2023-11-08 04:53:15 ET
Summary
- Freshpet’s revenue has grown exceptionally well, with a CAGR of +28%. This is driven by management’s aggressive go-to-market strategy in conjunction with a compelling product.
- We believe the pet market, in general, is highly lucrative, with management taking the necessary steps to grow the awareness of its value proposition to exploit this.
- FRPT is being disrupted by macroeconomic conditions, contributing to “teething” issues that come with fast-growth companies. We are seeing good progress toward its medium-term goals through scaling.
- We expect the company to maintain its growth and likely normalize at a superior financial level to its peers. This comes with material uncertainty, however.
- Freshpet is attractively priced so long as its growth can be maintained, which we suspect is possible. Given the macroeconomic environment and the cost of capital, a cash-burning investment is not a wise choice currently.
Investment thesis
Our current investment thesis is:
- Freshpet ( FRPT ) is a high-potential business that is delivering as we would expect. It is scaling well and due to its premium nature, is investing heavily in marketing to ensure sufficient brand development.
- The pet segment is highly attractive due to resilient consumer demand and an impressive growth trajectory in the pet health space.
- Following investment in scale and its distribution network, we see a good runway for growth and margin improvement. Macroeconomic conditions have the potential to distort this but the offsetting impact remains uncertain.
- With the business burning cash, we suggest investors remain patient until market conditions improve.
Company description
Freshpet, Inc. is a leading pet food company that specializes in providing fresh, refrigerated pet food products. Founded in 2006, Freshpet focuses on offering nutritious and high-quality pet food made from natural ingredients. The company's products are available in various forms, catering to both dogs and cats, and are sold through major retailers across the United States and Canada.
Share price
Freshpet's share price performance has been strong, significantly exceeding the wider market's return. This has been driven by positive financial development and a bullish outlook by investors.
Financial analysis
Presented above are Freshpet's financial results.
Revenue & Commercial Factors
Freshpet's revenue has grown impressively, with a CAGR of +28% during the last decade. This has been consistently strong, with sub-20% growth only twice in a fiscal year.
Business Model
Freshpet's core business model revolves around innovation in pet nutrition. Unlike a large portion of the market, it produces fresh pet food made from real, natural ingredients. Its products avoid artificial preservatives and fillers commonly found in traditional pet food, catering to pet owners seeking healthier options for their animals.
Its marketing emphasizes the use of high-quality ingredients, such as real meat, vegetables, and grains heavily as part of what the brand represents. Further, it offers a variety of recipes tailored to different pet needs, including age-specific and dietary requirement-specific formulas. The focus on this premium approach has allowed it to price significantly above the wider industry and justify this comfortably, as illustrated by its growth.
This has been a rapidly growing trend as pet owners understand the positives that stem from treating the health of pets similarly to that of humans. IDEXX ( IDXX ) is a business that is focused on the health of pets and has grown consistently for two decades without a single down year. Pet owners have shown an unwavering commitment to the lives of their pets and are willing to protect and enhance their lifestyle at a significant financial cost to themselves (Pets are seen as family members. We suggest any investor read the commercial factors underpinning IDEXX (such as our own paper here) to understand how lucrative and resilient this market can be.
Freshpet has done a fantastic job of investing in marketing to create awareness of its brand and products. This is a key barrier currently as many pet owners remain unaware and require education. This is a low-cost method to acquire a new customer and so significant investment currently is highly encouraged.
Freshpet has adapted to the e-commerce trend and also aggressively developed relationships with retailers to maximize the reach of its products to consumers, limiting the barriers to developing its brand and getting itself in front of consumers.
With a growing trend toward healthier lifestyles (among humans), driven by technological dissemination of information and social trends (also impacted by technology), we believe a knock-on effect could be felt in the pet food market, also.
Margins
Freshpet's margins have consistently worsened during the last decade as the business has scaled, reflecting growing customer acquisition costs and a renewed focus on growing its brand into a household name.
The company's GPM was broadly consistent between FY13 and FY19, reflecting the reinvestment of scale benefits to attract customers, as well as increased competition. The recent decline in margins is attributable to inflationary pressures, although the impact appears to be disproportionate relative to other businesses we have considered.
Freshpet is a young business with a premium approach, we believe a degree of this impact is likely "growing pains/mistakes", as the company has invested heavily in scale and headcount without sufficient demand to absorb the cost. Further, this is the time Management has faced justifying its pricing, as the offsetting price uplift has been limited.
We suspect Freshpet will see a rapid improvement in margins in the coming 1-3 years as its operational scale balances with demand, as well as pricing and cost pressures subside.
Quarterly results
Freshpet's recent performance continues to be strong, with top-line revenue growth of +43.1%, +26.7%, +25.6%, and +32.6%. In conjunction with this, margins have declined, although improved relative to FY22.
The company's impressive growth is a reflection of its broader trajectory, with strong household marketing penetration, increased placements nationally, and loyalty among its core customer base. In addition to this, it cannot be stressed the impact of pricing, as Freshpet has responded to inflationary pressures by hiking prices.
We believe the current macroeconomic environment is negatively weighing on the company. With heightened inflation and elevated interest rates, consumers are experiencing soaring living costs and thus pressures on finances. This is not to say consumers are contemplating not feeding their pets but rather are encouraged to trade down or not try Freshpet's products, which are marketed in the premium segment. We believe this is likely a factor that contributed to its weakening markets as Management saw elasticity in the market.
Looking ahead, we expect growth to sequential step-down, although remains strong on an absolute basis. The company will continue to benefit from its commercial development but market conditions will weigh more heavily, as the compounding impact is increasingly contributing to uncertainty.
Key takeaways from its most recent quarter are:
- Management is seeing a significant improvement in its operational performance following the decline in margins, particularly in its quality and logistical capabilities.
- Freshpet is seeing accelerating household penetration and a record of fridge placements. The consolidation of its brand as a leading value proposition will contribute to preferential treatment by retailers.
- Progressing following the launch of Ennis Kitchen, which is now producing >20% of total production from two lines. The expansion of this will drive margin improvement and streamline its operations.
- Positive operational developments have contributed to an increase in its 2023 guidance.
Balance sheet & Cash Flows
Freshpet has recently raised debt to continue funding its expansion nationally. The company is burning cash due to significant capex commitments in particular (31% of revenue). At the current level, the business is likely to require further debt/equity in the coming 2 years. Investors must consider whether they are willing to finance this business in the medium term.
Outlook
Presented above is Wall Street's consensus view on the coming years.
Analysts are forecasting a continuation of its strong growth, with a CAGR of +21% into FY27F. In conjunction with this, margins are expected to rapidly improve, reaching an adj. EBITDA-M of 17.0% in FY27F.
We consider these assumptions to be reasonable. With a quality product and an aggressive growth strategy, the business is well positioned to deliver this. It is facing headwinds but its national expansion alone should drive gross in excess.
Margin improvement is less certain. We do see sequential improvement, although we are hesitant to imply that ~17% is achievable. Analysts are likely factoring in the ~8% achieved in FY20 and scaling from there.
Industry analysis
Presented above is a comparison of Freshpet's growth and profitability to the average of its industry, as defined by Seeking Alpha (42 companies).
Freshpet performs well relative to its peers, primarily attributable to its life-cycle location. The packaged food industry is slow-moving at maturity given the high level of competition.
Freshpet is currently in its growth phase and executing extremely well, with only two businesses with better revenue growth over a 5Y period. Offsetting this is its margin weakness, although as we have discussed, the business has a good runway to improve this considerably.
Valuation
Freshpet is currently trading at 4.7x LTM Revenue and 3.8x NTM Revenue. This is a discount to its historical average.
A discount to its historical average is warranted in our view, owing to the company's wavering trajectory in recent years despite the positive developments. There is now uncertainty associated with margin development and whether growth can be maintained relative to historical perception. This said, the degree of discount appears far too large given the unit expansion being achieved which provides greater certainty around the achievability of growth.
Further, Freshpet is trading at a ~64% revenue premium to its peers, which is justifiable in our view due to its significant growth trajectory relative to its peers, who on a 5Y basis is less than a 1/3 of Freshpet's rate. Assuming Freshpet meets the analysts' forecast revenue, it would exceed this level in FY27F while likely having similar, if not better margins.
Key risks with our thesis
The risks to our current thesis are:
- Market saturation impacting the runway for growth.
- Further supply chain disruptions.
- Changing consumer preferences.
Final thoughts
Freshpet has the potential to be a fantastic long-term company in our view, although faces stiff competition and near-term issues as it seeks to scale. We suspect the company will achieve strong growth and sequential margin improvement in the near term, although this is predicated on its ability to continually develop its brand and grow consumer interest. This has become more uncertain due to the current macroeconomic conditions.
Management is broadly making all the correct decisions but this means burning cash. With the potential for a bear market ahead, we do not consider such an investment correct currently.
For further details see:
Freshpet: Pet Market Is Lucrative But Patience Is Key