My investment rating for Freshpet, Inc.’s (NASDAQ:FRPT) shares is a Hold. I have a positive opinion of FRPT’s top line growth prospects. But I do have concerns relating to future capital raising needs and near-term profitability challenges for the company. As such, my decision is to assign a Hold rating to FRPT stock.
Listed on the NASDAQ since November 2014, Freshpet is a company that sells pet (more specifically dogs and cats) food. In its fiscal 2022 10-K filing, FRPT noted that it boasts “the first fresh, refrigerated pet food manufacturing network in North America” with its “Freshpet Fridges” which are found in “25,281 retail locations” at the end of last year.
FRPT’s Medium Term Revenue Growth Target Is Realistic
At the 2023 Consumer Analyst Group of New York or CAGNY Conference on February 22, 2023, FRPT outlined its goal of achieving $1.8 billion in revenue in FY 2027, which translates into a five year top line CAGR of around +24.8%.
Freshpet’s intermediate term sales growth target appears to be pretty realistic taking into account three key factors.
Firstly, FRPT has a pretty decent track record. The company’s historical revenue CAGR for the 2010-2022 period was an even higher +40.6% based on S&P Capital IQ data.
Freshpet has also more than doubled the company’s share of the North American dog food market from 2.7% to 5.4% in the last five years as disclosed at the CAGNY Conference.
Secondly, Freshpet has ample room to increase its penetration of the North American pet food market. In its Q4 2022 earnings presentation, FRPT disclosed that its current household penetration is coming close to 10 million. As a comparison, about 90.5 million US households have pets as highlighted in Freshpet’s FY 2022 10-K filing.
Viewed from another perspective, FRPT’s target of delivering $1.8 billion of sales for 2027 will represent under 5% of the estimated size of the US dog food market in that year as per market research cited by the company at the February 2023 CAGNY Conference.
Thirdly, FRPT is targeting a very specific segment of pet owners whose household income exceeds $80,000 and spends twice or more on pet foods as compared to the average US pet owner. Freshpet refers to these pet owners as “high-profit pet owning households” or HIPPOHs which contribute roughly 87% of its revenue. FRPT estimated at the 2023 CAGNY Conference that the company has approximately 3.2 million HIPPOHs as its customers, and its market share in the HIPPOHs segment is close to 12%. Freshpet’s edge lies with its “fresh, refrigerated pet food manufacturing network” as mentioned in the preceding section which helps to meet HIPPOH’s demand for higher quality pet food.
Separately, FRPT also disclosed at the company’s most recent Q4 2022 financial results call on February 27, 2023 that it plans to offer a new customized product offering based on individual pets’ “feeding plans”, “activity level, body type”, and other characteristics. This recent development puts the company in a good position to expand its share in the HIPPOH’s segment, as this new customized product offering should be appealing to this group of high-income pet owners. This gives me the confidence that FRPT can realize its goal of tripling its HIPPOH’s client base to more than 9 million by 2027.
In summary, Freshpet has a long growth runway ahead considering its expected five year sales CAGR of almost +25% which is supported by multiple factors as outlined above.
But There Are Concerns Regarding Margin Contraction And Potential Fund Raising
Robust revenue growth alone isn’t sufficient to justify a valuation premium for FRPT. According to S&P Capital IQ data, Freshpet’s consensus forward next twelve months’ Enterprise Value-to-Revenue valuation multiple has been de-rated from its historical high of 18.3 times recorded in April 2021 to a they are 3.5 times currently. Investors’ worries relating to profitability and financing might have been responsible for FRPT’s valuation de-rating to some extent.
ace per S&P Capital IQ data, Freshpet’s EBITDA margin was as high as 14.7% in fiscal 2020, but the sell-side analysts forecast that FRPT’s EBITDA margins for FY 2023, FY 2024, and FY 2025 will be relatively lower at 3.4%, 6.8%, and 10.1% , respectively.
Part of the margin contraction for FRPT is attributable to inflationary cost pressures and supply chain costs which should eventually ease in time to come. But Freshpet will also have to incur higher expenses relating to quality control, marketing and production capacity expansion as it grows its top line; some of these costs or investments needed to support top line expansion will be a drag on FRPT’s profitability for a longer period of time.
On the other hand, Wall Street sees FRPT generating negative free cash flow of -$204 million, -$145 million, and -$129 million in FY 2023, FY 2024, and FY 2025, respectively based on data sourced from S&P Capital IQ. As such, it is natural to be worried that Freshpet could have to raise more funds somewhere down the road when equity markets and interest rates might be unfavorable.
At the CAGNY Conference in February 2023, FRPT acknowledged that it operates a “capital-intensive business” and admitted that an “equity raise” could possibly “happen in the next 2 or 3 years” (but not 2023). Freshpet also mentioned at the recent CAGNY Conference that it is considering debt financing options in the short term, and the company is willing to gear up to a maximum financial leverage ratio of four times.
Freshpet’s stock is deserving of a Hold rating. FRPT’s EBITDA margins in the next couple of years are likely to be lower than what they were in the past, and it is also highly probable that the company will have to issue new shares for the purpose of fund raising in time to come. On the other hand, FRPT has a long growth runway in view of the company’s mid-term financial target and its current penetration rate for the North American pet food market.