2023-10-06 18:11:17 ET
Summary
- The company's revenue increased by 25.6%, and the operating loss (% of revenue) reached 9.1%.
- Focusing on high-income consumers allows the company to demonstrate both rising product prices and increasing sales volumes in the face of pressure from macro headwinds.
- I believe the stock's current valuation looks fair, while I don't see any clear catalysts for growth in the coming quarters.
Introduction
Freshpet ( FRPT ) shares have risen 12% YTD. Despite the fact that the company continues to show positive revenue growth and improving operating margins amid pressure from macro headwinds, I believe it is still not the best time to buy shares of the company. In my article, I would like to analyze trading trends and share my expectations about the company's future operating and financial results, as well as the current business valuation.
Investment thesis
Freshpet has been one of my favorites for a long period of time during Covid due to its high potential market size, solid growth rate, sustainable business model and ability to achieve operating break-even in the future, however, I currently maintain a Hold recommendation on the stock. First, although the company's target audience is less sensitive to pressures from high inflation and rising interest rates, the business's revenue growth rate is slowing slightly. Secondly, in my assessment, the market is currently effectively pricing in the future prospects and cash flows of the business, so I do not see fundamental upside potential for the stock. Additionally, I believe the company's shares are not cheaply priced based on multiples. Thirdly, I do not see any clear drivers/catalysts for stock growth in the coming quarters that could contribute to higher stock prices.
Company overview
The Freshpet company produces and sells fresh food (without dyes or preservatives) for cats and dogs. Sales are carried out both through online channels and offline channels (installation of refrigerators). The company's products are aimed at the premium segment. The company operates in the North American and European markets.
2Q Earnings Review and expectations
The company's revenue increased by 25.6% YoY due to increased sales volumes and higher prices for the company's products.
Gross profit margin decreased from 35% in 2Q 2022 to 32.3% in 2Q 2023 due to increased depreciation expenses. SGA expenses (% of revenue) decreased from 47.4% in 2Q 2022 to 41.5% in 2Q 2023 due to a reduction in logistics costs and the realization of economies of scale.
Thus, operating loss (% of revenue) decreased from 12.4% in Q2 2022 to 9.1% in Q2 2023.
In addition, the company published guidance for 2023. Thus, management expects the revenue growth rate to be about 26%, and the adjusted EBITDA margin could reach 7.3%. You can see the details in the graph below.
On the one hand, I like the fact that the company is targeting consumers who are less price sensitive, which provides the company with the opportunity to both pass on increased inflation to the end consumer and expand its customer base in an uncertain macroeconomic environment.
However, on the other hand, if we look at the company's guidance for the second half of the year, we will see that the business growth rate will continue to be at a stable level, however, I personally cannot call this expected growth rate significant.
Additionally, it is important to remember that Freshpet is a classic example of a growth company, so a decline in sales could be critical to the company's stock price. At the moment, I see more risks to slowing current growth rates than to outpacing investor expectations.
Valuation
I prefer to use a multiplier to value high-growth companies because the DCF model is: 1) too sensitive to inputs 2) there is high uncertainty in predicting reductions in operating expenses. So, to evaluate the company, I use the revenue forecast in accordance with the company's guidance and a P/S multiple of 3.9x, which still implies a high premium to the sector median. Thus, according to my assessment, the fair price for the shares is around $58 with a downside potential of 2.3%.
Valuation Grade is F. In accordance with the EV/EBITDA ((FWD)) and P/Sales ((FWD)) multiples, the company is trading at 53x and 4x, which implies a premium to the sector median of about 383% and 263%, respectively. On the one hand, I understand that the relatively high multiple valuation is due to high revenue growth and investor expectations, but on the other hand, I believe that the market is currently effectively pricing in future flows and the fundamental upside is limited.
Risks
Revenue: a reduction in real consumer income, increased competition, and an ineffective marketing campaign can lead to a decrease in revenue growth.
Margin: reduced economies of scale, the need to increase marketing expenses and rising incoming costs can have a negative impact on the level of operating profitability of the business.
Drivers
Revenue: the ability to pass on higher inflation rates to the end consumer and increased sales volumes could support revenue growth rates in the future.
Margin: reduction in inflation, deleverage effect due to the implementation of economies of scale (reduction in logistics and marketing costs) can have a positive impact on the operating profitability of the business and contribute to achieving operating breakeven in the future.
M&A: I believe the company is an attractive acquisition target for larger players due to its loyal customer base and strong positioning in a growing market.
Conclusion
My current recommendation is Hold, as I believe investors will need to wait until the next quarter's financial results are released before making a decision to buy the stock. However, I avoid a sell recommendation because the company continues to demonstrate stable revenue growth and its operating loss is gradually narrowing. I will happily change my recommendation to buy when I see the first significant signs of improvement in the unit economics of the business.
For further details see:
Freshpet: Still Not The Best Time To Go Long