Freshpet Inc (FRPT) 2017 Q2 法說會逐字稿

Greetings, and welcome to the Freshpet Second Quarter 2017 Earnings Conference Call.

(Operator Instructions) As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Katie Turner.

Thank you, Ms. Turner, please go ahead.

Thank you.

Good afternoon, and welcome to Freshpet's Second Quarter 2017 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 involves 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 quarterly 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.

Finally, please note, 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 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.

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, and then offer some commentary on the operating environment.

Then Dick will review our financial results in more detail, and provide some visibility on the balance of the year.

Finally, Dick, Scott and I will be available to answer your questions.

We are very pleased with what we accomplished in the second quarter.

Our business responded positively to the investments we have made in line with the Feed the Growth strategy we initiated earlier this year.

We believe this positions us very well to exceed the net sales goal we established for the year.

Further, the second quarter results are a solid early indication of the effectiveness of our strategy and our ability to deliver our longer-term fiscal year 2020 financial objectives.

As a reminder, we expect to generate $300 million in net sales as soon as 2020, with 20% plus adjusted EBITDA margins, and delivering an annual growth rate of 15% to 20%.

Everything we see today demonstrates that our goals remain very achievable.

We have generated significant momentum in our business since the beginning of the year.

The most important result in the second quarter was the acceleration of our growth rate.

Net sales grew 21% compared to the second quarter last year behind the increased advertising investment, and improved sequentially from the 9.7% year-over-year net sales increase in Q1.

Our growth was broad-based.

Across measured channels and IRI, our refresh refrigerated consumption was up more than 28% versus a year ago in the quarter, and even the unmeasured pet specialty business, net sales were up 9% in the quarter, significantly outperforming the category in pet specialty, which was down versus a year ago.

We did experience about 300 basis points of drag from our baked product, but that simply highlights how strong our core fresh refrigerated business was, up 24% versus a year ago, and there was no unusual new distribution or pipeline fill in the quarter or in the base year to influence the year-on-year comparisons.

And since we do virtually no price promotions, the results are not driven by temporary price reductions.

The sale of full price product is what drove our results.

As such, we believe our results reflect the potency of our advertising campaign and the merits of our strategy.

Even more encouragingly, the advertising investment drove increases in household penetration, purchase frequency, dollars per buyer and same-store velocity.

In fact, according to IRI data, more than 80% of our growth in measured channels in the quarter came from velocity increases, and less than 20% came from new distribution.

These early results confirm the idea that the Freshpet proposition is very sticky with a very high repurchase rate.

When we launched our Feed the Growth strategy in March, we communicated an expectation for an accelerating growth rate throughout the year, with 20% plus growth by the fourth quarter.

Based on the second quarter results, we have generated an acceleration in net sales and 20% plus top line growth earlier than we projected.

Going forward, we have confidence in our growth rate for the balance of the year.

Keep in mind, though, that consistent with the plan we communicated to you in March, we will have much less marketing support in the second half of the year, and as a result, today, we are raising our net sales outlook for the year.

For 2017, we expect to deliver at least $156 million in net sales, an increase in net sales guidance from the previous $153 million, and up 17% as compared to the prior year.

This reflects the more rapid increase in the rated net sales growth we've experienced, but also maintains our conservative approach as we are just in the beginning of our new strategic plan.

Adjusted EBITDA for the second quarter also demonstrates our ability to absorb the higher marketing investments and begin to convert top line growth into profitability.

Despite increasing media spending by $1.8 million versus a year ago in the quarter, we delivered $3.2 million of adjusted EBITDA, and believe we are on track to meet or exceed $16 million of adjusted EBITDA for the year.

We will continue to prioritize increased investments for growth and efficiency improvements ahead of near-term profit growth.

If we have an opportunity to generate even more net sales growth or sustainable efficiency improvements with the potential to drive long-term profitability, we will strategically do so and still achieve our full year outlook for adjusted EBITDA.

As a result, we are not raising our adjusted EBITDA guidance at this time.

We made solid progress on new store growth.

We added 326 stores in the quarter, and as of 7/1/17, we had 17,357 stores.

New store growth will remain very lumpy as we move forward.

While we continue to believe there is significant upside in fridge placements, our Feed the Growth strategy makes us less dependent on new fridge placements to deliver our growth goals.

We continue to expect to achieve the vast majority of our growth goals on velocity increases alone.

It is also important to note that, while our brand is only present in about 50% ACV, we have broad geographic coverage.

So while we may not be in every grocery, mass or pet specialty outlet in a consumer's neighborhood, it is highly likely that the consumer who sees our advertising can find Freshpet in at least one of the grocery, mass or pet specialty outlets where she shops.

It would be easier for her to buy us on a regular basis if we were in the store she shopped more regularly, but most consumers shop at a variety of stores with some frequency.

And that increases the likelihood that she can find Freshpet in at least one of those outlets.

Additionally, it is important to keep in mind that measuring new store growth becomes increasingly complicated, as customers diversify the numbers of ways they serve our consumers, including adding click and pick, curbside delivery, direct-to-consumer delivery, installing a second cat-specific fridge in an existing store or upgrading the size of a fridge in a store.

None of these new or expanded offerings are captured in our existing new store metric, but all of them support an expansion the consumer base we serve.

In March, we told you that we were going to redirect our manufacturing and engineering talent from the design, construction and start-up of our expanded kitchens to instead focus on efficiency and quality improvement that could help fund the growth investments.

We set a target of 3 points of adjusted gross margin improvement by 2020.

During the second quarter, we made great strides in the production efficiency and quality improvement.

We expect to begin the benefit from our production efficiencies in the second half of this year, as our volume continues growing into the capacity.

At this point, I want to take a step back and provide one added insight on the Freshpet business and our strategy.

As we began to implement the Feed the Growth to strategy this year, it has become very apparent to us that our past and present efforts have produced a very reliable and predictable revenue growth machine.

We can now predict fairly reliably our revenue growth based on our planned advertising spend.

That is because the category has virtually no seasonality.

We do almost no price promotions, and a vast majority of our growth comes from velocity increases of existing items instead of from new distribution gains, geographic expansion or new product launches, all of which are valuable but a lot less predictable.

Our advertising spend and the ads we produce are completely within our control rather than dependent on customers, partners or new product success rates.

That means that we can determine our growth rate fairly reliably based on the decisions and investments we make rather than relying on a large number of less reliable external factors.

Because of years of testing and qualifying our message, we have incredibly good metrics on the net sales increase we get from each advertising GRP we buy.

And with such a low household penetration starting point and incredibly high purchase rate -- repurchase rate, the runway in front of us that comes from increased advertising is very long.

And as a result, we believe we will be able to sustain very rapid growth rates for several years before we will need to rely on less predictable sources of growth, such as geographic expansion, significant new products or big distribution wins.

That gives us the time to build a highly efficient, focused business with meaningful scale advantages and barriers to entry, all in support of a preferred product, and ultimately, a powerful brand equity.

That means that our investors should be able to enjoy both rapid growth and a higher degree of predictability of the revenue growth, an unusual and potent combination.

It also means that our investors should expect us to continue investing in increased levels of advertising and experimenting with new ways to deliver our message, all in the pursuit of rapid growth.

This does not mean that we won't innovate or expand.

It simply means that we can achieve our goals without big wins in those areas.

We will be very selective about any opportunities we're pursuing in those areas, and any opportunities we identify would be incremental to our base business growth and use to accelerate our growth even more.

And we know that the day will come when we will need those sources of growth and we'll not allow ourselves to fall behind.

This also does not mean that we are going to race ahead with rapid increases in our net sales guidance.

While the business appears to be very predictable compared to most other CPG businesses, we also want to be prudent in our expectations as we progress with our strategy.

We will use the predictability and reliability of our business to do responsible investment planning to maximize growth and profitability and avoid unpleasant surprises whenever possible.

But please don't let our focus on reliable and predictable growth leave you with the impression that we are anything other than very excited about our opportunities ahead.

As such, we are reiterating our confidence in our longer-term 2020 goals, including net sales of $300 million as soon as 2020, adjusted EBITDA margins of 20 plus percent and a growth rate of 15% to 20%.

Finally, I want to comment on 3 broad external factors that are important to our business.

First, many people have asked us about our approach to e-commerce and the implications of the announced acquisition of Whole Foods by Amazon.

We believe that Amazon's acquisition validates that it will take a combination of virtual and physical assets to compete in the future and meet the evolving consumer demands.

We fully intend to be prepared to meet those consumer demands in any way in which they develop.

We believe our brand and other fresh products are ideal partners for retailers who have a heavy investment in physical locations and refrigerated supply chains and use them to provide the freshest products to consumers at the best possible value.

We believe that is where the bulk of our business will be for the foreseeable future, and we will support it in a way that reflects that belief.

We also support -- we will also support those customers efforts to provide omni channel solutions, such as curbside and home delivery.

Our goal is to serve our Freshpet consumers, and we will do that in whatever way they find most useful.

Second, the further fracturing and diversification of media viewing and delivery is an important trend that we continue to monitor closely.

While our current results are built on the success of our existing TV and digital campaigns, we are continually experimenting with a variety of different media approaches that are designed to prepare us for the rapidly changing media world.

We have tested varying levels of digital marketing, digital in concert with TV, digital alone and a wide range of tests within the array of digital vehicles available to us.

We are very confident that we will be able to continue to expand the Freshpet household penetration as consumer viewing habits evolve.

That is where our highly innovative and entrepreneurial culture is a real strength, i.e., Scott and his team never sit still and are always trying new things.

As I've said since I joined Freshpet, the creativity and innovation of Scott and his team are incredible assets, and the rapid changing world of media is just another example of where that talent pays dividends for us.

Finally, we have been asked from time to time about the potential for a competitor to enter the Freshpet food category.

We firmly believe that our success will draw new competitors over time, and the objective of our Feed the Growth strategy is to build scale and brand equity that further extends our competitive advantages before competitors develop any meaningful presence.

We are well on our way to accomplishing that with the scale we have today and the renewed growth rate we have demonstrated.

In summary, we are pleased that our Feed the Growth strategy is off to a good start.

We have confidence that we can rapidly scale Freshpet into a meaningful business with strong profitability.

Here to discuss our view for the balance of the year is Dick Kassar, our CFO.

Thank you, Billy, and good afternoon, everyone.

I'll provide a little greater depth and give you an expanded view of the balance of the year.

As Billy indicated, we grew net sales in the quarter by 21% versus a year ago to $40 million, achieving our goal of 20-plus growth -- $0.20 growth 2 quarters sooner than we had projected.

As a result of the more rapid acceleration and the growth of business in the second quarter than we had projected and continued strength of the business early in quarter 3, we are raising our net sales guidance from at least $153 million to at least $156 million.

This reflects the greater-than-expected quarter 2 net sales and our confidence in the second half of the year.

At the same time, our annual outlook reflects the following: a low marketing spend relative to the first half of 2017 when we spent 72% of our marketing dollars, an accelerated growth rate in quarter 3 and quarter 4, which was already built into our full year outlook.

As a reminder, we previously communicated that we would have 20% growth in quarter 4. And although our pet specialty sales increased 9% in quarter 2, we believe it is prudent to maintain a conservative view on the health of the pet specialty channel.

The adjusted gross margin progress will continue to be a bit uneven, but we remain confident within our target of 1.5 points of adjusted gross margin run rate improvement by year-end.

The second quarter results are a good example, as adjusted gross margin grew 50 basis points versus a year ago, but was down 80 basis points from -- versus quarter one.

A significant portion of the change versus quarter one is relative to mix changes and the cost of some tests.

We are continuously working to improve our manufacturing processes.

For example, we are testing opportunities to increase the daily throughput of the kitchens.

We expect these to take time and result in near-term cost pressure until we perfect and fully implement those new methods.

We believe the long-term payback is worth the short-term investment, but it will make our near-term results a bit uneven.

We're getting significant scale benefits, as we deliver 20%-plus growth, and we expect that to continue.

We have also improved our yield since the first quarter on our Fresh From the Kitchen line, and expect that to continue for the balance of the year.

Additionally, we are continually reviewing our product portfolio to phase out underperforming items and simplify the lineup, and we'll take any charges necessary for discontinuances and obsolete or outdated inventory.

It's important to note that we will do this without risking adjusted EBITDA guidance we provided you.

However, while we will generate increased gross margin dollars from increased sales, we are not increasing our adjusted EBITDA guidance at this time.

For perspective, if we have taken the entire incremental contribution from the incremental net sales, we are now guiding to $3 million, we will generate an incremental $1.2 million in adjusted EBITDA contribution.

We plan to invest the incremental contribution benefit to gain greater supply chain efficiencies, investment in productivity enhancements, and this early stage in our Feed the Growth Plan, we'd like to have the flexibility to continue to invest in growth initiatives if the opportunity presents itself.

Our belief is that these near-term investments will lead to higher profitability and more growth longer term.

As a reminder, our adjusted EBITDA represents EBITDA plus loss on disposal of equipment, new plant startup expenses, share-based compensation, launch expenses, leadership transition expenses, secondary costs and warrant expense.

As you look at adjusted EBITDA for the second half of the year, it is important to note that our advertising investment was heavily front-loaded, so you should expect to see much greater adjusted EBITDA progress in the back half of the year.

With approximately 52% of our net sales to come in the back half of the year and less than 28% of the media spending, the adjusted EBITDA margin will expand quite a bit, and result in delivering our guidance of at least $16 million in adjusted EBITDA for the year.

Focusing on our balance sheet at June 30, 2017.

The company had cash and cash equivalents of $600,000 compared to $2 million at March 31, 2017.

The decrease in cash is primarily due to the timing of our media plan and increase in working capital due to our higher net sales.

At June 30, 2017, we had $7.5 million outstanding with $22.5 million remaining from our credit line.

[At least for] the last 2 years, we have generated positive cash flow from operation and expected this trend to continue in 2017.

Recall due to the reduced advertising investment in the second half, we would generate significantly more cash and adjusted EBITDA in the second half than in the first half of the year.

In summary, we feel very good about our progress.

Thus far, this year, we are on track to exceed our initial sales guidance, and have thus raised the guidance to reflect the business trends we are experiencing.

That concludes our financial overview.

Operator?

(Operator Instructions) Our first question comes from the line of Rupesh Parikh from Oppenheimer and Company.

So first area I just wanted to touch on is, on your fridge targets, I mean, clearly, retail landscape is more challenging.

We're seeing some closures out there and a number of retailers are focusing on potentially opening up fewer units down the road.

So -- and I guess, on the other hand, your business is very strong right now, so you guys are seeing great velocities.

So just wanted to get a sense, as you look out to next year and beyond, do you think that fridge growth can accelerate higher from the 10% rate currently?

First of all, I think, as you noted, it's important to point out that velocity growth is the biggest driver for us this year, and we expect it to continue to be the biggest driver of growth.

So while growing increasing number of fridges is always important for us to increase availability, I do think that we'll have some headwinds as we go through next year and the year after that as retail landscape changes.

But I don't think that changes our view on our ability to get to the net sales growth.

The -- we are going to drive this off of the velocity, and I think the retailers will look at the velocity and will make assessments about whether they need to add more fridges or not based on our success in the fridges that we're in.

So I think that it's going to be -- you're going to see some challenges on placing fridges, but I don't think that's going to change a whole lot of how we view our net sales growth.

Okay, great.

And then I guess going down the road, if you see greater velocity and maybe potentially less fridge growth, from a [Freshpet] perspective, would that be positive from ROIC as you would have there -- potentially have fewer fridges out there?

I mean, theoretically, yes, if you have less deployed capital and you have less cost to maintain, I'm sure, that would be great.

But our focus is on driving the net sales growth, and we'll get to the net sales growth with the velocity as the primary driver.

But if we can do it in a more efficient way, we'll take it.

Okay, great.

And then my last question.

As you look at the various channels, it sounds like pet super store, you saw a nice pickup there.

Curious what you're seeing in the other channels from a velocity perspective.

So we saw growth across all the channels, and that's really the real story here.

I mean, we view that as planned on success for us in the quarter.

So we've got every one of the -- every one of the channels to demonstrate growth.

In my time in CPG, that's not a common thing.

So the pet specialty was probably on the low end.

The high end was in the grocery channel, but mass was very strong.

Club was strong.

We did well -- we did it well everywhere.

Our next question comes from the line of Brian Holland with Consumer Edge Research.

Just a couple of housekeeping ones to start with respect to guidance.

So it seems like Q2 is more or less at the revised higher top line guidance for the full year.

It's sort of a flow-through from the Q2 beat, maybe a little bit on Q3.

If -- and you talked about the lower marketing spend in the back half and the predictability of that.

Now what kind of balance are you looking to strike that?

Maybe why not invest more in the advertising right now and continue to build that momentum?

Or do you think there's more than enough in the pipeline?

I'm just thinking about the reinvestment split with keeping the EBITDA in line and how much of that maybe goes back above the top line, and how much of it goes back into the supply chain as we look maybe in Q2 and then over the balance of the year?

Well, first of all, Brian, hats off to you for being closest to the pin on the revenue number for the quarter.

You called it pretty well.

Secondly, as we thought about the guidance that we provided, you have to remember that we're providing a floor.

What we said is at least.

We're not providing a target or a range.

So it is a floor.

So as you think about what's going to come in the back half of the year, we've given you -- what we think is a good reflection of what's happened in the second quarter, and a little bit of the visibility that we've got in the third quarter at this point.

As Dick said in his comments, the -- we don't have as much marketing support in the second half of the year.

There's obviously the uncertainty that happens around pet specialty.

So I think that there's a little bit of a let's take this cautiously and let's be conservative as we make our projections.

In terms of our willingness to invest, we are willing to invest in both things that will help drive the growth, as well as things that will help improve the long-term profitability of the business, and that's why we held the guidance where we did on the EBITDA.

We want to retain that flexibility if the opportunity presents itself.

Okay.

I was sort of flailing.

I had a bunch of questions, but then Dick answered most of them in his prepared remarks and ruined my queue, but that's fine.

Just maybe taking a step back, big picture, what we're seeing with respect to this growth and what's driving it, right?

So we talked about the increased advertising spend, but you also have these consumers that are sort of the early adopters.

And it seems like dollars per trip and trips per buyer, it seems to be going up, which implies that you're getting increased engagement from the legacy consumers, but -- and also maybe bringing new consumers based on the household penetration growth.

What's the mix of that and how do you -- what do you think about going forward?

Like how do you continue to engage that early adopter?

How was your advertising focused that way versus bringing new folks in?

I'm going to just give you a top line comment.

I'll ask Scott to fill in a little bit more detail on it, but I'd say that we're at very early stages of developing this brand.

As you've noted, our household penetration is very low and the awareness is very low.

So there's a lot of consumers out there who have not yet heard our story, and so the opportunity to engage them in the brand is still very fresh.

And beyond that, the consumers who have tried it are finding that satisfaction is high.

Repurchase is high, as they move further and further out the curve.

But I think that the opportunity, going forward, is to expand that franchise fairly quickly and fairly significantly.

And I don't think the consumers we're encountering now are a whole lot different than the ones that we've already gotten in the franchise, but Scott can give you a little bit more color on how we expect to grow that.

Yes.

And to reiterate what Billy was saying, we have incredible depth of opportunity with gaining new consumers into Freshpet.

A lot of people don't even know what Freshpet is today, so we're really early in that adoption curve, many more new consumers that we can bring into the franchise, and we have a really different approach to advertising in total.

It's a very highly responsive and adaptable model that we apply.

And if we're not making progress in any particular area, and it could literally be down to the types of shows in a certain evening that we're utilizing or in digital, and we constantly adapt that entire marketing model on a very weekly basis, every-other-week basis, so it's -- what we're doing is we're allowing the market to see where we make the most progress, and that's where we're investing the dollars, and that allows us to make sure we're getting the most productivity out of the advertising model.

We monitor it really closely.

We modify it periodically because it's been working so well.

So we think there's just the tremendous opportunity that continue to work that model and gain new consumers into the business.

I'll just get out of here with one last one.

Again, just kind of looking back at the store count and the base you're at today, and the focus there seems to be on our future store growth.

Billy, I think you and I talked before, 17,000-plus doors seems more than enough to double, maybe triple your household penetration from where you are right now.

So in that sense, maybe you don't need that many more stores, but I can appreciate that getting more stores brings more visibility.

People see the fridge and start asking questions about the brand, et cetera, et cetera.

But how much do you think about the velocity on that fridge and where you're at and the risk of extending yourself?

I mean, are we any -- I wouldn't think that we're anywhere near that point today, but how do you think about it going forward?

And do you have to be mindful about how fast you grow that distribution?

And what are your retail partners telling you about how fast they want you to grow or think you should grow from a placement standpoint?

Let me start at the end.

The retailers love to see the velocity increases in the fridge.

It's good for them.

It's very good for us as well, but they love to see that.

And that is the key metric that they'll use in deciding whether they'll put more fridges in more stores, but they also have other factors that they'll consider, amount of spaces available in the store, the demographics of the other stores as well as their, just frankly, their priorities or the strategies across the whole store, whether choosing to invest in today versus other categories.

In terms of how we think about it, I'll tell you, the velocity thing is critically important to me.

One of the interesting metrics when you look at this quarter, we had about the same amount of store growth this quarter that we did in the same quarter a year ago, but our growth rate was dramatically higher and they all came from the higher velocity.

And so [it causes the] ask, what are the benefits and what are sort of the implications of that higher velocity?

Well, one of them is we believe that the higher velocity will ultimately turn into better in-store conditions.

When you get the volume and the product turning, the consumer buys fresher product, they're more likely to see good stock rotation, more likely that the customer is going to find that a regular habit to stock the shelf, assuming it's a very good thing for us.

It also, frankly, the more volume we can pull out of the same fridge, it's that 1 fridge that we have to service, maintain, manage it from a capital perspective.

And from an operating expense, it's a very good thing for us.

When you think about the potential upside from the velocity in a fridge, we're nowhere near the range of what's possible out of the existing base.

We're about 50% ACV today.

Most consumers can find us in one of the stores they shop.

If we're not in the local grocery store, we're in a local Walmart.

We're in a local Target.

We're in a local pet specialty store in your neighborhood.

So the consumers can find us today wherever they're looking, but what we want to do is get the velocity up in the fridges where they are, because we think that in the end, the potential is to be if we're selling a -- in some fridges, $200 to $300 a week, we think they can get up to $400 or $500 a week.

And some that are $500 can get to $1,000.

I mean, it's not inconceivable for us to get to those kind of numbers.

We've got some fridges that are operating well above those levels.

Our next question comes from the line of Bill Chappell with SunTrust.

Yes.

Just for some -- Dick, as I look at gross margin in the second half, obviously, you said it's a big ramp.

Is there -- should we expect the kind of a stair step function from third quarter to fourth quarter?

Or are we going to take a nice jump immediately in the third quarter and be pretty similar as we get to the fourth?

Well, we're at 49.5%.

Last year, we finished at 49.6%.

We guided to 51.1% as the run rate in the fourth quarter of 2017.

It doesn't mean I'm going to be 51.1% for the year.

As we said in the script, we've been doing some testing, trying to get more efficiency on our core lines.

So I would -- we would be probably in the kind of the range we're in now in the third quarter.

And then by the fourth quarter, that testing -- because we're already a month and a week into this quarter.

The testing that we're doing in the second quarter and some in the third quarter will give us the opportunity to get that 1.5 points.

If you recall, we said in our 3-year plan, we were trying to get 3 points by 2020, and we're trying to get half of that this year and then carry into next year.

Okay, that helps.

And then on SG&A, just -- I think you said there was a $1.8 million higher advertising spend in the quarter and total SG&A was barely up more than that.

So were there other offsets in the quarter?

Did you end up spending as much as you originally planned on advertising?

Or did you end up getting -- feeling like you hit a ceiling and didn't need to spend as much?

No.

Really, what you're seeing buried in SG&A is our incentive accruals, and we book our incentive expense based on our progress on EBITDA for the year.

So you're seeing a slide-off that's approximately $1 million through June 30, 2017.

So we feel -- we still have about $3.8 million to go in the back 6 months in our media plan, and that's about 70% higher than what we spent in last year's back 6 months.

Got it.

And Billy, I guess the question is, have you done any testing?

Or maybe to Scott as well, to figure out what it does for sales as you start to pull back on advertising?

I mean, can you still get the same level of growth with a lower amount?

I mean, how sensitive is it or how inelastic is it, I guess, in terms of can you pull back meaningfully now that you've got the momentum going and really see it keep growing?

So Bill, this is Scott.

Typically, what we've seen throughout all the work we've done in media investments is every time we invest in media, and I'm just using that as a generic term for however we decide to communicate our dollars, whether it's TV or digital or print, no matter what vehicle it is, that drives us up to, really, a new plateau on the business and that gets us up to kind of that run rate.

And then what we've been able to see more and more is we really hold that rate, we used to see kind of a modest decline over time, which is typical when you kind of pull back on your advertising.

We're actually seeing kind of a steadying.

And then when we invest again, we kind of move into the next plateau.

So that's really how we look at the model working.

And once we are at that plateau, plateau from a dollar sales per month, however you want to think about it, that will -- that carries through forward and then you'll get the benefit versus the year ago for that same period until you go back on air or apply some additional media dollars to it.

Does that make sense?

So I think in order for us to see significant growth, we're going to need to utilize media.

It's not something that we're going to kind of pull back from and see significant growth on the business.

And if I were to extend that and say, we've been off the air from a television perspective since early June, so we're now 8 weeks in and we can see from the IRI data pretty consistently the business has really held its ground that we gained going back to the stickiness of the proposition.

When we go back on air, we expect to see the business to ramp up at a very consistent rate with what it did when we went on air early this year.

And that's part of the reliable and predictable model that we're seeing.

So I feel pretty good about the results that we've seen since we've been off air, and I'm looking forward to what happens when we go back on air.

Got it.

No, that helps.

And then last one.

You had alluded to cat fridges.

Is there a number of cat fridges where customers have opened the second -- I guess, created a second fridge yet or is there a number you can quote or are we -- that's still in the planning process?

We do have some cat fridges out there.

We have a handful of tests going on at a couple different grocery retailers and we also have some at mass.

We're also trying several different scenarios in fridge sizes, in the mix of products we're putting into the fridges and even some adjustments that we're making in the dog food fridges in order to kind of gain information to establish how we move forward with the cat portfolio in the future.

And I know you've heard us talk about this, we're in a really, really enviable position.

We really do kind of evaluate where are the different opportunities that -- as a company, that we can invest.

And cat -- building a cat portfolio is one of the many opportunities that we can invest.

And every kind of quarter, we really sit down and we evaluate where the best investments are and where we can get the best return on both kind of near-term and longer term, and that's really how we're making those decisions.

Our next question comes from the line of Robert Moskow with Crédit Suisse.

Just a couple questions.

Can you give us an update on how you're progressing with your broker network that you had, I guess, reorganized with Acosta?

What are you seeing from that?

And how is it helping you execute in-store?

And secondly, the advertising that you're doing this year, I thought I remembered like $13.5 million kind of being a number, up 60% from a year ago.

How are you tracking year-to-date on that?

Are you on track and maybe, roughly, how much of it was in first half?

Maybe you said that already, but maybe help me out.

Okay.

So from an averaging standpoint, we're exactly on track for we spend, what's the exact number we spent year-to-date, Dick?

$9.8 million.

Okay, $9.8 million of the $13.5 million, which is about a 70% increase versus year ago.

So exactly as we had planned and budgeted for the year.

Yes.

Okay.

And then -- so it'll taper down in the second half?

Yes, absolutely.

And similar to how we've done it in the past.

With regards to the broker network, and Acosta is our partner, we -- it's still fairly early.

We've actually -- it's been really kind of phased approach.

We started to change the way we do some coverage in mass and now into grocery.

We're seeing some slightly better results, but I don't think this is the perfect solution for us and we continue to evaluate what the perfect model is out there to cover our retail stores because we recognize that there's a significant opportunity there to improve our overall fridge conditions.

So we're -- always continue to evaluate what are the better -- best ways in order to do that.

What we do see is that when fridges do get up with the higher velocity levels, we do see kind of lower out-of-stocks, overall better conditions because it becomes a very habitual routine that's going on at retail.

So we're -- as we make nice progress on velocity, we think that in some cases, it will help to improve overall [retail] conditions.

And can I sneak one more in for Dick?

You might have mentioned it already, but what kind of manufacturing efficiencies are -- should we be in store for heading into next year?

How is your manufacturing kind of productivity going?

Well, it's going well.

As I said in the call, we're -- in the script, we were doing some testing now to increase our speed.

If you recall, we basically said when we were going to add the 2 additional lines that we'd expect to pick up 30% more velocity per hour, and we're working towards those goals.

In addition to that, we believe by the end of the third quarter, a fair amount of that testing will be behind us and we'll be picking up the 1.5 points by the fourth quarter.

Going into next year, as we said, we would have a 3-year goal to get to 3 full margin points in our COGS to our gross margin, and we'll be focusing on that during the budget planning coming in the back half of this year.

(Operator Instructions) Our next question comes from the line of Mark Astrachan with Stifel.

Curious about how you think about store growth from a fridge standpoint in the context of how you're thinking now about fridge expansion.

So what specifically do you think you get from new chains versus existing?

Maybe talk about how many in the quarter you place in existing stores versus other.

And I guess thinking about or are we talking about a slowdown within those stores, those chains you're already versus going into new and whether there's more opportunity going forward for that or sort of what are you seeing there that's really driving the rate of change from your end from the retailer end, slowing that uptick a bit?

I don't think we think of it as slowing.

I think what we told people our rate was, we're on track for the rate that we had projected and will project going forward.

The -- I think the thing you have to remember is it's very lumpy and also any progress that we make on putting a second fridge in a store or finding a way to support a curbside is not included in our store measures.

So the only that's included is when we open up a new outlet.

I can tell you we've been seeing success across the board in all sorts -- all classes of trade, we're seeing increased store count.

We're getting pretty good success in the independent stores, but we're also seeing some of the larger chain.

We're present in just about every chain at this point.

So there really aren't any places where we say would we have to open up a new chain.

It's really adding stores and chains at where we exist and we're making progress across the board.

Let me -- I'll build a couple of points potentially on top of it that, that maybe help a little bit, too.

If you think about our overall growth rate, we're -- in IRI, we're seeing around a 27%, 28% growth.

Of that, about 5 or 6 points of that are from distribution.

So the vast majority of it is velocity-based.

And we see the road in front of us where we can continue to see really strong velocity growth for a very, very long period into the future.

Now that aside, we do think that distribution growth is critically important, but we -- and as far as we can tell in front of us, we feel really -- we feel good about the number this year.

We like what we see in front of us, and we know we're going to continue to expand fridges.

We don't know the exact rate, as Billy said.

It could be lumpy.

What we are continuing to see is if you look at where the expense is coming from, it's coming from we're always getting new customers, there are literally new retailers every quarter that do come into play of various sizes.

The vast majority of them are from existing because we're in 9 of the top 10 pet food retailers in the country.

So the vast majority of them come from existing retailers that we work with.

But the thing that is most important, and we said it a couple of times, is when we do go into new stores within a tight geography, even geographies where we have high ACV, we do see incrementality coming from those individual stores.

So we do know that, that adds to the overall business growth over time.

And although you can -- can you drive down the road and -- a few miles away and can you get Freshpet most places in the U.S.?

Yes.

But we do think the distribution is a nice addition as a way for us to grow.

Velocity is going to be clearly the #1 and really carry us quite a long way into the future.

Got it.

That's helpful.

I guess sort of building on that and sort of a broader discussion.

So you're clearly seeing results from the increased ad spend.

Why not reassess or what goes into the decision to continue with what you've been doing historically in terms of spending less in the back half versus first half.

Meaning that you've had success, why not keep the pedal to the metal and sort of see where you can go?

Well, I think you heard in our comments that we're retaining the right to do that depending on how the year progresses.

But I think that if the conclusion you're reaching is that we should be continually increasing our investment in advertising, I think what you're hearing from us is that the data would support that and we feel pretty good about that.

And the model that we laid out for folks was that we weren't at a constant media spend, but our media spending would grow as our revenues would grow.

As we look at our plans for 2018, we're clearly going to look at, should we go to a more aggressive media spend over a longer period of time and will we get a good return for that?

The data we have so far suggest that might be the case.

But we really need to sit back and take a look at the whole range of opportunities for investment we can make as well as what kind of growth can we manage on a reliable basis.

We don't want to get in a position where we can't produce high-quality products and services in the right way.

Got it, okay.

And then just lastly for Dick.

The balance sheet or working capital, you made comments that the cash flow should improve over the balance of the year.

So assume that means some of those changes that you saw there is a drag to cash or cash use in the quarter would reverse going forward?

Yes.

And also our EBITDA comes in heavily.

We have $5.1 million through 6 months.

We said at least $16 million by year-end.

So that's certainly going to help.

But we're taking working capital hit in the first 6 months of the year because of the growth of our revenues.

I mean, last year, we were around low -- $33 million.

This year, we did $40 million.

So we went in, this quarter, we did $40 million.

So that's going to be a hit.

Growth from here will continue.

So we will see working capital gradually grow, but the big EBITDA pickup in the back half of the year is going to generate our better cash position than we currently have.

And we still have a fair amount of availability in our line.

Our next question comes from the line of Jon Andersen with William Blair.

On the velocity growth that you've experienced of late, the accelerated velocity growth, could you talk a little bit about how that breaks down?

I mean, to what extent is it being driven by the acquisition of new households, households penetration versus purchase frequency or dollars per buyer among existing accounts, existing customers, if you have a sense for that.

And how do you think about that going forward?

Is it a pretty balanced algorithm or are you looking to lean more heavily into kind of one side there or the other?

Jon, it's Scott.

So what we've typically done and typically seen over the years is we've seen really nice progression on all metrics from a consumer standpoint.

So we've seen really good progression on not only penetration but also buying rate, share requirements, loyalty.

So we -- that's typically what we've seen over time.

Now we know what we're doing now is we're kind of leaning more and more into advertising.

So we expect that penetration will be really one of the leading growth areas for us.

So we'll see more people coming into the business.

The main focus for us is when someone's in the business, they have an incredible product experience, and that's where we focus a lot of time, improving quality on a day in and day out -- monitoring and improving quality on a day in and day out basis.

So that's really the major metric that we see going forward.

We don't have data on a kind of monthly basis.

We typically look at it on a quarterly -- historically, annually.

But now we're starting to look at it on a quarterly basis and we're seeing a nice progression from a penetration standpoint, and the model really seems to be delivering and the investment really seems to be delivering on that penetration.

Is there anything with all of the -- with the demand generation investments you're making, and the media spending increases, is there anything that you're doing kind of in-store from a merchandising perspective, from a couponing perspective to build awareness, promote trial or is this all focused on outside-the-store media?

Well, the first piece that we've really established is the way we do business is we really don't almost do any coupons whatsoever.

I mean, we hand out more coupons personally than we distribute other than maybe if it's a small test somewhere.

We really don't do any couponing.

There's a really no merchandising on this business.

And really that's ideal from an efficiency standpoint and from a logistics standpoint, especially on the fresh business.

So that's really the business model we've established as we invest in the business.

So that's really -- like that's kind of the core piece there.

And it's -- basically, the way we see it going forward is continuing to invest in media and advertising that drive that penetration and improve and bring more consumers into the franchise.

I would add 1 piece to that, which is the sales folks that we have and the customers we have, when they do a really good job, that some of the very best work is getting the assortment right in each fridge.

So while we don't do price merchandising, but making sure that we're selling the right SKUs, we have the right number of facings for the right SKUs, can make meaningful difference in the productivity of any individual store's fridge.

And so there's really work that's done by our sales team to make that happen, by our customers and working with them and with the data they have in the stores to get different results out of the exact same lineup that we offer with the exact same fridge, you can get different results if you do a good job on your assortment.

Makes sense, that's helpful.

Two quick ones.

The commentary around competitor entry and you fully expect that you will draw competitors into the market over time.

Is that -- was that more of kind of a general broad-based statement?

Are you seeing anything in terms of change with respect to competition of late?

Well, I think as you know, there's a competitor who's been in 1 customer in the Southwest for several years.

They're still there.

They haven't gone away, and they haven't gained distribution anywhere else.

But I would suspect that they and others will find this category attractive and will make efforts to try to expand beyond their base or others will try to enter the category.

I think the message that we want to leave people with is we have a huge head start on anybody who tries to enter this and scale is a huge advantage.

Scale is expressed in the number of fridges that are placed.

Scale in terms of the brand equity that we're building, scale in our ability to efficiently distribute product or manufacture product in a low-cost, high-quality fashion.

And so while we've initiated this program this year to accelerate our growth and we intend to continue accelerating growth, anybody who chooses to enter the market, whether they're big or small is going to have to chase after someone who's moving very fast and already has a fairly sizable scale advantage.

Our next question comes from the line of Jason English with Goldman Sachs.

Billy, you walked us through a few of the metrics you're aspiring through in 2020, kind of reiterating top and bottom line.

Apologize if I missed it, but you had the unit number out there at 23,000.

Where do we stand on that today in terms of target?

I don't think we would change that based on what we know today.

I really just shorthanded goals for the year 2020 when I delivered my opening comments.

We wouldn't change that.

But what I would tell you, though, is we think we could get to the revenue number even if we don't get to that number just because of our demonstrated ability to improve velocity.

I think many are going to interpret the comments as sort of suggestive that you may not get the unit growth that you aspired to before.

And given that you guys are talking quite positively about the benefits of distribution, the second interpretation is you won't get there because retailers don't necessarily want more.

What...

Yes, that's not the interpretation that we want.

Okay, so that would be kind of off-base.

Yes, that's not the message that we're delivering.

What we think what we're telling you is we are incredibly encouraged by the velocity story that we're seeing and the way it's developing.

We are also seeing a very rapidly changing external environment that is not easy to project how many retailers are going to be out there and how many stores they're going to have 3 years from now.

It's -- we're not in any way that the retailers who have us are in any way unhappy with the results and seeing the opportunity to expand the footprint or the presence of our products in their stores.

It's just as you think about what's happened to the retail environment, we can't quite tell who's going to be where, who's going to have how many stores in 2020.

We're very confident that we have a very attractive proposition.

And if there is any form of retail contraction that occurs, we'll still get there on velocity.

No, that's helpful clarification.

I'm glad I asked the question.

I think that it's important to get that out there.

So let me ask a related question on the velocity momentum.

And Scott kind of talked about this earlier about the virtuous cycle of velocity help service, but there has been concern about out-of-stocks and fridge-holding capacity during peak shopping hours and the ability to seasonably grow scale as the coolers, the sales per cooler at that level given service levels.

Where are you now in terms of out-of-stocks, if you have any metrics?

How is it tracking?

And what's your view of how much higher sales can go in these coolers without jeopardizing sort of out-of-stocks and reaching a bit of a bottleneck on coolers?

Jason, so this is -- it's interesting because we've been facing this out-of-stock issue really for the past -- really since we've almost been in business.

So we've dealt with this and the irony of the situation is we've tried a lot of different things and it's gotten markedly better, in some cases, and not as -- we've made a little bit of progress here, a little bit of progress there, but we've kind of also lost some ground in a couple of cases, too.

Our average is -- the average fridge has about 6% out-of-stocks is the way to think about it.

Now that's not good and -- but if you were perfect at retail, you'd be about 3% out of stock.

Do we have out-of-stocks?

Absolutely.

Is it worse than a dry shelf stable product that you'd see out there?

Yes, it is a little bit worse.

Is it impeding some of our progress?

Yes, it is, and it's something that we're absolutely working on.

But the irony is -- also in this situation is, so we've doubled our sales over that period of time.

And then if we look at the fridges in the same chain where we do, I'll make up numbers for a second, but we do $200 a week and we're doing $400, $500 a week in the same chain.

The out-of-stocks seem to be at about the same level.

So we think this is something that's holding us back and there's opportunity, but we also know that there's incredible opportunity to kind of move forward even given the situation.

Now the thing that's nice is we're -- we think there's some potential breakthroughs.

But even beyond the retail piece, there are some other opportunities that we have to -- if consumers are running into this problem, they're finding alternative means in order to buy the product out there, whether it's something like an Instacart or dotcom-type product that's out there.

So that -- some consumers are actually solving it in that way.

Now that's not what we're really encouraging, but we know that that's a potential solution over time, too.

So we kind of see -- we see where we are.

We definitely are working on it.

We -- it's really frustrating to us.

We know that we will eventually kind of have a breakthrough.

And as the business gets a bigger, it's easier and easier for us to deploy different types of solutions to solve that problem.

So it's not just the total business, but on a per-store basis, it allows us to apply some different types of resources in that individual store as the business gets bigger.

That may not have made sense when we are doing $100 a store a week, if we're doing $200 a store a week, you can do some different things.

And I also just want to comment on the progress that has been made in that.

For example, Scott highlighted the out of stock is about 6%, that's what we're seeing now.

That's what we saw a year ago.

That's what we saw 2 years ago.

Yet, we're doing it at a higher velocity.

Velocity in [cross] -- some of the classes of trade this year is up 15%.

You'd expect that if you were growing at that rate of velocity growth, you'd see significantly more out-of-stocks than you are.

But we're actually doing -- the stores are doing a better job of servicing it and we're getting a little bit better coverage.

But as you grow, and you grow as fast as we are, you're racing to keep up.

So 6% is not a good place to be.

We'd rather be much better than that.

We're working on a lot of things to do that.

But the progress that we've made has kept that from becoming a bigger number even as we've increased the velocity.

One last question and I'll close it out.

Do you have any data on the interaction between consumer and the Blue Buffalo consumer?

And how are you thinking about the potential impact, if at all, of Blue Buffalo's expansion into mass-retail channel?

So we've lived in the same channel as Blue Buffalo for a number of years.

And over that period of time, we've doubled and tripled our business in pet, at the same time they've had incredible growth rates.

So we've actually seen a fair amount of synergies with participating and competing with them in the same format.

We've also seen a lot of pet specialty entries, none this size, but them come into grocery and mass over time.

There's a larger one this year.

We definitely kept a close eye on it.

It -- our business has really had nice performance this year regardless of that.

We do see strong interaction with Blue Buffalo, but it's not necessarily a replacement purchase.

Many times, it's an additive purchase between the 2 businesses.

But the thing that we think is really the greatest benefit potentially is, 80% of our business is done in grocery and mass.

And if they do come into grocery and mass, there's a real opportunity for them to bring additional traffic into the store.

As they bring additional traffic in, we think that there could be some really nice upside potential for us in many of those places that they're going to be distributed.

So it's -- I mean, the other thing is we know what our store number is and we're making nice progress in that through the year.

So it looks like it's going to be a really big launch and really different than I think what people have anticipated.

But I think that we could be a terrific partner at retail with them.

(Operator Instructions) Our next question comes from the line of George Kelly with Imperial Capital.

A couple of questions for you.

So first on the returns on advertising spending.

Wondering if there's been a deterioration at all since you started really ramping advertising spending in the first half of this year?

No, actually, there hasn't been.

We've actually seen -- we're trending slightly ahead of our model, just slightly ahead of our advertising model than what we planned and actually what we've seen in prior years.

So we're really encouraged by that.

Part of it has to do with the media planning and buying.

The other piece of it is the creative and the productivity that you can get out of the creative.

But we've been able to track slightly ahead of that, and we're really happy to see that because sometimes when you do spend more, you get diminishing returns, as you mentioned.

Wow, that's outstanding.

So and is that -- so you -- that's exceeded expectations.

You went through the math on the call during your prepared remarks of the incremental EBITDA that you're investing back into growth.

Is any of that incremental spending related to advertising or how are you allocating that?

At this point, we're -- if we do invest additional in media, it would be very modest.

There's going to be a couple of other testing and business development opportunities that we'll be investing in behind that.

So at this point, we don't anticipate significant investments and incremental investments in the -- in our marketing -- advertising.

Okay.

Got you.

And I take it you're not giving out any additional details on what those business development investments are?

Yes.

I don't -- right now, I don't -- they're small enough where they're things that probably aren't relevant to the overall success and they're things that we're working on for more '18s and '19s to -- in order to be prepared and really well positioned to, hopefully, exceed growth into the future.

And some of them is also our investments in efficiency improvements to help get the profitability that we want to have over the long haul.

So it's going to be a balance between both growth-oriented as well as profitability-oriented investments.

Okay.

And then next question on fridge productivity.

If you were to take your top -- I'm just throwing out a number, maybe it's 10% of fridges or maybe it's 25%.

But what -- how much more -- what's the velocity improvement over your average fridge with the top-performing group?

That's actually a really good question.

We actually track -- we'll do a lot of different detail on tracking same-store sales by -- we've done it by fridge type.

We've done it by length of time in fridges.

And we see very, very consistent growth across every different variable that you can imagine.

So whether it's fridge size, whether it's retailer, whether it's length of time in where a fridge has been placed, year after year, we're seeing really strong same-store sales growth.

So one of our largest retailers, for example, we -- where we have many years of history, we've been able to see well over 20% same-store sales growth in fridges that have been there for 2 and 3 and 4 years.

So it's a really good question, and it's an important thing for us to think about, but it's another one of those things that definitely show us the potential of the business and the productivity of the advertising.

And that the best time to put a fridge in for Freshpet is yesterday, we like to tell retailers.

But it can really be a slam-dunk success if they put it in there earlier.

Okay.

And then last question is just on pet specialty.

Did I hear you right that the overall specialty segment, the smaller segment of your business grew 9% in the quarter?

And have you heard just anecdotally, do you think that, that channel is improving or did you vastly outperform the overall traffic in the channel?

You heard correctly that our net sales in the quarter were up 9% in pet specialty and we did vastly outperform the category.

The data that we've seen we've now just transitioned from IRI to Nielsen, so we have visibility on pet specialty a little bit better.

And the category there was down mid-to-high single digits over that same period of time.

So we dramatically outperformed the category.

Thank you.

Ladies and gentlemen, there are no further questions at this time.

I'd like to turn the floor back to management for closing comments.

We appreciate your time and interest, and look forward to talking to you again at the end of Q3.

Thank you.

This concludes today's teleconference.

You may disconnect your lines at this time.

Thank you for your participation.