Usually a value investor doesn’t look at growth companies. However, in this case, Freshpet’s (NASDAQ:FRPT) healthy growth runway, fresh innovations, and strong competitive advantages made us take a look.
We weren’t disappointed.
A trend towards healthier and more ethical pet food
In a 2016 report, Nielsen reported that 95% of US pet owners consider their pets to be part of their family, up from 88% in 2007. People are now treating pets like their children, spending significant amounts of money to buy them high-quality food, sometimes sacrificing their own standards of living in their process.
Impressively, at least 55% of American and French pet owners claimed that, if they were on a strict budget, they’d be willing to give up chocolate in order for their pet to have high-quality food with the features that are important to them. Additionally, 43% of American pet owners with a Netflix subscription said they’d be willing to trade it for the same. – Source: 2016 Nielsen report
This report also showed that non-GMO and natural products were some of the most popular pet food preferences that owners had.
Source: Nielsen Report
85% of consumers in the study believe they can extend the lives of their pets based on what they feed them. 37% of millennials worry that the pet food they buy is making their pets obese. This all shows that consumers perceive nutritious fare as a cornerstone of their pets’ long-term well-being.
According to the study, consumers also are now more interested in non-traditional pet food forms.
Source: Nielsen Report
The demand for healthier and fresher pet food hasn’t abated in 2019, with Nielsen recently noting that sales for fresh pet foods in groceries and pet stores have jumped 70% from 2015 to 2018 to more than $546mil. These don’t include e-commerce sales or homemade fresh pet food.
Petco, one of the largest pet retailers in the US, recently announced that it wouldn’t be stocking pet foods with artificial flavors and preservatives by May 1. Petco frequently leads the industry – after it discontinued China manufactured products in 2014, other retailers quickly followed suit.
Another research firm, Clarkston Consulting, estimates that:
About half of pet owners could be potential buyers of these more expensive, ethically sourced, and organic varieties. – Source: The Atlantic
People are also demanding more ethical products, with a survey by Nielsen showing that 42% of NA people are willing to pay more for products or services from companies committed to positive social and environmental impact, up 7% from 2011.
So, if ethical products and healthy pet foods are both secular growth industries, are there any companies that could ride both these trends?
Freshpet is an American manufacturer of pet food. However, unlike most other pet food companies, it only sells refrigerated, fresh pet food. It manufactures its pet food in the US only and only uses sustainable energy sources. Its products appeal to consumers emotionally and morally, which allows it to price its products at much higher price points than competitors.
Freshpet has received many rave reviews from consumers, with many claiming that Freshpet helped their pet recover from a serious illness or claiming that Freshpet was the only thing their pet wanted. You can find many of these reviews here.
Substantial competitive advantages
Although the pet food industry is a very competitive area, with numerous pet food sellers and many viable alternatives besides Freshpet, we believe Freshpet still has a niche carved out for itself.
Firstly, the company has a first mover advantage and significant switching costs. According to wikiHow, dogs could take up to two weeks to switch foods, and those with sensitive stomachs could take six weeks.
Cats, meanwhile, could take up to a week to switch foods.
This is where first mover advantage comes in. Freshpet was the first company to sell refrigerated pet food. Many pet owners are now used to buying Freshpet for their pet and will be reluctant to change the food considering the amount of time it takes and the risk that their pet may not like the new food.
The fridges themselves are a significant competitive advantage. They are a massive upfront investment, deterring potential competitors. They also serve as a complement to Freshpet’s fast growing online business, helping Freshpet deliver foods with lower costs.
Source: Google Images
Freshpet also has a strong brand, aided by significant advertising and a quality product. It is fast growing on several social media sites.
Source: Social Blade
Lastly, Freshpet, unlike most other pet foods, has a substantial health benefit and has great palatability, which only helps solidify its strong brand and switching costs.
Source: January Investor Presentation
In many ways, Freshpet is not unlike Whole Foods, which has a similar fan following and caters towards the same health-conscious, price-insensitive consumer base.
A massive growth runway
The main external growth driver for Freshpet may be increased consumer ownership of pets.
Source: Investor Day Presentation
It also helps that small and medium dog ownership is growing the fastest, considering these owners tend to be more willing to pay for Freshpet than large dog owners due to cost.
Freshpet has its own flywheel model which looks quite similar to Amazon’s (NASDAQ:AMZN) flywheel. Like Amazon’s flywheel, it hinges on using cost synergies to increase revenues. Unlike Amazon, however, it uses increased SG&A spend instead of cost cuts to increase revenues, which makes sense, considering it’s a premium, high-end product.
Freshpet has been executing well on this strategy, having picked up 240bps of SG&A leverage which it spent on media advertising in order to drive future growth. Freshpet aims to pick up 700bps of SG&A leverage by 2022.
We made very good progress on delivering the fixed cost leverage in SG&A that we promised as part of our 2020 plan. Recall, we committed to deliver 700 basis points of fixed cost leverage in SG&A between the end of 2016 and 2020. In 2018, we picked up 240 basis points that we reinvested in higher media spending to drive further growth. – Q4 conference call
Using advertising should help grow revenues substantially, considering Freshpet’s low consumer awareness vs. competitors. We estimate advertising alone could double the company’s revenues.
Source: Freshpet Investor Day Presentation
Freshpet also has other growth levers, one of which is international expansion. It plans to expand into the UK markets, as stated in the 10-K:
Additionally, we believe that there are opportunities to expand our network into international markets as demonstrated with our recent initiatives in the U.K. market. – 2018 10-K
So far, these efforts have yielded great results, but revenues will only start becoming material in 2020 and above.
Source: January Investor Presentation
We are quite optimistic on international expansion considering Freshpet’s early results, a similar customer base, and a shift to healthy foods in these markets.
Lastly, Freshpet also has an opportunity to grow sales further by upgrading or increasing the number of its fridges and offering customers a greater variety of products.
Source: Q4 Investor Presentation
So, we think there’s a long road in front of this. Obviously the second fridges will go in the most productive stores that we have, first, but we think that there is a pretty broad opportunity across the entire portfolio over the next couple of years to expand out into the seconds and thirds in some cases across – really across the US and our broader array of customers. – Q4 Conference Call
In the end, Freshpet’s growth is not weakening, but accelerating. Considering the overall growth of pet ownership, the strong secular growth of pet humanization and healthy pet food, and the company’s unique competitive advantages and growth drivers, we believe its growth should continue for at least a decade.
Profitability and cash flow
What many bears miss about Freshpet’s profitability is the fact that a substantial amount of SG&A is used for advertising to drive growth.
Source: Q4 Investor Presentation
Excluding investments in international development and staffing, adjusted EBITDA guidance would be up more than 50%. This shows true profitability is probably much higher than the current level.
Even with these investments though, adjusted EBITDA is up nearly 4x from 2014. Interestingly, Freshpet is aiming to deliver $60mil in adjusted EBITDA by 2020, which involves increasing sales, improving gross margins, and reducing investments in international markets.
That would mean greater than 100% growth in adjusted EBITDA from 2019 to 2020. Great for a company that hasn’t grown adjusted EBITDA much in the last few years.
Freshpet’s situation reminds us of Amazon, which invested heavily in the first few years and showed very little cash flow or profitability until recently.
Freshpet is also now a self-sustaining business, making more than $2mil in cash flow in 2018.
Source: 2018 10-K
This reduces the reliance on outside capital and reduces the risk of investing in Freshpet.
The main risk concerning Freshpet is its high valuation. It still trades at nearly 5x estimated 2020 sales and ~24x 2020 guided adjusted EBITDA. Although a premium is warranted given the company’s niche status and strong growth runway, we believe this price is still too high. We would wait for a correction to add to our position meaningfully, and we believe other investors should do the same.
Investors should definitely put Freshpet on the watchlist. Freshpet has an opportunity to create substantial shareholder value in the future and has a good chance of becoming one of the largest players in the pet food space. Bite carefully though, as this is one of the stocks that may be affected substantially by a recession or correction.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.