Growing at a 5 year CAGR rate 3.15%, the 21.4 billion cat and dog food industry in North America is a highly competitive one with major incumbents like Nestle Purina, Mars Petcare, Colgate Palmolive, Big Heart Pet brands and Blue Buffalo, coupled with many other private brands tussling it out for market share. Increasing trend of humanization of pets and a shifting preference for organic food consumption have led to a premiumization of pet food. Here, enter Freshpet (FRPT:NASDAQ), a new dog at a new field, becoming a public company in Nov 2014 to extend its paw into the industry.
|North America Cat and Dog Food Market|
|CAGR from 2010 to 2014||3.15%|
Source: Pet Food Institute
Freshpet is disrupting the industry with its unprecedented unique value proposition to deliver fresh and quality-assured cat and dog food to caring and health-conscious pet-owners of North America. Traditionally, this feat is difficult to perform since shelved food turn bad too quickly. However, adopting an audacious business model, its line of products - Select, Vital, Nature's fresh and Fresh Baked - are kept chilled in more than 15,000 proprietary fridges littered around huge discount retailers like Wal-mart and Target and pet-focused retailers like Petco. It takes control of its own manufacturing and with a highest grade food certification, reinforces its value proposition of quality assured food, while achieving an impressive 35.4% CAGR of sales for the past 3 years. The humanization narrative is reinforced yet again in their brand strategy as they portray their pet food as food even desirable by human.
However, as palatable as it sounds, FRPT's share price has cratered close to 77% from its 52 weeks high of $25.46 in April to the current level. Short interest is at a jaw-dropping 47.19% (Source: NASDAQ Data). The company has sustained operating losses in almost quarters for 3 years except for Q4 2014. There were also mentions on social media of its food turning moldy which diluted the credibility of its brand. However, as the economics of the business play out, and there is proof of that, FRPT will bite harder than what its current stock price is showing.
Cost and Sales Economics
One issue constantly bugging the company has always been its capex-driven growth model. The nature of its products requires FRPT to install a fridge at every single retailer it partners with and subsequently replaces and services it should the need arises. As a result, tremendous capital expenditure is required, to both maintain and to grow the company in the future, causing a drag on the free cash flow to firm in the future.
|Capital as % of Sales||0.95||0.86||0.73|
|Sales in USD million||63.2||86.8||110.5|
|Invested Capital in USD million||60.1||74.3||81|
This is reflected in its fundamentals as we observe FRPT's TTM capital to sales ratio of 0.73 is almost 2.5X higher than Blue Buffalo's 3 year average of 0.3.
One explanation for this could be how FRPT is a newcomer to this industry and the productivity of its fridges has not reached those of a more mature company, much like how the same-store-sales of a new retail company would be low initially, only to accelerate as brand loyalty and recognition become established and its advertisement effects come into play. And peering back into history, we see a very clear development of this.
|Revenue in USD mil||43.5||63.2||86.8||110.5|
|number of fridge reported||8,514||10,836||13,386||14,670|
|Sales per fridge in USD thousands||5.11||5.83||6.48||7.53|
|Sales per fridge per quarter||2014Q3||2014Q4||2015Q1||2015Q2||2015Q3|
|Revenue in USD mil||22.5||24.5||26.1||28.4||30.6|
|number of fridge reported||12900||13300||14019||14354||14670|
|Sales per fridge in USD thousands||1.74||1.84||1.86||1.98||2.09|
From 2012 to 2014, the annual sales per fridge has increased from 5.11 to 6.48 (in thousands). Last twelve months has reported a sales per fridge of 7.53 thousands. Magnifying the time period and we see that quarterly sales per fridge from Q3 2014 to Q3 2015 has been increasing at a compounded rate of 5%. Likewise, sales turnover ratio has improved 23% from 2012 to 2014. Albeit how cumbersome it is, the fridges are in fact becoming more productive in supporting sales, pointing to an accelerating inventory velocity. Going forward, the productivity of FRPT's capital should continue to increase as existing customers become repeat customers from the inertia to change their pet's diet while market capture widens as targeted clientele switch to FRPT.
Next, mainly due to its abnormally high SG&A as a proportion of revenue, FRPT's operating margin has been negative except for Q4 2014. Like rotten apples, any sane investors would have discarded this stock especially when we compare FRPT's TTM SG&A ratio to sales of 52.94% to BUFF's roughly 20% for the preceding 3 years. This, however, is a cat-dog comparison. Look at BUFF's revenue - it is about 9 times more than that of FRPT's TTM 110M. And the initial scale advantage would have been reaped in Buffalo's case.
|Sales in USDmil||43.5||63.2||86.8||110.5|
|SG&A in USDmil||35.4||39.6$||48.6||58.5|
|Advertisement in USDmil||10.7||12||14.2|
Back to FRPT, economics of scale are taking place. Its SG&A proportion has decreased from 81.3% in 2012E to 52.9% in the TTM. One possible explanation is marketing scale. As companies expand, they are able to spread their advertisement cost by a larger output while at the same time, management learns which form of advertisement generates the highest ROI and efficiency of each advertisement dollar increases. From FY2012 to FY2014, advertisement as a proportion of sales has fallen from 24.6% to 16%. Management has acknowledged as well in 2015Q3 earning report that they are learning what works for the business and they will focus their advertisement dollars on the right medium. Other scale effects include manufacturing, R&D and distribution. Again, referencing to BUFF, its SG&A proportion has been tickling up since 2012 which might indicate that maybe the industrial minimum efficient scale is roughly 600M sales. With its infantile scale, FRPT's operating margin should improve with larger sales.
Next, a value chain analysis of FRPT reveals that FRPT boasts a very defensible economic moat. Its core activities from zero preservatives, organic food production processes to R&D efforts towards healthier and fresher food to its commitment to deliver fresh food to customers reinforce its Unique Value Proposition - pet food that even humans are tempted to consume. Its marketing effort is consistent with this, often using humans to test out their food and convince pet owners of the superiority of their pet treats. And of course there are trade-offs with such a business model. A new entrant can only enter the "fresh pet food" niche by, if not through installing tens and thousands of pet food dedicated fridges, finding an innovative way to deliver fresh pet food to the consumer. Such a value proposition cannot be easily replicated, even with major incumbents like Nestle Purina, Mars Petcare and Blue Buffalo, simply because it conflicts with their own value proposition and branding.
This competitive advantage in delivering healthy and delicious food to pet-conscious is evident in the premium of FRPT's pricing. Compared to BUFF, FRPT has a gross margin higher by 8%. For the complaints about FRPT's products being too expensive, they are probably not the consumer group that FRPT is targeting and so naturally its premium price will drive them out.
Source: Freshpet ICL Conference Presentation
Richard Thompson was the CEO of Meow Mix from 2002 to 2006 in which he bought the company with JW Childs Associate from Nestle for $167M. In 4 years' time, Meow Mix was sold to Del Monte Food for $720M a 553M appreciation of the firm value. Under his management, Meow Mix's revenue grew at a CAGR rate of 10% to $250M. Historically, he has successfully nurtured a business similar to FRPT and more than quadruple the value of the company. With his entire Meow Mix team in FRPT, shareholders should look forward to the same degree of success. Management probably agreed with the prospect of the firm when there were significant insider buys during November coupled with a colossal scoop of shares by MidOcean Associates SPC.
Lastly, with a current cash balance of around 19M, no net debt and a 40M credit line which allow FRPT to borrow on average 4.25% (which can be expanded to 60M subjected to certain covenants), liquidity does not seem to be a ratio. For the TTM, EBIT is positive and there is no cash burn from operations. However, there is projected to be 30M - 32M of capex in the short run, of which 10.2M was recorded. So with about 20M capex outstanding and about 8.5M annually for fridges, the company will be able to cover its projected cash flow needs in the short run.
I will intend to incorporate the aforementioned analysis of margins, sales growth and liquidity in a DCF below using these assumptions:
1) Capital as % of sales ratio converge to 0.5, which is slightly higher than BUFF of 0.3 because of its need to use fridges to expand the business
2) Operating margin converges to 18%, slightly lower than BUFF of 2%. Higher gross margin from economic moat should somewhat offset the higher SG&A associated with maintenance of the fridges
3) Debt structure follows guidance of company but debt is refinanced in the 3rd year instead to 80M which is assumed to be due in 2023 so as to provide for the required expansion liquidity. Cost of debt remains at the higher end of the current arrangement, assuming higher leverage.
4)Effective tax rate of 35% , after exhausting 163M of NOL
5)3 Stage growth model of 30% for 5 years, before decaying to 5% to reflect its status as a growth stock
6)Perpetuity growth rate at 3%
7)Working capital at 4% of Revenue based on average
8)Beta used reflects that of a health and wellness company which is higher than a grocery store.
Doing a DCF analysis, we acquire a fair value of $20.8 which is more than 3X the current price. There is market debt of 90.3M which is the estimated market value of debt from the future since some of the expansion will have to be funded by debt due to a lack of cash.
I performed a sensitivity test on the convergence rate and targeted operating margin and even with a slow convergence and a 15% final margin, we end up with a fair value of $13.00 per share.
Let's consider a bear case where the following parameters are adjusted:
1) 3 stage growth rate starts with 20% instead and decays to 5% as for some reason, say the resurfacing of moldy products or other distributional risk that caused take-up rate of FRPT's products to decrease.
2) Projected Sales to capital ratio is at 0.6, double of BUFF because velocity fails to pick up.
3) Operating margin gets stuck at 15% as the cost of maintenance the fridges increases in the future and suppliers of raw materials pass on higher cost of produce to FRPT.
The DCF model yields a bear case valuation of FRPT of $7.88 per share which provides the investor with a margin of safety of around 24% from current prices.
Although FRPT has no particular catalyst, we expect the stock prices to move closer to that level if future earnings reports confirmed the analysis.
Alternatively, value could still be realized by management, similar to Meow Mix, through an acquisition. Once Freshpet captures a customer base and scatter its fridges all over North America, it will definitely be a potential takeover target from firms looking to expand and consolidate their market share. If share prices languish around this level while its revenue grow, stock holders should expect buyout offers.
FRPT is a misunderstood creature who hasn't been given enough time to realize its potential. Instead of parroting market sentiments and punishing the stock, this could just become the new pet stock of the contrarian growth investor.
Disclosure: I am/we are long FRPT.
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.