Would you pay $10 per day to feed your dog?

To be clear, I wouldn’t. I don’t even pay $10 per day to feed myself. But in a world where people seriously buy insurance for their dogs, why not?

For those of you who don’t follow the IPO market (that is, when a company becomes public and when everyone can invest in a company, not just billionaires), Freshpet is having its IPO tomorrow and it’s probably one of the most hyped companies since Alibaba. So the question is, am I going to invest in it? And, better yet I suppose, should you?

Let’s take a closer look at the company. Freshpet sells pet food; specifically, it sell refrigerated pet food. As in, food in a fridge. For animals. In case you don’t know, this implies:

a) A much higher cost to deliver stuff, since the delivery truck has to be refrigerated (or you have to package the stuff with dry ice and special insulation, which is about as costly)

b) A much higher storage cost, since you have to pay electricity to refrigerate it.

c) More waste, since this stuff expires much faster than food that is kept on shelves

If you ever had a dog, you know that chow pretty much comes in bags, which allows sellers to avoid exactly the three problems above. The bags can be shipped in any regular plane or truck and it can be shipped with pretty much anything else the store sells. For this very reason, regular pet food is far cheaper.

But Freshpet’s approach also comes with benefits. If you want to feed your animal real meat, it’s quite obvious you need to buy something that is either 1) refrigerated 2) frozen. While the frozen pet food approach would make sense, we aren’t there yet (there is little interest in advertising a fresh product if your product is actually frozen; nevertheless, it exists and is fairly popular).

In a world where people care more and more about their pets, is there a market for high-quality, refrigerated pet food? Better question yes, can this be converted into a real company that is actually worth investing into? Let’s analyze both the good parts and the bad parts of Freshpet to determiner whether it’s an investment that’s worth doing.

The Good:

1) Freshpet is a clear winner.

It makes zero doubt to be that Freshpet is a winning company. Based on its numbers, it managed to stand out in an oversaturated market at a time where everyone thought pretty much every innovation in the field of pet food had been done. It is growing at an insane number and shows no signs of slowing down. Just look at its numbers:

With numbers that are even better in the first half of 2014, Freshpet is ripe for its IPO, which will bring much needed funds (more on that later). With sales growing something like 52% year over year and still a lot of room for growth (Freshpet estimates it can grow up to 35,000 fridges, enough to maintain the same growth for the next three years and that’s just for new points of sale), I don’t believe Freshpet’s success will end anytime soon. It belongs in the closed and recondite groups of winners and winners tend to know what they are doing.

Freshpet somehow managed to start an impossible task and succeed. There is no doubt we face a full team of competent, veteran managers with a strong interest and passion into growing the company into an even more successful business.

2) Freshpet is in a winning market

I have a not-so-happy story to tell from a few years back. I was once in Verdun (Verdun is to Montreal as post-Katrina Orleans is to the United States), about to checkout, when I noticed a fat lady in front of me with the following items in her cart:

a) A pack of cigarettes

c)A large bag of dog chow

d) Jars of baby food

She was a few dollars short for her order. Guess which item she removed from her cart? Yep, the baby food.

It’s sad to say, but if you told me that some people today would rather feed their dogs than their children, I would believe you. Based on that premise, I believe Freshpet has a bright future ahead of itself. There are two markets I would bet strongly on: old people and domestic animals. Both these markets are going to keep growing at a phenomenal rate for the years to come simple because we live in an affection-starved world and people would do anything to even have the impression that they are loved. That’s why private senior centers will always work and that’s why people will keep buying super-expensive food for their animals.

Many people today consider animals to be fully part of their families, a sentiment I can fully understand. People love their pets and quite possibly more than their love their parents.

3) Decent IPO price

At the upper range of its IPO price (the price you need to pay to buy a share of Freshpet a microsecond before everyone can actually buy it), Freshpet is not overpriced. With an expected market cap of $413 millions, Freshpet would trade at a little bit than 5 times its 2014’s sales of $80,000,000. With a gross margin (revenue minus cost of product divided by revenue) at 42-48% (that’s an outstanding margin that beats even Apple, the God of Stocks) and quick growth, I believe the valuation is justified. For instance, in three years, it should reach $250 millions in sales easily and if it can somehow maintain its high margin (which I believe it will), we will have a company worth close to a billion on our hands.

4) Deep inner knowledge of the market it plays in

I mentioned the very competent managers the company have. Let me clarify on that.

You can be an average manager and start a web hosting company pretty much easily. Get a few talented engineers, spend a few millions and voilà, you got a company worth hundreds of billions on your hands.

But in a market that is oversaturated and dominated by a few key players, it’s a far harder task. Let’s say you wanted to sell a new toothpaste brand: how would you do it? How would you reach out to customers? How are you going go convince them to try your product instead of what they normally buy?

In fact, how are you even going to get your products into large stores? It’s a Catch-22: people won’t be interested in trying your product until they can find it in the place they normally shop at and they won’t find it in the place they normally shop at until you can convince enough people to try your product. And at the end, why would they care? What’s wrong about the product they used before? They’ve been using that product for years and it always worked, why change! Why take the risk?

That’s the challenge Freshpet was facing, and it somehow suceeded.

I’m not sure how, but they did it. There are ways to reach your goal, of course, and no company is eternal. Even Coca-Cola could technically be beaten by a new soft drink player and if you don’t believe me, read on the tainted beer scandal of Dow Breweries. It’s doable, but it’s just very, very hard.

Freshpet has a deep inner knowledge of the world of pet food and you can notice that immediately. For instance, Freshpet does not call its clients “dog owners.” They call them “dog parents.” They do not call the places they make their food “factories” but “kitchens.” It knows who its customers are and it reaches out directly to them in a way large pet food sellers can’t.

5) Excellent reviews and outstanding products

… and, at last, the outstanding reviews of all their products. Freshpet offers excellent products that are clearly well-liked by their customers. I have no problems believing animals prefer fresh food to chow. I don’t know if it will make them healthier, but if someone told me his dog prefers fresh food to regular chow, I would have no problems believing it.

Great reviews ensure repeating customers and this is not a product that can be simply copied. I mean, technically, it could, but it will take years and years for a competitor to establish itself like Freshpet did, along with a major initial investment and huge risks. And at the end, the brand will ensure people remain loyal to the original product. Thus, I believe Freshpet’s margin to be sustainable over time.

6) A prime takeover company

I do believe Freshpet would make a prime takeover candidate in a few years for a mature, larger company. Because of how it’s designed, it’s attractive to several diversified consumer products companies. Think about it: in a world where Proctor and Gamble and Kraft have hundreds and hundreds of brans, there is a strong appeal in adding another and with its shares now on the stock market, the probability increases significantly. Big companies love that kind of diversification and could use it to reignite a stagnating market of theirs, or at least obtain a competitive advantage over their competitors. I do believe we will see hostile takeover attempts in 3-5 years for this company simply because it fits the profile well. I would estimate the takeover price, if one happen, at something like 1.5 billions - 2 billions (in five years). Not a bad return indeed.

The Bad

1) Freshpet is burning through money faster than my ex Tara

You know the feeling when you have to lock your credit card in your safe because your girlfriend might grab it while you sleep and make a copy? Yeah, this is what investing in Freshpet feels like.

Freshpet is burning cash at a catastrophic rate. As if things couldn’t get worse, it is still very far from profitable and it will be many years before they will be able to stop plundering their cash reserves. In fact, that IPO is just in time, because Freshpet needs money, and it needs it now to continue growing (which it absolutely has to do).

In short, you are investing into a company that needs cash and a lot of it; in 2013, it burned through $30 millions like it was nothing and the $167 millions they will get from the IPO (less fees) will last them five years at most. Can it reissue shares so shortly after an IPO to raise more capital if needed? Doubtful, meaning they will have to look at the debt market - except that Freshpet already has a sizeable debt of $83M.

Then again, it can be argued that the cash they burn to pay for expansion. After all, in 2013, Freshpet added 2,322 of its fridges. A cost of roughly $12900 per fridge is nothing out of ordinary if you consider the cost of the fridge itself plus the cost of stocking it, as well as the marketing cost. In fact, of the 30 millions dollar it burned, $22 millions were used specifically for adding fridges. Another 8 millions was used as dividend on their special shares and Freshpet plans to use the IPO proceeds to rebuy those dividends. It can thus be argued  that Freshpet is already profitable or on the brink of it.

On a completely unrelated sidenote, I haven’t exactly have the healthiest love relationships.

2) Overall, it’s just another pet food company

There is nothing special about Freshpet. It makes pet food. Okay? There is nothing revolutionary or extraordinary about it. In fact, their food is not even organic (which would be ridiculous for animals, I agree, but some people do feed their animals organic products), which would really differentiate them from the other 200 companies making pet foods.

You’re not investing in a website that owns the eCommerce market of China. You’re not investing in cool electric cars from the future or a new revolutionary process that is patented and has the potential to save some companies billions. You’re investing in pet food. Great pet products, certainly, but pet products nonetheless. Not super-exciting and nothing revolutionary or extraordinary her.

Sure, Freshpet is the only one that I know offers fresh dog food, but how much of an advantage over competitors can they have over that simple fact? I don’t think anyone else is going to start selling refrigerated products simply because Freshpet dominates that part of the market, but how important exactly is that part of the market and how many people are going to stick with those products for the conceivable life of their animals? Why not another brand that is cheaper?

In other words, is Freshpet’s advantage strong enough to justify it being a real long-term profitable investment or will its idea erode over time once the novelty factors wears off and people stop paying a premium just to have a product that is refrigerated instead of shelved?

3) Refrigerated pet food?

I admit I was puzzled by the idea at first. I mean, it makes little sense at first to spend so many resources for an advantage that seems so marginal, at least at first. Think of all the energy that is wasted to store and keep those products at a perfect temperature? Also, unlike dog chow, those products expire - what happens to those products them?

Freshpet is unique for fabricating its own fridges and placing them into stores. It looks like something like this:

Looks decent. Hell, it looks great. If I had a dog, would I be tempted to try it? Certainly. That’s one awesome-looking dog at the top here (and cat, yes, yes).But how much do these cost exactly? Each fridges takes 15 months to pay for itself. The company needs to pay for the construction cost, the stocking fees, the electricity, the maintenance, etc. Seems like a lot of trouble for pet food.

It does make the company stand out. Unless you’re blind, you really can’t miss it. However…

4) Would you pay $10 per day to feed your dog?

… and we go back to the title of this article, and the main problem with Freshpet. This problem is well described in this article and I admit I had trouble getting my head around it.

I did some research, and the cost of feeding a large dog with regular chow food varies from $20 to $60 per month. Let’s say you don’t want to feed your dog crap (which I assume the $20 product is, but that might not be true, I admit) and go for close to the upper bound, $50. Are you ready to spend six times more, $300 per month, to feed your dog Freshpet?

My first reaction to that was, “Lol, no.” At this price, you might as well feed your dog real chicken and come out ahead. But in a world where people buy $5 lattés from Starbucks, why not? I think people who love their pets and have a lot of money feel increasingly bad at feeding their dogs some kind of dried nuggets while they themselves buy $100 steaks (and up), sushis, caviars and so on. People even tend to associate human feelings to their animals - perhaps they feel the animal is eating it because it’s hungry and does not truly enjoy it. Perhaps they feel dogs are happier when they eat meat and now dried stuff (and perhaps they are even right). How many times do dogowners give their pets leftovers from a meal? Quite often indeed.

In that optic, and in the optic that people pay $1,200 for a phone they to browse Facebook, I guess Freshpet does make sense. Also, theanalysis of $10 a month to feed a dog is in the absolute upper limit and slightly exaggerated: this was the cost for a large dog, and you can actually buy in bulk for much cheaper. You could also mix half Freshpet, half chow. At $4 per day, I think the cost, while in my mind still incredible (A friend of mine did a challenge to eat for $1 a meal and suceeded easily), I think Freshpet will catch on.

5) Extremely strong competitors

Freshpet will face the already well-established, well-advertised and profitable Iams, Pedigree, Purina et al. Even in the fancy pet food category, Freshpet faces strong competitors such as Taste of the Wild, Greenies, Hill’ Science and so on. In fact, look at all the dog food brands there already area on the market.

Can it continue to grow at an alarming speed while the sales of its competitors barely rise? It goes without saying that when people buy Freshpet, they do not buy Pedigree or Iams or whatever (or they buy less of it). Will those big companies tolerate it? Will they try to launch their own refrigerated food perhaps? I don’t think they will - it would be far more cost-effective to buy Freshpet, even at a premium (see: my point 6 of “the good”).

Overall, Freshpet will face aggressive competitors with strong teams and a lot of verve to succeed and increase their sales. The US market dog food is $8.5 billions per year at the moment and Freshpet barely touches 1% of that. At 5%, it will start to seriously attract attention.

6) Freshpet plays a dangerous gambit

Freshpet’s entire business model is peculiar to say the least. Unlike dry dog food, refrigerated dog food can only be kept for a limited time - presumably a very limited time (months). This in effect means at best having to sell its expiring products at a significant discount, which may hurt its image, at worst having to throw it away or give it to shelters.

But this is only the small part of the problem. In fact, Freshpet plays a dangerous game: it has to convince retailers to place Freshpet fridges in their stores. These fridges take space and, in every store, space is valuable. The space occupied by Freshpet is space that could be used by something else, potentially something more profitable. Thus, if stores suddenly decide that space could be used for something better, Freshpet could be dumped in a whim. A mitigating factor to that risk is that people who are used to buy Freshpet will return to the store specifically to buy Freshpet products, thus producing returning customers for the store. However, this is still a very dangerous game, and if Freshpet was to start failing, it would fail fast. Finally, stores cannot place Freshpet products anywhere: it needs to be near an electrical outlet. Furthermore, the store will incur a cost for running the refrigireator, which has to be powered and running 24/7.

Freshpet plays another dangerous gambit: it has to stock up those fridges regularly. It cannot, like for dried food, have it shipped alongside other products. Its products need to be refrigerated from point A to B, that is, from the moment it is made to the moment the customer buys it. This is not a simple task and, thus far, has cost quite a lot to do. But then again, the more fridges Freshpet has, the lower its restocking costs since every additional fridge in a sector will cost less to provision. Also, Freshpet has to anticipate demande to deliver the right products at the right place.

Conclusion

So, conclusion: is there a market for fresh, healthy, nutritious, natural, refrigerated pet food? I believe that there is. Am I going to be investing in Freshpet IPO? At a price under $14 per share, without a doubt. Inbetween $14 and $16, most likely. Between $16-18, this will depend on volume, how the stock fares and how the general market is doing. Inbetween $18-20, most likely not and over $20, no.

Make no mistake: Freshpet is no Alibaba. However, it’s the kind of company that will either earn you a -50% return or a +300% return over five years. It will either keep growing at a rocket speed and eventually become a market leader or fail miserably and be shoved in a pit with the other 200 pet food companies that will be quashed by the winds of time. Overall, it is a good gamble and if I had to bet on either scenario, I would bet on Freshpet becoming succesful. I’m buying.

Verdict: Investing around $3,000-$4,000 during the IPO. Will edit once I manage to buy.

UPDATE 11/7: Stock opened up at 20 and I sighed heavily. It dropped down to $19 and I considered buying, but I am overexposed to the market at the moment and there are several great IPOs coming in the coming days. I chose not to buy. Stock is back above $20 and I don’t see it coming back down from there. At $18, I would buy some.

UPDATE 11/7 (2): Took a small position at 19.51. Bought about half of what I wanted to buy (100 shares). Will buy another 100 shares if it gets to $16-17.

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