Greetings, and welcome to Freshpet's Second Quarter 2021 Earnings Conference Call. At this time, all participants are in a listen only mode. A question and answer session will follow the formal presentation. As a reminder, this conference is being recorded. I would now like to turn this conference over to your host, Mr.
Jeff Pisonic at ICR. Thank you, sir. You may begin your presentation.
Thank you. Good afternoon and welcome to Freshpet's 2nd quarter 2021 Earnings Call and Webcast. On today's call are Billy Cyr, Chief Executive Officer and Heather Pomerantz, Chief Financial Officer. Scott Morris, Chief Operating Officer will also be available for Q and 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 ks filed with the SEC 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 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 considered in isolation or as a substitute for the financial information presented in accordance with GAAP. Please refer to today's press release for how management with GAAP and limitations associated with such non GAAP measures. Finally, the company has produced a supplemental presentation that contains many of the metrics that will be discussed on this call.
That presentation can be found on the company's investor website. Management's Commentary will not specifically walk through the presentation on the call, rather a summary of the results and guidance they will discuss today. Now I'd like to turn the call over to Billy Cyr, Chief Executive Officer.
Thank you, Jeff, and good afternoon, everyone. I want to start by giving you the punch line upfront. Our net sales continue to grow strongly, up 36% in the quarter. So we are raising our net sales guidance for the year. We are now projecting that we will end the year with greater than $445,000,000 in net sales, Resulting in the growth rate of 40% for the year and a second half growth rate of 44%.
We are not however raising our adjusted EBITDA guidance for the year as We'll use the incremental contribution produced by the higher net sales to offset some inflation and temporary operating inefficiencies we've experienced. We've announced that we will take pricing to cover those incremental costs later this year, but it won't have much impact until next year. We believe this is a balanced and reasonable approach to creating the greatest long term value for our shareholders. We are able to raise our net sales guidance because we've been very successful at ramping up our production, producing 44% more pounds in the quarter than we did year ago. This enabled us to generate 36% more in net sales than the year ago quarter, while also beginning to restore Our in house inventory, adding approximately $5,000,000 of net sales value of finished product inventory to our quarter end inventory versus where we began the quarter.
In the challenging labor market in which we are operating, that is a significant achievement for our manufacturing and HR teams. And as you will hear in a few minutes, We are taking an even more aggressive approach to our labor strategy with the goal of creating a strong, stable workforce with a distinctive career offering for our employees that will enable them to build more skills, add more value and share in the benefits of that added value. Our strong production performance Enabling us to refill the trade inventory that we had drawn down during the back half of twenty twenty and satisfy our customers and consumers with much better in stock conditions. But we are still not done refilling the trade inventory. Frankly, the depth of the trade inventory hole we had dug during the back half of twenty twenty It was deeper than we had expected and our efforts were compounded by additional obstacles downstream from our manufacturing operations In the 3rd party warehouse and logistics network we use, we and our logistics partners have moved quickly to resolve those issues.
But in today's tight labor market, the changes they are making will take a bit of time to fully resolve the issues. Despite all those challenges, most consumers can find a wide variety of Freshpet items in most stores at this point, but we still have work to do on We are on our way, however, and our strong production performance is enabling us to rebuild our internal inventories so we can better service our customers. As we look forward, we will post sizable gains in net sales each quarter for the balance of the year. We anticipate that Q3 and Q4 reported growth will be in excess of the consumption growth rate as consumers will be able to find the items they are looking for to deliver net sales growth in excess of 40% during the back half of the year and also set us up for a fast start next year. Our capacity expansion plans to support that growth are on track.
We are now running the bag line in Kitchens 2.0, 20 fourseven We'll take the Rolls line in that facility to 20 fourseven in August. We'll be moving staffing from Kitchens 1.0 Kitchens 2.0 for the ramp up of the Rolls line as the higher throughput on the lines in Kitchens 2.0 make it a better Our staffing and to have them work in Kitchens 1.0. In September, we'll be starting up our second line at Kitchen South with a 2 shift operation. And in January, we will start up a 3rd line at Kitchen South. That line will also be our first test, the new cooking technology that If successful, could allow us to produce twice as much product in a significantly smaller footprint.
If that plays out the way we expect it to, it will form the foundation for Ennis Phase 2 and for the 2nd building at Kitchen South. Finally, our construction project in Ennis, Texas remains on track and we anticipate starting up our first line there in Q2 of 2022. We hope to be under roof next month, which is an important milestone as it will substantially mitigate weather risk through the completion of the project. It has been a very rainy first half of the year in Ennis, but our team has still managed to get quite a bit done. Additionally, we have already begun hiring team members for the Ennis facility and are quite pleased with our ability to attract the talent we need.
The first ten Ennis employees arrived in Bethlehem in late June to begin training on our We'll spend several months here getting operating experience. We've at least 2 more waves of employees who will arrive in Bethlehem in the coming months. By the time we start up In his kitchen, we expect to have approximately 50 experienced employees to lead the startup between those who choose to transfer from PA to Texas and those who did several months of training in PA. That will greatly reduce our startup risk. We expect to bring on All three lines in Ennis by the end of 2022 and we'll have our first line in Kitchen South Building 2 ready to go in Q1 of 2023.
In total, we'll be starting up at least one new line per quarter until Q4 of 2023. That will be 8 consecutive quarters with We'll make a decision on the construction of the second phase of Ennis sometime in the next 6 to 9 months, but have already done some site preparation work there, So that we are ready once the decision is made on when to build it and what technology we will install there. We believe there is ample demand to support this planned capacity expansion. Despite our out of stocks and delayed start to marketing this year, we still grew household penetration by 19% in the 2nd quarter And the buying rate grew at a very high rate of 12%. As we have said many times, there is strong underlying growth in the buying rate for Freshpet when it is not being diluted by so many new users.
Because of our delayed start to the marketing this year In the out of stocks, the household penetration growth was below our long term growth rate in the quarter, but that simply exposed the underlying strength in the buying rate. We expect household penetration gains to reaccelerate in the coming months as we ramp up our marketing investment. The consumption growth was broad based, but was particularly strong in Pet Specialty, it was up 57%. Our e commerce business grew strongly again this quarter, up 46% versus a very strong quarter a year ago and accounting for 5.6% of our total sales in the quarter. The launch of chew.com occurred in early July, so that is not reflected in these numbers.
It's still too early to make any meaningful comments on the impact that We might have on our business, but we are encouraged by the potential. Store count grew by 265 in the quarter and we remain on track for our projected 1,000 store increase this year. We also saw meaningful increases in second fridges and upgrades despite our supply limitations and have now exceeded our guidance for the year in both categories. 2nd fridges grew by 510 stores to 3,108 And we upgraded 324 more stores and have now completed 3,003 upgrades cumulatively since we started the program. We are also anticipating significant increases in stores and second fridges next year based on our increased supply and rapid growth.
Our international business grew 48% in the quarter with strong growth in both the UK and Canada and has real momentum. Clearly, the Freshpet model is working outside the U. S. I want to briefly comment on the cost environment and Heather will provide more color on it in her comments. Overall, we are seeing broad scale inflation That is no different than what you are hearing in reports from other CPG companies.
Some of the increased costs are clearly permanent and others may be more cyclical. In either case, they will have an impact on our profitability this year and that is why we are not raising our adjusted EBITDA in line with our net sales growth. Last week, we announced to our customers that we'd be taking price increases late this year. Those increases Are designed to cover the inflation we are seeing today and that we expect to see when our fixed price contracts end later this year. It's also intended to cover the significant increase in labor costs we are seeing in the market.
Our price increases will be very noticeable to consumers because we don't do any merchandising. Thus, we can't reduce that. And we believe that downsizing our packages will be disruptive to consumers who expect a bag or roll to feed their pet for a set number of days. As such, we are being very thoughtful about the price increases we are taking, Considering the strategic goal of each item in our line, the underlying profitability and the anticipated cost increases we are seeing. We have a successful track record of doing this before and are comfortable doing it again.
I also want to comment on one important aspect of the inflation we are seeing, Labor costs. Many of our suppliers are having to pay higher costs for their labor and are passing those costs on to us under the terms of our agreements with them. We also raised our wage rates earlier this year in line with our normal annual practice. But in light of the environment we Operating in, it is clearly not enough. So we will be raising wages the second time later this year.
In doing that, we are mindful of the competitive market for labor and seek to be competitive with other employers, but our new wage program is driven by a different philosophy. We are driven by the idea that our dedicated team deserve to have the opportunity to earn a wage that will enable them to support their families comfortably, while also providing them with long term career growth opportunities. But it must also deliver a good return for Freshpet. We are not seeking the minimum wage we can pay to get the job done. We want to create a win win for our team members and our shareholders.
That is why we treat our team members as owners and partners with us in the development of the Freshpet business. That is the people part of our Pets People Planet philosophy. The key to creating that win win is for us to invest in the training and skill Our team members, enabling them to add greater value to our business and thus justifying the higher wages that we pay. While many employers and much of the public communication is focused on the entry level wage, our focus is on the wage we pay to those employees who are contributing at a higher level. The heavily advertised and promoted wage rates are only what you pay to get someone into your lobby for an interview.
If that is where our employees career so that we can provide them with a much higher wage. In fact, our typical production employee will see their hourly wage go up by about $3 per hour within the first 6 months as they progress through our Freshpet Academy training program and up by another $3.50 per hour within 9 months after that. At that level, the typical employee who has a working spouse and up to 3 kids at home will be earning a wage that comfortably supports their family and significantly more than the advertised page rates you see from many other employers. We believe that approach delivers a significantly better return for Freshpet. A highly skilled worker is dramatically more productive than an entry level employee, justifying both the investment in their training and the wages we pay them.
We also know that it is not enough to pay good wages and have good benefits. We have to treat our employees well every day. Those of you who have been to our Freshpet Kitchens have seen many of the things we do to make working in a cold wet environment more comfortable. We also grant stock to every employee each year after they've been with us for at least 1 year. That drives the ownership mindset we seek to create.
All this is not easy to accomplish, particularly in the current environment. Challenges with childcare, perceived health risks, Government stimulus and an overall competitive environment for entry level talent is particularly challenging for a company that is growing as fast as we are. We constantly need to hire and train more new employees and the kind of work we do is not for everyone. So we've invested heavily in our recruiting team and in our training department over the past year and we'll continue to do more. And we are starting early with our recruiting and training of the team who will start up our facility in Ennis.
In total, we believe this is the right approach for Freshpet and will differentiate us as an employer. Finally, We will be releasing our inaugural sustainability report in about 1 week. We are a young company, but sustainability has been embedded in our culture since our founding. What we haven't done in the past is document our progress nor set explicit targets for our efforts. We just did what seemed like the right thing for Pets, People and Planet.
We realize that our investors are expecting more from us and our sustainability report is designed to address that interest. Now let me turn it over to Heather for a more detailed look at our results.
Thank you, Billy, and good afternoon, everyone. As Billy indicated, Net sales for Q2 of 2021 were $108,600,000 up 36% versus year ago. Actual Nielsen mega channel consumption was up 37% versus the depressed year ago period, which was the post COVID frock. The year ago period also included significant trade inventory refill behind the Q1 2020 COVID surge. So the base year net sales were significantly in excess of consumption.
We did the same thing this year, refilling about $8,000,000 of trade inventory, thanks to the very strong production performance. We also built our own inventory a bit during which has helped us improve customer service on some lower volume SKUs that are produced less frequently and where our service has been particularly poor. A reconciliation of the Nielsen consumption to this quarter's net sales can be found in the accompanying presentation on our Investor Relations website. The growth in the quarter continued to be led by strong performance in the pet specialty channel with Nielsen measured big box Pet Specialty consumption up 57% in the quarter. Our e commerce business also performed well growing 46% in the quarter and now accounts for 5.6 percent of sales.
As Billy indicated, that does not include any sales through chewy.com as that service did not begin until July. Additionally, our international business grew 48% in the quarter and we continue to see and strong momentum in those markets behind the advertising investments we have been making. Adjusted EBITDA for Q2 was $10,900,000 down 2.9% versus the year ago. The underperformance on adjusted EBITDA traces to both inflation and some temporary inefficiencies that we have described previously, largely in freight. Freight costs were 11 of net sales for the Q2 versus 7.8% in the year ago.
A portion of this is due to freight inflation, but a larger portion is due to the systems issue that we spoke to in the Q1, which prevents us from being able to to consolidate load when we are shipping less than 100 percent of a customer's order. That issue is created by both our relatively low inventory and also by the inability of our current system to allocate inventory to shipments prior to scheduling the transportation. I have included a chart in the accompanying presentation to remind you of the impact this has on our costs. Both increasing our available inventory and implementing our new ERP system will eliminate this issue. The available inventory will gradually improve during Q3 and the new system will be implemented in Q4.
The freight inflation portion will be covered via other realized efficiencies as we scale and pricing. It is also important to note that in July, we opened our new Dallas DC. We are shipping a small quantity of product from Bethlehem to the Dallas DC to do the necessary testing and preparation for the opening of Ennis next year. We are only shipping to a very small number of customers in nearby markets during this test phase. But longer term, DAC DC will not only enable us to have lower freight costs in a large part of the U.
S, but it will provide some insulation from the labor and weather issues we have experienced in our Pennsylvania BC. Again, there won't be a near term The other cost issues came in cost of goods sold, where our gross margin was negatively impacted by inflation, mainly due to beef and corrugate and some of the temporary operating inefficiencies we have as we scale our production. As we add shift, there is a learning curve for our team that results in lower shippable production per hour of operation until we get up to speed. This includes higher labor costs and excess disposals of product. We added significant production in the quarter and are still adding production hours.
So we expect a portion of this issue to continue, but it becomes a smaller portion of our total operation as we scale. Adjusted gross margin in the quarter was 46.1%, down from 49.1% in the year ago quarter for those reasons. As we look forward, we expect to see more inflation as suppliers pass on their higher labor costs and we increased wages again to ensure we are able to adequately staff our operations. Our announced price increase will cover those costs. However, The impact will not be felt until next year.
Media investment in the quarter was slightly above our long term rate at 12.9% of net sales, in line with the year ago. This year's media was skewed towards the back half of the quarter, so we did not get the full benefit of the investment in the quarter. Excluding the higher freight and lower media costs in the quarter, adjusted SG and A was down 200 basis points versus a year ago, giving us the confidence that our long term roadmap towards 1,000 basis points of SG and A leverage by 2025, excluding media spend is on track. We incurred $700,000 in COVID related expenses in the quarter and have added those back. We expect to complete our COVID add back in Q3 as we rolled back our COVID incentives at the beginning of July and vaccines are broadly available.
Our net cash from operations was $2,900,000 in the year to date period ended Q2. Our cash from operations was impacted by accounts receivable and inventory working capital needs due to strong net sales growth and production in the last month of the quarter. Our cash on hand at the end of the quarter was 280,000,000 We spent $68,300,000 in CapEx in the quarter. The Ennis facility is entering some of its highest investment quarters as all the site preparation is complete, foundations have been poured and steel has been going up for 4 months now. You can see a picture of the current state of the Ennis construction in our supplemental presentation.
Additionally, the second line at Kitchen South is on track to produce product by the end of Q3 and the 3rd line there will come online at the beginning of 2022. We are also taking advantage of the incremental capacity that is coming online to make some upgrades in our existing Kitchens 1.0 and expect to have that work completed by the end of the year. That work will improve quality and reduce some of our labor costs on one of the existing lines. To accomplish that, we have delayed our ERP implementation by 1 month to November 1. This will allow us to synchronize the shutdown of the kitchen to both install new equipment and transition our systems at the same time, reducing the total downtime for our operations.
Turning to our guidance for 2021. As Billy indicated, we are raising our net sales guidance by $15,000,000 to an updated target of greater than $445,000,000 to reflect the strong underlying trends in the business. This guidance implies that 2021 will be our strongest year of growth since we went public in 2014 and also implies that our back half growth will be in excess of 44%, setting us up with considerable momentum as we transition into 2022. The growth during the back half of this year will be in excess of the Nielsen measured consumption growth as a year ago included a significant drawdown of trade inventory due to COVID related production shortfall. We do not expect to have those issues this year.
The second half growth will accelerate as we move towards the end of the year with Q4 growth and net sales greater than Q3 behind increased production capacity, strong Q4 marketing and a soft year ago comparison. We are not raising the adjusted EBITDA guidance due to the inflationary pressures and temporary operating inefficiencies we discussed on this call. Once we have increased pricing in place to address those issues at the end of this year, We expect to once again see the leverage we get from scale show up in accelerating adjusted EBITDA margin. In particular, As we look to the back half, please take into account the following. In Q3, we expect Nielsen Mega Channel consumption growth to slow until early September and then accelerate due to increased supply driving better in store conditions and higher media investment than in the year ago.
We expect gross margin to decline versus the year ago as inflation and temporary operating inefficiencies exceed the underlying process improvements we are gaining from Kitchens 2.0 and our increased pricing will not meaningfully impact this year. We will continue to experience higher freight costs due to our depleted inventory levels for most of Q3. This will diminish our leverage gains and adjusted SG and A excluding media this year, but we expect those increased costs to cease beginning in November. We will have a large advertising investment plan for Q3 and Q4 as a match for the increased production capacity we have created. In closing, our guidance for 2021 calls for net sales greater than $445,000,000 up 40% a year ago and an increase from our prior guidance of greater than $430,000,000 and adjusted EBITDA of greater than $61,000,000 up 30% versus year ago is unchanged.
We believe we are well positioned to continue accelerating our growth. We now have Production capacity to support approximately $600,000,000 in run rate sales and are adding 1 new production line per quarter for the next 8 quarters with a balance sheet to support the capacity additions. A proven business model that can drive increased household penetration and a product that drives increased buying rates. More than 25,000 Freshpet fridges across multiple classes of trade and in 3 countries with a reliable service network that supports them, plus a strong presence with a leading player in the pet food e commerce space. Significant scale in the pet category and category leading growth that encourages our to further accelerate our growth.
We believe that positions us to win as the fresh pet food segment becomes a sizable portion of the growing pet food category. That will also enable us to accelerate our growth towards our 2025 goal of 11,000,000 households, dollars 1,250,000,000 in net sales and a 25% adjusted EBITDA margin. That concludes our overview. We will now be glad to take your questions. Operator?
At this time, we will be conducting a question and answer session. A confirmation Our first question comes from the line of Rupesh Parikh with Oppenheimer. You may proceed with your question.
Good afternoon. Thanks for taking my question. So I guess, Billy, Heather, you're starting out on the pricing front. At this point, any sense of whether there's any retail resistance to the price increases you guys anticipate taking? And then secondly, how do you think your projected price increase as compared to maybe some of the other pet food out there?
We'll let Scott take that one.
Hey, Rakesh. So, we sent out a letter at the end of last week. We carefully went over this with our sales team. We had some conversations with a handful of customers, even right as we were developing the price increase. We also looked around What we're seeing in the market, we have not heard resistance.
From our understanding, a lot of people are taking pricing at this point. So I think it's something that a lot of people anticipated and expected. The thing I want to say about the way we did it is we pushed it off as far as we possibly could. We want to take a consumer centric approach like we do to every single thing we do. We want to make sure that everyone wins in every single thing we do too.
So we want to really avoid any pricing impact until our availability and our inventory issues were a little bit more Muted and not as visible to consumers. So we really pushed it off as far as we possibly could. And again, we want to think about what is the best way to do this Consumer, for our customers and then also Freshpet, it's a pretty wide array on the pricing, meaning there are some items that will move, maybe not at all, And there are some items that will move significantly. And we've done this several times before. And I think at this point, we really understand the best Practice on how to do this, how to minimize the impact and how to implement it where we'll realize the greatest benefit And the limit as limited impact as possible.
Okay, great. And then maybe just one follow-up question just on out of stocks or retail. I'm just curious the latest thinking in terms of when you guys think the out of stocks will be at levels that you guys are happy with?
Rupesh, you'll see in the deck that we published, it shows the TDPs, which is while it's not the best measure of In stocks, it's a reasonable measure and the TDP data that's in there shows that the last measure was like 778. If you take our ACV that we have today and you multiply it by this the average number of SKUs we had in distribution at our peak last summer, We'd have to be at like 8.50 to be at the same place and you can see the line, the slope of the line is moving up at a fairly consistent rate. So I'd expect you could take a look at that and you could make your own projection. The thing that's tough is the tail end is always the hardest part to get. When you're getting into smaller SKUs that are in only in specific channels.
Those are always going to be the toughest parts of it, but it will happen sometime in this quarter.
Great. Thank you. I'll pass it along. Thanks, Rupesh.
Our next question comes from the line of Bill With Truett Securities, you may proceed with your question.
Thanks. Good afternoon.
Hello there, Bill.
Hey, Billy, Scott. And I'm just kind of following up on Rupesh's question. I don't fully understand like why not Be more aggressive with pricing. I mean, all your competitors are stepping up pricing and every CPG company is passing off pricing. You have a potential where the price gaps go away with you and some of the premium, I guess, dry dog food players.
And so it and there certainly hasn't been any real elasticity. So I understand protecting consumer and good consumer and all that, but
I mean, why not this is
a window that's open, why not be more aggressive right now?
So Bill, as you know, we have very, very aggressive penetration growth goals. And that is really fundamental to us achieving on our objectives in the next several years. So, the single best thing that you can make sure you're doing, and again, I'm looking across the portfolio. So there are items again, we will not touch a couple of items because they're the most price sensitive. And there are some items that we have some opportunity.
We have some They're fairly we had the opportunity to take some significant room there. We will be aggressive on those items. But over time, what we want to do is we want to build a really, really strong consumer franchise with many, many consumers coming into our brand, into our portfolio. We want to make sure that there are items where there are features and benefits that people are comfortable and willing to pay for. And we want to go over time from a business Consumer portfolio and we feel that we're going to I mean, we put out a letter.
We It's going to be the most aggressive price increase we've taken in potentially ever across the entire line, But it will not be, we're not our goal is not to try and get every single thing we could get. Our goal is to make sure we get what we need And to make sure that we're keeping us as available as possible for as many consumers as possible.
Yes. So let me just add Add to that, that I don't think we've disclosed yet what the magnitude of the price increases. So in terms of your question about are we being aggressive enough, there's 2 sides. There's one is the Size of it and the second is the pricing the timing. On the size part, we haven't disclosed that.
It's out with for customers. The second part of that on the timing, many of our customers require 90 day Advance notice on a price increase. And so practically speaking, you won't see it until 90 days down the road. We also disclosed that we're doing an ERP conversion on November first, which everybody always talks about those potentially creating some disruptions in business. So we wanted to get that behind us before we got in a position we were during the pricing.
But the reality is the price increases will get the full benefit of the price increases in next year.
Just to be clear, you don't see nearing a price ceiling at this point?
We don't see nearing a price ceiling? No. Okay. And then just
one other question maybe Heather that helped. Has there been a meaningful change in terms of The Innis or even Kitchen Tidu kind of costs to completion or labor or Potential that can add just certainly construction costs have skyrocketed over the past few months, but also with labor And just trying to find labor, have your calculations changed meaningfully over the past since you really talked about it a few months ago? No
change, Bill, to our plans. The team was very proactive in terms of being able to secure material ahead, had good foresight there. So no risk in terms of NF Phase 1 timeline at all with respect to materials or construction. And in terms of labor, same thing. Actually, the market there is a little bit better than the labor market and it's a little bit better than What we see in Pennsylvania.
And so as they start thinking ahead about having the right labor in place for the commissioning where as you heard Billy talk about In our comments, we're well ahead already hiring staff to start training. So in good shape there as well. Yes.
And Bill, the biggest piece on this change is the labor second wage increase that we're taking in in our facilities here in Bethlehem, which will be effective on 91. We did one in May. We're doing a second one here. That's the big cost increase that we're seeing.
Got it. Thanks for the color. Thank you.
Our next question comes from the line of Mark Astrachan With Stifel, you may proceed with your question.
Thanks and afternoon everyone. I guess a couple of questions for you. One just more point of clarification. So anything in the guidance in the $445,000,000 or
at least
$445,000,000 that is related to inventory It would have been different than what you were expecting on the last quarter, meaning that we're trying to figure out how to about kind of the apples to applesales growth. So any change there in terms of what's embedded? And then second question Is maybe a broader question, but you've had some time to reflect on out of stocks at this point. Obviously, still not completely resolved, but more than it's been. Any impact on the business as best you can tell?
Any impact from a retailer From a consumer perspective, one of the things that I've been hit on more than a few times by, I call Concern folks, I guess, is, hey, are we seeing any impact on demand here because scanner data is slowing? Obviously, the comparisons are what they are, but anything You can do to discuss that I think would be helpful.
Yes. Let me take the first part of that and I'll have Scott to talk about the This is Pat on the and anything related to our customers. But as I said in the scripted comments at the beginning, The size of the trade inventory hole has turned out to be larger than what we thought. And while we don't have a precise number that we are putting in there versus what we've been saying before, I would suspect that the number that you're seeing is probably at least $5,000,000 bigger than what we had previously outlined. So when we gave our guidance at greater than 445, we did reflect on that.
But the reality is that the slope The line that we're seeing on our consumption in the Nielsen data we're seeing is pretty much right on where we thought it would be. In fact, we have a chart in the deck that kind of shows you where that's falling at this point. And so people who have been talking about slowing growth, I remind them that I've been telling them that this is what it's going to look like for quite some time just because of what happened in the year ago and the odd dynamics of the year ago. But the line is falling exactly where we thought it would be and that's why we feel very comfortable taking the guidance up and the trade inventory holds a little bit larger. From a consumer perspective, you'll also see that the household penetration gains slowed in the quarter versus what our long term run rate is.
We do think that out of stocks played a significant role in that. In that, we're now about a year of consumers struggling to find the item they So clearly, we're not getting the conversion from the advertising to the household penetration because of it. But it also So, to reveal again that when you aren't diluting your household penetration gains with significant numbers of new users That the buying rate goes through the roof. And so we had the strongest buying rate growth we've had as long as I've been here. So I think at the end of the day, We have seen this before that when we do have shortages like this, the penetration gains bounce back and so we're not concerned by it.
And the mix of buying rate and Penetration will probably swing back to penetration, beginning in the Q4 of this year and continuing throughout next year. I know Scott, You want to talk about the customer impact of the out of stocks? Got it.
Got there.
I guess not. That must have dropped. So anyway, I guess I would say that the customers the customer feedback that we're getting is obviously they're as frustrated as we are by the shortages. And at this point, we've communicated very aggressively with them what our plans are. And we expect that they are all waiting to see improvements in our position inventory position before they start putting in more fridges.
But they know this is This segment to be in, they know this is where the category is going.
Great. Thank you.
Our next question comes from the line of Ken Goldman with JPMorgan. You may proceed with your question.
Hi, thank you. 2 from
me. Heather, did you mention and perhaps I missed it, how much trade inventory you're modeling
in the back half of the year and what the timing of that might be between the two In the back half of the year and what the timing of that might be between the two quarters?
No. We touched on the Q2 refill being $8,000,000 We didn't touch on Because we don't know the full magnitude of the number, Ken, so we didn't touch on a specific number for the back half with respect to that. But we do anticipate some continued trade resale in the back half.
Okay. But With a follow-up to that, I guess, what are you modeling in? Are you modeling in a number that you think is beatable there or is conservative? Or because I'm just trying to
get a sense because you did raise your guidance, how much of that guidance raise was because of an expectation for increased, I guess, pipeline fill for lack of a better phrase?
I guess, let me take that, Ken. First of all, I think it will be skewed more to Q3 than it is Q4, where they in because we're still refilling it as speak and we expect it to be done by the end of Q3. And at the same time, we also said in the comments that Q4 would be bigger than Q3. If you Call last year, Q4 and Q3 were about the same size, but we think Q4 will be bigger because of the heavier marketing investment that we this year. We also have the available supply this year in Q4 because we're bringing on that second line of Kitchen South that comes on September in addition to the capacity that we already have online.
So when we gave The guidance at $445,000,000 we had a pretty good handle on where the consumption line was headed and we also had a sense for how much of trade inventory refills happened in Q2, What we think will happen in Q3 and we're quite comfortable with the guide we gave being the sum of those 2 and will be in excess of 445.
Okay. Thank you. And then quickly, you've raised your outlook for sales, obviously. You also raised your outlook for capacity in the back half
of the year. Is it fair to
say that these factors are unrelated? I would assume so because your second half shipments Still be well above your theoretical capacity. I just wanted to make sure that it's more demand and pull driven
and not push. Yes. I mean, without a doubt, it is there's nothing that's changed about the way we generate demand. Frankly, what we We're updating is what we actually think those pieces of equipment can get and what our staffing will get. As you heard, it's a rather dynamic staffing environment for us.
And we've been finding ways to move our staffing around and also attract staffing that gives us a higher degree of confidence in our ability to The revenues that we included in the chart that you're referring to in the deck, but it is not at all driven by a It's all being driven by our efforts to secure the maximum supply. Frankly, we've been so frustrated, Ken, by our ability to get caught up and frankly, our Customers have already been frustrated as well. And this is us looking for every way in which we can get more productivity out. And we think we found some pretty good ways. We said before too that Kitchens 2 is turning out to be more productive than we had expected.
The capacity on that operation is remarkably good.
And to actually extend that to tiny bit further, and sorry, I dropped off a moment ago, folks. But capacity has been and will be Probably the single biggest limiter that we have for a very long period of time. Understood. Thank you.
Our next question comes from the line of Peter Benedict with Baird. You may proceed with your question.
Hi, guys. Thanks. First just on the increase in the revenue plan for this year. Just curious if the addition of Chewy played a role there Or if you guys had always kind of had something in there for Chewy on the initial guidance. That's my first question.
We always had it in there.
Okay. Thanks.
Yes. And then, I guess on the I think I kind of frame now the magnitude of the price increase. How about just on the wages? If you think about the 2 that you all have taken, can you give us a sense of how much wages maybe have gone up Yes, versus 2020 to 2020 level, I guess, as we look for all of this year. Thanks.
Well, I'll just talk about it in terms of what the hourly wage is Don. I don't want to go into the specifics of the total at this point. We might find another way to have a conversation about that. But our regular wage increase after we did some normal Back in May was a 3% increase and we realized that that was not going to get us where we wanted to get to. So the increase that we're Taking in September is much more sizable than that.
It varies by level in the organization, but the headline number will be a 20% increase.
And Peter, I think the other way to think about that is we are trying to kind of go back The principles on how we operate and think about like the business. And we believe this is a real significant investment in our company. And because we want the best quality, we want the most efficiency, we want the most effective lines possible. And quite honestly, just growth requires to get more out of our lines, but also if there are more people. And could you imagine if you were adding to your team and someone came in and they were there for A week, a month, 3 months, 6 months and then they left and you have to start over again and again.
It puts strain on the rest of the team. So We're trying to like really create a completely different approach to this and really invest in kind of the vision for where we're going.
Yes. No, it makes sense, Scott. Smart move and it makes a lot of sense. I think, Bill, you said Dynamics capping environment, Dynamics is
an understatement.
My last question is just about with the households that are being added, the millennial and the Gen Z households, Just curious, remind us kind of what products maybe they're gravitating to any differently than maybe your legacy customers And how that maybe influences your innovation plans for the next few years? Just curious how that's trending?
Yes, actually, that's an important question. There's some interesting data that's actually out there at this point. So it looks like more pets were added last than any year that we've been able to kind of track back and look at. Of the pets so that's about it was about a 5% increase. So usually like 2% increase in pets or it was like about a 5% increase.
So the number that's been thrown around 7,000,000 more cats and dogs, Right, that are kind of now with consumers versus in shelters or whatever. Of those, the biggest group that acquired Pet Right. It was millennial and Gen Z. And also that group is willing to spend more on pet products, and they're also more thoughtful about the products that they want. So this is kind of exactly what you're talking about.
When we look across our portfolio and we think about how we're doing, first of all, we well over index with Millennium Gen Z. We really think we're a key piece of how pet food should shape into the future. In addition to that, we're taking one of our brands, it's called Nature's Fresh. It's been in the natural channel. And we are taking that brand and we're doing every single thing we can to position that very specifically to win against millennial Gen Z.
It's always been GAAP rated meats. I don't want to get into too long an answer. We talk more about it at the Sustainability Summit, But it's GAAP rated meats. It's actually carbon neutral now. It's one of the first carbon neutral pet brands out there and the largest as far as we can tell.
So we've really taken a different approach. You'll see a lot of work we're doing on overall the brand, How we're talking about it, communicating it, packaging, formulation, etcetera. And then finally, one of the things that we're doing where we think there's tremendous opportunity over time, We've mentioned it in the past, but we're launching this product called Spring and Sprout. It should start shipping, like right in the next couple of weeks. I haven't seen it on shelf yet anywhere.
But we've announced this in the past, it is a plant based meat product. It's a terrific product. We're really, really excited about it. And it really addresses both Ethics in meat, but also environmental concerns around proteins. And we think that's going to be an important product, an important addition to the portfolio that we're building out over time that's focused on the kind of younger consumers.
Okay, great. Thanks so much for that.
Our next question comes from the line of Beth Wissink with Jefferies. You may proceed with your question.
Thank you. Good afternoon, everyone. We have two questions, if we could. Heather, I think this one may be suited for you, but it's related to the one line per quarter addition and capacity. If you could just help us think through the stair step of how much Revenue value each line could add as we think about the next 6 to 8 quarters or so?
Sure. So, actually, in the accompanying presentation, there's a chart that shows that continued ramp up. But when you think about where we are headed versus the end of this year, we're adding the one line, One additional line in Kitchen South, which brings the installed revenue capacity by the end of this year to 760,000,000. So that's Sort of the first phase of the project. As we enter next year, we have an additional line at Kitchen South that will come on actually in the beginning of Q1, and that line will have revenue capacity of about $50,000,000 then and it starts to ramp up.
So starting in beginning of Q2 And then each Q3 and Q4 will have each of the NS line coming on NS Phase 1 line coming on board with a total of $400,000,000 by the end of 2022 in Ennis. And at the same time, we'll be working on our Kitchen South Building 2 project. The plan on that project is to install Three lines over the course of 2023 with revenue worth about $300,000,000 There's some variables to those numbers, and the See is that we have new technology that we're testing. And so depending on that new technology, Kitchen South Phase 2 building 2 as well as the 2nd phase of Ennis could be impacted with incremental revenue potential depending on the actual outcome of the new technology.
Okay. That's very helpful. And then just one follow-up on pricing. I just wanted to be compartmentalize the 2 drivers. So labor inflation being one Reason to take price.
The other you mentioned was shipping inefficiencies. And Heather, maybe just to talk a little bit more about the temporary nature of that. Think you mentioned as the back half progresses and as you gain efficiency, the inefficiency burden on gross margin would start to mitigate. So just wanting to understand a little bit about, Are you taking price to cover both and then once those inefficiencies roll off, you'll see a little bit of margin benefit? Or do you expect us to just cover the ongoing shipping in
Yes. So I'll just describe first the inefficiencies. There's 2 elements of inefficiencies, one that impacts Gross margin, the other that impacts SG and A where the logistics costs are in our P and L. But what emerged in Q2, we described as some Temporary processing inefficiencies or temporary operating inefficiencies as we've been ramping up the new lines in Plant 2 as you would expect with new staff. We just some of those sort of getting the kinks out as you're ramping up sort of exceeded expectations.
And we do have Many new folks that are coming into that facility, and so there's a lot of training and learning curve that has to happen there. Those inefficiencies we expect actually by the end of this year to be self resolved in Plant 2. The other inefficiency is in freight that we've been talking about since the beginning of the year, where our systems don't allow us to allocate inventory to orders and Transportation is planned because our toll rates are so low with a much larger expectation than is actually shipped. And so that inefficiency also Two things will happen. 1, as we improve our inventory position and have improved fill rates that will self resolve.
But we also are building the capability to allocate inventory into our new ERP. And so that will by November that particular issue will be resolved. Our pricing plans are looking ahead, are focused on where we expect inflation to be headed into next year. And obviously, there's Few variables to that, but at this point, it's really to offset the expected anticipated inflation, as Scott mentioned earlier, and we'll see where that lands up as we the big variable of course for us will be chicken and where we lock that pricing at the end
of this year. And Steph, I would I'd add to that, that we think that some of our cost increases are As Heather described in sort of our temporary inefficiencies and we're not pricing for those because we think those are going to go away. What we're pricing for Is the inflation that we think is not going to be erode go away, which is basically the inflation that's due to labor, both our own internal labor as well as the labor at some of our suppliers and they're going to start passing that labor cost on to us and we're already seeing it this year. And so anything that has the labor component that's driving inflation. We have to price to cover that.
But if it's our own temporary inefficiencies, we're not pricing for that. We're going to get the efficiency gains from our operation as we've described it in the past, both from scale as well as from moving to the more efficient lines that we've got. And then also Diversifying our shipping to a second shipping point, those kinds of things are going to get us the efficiencies that we need to drive the margin.
That's very helpful. Thank you.
Thanks.
Our next question comes from the line of Jon Andersen with William Blair. You may proceed with your question.
Hi. Excuse me. Good afternoon, everybody.
Good afternoon.
My first question is on, should we and I guess multifaceted. I'm curious how you think the addition of Chewy will help To what extent will accelerate your e commerce business and where you think, e commerce goes as a percentage of sales over the next Couple of years. And then where do you think the biggest benefit will be derived? Is this a household acquisition tool? Is it A buy rate enhancer or some combination of both?
So, hey, John. It's Scott. So, we touched a little bit on this. We had a couple of discussions where we've touched a tiny bit on this. But look, we think that If you broadly look at where we are today, we recognize there are definitely a group of consumers that want to be able to get Products delivered to their homes in some way.
There are right now, we have a handful of ways that you can do it. You can do the click on click and pick, The buy online, pick up in store, there are a handful of services. We think that the partnership with Chewy makes a lot of sense For both companies, we're really excited about it. I believe, personally, that over time, what will I think as consumers get into a regular cadence, I think that it will not only provide an opportunity for consumers that want convenience, But also consumers that want a consistent cadence. So I think it will give us a great opportunity to expand buying rate over time.
So with respect To the specifics around that, we don't know. We're 2 weeks, 3 weeks into launch. It's super early. They're great partners. They seem like, it seems like it's going to be a great partnership and relationship over time.
I don't know how it shapes, but the research we had done demonstrates that it will both open up penetration and buying rate over time. And I think there is a ton of potential there.
Okay. And have you structured your kind of the product And your pricing in a way that makes you channel agnostic across the portfolio at this point?
Yes, we have. And it's we one of the things like and I know like everyone's thinking like Scott mentioned principles and values like multiple times here. But one of the things we have down like and I'm serious about like every time I do everything, Like anything we do, I literally look at and go, how does everyone win from this activity, right? How does the consumer win? How did our partners win?
All of our partners win. How does Fresh And if we can't construct a way that everyone wins, we are very, very we just won't do it. And we're super fortunate. We've got we have more potential. We have tons and tons of potential, and we have so much opportunity for growth That we want to be really kind of thoughtful in the way we're constructing our business, our portfolio, who are the partners that we're working with, etcetera.
So, yes, we are agnostic, if you want to talk about it that way. But, I mean, every different customer, every different channel brings different benefits. They have different types of consumers. And we're making sure that we're kind of developing a portfolio that best meets what that consumer and what that customer is looking for.
Okay. That's helpful. One quick follow-up. In the prepared comments, someone I think maybe Billy mentioned expecting More stores and second fridges next year with supply conditions better, in store merchandising Conditions improved. Could you add a little bit more color to that?
Maybe it's too early to think that way, but you're up low to mid single digits In store count, in the first half of this year, do we see acceleration off of that in 2022 given the commentary? Thanks.
So, yes, it's another it's an important question. I mean, keep in mind that the vast majority of our growth comes from Penetration, which is behind our marketing advertising. That's really what that drives 80% plus of the growth for the business. Back to the store piece, it is obviously really important. The thing that makes our marketing more effective is the widening availability.
It makes it more accessible, more convenient in more stores. And then even the second coolers, the productivity of the second coolers has been extraordinary. The problem is we got
to keep them full.
That's been our biggest trick. But adding second coolers into productive stores This is really, really powerful. So the way I look at this is, rightfully so, the conversations we're having with our partners Are very centered around, hey, we don't have enough product. So there has been some hesitancy to add lots of coolers. Look, we're having a great year.
Like we're progressing nicely. There's a lot of second coolers that have been added. You can it's page 26 in the PowerPoint. So we're making really nice progress. But there are some people that are kind of slow walking.
And as we have more product next year, we think that like we think everybody's figured this out in the last 18 months, 24 months. Look at the size of Freshpet. Look at the consistent year on year growth of Freshpet. Look at the same store sales growth of Freshpet. Look at the stickiness of the consumers that it brings in.
So I think people that haven't been awakened to the potential of what Freshpet can do for the category, I think are really there. And I think it's going to create a tremendous opportunity for us. Like we're definitely not ready. We got to finish this year. We're definitely not ready to give numbers, but I think it's been really encouraging.
Don't know what the numbers will look like next But it's been encouraging and we should see, I would say, a good year around that. But going back to the first point, the vast majority of it is penetration and And advertising based, we should be spending more dollars than ever next year in advertising and that should drive velocity Penetration, velocity and overall revenue growth.
Thanks so much.
Our next question comes from the line of Robert Moskow with Credit Suisse. You may proceed with your question.
Scott, I'm glad that you've devised a win win win system for your customers and everyone. I wish you worked in the auto industry. It might help out my family quite a bit. Yes. We need to get you where you can help us out more.
So I had a question on Slide 17 Actually, you provide your fill rates going back. I guess this is several quarters. And I guess what's noticeable to me is, it looks like it doesn't get much past 65%,
And you
have a trend line moving up into the right. A couple of questions. Is this are these yellow dots, Is the most recent one, the one on the farthest to the right or is it somewhere else? Like what was your fill rate in the quarter? And If your fill rates are kind of in this 40% to 65% range for what looks like a pretty long period, Is it possible that this might be part of the nature of the business that there's just a That there might be something intrinsically difficult about keeping these fringes full given the multiple steps to get Product into them.
Just a quick question.
Rob, I think you're referring to the slide that says as we rebuild inventory, so rates go up. Is that the one you're referring to?
Yes, that's the one.
So that is data that says the slide we used last quarter. It's not the recent most recent data we're to demonstrate the point. But the reality is we've operated at fill rates that were in the 90 plus percent for quite a long time until we got into COVID. So it's not there's nothing about this business model that keeps you from getting to for full trucks. And in fact, with the new ERP system, we'll be able to allocate the orders, the inventory to the orders and we'll be able to get to full trucks.
The other part of it is getting the fridges full. And what we're finding is and it's not surprising is that the higher the velocity of the business, the better the fridge conditions are Because the stores then have more reason, more incentive, more reminder to keep filling the fridges. So some of our best filled fridges are in the highest velocity stores. So It's a learning curve when you are low volume and low velocity to get purchased full. But as you get to be a more Important part of the store's volume and a more important habit, the fridges look better.
Okay. But so what do those dots represent then, Billy? Are those Quarterly results or monthly results or what are they?
I think they're just observations.
Yes, it's showing the correlation of the one on the left is the correlation of the fill rate with inventory levels. And so you see as inventory levels are improving, the fill rate approved. And then on the right, the chart there It's showing the direct correlation that we have where the cost per pound is goes down as the fill rate improves. And so it's not a period of time. It's more the link of those two factors with But
each data point is an instant. It's an instant.
It's an instant a day or a week.
Okay. So they're very short time. Okay. Now, so basically, I mean, The fuller the truck, the more cost effective it is. I got you now.
Okay. And then a follow-up then. You talked about the ERP transition in November.
It seems like a lot
is happening all at once. How much inventory do you need to build up to give you cushion during that transition? Because it seems like inventory is still not where you want it to be.
Yes. So the thing good is when we do The conversion will have to shut down the operation for a couple of days to implement the system, do the testing, the training and whatnot. And we're taking advantage of that downtime to actually upgrade some equipment on one of our lines. But how much inventory do you have to build? I mean, Ideally, you would be in a position where you could continue to ship your orders during that time period with a high fill rate.
We think that full inventory on our business is Somewhere between 4 5 weeks of inventory. That sounds like a lot for a fresh products business, but you have the range of brands and SKUs that we have across the portfolio. So you need to have about 4 to 5 weeks of inventory. Today, it depends on what day you're looking at, but we probably have about 2 to 2.5 weeks of inventory. But we're producing, as you saw on the other charts, we're producing well in excess of demand every week, well in excess of consumption every week.
So we're building both Our inventory and trade inventory as this goes. So we should be good. Hey, Rob.
And the other thing to think about is And I'm not minimizing it because they're big things. There is a lot going on, but we've been doing like there's a group of 40 people here that literally started the company, right, that started we all started together pretty much in the
very beginning. So
Every 3 years or less, we double the size of the company since 2006. So now the numbers are getting bigger and But we brought in like smarter people, right? There's Billy and Heather are on the phone. And I'm just focusing on the win, win, win. So, but in all seriousness, there's always been a lot going on.
And we're not by no means were Perfect, but we've been able to manage a lot of it really, really well.
Okay. All right. Thank you. Thanks.
Our final question comes from the line of Ryan Bell with Consumer Edge Research. You may proceed with your question.
Hi, everyone. Regarding the household dynamics, you said you're seeing a slowing in household penetration sort of relative to the expectation and the Is the primary driver of that, that the increased buy rate is coming from just having more long term users and fewer New buyers coming in that would dilute the buy rate? Or is there something else maybe for some of the new users that are saying also buying at higher rate?
Well, we saw the data we published earlier this year. The first part is yes. When you aren't diluting the existing buyers as The buying rate goes up. So there's no doubt about that. And if next year with the Scotts enormous marketing budget, If we start posting 30 plus percent increases in penetration, you should expect the buying rate to go down, not go up.
It's just the way the math could end up But there is a longer term phenomenon that's going on, which is that we've seen each cohort that entered the franchise over the last 5 years Started at a higher level of purchasing than the cohort that came in the year before them. So they are coming in with they're buying higher value items Higher price per pound items, they're buying more of them. They're making they're using the product more frequently or more regularly. So we're seeing that phenomenon. There's also the like There's some amount of consumer hoarding that's going on, as consumers found there's a scarcity of the Freshpet product So the one in the store, they bought it.
And then what that does is it gives the buying rate for some user, lucky user found it goes up and the penetration for the other guy goes down because they couldn't find anything. I think that's small, but it is real. That's helpful. And
about the specialty channels, do you think that that's And regarding the Chewy relationship, I know it's been early, but have you found anything in terms of How that's impacting your existing e commerce user base?
Ben, do you want to take those 2?
Yes. So on the pet specialty piece, so I don't know if you caught it earlier, but one of the things that we're definitely seeing is a lot of new consumers, Very heavy millennial Gen Z. They think about shopping differently and where they're shopping, how they're shopping the types of food that they want to buy. We think that this is a trend that's driving pet specialty in general. Like if you look at their numbers overall across the board in food, they're up.
They're doing nicely. And if you look at our numbers, they're nothing short of extraordinary. We think that there's like a pretty long road in front of this. In addition to that kind of that secular trend, we've also added a lot of second coolers in many of these stores, which allows for a broader product portfolio. And hopefully, in many cases, a little bit more product, which makes it more available.
So we continue to we expect to continue to see really strong growth rates And Pet for a pretty long period of time. Don't know how long, but I think it will be for quite a while. It's Again, we're very excited about the Chewy partnership, the relationship. We think there's a lot of potential there. It's super early and we don't we won't get into the specifics of Dynamics between customers, etcetera.
We just don't get into that level of data. So but it's way even if I even if we were going to do It's way early, way early. Thanks. And the last one for me. In terms of the freight cost Impact is being driven by some of the issues with existing ERP system.
Is there a way to Give the magnitude of that actual impact that we would expect to be going away.
Yes. So, as you heard me talked about the Freight as a percent of net sales at 11% for the quarter versus 7.8% last year. We do have freight inflation in the first half of about 10%. The way that it splits out in terms of the inflation versus the fill rate inefficiency, About 100 basis points, comes from the inflation in the first half and the balance of it is coming from the fill rate issue. So depending on the quarter, it's somewhere between 150 to 200 basis points of an impact.
Thanks. That's very helpful. That was it for me. Thank you so much.
Thanks, Ryan.
Ladies and gentlemen, we have reached the end of today's question and session. I would like to turn this call back over to Mr. Billy Cyr for closing remarks.
Thank you. I'm going to close with a quote from Ann Tyler, the author of Gentle tourists, ever consider what our dogs must think of us? I mean, here we come back from a grocery store with the most amazing haul, Chicken, pork, half a cow, they must think we're the greatest hunters on earth. And I would add to that, include Freshpet and they'll think you are a god. Thanks everybody for your interest and your attention.
Thank you for joining us today. This concludes today's conference. You may disconnect your lines at this time.