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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Greetings and welcome to the Freshpet Third Quarter 2018 Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Katie Turner. Please go ahead, Katie.
Thank you. Good afternoon and welcome to Freshpet’s third quarter 2018 earnings conference call and webcast. On today’s call are Billy Cyr, Chief Executive Officer and Dick Kassar, Chief Financial Officer. Scott Morris, Chief Operating Officer will also be available for Q&A.
Before we begin, please remember that during the course of this call, management may make forward-looking statements within the meaning of the federal securities laws. These statements are based on management’s current expectations and beliefs and involve risks and uncertainties that could cause actual results to differ materially from those described in these forward-looking statements. Please refer to the company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission and the company’s press release issued today for a detailed discussion of the risks that could cause actual results to differ materially from those expressed or implied in any forward-looking statements made today.
Please note that on today’s call, management will refer to non-GAAP financial measures such as EBITDA and adjusted EBITDA among others. While the company believes these non-GAAP financial measures provide useful information for investors, the presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP. Please refer to today’s press release for a reconciliation of the non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP.
Finally, please note that the company has posted and updated its investor presentation on its website prior to its appearance this week and an investor event in Chicago. The presentation is similar to the presentation last provided by the company in September, but now includes updated scanner and household penetration data that covers the third quarter. The company does not intend to review the presentation on this call, but believe it provides useful information on Freshpet.
And now, I would like to turn the call over to Billy Cyr, CEO.
Thank you, Katie and good afternoon everyone. To begin, I will provide an overview of our financial highlights and recent business performance and then Dick will provide greater detail on our financial results. Finally, Dick, Scott and I will be available to answer your questions.
We are very pleased with our third quarter top and bottom line results. Our strong net sales growth enabled us to deliver significant operational scale gains that helped to offset lower than anticipated adjusted gross margin and deliver strong adjusted EBITDA growth versus year ago. Q3 was an inflection point in the development of our Feed the Growth strategy. We are able to continue driving strong top line growth and began to show for the first time that we can simultaneously convert that into significant adjusted EBITDA growth. We still have a long way to go to fully demonstrate the long-term profit potential of the business, but this quarter is an important step towards proving that we can grow into our scale and thus drive our profitability. We continue to believe that our top line growth trend is sustainable and scale benefits are expandable, the adjusted gross margin issues can be remedied, but it will take a bit of time and the adjusted EBITDA will continue to grow with scale. Dick and I will discuss each of those items in more detail.
Recall, our Feed the Growth plan is designed to accelerate Freshpet’s rate of growth enabling us to fulfill our mission of providing more pets with fresh, all natural foods that enrich their lives and the relationships with their pet parents. We are committed to doing so in ways that are good for our pets, for people and for our planet. In the pursuit of our mission, we expect to deliver significant value to all of our stakeholders. We will accomplish this by creating a virtuous cycle, where increased investment in advertising drives increasing scale that we can use to drive greater distribution, increased manufacturing utilization and efficiency and better leverages our organizational capacity. We expect this will produce increased financial returns that we can use to drive further growth and long-term profitability enabling us to serve more pets.
Our financial goal is to deliver $300 million in net sales as soon as 2020 with a 20% plus adjusted EBITDA margin. Along the way, we expect to create significant scale gains that we can harvest for reinvestment in growing the Freshpet brand and ultimately take some of those gains to the bottom line. Our third quarter results confirmed that we are on track to deliver the accelerated growth rate we expect in 2018 and we are progressing well towards our longer term targets. Our increased investment in advertising in conjunction with consistent distribution improvements and focused product innovation have enabled us to cycle last year’s strong growth and deliver an acceleration in Freshpet’s consumption growth rate.
In the Nielsen Mega Channel, which includes grocery, mass, club, big box pet and whole foods, fresh consumption in the quarter was up 31% an acceleration from fiscal year ‘17 to 21%, Q1’s 25% and Q2’s 28%. Consumption growth was broad-based with all classes of trade, up more than 25 points versus the category, including our big box pet specialty business, where consumption was up 23% versus year ago for the quarter while the category declined mid single-digits in the channel. Grocery was up more than 37%. Mass consumption was up 28%. Even our tiny, but fast-growing e-commerce business, including sales via curbside programs, home delivery via Instacart and Shipt and traditional e-commerce like FreshDirect and AmazonFresh more than doubled versus the year ago and now accounts for about 1.5% of net sales.
Encouragingly, more than 70% of the e-commerce sales supported our existing retail fridge network meaning the consumer ordered the product online, but chose to have delivery or pickup from their local retail store. We experienced strong growth across all package forms. Growth was particularly strong on our bag products driven by continued growth on the Fresh From the Kitchen product we launched more than 2 years ago and by strong innovation on our Roasted Meals products. The Roasted Meals products grew at double the rate of the balance of the business behind our new small dog offering a beef version of our Roasted Meals and a new multi-protein product. This shift towards our higher value bagged items drove a Nielsen reported 4.9% increase in retail dollars per pound on our core dog food products in the quarter, up from 1.1% growth in the year ago period.
Our core fresh dog food, which consists of our Rolls, Roasted Meals and Fresh From the Kitchen main meal products, consumption grew at the fastest rate more than 34% in part driven by strong household penetration gain behind our new product innovations. Our core dog food household penetration was up 22% versus year ago and the total brand household penetration exceeded 2% for the first time, up significantly from 1.4% when we started to beat the growth. Further, velocity gains accounted for over 70% of our net sales growth with average velocity gains of greater than 20% for most customers and even in the face of continued store closures, we grew distribution across the Nielsen Mega Channel by 2.9 points of ACV or about 7%, with a total of 445 net new stores. At the end of Q3, we had 19,107 stores. We have also upgraded 761 stores to larger fridges this year, with an additional 52 in Q3. The combination of a 7% increase in ACV and better in-store presence resulted in an increase of more than 11% in total distribution points versus year ago as measured by Nielsen. Total distribution point is the product of ACV distribution and average SKUs in distribution and is a good proxy for the scale of our retail presence as it both adds stores and increase the size and number of fridges in existing stores.
Net sales were up 27% versus the strong quarter a year ago. The gap between the consumption growth rate of 31% and a net sales growth rate of 27% is due to the discontinuation of the baked business approximately 1 point, slower growth in unmeasured channels in the U.S. and in countries outside the U.S. and normal trade inventory fluctuations. This is the last quarter with any meaningful baked business impacting the year-on-year comparisons. We had about 350,000 of baked sales in Q3 a year ago.
As I mentioned, our adjusted gross margin progress in Q3 was disappointing at 49.6%, down versus Q2 and the year ago. This was the result of higher commodity costs and inbound freight, the planned increase in staffing cost to prepare for a 24/7 production schedule, some production issues that are the result of training so many new employees, and a mix impact created by the rapid growth of our bagged products. Dick will provide more detail on each of these items. What I can tell you is that some of these issues are temporary such as the incremental staffing and the production issue and we expect to resolve them as part of our ongoing operating efforts. The remainder of the issues such as commodity costs and the mix impact will require more comprehensive interventions that we are putting in place as part of our 2019 plan.
One area in particular I would like to comment on is the impact of mix on our adjusted gross margin. As I said earlier, we have had tremendous success this year with some new bank product innovations. They are driving strong consumption gains, higher revenue per pound and higher penny profit per pound. They are also driving a higher margin on our bagged products lineup versus our previous bagged product lineup, a lower margin than on our rolls. So while the rapid growth of the bagged products is having a positive impact on our total net sales generating higher revenue per pound is having a larger than planned negative impact on our overall gross margin. It will also cause us to add staffing to convert two more lines to a 24/7 operation sooner than previously anticipated.
We are developing both near-term and longer term solutions that will recover the gross margin impact due to mix, including pricing and operating efficiency improvements. We are confident that we can get back on track versus our longer term adjusted gross margin goals. Importantly, this situation is a result of stronger than planned successes on our product innovations and demonstrates our ability to command higher prices per pound. Most people, that is a high class problem, better than expected sales and increasing price premiums with a modest issue on margin, no matter how you think about it though, we have a plan in place to fix it.
In Q3, media spending was up $500,000 versus a year ago or 13%, but down as a percent of net sales and we gained 60 basis points of improved absorption in SG&A despite some unfavorable timing of annual expenses. Adjusted EBITDA in the quarter was $6.7 million, up 20% from year ago due largely to our 27% Q3 net sales increase and despite the higher media spending in the absolute. This is an early indication of our ability to drive strong top line growth, while simultaneously delivering significant adjusted EBITDA growth. We believe there is lots more of that to come. Our long-term plan calls for improving the structural profitability of the business by more than 900 basis points versus where we ended 2016, with 700 basis points coming from increased absorption in SG&A excluding media and the balance coming from scale benefits and manufacturing that help improve adjusted gross margin as we also continue to drive improvements in throughput, yield and capacity utilization. We have already begun demonstrating some elements of the scale benefits, particularly in G&A, where we have a very clear path to achieve what we have outlined. At the same time, we are very cognizant that we must deliver the manufacturing scale benefits to improve adjusted gross profit margin more consistently over time.
Looking ahead, we are off to a very good start for Q4 and expect to see our strong consumption growth rates continue enabling us to deliver the 25% growth we committed for the year. It is very clear to us that we were winning formula for top line growth something that is very scarce in the current CPG environment. We have advertising and it consistently and efficiently delivers the household penetration gains we need to drive franchise growth. Our focused product innovation is further increasing household penetration. The exceptional quality of Freshpet produces differences that are noticeable to the pet and the pet parent. These help drive exceptional repurchase rates that convert the household penetration gains into sustained sales gains and our efforts to continually strengthen our retail presence through better fridge placement, larger coolers, second coolers and new stores is paying significant dividends. These are the key elements of the virtuous cycle in our Feed the Growth plan.
In closing, I believe our third quarter results validate that our Feed the Growth plan is working delivering the accelerated growth rate we expected and putting us on track to deliver our longer term 2020 goals. And we remain convinced that we will increasingly be able to translate the top line gains into improved profitability largely through scale and leverage. Further, these results increase our confidence that Freshpet has the ability to become a very sizable brand in the attractive pet food industry and fulfill its mission of delivering fresh all natural foods to pets that enrich their lives and strengthen their relationship with their pet parents and doing that in ways that are good for pets, people and the planet.
Before I turn this over to Dick, I would like to give you a brief update on our Kitchens 2.0 capacity expansion project. There is not much to report other than we have filed the necessary permits and remain on track for construction to begin in the spring of 2019. Our plan calls for the startup of the expanded plan to begin in the second half of 2020 and we remain on track to deliver that. Additionally, we are still planning on locking in the financing for that project in the fourth quarter of this year. As we said at our Investor Day in August, this will be bank financing and we will not be issuing any new equity to finance that project.
Finally, I want to be sure that all of you saw our announcement in late September about the addition of [indiscernible] to our board. DD brings a wealth of food and retailing experience and is a passionate pet parent. She most recently served as an SVP at Walmart with responsibility for fresh food and prior to that led the private brand business in safe way. We are thrilled to have her on board.
I will now turn it over to Dick to discuss our Q3 financials.
Thank you, Billy and good afternoon everyone. As Billy indicated, net sales in the quarter were $50.8 million, up 27% versus the year ago period. I would like to remind you that we adopted new revenue recognition standards this year, so the net sales in the prior year quarter three were $40.1 million under the new standards. Excluding the discontinued baked items, Frespet net sales were up $0.28 a quarter. Discontinued acceleration in the Freshpet growth rate is a result of the increased investment we made in advertising this year. Our year-to-date advertising investment is up $6.3 million versus a year ago and that is the biggest driver of the growth. However, our new products are also performing particularly well, producing growth on our Roasted Meals line that is double the growth rate of the rest of the business. That is better performance than we expected at the beginning of the year and better than our typical new product launches.
Further, our fridge upgrades are delivering the anticipated growth and accelerating contributing significant growth in key customers where they have in place. This broad-based growth is very encouraging and sustainable with a multiyear runway for further expansion. This strong performance puts us slightly ahead of the pace we committed to when we raised our guidance in August. We committed to 25% growth for the year, which would mean 25% growth in the back half of the year and we delivered 27% in quarter three. We remain very confident we can continue to deliver the high level of consumption growth that we have delivered to-date for the balance of the year. The October results confirm this. However, it is always difficult to predict changes in our customers’ year end inventories and any weather related disruptions to the transportation network at year end. So we are reiterating our confidence that we will exceed $190 million in net sales for the year.
Adjusted gross margin for the quarter was 49.6%, down 260 basis points for the year ago period and down 160 basis points from quarter two. As Billy mentioned, we are disappointed with this result, but believe that many of the issues we faced in the quarter are temporary and can be overcome. The 160 basis points of headwinds in adjusted gross margin versus quarter two and 330 basis points versus year ago were partially offset by scale benefits and efficiency improvements. The headwinds were 40 basis points of an added cost from quarter three versus quarter two from the expansion to a 7-day production schedule, 190 basis points for the quarter versus year ago. We successfully started a 7-day schedule in mid-September, so we did not receive any production benefit in the quarter.
If you look at that benefit in quarter four, however, the rapid growth of our bag business is going to cause us to add 2 new 7-day production shifts in Bethlehem sooner than anticipated and that will result in about 60 basis points of underutilized labor expense in quarter four. Second, we absorbed an increase of 60 basis points of commodities and inbound freight inflation versus quarter two. In total, we expect to absorb approximately $3.5 million or 180 basis points in higher commodity costs for 2018. While we expect commodities to vary over time, we were developing plans to address the higher cost and the benefits will be realized in 2019. Those actions will include pricing and mix exchanges eliminating lower margin SKUs and new innovations that drives higher margin items. In quarter three, we absorbed 10 basis points of adjusted gross margin versus quarter two and 60 basis versus a year ago to a mix shift within our core dog products. As Billy said, the rapid growth of our bag products resulted in stronger than expected sales growth and positive impact on gross profit per pound, but also a negative impact on adjusted gross margin. We are fortunate to have strong growth on such premium-priced items and plans to place to improve the gross margin via both productivity and improvements and pricing.
Finally, we absorbed 50 basis points higher scrapping costs in quarter three versus quarter two. We have very high standards for our quality and we will scrap the entire batches of our production runs, if the product does not meet our standards, a critical driver of very high repurchase rate is the exceptional quality of Freshpet and we will not do anything that will compromise our commitment to deliver the highest quality product to our consumers everyday. In quarter three, we had several batches that do not meet our standard due to routine issues that can be avoided with more training and improved systems, but they were scrapped. Unfortunately, those negative items will offset good progress on throughput. We had record production months in the quarter and so a good improvement on both throughput and yield. In combination with the action listed above, we remain confident we can achieve our long-term margin goals. But as we have said, it will be lumpy.
Adjusted SG&A in the quarter was $21.6 million or 42.5% of net sale, an improvement of 270 basis points. The improvement in adjusted SG&A leverage was a result of efficiencies gained within logistics as well as scale improvements within G&A that totaled 150 basis points versus year ago. Additionally, even though our media spending increases versus a year ago, it contributed 120 basis points of improvement as we began to grow into our media spending. This puts us on track towards the 900 basis points of fixed cost pickup we expect to achieve by 2020.
Adjusted EBITDA in the quarter was $6.7 million, up $1.1 million from the year ago period driven by the increase in revenue. As in the past, our EBITDA for the year is weighted towards the back half due to our significant heavier media spending in the first half of the year and the resulting net sales we expect to accelerate in the second half of the year. With these results, we remain confident we can deliver the updated EBITDA guidance we provided in August. We expect the strong sales momentum to continue that we will begin to benefit from 24/7 production capacity we have put in place. We will continue to face higher commodity and in-bound freight costs, but affected those into our thinking. We paid back $2 million of debt in the quarter, so we have $2 million drawn on our revolver at the end of the quarter.
We ended the quarter with $2.9 million in cash. We continue to expect to produce positive annual cash flow from operations and then the year get free excluding the impact of our Kitchens 2.0 capacity expansion. For a perspective, we have now spent $1.3 million on Kitchens 2.0 and expect to spend a total of $2.5 million this year on the project. To reiterate, we are very encouraged by our progress so far this year, particularly with the strong net sales growth. We remain confident in our ability to deliver our long-term financial goals. We have proven the ability to accelerate our growth and are beginning to capture the scale benefits in our structural profitability. We expect that to continue for the remainder of this year and into next year. We know we have some issues to address in adjusted gross margin, but are confident that we have put in place plans to address those and remain committed to delivering our longer term profitability improvement.
That concludes our overview. We will now be glad to take your questions. Operator?
Thank you. [Operator Instructions] Our first question today is coming from Peter Benedict from Robert W. Baird. Your line is now live.
Hi, guys. Couple of questions. First just maybe a little bit more on the input cost dynamics thinking about the commodity items that you have got a lot of movement in those, how are you looking – I guess as you are starting to lock in your product for next year, how do you think the commodity input cost picture looks? That’s my first question.
Yes. We haven’t locked in our chicken prices yet for next year, but we feel based on the market that we will not see any increase and we potentially could see decline, but we don’t have it at this point in time. Beef prices longer term, are looking pretty good the next 6 months for 2019. So, we feel good about where that is. We did have innovation quite a bit in the quarter on the bag lines and those new products took a little bit longer to produce than we anticipated and we suffered some consequences associated with actual throughput for that period of time. But longer term, we have things in place whether it’s pricing, greater scale and potential for our employees who we brought in for our 7-day shift for the one line and then we are bringing in January 2 two more lines on the 7-day shift to just get more acclimated to the environment and produce at a better rate.
Okay, that’s helpful. Are you guys able to give a sense maybe you had in the past, I apologize, but in terms of just the number of employees that you are increasing down in Bethlehem you said you had some – you are working on kind of the training process and whatnot, so I am just curious that the magnitude in terms of how many new members our employees are on the floor today maybe versus a year ago and where is that number going to be a year from now, that’s my next question?
So I think we have pulled – Peter it’s Billy, I think we have told people when they were in Kitchens we had about 221 employees in the kitchen that when we ultimately expanded we would add somewhere between 100 and 200 employees. As we have gone from the five-day operation to seven-day operation, we have moved that in steps. We moved – for example we moved all our maintenance people to the seven-day operation earliest. And we add each of the lines at a time. So the biggest chunk came in the first wave, each successive wave just brings the people who operate those lines. But I would think of it is in the 20, 25 range for each one of the lines is the way to think about the incremental staffing.
Okay, that’s helpful. And then Bill I guess one last one for you, just we are starting to see some more competing fresh product out in the market not much, but is starting to show up in certain places, particularly at PetSmart and so just curious your take on what that all means is that a risk for you guys, is that a validation of the category, just what are you seeing in terms of competing fresh product in the marketplace? Thank you.
Hey Peter, it’s Scott. I will go ahead and answer that. So there has been a few folks that have kind of come into the market over time in and out. The folks that have been around for about 3 years at ACV just kind of backup I think it is important perspective. So they started off in around I think 36 stores, I think they are down to 24 stores. We actually do about 7x of sales velocity that they do in the same stores when we are into the same stores together. So we have a similar dynamic where there is another retailer that recently put some fresh products in. And there the competitor is doing $33 a week and we are doing $320 something a week. So we are not quite 10, but we are in the neighborhood of pre-dramatic difference. So we obviously watch this incredibly closely. And I think what it comes back is the quality of the products that we are making, delivering to consumers and the overall value proposition. It seems to be something where it puts us in a situation where we haven’t had issues or challenges to kind of the product. And we have also maintained the growth rate that we have had in those retailers. So when those products have been added, we have a similar growth rate that we have in other store. So it really has impacted our growth rate and our performance has been very, very strong and many times multiple what the sales of those other products are. We have been able to get all this through we buy a lot of POS data through like net and Nielsen or IRI. And so we have been able to keep really close track. It’s really a good question. We are very, very on top of it. But it had very, very little to no impact whatsoever to our business, but something we want to kind of keep the close eye to.
And Peter, let me add to that because the note that I saw that you put out last night which kind of address sort of longer term strategic consequences of having a new entrant behind them, behind us, I think it was pretty much on point and that you have got to expect that as we get the traction that we are getting that we will attract followers. There is no doubt about it. Our goal is to get as much of a head start as we possibly can to define the rules of engagement to find the way the consumer thinks about the category long before anybody else enters. And I think it’s the data you put out and your deck suggest is that the guy who is the groundbreaker ultimately ends up having the lion share of the category and that’s certainly what we would expect. But at this point it doesn’t appear that we have got as Scott indicated anyone who really is a much of a follower at this point.
Okay, great. Thanks so much guys. Good luck.
Thank you.
Thank you. Our next question is coming from Rupesh Parikh from Oppenheimer. Your line is now live.
Good afternoon and thanks for taking my questions. So on the gross margins, this may be just additional clarity from what you guys said in your prepared comments, but how quickly do think they can be adjusted is it something that could take a few quarters. And then secondly, I think you said that you are still comfortable with the longer term expectations for gross margin, so just wondering if you can just provide some more clarity in terms of some of the offsets that you think could help to offset some of the headwinds you are seeing right now?
Yes. Let me take it. I think that there are as we have said there are. The headwinds we faced on the two buckets sort of the more operational pieces and I define those as the staffing that we had the interim staffing as well as some of the scrapping expenses that we incurred in the quarter. And the longer term issues are those things the commodity inputs and the mix impact. We are putting in place for 2019 the structural changes that will impact those second pieces. So they will flow through as you think about next year’s plan. They won’t all begin on January 1 and begin early enough in the year that will have a significant impact on the year. And those includes the things that we have talked about before which is innovation as the driver mix. Our pricing is one of the tools that we are adding to that mix. And the combination of those is ultimately going to get us I think some significant improvement. The other piece is the operational side of things really come with the training, skill development in our organization putting in place the systems that we need to put in place so that we can avoid the issues that we saw and then frankly just growing through the staffing. Bringing on the right people that we think we need to help us deliver the results that we need. So that’s another one that will face itself. I don’t want to make it sound like it won’t be lumpy going forward. It will be and we said all along that gross margin will be lumpy when you are growing at the rate that we are growing is expected to be lumpy, doesn’t come as evenly as one might hope. But it’s always going to be heading in the right direction. In terms of getting to our longer term, getting to 2020 adjusted gross margin, we think the structural changes we are putting in place in 2019 in combination with the continuing ongoing operating improvements and growing in the scale, we still feel good about getting to the goal and remember our goal is combined with benefits of scale and also the SG&A goal totally get us to the 20 percent plus EBIT – adjusted EBITDA margin.
Okay, great. Thank you.
Thank you. Our next question is coming from Brian Holland from Consumer Edge Research. Your line is now live.
Yes. Thanks. Good evening, a question on – just following-up on the gross margin component, my understanding was that the bag product has sort of been inherently lower margin SKU than the low, maybe you can clarify whether that is or isn’t, but if it is and that’s growing faster and that’s where maybe some of the new newer pet parents are migrating to, why doesn’t that alter your assumptions or maybe you always assume that that was – that the mix was going to evolve towards the bag product, can you just maybe sort of clarify the mix within the context of your long-term outlook?
Yes. When we laid out the goals, we clearly had an expectation for some amount of mix change. What we commented in this discussion today was – or in the comments we made today was that we saw an unusually high level of shift towards the bag products behind the innovations that we have launched this year. And that was a little bit out of pattern with what we had planned. And frankly as we talk about the plans for next year that’s why we are talking about doing some more structural or systemic changes both pricing and some innovation that can help correct for that issue. The products we launched are phenomenally successful. They are doing incredibly well. We think we have got some pricing power and think we will take advantage of that in order to get the margin back to where we need to get it. Your – opening part of your question is yes, our bags are lower margin than our Rolls are. But part of our goal here is to improve the efficiency on the bag part of our line. That’s frankly where we have some of the biggest opportunities for efficiency improvements both in the current operation and also in the next generation of the facility. In fact when we laid out the plan for the Kitchens 2.0, we called out and pointed out that there was a significant gain and some operating efficiency particularly because of some throughput gains we get on the bags lines.
Okay, got it. And then obviously you have had some benefit from the upgraded fridges, also from innovation, just curious especially it seems like the small dog innovation, marketing specifically to that admittedly large subset is having a fair amount of success, as you build your innovation pipeline, but sort of working against a relatively fixed real estate on shelf, obviously that’s evolving as you get fridge upgrades, but how do you think about managing the innovation pipeline and prioritizing what’s in those fridges, because I think as I understand that you have had to make some sacrifices or at least make some decisions about maybe impacting cats, etcetera, how do you think about managing what seems to be a pretty successful innovation pipeline with the amount of shelf space you have available?
So Brian, it’s Scott. The first piece is obviously identifying innovation that helps us to expand our overall business proposition and the appeal of the franchise and the portfolio. And once we do that then we do a pretty detailed evaluation and sometimes just market level testing to really understand are we getting incremental dollars per literally down to linear inch and also understand the gross margin impact of making trade outs within the fridge. Historically we have done very well with those trade-outs. They have delivered a lot of incrementality to the business and helped to kind of facilitate additional growth on top of the media. In the future what we are starting to do and think more about is adding upgraded or larger fridges. And then in many cases, in many scenarios even second fridges to help basically expand and continue to put in incremental innovation. So I think in 2019 what you are going to see, you are going to see some evolve. You are going to see better products going in and swapping out for some of the existing products, because we believe they are more productive and will increase the amount of dollars that we get for our overall fridge. But we are also making sure that we get as many fridge upgrades and then secondary fridge locations that now only help with overall sales and being able to carry innovation, but also from help us limit spoiled and out of stocks.
It’s helpful. Okay, guys. That’s helpful. Thank you. Last one for me just curious how you guys think about pricing, I know you talked about on this call you have indicated back at the Investor Day that pricing was something that you were exploring as a lever to pull, just curious given the uniqueness of your product in the store and certainly understand that they are competitors out there are evolving, but the uniqueness of your product as you are looking to attract new customers, how do you think about assessing how much pricing power you have and the sensitivity there, the demand elasticity, just curious sort of how you think about that?
So I think the thing that we have been able to demonstrate which it gives us an indication on the pricing power that we have is we have been able to bring incremental innovation to the market that’s typically higher priced, higher price per pound. And when we have done that the items have typically been successful. We also as we are bringing in higher and higher priced products and those are successful that’s obviously a great indication to. So as we look through the fridge and the different items obviously you can be very strategic about where are the pricing potential and the pricing opportunities are on the line and those are the ones that you want to take into consideration and evaluate for if you were going to take price what you would actually execute against. Did that help?
Yes. Thanks Scott.
Alright.
Thank you. Our next question is coming from Jason English from Goldman Sachs. Your line is now live.
Hi, good evening folks.
Hi.
The – flashing around two months ago to your Analyst Day, I think you put out adjusted gross margin target of 51.2 for the year, I apologize if I missed it, but can you update us on where you stand now for the full year?
Yes. We are – we were looking at 51.2 by year end and currently year-to-date we are about 50.3. So we will be probably in the range of 50.3 to 50.4 for the year.
And is it – I know you are not in a position right now to give 2019 guidance, but given the nature of some of the issues you are talking about as well as the comments on this will take time, it sounds like ‘19 you are going to see limited progression, so to get to 52 by 2020, we really need a bit of a hockey stick at the tail end, is that the right way to think about it?
No.
We are at a run rate about $190 million right now, where our objective is to get to $300 million which is about 25% increase in throughput by the end of 2020. We will see the benefits of scale and that will come to us and what we have always said we would get 9 points, 7 points on G&A and approximately 2 points on margin. That 25% increase in scale along with some issues that we discussed earlier whether it’s pricing or whether it’s better hire trained employees any a full work force who have been managing seven days on three lines for not only nine months – nine months to ten months in 2019, but in 12 months of 2020 we expect to achieve those goals.
Jason if you think about ‘19 though some of the interventions we are putting in place would be at the very beginning of the year, all those will kind of grow through them. So, I don’t think it’s a hockey stick, I don’t think it’s a fair characterization. I think it will be more meaningful progress made in ‘19 than that would suggest. I would say though that there is going to be incremental staffing that’s going to be at the beginning of the year just as we grow into this, but there certainly will be progress mid ‘19.
No, that’s encouraging to hear. So the remediation efforts you are talking about are a series of multiple months, not many quarters before we start to see the fruits of those labors borne out in the P&L, yes?
Yes, I mean I wouldn’t expect it in the fourth quarter this year. So if you are thinking about….
No totally.
You will start seeing into ‘19 yes.
And a quick question on leverage little bit further down the P&L, SG&A up pretty substantially this quarter despite the moderation in media growth I think by our math it’s around $4 million roughly ex media round numbers. What’s driving that increase?
Yes. Well, we accrue our incentive payments as we progress towards the year though in the first quarter with minimal EBITDA that’s basically we accrue our EBITDA based on the results of that period divided by the entire year projection of what we guided to $20 million. And as we progress you will see incremental amounts there. Additionally, we changed our likelihood of achieving our 2020 executive objectives and we went from a 50% accrual rate to a 75% accrual rate for restricted stock units – sorry for options and that was booked in the third quarter.
Got it. That’s helpful. And I believe that the bulkier logistics costs run through SG&A rather than COGS, how much pressure are you seeing from that, well, first is my understanding correct? And then secondly how much pressure are you seeing in SG&A due to those logistics inflation?
So what we actually was an improvement there, because of scale – we are getting scale benefit, it’s just not as much improvement as we had expected to see in the quarter the place where we saw freight inflation was on inbound related to the raw materials we bring in, but on the outbound which is where we have the freight and SG&A we actually saw some improvements just not as much as we thought, because when you are shipping LTL, as you go from 2 pallets to 4 pallets or 4 pallets to 8 pallets or whatever you get significant scale benefits in freight and that’s one of the things that we are seeing.
And was it the incremental dollars in SG&A when you said we had a growth of X millions of dollars for the period, SG&A is variable expenses along with brokerage and freight is a variable expense along with brokerage and some of that and basically chill and repairs. So those are kind of variable and semi-variable which grows in dollars, but not necessarily percentage as we continue to grow top line.
Got it. Understood. And congrats on the top line momentum, it’s impressive. I will pass it on. Thank you.
Thanks.
Thank you. Our next question is from Jon Andersen from William Blair. Your line is now live.
Hi, good afternoon everybody.
Hi, Jon.
Most of my questions have been answered. I guess maybe what I will ask about is media spending, I think this is the first quarter for some time where you are seeing the media, you got some leverage on your media spend in terms of the ratio for percent of sales as you look forward kind of 2019 2020 of how should we think about your media spending? And if you continue to leverage that line, how confident are you that you can kind of keep the kind of revenue growth rates up that we have seen the past couple of years where you have accelerated or ticket up your media spending pretty dramatically?
Yes. First of all, Jon I am talking about this on an annual basis not on the quarters, because we are still going to look at varying our spending within the quarters. So just as you think about it on an annual basis, we told folks that we would be roughly in the 12% range for spending this year, up 12% of sales. We told folks that in 2020 we would be at 9% of sales. We are inclined to keep our foot on the gas and spend at a higher level, but in the absolute dollars, it maybe closer to what we would be spending at the 9% level in 2020 where we would spend that also in 2019 that sort of the bias we have been communicating that fairly consistently over time. But what we also told folks we are reviewing the plant expansion announcement back in August is that as we think about the next phase beyond that, whenever we have ample capacity available to us we're obviously is to our benefit to grow into it quickly. So while we think the 9% is sort of the right ongoing sustaining level, there will be periods where we will spend in advance of that or in excess of that just because we have the ability to do that with the plant capacity and there were times when we kind of glide our way. And right now we feel like we have the right level of media spending to glide our way to the $300 million in full capacity utilization in 2020.
Excellent. That's helpful. On the upgrades, I think you mentioned upgrades to the fridges that is – that you’ve done around 800, I think the – year-to-date I think the target was around 1,000. If those are performing well and it sounds like they are. Does it make sense or is there opportunity or both to do more upgrades in 2019 and 2020?
Just to be – I just want to make sure. I think the way when we originally introduced that, we’d talked about 1,000 upgrades between now and the end of Q1 of ‘19. So, we – we’re actually – we feel like we’re really like nicely on pace. We either have a chance to maybe do slightly better than that. But obviously we – wherever there's an opportunity to upgrade fridges, if we feel like we can get the payback within the appropriate timeframe and make sure we're getting a good ROIC on those fridge investments, I think in every one of those cases we’re evaluating that, because we are getting very strong results and it also puts us in a better position for the long-term. We’re getting better fridges with great warranties, more consistent performance, better merchandising et cetera. So, there's lots of components to that as we evaluate that. So that could potentially step up further and I think we will see more second fridges over the course of this next year really become something that’s more of a trend for us and we’ll be talking a lot about that.
Excellent. Last one for me, just on the bag product that's doing so well. What do you make of that, Billy, why is that product so much more appealing right now at least for the – your customer base at the moment than be a – than the legacy rolled product? Is it convenience? Is it kind of the small dog aspects bringing in incremental users? Just trying to get a sense maybe just – there’s been more innovation there and it’s the new – the new, new thing, but what is it say about the portfolio and perhaps what are some of the things that consumers are looking for your franchise that, that bag product is selling so well?
Yes he –Scott is a brilliant innovator. I think the reality is remember – the real big step change here was that we launched those three new products this year and they’ve skewed the business growth towards bags more than had been before. Until this year our Fresh From The Kitchen business was growing very, very nicely. It was our highest price per pound item. It’s a little bit harder to make and so one of the things we’ve been working on is improving the yield and throughput on that and also our next-generation facilities got some step changes in our ability to produce that, but that's been growing very, very consistently.
The step change this year was the new innovations and there are just really good insights about what pet parents are motivated by and what they need for their pet and we had a great product that just – when you create a small dog version for them, it makes a difference in broader new group of people into buying the product and we brought the Multi-Protein now is an idea that made a lot of sense to the pet parents. So, I think it speaks well of the innovation capability that we have in this company and I think that makes a big difference. But I would expect that we’d apply that same innovation skills to the other parts of the line and that’s frankly one of the things that we look to do in ‘19 and ‘20. It doesn’t just have to be on our bag products, we can do great innovation on other parts of the lineup as well.
And Billy just trying to get me – to get him a Coke from the fridge or something, but and also as I think that is, I think that is the key point that Billy was making, which is on innovation we thought we had some great components and great pieces of innovation that we could bring and add to the fridge, but we made conscious choices in that to help us accelerate our top-line and we do need to apply that. So when we make choices we’re taking items out of the fridge and putting other items in and we’ve actually facilitated that bag growth. Now recognize that the innovation in bags and the new items that we brought are actually fulfilling what they were supposed to, which is they are a higher margin than are the existing bag items. So, we’re going in the right direction, but we’re not all the way there and we have some more work to do.
Right. Thanks, guys. Good luck, and congrats on good quarter.
Thanks.
Thanks, Jon. Take care.
Thank you. Our next question is coming from Robert Moskow from Credit Suisse. Your line is now live.
Hi. Thank you. One additional question on the, I guess one of the things that really surprised me the most this year was that your growth in pet specialty was so strong and a year ago, I think we all would have said that the specialty channel is challenged on many fronts. So has this been happening, because you won out a lot of space or attention in store at the expense of other pet competitors? And I am thinking of some dry competitors that have one in particular that seems to have like lost a lot of goodwill in this channel? And then heading into 2019 can you keep growing on top of that I guess? Thanks.
So, it’s actually, I think your assessment is super logical from the standpoint of did we gain, based on what’s going on the channel, did we pickup additional space, merchandising etcetera. We actually have the same – basically the same number of fridges in pet specialty that we had in the same locations that we had. There is a handful of incremental kitchen, but that’s not really the contributor. The thing we have historically seen which has really been interesting is pet specialty has been one of the – has the greatest response rate to media that we have seen. And when we are able to really increase the media to another kind of significant increase in plateau this year, they got a significant benefit from the media, but the innovation that was brought there in that channel in addition to some things that we have done with the partnerships and supply chain have really enabled us to kind of continue to accelerate growth. So I think there are several components to it, ACV growth or distribution growth placement was a very, very minor component of it. So we are obviously very, very happy to see that and to see that outperformance. It’s obviously a channel that there is a lot of business in and we think there is a very long road in front of it. The way we are thinking about it and the way we are crafting our plan for next year is we continue to expect to significantly outpace any growth or whatever their trends by a pretty dramatic rate. So, I don’t know if they will get to growth next year, but we expect to have not that different growth rates in pet specialty that we have in our other pieces of business.
Okay. And then the last question is for Dick, there is a lot going on at the plants, a lot of retraining going on and you are having to scrap some production runs, so is the visibility to this $20 million EBITDA number, is it still quite good despite all of those kind of operational challenges, the short-term challenges or is there stretching on the downside and there is a bit of a risk?
No, not at all. I mean, at Investor Day, we included in that presentation basically how we are going to get there from where we were at that particular point in time. And with another $110 million of sales to come through that facility simultaneously basically finishing manning that facility basically some time in the second quarter of 2019 that gives us a fair amount of time to get the staff up and running at a very efficient rate simultaneously while for some of those bag products and other products that we deem that we produce some of the SKUs with lower margins and we are going to do some pricing on some other SKUs. So, overall, we feel very confident of achieving our gross margin objective of 52% for 2020.
Okay. What I was really asking about is fourth quarter though, because you also have $20 million?
For this quarter, no, there is no impact for this year, I am sorry, no impact. This year we have no issues associated with the fourth quarter, I was going towards 2020.
Okay. So, even though there has been a lot of – there has been some starts on the production lines, your fourth quarter gross margin is going to be weaker than you thought, but you have enough top line to offset that and still hit your $20 million EBITDA number for the year. That’s good visibility?
Yes, we have very good visibility and we are through the first one for the quarter, how our production in September, October, November accounts, for our costs for the quarter. So we have pretty good visibility. We think we are very, very comfortable with our guidance.
Okay. So, that’s clear. Alright. I will follow-up. Thank you.
Thank you. Our next question is coming from Mark Astrachan from Stifel. Your line is now live.
Hey, good afternoon everyone. Couple of housekeeping questions first. I guess one sort of a housekeeping question and I will let you judge what that really is, but the real – can you tell kind of level of pricing you are thinking about taking for next year and the other sort of related one I guess if you look at like the snacks that are in the fridge, I assume that’s part of what you are talking about in terms of prioritizing products, what would be margins on those or even velocity relative to what’s in the fridge meaning can you get the incremental lift if you take those out and is that kind of directionally what we are talking about?
So, in terms of the pricing for next year, we are not going disclose what we are planning right now and say I think Scott said earlier we are going to be selective about how we approach it and we are going to look for things that have the greatest leverage to take the pricing, but we will provide much more detail on that when we get into the first quarter and layout our plan for 2019. In terms of the items within the fridge, obviously, I think you are focusing on the treats that we are commenting, it’s about the treats, yes, the margins on those are very good, very, very strong. The velocities on them aren’t always quite as strong as the rest of the portfolio. So there is always little bit of a balance that you have look at as you prioritize that in the fridges. But when Scott talked about sort of optimizing the portfolio it’s a little bit more of an art than that, you just want to make sure you have the right range of products that you can have adequate inventory, adequate presence and at the same time on each of the items, but at the same time have a broad enough array to attract a broad number of consumers. There is no doubt the highest growth and long-term potential for us is on the main meal part of the business. So the bags and the rolls, because those once you get in the routine and the consumer is buying you on a regular basis and we see the buying rate continue to go up, that’s a real strong franchise for us. The rest of the business is well, it could be a good margin, it’s a little bit more discretionary in terms of its purchases.
Got it. That’s helpful. And then last question I guess broader strokes of top line trends are what they are in the category is doing obviously less. As you have these discussions with retailers and the question as always just given the growth why not more fridges. I guess maybe asking it in a different way, how do you make room in pet isles or what is the conversation like with the retailer who says they don’t have enough room in the pet aisle for refrigerators, because it seems like in having discussions with certain retailers maybe a lot of them that seems to be a bigger impediment maybe I would have thought. So, is that fair, how do you deal with the problem when its discussed, any sort of example is not specific, but sort of broader strokes on what you can do to kind of alleviate problems around that?
So this is Scott. And I think it’s an important question something that sales team has spent a lot of time working through in analyzing. There is some really interesting dynamics in the marketplace today. So obviously everyone is looking for growth. Pet is a key category for many retailers, some have prioritized it higher, some have potentially de-prioritized it a little bit. And I think now you are looking for growth, they are looking for good gross margins, but the other trend that I think that more and retailers are really taking into consideration is they really don’t want to show roomed and that concept of I don’t want to go and shop for something at retail and then someone to be able to make a couple of clicks online and be able to get delivered to their doorstep at a similar or potentially even lower price and because of the development of fresh and where it is and how they are focusing on fresh, I think we are fitting more and more strategically with the way retailers are looking at their competitive advantage. So as you know we have got over 19,000 stores of really big fridge network. It’s consistently grown over time. We really feel great about the foregoing growth velocities number one, but we do feel like we are consistently getting more and more fridge growth over time. But getting back to your specific question is as we have grown velocity in that velocity component and every 3 or so years we have almost doubled the fridge velocity. So the conversation 3 years ago was a lot different than it is today. I think more and more retailers as they are looking for growth they don’t want to get showroom and our velocities way up. I think that’s when the bell and the lights are kind of going on and the bells going off for a lot of retailers to not only put fridges in for the first time, more fridges throughout their entire chain. And so I think maybe 3 years ago, people have said they didn’t have room for fresh, I think today it’s not a niche anymore. I think we have been able to demonstrate that we are investing behind it. We have got great growth – we have got velocity and now where we used to be kind of maybe a little below average on a dollars per linear fit, we are actually well above on a dollars per linear foot or however – whatever measure they want to look at in addition to having great gross margin, in addition to not having the ability to get really show-roomed out. So there is a lot of advantage that it brings. And I think that we have been able to keep that steady progress. And I think that we are going to continue to see really, really good fridge growth progress over time, but it is – it’s a complex question and there is a lot of thinking. The thing that typically getting away from retailers in that and this is a long discussion, I apologize for the super long answer, but there is typically other things going on within their – not just intersection but within their store and the overall kind of retail environment for them that typically get in the way. There are kind of corporate level priorities that sometimes get in the way and kind of slow us down, but the longer that we improve our performance and has great velocity and great growth rates, the more I think that that those continue to come by the wayside and then we are able to take advantage of opportunities as they come up.
Thank you.
Thank you. We reached the end of our question-and-answer session. I would like to turn the floor back over to management for any further or closing comments.
Thank you for your interest and attention. As you heard, we remain very committed to delivering our 2020 goals and view this quarter as a very good steppingstone along that way. And we look forward to coming back to you with the plan for 2019 which was due sometime early in 2019 and we feel confident it will put us on path towards those 2020 goals. Thank you again.
Thank you. It does conclude today’s teleconference. You may disconnect your lines at this time and have a wonderful day. We thank you for your participation today.