We believe Freshpet is an attractive short currently valued at ~4x revenue with short interest of ~15% at an all-time low. Our base-case suggests fair value of ~$12 per share (~30% downside) and a floor of $6 (~60% downside).
Brief Company Overview
Freshpet claims to be disrupting the pet food industry by encouraging “pet parents” to reassess conventional pet food offerings such as dry kibble and wet cans. Freshpet is the only pet food company that offers fresh, refrigerated pet food that is all-natural, preservative-free, and less-processed in multiple forms including slice and serve rolls, bagged meals, and tubs.
Freshpet products are sold through the grocery, mass retail, club, natural, and pet specialty channels in branded, company-owned refrigerators that are designed, installed, and maintained by the company. Freshpet’s leading blue-chip retail partners include Target, Walmart, Kroger, Petco, Petsmart, Publix, Safeway, and Whole Foods. Today, Freshpet owns and operates a total of 17,357 refrigerators, with ~49% placed in the grocery channel, ~26% in pet specialty, ~22% in mass and club, and the remainder in natural food stores. Approximately 95% of Freshpet’s revenue is generated through brick-and-mortar stores with the balance generated through e-commerce.
We believe Freshpet will remain a niche product that is unlikely to gain mass market adoption
Founded in 2005, Freshpet has failed to take meaningful market share in the $24B North American pet food industry despite substantial distribution investments with blue-chip retail partners and double digit advertising spend as a percent of revenue on national television and online media campaigns.
Freshpet sells a high cost, perishable product. The company encourages pet parents to gradually transition their dog to a Freshpet-only diet. However, we believe Freshpet rolls are unlikely to displace traditional dry kibble (oftentimes mixed in with boiled chicken and steamed vegetables) on a large enough scale. Part of the reason why we believe adoption is so low is because the products have a shelf life of only 7 days after opening and must be stored in the refrigerator.
To highlight the low level of penetration that Freshpet has achieved, we point to revenue per refrigerator of only ~$22 per day. For context, a six-pound chicken, vegetable, and rice roll sold at Walmart costs ~$13. Our point being that despite each refrigerator being stocked with as many as ~10-20 SKU’s, Freshpet might only be selling of 1-2 six-pound rolls per day.
We attempt to compare the productivity of Freshpet’s retail space to that of their retail partners in the aggregate. We believe Freshpet is likely a drag on retail partners’ store-wide revenue productivity, measured by revenue per selling square ft., particularly outside of the pet specialty channel, where the delta is ~2-3x lower for Freshpet. Freshpet refrigerators are 4 ft. wide. by 7 ft. tall, equivalent to ~$280 of revenue per selling square foot ($203 in Pet Specialty and Natural/$321 in Grocery, Mass and Club). We believe this may explain why Freshpet has failed to gain traction in Costco ($1,540 revenue per square ft.) and might explain the nearly full penetration of the pet specialty channel with Petsmart ($250 revenue per square ft.) and Petco ($220 revenue per square ft.). Admittedly, it is difficult to make an apples-to-apples comparison between Freshpet’s refrigerator space and the aggregate square footage provided by their retail partners.
Freshpet is already ~70% penetrated in management’s base-case TAM of 25,000 units. Based on total retail partner locations, we believe achieving 25,000 units is a reasonable feat. However, we doubt Freshpet’s stretch-case TAM of 35,000 units given the implications of cannibalization on existing refrigerator units. We believe much of the low-hanging fruit, in terms of highest-quality retail locations measured by foot traffic, have likely been penetrated, and therefore will be incrementally more challenging for Freshpet to generate increasing marginal unit-level productivity going forward.
2. Given our skepticism of Freshpet’s potential for mass market adoption, we question management’s implied double-digit velocity growth guidance required to achieve a near doubling of total revenue by FY 2020.
Contributing to our elevated level of conviction is the high hurdle management has set for double-digit revenue growth over the next three years. Freshpet has built their FY 2020 revenue expectation of $300mm largely on the acceleration of consumer purchasing velocity as a direct result of increased advertising spend with the goal of stimulating consumer awareness, trial, and adoption. Unit growth is expected to remain flat over this period.
Velocity is a critical component of Freshpet’s recently launched “Feed the Growth” campaign intended to drive double-digit revenue growth through FY 2020. Freshpet claims this newfound strategy will allow the company to be less dependent on new refrigerator placements to deliver growth goals, and that the vast majority of future growth can be achieved on velocity growth alone. The “Feed the Growth” flywheel is designed to drive velocity gains, supplemented by distribution gains, through increased investment in national television and digital advertising. Incremental revenue growth is expected to produce fixed cost leverage that will be reinvested back into advertising in order to continuously drive same-store velocity through increased consumer awareness. Freshpet expects to increase advertising spend by ~60% in FY 2017 and ultimately remain at~15% of revenue through FY 2020.
However, we question management’s expectation for such a steep inflection in advertising productivity, measured by us as incremental revenue dollars from velocity over incremental advertising spend. Unless Freshpet has some proprietary formula for increasing advertising productivity, we find it hard to believe that each incremental dollar spent on advertising will yield such fruitful returns given the fact that Freshpet will be using the same method of advertising (national television and digital media campaigns) as the company has over the past three years.
3. Looking at Freshpet’s products on a granular level, we have concluded that Freshpet offers an inferior value proposition that will soon be recognized by consumers and will therefore create challenges for future velocity growth
Freshpet’s management team boasts about having the highest consumer repurchase rate in the entire pet food category given how good the Freshpet product is and how much people love their pets. In addition, management claims that Freshpet owns title to the highest consumer repurchase rate among any CPG company they have ever seen in 30+ years allowing them to focus solely on advertising given the strength of the product’s value proposition. We believe these facts are intended to portray a high-quality revenue base supported by consumer stickiness and brand loyalty.
However, a closer look at both the level of moisture content and corresponding calories per pound, coupled with the company’s suggested feeding guidelines and the advocacy for a Freshpet-only diet, reveal to us the company’s manufacturing of repeat consumer purchasing.
As background, all pet food labels require a “guaranteed analysis” advising consumers of the product’s nutritional contents. At a minimum, guarantees are required for minimum percentages of crude fat and protein, and maximum percentages of crude fiber and moisture.
Using this framework, Freshpet’s extremely high moisture content results in a high cost product delivering insufficient calories. The median moisture content in all ten of Freshpet’s dog food rolls is ~77% (Freshpet Select and Freshpet Vital brands) compared to the median moisture content of ~49% for Blue Buffalo, ~43% for Natural Balance, ~43% for Redbarn, and ~68% for Country Pet Naturals. We note that according to AAFCO regulation (the Association of American Feed Control Officials), an organization in charge of the sale and distribution of animal feeds, 78% is the maximum allowable moisture content for dog food. High levels of moisture yield lower calories per pound. Dogs must therefore consume a greater volume of food in order to get the right amount of nutritional requirements, leading to pet parents having to purchase more product.
Although Freshpet touts its high repurchase rate, our assessment indicates that such high levels of repurchasing are out of necessity in order to satisfy daily calorie requirements. We don’t believe this positioning is sustainable especially when consumers will be presented with additional options with increased competition in the grocery and mass retail channels.
According to Freshpet’s suggested daily feeding guidelines for a 40-pound dog, a Freshpet-only diet would actually fail to satisfy daily caloric requirements unless the consumer purchased multiples of the suggested portion sizes. In fact, it would require the purchase of 60 one-pound Freshpet rolls each month in order to satisfy a 40-pound dog’s daily calorie requirement assuming a Freshpet-only diet, compared to only 26 one-pound Blue Buffalo rolls. Converting the number of one-pound Freshpet rolls to purchase each month, in order to satisfy daily caloric requirements, to an equivalent number of fifteen-pound bags of traditional kibble, reveals to us that a pet parent would only need to purchase 2 fifteen-pound bags of kibble per month compared to 60 one-pound Freshpet rolls.
We emphasize the annual cost to feed a 40-pound dog a branded roll-only diet vs. a Kibble-only diet, layered on top of the fulfillment of the daily caloric requirement. Our analysis reveals that Freshpet is the most expensive branded dog food roll to feed one’s 40-pound dog a Freshpet-only diet despite satisfying only 50% of the calories a 40-pound dog requires, ultimately driving the consumer to purchase greater than suggested quantity of Freshpet rolls.
Further, we find it to be strange that Freshpet is the only brand that provides consumers with daily feeding guidelines measured in pounds rather than inches for products sold in roll form, which we believe is inherently more difficult for consumers to measure with a naked eye, as opposed to inches which can be more easily measured. Although subtle, we believe this contributes to consumer’s buying more than they normally would another brand.