Description

We believe Freshpet is an attractive short currently valued at ~4x revenue with short interest of ~15% at an all-time low. Our base-case suggests fair value of ~$12 per share (~30% downside) and a floor of $6 (~60% downside).

Brief Company Overview

• Freshpet claims to be disrupting the pet food industry by encouraging “pet parents” to reassess conventional pet food offerings such as dry kibble and wet cans. Freshpet is the only pet food company that offers fresh, refrigerated pet food that is all-natural, preservative-free, and less-processed in multiple forms including slice and serve rolls, bagged meals, and tubs.

• Freshpet products are sold through the grocery, mass retail, club, natural, and pet specialty channels in branded, company-owned refrigerators that are designed, installed, and maintained by the company. Freshpet’s leading blue-chip retail partners include Target, Walmart, Kroger, Petco, Petsmart, Publix, Safeway, and Whole Foods. Today, Freshpet owns and operates a total of 17,357 refrigerators, with ~49% placed in the grocery channel, ~26% in pet specialty, ~22% in mass and club, and the remainder in natural food stores. Approximately 95% of Freshpet’s revenue is generated through brick-and-mortar stores with the balance generated through e-commerce.

Short Thesis

1. We believe Freshpet will remain a niche product that is unlikely to gain mass market adoption

• Founded in 2005, Freshpet has failed to take meaningful market share in the $24B North American pet food industry despite substantial distribution investments with blue-chip retail partners and double digit advertising spend as a percent of revenue on national television and online media campaigns.

• Freshpet sells a high cost, perishable product. The company encourages pet parents to gradually transition their dog to a Freshpet-only diet. However, we believe Freshpet rolls are unlikely to displace traditional dry kibble (oftentimes mixed in with boiled chicken and steamed vegetables) on a large enough scale. Part of the reason why we believe adoption is so low is because the products have a shelf life of only 7 days after opening and must be stored in the refrigerator.

• To highlight the low level of penetration that Freshpet has achieved, we point to revenue per refrigerator of only ~$22 per day. For context, a six-pound chicken, vegetable, and rice roll sold at Walmart costs ~$13. Our point being that despite each refrigerator being stocked with as many as ~10-20 SKU’s, Freshpet might only be selling of 1-2 six-pound rolls per day.

• We attempt to compare the productivity of Freshpet’s retail space to that of their retail partners in the aggregate. We believe Freshpet is likely a drag on retail partners’ store-wide revenue productivity, measured by revenue per selling square ft., particularly outside of the pet specialty channel, where the delta is ~2-3x lower for Freshpet. Freshpet refrigerators are 4 ft. wide. by 7 ft. tall, equivalent to ~$280 of revenue per selling square foot ($203 in Pet Specialty and Natural/$321 in Grocery, Mass and Club). We believe this may explain why Freshpet has failed to gain traction in Costco ($1,540 revenue per square ft.) and might explain the nearly full penetration of the pet specialty channel with Petsmart ($250 revenue per square ft.) and Petco ($220 revenue per square ft.). Admittedly, it is difficult to make an apples-to-apples comparison between Freshpet’s refrigerator space and the aggregate square footage provided by their retail partners.

• Freshpet is already ~70% penetrated in management’s base-case TAM of 25,000 units. Based on total retail partner locations, we believe achieving 25,000 units is a reasonable feat.  However, we doubt Freshpet’s stretch-case TAM of 35,000 units given the implications of cannibalization on existing refrigerator units. We believe much of the low-hanging fruit, in terms of highest-quality retail locations measured by foot traffic, have likely been penetrated, and therefore will be incrementally more challenging for Freshpet to generate increasing marginal unit-level productivity going forward.

2. Given our skepticism of Freshpet’s potential for mass market adoption, we question management’s implied double-digit velocity growth guidance required to achieve a near doubling of total revenue by FY 2020.

• Contributing to our elevated level of conviction  is the high hurdle management has set for double-digit revenue growth over the next three years. Freshpet has built their FY 2020 revenue expectation of $300mm largely on the acceleration of consumer purchasing velocity as a direct result of increased advertising spend with the goal of stimulating consumer awareness, trial, and adoption. Unit growth is expected to remain flat over this period.

• Velocity is a critical component of Freshpet’s recently launched “Feed the Growth” campaign intended to drive double-digit revenue growth through FY 2020. Freshpet claims this newfound strategy will allow the company to be less dependent on new refrigerator placements to deliver growth goals, and that the vast majority of future growth can be achieved on velocity growth alone. The “Feed the Growth” flywheel is designed to drive velocity gains, supplemented by distribution gains, through increased investment in national television and digital advertising. Incremental revenue growth is expected to produce fixed cost leverage that will be reinvested back into advertising in order to continuously drive same-store velocity through increased consumer awareness.  Freshpet expects to increase advertising spend by ~60% in FY 2017 and ultimately remain at~15% of revenue through FY 2020.

• However, we question management’s expectation for such a steep inflection in advertising productivity, measured by us as incremental revenue dollars from velocity over incremental advertising spend. Unless Freshpet has some proprietary formula for increasing advertising productivity, we find it hard to believe that each incremental dollar spent on advertising will yield such fruitful returns given the fact that Freshpet will be using the same method of advertising (national television and digital media campaigns) as the company has over the past three years.

3.  Looking at Freshpet’s products on a granular level, we have concluded that Freshpet offers an inferior value proposition that will soon be recognized by consumers and will therefore create challenges for future velocity growth

• Freshpet’s management team boasts about having the highest consumer repurchase rate in the entire pet food category given how good the Freshpet product is and how much people love their pets.  In addition, management claims that Freshpet owns title to the highest consumer repurchase rate among any CPG company they have ever seen in 30+ years allowing them to focus solely on advertising given the strength of the product’s value proposition. We believe these facts are intended to portray a high-quality revenue base supported by consumer stickiness and brand loyalty.

• However, a closer look at both the level of moisture content and corresponding calories per pound, coupled with the company’s suggested feeding guidelines and the advocacy for a Freshpet-only diet, reveal to us the company’s manufacturing of repeat consumer purchasing.

• As background, all pet food labels require a “guaranteed analysis” advising consumers of the product’s nutritional contents. At a minimum, guarantees are required for minimum percentages of crude fat and protein, and maximum percentages of crude fiber and moisture.

• Using this framework, Freshpet’s extremely high moisture content results in a high cost product delivering insufficient calories. The median moisture content in all ten of Freshpet’s dog food rolls is ~77% (Freshpet Select and Freshpet Vital brands) compared to the median moisture content of ~49% for Blue Buffalo, ~43% for Natural Balance, ~43% for Redbarn, and ~68% for Country Pet Naturals. We note that according to AAFCO regulation (the Association of American Feed Control Officials), an organization in charge of the sale and distribution of animal feeds, 78% is the maximum allowable moisture content for dog food.  High levels of moisture yield lower calories per pound. Dogs must therefore consume a greater volume of food in order to get the right amount of nutritional requirements, leading to pet parents having to purchase more product.

• Although Freshpet touts its high repurchase rate, our assessment indicates that such high levels of repurchasing are out of necessity in order to satisfy daily calorie requirements. We don’t believe this positioning is sustainable especially when consumers will be presented with additional options with increased competition in the grocery and mass retail channels.

• According to Freshpet’s suggested daily feeding guidelines for a 40-pound dog, a Freshpet-only diet would actually fail to satisfy daily caloric requirements unless the consumer purchased multiples of the suggested portion sizes. In fact, it would require the purchase of 60 one-pound Freshpet rolls each month in order to satisfy a 40-pound dog’s daily calorie requirement assuming a Freshpet-only diet, compared to only 26 one-pound Blue Buffalo rolls. Converting the number of one-pound Freshpet rolls to purchase each month, in order to satisfy daily caloric requirements, to an equivalent number of fifteen-pound bags of traditional kibble, reveals to us that a pet parent would only need to purchase 2 fifteen-pound bags of kibble per month compared to 60 one-pound Freshpet rolls.

• We emphasize the annual cost to feed a 40-pound dog a branded roll-only diet vs. a Kibble-only diet, layered on top of the fulfillment of the daily caloric requirement. Our analysis reveals that Freshpet is the most expensive branded dog food roll to feed one’s 40-pound dog a Freshpet-only diet despite satisfying only 50% of the calories a 40-pound dog requires, ultimately driving the consumer to purchase greater than suggested quantity of Freshpet rolls.

• Further, we find it to be strange that Freshpet is the only brand that provides consumers with daily feeding guidelines measured in pounds rather than inches for products sold in roll form, which we believe is inherently more difficult for consumers to measure with a naked eye, as opposed to inches which can be more easily measured. Although subtle, we believe this contributes to consumer’s buying more than they normally would another brand.

4.  We expect heightened competition in the mass retail and grocery channel to threaten Freshpet’s most productive channels

• We anticipate growing competition in the grocery and mass retail channel for all-natural dog food rolls, which we believe will undoubtedly yield greater instances of side-by-side comparisons between brands, leaving Freshpet on the losing end due to its inferior value proposition. Specifically, Blue Buffalo (NASDAQ:BUFF), a ~$5B market cap pet food company with greater than ~$1B in sales, ~86% consumer aided awareness, and ~8% market share of the pet food category, recently partnered with Target, Kroger, Meijer and Publix, four of the leading mass retail and grocery chains in the U.S. Blue Buffalo is entering with their Life-Protection Formula brand, consisting of four rolls (Smokehouse Beef & Carrot, Chicken & Spinach, Pork & Apple, and Turkey & Cranberry), that we believe will directly compete against Freshpet.

• We highlight the importance of the Grocery channel for Freshpet as evidenced by the disproportionate mix of incremental unit growth in Grocery relative to other channels. Ultimately, we believe that Freshpet is not well-suited for mass market retail competition over the long term given higher price point, lower value, and lower quality.

• It’s pivotal to note that Target, Kroger, and Publix account for ~27% of Freshpet’s base-case TAM of 25,000 units. Blue Buffalo’s entry into these stores has pushed Freshpet’s base-case TAM overlap to ~83% with the potential to reach ~100% as Blue Buffalo navigates the mass market, club, and grocery channels and introduces the full breadth of their product set. In stark contrast to our belief that Blue Buffalo will steal velocity gains from Freshpet as a substitute product at a lower annual cost, Freshpet’s management believes that Blue Buffalo’s entrance into the mass and grocery channel will contribute to Freshpet’s consumer purchasing velocity gains given their claim of overall increased foot traffic from Blue Buffalo consumers. Further, Freshpet adamantly believes that Blue Buffalo is not a replacement purchase, but an additive one. We find these claims by Freshpet’s management to be either naïve or disingenuous.

• Thus, we believe Freshpet’s revenue model will be pressured given the fact that Freshpet generates the greatest revenue per unit in the Grocery, Mass, and Club channel.

5.  A closer look at Freshpet’s financial metrics yields a much less attractive picture than management portrays

• Freshpet’s growth model is structurally disadvantaged whereby it must continually expend capital to grow into its TAM despite increasing cannibalization and poor economic returns. Although Freshpet does not directly break out capex per refrigerator, as the “other & miscellaneous” capex obfuscates unit-level capex, the company fails to include the $1,000 new store marketing allowance. According to the footnotes, this marketing allowance is necessary in order to grow the distribution network. By this measure, it appears as if refrigerator capex is rising.

• Freshpet is not a free cash flowing business given the capital intensity of refrigerator placements. Management’s “future economic model” calls for ~$45mm of free cash flow, $60mm of Adjusted EBITDA, and $300mm in revenue. However, Freshpet will need to expend ~$50mm of capex from now until FY 2020 (~5,600 incremental units multiplied by $9,000 capex per unit). In other words, we’re likely to see continued cash burn over the next several years, and if coupled with a slowdown in velocity growth, could lead to a need for additional debt or equity capital.

• We believe Freshpet is also misleading investors by overstating their refrigerator payback period by excluding outbound freight, marketing allowances, and brokerage expenses. In Freshpet’s S-1 filing dating back to FY 2014, the company cited an average cash-on-cash payback period of less than 15 months, calculated by comparing total current costs of a refrigerator, only inclusive of installation and maintenance, to the current gross margin on net revenue. Based on our assessment, we have determined that the true payback period is nearly ~2x the company’s estimate.

• We also believe that management is overstating non-GAAP profitability by adding back launch expenses to Adjusted EBITDA despite our belief that launch expenses are a normal, recurring cost of distribution growth. The company defines launch expenses as new store marketing allowance of $1,000 for each store added to the distribution network: as well as non-capitalized freight costs associated with refrigerator placements.

Valuation

• Freshpet’s base-case targets $300mm of total revenue by FY 2020. Assuming 90% of Freshpet’s incremental units are placed in the grocery, mass, and club channel (which have generated ~$9,000 in revenue per refrigerator over the trailing twelve months) with the balance of incremental units placed in pet specialty and natural food stores (which have generated ~$5,600 in revenue per refrigerator over the trailing twelve months), Freshpet would need to generate a ~14% velocity CAGR through FY 2020 to achieve its total revenue target.

• Our base-case reflects our skepticism about the company’s future velocity growth.  We use 6% velocity growth, coupled with management’s reasonable 9% distribution growth target, to achieve $233mm of total revenue by FY 2020.

• We also compress our out-year multiple to 2.5x to not only reflect the median private market takeout multiple of other pet food companies over the past decade, but to also reflect our belief that a rational market will fail to pay up for a business with ~95% penetration of its base-case TAM while experiencing heightened competition from a substitute product.

• Under this scenario, we derive a base-case fair value of ~$12 (~30% downside) with a floor of ~$6 (~60% downside), discounted back to the present at the company’s 10% cost of capital.

Catalyst

• Disappointing near-term velocity growth as a result of unproductive advertising spending resulting in the collapse of the “Feed the Growth” flywheel.

• Perpetual cash burn from refrigerator placements requiring debt and/or equity financing

• Multiple compression to better reflect private market value and a soon-to-be ~95% penetrated TAM