Freshpet Inc (FRPT) 2016 Q4 法說會逐字稿

Greetings and welcome to the Freshpet, Inc. fourth-quarter and full-year 2016 earnings conference call. (Operator Instructions) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Katie Turner. Thank you, Ms. Turner. You may begin.

Thank you. Good afternoon and welcome to Freshpet's fourth-quarter and full-year 2016 earnings conference call and webcast. On today's call are Billy Cyr, Chief Executive Officer; Dick Kassar, Chief Financial Officer; and 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 meanings of the federal securities laws. These statements are based on management's current expectations and beliefs and involve risk and uncertainties that could cause actual results to differ materially from those described in these forward-looking statements.

Please refer to the Company's quarterly report on Form 10-K to be filed with the Securities and Exchange Commission and in 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.

To accompany management's discussion, there are presentation slides available on the investors section of Freshpet's website at www.freshpet.com. If you have not accessed the presentation, we welcome you to do so at this time.

Finally, please note that on today's call, management will refer to certain non-GAAP financial measures, such as EBITDA and adjusted EBITDA. 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 or 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 non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP.

Now I'd like to turn the call over to Billy Cyr, Chief Executive Officer.

Thank you, Katie, and good afternoon, everyone. To begin, I will provide a brief overview of our financial highlights and recent business performance. Then Dick will review our financial results in more detail.

I will then discuss our updated business strategy. During that time, you can reference the presentation slides available on our website. I will then turn it back to Dick to provide our guidance for 2017. Finally, Dick, Scott, and I will be available to answer your questions.

I continue to believe, unlike many other CPG companies, our challenge is not where to find growth, but which sources to pursue first. The Company lives at the intersection of two very powerful macro trends: the humanization of pets and a desire for more natural, wholesome food.

The team at Freshpet has responded to those trends to create a strongly preferred product, compelling advertising, and a proprietary manufacturing and distribution system that give this Company numerous paths to growth. Our challenge is to choose the path with the best long-term return for our shareholders.

We begin 2017 very well positioned for future growth. Our plant expansion has been completed and we now have ample capacity for the next stage of our growth trajectory. Our product quality continues to improve. The new advertising message has proven in premarket testing and in our limited in-market testing to be highly effective.

The Company's operating cash flow continues to grow and our major CapEx needs are behind us. Finally, we have strengthened our team.

Getting to this position was not easy. There have been bumps along the way, but we have arrived at a place where the Company can confidently re-accelerate its growth. It will take increased strategic investments, but we expect to be able to grow net sales more quickly and that will drive greater leverage across our business model, improve profitability, and enhance long-term shareholder value.

While 2016 was a transition year, we did accomplish quite a bit. We delivered a 14% -- 14.5% increase in our top line behind increased same-store sales and a strong consumer repeat rate, 11% growth in distribution to 16,609 stores, a 59% increase in adjusted EBITDA to $17.7 million when compared to the prior year.

While these results are below what we anticipated at the beginning of 2016, they are consistent with the guidance we provided at the end of the third quarter, indicating that the work that Scott and Dick did to stabilize the business in the midst of so much transition last year is beginning to pay off. That positions the Company well to begin its next phase of growth.

With that overview, I would now like to turn the call over to Dick, our Chief Financial Officer, who will review our financial results in more detail.

Thank you, Billy, and good afternoon, everyone. I will review our fourth-quarter and 2016 financial results, and then I will review our annual guidance for 2017.

For the fourth quarter, net sales increased 12.8% to $34.1 million over the prior-year quarter. Our fresh offering grew 15.2% during the same period. This growth resulted from both distribution and velocity gains, including a 10.6% year-over-year increase in Freshpet Fridges.

Gross profit for the quarter was $15.2 million compared to $13.7 million during the same period last year. Gross margin was 44.7% for the fourth quarter of 2016 compared to 45.3% in the fourth quarter last year. Adjusted gross margin was 49.9% compared to 47.5% in the prior-year period, excluding depreciation and nonrecurring costs associated with our new plan start-up.

Adjusted SG&A expense for the fourth quarter of 2016 improved to 38.2% of net sales compared to 40.9% for the fourth quarter of 2015, excluding stock-based compensation expenses as well as a minimal true-up of leadership transition expense in the fourth quarter of 2016. Looking ahead, we expect SG&A to decrease, excluding any increase in TV and digital advertising, as a percentage of net sales as we increasingly scale our operations and better utilize our existing infrastructure while growing net sales. Adjusted EBITDA increased $2.3 million to $6.4 million for the fourth quarter.

Focusing on our balance sheet, at December 31, 2016, the Company had cash and cash equivalents of $3.9 million compared to $8.1 million at the end of 2015. The decrease in cash is primarily due to expenditures related to the expansion of our Freshpet Kitchens and investments to increase distribution through the purchase of additional Freshpet Fridges.

At year-end, we had $7 million outstanding of our $30 million remaining credit line. We expect to pay back this borrowing during 2017. For each quarter of 2015 and 2016, we have generated positive cash flow from operation and expect this trend to continue in 2017.

Now I'm going to turn it to Billy to outline the Company's strategic plan.

Please turn to the accompanying presentation that we have provided so that you can follow along. Also please note the safe harbor statement on page 2 and the reference to certain non-GAAP measures in the presentation. Please see the press release or latest 10-K for more information on how to reconcile those measures with GAAP.

We have told you in the past that Freshpet has brought the most significant innovation to the pet food category in more than 70 years. By bringing fresh food to pets, we are a first mover and have revolutionized the pet food aisle.

We are changing the way pets eat. We receive thousands of letters from pet parents thanking us for saving their pets who refuse to eat and overcoming various maladies that pets were suffering from. It is this dramatic innovation, driven by strong consumer marketing and outstanding retail execution, that we expect will lead to strong growth and outpace the pet food industry growth for many years to come.

Our challenge is to create an effective and efficient path to growth to not only continue to change the way pets eat, but also to create significant shareholder value. On slide 3, I conducted the traditional 100-day review of the business when I joined last September. I studied the products in the plant, the customers and the consumer, the marketing and the organization, the category and the competitors, and much more.

I continue to be impressed and believe that Freshpet has the potential to be a $300-million-plus business in 2020. I am glad that I joined the team, but I also learned that we have underinvested in the marketing needed to achieve that goal. And in particular, we have underinvested in our core fresh business in the US.

To provide a framework of understanding for our strategy ahead, I would like to briefly summarize what I learned in a bit more detail. Slide 4. As I said at the beginning, Freshpet lives at the intersection of two very powerful macro trends in CPG today: the humanization of pets and the drive for fresh wholesome food. A single tailwind is not easy to come by, and we have two.

Slide 5. The founders of Freshpet, led by Scott, saw this and built a very strong proprietary position around a breakthrough product innovation. They knew that while human food technology had made major leaps forward, pet food technology was sorely outdated.

They created a product with demonstrable product preference, the manufacturing systems to produce it, built out the only chilled pet food distribution system to support it, and defined the marketing message to drive it. This was not easy work and there were many slips along the way, but that is to be expected when you are transforming a category in such a significant way. And the result is one of the strongest and most protectable positions in the pet food and CPG industries.

It would be very difficult and expensive for someone to replicate what the team at Freshpet has created. We have a one-of-a-kind manufacturing facility, an installed base of 16,600-plus chillers, a category-defining brand with a growing reputation for the quality we deliver, and the cost advantages that come with the scale we are building.

I haven't seen something like this since Tropicana converted the orange juice industry from the standard 12-ounce frozen concentrated cans that dominated the market for many years to the new category standard of ready-to-drink not-from-concentrate juice.

Slide 6. Along the way, a different kind of company was created. Freshpet is a thoroughly modern company with environmental responsibility built into the fabric of our operations, consumer and community engagement at the heart of what we do, and a thoroughly engaged group of employees who demonstrate ownership behavior and values every day. I believe those intangible qualities are a core competitive advantage for us.

Slide 7. All of that -- the exceptional product, proprietary business system, and highly engaged employees -- drove rapid and sustained growth for the better part of the last decade. We consistently added stores and increased sales.

One of the things that impressed me most during my due diligence of the Company was that it was growing both distribution and sales per point of distribution at the same time on the vast majority of the SKUs and on the business as a whole. In my experience, that is the mark of a winner.

Slide 8. But as all of you know, the growth rate slowed over the past two years and margins have not materialized as planned. There are many potential causes of the decline in the growth rate.

Slide 9. One thing I can say with confidence: the declining growth rate was not caused by a decline in consumer interest. Freshpet's Net Promoter Score is outstanding. But perhaps the most telling statistic I've come across is that the repeat rate for Freshpet is 71%. That is the highest we have measured in the pet food category, and I've been in the CPG business for more than 31 years and that is one of the highest repeat rates I have seen.

It is a testament to how good the Freshpet product is and how much people love their pets. It also provides the linchpin that we will leverage to drive this business forward. A high repeat rate means that we can focus our marketing spend on generating awareness and trial because the product proposition itself will generate the stickiness that we need to develop a strong and deep consumer franchise.

Slide 10. After my extensive review, I concluded that the single biggest issue we must address is Freshpet's incredibly low household penetration and awareness. Having a very high repeat rate does not help you much if very few people know how to try the brand.

Freshpet's household penetration is only about 1.4% and household-aided awareness is around 35%. Both are well below other fast-growing pet food brands. Growing the awareness and penetration is our single biggest opportunity.

Slide 11. When I step back, it is very clear to me that Freshpet has arrived at that moment in time where we have the opportunity to rapidly scale the brand. We have an on-trend product with demonstrable consumer preference; reasonable, although they can be improved, margins; an untapped consumer audience; available production capacity; very little debt to serve us; a proven marketing message; and sufficient retail distribution to justify extensive marketing. If there ever was a time and an opportunity to rapidly scale this business, it is now.

Slide 12. We call our new strategic plan Feed the Growth. It calls on every employee to contribute in some way to growing the Freshpet brand. The roles of the sales and marketing teams are obvious. They must present the brand to more consumers in more places with a compelling and attractive message and presentation.

Our manufacturing team must produce consistent high-quality product and find ways to save money to invest in the marketing. The finance team must use their analytical skills to identify additional savings opportunities. The R&D team must find new and simple ways to drive interest in the winning products we have.

Slide 13. To have the greatest impact, we must focus our organizational efforts and resources. Thus our plan going forward calls for us to tighten our focus and simplify our efforts. We will focus our energy on, first, fresh refrigerated products.

We have our greatest product advantage on those, with a compelling marketing message to support it and the strongest proprietary position there. Baked will remain a part of the business, but it will not get the same level of investment that we give to our fresh refrigerated products.

Second, channels with highly efficient and reliable refrigerated supply chains. Our biggest whitespace opportunities are in food, mass, and club outlets, where we have less than 50% ACV distribution today, yet they still account for almost 80% of our sales.

Along with pet specialty, where we've built out a more effective supply chain with some key distributors, we will focus on building scale in refrigerated distribution and expanding our reach to outlets we don't service today. That will deliver the highest-quality product to the consumer at the best possible value.

Third, the US. We are very encouraged by our fledgling test in the UK and will continue to advance that learning while working to define what the future of our business in Europe looks like. But for the near term, we will invest most heavily in the US, where we have the greatest scale and expertise, the lowest operating costs, and a clearly defined and winning marketing plan.

Slide 14. Our Feed the Growth Plan has three simple elements. First, drive household awareness and penetration. We need to increase our investment in the proven marketing message we have tested. In combination with the brand's high repeat rates, this should build a large base of highly loyal users capable of supporting a much larger business than we have today.

Our plan calls for increasing our advertising investment by approximately 60% over 2016. This is both in TV and digital. Second, accelerate Freshpet Fridge placements. The one capability gap I identified during my review of the Company's operations was in our selling approach. We are changing that now by better aligning with our customer strategies and providing them with more ways to engage their shoppers with the brand.

Today, I believe our customers think that Freshpet is a nice-to-have optional part of their pet food section to implement when they have enough room for it. We aspire to become an essential component of their pet food sections, no matter how big they are, by delivering a large number of high-value shoppers to their stores on a frequent basis and generating strong same-store sales growth. We expect that this will ultimately increase the rate of new fridge placements beginning in 2018.

Third, strengthen adjusted gross margin. Our technical team has done an incredible job defining and constructing one-of-a-kind manufacturing capability that is sufficient to sustain this business for the next several years. We think that now is the time to turn their attention, with the help of our R&D team, to optimizing those operations, lowering our costs, and increasing the adjusted gross margin. These lower costs and increased adjusted gross margin should support the added marketing investment over time.

We have numerous opportunities to increase the throughput yield and reliability of the operation and are willing to invest to deliver meaningful savings. We have set a goal of significantly increasing the adjusted gross margin and gross profit over the next four years.

Slide 15. This strategy results in the Feed the Growth model. This is a fairly standard productivity loop that can sustain long-term growth behind continually investing in activities that drive increased scale and more complete cost absorption. And on top of that, we will generate incremental cost savings through solid technical work in our plant. Freshpet is perfectly designed to take advantage of this virtuous cycle at this stage.

Slide 16. Another way to look at this is to see how our growth helps us absorb our fixed infrastructure costs. We have significant unused capacity and an organization designed for a bigger business. That is why scaling the business quickly is so valuable to us.

Slide 17. We arrived at this strategy towards the end of my 100 days and began several tests in the fourth quarter and continued during Q1 to see if the strategy would work and to what degree. I want to caution that it is very early and we still have much to learn.

And we want to be appropriately cautious about jumping to conclusions too quickly. The last thing we want to do is overestimate the results and squander a good idea because we promised amazing results and only delivered outstanding results.

Slide 18. What we have seen so far is encouraging and gives us confidence to move ahead with the plan. We put our proven marketing message on the air in early September 2016 for a few weeks and then again in January. We expect there to be a bit of a lag from the time the advertising airs until the consumption increases and an even longer lag until it turns into increased shipments. But we've seen both IRI and customer level data show strong increases in consumption over the past two months.

Slide 19. In fact, since we began airing our new advertising campaign, IRI results in the food channel have been up more than 20% on a consistent basis. And the broader multi-outlet measure has been up in the high teens and is now exceeding 20%.

We are driving growth across all classes of trade and accelerating as our advertising program is getting traction. This is encouraging, but we will continue to watch this closely to ensure that it sustains. But as of now, we are quite comfortable with our investment.

Slide 20. It will take longer to see any impact from our new selling approach. In the last few months, we have developed and presented dramatically new plans to 3 of our top 10 customers and the feedback has been very encouraging. Those customers have changed their perception of our Company and have begun thinking about Freshpet as a strategic necessity in their pet category rather than as an opportunistic addition.

We don't expect that to turn into a significant number of new stores this year, as new fridge placement decisions have very long lead times. But they result in a variety of retail experiments this year and plans for expansion in 2018 and beyond. And our goal is to make the brand strategic for at least our top 10 to 15 customers and it will take time to develop and implement programs at each of those customers.

To help facilitate that, we have revamped and reenergized our relationship with Acosta, our sales agency, and expect that renewed program to deliver meaningful benefits for our customers, Acosta, and us.

Slide 21. Finally, our engineering teams have begun to develop a long list of efficiency improvements we can implement to drive down costs and increase adjusted gross margin. We have several experiments underway and ideas being tested.

I want to stress that we will not allow cost reductions to reduce the quality of our products. In fact, we continue to find ways to improve the quality and reliability of our products through standardization and simplification efforts that will ultimately lower our costs.

Slide 22. It is also important to note that we plan to focus our R&D efforts on more near-in opportunities and optimization efforts over the near term. Our existing products are so far ahead of the competition and yet not broadly known.

Rather than invest in the next generation of breakthrough new products, we are going to drive the products we have today with a robust collection of relevant product upgrades and news built on our existing technical platform, not new platforms that require massive disruption to our plants. This approach will greatly simplify the challenges for our technical teams and allow them to optimize the systems we have today rather than invent and implement new systems. This is a key enabling choice we have made.

Slide 23. As we look forward, you should expect us to deliver an accelerating rate of growth as we progress throughout 2017. You will recall that we ended 2016 with a 13% growth rate in the fourth quarter. We expect to deliver a similar growth rate on fresh in the first quarter, but that will be dragged down a bit by baked, delivering overall growth in the low double digits in the first quarter.

The first quarter marketing investment is also up against a meaningful investment in marketing in the year-ago period. And we will have the delay between increased consumption and increased shipments I mentioned earlier.

We are also streamlining some customers' inventory to improve our production efficiency and to ensure that the consumer gets the freshest product possible. But you should expect to see the growth rate begin to increase in the second quarter and accelerate from there. By the end of 2017, we expect to have a run rate that is approximately 20% ahead of where we are today.

As I mentioned earlier, we expect new store growth to begin to accelerate in early 2018 and continue beyond that. We believe adjusted gross margin expansion will not begin until the second half of this year, and visibility on it will be a bit clouded if we cross a capacity threshold requiring us to add incremental staffing to keep up with the demand. We will do our best to isolate the effects in our reporting.

We expect to enter 2018 with an adjusted gross margin run rate on a mix-neutral basis up 1.5 points versus fiscal year 2016. Our goal will be to accelerate that in 2018 behind the implementation of some of the projects we are testing today.

Finally, we expect our adjusted EBITDA margin to begin the year well below the first half of 2016 as we increase our marketing investment quite significantly. It will begin to rebound in the second half of 2017 as compared to the first half of this year, but the full year will be down versus 2016 behind the higher marketing investment. We expect to end the year with an annualized run rate EBITDA that is approximately 50% ahead of our full-year 2017 guidance, which Dick will review.

We believe we're making positive strategic marketing investments in our business that will deliver a strong return over time. To be clear, we could have chosen to invest less, generate more EBITDA, and grow at a slower rate. But we are very convinced that scaling this business quickly is in the best interest of our shareholders and that the marketing program we have justifies this short-term reduction to our EBITDA. We expect the strategic plan to pay dividends in 2018 and beyond.

Slide 24. Longer term, we think the Company will become profitable on a net income basis in 2018. The operating model for the Company will deliver growth rates in the range of 15% to 20% for the next 2 years, adjusted gross margin in the 50%-plus range, and adjusted EBITDA margin in excess of 20% while supporting higher investments in marketing.

Basically, we are driving revenue up faster and getting the scale benefits on our SG&A while using increased gross margin to support the higher marketing investment. And we will generate about 15% of net sales in free cash flow. We believe this is a winning model for Freshpet.

Slide 25. In summary, the Feed the Growth Plan more rapidly scales the business. It re-accelerates the growth of the business behind a potent advertising message and a greater investment in media. It improves the structural economics of the business by allowing us to grow into the scale we have built and expands our adjusted gross margin. And it sets the Company up for more rapid revenue and earnings growth in 2018 and beyond.

Slide 26. Ultimately, we believe this rapid scaling plan will create a sustainable competitive advantage that will make Freshpet a very attractive company and investment. We will have the first-mover advantage supporting a strong installed base of chillers and significant manufacturing and distribution scale.

We will have extended our operating expertise in this new space to become an even greater differentiator and added a meaningful brand equity to it. Our Board and management team believe this is the right plan and we are determined to bring it to fruition.

We understand that it means we are asking our shareholders to take a short-term pause in the earnings growth they may have been expecting. I assure you that we could have chosen to spend less on advertising and delivered a higher level of adjusted EBITDA, but we are convinced that this incremental advertising investment is the right thing to do, that the evidence supports doing it now, and that this is the best way to create the greatest long-term value for the Company and our shareholders. So we were getting behind our Feed the Growth rapid scaling plan and driving it with all the excellence we can muster.

I will now turn it over to Dick, who will provide our guidance for 2017.

Thanks, Billy. As a result of this new strategy, we expect the following financial results for the year ended December 31, 2017, as compared to 2016. To exceed net sales of $153 million, an increase of approximately 15%, with the growth rate accelerating as the year progresses; to exceed adjusted EBITDA of $16 million, a decrease of approximately 9%; and to exceed Freshpet Fridges of over 18,200, an increase of approximately 10%.

From a seasonality perspective, we expect our net sales growth to be more weighted to the second half of the year as we realize full benefits of our increased media spend along with increased distribution. We expect adjusted EBITDA to more heavily weigh to the fourth quarter, when our expenditures lighten considerably due to the timing of our planned media program, which we will frontload to gain the maximum learning quickly.

As a reminder, our adjusted EBITDA represents EBITDA plus loss on disposal of equipment, new plan startup expenses, share-based compensation, launch expenses, leadership transition expense, secondary costs and warrant expense. We see strong growth for our products across our distribution network, and we will continue to maintain a strong balance sheet and liquidity to meet the demand and further grow our distribution network.

That concludes our financial overview. Billy, Scott, and I are now available to take your questions. Operator?

(Operator Instructions) Peter Benedict, Robert W Baird.

Thanks for taking the question. I appreciate those slides. Two things. First, Billy, maybe talk about this Acosta relationship and program. Obviously you're outlining some nice growth acceleration in the top line, particularly as you get past this year. How confident are you that you can support that in terms of in-stocks and execution at the retail level? That's my first question.

Okay. Obviously as we get the velocity cranked up, that is going to be an area of focus for us. We did have a conversation with Acosta and we sat down and looked at what their capabilities are and what our needs are.

And what we ultimately concluded is we need to make a couple changes in the way we are doing business with them. And they are better for them and better for us. But one of the most important pieces is we are providing more frequent coverage of stores than we did in the past.

We will be back in coverage with them on a basically once-every-other-week basis and that ought to help us do a better job of creating the awareness of the need to stock the category, to train the in-store personnel than what we've had in the past.

A second part of this is going to be leveraging Acosta's relationships at the headquarters level a little bit better than we have in the past by being -- and becoming more strategic aligned with the customer. So by that, I mean they have pretty deep relationships with the customer and they have a deep bench of resources in each of their customer team offices.

And finding ways to get access to those relationships and also to get access to the data that they use on a day-to-day base to manage the business will help us be much more responsive to what the customers' near-term and immediate needs are. And I think that's going to help us in expanding the number of fridges that we get out in stores as well as giving us access to new opportunities for in-store placements and merchandising.

There's a lot more detail that goes underneath it, but I would describe it as a complete change in what it is that we are doing with Acosta. And we feel pretty good about it, but we are also going to watch it and measure it very closely.

Okay, that's helpful, thanks. And then on the media investment, I apologize if I missed this or if you mentioned this. But on that slide 24 where you said media investment is 6% of sales in 2016 rising to about 9% in 2020, what's in media investment? How is that different than advertising? Just help us understand what's captured in that number.

Actually that would be -- in that media investment, it would be basically all of our marketing communications. It would include TV and digital and any other communications that we would touch the consumer.

Okay, thanks. And then my last question, and I'll turn it over to the other guys. You've obviously -- we've been seeing in pet food in general just a channel shift away from the superstores. PetSmart, Petco have been losing probably some share. A trend towards online.

How are you thinking about positioning Freshpet online within this plan? And then also how are you thinking about -- I guess Acosta is going to help a little bit maybe with the pet specialty, but helping stabilize trends within pet specialty? Thanks.

Peter, as you know, about 80% of our business is done in grocery and mass. So we are fortunate; we are not as affected by what's going on in pet specialty.

What we are seeing is that there is definitely a leveling going on in pet specialty, meaning there were some real declines last year. We are seeing it kind of level out and we are seeing that balance out.

From an online perspective, that was greatly impacted by online, but also everyone else is sharpening their pencils. Specifically to online, we are involved with jet and walmart.com and they are building out refrigerated supply chain. And we really like the model that they are building out there.

We also have FreshDirect, Peapod, and a handful of other smaller players that are involved in that refrigerated supply space. So we are working with them; we are keeping a close eye on that. And what we anticipate is we are already seeing nice response even in that pet specialty channel due to the advertising that we've put in the market.

I would add to that just quickly. As I said in outlining our strategy, we are really focused on anybody who's got an efficient and effective refrigerated supply chain, we will do business with them. We think our customers, the food mass customers and club customers as we develop them, they are going to be obviously advantaged on a value basis to the extent that they have a very efficient supply chain.

But as people develop an online version of a refrigerated supply chain, we will make our products available in those channels. But our real focus is not to build the channel, but to be there when somebody builds a refrigerated supply chain that works.

All right, great. Thanks very much.

Jason English, Goldman Sachs.

Thank you for letting me ask a question. Interesting plan of attack on the forward. I think it makes a lot of sense. Obviously requires a bit of faith. But I wish you the best of luck. I think it makes tremendous sense.

To dig into a few of the details, the pie chart in terms of business mix was a little surprising to me. Given that through the first three quarters, based on your 10-Q disclosure, pet specialty was running at around 22% of sales. To drop to around 19% for full year implies sharp -- sharp -- 30%, 40% type drop in the fourth quarter.

Is this apples to apples? Is this kind of what happened? If so, kind of building on the last question, can you give us some more context? Because I know it's not a huge chunk of your business, but if it's going to be down that much, that's obviously a problem.

Well, Jason, when we break it out, we group together natural and pet together. So you are looking at that, where those 2 together are adding up to 22%. And what we've done in this pie chart is refrigerated food/mass/club natural is in that grouping. We've broken out pet specialty separately here and that's the 19%.

We don't anticipate to see really a drop off at all. We actually anticipate to see a slight gain throughout the year. Pet specialty lagging behind the overall growth of the business. But we definitely -- and we are already seeing that is getting some growth out of the pet specialty piece. But I think the math that you are trying to cross-link there is the natural piece is actually brought into that 77% piece of the pie.

Okay, that's a relief. That's good, because it was a little nerve-racking before when I did the math. Second question in terms magnitude of the spend, I think you said you are going to take A&P up around 60%.

Is that the 6% of sales, which I think equates to around $1 million, growing by 60%, which is going to get you to around $8 million and change as a percentage of sales? Is that what we are applying the 60% to?

Yes, we had 6% basically for the last several years and we decided to take it up to 9%. And we've disclosed previously we've spent $8 million to $9 million in media and we are looking at a number 60% higher than that for 2017.

Got it, okay. And then last question. Billy, you mentioned, I know, last time when we sat with, you talked about your top-to-top discussions with a lot of key retailers. It sounds like you walked away with some insight in terms of how you can rejigger your selling approach out there.

I think in your prepared remarks, though, you said you don't expect fruits of those labors to be born until we get to 2018. And my question then is why is there a degree of conservatism there? Do you think we could actually start to see some unit growth pickup in the back half of the year? There it is; I will leave it there and pass it on.

Yes, this gets back to what is the cycle for our customers' decision-making. So for example, one of our largest customers has already made all their decisions for this year for where the new placements will be. And so any incremental efforts that we make at revamping our selling approach and better aligning with their strategies is really only going to have impact on the implementation that they do starting in February of 2018.

We have had conversations at a very senior level with some of the top customers and are aligned with their strategies. But the new strategies are much more engaging or labor-consuming or time-consuming. Meaning, we have to connect with more points within the customer in order to get to the implementation that we want to get.

So that will inherently take us a little bit longer. And the hope is that as we get into those pads, instead of picking up ones and twos, we start picking up larger chunks of stores as a result of the more intensive effort we put in with the customer.

We think that's the case. Our early work would suggest that they are engaged at that level, but we haven't seen enough results. So is there some conservatism? I'd say it's realism based on where we are today, and I'd love to be accused of being conservative later on.

Right on. All right. Thanks a lot, guys.

Mark Astrachan, Stifel.

Thanks for taking our question. We've noticed you've expanded the tests with Tesco in the UK. Could you please talk about how that happened, considering the US focus we are hearing today?

It's a good question. Yes, the test in the UK is expanding because the early results were good. We are still managing that as a business that we are trying to refine and figure out what the model ultimately looks like.

We supply that out of the United States. We have a small team on the ground there that is able to help us operate it. But until we really figured out that model, the investments there will be rather limited.

Having said that, we were very encouraged by what we've seen. We think the long-term prospects are really good. But there's some work to do to figure out exactly how to make that model work the best. And yes, it is a very significant expansion in the number of stores, but the financial investment that we are making is rather limited.

Thank you. And also, any update on the Costco test and how does that fit with the new focus?

So absolutely club would be a key part of our focus, along with grocery and mass. We continue to make slow but very steady progress across all of our club channel, and specifically in Costco.

It's something that we don't anticipate to be a key growth driver this year. We think the key growth drivers will be really on our grocery and mass piece of businesses. But club is continuing to develop and every club is obviously highly valuable and highly productive. We think that that will have more of an impact on the business actually in 2018.

Thanks a lot.

Robert Moskow, Credit Suisse.

Two questions. Billy and Scott, I remember hearing that a couple of the obstacles here with big customers was, one, they are skeptical about whether some of these refrigerators would succeed in lower income demographic regions. And whether the refrigerators would earn their square footage space there.

And then the other one was getting them to participate in managing the inventory in the stores. Are you still having those conversations, I suppose? And is that what you mean by pushing to get to expand the distribution faster? Are you making any headway in getting them to push those stores into lower income regions, first of all? And then a follow-up.

Rob, let me start framing the way the customers are thinking about it. The skepticism -- there is this thought amongst many of our customers that as a premium-priced product that this is a product that's not appealing to a wide socioeconomic base.

But if you think about how successful we are in 2,000 Walmarts and a variety of other stores that cater to a lower income or a more moderate income group, you have to conclude that the brand does have much broader reach than just a higher socioeconomic group.

The challenge for us as I have kind of gone at this is customers think about us one store or a store at a time. Meaning, they think about it in terms of what are the demographics for that store. And also how much space do they have in that store. And that's a good way to think about it. In a lot of ways, that's been most of the way they got to where they are today.

But I think we have demonstrated enough success across a broad enough range of socioeconomic groups that I think customers now need to think about us in a more strategic way, as in we are an essential part of the category. And start thinking about us not one store at time, but think about us as a brand that they would reach across their channel, across all their stores.

Are we going to work in every single store? I don't know that that's the case. But I certainly think that a customer who has us -- where we are successful in 45% of their stores certainly should be successful in 75%, 80%, 90% of their stores. Because the stores that are still out there that remain possible for us are still very similar to the stores they are already in.

So I think that the way we need to change the customers' thinking is from a store at a time to thinking about this as now an essential brand in the category. And if you have the kind of growth rates that we've got and then the trends that we've got on the growth line, you look at it and you'd say, boy, this is a way in which if you were in the pet business, this is a way for you to get some really meaningful growth. Because we are becoming a big enough player where our growth can actually mean real dollars to the retailer, and we do deliver pretty good margins to them.

On the second question about the replenishment part, that will remain an issue until we just kind of work at it day in and day out and making sure that we get the in-store conditions where we want them to be. That's what we are working on with Acosta. Acosta knows what we expect of them and we are working on that pretty hard.

But I also am a believer that as we built the scale of the business and we get more velocity, as we get more velocity, the store personnel will learn a little bit better that this is an essential category to keep in stock. So I think in that case, scale will help us a little bit.

Got it. All right. Thank you very much.

(Operator Instructions) Bill Chappell, SunTrust Humphries (sic - SunTrust Robinson Humphrey).

Billy, just one question. Obviously there's a lot -- I understand the media spend and the push behind that and reintroducing the brand. But what about -- there seems very little in terms of increasing trade promotion or sampling or the other alternative in terms of building brand awareness.

What was the thought process of going so focused on the straight media spend versus doing both that and trade promotion? Because it doesn't seem like they will have any impact on gross margin over the next few years as you ramp up support.

I guess the way I describe this is media is the first, the most immediate, and the most proven and that's where we're going to start. But when I describe the interactions that we have with the customers, as part of becoming a more strategic partner, one of the things we are looking for is ways in which the customers can choose to invest behind our business to get a disproportionate amount of the growth in their market.

So part of our conversations with them are how do we connect our efforts with what they are doing, recognizing that we don't like to see price discounting in the market. We really like the pricing position that we have. We don't want to see a lot of discounted price. We want to be a product that sells every day at full price if we can.

So the efforts we look at will be things that might be more like in-store sampling or sampling opportunities, selling sample sizes. Connecting with their click-and-pick programs, which we think is a great vehicle for us where the consumer orders online and then they pick it up at the store. But what we can do is market to them online as a way to help drive those purchases.

So the idea here is each retailer has a different set of marketing strategies that they use to reach the kinds of shoppers they are most interested in. And we need to partner with them on those programs as a way to help drive the business.

That's the nature of the conversations that we are having with the customers. That ultimately will turn into some form of partnership spending that we will have come out of our marketing spend. But I certainly hope it doesn't turn into price discounting.

Okay. And then just one last. Maybe I missed this, but why is 9% the right number? Why not 7%, why not 10%? What's magic about 9% in terms of where you should be in terms of marketing spend?

9% is our best guess today based on looking at a little bit of external benchmarking as well as what our testing so far would suggest. We will be smart enough to continue to revisit that as we go along. But the best indication right now is that that's about the right level that will support the kind of growth that we think we need to sustain this business going forward.

And how would that put you within peers?

Well, in terms of the percent spent on advertising?

Yes.

Is that what you're asking? I don't know what the exact benchmarks are there. It's probably -- we are probably going to be -- because we are starting at a smaller scale, we'll probably be on the higher end.

The data that we looked at showed people starting there as they were emerging. And then as they got built in scale, they ultimately grew into the spend. And so the spend numbers came down as a percent of revenue.

But we are giving you a horizon here out through 2020, which our scale will still be smaller than what many of the people are that we are benchmarking. So their percent of revenue was much smaller, but it was on a much larger scale of revenue.

Got it. Thanks so much.

Eric Gottlieb, D.A. Davidson.

Yes, thanks for taking my question. So I'm just trying to get a sense around the $300 million by 2020. Can we talk geographies and also channels? Like, what do you expect the mix to be when we get to that point?

So the focus right now is that the growth that we described in getting to the $300 million, we think we can get there within with the US and the Canadian business that we have today and with a fledgling European business. We are not depending on significant growth in Europe to be a driver of getting to that $300 million number.

If you think about how much untapped potential we have in the US, either looking at our low household penetration or looking at the fact that we are only in 45% ACV in the food and mass channels, you could quickly see that we could double this business and still not really get to levels that are stretching credibility, where you'd need to get into new channels of distribution or into new geographies.

So as you look and model our business going forward, you ought to model it on the channels that we are in. And just expect that we continue to grow them out, both in terms of the number of stores as well as the velocity in those stores.

Okay. And in terms of the stock-out issue that I guess was brought up a little bit earlier, what kind of an opportunity do you think this is? If this gets straightened out, what do you think this could add? Like, how much sales are you losing because product just isn't being stocked right? In your estimation?

We think it's somewhere in the neighborhood of 4% to 5%. It's one of these things that it's pretty difficult to tell and it's something that if we can get it fixed initially, it would return that type of number. But then it becomes a longer-term annuity for the business.

It's one of those situations where if someone comes to a store their product is not in, there is a high likelihood they're going to choose another product. But there's also a likelihood that we aggravate someone and we lose them from the business.

It's upfront, it's a small single digit, but long term we think it's a real core to building the business. Which is why we are investing in that; we are changing the structure around how we are covering retail. And we are really asking for the retailers to help step up and partner with us because of the opportunity that the brand presents to them.

Okay. And then outlet growth. If I'm doing my math right, we are going to double sales essentially 38% as we come from new stores. And the rest is going to come from increase in sales per store, including those new ones.

And some of that is going to be that stock-out issue and some of it is just going to be increased turn. I'm thinking out loud here. I don't even know if there's a question. I'm just wondering is that the way you are thinking about it as well?

Yes.

It's mostly an increase in sales per store?

Yes. One of the things that we've been watching closely lately is we look at how many new stores we get and we also look at what our velocity is. And we've seen over the last, call it, what, three to six months where the growth in velocity improvement versus -- the amount of growth that's coming from velocity increases verses from new stores has gotten -- the gap has gotten bigger.

More of it has come from velocity. And frankly, we think that's to be expected when you get the advertising going. If you increase the advertising, you should expect that to drive velocity fairly considerably.

Do you keep track of stores that may have fallen off? We only see the like the net number at the end of the year, but I'm curious how much added versus subtracted.

Yes, we absolutely do keep track of both. And one of the things that's pretty dynamic is, as you can imagine, especially in your smaller stores, there's always store closings and there's always store openings. And that makes it fairly dynamic. But we keep track of both and we report a net number.

Okay. But you're not going to -- okay. All right, I think that's it for me. Is there any kind of education program to counter this stock-out issue other than just increasing scale and then figuring it out?

Yes, and that would be done on an individual retailer basis. But also, we're having Acosta help support that program at retail and educate at retail.

But as I was mentioning, it's going to be important that many retailers that look at this, they realize the opportunity and that they are helping to educate their operations team to support this. And it's a unique situation that we are delivering into a refrigerated area of the store and it's being stocked in pet. So that complexity takes time to overcome.

Now, the one thing we do know is the longer we are in a store, the more -- the less problems we typically have. The store personnel get trained over time. The more often they are going to our fridge, the more likely it is to get stocked because it just becomes a habit.

So that's how we see it developing. But part of it is education, part of it is us giving a helping hand. And we do -- we have seen and we've done same-store tests where we've broken it out and we've seen improvements in the programs that we are putting in place. So it's something that's going to take quite a while to, I would say, resolve. And it's never going to be perfect, but we can make good progress on it.

Okay. And one last question and I will pass it on. Is there any pricing built into your 2020 outlet?

No.

No, there's not.

Okay. All right. Thank you.

Jon Andersen, William Blair.

Most of my questions have been answered; just one or two. First one -- I get the investment in media spending will drive awareness and hopefully trial and repeat. And I guess that can have -- that should over time have a beneficial effect on the fridge placements.

But is there anything you're doing or have considered doing from an investment standpoint in driving placement of new fridges sooner rather than later? I'm thinking different kind of size fridges, configurations of fridges, maybe investments you can make there to accelerate that as well?

We have. We've looked at and we have in our inventory several different scenarios from a fridge standpoint size and heights. Because there's a lot of unique situations that we see at retail. So we are looking to broaden our fridge portfolio to meet more of the needs at different retail situations.

But also, as we are developing, especially with key retailers, we're developing partnerships. We're looking at different ways to get them comfortable with the investment and figuring out how they can utilize many of the tools that they have in order to help drive velocity, drive consumers to the fridge, and then that would facilitate fridge placement.

And one of the other things that we've done is we actually have a small inventory of what we are calling test fridges that allow us to put them into certain locations, evaluate the performance of those fridges, and really get both us comfortable with the investment and the retailer comfortable with the placement in those stores. And it allows us to make a really educated decision as part of a partnership.

Okay, thanks. One quick follow-up. I think Billy mentioned earlier that something like -- I think it was 3 out of 10 of your large customers now deem Freshpet as I think it was strategic. And I'm just wondering. is that 3 out of 10 because that's where you've kind of started your discussions and are further along in terms of the relationship development there?

And then once a top customer makes this shift to considering the relationship as strategic, does that give you the opportunity to maybe knock off bigger chunks of their store base at one time? Or is it really more of it's going to be a door-by-door type of rollout process? Thanks.

So the strategy shift that we've made is to go into the customer and talk to them. Our biggest, most strategic customers who have lots and lots of data about their shoppers and have very distinct strategies for how they want to build their business.

And we've gone into those customers and sat down with them and asked them what are their strategies broadly? What are their strategies in the pet category? What is the role that we can fill? What is the role that we have been filling?

And rather than just laying out for them an economic opportunity, we've been trying to figure out how we can help them use our brand, our assets, the resources that we bring to better help them deliver their strategies.

We've had those conversations with a couple of the retailers. We have not had it with all 10. We have had it with about 3 of those retailers so far. And when you have those kinds of conversations, what you realize is you now get invited into the next level discussion.

And the next level discussion is where you are now talking about bigger chunks of stores; more intensive involvement on their part rather than just having a transaction where we place a fridge in and the consumer is given the opportunity to buy the product. But now we start talking about merchandising opportunities and how we can co-market together.

And we are just in the early stage of that, so I don't want to promise anything behind it. But we've now gotten to that next level of the conversation with a couple of the key retailers. And our expectation is that that is going to turn into bigger chunks of new stores. And in the stores we are already in, more intensive engagement with them.

And we believe that we'll start seeing the benefits of that in 2018. But it's very intensive work. It's no longer just sell-in the fridge and do the work to do the installation; it's now you got to engage with them in a variety of ways, everything from with their data and their data analytics, whether it is their loyalty card or shopper card. With their digital marketing program, with their curbside marketing program, whatever it is.

There are a lot more points of engagement, it takes longer, and it's more complicated. But we think it ultimately leads to bigger returns.

Thank you and best of luck going forward.

Great. Thank you.

Thank you. There are no further questions at this time. I would like to turn the floor back to Billy Cyr for closing comments.

We appreciate all the questions and support. And please don't hesitate to reach out to the folks at ICR if there are any further comments or questions. Thank you very much.

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.