Freshpet Inc (FRPT) 2017 Q3 法說會逐字稿

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

At this time, all participants are in a listen-only mode.

A question-and-answer session will follow the formal presentation.

(Operator Instructions).

As a reminder, this conference is being recorded.

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

Thank you.

Good afternoon, and welcome to Freshpet's third quarter 2017 earnings conference call and webcast.

On the call today 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 annual report on Form 10-K filed with the Securities and Exchange Commission, and the company's press release issued today for a detailed discussion of the risks that could cause actual results to differ materially from those expressed or implied in any forward-looking statements made today.

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.

And with that, I'd like to turn the call over to Billy Cyr, CEO.

Thank you, Katie, and good afternoon, everyone.

To begin, I'll provide a brief overview of our financial highlights and recent business performance and then offer some commentary on the industry.

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 our operational and financial results for the third quarter.

Our business continued to respond 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 guidance we established at the end of Q2.

Further, we began to realize the returns from our manufacturing efficiency improvement efforts in the quarter, an important part of the virtuous cycle.

In total, the third quarter results provide continued evidence of the effectiveness of our strategy and 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%.

Our third quarter results continue to affirm that we are on track to deliver our longer-term goals.

The momentum we established during the first half continued into the third quarter, as net sales grew 19% compared to the third quarter last year and sequentially versus Q2 despite our planned lower second half advertising investment and the temporary impact of the hurricanes.

In essence, the business proved how sticky it is, as we were able to retain the pet parents who joined the franchise in the first half and then add a few more with the smaller media investment we made later in Q3.

Our growth was broad-based.

The fresh refrigerated consumption was more than 21% versus a year ago in the quarter.

The greatest fresh refrigerated growth was in grocery, where Nielsen measured consumption was up more than 29%, and mass was up more than 22%.

Even in pet specialty, where the category was down 8 points, our business was up 7%.

Pet specialty accounted for 16% of our business in the quarter.

We did experience about 200 basis points of drag from our baked product.

That simply highlights the strength of our core fresh refrigerated business.

This growth was largely the result of continued increases in household penetration and buying rate behind the advertising investment we have made year-to-date.

This resulted in velocity increases that continue to be the primary driver of growth, contributing about 75% of the growth in the quarter.

This is in line with what we would expect based on the advertising investment we made and the increase in our new fridge placements, and we expect it to continue to be the most significant contributor to our growth going forward.

Adjusted EBITDA for the third quarter increased versus the previous period and the year-ago period due to the benefits of higher net sales, added scale, the strong performance by our manufacturing team, and, when compared to the previous quarter, the reduced advertising investment.

We believe we are well-positioned to exceed the adjusted EBITDA guidance we gave you at the beginning of the year.

One of the biggest drivers of adjusted EBITDA growth for the quarter was a strong sequential improvement in adjusted gross profit and margin.

Adjusted gross profit dollars increased $1.3 million, and our adjusted gross profit margin was 50.9%, up 180 basis points versus Q2.

The key drivers of this improvement were throughput and yield increases made by our manufacturing team as we further optimize our new lines.

This performance gives us added confidence that we can hit both our near-term goal of a 1.5-point increase in adjusted gross margin run rate by the end of the year, and a 3-point increase by 2020.

That improvement in adjusted gross margin is a critical part of our virtuous cycle business plan, where we invest in increased advertising to drive velocity gains that will support distribution expansion, resulting in economies of scale that can help fuel incremental marketing investments.

Our net store count at the end of the quarter was 17,650, an increase of 293 net new stores in the quarter.

During Q3, we added more new stores than we've added in any quarter since the first quarter of 2015.

These included 214 stores in the chains representing the top 10 grocery mass retailers in America.

Leading retailers are clearly recognizing the benefits of the rapid revenue growth and higher profit margins that Freshpet offers and are choosing to add fridges when they open new stores, remodel stores, or decide to make major category changes.

Many of our conversations with retailers have shifted from how do I find space for a fridge to I want to build my set around premium brands, and Freshpet is a critical part of that.

However, we are also experiencing a significant increase in the number of store closings this year as certain retailers go through bankruptcies or close under-performing locations.

Year-to-date, we have recorded 209 store closings, 120 more store closings than we experienced in the prior year-to-date.

As you would expect, approximately 75% of those closings were in smaller chains and independents, who tend to have the lowest sales per store.

The largest number of losses came in independent pet stores.

Only about 25% of closed stores were from chains amongst our top 10 grocery and mass retailers.

I think it is important to note that when a store closes, the volume does not go away.

Most of the volume bought in those stores moves to neighboring stores, oftentimes to better-performing stores where we already have a fridge.

We are reiterating our net store target for the year, but that is, in part, depending on how many potential store closings we experience in Q4.

We are confident in our ability to add stores and continue to increase velocity, regardless of future store closures, behind our stepped-up advertising investment, and we remain focused on further increasing household penetration as our primary business driver.

Finally, I want to comment on the evolving competitive environment in premium pet food.

As most of you know, there have been certain brands that have shifted their distribution from pet specialty to grocery and mass outlets over the past year, and we expect there will be more.

To date, there has been very little impact on our business.

We have not lost any distribution, our growth trends have continued uninterrupted, and retailers remain very interested in increasing their engagement with our brand.

These results reaffirm for us that Freshpet is a highly distinctive proposition for both the consumer and the retailer, and that it is well-insulated from competition.

We also believe that, longer-term, the arrival of these other brands in grocery and mass will lead to increased premiumization of the category across all retailers, a phenomenon that is good for our business.

Going forward, we remain confident that we have a winning strategy and winning brand that positions us well for the foreseeable future.

In summary, we are pleased with the progress we made against our Feed the Growth strategy in the quarter.

We continued our strong growth, demonstrated an ability to reduce cost and increase margin, and proved that our strategy and business model are well-insulated against the ever-changing retail and competitive environment.

This further strengthens our confidence that we can rapidly scale Freshpet into a meaningful business with strong profitability.

Now, here to discuss our results in more detail and provide a view for the balance of the year is Dick Kassar, our CFO.

Thank you, Billy, and good afternoon, everyone.

As Billy indicated, we grew net sales for the quarter by 19% versus a year ago, to $41.2 million.

The growth was broad-based and consistent throughout the quarter, with all major product segments and channels growing significantly.

Additionally, despite going dark on TV media at the beginning of June until mid-August, we were able to maintain the consumers who joined our franchise in the first half of the year, and grow revenue sequentially quarter-on-quarter.

In fact, we actually saw a small amount of sequential growth due to digital media spending during the time our TV was off-air, and then saw virtually the same rate of growth resume as soon as TV went back on air in the second half of the quarter.

This continues to validate our products and proposition are highly appealing and deliver one of our greatest strengths, our 71% repeat rate that enabled the sequential growth we generated in the quarter despite reduced media spending.

As we look at our growth trends for the year-to-date, we are encouraged by the steady increase in consumption growth.

The first quarter consumption growth of our fresh product in Nielsen's xAOC, which does not include pet specialty, was 23%.

The second quarter increased to 26.7%, and the third quarter, until the hurricanes disrupted customers and consumers in Texas and Florida in late August, was running at 27% growth, and continued at that rate of higher outside of Florida for the balance of the quarter.

By mid-October, as customers and consumers recovered from the floods and power outages, we had resumed our level of measured growth nationally.

Thus, we are confident that we will exceed our guidance of $156 million in net sales for the year.

The adjusted gross margin profit is the highlight of the quarter.

Last quarter, we discussed the short-term impacts to adjusted gross margins as a result of key testing designed to increase throughput.

In quarter 3, we began to reap the benefits of the testing and demonstrated the ability to produce a significant increase in volume from our existing staffing levels, which has enabled us to delay the addition of another shift until early next year.

Additional testing designed to improve yields conducted in the first half of the year were successful, and we improved yields on our Fresh From the Kitchen line over the past 5 months.

That has also helped the adjusted gross margin.

As a result of those efforts and other continued improvements, we generated adjusted gross margin of 50.9%, up 180 basis points from quarter 2. We remain confident we can deliver a 51.4% adjusted gross margin quarter 4, or 1.5 points of improvement during fiscal year '17, and we are on track to deliver our 2020 goal of a 3-point improvement in adjusted gross margin.

We expect that the adjusted gross margin progress will continue to be a bit lumpy going forward, particularly as we grow into a new shift in the plan to support higher volumes in early 2018.

In addition, our team will continue to test and learn to achieve the productivity improvements designed to help us deliver our long-term goals.

Adjusted EBITDA was $5.5 million for the quarter.

This is a step up versus a year ago and quarter 2, and is largely the result of higher net sales, planned lower media expenditures than the prior period, the added benefit of scale, and the improved adjusted gross profit.

For perspective, in the quarter, we spent $4 million on media, mostly in the back half of the quarter.

That spending was down from $4.7 million we spent in quarter 2, but well ahead of the smaller media spend we have slated for quarter 4.

Additionally, we did experience and will continue to experience some modest near-term increases in freight costs due to higher fuel costs, warehouse labor, and a shortage of trucks due to the increased demand of the relief efforts in the Gulf States.

Year-to-date, we have delivered $10.6 million of adjusted EBITDA.

Due to the expected higher net sales and lower media spend in quarter 4, we believe we are on track to exceed our adjusted EBITDA guidance for the year of $16 million.

We continue to expect a strong fourth quarter of adjusted EBITDA.

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

Focusing on our balance sheet at September 30, 2017, the company had cash and cash equivalents of $2 million, compared to $1.7 million at June 30, 2017.

The increase in cash is primarily due to growing net sales and improved margins.

As of September 30, 2017, we had $5.5 million outstanding, with $24.5 million remaining from our credit line.

For each of the last 2 years, we have generated positive cash flow from operation and expect this trend to continue into 2017.

Also, as we previously announced, we have amended our credit facility to replace the primarily term-based existing facility of $30 million and $10 million revolver with a straight $30 million revolver and expansion features, including an additional $10 million, which extends through September 2020.

This amended facility will provide greater flexibility, lower rates on the unused portion, and lower fees on the unused portion than the previous arrangement.

In summary, we feel very good about our progress thus far this year and are on track to exceed our most recent net sales guidance of $156 million and adjusted EBITDA guidance of $16 million.

That concludes our financial review.

We will now be glad to take your questions.

Operator?

At this time, we will be conducting a question-and-answer session.

(Operator Instructions).

Our first question comes from Rupesh Parikh with Oppenheimer & Company.

Please proceed with your question.

Maybe to start out with a housekeeping question, is there a way to help us understand or quantify what the impact of the hurricane was for the quarter on the sales line?

Yes, we think of it as -- this is Billy.

Rupesh, think of it as about a 2-point impact on the growth rate in the quarter.

So we reported 19; you could assume we might have been somewhere in the neighborhood of 21 in the quarter if we hadn't had the impact of the hurricane.

Okay, great.

And then I guess my main question -- as you look at your longer-term targets out there, you had said that the retail backdrop is challenging and maybe you see store closures persist for maybe for several quarters.

I'm just curious if you guys still feel confident in being able to achieve those targets in that type of environment.

We definitely do.

As you saw in the quarter, the gains that we made -- even in the face of a fairly significant number of store closings, the gains we made were velocity-driven, and we expect that to continue going into the future.

The model that we're building is increasingly becoming a velocity-driven model, and we think that will sustain us for quite some time, so we're not particularly worried about it.

And particularly when you think about it, it's the stores that are seemingly most vulnerable are the smaller or the lower-performing stores, so we're fairly well-insulated.

They're not huge impacts.

They impact the number of stores more than they impact the volume.

Our next question comes from Peter Benedict with Robert W. Baird.

Please proceed with your question.

First, I just want to start with the media spend.

I mean, you said, I think it was, 4 in this quarter versus 4.7 in 2Q.

Can you remind us what you spent in the first quarter and then what the plan is here for the fourth quarter?

Yes, we spent $5 million in the first quarter, Peter, and a real small amount in the fourth quarter, around $300,000, $400,000.

Okay.

And, I mean, I know you guys aren't talking right now to '18, but how should we think, just high-level, about what your thoughts are in terms of the incremental media spend?

I mean, clearly the velocity response I guess has been certainly at least as good as what you thought, and you've added probably $5 million incremental year-over-year, or something in that area.

How are you thinking right now about '18?

Or when do you guys expect to give us a sense of what you're thinking for '18 in terms of incremental media spend?

Well, first of all, your premise that we feel very good about the impact of the advertising is right, and that gives us confidence that as we look at 2018, we'll certainly lean on the advertising pretty hard.

In terms of the specific amount and when we'll be able to talk about that, we're still working through that, and our current plan is that we'll be out sometime at the -- when we release 2017 final results in March, we'll be able to talk to you a little bit about what we'll do in 2018.

Okay.

Thanks, Billy.

And then I guess, Dick, one other for you just around -- what are your thoughts here around the CapEx plan for the year?

I think you've already spent more than $10 million.

I think that was what we at least had had for the year, but what is the CapEx view for this year?

What are you spending it on?

And maybe any longer-term thoughts would be great too.

Thank you.

Yes, we're expecting about $11 million to $11.5 million by year-end.

It would be on fridges and some maintenance CapEx.

Our next question comes from Jon Andersen with William Blair.

Please proceed with your question.

With respect to consumption, could you talk a little bit more about what you're seeing in terms of the household penetration versus the buying rate?

I know you mentioned, Billy, both factors are driving the strong consumption.

Can you talk a little bit about where you stand with respect to penetration and what you're seeing in terms of uptake in the buying rate, what the principal driver is here?

I would say that we're seeing fairly balanced growth on both sides.

We won't talk about specific numbers at this point, because we tend to look at those on an annual basis, and when we look at them on a quarterly basis, we're just not as comfortable with the reliability you get on a quarter-by-quarter basis.

But suffice it to say, the data that we've seen so far and the data that's publicly available would support that we're getting growth on both the household penetration and the buying rate, and it's in line with what we would expect if we were on our way to delivering our long-term goals.

You can get to the 2020 goals, doubling the penetration, keeping the buying rate the same or taking the penetration up, call it 50%, and getting the buying rate to go up a commensurate amount, and that gets you in the same place, and we think we're going to end up with a balance of the 2 that'll ultimately get us to our 2020 goals.

But both of them are moving, and the behavior -- it's a consumer behavior that we feel very good about.

We want to attract new people, but we want the people who are in the franchise to find ways to use the product at an increasing rate, and we're seeing both.

And are you finding that the incremental media spending that you're doing, that you've done this year -- is that tilted more towards traditional or tilted more towards digital media?

And where do you think you're getting kind of the greatest return at this point?

Hey, Jon, it's Scott.

The majority of the spend is still in traditional media, and we've continued to evolve that, and the way we're spending it in more traditional means through TV, but we also had the greatest increase in our digital spending this year, in addition to an increase in social media that we've invested behind.

We fully understand the shift in the marketplace, but we're continuing to get great returns in the traditional media, along with very similar types of payback in digital, and we have a lot of confidence that we can continue to both expand the TV and digital and get similar rates of return into the future.

Great.

Last one for me is just I know you've made some changes to your kind of distribution or your merchandising approach with a relatively new partner, I believe.

How are you feeling about kind of service levels in stock in-store, the progress you're making there, and any additional work that needs to be done?

Thanks.

So every year, we make minor modifications and changes in our retail coverage.

It's one of the pieces that we feel like we have opportunities around to continue to improve.

We're continuing to test different ways to improve retail conditions.

We're seeing some progress, but not what we would -- not as much as we would like to see.

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

Please proceed with your question.

Just quick housekeeping.

As I understand it, I think you guys are among -- if not the shared leader in Whole Foods.

I'm just curious if you can talk at all about what you're seeing there, as obviously we've heard of traffic spikes there precipitated by lower pricing from Amazon.

I'm just curious if you're seeing any lift there, anything worth mentioning.

We are seeing a slight uptick there, but it is a smaller piece of our business, so it's not having as much impact in the overall results.

But definitely we're seeing a little bit of an uptick.

We like the progress.

We like what we're seeing at Whole Foods, and really, quite honestly, we like what we're seeing pretty much across all of our retail customers.

Thanks, Scott.

And then just thinking about -- I mean, I think it's implied by the data and the panel data that's coming in, but I'm just curious what you guys are learning about your more recent adopters here, because obviously we're seeing household penetrations spike, and that's commensurate with the increase in advertising spend.

The dollars per buyer seem to be going up, which would certainly imply that your early adopters are increasingly reliant on the brand.

I'm just wondering if that sort of matches your own internal work and what you're learning about folks who have come on, not just in the past 6 months, but maybe 9 to 12.

So, Brian, we've continued to watch people come into the brand over time, and we see a very consistent introduction to the brand, trial, and then repeat.

And what we believe is driving our buying rate is not necessarily the new users.

It's the people that have been with the brand for a longer period of time that are having a really positive experience.

Typically, the people that are buying the brand first time in, we get great repeat rate, but it does take a while for them to kind of come up to the usage level that we're seeing of the existing user base.

Okay.

Thanks.

And then maybe this is tied into that question, but I'll get out of here on this one.

As you think about the marketing cadence for next year and how much you want to spend as a percentage of sales -- I guess you're targeting 9 by 2020.

What are you seeing this year as far as the growth in household penetration sort of relative to your expectations?

Because, obviously, you're well on your way on the revenue side, as Dick referenced in his prepared remarks, but I'm just curious if it's the mix that you expected to happen, so, i.e., early adopters increasing their usage and their reliance and the amount of new adopters coming in, because I would suspect that your marketing spend is maybe more -- and I could be wrong, and you can correct me -- is more aimed at bringing in new customers as that repeat rate, the quality of the brand and the user experience is what's sort of bringing them along.

Once you get them in, you can keep them in, but it's about getting that new customer, so I'm curious how successful you feel that part of the equation has been and how that sort of informs the way you think about spending going forward.

When we put the model together -- and the nice thing about this is we have a lot of history in doing this.

We've been doing this for 4 or 5 years.

This is the first year that we've done it at the level of investment in advertising that we are currently spending this year, but it's been very, very consistent year-after-year.

The thing that we modeled out was a little bit -- very consistent with the penetration increases that we're seeing kind of quarter-to-quarter.

The thing that's been a pleasant surprise is, typically when you see -- you drive penetration, your buying rate can basically hover at the same level or slightly go down because you're pushing new people into the brand.

What we've been able to see is both of those going up at the same time.

So that's been a little bit of a surprise, is that buying rate has been able to increase at the same rate that -- at the same time the penetration rate has grown.

And it's just a -- look, it's what's giving us that slight bit of upside from where we anticipated.

We feel really good that we're able to see those 2 metrics work together.

And Brian, I would go on to say that when we embarked on the plan this year, we had a pretty good idea where this was going to take us, but we also wanted to be able to see it so we could make some adjustments as we head into 2018, and what we've seen and what we've learned gives us increasing confidence that we can move both metrics, but we think we can get to our -- we can get to the goals that we need to get to, even if we're just driving the household penetration side.

The fact that, as Scott said, we're getting the buying rate to go up at the same time, it makes that task that much easier, and also it confirms the stickiness of the brand, in essence.

The consumer satisfaction with the product is so high, that once you get them to try it, they stick with it, and that's really the essence of our strategy.

There are a lot of moving parts, but that, in the end, is the core of the strategy.

Our next question comes from Robert Moskow with Credit Suisse.

Please proceed.

I have just a couple quick ones.

The first is Kroger, I think, said on its call that it's going to expand its shelf space to the pet food category.

I want to know if you're going to benefit from that and if you've had some conversations, I guess, with that retailer.

Also, Walmart is doing better.

I would hope that maybe that's another one of the elements of your bullish commentary about the grocery trade.

I know you don't want to talk about them specifically, but maybe you can talk about them kind of broadly.

And then, lastly, just to make sure I understand the language correctly, I think last quarter you also said that you would exceed these dollar sales numbers, exceed $156 million, and then also exceed the -- I think it was $16 million for EBITDA.

Are you raising beyond what you said last quarter, or are you just saying we continue to believe that we can raise beyond those numbers?

We're reiterating the number that we had, but it's a number set that we will exceed those numbers.

We just don't feel like it's a good or a productive exercise at this point for us to be more precise than that at this point.

But in relation to your questions about the key retailers you highlighted, Walmart and Kroger -- obviously, we won't talk about the specific decisions that they may be making going forward, but what I can tell you is -- and the data that we've gotten so far is that we are doing very, very well with each of those retailers, and the data we have has our growth rate with them north of the average growth rate we're seeing for the total business.

Obviously, that's going to be true of most people in the grocery and mass category, because specialty would be on the lower end, and the weighted average gets us up to the numbers that we're reporting.

But we feel very good about the trends, and, frankly, they're feeling very good about our business as well.

The pace with which you add stores is obviously a function of many broader strategic decisions that each of those retailers will make about the role of the category, how they're planning their stores, how much money they're putting into store renovations or store improvement, but suffice it to say that I think both of them are very happy with the results that they're seeing, and we'd expect to be a key part of their changes going forward.

And Billy, I think it might have been last year where most of our discussions were about some of the obstacles that had popped up in terms of getting new refrigerators into some of these major chains.

Are you seeing some of those obstacles kind of fade away a bit?

I'd say that it still remains a pretty important challenge for our sales organization to get the fridges placed.

Remember, we talked about the obstacles being a lack of space.

Some of the retailers were concerned that the product might be appropriate only for certain of their stores, not for all of their stores.

And I think what I would say is they still have the space constraints they have, and they've added a new issue, which is how much capital do they want to put into their stores, meaning remodeling, reorganizing their stores, when so much of the business is moving towards e-commerce.

Kroger and Walmart, for example, have indicated they're spending a ton of money on building out curbside programs and less on the sort of inside-the-box programs.

But the other part of that challenge was convincing the retailers that this was a proposition that works for a wide range of consumers in a larger number of their stores.

I think we're convincing them this year with the growth rates they're seeing and the breadth of the success we're seeing, so that's really not as big a concern any longer.

I think that they're starting to become convinced that this proposition is much more mainstream than you might think.

It didn't eliminate the other challenges, but it does make it so it gets easier to get through that part of the conversation.

That's what my comments meant.

I think the retailers have gone from saying, gee, I don't have space for this, to saying I really want to build a premium pet food section, and in building a premium pet food section, you're going to be a key part of that.

And remember, that's not just us.

That's a variety of external factors that are also working in our favor too.

There's a lot more opportunity and activity that's related around the premium part of the category.

Our next question comes from Jason English with Goldman Sachs.

Please proceed with your question.

I guess I'll build off of the last comment you made, Billy, in terms of maybe one reluctance for retailers being to spend the money behind refurbishing some stores and arguably making some space for your coolers.

Is this the reason that you're CapEx is tracking above what you had expected, especially given that you're kind of adding net fewer new units than we thought, or is there another factor at play?

Well, we've added a lot more stores than the net differential that we're showing, and when a store closes, we take that fridge back for refurbishment, and when the new store comes in, we're spending an average of $3,500 for a new store.

So even though our net store gain is sitting -- our net store gain for the year is estimated at 1,600.

Our gross store gain is approximately 2,000, and reintroducing those stores with our refurbished chillers is something that will benefit us long-term, but it doesn't necessarily happen at the time the store is closed.

Got it.

So it's not like the cost of the fridges that you're placing is going higher or the cost to actually place them is going higher.

It's just a mix of new units net of the ones that are being brought back.

Yes.

Absolutely.

And I would say also, though, Jason, as you think about us moving forward, one of the things is the velocity improves in a store.

We would love to see the retailer move from a smaller fridge to a larger fridge, and that, of course, wouldn't change the store count, but it would change -- it would involve some CapEx, and so you'll see some of that as we drive velocity.

Totally.

Makes sense.

And then SG&A up a little bit north of $4 million.

I think you chalked up around $2 million to higher marketing.

You mentioned higher freight costs, but freight cost doesn't look like it's big enough to drive the bulk of the remainder.

What is the bulk of the remainder that's caused the non-marketing or non-media step-up in SG&A?

Incentive comp.

That's a high-quality problem.

Okay.

It's the versus the prior year, Jason.

That's why, incentive comp.

Got it.

That makes a lot of sense.

And last question, Billy, you mentioned that despite sort of the encroachment from some new competitors at retail, which is only likely to build as we flip the calendar into next year, with shelf resets more broadly -- you mentioned you're not really seeing an impact on your business overall.

Can you delve a little bit deeper and talk about how your performance in stores where you've seen the new competitors come in compares to the stores where you haven't?

Obviously, it's still relatively early in that game, so we're looking at the data as frequently as we can get it from the retailers or through Nielsen, but what I'd say is, first of all, we haven't lost fridges, so as the new competitor comes in and puts in fairly large sets in the customers that they're using as their initial launch customers, we aren't losing our fridges in the stores, so that's the first part.

The second part is when we look at the growth rate that we have in the stores where the new competitor shows up versus the stores where they're not, we're not seeing a measurable or noticeable difference in the growth rate that we see in those stores, and so we're feeling pretty good that the consumer behavior, the consumer traction that we get against our brand, is not being hurt.

We actually would expect that, over time, it might actually help us, because it's bringing the right kinds of consumers into those stores, and we do believe we have a very attractive proposition.

But at this point, again, being relatively early in the game, we're not seeing a measurable difference between our performance in stores with them and stores without them.

Our next question comes from George Kelly with Imperial Capital.

Please proceed with your question.

A couple questions for you, first on media spending, media advertising for the full-year.

Has your expectation for the level of spending changed at all since the beginning of the year?

No, it hasn't.

We've continually monitored it, but we ultimately are keeping the original plan in place.

Okay.

And then, secondly, on pet specialty, I'm wondering if the trend there changed at all in the third quarter or subsequent to the quarter, if it's just been kind of consistent with what you saw earlier in the year or if it has changed.

So, remember, we grew -- our reported sales growth in the second quarter was 9%.

In the third quarter, we're showing 7% in pet specialty.

There's a little bit of a wobble there because we have a distributor who takes shipment when they get them, but if you look at it on a consumption basis, we're seeing pretty consistent 7% -- roughly 7% growth during the quarter and since the quarter ended, so we're feeling very good about the consistent pattern there.

Our next question comes from Mark Astrachan with Stifel.

Please proceed with your question.

Dick, I wanted to ask a bit of a housekeeping question first.

Can you just remind us what the run rate CapEx is?

I guess maybe thinking about it on a maintenance basis, you mentioned the cost per fridge, so that doesn't sound like it's changed.

Sort of how do you think about -- or how should we think about modeling the non-variable piece, meaning the non-new-fridge growth going forward?

Well, first of all, the maintenance on fridges is expensive, and it's sitting in SG&A for the most part.

If we're changing a compressor, we may capitalize, but that's immaterial.

Maintenance CapEx for this year is around $2.5 million.

The balance of the CapEx is primarily fridges, and as I said earlier, it's more than the number of stores that we gain for the year.

It's on a gross basis.

Got it.

Okay.

So basically, going forward, it's the maintenance piece plus whatever new fridges you're going to be adding, effectively.

Yes.

Exactly.

Okay.

All right.

And then I wanted to go back to some of the other questions folks were asking and maybe do it in a bit of a different way.

How do you guys think folks are using Freshpet at this point?

Do you think it's becoming the product that pets are consuming?

Is it still being mixed with other products?

Have you noticed any change in whatever folks are mixing there?

And any sort of thoughts on sort of how you want to see the product in the future?

Hey, Mark, it's Scott.

So it's been really consistent to what we've seen in the past.

Typically, when people come in, they are initially using it as a mixer or a topper that they're mixing in with dry food, which is fairly logical, but what happens over time is that the majority of people continue to move further and further into the brand, and the ratio becomes a higher and higher amount of they're feeding Freshpet to dry, and over time, one of the biggest pieces of our volume is actually people that use us exclusively.

Now, it's not a tremendous number of people, but there are a lot of people that generate a lot of volume where they're using Freshpet exclusively as their pet's meal and then potentially mixing a little bit of dry in as a crunch or a topper.

So the reason for that is it's typically the product performance.

You get great palatability, and people are really happy with the experience that they have with the product overall -- the handling, the smell, and the response from their pet.

So that's typically the progression that we see, is where people come in and they're mixing, over time they feed more and more, and then a lot of people will actually feed it exclusively over time, and we -- obviously, that's terrific for us.

And we're continuing to see new people come in and use it that way and transition into the brand.

Got it.

And so if you think about the velocity per store or just the overall velocity acceleration, how do you parse it out between those that are new to the product, that are trying it out, that are on the sort of lower end in mixing end of the spectrum versus those that are using it more?

I mean, what is driving the acceleration, as best you can tell?

The acceleration on a per-store basis?

Yes, I mean, just overall.

Obviously, it's going up, so that means that they, presumably, like it.

Yes, so if you think about it in the existing stores that we're in, basically what we're seeing is we're seeing more people come into the brand, and as those people come into the brand, they're -- even if it's a new store or an existing store, they're discovering it, and they're coming in and they're buying it, and then what we're having is people that have been in the brand and using it for a period of time are now buying more, and the result is a higher level of velocity in the existing stores.

So we have kind of both aspects working for us.

We have the penetration with more consumers.

In addition, we have the buying rate increasing too, and that is resulting in the velocity increases.

We think, over time -- we certainly hope buying rate continues to increase and surprise us on the upside, but we believe, over time, that the focus in advertising, both this year and then going forward over time, will drive the penetration rate higher and continue to see these great velocity increases that we're seeing in same-store sales.

Got it.

And just lastly, following up on that, it sounds like you've got pretty good data as far as who's purchasing what, so those newer consumers to the product, how do you follow up with them and make sure they become heavier users?

We have our own panel of several hundred people that we continue to cycle through, and we're always making sure we have samples of new consumers in, but we also utilize that supplement that with panel data that's out there, which is always a really good resource.

And then thing where there's amazing, amazing information is the retailers POS shopper card data.

The amount of information that you can kind of garner and understand in shopper behavior from there is tremendous and really kind of second to none.

And Mark, I think it's also important to note that one of the beauties of having such a strong product as Freshpet that drives the repurchase rates that we've got is that we can really spend our money focus on bringing people into the franchise for the first time because the product does the job the second, third and fourth time, as opposed to us having to provide promotional incentives or reminders.

Yes, the advertising gets seen by our existing users, and it does remind them to stay in the franchise, but the reality is the product is so good, it is what drives the repurchase rate, and our focus ends up being on bringing new people in.

Our next question comes from Pablo Zuanic with SIG.

Please proceed with your question.

Just two quick questions.

One, can you talk about the quality of the cooler expansion?

I understand that we're talking in terms of numbers of fridges, but one thing is if it's a Target type and a big fridge compared to a small little fridge at the bottom of ShopRite, so just talk about the quality of the cooler expansion and how much of the refrigerator expansion is actually -- are they more in the same store or expanding in the same store?

That's one part, and the second part is that -- going back to the competition question, I could bring that into three areas, right?

What's happening with, say, Instinct?

I see the Instinct coolers at PetSmart, but I don't see them at grocery for the most part, so as stores expand or add more coolers or add coolers to their stores, are you facing any competition there?

That's one way I would ask that question.

Two, is there any private-label threat?

I mean, are we going to see a Pure Balance type of refrigerated pet food at Walmart?

And three, I agree that as Blue Buffalo and other companies enter the -- that the retailers expand the natural section in the aisles and their pet food section, that's probably good overall for you, but when I go to a Target and I see Blue Buffalo putting all their little posters on your coolers pretty much telling people to go to the Blue aisle, I wonder how can that affect your brand.

So if you can touch on that, the quality of cooler expansion, and then that 3-part question on competition.

Thanks.

Okay, let me see if I can capture all that.

So from a cooler quality standpoint, the way we look at coolers -- there are multiple aspects.

One of the is size, but then the other one is actually location, and we really -- we actually grade those out.

So from a cooler size standpoint, it's staying consistent with the existing cooler base that we have installed.

So what I mean by that, if you think about the spread of large, medium and small coolers, the new coolers that we're putting in are a similar base.

Now, the really important aspect is are they going into really good stores or higher-quality stores, and we are actually going into very high-quality stores.

We also grade those out.

So we're going into kind of tier-1 and tier-2 stores is the majority of the expansion.

So we're happy with the quality of the coolers and also the types of retailers we go in.

The placement, you're right, we're not going into end-caps on Target.

There are only so many of those around.

But we are going into end caps in place -- and actually, we're better off in first position, which is another place we go into on a very often basis.

So, overall, with quality coolers, very consistent with the existing base that we have installed.

From a competition standpoint, you're right, Instinct is out there.

They've been there for many years.

That is a frozen, raw product.

It's a very nice product, and they're an excellent company.

They do a great job.

Right now, in kind of the mainstream kind of grocery and mass, we haven't entered into a conversation with anyone, and it comes up often, that's interested in doing anything from a raw standpoint, which is what the Instinct product is.

So we're not really concerned about that coming into kind of a mainstream proposition end.

They're actually not coolers; they're actually freezers going into grocery and mass at this point.

It could happen one day.

We exist with them quite well today, and we think we could exist with them into the future, but we don't see that as something in the near-term.

The next question that you asked was private-label.

I'd say for the past 5 years, every 6 months or a year, we get someone asking us a question about private-label.

It's something that's interesting and that we're always thinking about and evaluating and considering.

At this point, we want to really stay focused on building out our brand and our coolers and what the opportunity is.

The benefits to the retailer are really strong.

When we're getting to a point where we not only have size, but we also have growth rates, we're starting to get to a reasonably nice size and share within the retailers we're in, and we also have really great growth rate.

We're continuing to perform much, much better than the category average.

It can be a really productive conversation with the retailers around that.

And then, lastly, and I'm going through these quickly, but you had mentioned Blue at Target.

If you look at IRI or Nielsen data and you look at the performance of Blue at Target, they seem to be doing really well.

When you look at our performance, we've been very, very happy with the results that we're seeing at accounts where we are and Blue has come in.

We think that it might be a nice opportunity to drive traffic.

I would request that they don't put their POS on our coolers, so if you happen to see any of that, let me know, but we've been very happy with the performance that we've seen in the accounts where we're crossing with Blue.

But, yes, we'd rather them not putting their signs on our coolers.

Thanks.

That's helpful.

Just one quick follow-up.

I realize the focus is on the U.S., and you've said that the U.K. is more a test, but I was surprised that you have your coolers there at most Tescos (indiscernible) neighborhood, and they had a pretty big Freshpet cooler compared to what I would see at Walmart here.

I'm just trying to get a sense of what are you trying to do there.

I was surprised, again, by the distribution with Tesco and the size of the coolers, but it's not a priority right now, obviously, so are you going to pull out, and could that be a big source of savings down the road?

Thanks.

So when it comes to Tesco in the U.K., when we're doing a test, we want to do it similar to how we would enter the market.

So when we say it's something that we're testing, we are still kind of testing and evaluating that marketplace.

We want to put in a full-size cooler.

We want to have the right product mix and portfolio there that's available to consumers.

What we aren't doing is we're not spending -- we're spending at a very conservative level, at what we would call a test level.

It is in 300 stores in the U.K. now.

We've seen nice expansion.

We've been happy with that progress.

But cooler size doesn't necessarily represent, I think, the correlation to the investment that we're putting into the marketing, and I think that's really what we're referring to when we refer to it as a test market.

And I'd also emphasize that the decisions that we would make on markets outside of the U.S. are not digital decisions either yes or no.

I think you get in, you put your toe in the water, you try some things.

As they work, you do a little bit more, you invest a little bit more, you try some more things, until you get the model right, and at some point, you do put your foot on the gas and say now I'm convinced I've got everything ready to go, but there's a steady process or progress that you make from having a few coolers in a few stores with a few employees, and you build that base up until you get to the point where you're ready to go and you're convinced you've got the model right.

Our confidence is growing.

We feel better about it, but it still isn't to the point where we'd say it's a priority or something we would build into our longer-term growth goals.

But we do feel very optimistic about the progress we've made.

Our final question comes from Bill Chappell with SunTrust Robinson Humphrey.

Please proceed with your question.

Just one comment you had said about the lumpiness of gross margins and the new line coming on, is that going to affect the fourth quarter, or is that more next year?

That's more next year.

Okay.

So it shouldn't have -- go ahead.

No, Bill, I would just highlight one of the real key accomplishments of our manufacturing organization this year is they did a really nice job of figuring out how to get more throughput out of the existing staffing.

If you recall, earlier in the year, we had outlooked that we might need to add staffing to hit the numbers that we had, and we were able to get the throughput up to the point where that's now been pushed into next year.

It will be lumpy.

It will be a meaningful shift in the amount of staffing that we have, but we were able to push it back through some really good work that was done, and it's part of what gives us confidence in our ability to, long-term, driven the adjusted gross margin on this business.

Got it.

No, that helps.

And then just, finally, on kind of the state of the pet specialty.

I think you said the category was down 8%.

Is that something that curated during the quarter, or was it pretty steady at that level the whole quarter?

And then with that in mind, when you talk about store closings -- I know it wasn't necessarily pet specialty, but do you expect to see an acceleration of mom-and-pop closures as we move into next year?

Or kind of give us an understanding of how that plays out.

I understand that you have good exposure on all channels, so it's less of an impact, but just kind of what you're seeing.

So this is through the Nielsen IRI data.

We did see a little bit of acceleration in pet specialty declines through the quarter, which I think we were kind of feeling it might have leveled off, and that's not for us.

That's just generally for the category.

We actually had a nice quarter in pet, and we have -- it's really working well behind the advertising and the product mix that we have in there currently.

So the growth that's going on there seems to be kind of coming along well.

And the second part of the question I think was that --

You talked about store closures.

Just kind of is that a trend?

Oh, store closures.

Actually, yes.

Yes, that's right.

So the store closures -- I think next year, from what we're hearing, I think it will be more centered around mom-and-pop types of store closures.

The smaller pet stores I think are having a little bit of a tougher go.

I don't know if they've been able to kind of adapt as well.

I think they were -- they had slow traffic before, and now I think their traffic has kind of fallen off a little bit, and I don't think they've been able to adapt as well to kind of the newer marketplace.

Ladies and gentlemen, we have reached the end of the question-and-answer session, and I would like to turn the call back to management for closing remarks.

Well, once again, we thank you for your interest and attention, and this concludes our call, so thank you very much.

This concludes today's conference.

You may disconnect your lines at this time.

Thank you for your participation.