Description

Introduction:

 

Tattooed Chef manufactures and distributes sustainably sourced plant-based food, both through their branded Tattooed Chef product line as well as their private label business. They went public via SPAC and began trading in October of 2020. Post-merger the stock rose significantly to a high of ~$25 due to hype around the company’s growth prospects. While the stock price has dropped sharply in the last year, it still trades at ~$6-7/sh which is unusual for other SPAC deals consummated around the same time. The company has a cult-like following amongst retail investors and a number of prominent social media influencers have promoted the stock in recent years.

At an enterprise value of $510 million TTCF is grossly overvalued. Investors are valuing the company at a multiple of revenue due to the perceived growth of their branded products, when in reality their branded growth has ended and recent top-line growth has been driven by acquisitions. The company is unprofitable, has burned through almost all of the cash proceeds from the SPAC-merger, and is heading towards a liquidity crisis in 1-2 quarters. In the next year an equity raise, slowing revenue growth, and margin deterioration are catalysts to drive the stock lower.

Company Overview:

The company was priorly known as Itella International before merging with the SPAC Sponsor, Forum Merger II Corporation, led by current board member David Boris, who has served on several boards of SPACs that have all gone bankrupt or fallen 99%. The founder and CEO, Salvatore “Sam” Galetti owns ~40% of the shares outstanding. His daughter and co-founder Sarah Galetti is the actual “Tattooed Chef” behind the brand name, serving as Chief Creative Officer and developing the recipes. Management is new to running a public company and has struggled with accounting, filing late 3 times and amending 3 of 2021’s 10-Q filings.

For the latest quarter, Q2 2022, Tattooed Chef reported ~$58 million in revenue and a 1.3% gross profit margin. This is a ~16% year-over-year increase from Q2 2021 revenue of ~$50 million. Branded products make up ~60% of revenue, while private label products make up ~40%. The company has never reported positive operating income since going public. Operating losses were ($17) million in 1Q22 and ($24) million in 2Q22.

 

Tattooed Chef sells their food products to club and regular grocery retailers. Although the company highlights their distribution growth from 4 retailers in 2020 to 160 retailers in 2021, only four customers accounted for 68% of the Company’s revenue during the three months ended June 30, 2022, and three customers accounted for 60% of accounts receivable.

Tattooed Chef does not disclose the names of these customers and refers to them as Customers A, B, C, and D in their filings. Due to the receivable concentration, the asset-backed revolver credit document has account-specific concentration limits for Walmart, Trader Joes and Costco, Aldi, UNFI, and Whole Foods: some combination of these retailers are presumably Customers A, B, C, and D. The company’s best selling products include cauliflower crust frozen pizzas, acai bowls, zucchini spirals, and riced cauliflower. Similarly, although the company boasts growth to over 140+ SKUs, their revenue is highly concentrated amongst the top 5 SKUs which account for over 90% of sales.

Margins have deteriorated significantly: in 2Q21 gross profit margin was 16.5%, which dropped to ~9.5% in 3Q21, 2.1% in 4Q21, and in the latest quarter 2Q22 1.3%. Operating profit margins have also trended downwards, with a -40% operating margin for 2Q22. Below is our analysis of what is driving the margins lower.

Slowing Branded Growth, Questionable Acquisitions

The company’s growth strategy is primarily focused on increasing Tattooed Chef branded label revenue and decreasing private label revenue as a percentage of the whole, as the branded products command a higher price whereas the private label products are commodity-like and have lower margins.

 

In May 2021, TTCF purchased New Mexico Food Distributors, Inc. and Karsten Tortilla Factory, LLC, for $37mm with cash. In December 2021, they purchased Belmont Confections, Inc., or “BCI” for $18 million cash and stock. These companies were private label food manufacturers. The purpose of these acquisitions was to add manufacturing capacity and allow for Tattooed Chef’s new push into branded Mexican food and plant-based bars.

Despite acquiring it over a year ago, in the latest filing the company reported that the Karsten facility is “not currently in operation and is expected to become active during the third quarter of 2022.” BCI is also not yet operational and is expected to start manufacturing Tattooed Chef branded products during the third quarter of 2022. In 1Q21, a combined ~ $17.5/20mm year-over-year revenue increase came from private label revenue contributed by the acquired entities. In 2Q22, Of the $8 million in year-over-year revenue growth, branded product revenue increased only 3%, contributing $1 million, with the rest of the growth coming from an increase in private label revenue, also from the acquisitions. In 1Q22, NMFD produced a net loss of $.5mm and BCI produced a net loss of $.6mm.

While the hispanic ambient space is growing, TTCF’s hispanic products, such as the burritos, are at a high price point in a crowded space where producers frequently produce at half the cost. The recent acquisitions represent management's belief in their ability to pivot into extremely niche and crowded spaces at a very high price point. Given that the top 5 SKUs, those being the best-selling products such as the acai bowls, cauliflower-crust pizzas, zucchini spirals, etc. account for over 90% of revenue, the other 135 SKUs that Tattooed Chef are developing are expensive to test and manufacture yet have no guarantee of a positive ROI.

Ineffective Marketing Spend

Sales and marketing expenses were $14.8 million for the six months ended June 30, 2022. For the six months ended June 30, 2022, sales and marketing expenses were $24.9 million, about $50mm on an annualized basis. The majority of the company’s marketing spend is understandably directed towards the branded product segment - the company states that the significant increase in advertising and marketing expenses are due to “our heavy investment in the Tattooed Chef brand, in order to increase distribution, raise brand awareness, and drive sales in the new stores.”

This equates to a significant 70% increase in year-over-year marketing expenses driving only a 3.5% year-over-year increase in branded revenue, suggesting that the marketing spend is incredibly inefficient. In an interview publicly available on Tegus with the former Head of E-Commerce and Digital Marketing who left the company in 2021, he explained that Tattooed Chef’s marketing budget was given with no oversight to an agency called NitroC, and that the head of NitroC’s “advertising strategy was just backwards. It was spent mostly on AOL and yahoo.com and online solitaire games. And I look through what we spent about $10 million. 85% of this was just spent against a demo that's never going to convert for Tattooed Chef.”

When he brought up his concerns about the wasted marketing spend to Tattooed Chef’s CEO, Salvatore Galetti, he was vetoed by the CEO because of his “close relationship with the person from NitroC,” who also had a “vested interest in Tattooed Chef, so the CEO didn't want to jeopardize that relationship.” Frustrated by the lack of organizational ethics and discipline, the individual left the company. While we are cautious to not overweight expert network transcripts, NitroC does advertise their partnership with Tattooed Chef on their website. Other instances of questionable marketing tactics are publicly available - for example, the company paid to have famous rapper Machine Gun Kelly hold a Tattooed Chef pizza in front of his crotch in a music video, and also paid to set up a stall selling cold-brew coffees at an A-list event at music festival Coachella.

Customer / Product Shift Leading to Revenue and Margin Deterioration:

On the surface, Tattooed Chef claims that the decrease in GPM “is primarily due to the increases in cost of freight, packaging, and labor due to inflation” and the increase in “fixed costs including rent and depreciation expenses” from the acquisitions completed. Although this likely accounts for a portion of margin deterioration, two other factors are also key contributors: the first, discussed above, is the increasing concentration of lower-margin private label revenue due to flat branded segment growth and the acquisitions, and the second is the shift in customer mix.

For context, TTCF’s customers can be classified into three different categories in terms of how they determine brands offered, the number of SKUs, and shelf space: 1.) At certain distributors like Walmart it is all performance based. 2.) Other players in the space like Target and Kroger charge brands slotting fees to stock their products 3.) Finally, club retail food distributors such as Costco and Sam’s Club hire purchasers to select the brands they believe are upcoming, boutique, and premium; their customers tend to be more affluent and shelf-space tends to be more variable as certain brands fall in and out of style.

While originally TTCF’s concentrated customer base was composed primarily of club retailers such as Costco and Sam’s Club, it seems that TTCF’s products have fallen out of popularity with these customers. Club retailers want product exclusivity so that they can market unique, limited offerings to their customers who pay for memberships, however in the pursuit of growth, Tattooed Chef has focused on distributing their products as widely as possible. In another Tegus interview conducted with the frozen foods merchant at Sam’s Club that originally onboarded TTCF’s product, he described their relationship with Sam’s Club: “post IPO, their presence in Sam's Club has deteriorated significantly. And a lot of that has been due to the fact that they've been taking all their innovation to their other retail launches.” On the Sams.com website, it appears that only 1 Tattooed Chef SKU is available, and in the filings, Sam's Club’s percentage of revenue is no longer reported as it has dipped below 10%. Similarly, Costco has found lower-priced replacement products for some of Tattooed Chef’s products, and now carries lower SKUs also.

TTCF has made up for this loss in club-retailer distribution by increasing spending on slotting fees at pay-for-shelf-space distributors like Target and Kroger. The company has advertised these recent launches heavily, yet from the same interview, the Sam’s Club buyer noted that “Kroger has the most expensive slotting fees out there.” These slotting fees will continue to impact margins going forward. While recently the company announced an expanded distribtion agreement with Walmart, expanding shelf presence from 5 to 13 SKUs, there is no guarantee these newer products will perform well enough for Walmart to continue restocking, especially given that the top-5 selling SKUs account for ~90% of revenue. 

Cash Burn and Future Liquidity

The narrowing margins, shifting customer and product mix, and inefficient marketing spend has led to persistent cash burn at the company. The company has burned through almost all of the ~$240 million in cash received from the SPAC merger and warrant exercise proceeds. As of the latest quarter end, the company finished 2Q22 with $27.7 million remaining in cash. Although management states in the filings that they believe cash on hand plus availability under the credit facility is sufficient for at least the next 12 months, they seem likely to run out of cash within the next 2 quarters.

Cash used in operations was ($18) million in 4Q21, ($26) million in 1Q22, and ($24) million in 2Q22. The company’s only available source of additional funding is an asset-backed revolving credit facility with a $45 million limit from UMB bank. Not surprisingly, UMB Bank’s investment management arm is the largest institutional owner of the equity with almost 4% of the shares outstanding at an average cost of ~$20/share, which explains their initially perplexing decision to expand the facility limit from $25 million to $45 million at the end of the latest quarter.

The facility allows Tattooed Chef to borrow against up to 85% of eligible accounts receivable and 50% of eligible inventory, using the underlying receivables and inventory as collateral. If there is any outstanding balance on the facility, Tattooed Chef must use any cash inflow from customer payments of their receivables to immediately repay the principal on the facility. It is essentially a last-resort form of financing, and comes with a $20 million minimum liquidity covenant.

If Tattooed Chef borrows the full $45 million available, this would increase available cash to ~$73 million. After deducting short term liabilities of $30.5 million of accounts payable to vendors and $5 million in the current portion of notes payable, net cash is $37.5 million. This allows Tattooed Chef only $17.5 million of additional cash burn before breaching the minimum liquidity covenant. The company is guiding to ~$140 million in revenue for the remaining half of 2022 at a gross margin of 10%, which is ~$7mm of gross profit a quarter. With almost $25 million of operating expenses a quarter, even excluding the company’s ~$5 million in capital expenditures per quarter, it seems likely they will breach the covenant before next quarter’s reporting date given the historical cash burn levels.

 

Conclusion

At this price, Tattooed Chef is a compelling short. The borrow cost is 11-13% to short. Given the unfavorable long-term prospects for the company, the options chain appears more attractive than a standard short position, given that there are in-the-money January 2024 expiry puts. These long-dated puts give ~1.5 years for the thesis to play out while limiting downside risk in the event of a squeeze. 

Catalyst

Impending equity raise: In the current market conditions, institutional investor enthusiasm for cash-burning companies is low. Assuming they are able to raise equity, it will presumably be significantly dilutive. The CEO owning ~40% of the S/O would likely also act as a deterrent for institutional investors in the event of an equity raise. A few weeks after releasing last quarter's results, the company announced they purchased another manufacturing facility for ~$10 million, and expects that "the operations of this new facility will be cashflow neutral through the remainder of 2022." This purchase doesn't help their liquidity issues and increases the chances they will have to raise capital soon. 

Slowing demand for the plant based products the company sells leading to an overall decrease in revenue. We note that although vegan / vegetarian customers represent only 1-5% of the market, the company benefited from a huge fad in 2019/2020 for plant-based food and meats, and another large demand tailwind in 2020/2021 for any frozen food product due to the Covid-19 pandemic and limited supply of other food items in stores. The plant-based space has also seen an influx of competitors in recent years. Going forward these trends are likely to normalize - Beyond Meat's recent performance is a good example - one can read the recent VIC short report on Beyond Meat published by Pridwen earlier this month. 

Tattooed Chef plans to implement the first ever price increases for Tattooed Chef branded products in 4Q22 - with current macroeconomic conditions it does not seem likely that retailers and customers will react favorably, and the company has lost business to cheaper private label products and competitors in the past.