Freshpet Inc (FRPT) 2018 Q3 法說會逐字稿

Greetings and welcome to the Freshpet Third Quarter 2018 Conference Call.

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

It is now my pleasure to introduce your host, Katie Turner.

Please go ahead, Katie.

Thank you.

Good afternoon, and welcome to Freshpet's Third Quarter 2018 Earnings Conference Call and Webcast.

On today's call are Billy Cyr, Chief Executive Officer; and Dick Kassar, Chief Financial Officer.

Scott Morris, Chief Operating Officer, will also be available for Q&A.

Before we begin, please remember that during the course of this call, management may make forward-looking statements within the meaning of the federal securities laws.

These statements are based on management's current expectations and beliefs and involve risks and uncertainties that could cause actual results to differ materially from those described in these forward-looking statements.

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

Please note that on today's call, management will refer to certain non-GAAP financial measures, such as EBITDA and adjusted EBITDA, among others.

While the company believes these non-GAAP financial measures provide useful information for investors, the presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP.

Please refer to today's press release for a reconciliation of the non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP.

Finally, please note that the company has posted an updated investor presentation on its website prior to its appearance this week at an investor event in Chicago.

The presentation is similar to the presentation last provided by the company in September but now includes updated scanner and household penetration data that covers the third quarter.

The company does not intend to review the presentation on this call but believes it provides useful information on Freshpet.

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

Thank you, Katie, and good afternoon, everyone.

To begin, I will provide an overview of our financial highlights and recent business performance and then Dick will provide greater detail on our financial results.

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

We are very pleased with our third quarter top and bottom line results.

Our strong net sales growth enabled us to deliver significant operational scale gains that helped to offset lower-than-anticipated adjusted gross margin and deliver strong adjusted EBITDA growth versus a year ago.

Q3 was an inflection point in the development of our Feed the Growth strategy.

We were able to continue driving strong top line growth and began to show, for the first time, that we could simultaneously convert that into significant adjusted EBITDA growth.

We still have a long way to go to fully demonstrate the long-term profit potential of the business, but this quarter is an important step towards proving that we can grow into our scale and thus drive our profitability.

We continue to believe that our top line growth trend is sustainable, the scale benefits are expandable, the adjusted gross margin issues can be remedied, but it will take a bit of time, and the adjusted EBITDA will continue to grow with scale.

Dick and I will discuss each of those items in more detail.

Recall, our Feed the Growth plan is designed to accelerate Freshpet's rate of growth, enabling us to fulfill our mission of providing more pets with fresh, all-natural foods that enrich their lives and their relationships with their pet parents.

We're committed to doing so in ways that are good for our pets, for people and for our planet.

In the pursuit of our mission, we expect to deliver significant value to all of our stakeholders.

We will accomplish this by creating a virtuous cycle, where increased investment in advertising drives increasing scale that we can use to drive greater distribution, increased manufacturing utilization and efficiency and better leverages our organizational capacity.

We expect this will produce increased financial returns that we can use to drive further growth and long-term profitability, enabling us to serve more pets.

Our financial goal is to deliver $300 million in net sales as soon as 2020 with a 20-plus percent adjusted EBITDA margin.

Along the way, we expect to create significant scale gains that we can harvest for reinvestment in growing the Freshpet brand and ultimately, take some of those gains to the bottom line.

Our third quarter results confirm that we are on track to deliver the accelerated growth rate we expect in 2018, and we're progressing well towards our longer-term targets.

Our increased investment in advertising in conjunction with consistent distribution improvements and focused product innovation have enabled us to cycle last year's strong growth and deliver an acceleration in Freshpet's consumption growth rate.

In the Nielsen mega-channel, which includes grocery, mass, club, big box pet and whole foods, fresh consumption in the quarter was up 31%, an acceleration from fiscal year '17's 21%, Q1's 25% and Q2's 28%.

The consumption growth was broad-based with all classes of trade up more than 25 points versus the category, including our big box pet specialty business where consumption was up 23% versus a year ago for the quarter, while the category declined in mid-single digits in the channel.

Grocery was up more than 37%, mass consumption was up 28%.

Even our tiny but fast-growing e-commerce business including sales via curbside programs, home delivery via Instacart and Shipt and traditional e-commerce like FreshDirect and AmazonFresh more than doubled versus the year ago and now accounts for about 1.5% of net sales.

Encouragingly, more than 70% of the e-commerce sales supported our existing retail fridge network, meaning the consumer ordered the product online but chose to have delivery or pick-up from their local retail store.

We experienced strong growth across all package forms.

Growth was particularly strong on our bagged products, driven by continued growth on the Fresh From The Kitchen product we launched more than 2 years ago and by strong innovation on our roasted meals products.

Our roasted meals products grew at double the rate of the balance of the business, behind our new small dog offering, a beef version of our roasted meals and a new multi-protein product.

This shift towards our higher-value bagged items drove a Nielsen-reported 4.9% increase in retail dollars per pound on our core dog food products in the quarter, up from 1.1% growth in the year-ago period.

On our core fresh dog food, which consists of our rolls, roasted meals and Fresh From The Kitchen main meal products, consumption grew at the fastest rate, more than 34%, in part driven by strong household penetration gains behind our new product innovations.

Our core dog, dog food, household penetration was up 22% versus a year ago, and the total brand household penetration exceeded 2% for the first time, up significantly from 1.4% when we started Feed the Growth.

Further, velocity gains accounted for over 70% of our net sales growth, with average velocity gains of greater than 20% for most customers.

And even in the face of continued store closures, we grew distribution across the Nielsen mega-channel by 2.9 points of ACV or about 7% with a total of 445 net new stores.

At the end of Q3, we had 19,107 stores.

We've also upgraded 761 stores to larger fridges this year, with an additional 52 in Q3.

The combination of a 7% increase in ACV and better in-store presence resulted in an increase of more than 11% in total distribution points versus a year ago as measured by Nielsen.

Total distribution points is the product of ACV distribution and average SKUs in distribution and is a good proxy for the scale of our retail presence as we both add stores and increase the size and number of fridges in existing stores.

Net sales were up 27% versus the strong quarter a year ago.

The gap between the consumption growth rate of 31% and the net sales growth rate of 27% is due to the discontinuation of the baked business, approximately 1 point, slower growth in unmeasured channels in the U.S. and in countries outside the U.S. and normal trade inventory fluctuations.

This is the last quarter with any meaningful baked business impacting the year-on-year comparisons.

We had about 350,000 of baked sales in Q3 a year ago.

As I mentioned, our adjusted gross margin progress in Q3 was disappointing at 49.6%, down versus Q2 in the year ago.

This was the result of higher commodity cost in inbound freight, a planned increase in staffing cost to prepare for a 24/7 production schedule, some production issues that are the result of training so many new employees and a mix impact created by the rapid growth of our bagged products.

Dick will provide more detail on each of these items.

What I can tell you is that some of these issues are temporary, which is the incremental staffing and the production issue, and we expect to resolve them as part of our ongoing operating efforts.

The remainder of the issues, such as commodity costs and the mix impact, will require more comprehensive interventions that we are putting in place as part of our 2019 plan.

One area in particular I would like to comment on is the impact of mix on our adjusted gross margin.

As I said earlier, we have had tremendous success this year with some new bagged product innovations.

They are driving strong consumption gains, higher revenue per pound and higher penny profit per pound.

They're also driving a higher margin on our bagged products lineup versus our previous bagged product lineup but lower margin than on our rolls.

So while the rapid growth of the bagged products is having a positive impact on our total net sales generating higher revenue per pound, it's having a larger-than-planned negative impact on our overall gross margin.

It will also cause us to add staffing to convert 2 more lines to a 24/7 operation sooner than previously anticipated.

We are developing both near-term and longer-term solutions that will recover the gross margin impact due to mix, including pricing and operating efficiency improvements.

We are confident that we can get back on track versus our longer-term adjusted gross margin goals.

Importantly, this situation is the result of stronger-than-planned successes on our product innovations and demonstrates our ability to command higher prices per pound.

For most people, that is a high-class problem, better-than-expected sales and increasing price premiums with a modest issue on margin.

No matter how you think about it though, we have a plan in place to fix it.

In Q3, media spending was up $500,000 versus year-ago or 13% but down as a percent of net sales.

And we gained 60 basis points of improved absorption in SG&A, despite some unfavorable timing of annual expenses.

Adjusted EBITDA in the quarter was $6.7 million, up 20% from year-ago due largely to our 27% Q3 net sales increase and despite the higher media spending in the absolute.

This is an early indication of our ability to drive strong top line growth, while simultaneously delivering significant adjusted EBITDA growth.

We believe there is lots more of that to come.

Our long-term plan calls for improving the structural profitability of the business by more than 900 basis points versus where we ended 2016, with 700 basis points coming from increased absorption in SG&A, excluding media, and the balance coming from scale benefits in manufacturing that help improve adjusted gross margin as we also continue to drive improvements in throughput, yield and capacity utilization.

We have already begun demonstrating some elements of the scale benefits, particularly in G&A where we have a very clear path to achieve what we have outlined.

And at the same time, we are very cognizant that we must deliver the manufacturing scale benefits to improve adjusted gross profit margin more consistently over time.

Looking ahead, we are off to a very good start for Q4 and expect to see our strong consumption growth rates continue, enabling us to deliver the 25% growth we committed for the year.

It is very clear to us that we have a winning formula for top line growth, something that is very scarce in the current CPG environment.

We have advertising that consistently and efficiently delivers the household penetration gains we need to drive franchise growth.

Our focused product innovation is further increasing household penetration.

The exceptional quality of Freshpet produces differences that are noticeable to the pet and the pet parent.

These help drive exceptional repurchase rates that convert the household penetration gains into sustained sales gains.

And our efforts to continually strengthen our retail presence through better fridge placement, larger coolers, second coolers and new stores is paying significant dividends.

These are the key elements of the virtuous cycle on our Feed the Growth plan.

In closing, I believe our third quarter results validate that our Feed the Growth plan is working, delivering the accelerated growth rate we expected and putting us on track to deliver our longer-term 2020 goals.

And we remain convinced that we will increasingly be able to translate the top line gains into improved profitability, largely through scale and leverage.

Further, these results increase our confidence that Freshpet has the ability to become a very sizable brand in the attractive pet food industry and fulfill its mission of delivering fresh, all-natural foods to pets that enrich their lives and strengthen their relationship with their pet parents and doing that in ways that are good for pets, people and the planet.

Before I turn this over to Dick, I would like to give you a brief update on our Kitchens 2.0 capacity expansion project.

There's not much to report other than we have filed the necessary permits and remain on track for construction to begin in the spring of 2019.

Our plan calls for the start-up of the expanded plant to begin in the second half of 2020, and we remain on track to deliver that.

Additionally, we are still planning on locking in the financing for that project in the fourth quarter of this year.

As we said at our Investor Day in August, this will be bank financing and we will not be issuing any new equity to finance that project.

Finally, I want to be sure that all of you saw our announcement in late September about the addition of DeDe Priest to our board.

DeDe brings a wealth of food and retailing experience and is a passionate pet parent.

She most recently served as an SVP at Walmart with the responsibility for fresh food.

And prior to that, led the private brands business at Safeway.

We are thrilled to have her on board.

I will now turn it over to Dick to discuss our Q3 financials.

Thank you, Billy and good afternoon, everyone.

As Billy indicated, net sales in the quarter were $50.8 million, up 27% versus the year-ago period.

I would like to remind you that we've adopted new revenue recognition standards this year, so the net sales in the prior year quarter 3 were $40.1 million under the new standards.

Excluding the discontinued baked items, the Freshpet net sales were up 28% in the quarter.

This continued acceleration of the Freshpet growth rate is the result of the increased investment we made in advertising this year.

Our year-to-date advertising investment is up $6.3 million versus a year ago, and that is the biggest driver of the growth.

However, our new products are also performing particularly well, producing growth on our roasted meals line that is double the growth rate of the rest of the business.

That is better performance than we expected at the beginning of the year and better than our typical new product launches.

Further, our fridge upgrades are delivering the anticipated growth and accelerating contributing significant growth in key customers where they have been placed.

This broad-based growth is very encouraging and sustainable with a multiyear runway for further expansion.

This strong performance puts us slightly ahead of the pace we committed to when we raised our guidance in August.

We've committed to 25% [gross] for the year, which would mean 25% growth in the back half of the year, and we delivered 27% in quarter 3. We remain very confident that we can continue to deliver the high level of consumption growth that we have delivered to date for the balance of the year.

The October results confirm this.

However, it is always difficult to predict changes in our customers' year-end inventories and any weather-related disruptions to the transportation network at year-end.

So we are reiterating our confidence that we'll exceed $190 million in the net sales for the year.

Adjusted gross margin for the quarter was 49.6%, down 260 basis points from the year-ago period and down 160 basis points from quarter 2. As Billy mentioned, we are disappointed in this result but believe that many of the issues we've faced in the quarter are temporary and can be overcome.

The 160 basis points of headwinds in adjusted gross margin versus quarter 2 and 330 basis points versus year-ago were partially offset by scale benefits and efficiency improvements.

The headwinds were 40 basis points of an added cost in quarter 3 versus quarter 2 from the expansion to a 7-day production schedule or 90 basis points for the quarter versus a year ago.

We successfully started the 7-day schedule in mid-September, so we did not receive any production benefit in the quarter.

We will get that benefit in quarter 4. However, the rapid growth of our bagged business is going to cause us to add 2 new 7-day production shifts in Bethlehem sooner than anticipated, and that will result in about 60 basis points of unutilized labor expense in quarter 4.

Second, we absorbed an increase of 60 basis points of commodities and inbound freight inflation versus quarter 2 in total.

We expect to absorb approximately $3.5 million or 180 basis points in higher commodity costs for 2018.

While we expect commodities to vary over time, we are developing plans to address the higher cost, and the benefits will be realized in 2019.

Those actions will include pricing and mix changes, eliminating lower-margin SKUs and new innovations that drive higher-margin items.

Third, in quarter 3, we absorbed 10 basis points of adjusted gross margin versus quarter 2 and 60 basis versus a year ago due to a mix shift within our core dog products.

As Billy said, the rapid growth of our bagged products resulted in a stronger-than-expected sales growth and positive impact on gross profit per pound but also a negative impact on adjusted gross margin.

We are fortunate to have strong growth on such premium priced items and plans to place -- to improve the growth margin via both productivity and improvements and pricing.

Finally, we absorbed a 50 basis points of higher scrapping costs in quarter 3 versus quarter 2. We have very high standards for our quality, and we'll scrap the entire batches or production runs if the product does not meet our standards.

A critical driver of very high repurchase rate is the exceptional quality of Freshpet, and we will not do anything that will compromise our commitment to deliver the highest-quality product to our consumers every day.

In quarter 3, we had several batches that did not meet our standard due to routine issues that can be avoided with more training and improved systems, so they were scrapped.

Unfortunately, those negative items offset good progress on throughput.

We had record production months in the quarter and saw a good improvement on both throughput and yield.

In combination with the actions listed above, we remain confident we can achieve our long-term margin goals, but as we have said, it will be lumpy.

Adjusted SG&A in the quarter was $21.6 million or 42.5% of net sales, an improvement of 270 basis points.

The improvement in adjusted SG&A leverage was a result of efficiencies gained within logistics as well as scale improvements within G&A that total 150 basis points versus a year ago.

Additionally, even though our media spending increased versus a year ago, it contributed 120 basis points of improvement as we've begun to grow into our media spending.

This puts us on track towards the 900 basis points of fixed-cost pick-up we expect to achieve by 2020.

Adjusted EBITDA in the quarter was $6.7 million, up 1.1% from the year-ago period, driven by the increase in revenue.

As in the past, our EBITDA for the year, we weighted towards the back half due to our significant heavier media spending in the first half of the year and the resulting net sales we expect to accelerate in the second half of the year.

With these results, we remain confident that we can deliver the updated EBITDA guidance we provided in August.

We expect the strong sales momentum to continue that we will begin to benefit from 24/7 production capacity we put in place.

We will continue to face higher commodity and inbound freight costs but have factored those into our thinking.

We paid back $2 million of debt in the quarter, so we had $2 million drawn on our revolver at the end of the quarter.

We ended the quarter with $2.9 million in cash.

We continue to expect to produce positive annual cash flow from operations and end the year debt-free, excluding the impact of our Kitchens 2.0 capacity expansion.

For perspective, we have now spent $1.3 million on Kitchens 2.0 and expect to spend a total of $2.5 million this year on the project.

To reiterate, we are very encouraged by our progress so far this year, particularly with the strong net sales growth.

We remain confident in our ability to deliver our long-term financial goals.

We have proven the ability to accelerate our growth and are beginning to capture the scale benefits in our structural profitability.

We expect that to continue for the remainder of this year and into next year.

We know we have some issues to address in adjusted gross margin but are confident we have put in place plans to address those and remain committed to delivering our longer-term profitability improvement.

That concludes our overview.

We will now be glad to take your questions.

Operator?

(Operator Instructions) Our first question today is coming from Peter Benedict from Robert W. Baird.

A couple of questions.

First, just a little bit more on the input cost dynamics, thinking about the commodity items that you've got a lot of movement in those.

What -- how are you looking as you -- I guess as you're starting to lock in your product for next year, how do you think the commodity input cost picture looks?

That's my first question.

Yes.

We haven't locked in our chicken prices yet for next year, but we feel, based on the market, that we will not see any increase and would potentially could see a decline, but we don't have it at this point in time.

Beef prices have -- longer term are looking pretty good over the next 6 months for 2019, so we feel good about where that is.

We did have innovation quite a bit in the quarter on the bagged lines and those new products took a little bit longer to produce than we were anticipating.

And we suffered some consequences associated with actual throughput for that period of time.

But longer term, we have things in place, whether it's pricing, greater scale and the potential for our employees who we brought in for our 7-day shift for the one line and then we're bringing in, in January, 2 more lines on a 7-day shift to just get more acclimated to the environment and produce at a better rate.

Okay.

That's helpful.

Are you guys able to give a sense, maybe you had in the past, I apologize, but in terms of just the number of employees that you're increasing down in Bethlehem, you said you had some -- you're working on kind of a training process and whatnot.

So I'm just curious, the magnitude in terms of how many new members or employees are on the floor there today maybe versus a year ago and where is that number going to be a year from now?

That's my next question.

So I think we told -- Peter, this is Billy.

I think we told people when they were at the kitchens -- we had about 221 employees in the kitchens, that when we ultimately expanded, we would add somewhere to between 100 and 200 employees.

As we've gone from the 5-day operations to 7-day operation, we've moved that in steps.

We moved -- for example, we moved all our maintenance people to the 7-day operation earliest, then we add each of the lines one at a time.

So the biggest chunk came in the first wave.

Each successive wave just brings the people who operate the lines.

But I would think of it as in the 20, 25 range for each one of the lines is the way to think about the incremental staffing.

Okay.

That's helpful.

And then Billy, I guess one last one for you.

Just we're starting to see some more competing fresh product out in the market, not much, but it is starting to show up in certain places, particularly at PetSmart.

And so just curious, your take on what that all means.

Is that a risk for you guys?

Is that validation of the category?

Just what are you seeing in terms of competing fresh product in the marketplace?

Peter, it's Scott.

I'll go ahead and answer that.

So there's been a few folks that have kind of come into the market over time in and out.

The folks that have been around for about 3 years at HEB, just to kind of back up, and I think it's an important perspective, so they started off in around I think 36 stores.

I think they're down to 24 stores.

We actually do about 7x the sales velocity that they do in the same stores when we're in the same stores together.

So we have a similar dynamic where there's another retailer that recently put some fresh products in.

And they're -- the competitor is doing $33 a week and we're doing $320-something a week.

So we're not quite 10, but we're in the neighborhood of a pretty dramatic difference.

So we obviously watch this stuff incredibly closely.

And I think what it comes back to is the quality of the products that we're making, delivering to consumers and the overall value proposition.

Seems to be something where it puts us in a situation where we haven't had issues or challenges to kind of the product.

And we've also maintained the growth rate that we've had in those retailers.

So if you -- when those products have been added, we have a similar growth rate that we have in other stores.

So it really hasn't impacted our growth rate and our performance has been very, very strong and many, many times multiple what the sales of those other products are.

We've been able to get all this through -- we buy a lot of POS data through like Nielsen or IRI.

And so we've been able to keep a really close track.

So a really good question.

We are very, very on top of it.

But it had very, very little to no impact whatsoever to our business but something we want to kind of keep a close eye to.

And Peter, let me add to that because the note that I saw that you put out last night, which kind of addressed the sort of longer-term strategic consequences of having a new entrant behind them -- behind us.

I think it was pretty much on point in that you've got to expect that, as we get the traction that we're getting, that we will attract followers.

There's no doubt about it.

Our goal is to get as much of a head start as we possibly can to define the rules of engagement, define the way the consumer thinks about the category, long before anybody else enters.

And I think as the data you put out in your deck suggests that the guy who is the groundbreaker ultimately ends up having the lion's share of the category, and that's certainly what we would expect.

But at this point, it doesn't appear that we've got, as Scott indicated, anyone who really is a -- much of a follower at this point.

Our next question is coming from Rupesh Parikh from Oppenheimer.

So on the gross margins, this may be just additional clarity from what you guys said in your prepared comments, but how quickly do you think they can be adjusted?

Is this something that could take a few quarters?

And then secondly, I think you said that you're still comfortable with the longer-term expectations for gross margin.

So just wondering if you can just provide some more clarity in terms of some of the offsets that you think could help offset some of the headwinds you're seeing right now?

Yes.

Let me take it.

The -- I think that there are -- as we said, there are basically -- the headwinds we faced fall into 2 buckets, sort of the more operational pieces, and I define those as the staffing that we had, the interim staffing as well as some of the scrapping expenses that we occurred -- incurred in the quarter.

And the longer-term issues are those things that -- the commodity inputs and the mix impact.

We are putting in place for 2019, the structural changes that will impact those second pieces.

So they will flow through as you think about next year's plan.

They won't all begin on January 1, but they'll begin early enough in the year, that will have a significant impact on the year.

And those include the things that we've talked about before, which is innovation as a driver, mix -- or pricing is one of the tools that we're adding to that mix.

And the combination of those is ultimately going to get us, I think, some significant improvement.

The other piece is the operational side of things, really come with the training, skill development in our organization, putting in place the systems that we need to put in place so that we can avoid the issues that we saw and then, frankly, just growing through the staffing.

Bringing on the right people that we think we need to help us deliver the results that we need.

So that's another one that will phase itself.

I don't want to make it sound like it won't be lumpy though going forward.

It will be.

And we said all along that gross margin will be lumpy.

When you're growing at the rate that we're growing, you should expect it will be lumpy.

It doesn't come as evenly as one might hope.

But it's always going to be heading in the right direction.

In terms of getting to our longer term, getting to the 2020 adjusted gross margin, we think the structural changes we're putting in place in 2019, in combination with the continuing ongoing operating improvements and growing into the scale, we still feel good about it getting to the goal.

And remember, our goal is combined with benefits of scale and also the SG&A goal to ultimately get us to the 20-plus percent adjusted EBITDA margin.

Our next question is coming from Brian Holland from Consumer Edge Research.

Question on the -- just following up on the gross margin component.

My understanding was that the bagged product is sort of an inherently lower-margin SKU than the roll.

Maybe you can clarify whether that is or isn't.

But if it is and that's growing faster, and that's where maybe some of the newer pet parents are migrating to, why doesn't that alter your assumptions?

Or maybe you always assume that, that was -- that the mix was going to evolve towards the bagged product.

Can you just maybe sort of clarify the mix within the context of your long-term outlook?

Yes.

When we laid out the goals, we clearly had an expectation for some amount of mix change.

What we commented in this discussion today was -- or in the comments that we made today was that we saw an unusually high level of shift towards the bagged products behind the innovations that we launched this year, and that was a little bit out of pattern with what we had planned and frankly, as we talk about plans for next year, that's why we're talking about doing some more structural or systemic changes, both pricing and some innovation that can help correct for that issue.

The products we launched are phenomenally successful.

They're doing incredibly well.

We think we've got some pricing power, and we think we'll take advantage of that in order to get the margin back to where we need to get it.

Your opening part of your question is, yes, our bags are lower-margin than our rolls are, but part of our goal here is to improve the efficiency on the bag part of our lines.

That's frankly where we have some of the biggest opportunities for efficiency improvements, both in the current operation and also in the next generation of the facility.

In fact, when we laid out the plan for the Kitchens 2.0, we called out and have pointed out that there was a significant gain in some operating efficiency, particularly because of some throughput gains we get on the bags lines.

Okay.

Got it.

And then obviously, you've had some benefit from the upgraded fridges, also from innovation.

Just curious, especially it seemed like the small dog innovation marketing specifically to that admittedly large subset is having a fair amount of success.

As you build your innovation pipeline but sort of working against a relatively fixed real estate on shelf, obviously, that's evolving as you get fridge upgrades.

But how do you think about managing the innovation pipeline and prioritizing what's in those fridges?

Because I think, as I understand it, you've had to make some sacrifices or at least make some decisions about maybe impacting cat, et cetera.

How do you think about managing what seems to be a pretty successful innovation pipeline with the amount of shelf space you have available?

So Brian, it's Scott.

The first piece is obviously identifying innovation that helps us expand our overall business proposition and the appeal of the franchise in the portfolio.

And once we do that, then we do a pretty detailed evaluation and sometimes just market-level testing to really understand, are we getting incremental dollars per -- literally down to linear inch, and also understanding the gross margin impact of making trade-outs within the fridge.

Historically, we've done very well with those trade-outs.

They have delivered a lot of incrementality to the business and helped kind of facilitate additional growth on top of the media.

In the future, what we're starting to do and think more about is adding upgraded or larger fridges.

And then in many cases, in many scenarios, even second fridges, to help basically expand and continue to put in incremental innovation.

So I think in 2019, what you're going to see, you're going to see some of both.

You're going to see better products going in and swapping out for some of the existing products because we believe they're more productive and will increase the amount of dollars that we get for our overall fridge.

But we're also making sure that we get as many fridge upgrades and then secondary fridge locations that not only help with the overall sales and being able to carry innovation but also from -- help us limit, spoils and out-of-stocks.

Okay.

That's helpful.

Okay, got it.

That's helpful.

Last one for me, just curious how you guys think about pricing.

I know you've talked about on this call, you've indicated back at the Investor Day that pricing was something that you were exploring as a lever to pull.

Just curious, given the uniqueness of your product in the store and certainly understand that there are competitors out there who are evolving.

But the uniqueness of your product as you are looking to attract new customers, how do you think about assessing how much pricing power you have and the sensitivity there, the demand elasticity?

Just curious sort of how you think about that.

So I think the thing that we've been able to demonstrate, which is it gives us an indication on the pricing power that we have is we've been able to bring incremental innovation to the market that's typically higher price per pound.

And when we've done that, the items have typically been successful.

We also, as we're bringing in higher and higher priced products and they're successful, that's obviously a great indication too.

So as we look through the fridge and the different items, obviously, you can be very strategic about where the pricing potential and the pricing opportunities are on the line, and those are the ones that you want to take into consideration and evaluate for if you were going to take price, what you would actually execute against.

So does that help?

,

Our next question is coming from Jason English from Goldman Sachs.

The -- flashing back around 2 months ago to your Analyst Day, I think you put out an adjusted gross margin target of 51.2 for the year?

I apologize if I missed it, but can you update us on where you stand now for the full year?

Yes.

We were looking at 51.2 by year-end.

And currently, year-to-date, we're about 50.3.

So we'll be probably in the range of 50.3 to 50.4 for the year.

And is it -- I know you're not in a position right now to give 2019 guidance.

But given the nature of some of the issues you're talking about as well as the comments on, this will take time.

It sounds like, '19 you're going to see limited progression.

So to get to 52 by 2020, we really need a bit of a hockey stick at the tail end.

Is that the right way to think about it?

No.

We're at a run rate of about $190 million right now.

Our objective is to get to $300 million, which is about a 25% increase in throughput by the end of 2020.

We will see the benefits of scale, and that will come to us.

And what we've always said, we will get 9 points, 7 points on G&A and approximately 2 points on margin.

That 25% increase in scale, along with some issues that we discussed earlier, whether it's pricing or whether it's better -- higher-trained employees.

And a full workforce who've been managing 7 days on 3 lines for not only 9 months in -- 9 to 10 months in 2019 but in 12 months of 2020, we expect to achieve those goals.

I think, Jason, if you think about '19, though, some of the interventions we're putting in place will be at the very beginning of the year.

Others will kind of grow through them.

So I don't think it's a hockey stick, I don't think it's a fair characterization.

I think it will be more meaningful progress made in '19 than that would suggest.

I would say though that there's going to be incremental staffing that's going to be at the beginning of the year just as we grow into this.

But there certainly will be progress made in '19.

No, that's encouraging to hear.

So the remediation efforts you're talking about are a series of multiple months, not many quarters, before we start to see the fruits of those labors borne out in the P&L, yes?

Yes.

I mean, I wouldn't expect it in the fourth quarter this year.

So if you're thinking about seeing it...

No, totally.

Start seeing -- you'll start seeing it in '19, yes.

And a quick question on leverage a little bit further down the P&L.

SG&A, up pretty substantially this quarter, despite the moderation in media growth.

I think by our math, it's around $4 million roughly ex media, round numbers.

What's driving that increase?

Yes.

Well, we accrue our incentive payments as we progress towards the year.

So in the first quarter, with minimal EBITDA, that's basically -- we accrue our EBITDA based on the results of that period divided by the entire year projection of what we guided to $20 million.

And as we progress, you'll see incremental amounts there.

Additionally, we changed our likelihood of achieving our 2020 executive objectives, and we went from a 50% accrual rate to a 75% accrual rate for restrictive stock units -- I'm sorry, for options, and that was booked in the third quarter.

Got it.

That's helpful.

And I believe that the bulk of your logistics costs run through SG&A rather than COGS.

How much pressure are you seeing from that?

Well, first, is my understanding correct?

And then secondly, how much pressure are you seeing in SG&A due to those logistics inflation?

So what we actually saw was improvement there because the scale -- we're getting scale benefit, it's just not as much improvement as we had expected to see in the quarter.

The place where we saw freight inflation was on inbound, inbound related to the raw materials we bring in.

But on the outbound, which is where we have the freight in SG&A, we actually saw some improvements, just not as much as we thought.

Because our -- when you're shipping LTL, as you go from 2 pallets to 4 pallets or 4 pallets to 8 pallets or whatever, you get significant scale benefits in freight, and that's one of the things that we're seeing.

And with the incremental dollars in SG&A, when you said we had a growth of x millions of dollars for the period, SG&A is a variable expense along with brokerage...

Freight, right.

And freight is a variable expense along with brokerage.

And some of that -- and basically chiller repairs.

So those are kind of variable or semi-variable, which grows in dollars but not necessarily in percentage as we continue to grow top line.

Our next question is coming from Jon Andersen from William Blair.

Both my questions have been answered.

I guess, maybe what I'll ask about is media spending.

I think this is the first quarter for some time where you've seen the media -- you've gotten some leverage on your media spend in terms of the ratio or percent of sales.

As you look forward, kind of 2019, 2020, how should we think about your media spending?

And if you continue to leverage that line, how confident are you that you could kind of keep the kind of revenue growth rates up that we've seen the past couple of years, where you have accelerated or taken up your media spending pretty dramatically?

Yes, first of all, Jon, I'm talking about this on an annual basis, not on the quarters because we're still going to look at varying our spending within the quarters.

So just as you think about it, on an annual basis, we've told folks that we would be roughly in the 12% range for spending this year, up 12% of sales.

We told folks that in 2020, we'd be at 9% of sales.

We're inclined to keep our foot on the gas and spend at a higher level.

But in the absolute dollars, it may be closer to what we would be spending at the 9% level in 2020, but we would spend that also in 2019.

That's sort of the bias.

And we've been communicating that fairly consistently over time.

What we also told folks when we were reviewing the plant expansion announcement back in August is that as we think about the next phase beyond that, whenever we have ample capacity available to us, we are obviously, it's to our benefit to grow into it quickly.

So while we think the 9% is sort of the right ongoing sustaining level, there will be periods where we will spend in advance of that -- or in excess of that, just because we have the ability to do that with the plant capacity and there will be times when we kind of glide our way.

And right now, we feel like we have the right level of media spending to glide our way to the $300 million in full capacity utilization in 2020.

Excellent.

That's helpful.

On the upgrades, I think you mentioned upgrades to the fridges that is -- that you've done around 800, I think the year-to-date, I think the target was around 1,000.

If those are performing well, and it sounds like they are, does it make sense or is there opportunity or both to do more upgrades in 2019 and 2020?

Just to be -- I just want to make sure.

I think the way when we originally introduced it, we had talked about 1,000 upgrades between now and the end of Q1 of '19.

So we're actually -- we feel like we're really like nicely on pace, with a chance to maybe do slightly better than that.

But obviously, we -- wherever there's an opportunity to upgrade fridges, if we feel like we can get the payback within the appropriate time frame and make sure we're getting a good ROIC on those fridge investments, I think in every one of those cases we're evaluating that because we are getting very strong results and it also puts us in a better position for the long term.

We're getting better fridges with great warranties, more consistent performance, better merchandising, et cetera.

So there's lots of components to that as we evaluate that.

So that could potentially step-up further.

And I think we will see more second fridges over the course of this next year really become something that's more of a trend for us, and we'll be talking a lot about that.

Excellent.

Last one for me.

Just on the bagged product that's doing so well, what do you make of that, Billy?

Why is that product so much more appealing right now, at least for your customer base at the moment than the legacy rolled product?

Is it convenience?

Is it kind of the small dog aspect, bringing in incremental users?

Just trying to get a sense.

Maybe it's just -- there's been more innovation there and it's the new, the new, new thing.

But what does it say about the portfolio and perhaps what are some of the things that consumers are looking for in your franchise that the bagged product is selling so well.

It says that Scott's a brilliant innovator.

No, I think the reality is -- remember, the real big step change here was that we launched those 3 new products this year, and they skewed the business growth towards bags more than they have been before.

Until this year, our Fresh From The Kitchen business was growing very, very nicely.

It was our highest price per pound item.

It's a little bit harder to make and so one of the things we've been working on is improving the yield and throughput on that and also our next-generation facility has got some step changes in our ability to produce that.

But that's been growing very, very consistently.

The step change this year was the new innovations.

And there's just really good insights about what pet parents are motivated by and what they need for their pet.

And we had a great product that just -- when you created a small dog version for them, it makes a difference and it brought a new group of people into buying the product.

And we've brought the multi-protein out, that was an idea that made a lot of sense to the pet parents.

So I think it speaks well of the innovation capability that we have in this company, and I think that makes a big difference.

But I would expect that we would apply that same innovation skill to other parts of the line.

And that's frankly one of the things that we look to do in '19 and '20.

It doesn't just have to be on our bagged products.

We can do great innovation in other parts of the lineup as well.

And Billy's just trying to get me to get him a Coke from the fridge or something.

But in all seriousness, I think that is the key point that Billy was making, which is on innovation, we thought we had some great components and great pieces of innovation that we could bring and add to the fridge.

But we made conscious choices in that to help us accelerate our top line.

And we do need to apply that.

So when we make choices, we're taking items out of the fridge and putting other items in and we've actually facilitated that bag growth.

Now recognize that the innovation in bags and the new items that we brought are actually fulfilling what they were supposed to, which is they are higher-margin than are the existing bag items.

So we're going in the right direction but we're not all the way there, and we have some more work to do.

Our next question is coming from Robert Moskow from Crédit Suisse.

One additional question.

On the -- I guess, one of the things that really surprised me the most this year was that your growth in pet specialty was so strong.

And a year ago, I think we all would've said that that's -- the specialty channel is challenged on many fronts.

So has this been happening because you've won out a lot of space or attention in store at the expense of other pet competitors?

And I'm thinking of some dry competitors that have -- one in particular that seems to have, like, lost a lot of goodwill in this channel.

And then heading into 2019, can you keep growing on top of that, I guess?

So it's actually -- I think your assessment is super logical from the standpoint of did we gain -- based on what's going on in the channel, did we pick up additional space, merchandising, et cetera?

We actually have the same -- basically the same number of fridges in pet specialty that we had in the same locations that we had.

There's a handful of incremental locations, but that's not really the contributor.

The thing that we've historically seen, which has really been interesting is pet specialty has been one of the -- has the greatest response rate to media that we've seen.

And when we were able to really increase the media to another kind of significant increase in plateau this year, they got a significant benefit from the media.

But the innovation that was brought there in that channel in addition to some things that we've done with the partnerships and the supply chain have really enabled us to kind of continue to accelerate growth.

So I think there's several components to it, ACV growth or distribution growth placement was a very, very minor component of it.

So we're obviously very, very happy to see that and to see that outperformance.

It's obviously a channel that there's a lot of business in, and we think there's a very long road in front of it.

The way we think about it and the way we're crafting our plan for next year is we continue to expect to significantly, significantly outpace any growth or whatever their trends are by a pretty dramatic rate.

So I don't know if they'll get to growth next year, but we expect to have not that different growth rates in pet specialty that we have in our other pieces of business.

Okay.

And then the last question is for Dick.

There's a lot going on at the plants, a lot of retraining going on and you're having to scrap some production runs.

So is the visibility to this $20 million EBITDA number, is it still quite good despite all those kind of operational challenges, the short-term challenges?

Or is there a stretch on the downside and there's a bit of a risk?

No, not at all.

I mean, we went -- at the Investor Day, we included in that presentation basically how we were going to get there from where we were at that particular point in time.

And with another $110 million of sales to come through that facility simultaneously, basically finishing manning that facility, basically sometime in the second quarter of 2019.

That gives us a fair amount of time to get the staff up and running at a very efficient rate simultaneously while for some of those bagged products and other products that we deemed that we've reduced some of SKUs with lower margins and we're going to do some pricing on some other SKUs.

So overall, we feel very confident of achieving our gross margin objective of 52% by -- for 2020.

Okay.

What I was really asking about is fourth quarter, though, because you also have $20 million...

Yes.

Oh, for this book?

Oh no, there's no impact for this year.

I'm sorry.

No impact.

This year, we have no issues associated with the fourth quarter.

I was going towards 2020.

Okay, so even though there has been a lot of fits and starts on the production lines, your fourth quarter gross margin is going to be weaker than you thought, but you have enough top line to offset that and still hit your $20 million EBITDA number for the year?

That's good visibility.

Yes.

We have very good visibility.

And we're through the first one for the quarter.

You know how our production at the -- in September, October, November accounts for our cost for the quarters.

So we have pretty good visibility.

We think we're very comfortable with our guidance.

Our next question is coming from Mark Astrachan from Stifel.

A couple of housekeeping questions first.

I guess one is sort of a housekeeping question and I'll let you judge whether it really is.

But the real one, can you tell what kind of level of pricing you're thinking about taking for next year?

And the other sort of related one is I guess if you look at like the snacks that are in the fridge, I assume that's part of what you're talking about in terms of prioritizing products.

What would be margins on those or even velocity relative to what's in the fridge?

Meaning can you get an incremental lift if you take those out?

Is that kind of directionally what we're talking about?

So in terms of the pricing for next year, we're not going to disclose what we're planning right now other than to say I, think Scott said earlier, we're going to be selective about how we approach it, and we're going to look for things that have the greatest leverage to take the pricing.

But we'll provide much more detail on that when we get into the first quarter and lay out our plan for 2019.

In terms of the items within the fridge, obviously, you're -- I think you're focusing on the treats that we're -- your comment is about the treats.

The margins on those are very good, very, very strong.

The velocities on them aren't always quite as strong as the rest of the portfolio.

So there's always a little bit of a balance that you have to look at as you prioritize items in the fridges.

But when Scott talked about sort of optimizing the portfolio, it's a little bit more of an art than that.

It's -- you just want to make sure you have the right range of products that you can have adequate inventory, adequate presence and at the same time -- on each of the items, but at the same time, have a broad enough array to attract the broadest number of consumers.

There is no doubt the highest growth and long-term potential for us is on the main meal part of the business.

So the bags and the rolls because those -- once you get in the routine and the consumer is buying you on a regular basis and we see the buying rate continue to go up, that's a real strong franchise for us.

The rest of the business is, while it could be good margin, is a little bit more discretionary in terms of its purchases.

Got it.

That's helpful.

And then, last question, I guess broader strokes, so top line trends are what they are in a category that's doing obviously less.

As you have these discussions with retailers, I think, the question is always, given the growth, why not more fridges?

I guess maybe asking it in a different way, how do you make room in pet aisles?

Or what is the conversation like with a retailer who says they don't have enough room in the pet aisle for refrigerators?

Because it seems like in having discussions with certain retailers, maybe a lot of them, that seems to be a bigger impediment than maybe I would've thought.

So is that fair?

How do you deal with that problem when it's discussed?

Any sort of examples not specific but sort of broader strokes on what you can do to kind of alleviate problems around that?

So -- this is Scott.

And I think it's an important question, something that the sales team has spent a lot of time working through and analyzing.

And there's some really interesting dynamics in the marketplace today.

So obviously, everyone's looking for growth.

Pet is a key category for many retailers.

Some have prioritized it higher, some have potentially de-prioritized it a little bit.

And I think not only are they looking for growth, they're looking for good gross margin.

But the other trend that I think that more and more retailers are really taking into consideration is they really don't want to get show-roomed.

And that concept of I don't want to go and shop for something at retail.

And then someone to be able to make a couple of clicks online and be able to get it delivered to their doorstep at a similar or potentially even lower price.

And because of the development of fresh and where it is and how they're focusing on fresh, I think we're fitting more and more strategically with the way retailers are looking at their competitive advantage.

So as you know, we've got over 19,000 stores, a really big fridge network, it's consistently grown over time.

We really feel great about the forward-going growth.

Velocity is number one, but we do feel like we're consistently getting more and more fridge growth over time.

But getting back to your specific question is, as we've grown velocity and that velocity component and every 3-or-so years, we've almost doubled the fridge velocity.

So the conversation 3 years ago was a lot different than it is today.

I think more and more retailers, as they're looking for growth, they don't want to get show-roomed and our velocity is way up.

I think that's when the bell and the lights are kind of going on and the bells are going off for a lot of retailers that not only put fridges in for the first time but more fridges throughout their entire chain.

So I think maybe 3 years ago, people would say, I didn't have room for fresh.

And I think today it's not a niche anymore.

I think we've been able to demonstrate that we're investing behind it.

We've got great growth.

We've got velocity.

And now, where we used to be kind of maybe a little bit below average on a dollars per linear foot, we're actually well above on a dollars per linear foot or however, whatever measure they want to look at, in addition to having great gross margin, in addition to not having the ability to get really show-roomed out.

So there's a lot of advantage that it brings, and I think that we've been able to keep that steady progress, and I think that we're going to continue to see really, really good fridge growth progress over time.

But it's a complex question and it's a lot of thinking.

The things that typically get in the way for retailers in this -- and this is a long discussion, I apologize for the super-long answer.

But there's typically other things going on within there, not just in their section but within their store and the overall kind of retail environment for them that typically get in the way.

There are kind of corporate-level priorities that sometimes get in the way and kind of slow us down.

But the longer that we prove our performance and have great velocity and great growth rates, the more I think that those continue to come by the wayside and then we're able to take advantage of opportunities as they come up.

We've reached the end of our question-and-answer session.

I would like to turn the floor back over to management for any further or closing comments.

Thank you for your interest and attention.

As you heard, we remain very committed to delivering our 2020 goals and view this quarter as a very good stepping stone along that way.

And we look forward to coming back to you with the plan for 2019, which we'll do sometime early in 2019.

And we feel confident that it will put us on-path towards those 2020 goals.

Thank you again.

Thank you.

That does conclude today's teleconference.

You may disconnect your line at this time, and have a wonderful day.

We thank you for your participation today.