Freshpet: Set To Benefit From Positive Trends In Pets Space

| About: Freshpet (FRPT)
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The recent results validate that the visibility has improved for the company.

Industry trends remain supportive, with new products and expanding distribution offering a further boost to the topline growth.

Margin stability, decent leverage, good balance sheet and improving cash flows may offset concerns related to rich valuation, i.e. even if one completely ignores the acquisition thesis.

Looking at the stock performance, investor expectations for Freshpet Inc. (FRPT) seem to have been reset from the IPO levels, and the reasons have been varied; a weaker-than-expected topline growth, earnings miss, margin deterioration and management changes more recently, but the fundamentals offer good reason to take a closer look at current levels, with visibility improving and industry dynamics favorable.

No doubt, there are things that are still concerning, be it the valuation, with the stock trading at more than 50 times forward earnings, less than impressive performance of most pet products retailers, relatively smaller size of the company, and a continued margin compression. Market's positive reaction to the decent set of results may also subside over the coming days, but even with these concerns, there are enough reasons to believe that the company has turned the corner and positives seem firmly in place to offset these issues.

The industry as a whole is benefiting from improving demand for premium and specialty pet products & services driven by changing consumer preferences and rising pet ownership. Having successfully created a differentiated market position with its prepared food for pets and thousands of fridges, the company seems well positioned to grow organically via new products and expanding distribution, while improving profitability via increased utilization rates from growing revenues and leveraging operating expenses. Over the coming months, seasonality, combined with benefits from the recently launched products and expected double-digit growth of fridges in the market do suggest a strong second half. Of course, onboarding of the new CEO may further improve the sentiment around the stock.

Favorable industry trends helped by decent growth catalysts

The broader pet products & services space is benefiting from some interesting consumer trends. As covered in my recent note on Blue Buffalo (NASDAQ:BUFF), pet ownership is rising with customers increasingly going for premium products, providing pricing power for some brands, as reflected by the average price per pound of pet food that has grown by more than 40% over past five years, and challenge for behemoths in the pet food space like Nestle S.A. (OTCPK:NSRGY) and its Purina brand. The space is expected to continue to grow around a low single-digit rate and premium products around 10-15%, driving players like J.M. Smucker (NYSE:SJM) and Mars Inc. to stay aggressive on the acquisitions front.

Most metrics seem to suggest that the current growth rate is sustainable. Besides the topline growth of more than 16% during the most recent quarter, fridge count grew by 10%, velocity per fridge improved and store count also increased. With almost 16,000 fridges deployed, there is almost an equal size of white space opportunity available across North America. A testing with a major U.K. based retailer is underway that is expected to expand over the coming months.

The launch of new products and expansion of recently launched products, like shredded dog food, dog cups, etc., are another growth opportunities that might offer a decent push over the coming months. The revenue from cat-focused products is relatively weak, but with new products for cats, product stuffing across the existing fridges and expansion of cat fridges should help.

Margins should stabilize and cash flows improve

Gross margins have been weak compared to last year, but much of the weakness was due to the startup costs, product mix, and new product introductions; things that may get corrected once the new capacity and products achieve scale. In the meantime, leverage at the operating expense level is already visible with shrinking SG&A as a percentage of revenues.

The completion of the company's Phase two of the expansion plan that constituted most of the capital expenditure over the past few quarters should offer a significant boost to the free cash flows, besides supporting the incremental growth.

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.

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