easing headwinds are improving operational performance.
Net sales are expected to keep increasing at a fast pace
The company has achieved impressive sales growth rates in recent years boosted by growing demand and product innovation, and these growth rates do not seem to slow down as the company reported net sales 39.92% higher in 2022 compared to 2021, which is impressive.
As of 2023, net sales increased by 26.75% year over year in Q1, by 25.56% in Q2, and by 32.57% in Q3 (as volumes increased by 23% year over year) partly boosted by product price raises as the year is expected to close with a ~33% increase to ~$755 million. Furthermore, growth is expected to continue throughout 2024 as sales are expected to increase by a further ~25%, and the management has a very ambitious plan to reach the $1.8 billion mark by 2027, which would translate into an increase of 138% compared to 2023.
The company estimates that the North American dog and cat food market will grow at a CAGR of 5.7% from 2022 to 2027, which doesn't necessarily mean that it will have to make disproportionate efforts to achieve its goals since, in my opinion, pet humanization trends should boost demand for the specific products that Freshpet manufactures as more and more pet owners are considering their pets as another family member, a growing trend known as pet parenting. Also, the company is heavily investing in marketing, and the stores that sell their products are increasing the space dedicated to them.
It is these high growth expectations that have led the company's shares to persistently trade at high PS ratios, which currently stand at 5.746 despite contracted margins and profitability issues. Furthermore, the company also raises the possibility of expanding its operations in other countries in the future, which means there are still many markets to explore.
Although this ratio indeed is 20% lower than the average of recent years and 74% lower compared to the peak of 22.35 reached in 2021, we must take into account that this ratio is high when considering that profit margins have not been high enough for the company to report positive net income in any of the past few years, and although cash from operations has been positive since 2015 except in 2022 (as inventories and receivables increased significantly in that year), free cash flow has been negative year after year as the company has been heavily investing to achieve and support growth.
Therefore, I consider that a P/S ratio that translates into only $0.17 in annual revenues for each dollar held in shares in a company whose margins have not been exceptional even before the current headwinds still reflects a lot of optimism not only in terms of expected revenue growth for the coming years but also in the sense that the investment community truly expects the company to become cash-positive by 2026 as does the management.
Profit margins are expected to keep expanding
Despite some margin expansion before 2021, the company has reported negative net income year after year, and the situation has only gotten worse since 2021 as increased transportation costs and inflationary pressures have had a significant impact on gross profit margins, which are currently at 30.95% ((TTM)), and took the EBITDA margin to negative territory, although this has improved slightly in recent quarters as the trailing twelve months' EBITDA margin reached 2.59%.
The profitability profile has certainly improved throughout 2023 as the company reported a gross profit margin of 33.04% in Q3 and an EBITDA margin of 6.76% as the management has recently made efforts to reduce logistic and disposal costs. Easing inflationary pressures and product price raises also helped boost margins as the company raised the price of its products by 7.5% in 2023, with part of the increase taking place in February and the rest in September, and the management expects margins to continue expanding in 2024.
The company launched an operational improvement plan in August 2022 which consists of increasing production capacity, improving logistics efficiency, improving the quality of its products, and adapting the price of its products based on raw material prices.
Freshpet 2023 operational improvements plan (Q3 2023 Earnings Call presentation)
In recent months, as part of the plan, there have been significant changes in the corporate structure in the form of staff renewal in key areas, and operating costs related to logistics decreased from 12.2% of net sales in Q3 2022 to 6.8% in the past quarter boosted by efficiency improvement efforts and lower fuel costs. These efficiency improvements also include higher fill rates and larger order sizes thanks to bracket pricing implementation. During the same period, input costs also decreased from 34.7% to 34.1%, and quality costs declined from 6.2% to 4.3%.
Freshpet Q3 2023 key operating costs (Q3 2023 Earnings Call presentation)
Thanks to this, the company reported a net loss of $7.2 million in Q3 2023 (vs. a net loss of $18.4 million reported in the same quarter of 2022), so it seems that becoming profitable is slowly becoming a reality, and its goal is to reach an adjusted EBITDA margin of 18% by 2027. At this point, it would be prudent to put into question whether the company will achieve (and maintain) such a high adjusted EBITDA margin, but even just getting close to it should be enough to make Freshpet a highly profitable company, especially once the current growth stage is completed and it reaches a more mature one.
The company has recently acquired enough debt to finance planned spending for 2024
Long-term debt increased to $392 million in Q1 2023 as the company has raised enough resources to fund marketing efforts, operational improvement projects, and increased capacity projects to adapt to increased demand for 2023 and 2024. The company finally made use of debt as it had been unable to generate positive cash with which to make these investments. In this regard, the company now holds $338.11 million in cash and equivalents, which the management estimates will be enough to cover all investments planned for 2024. Of these $338 million, over $100 million will be used in media spending in 2024 alone, so the remainder will be allocated to the rest of the items, including product launches, capacity expansion, and offsetting for low margins, among others.
The company expects to be cash flow positive in 2026, so it will still need to be financed to cover the investments planned for 2025. Still, it is important to note that debt usage won't be likely as high as in 2023 thanks to (expected) improved margins and higher net sales, which should help in covering part of these investments. Furthermore, the recently incurred debt has covered two entire years of growth and maintenance of (unprofitable) operations, whereas the company only needs to fund one more year.
Inventories more than tripled in the past few years to $59 million, and the same happened to accounts receivable, which currently stands at $54 million. Most of this increase took place in 2022. On the other hand, accounts payable is lower at $41 million. This explains part of the impact on the company's ability to generate positive cash from operations in 2022.
Indeed, cash from operations has been steadily positive in the past few years except in 2022 and reached $49.42 million in the past twelve months.
As for the past quarter, the company reported cash from operations of $39.2 million as inventories decreased by $6.2 million and accounts payable increased by $8.5 million, which contributed to cash generation as accounts receivable increased by just $2.5 million. This also reflects how recent margin expansion translated into higher cash from operations (excluding changes in inventories, payables, and receivables). Despite this, trailing twelve months' capital expenditures continue to be very high at $224 million as the company has been systematically adding new product lines to keep up with increasing demand.
In this regard, the company has been, and continues, building new manufacturing facilities and expanding existing ones, which is one of the main reasons capital expenditures are so high. Nevertheless, this should be relatively temporary as capital expenditures should decline once the company moves from such an intense growth stage to one in which goals shift more specifically towards margin expansion.
Share dilution
In addition to using debt, the company has been issuing shares to finance recent and planned investments as the total number of shares outstanding has increased by 36.42% since January 2020.
This has allowed the company to obtain $257.5 million in 2020, $334.4 million in 2021, and $338.0 million in 2022. In 2023, the company no longer used share issuance to finance itself as it made extensive use of debt, but investors should expect share issuance to continue at some point in the foreseeable future as the company needs proceeds to fund investments and operations for 2025.
Risks worth mentioning
Before investing in Freshpet, I believe it is important for potential investors to keep in mind that this is, in my opinion, a highly speculative investment. Therefore, below I would like to highlight those risks that I consider most significant for the short and medium term.
- Recent interest rate hikes could cause a recession, which could, in turn, have a significant impact not only on demand for products as consumers could opt for more affordable options, but also on profit margins due to lower volumes.
- Revenue growth rates may not be as high as expected in the coming quarters and years, which could sow more pessimism among investors.
- A worsening of inflationary pressures, supply chain issues, or transportation costs could have a significant impact on profit margins, making it significantly difficult for the company to finance a portion of expected investments with cash generated through operations.
- Capital expenditures could remain elevated if the company continues to expand its production capacity to support growth. This could force it to continue taking on debt or issuing more shares.
- More share dilution (or debt usage) is to be expected at some point in 2024 (or early 2025) as the company needs to fund investments for 2025.
Conclusion
Freshpet's revenue expansion in recent years has been impressive, and so is the expected growth for 2023, 2024, and beyond. Despite this, the share price continues to trade 54% below those levels experienced in May 2021 when all-time highs were reached. The company has not yet managed to operate profitably as cash from operations is not enough to fund capital expenditures, and the company keeps reporting negative net income quarter after quarter. In addition, the company has had to use debt to finance all investments planned for the rest of 2023 and 2024.
Recent margin expansion is allowing the company to achieve significant improvements in cash from operations, which is relatively high compared to the past. Even so, capital expenditures continue very high as the company is heavily investing in capacity expansion. Also, as part of the growth plans, the cost of product launches and media spending will represent a significant expense for 2024 and beyond. The management expects the company to become profitable by 2026, so the company will therefore need to get financed, through more share issuance or debt usage, to make expected investments in 2025.
Despite the recent share price surge, I still consider that investing in Freshpet to achieve capital returns in the long term is not a bad idea as it is expected to grow at very high rates and eventually become profitable, but due to the speculative nature of the investment, I believe that only those investors with enough risk appetite should venture into it. Furthermore, a high P/S ratio suggests that a significant part of the expected revenue growth and margin expansion (in the foreseeable future) is reflected in the price, which is why I would strongly recommend averaging down.
For further details see:
Freshpet: Operational Performance Is Improving, But Major Risks Should Be Considered (Rating Upgrade)