2023-05-24 14:00:00 ET
Summary
- Freshpet’s impressive growth is offset by its consistent losses.
- High costs and lack of leverage in business model make attaining profitability challenging.
- Potential downside to $35 for the stock.
Introduction
Still got your pandemic puppy? Feeding it natural, fresh, gourmet meals? If you’re not cooking pet meals yourself, you’re probably a Freshpet ( FRPT ) customer! The company was a Covid beneficiary and saw its stock go vertical during the pandemic, tripling in price. Alas, all those gains have now evaporated and it is back to the same level it was at the end of 2019. Revenue has doubled, but profits are still elusive.
Company background
Freshpet makes and sells fresh meals for dogs and cats. It operates in North America and Europe. It installs refrigerators to store and display its products in supermarkets. It also sells its products through online channels.
The company’s tagline is “It’s not dog food. It’s food food.” It appeals to a segment of pet owners who would like to feed their pets fresh (albeit factory-made) food, rather than the standard dry kibble. The company claims not to use preservatives or artificial colors and flavors.
The company was formed in 2004 and is headquartered in Secaucus, NJ. It has manufacturing facilities in Bethlehem, PA and Ennis, TX.
Freshpet quarterly financial overview
For the first quarter of 2023, the company reported $167.5 million in revenue, up 27% YoY, driven by increases in volume and price. Gross margin was a respectable 30%. Operating income was a loss of $21.5 million (-12.8% operating margin). After interest expense, the company had a net loss of $24.8 million or $0.52 for each of its 48 million shares.
Freshpet grew its cash balance to $410 million in the quarter after issuing convertible debt at a 3% interest rate. It showed debt outstanding of $392 million, almost offsetting its cash hoard.
The company has a market capitalization of $3.2 billion and an enterprise value of the same amount given its zero net debt position.
The balance sheet showed nothing amiss. The company has an accumulated deficit of $320 million, which points to its past unprofitability and indicates the value of the tax shield available to shelter future profits, if any.
The cash flow statement showed Freshpet continues to burn cash. The business is very capital intensive, and capex of $58 million for the quarter was four times depreciation. Depreciation will go up over time, hurting reported margins.
The company guided to $750 million in revenue for 2023 (up 26% YoY), with adjusted EBITDA of $50 million and capital expenditure of $240 million. Annualizing first quarter figures, one would expect depreciation of $60 million and stock compensation of $35 million for the year, which when subtracted from the adjusted EBITDA guidance would imply EBIT of -$45 million. Cash burn would be about $200 million for the year, assuming not much movement in working capital.
FRPT stock valuation and recommendation
Freshpet is expected to be unprofitable this year and next. To value the company, I will assume that it will be able to attain a 5% operating margin over the long term.
A 5% margin on 2023 revenue of $750 million would result in normalized annual operating profit of $37.5 million. At this rate, the company will be able to use its tax shield for 8.5 years. To be conservative, I will assume that it will never pay taxes. Thus, it would have the same $37.5 million in after-tax operating income or $0.78 per share. In recognition of its 26% revenue growth, I will apply a 50x multiple to arrive at a per share value of $39 for the business. At the end of the year, I would expect the company to have net debt of $185 million or close to $4 per share. I will subtract this from the business value to arrive at fair value for the equity of $35 per share. This represents almost 50% downside from the current share price of $67.
I will present a bull case in which the company reaches an 8% operating margin, even though I think this is overly optimistic. This would result in normalized annual operating profit of $60 million or $1.25 per share. At this level, the tax shield will last for a shorter time-frame, but I will be generous and assume it lasts forever. At a higher 60x multiple, one would get the business being worth $75. Subtracting net debt of $4 per share would result in fair value for the shares of $71. Thus, the upside in the bull case here would be a mere 6% from the current share price. This is an intrinsically low margin business with high costs, and it is hard to see any fundamental upside.
In a bear case, the company will get to a 3% operating margin, resulting in operating profit of $22.5 million or $0.47 per share. At a 50x multiple, this would imply a business value of $24 and equity value of $20. This would be close to the company’s current book value.
I recommend that investors sell any positions in FRPT stock before it goes to the dogs. For those who are so inclined, I recommend shorting the stock. The short interest is moderate at 16% of float. The cost to borrow the stock is a few % a year, less than what you can earn by deploying the cash proceeds in short-term bonds.
External ratings
Seeking Alpha’s quantitative rating system gives Freshpet a composite rating of 3.1, amounting to a hold, with D’s for valuation and profitability, offset by an A+ for growth. I would agree with these grades. Wall Street analysts are far more optimistic, with a rating of 4.5, translating to a buy (and almost a strong one). No surprise that their price targets have neatly tracked the stock higher and lower over time.
Risks are moderate
The risks here are moderate. The main risk for any short position in a small or mid-cap growth company is a potential acquisition. It is possible that a larger player in the pet food space would want to buy growth at any price. I believe that the environment for corporate acquisitions is more challenged now with higher interest rates, but investment bankers can be a convincing bunch. And corporate executives love to imagine the synergies from combining businesses.
Private equity firms are sitting on a lot of dry powder and it is possible they would be tempted to buy a company that is growing, with the hope of flipping it to a corporate buyer in due course. They are likely to be turned off by the cash burn, but they may believe the company can be more efficiently run. Cutting costs and compromising quality will hurt the brand over the long term, but that’s not a time-frame private equity is typically concerned with.
Fundamentally, the company could continue to grow rapidly and increase its margins more than I have projected. Another pandemic could make people spend more money on premium pet food and chase related stocks.
For further details see:
Freshpet: Stale Economics