Petco Health and Wellness Company, Inc.

And welcome to Petco's second quarter fiscal 2021 earnings conference call. All participants are in listen-only mode. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then 1 on your touch-tone phone. And to remove yourself from queue, please press star then 2. Please note, today's event is being recorded. I would now like to turn the conference over to Christy Moser, Vice President and Investor Relations Officer. Christy, you may begin.

Thanks very much and welcome everybody to Petco's second quarter fiscal 2021 earnings conference call. We are webcasting live over the internet. To access the call on the internet, please go to Petco's website at Petco.com and follow the links from there. In addition to the earnings release, there's a presentation available for download summarizing our second quarter 2021 results as well as an infographic. On the call today are Mr. Ron Coughlin, PECO's Chairman and Chief Executive Officer, Mr. Mike Nuzzo, PECO's Chief Operating Officer and President of PECO Services, and Mr. Brian LaRose, PECO's newly appointed Chief Financial Officer. In a moment, Ron and Mike will walk you through PECO's recent financial and operating performance for the quarter. But before we begin our remarks, I would like to remind you that in this call, we will make forward-looking statements in regards to our current beliefs plans, and expectations, which are not guarantees of future performance and are subject to a number of risks and uncertainties and other factors that could cause actual results to differ materially from the results and events contemplated by such forward-looking statements. These risks and uncertainties include those set forth in our earnings release as well as with our filings with the Securities and Exchange Commission. These forward-looking statements are made only as of the date hereof, except as required by law, We undertake no obligation to update or revise any of them, whether as a result of new information, future events, or otherwise. In addition, today's presentation contains references to non-GAAP financial measures. Reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures are included in our earnings release and our filings with the Securities and Exchange Commission. During the question and answer of today's call, please limit yourself to one question and one follow-up. Now let me turn it over to Ron.

Thanks, Christy, and good morning, everyone. Thank you for joining us today. Our incredible team's delivery against purpose-driven performance this quarter has once again exceeded our expectations in terms of both quarterly numbers as well as acceleration of transformative initiatives. We posted record quarterly revenue growth and comp growth of 20% and over 30% on a two-year stack with strong profit flow-through. Q2 was a quarter that truly highlighted the strength of our unique model with world-class digital capabilities, robust services offerings, and a nationwide physical pet care center footprint that provides both a great in-store experience and logistics competitive advantages. Those capabilities are enabling a growing customer base. It is becoming more and more valuable with significant growth in recurring revenue customers, loyalty customers, multi-channel customers, and premium product and services customers. The category continues to thrive, and within it, according to Nielsen, we are taking share. Our transformation continues to accelerate with the fastest veterinary expansion in history, furthering our digital competitive advantages and expansion of our merchandise differentiation against the competition of through powerful owned and exclusive brands. Looking back to a year ago, pundits questioned whether the behavior shifts related to COVID lockdowns would generate abandonment of physical retail shopping towards digital only. With reopening at Petco, we now know the story is a very different one. Pet parents have come back to our pet care centers in droves. They've come back to get advice on what's the best food for Ivan the Doberman. They've come back to get Coco the Maltese groomed. They've come back so that Tango the Tabby can receive high-quality care in one of our vet hospitals or immunizations at our Vetco clinics. And they've come back because their pets just love being in our pet care centers. All of this is driven by our incredible, knowledgeable, and passionate partners, but they've also come back because we offer an omnichannel experience like no other in the category. While we have great offerings for all customers, for those 39% of customers stating they want to shop in an omnichannel manner, there is no one that compares to Petco. This provides us with a growth runway for years to come. I couldn't be more proud of how our 27,000 plus partners continue to execute with excellence. Rallying together to deliver our 11th consecutive quarter of comp growth. Our transformation from a traditional retailer into a disruptive, integrated, omnichannel provider of veterinary care, services, and premium products is tangibly driving performance. Our differentiated model with powerful marketing is enabling customer acquisition and increasing spend with strength in both basket and transactions on both the one-year and two-year stack basis. powered by growth in recurring revenue and loyalty programs. We exited Q2 with momentum, even as we're lapping last year's strong double-digit comp growth, including last July, where the comp was especially strong. And that momentum is carried into Q3, reassuring signals that we can lap the second half of the year strongly, giving us confidence to raise our full-year guidance beyond the Q2 beat. which Mike will discuss in a few minutes. Importantly, we have significant runway for continued growth as we execute against our proven multi-year transformation strategy across services, veterinary care, digital, owned and premium brands, and more. An area of particular focus is pet health. It represents a combined total addressable market of almost $50 billion. In the $35 billion veterinary part of the space, we're attacking the largest bucket of addressable market, executing the fastest national vet hospital rollout with 155 hospitals at the end of the quarter, rapidly expanding our vetco clinics from 800 pet care centers at the beginning of the year to 1,100 at the end of the quarter with continued headroom for growth. The $11 billion prescription drug and food market, where we've historically been underdeveloped, provides us with tremendous headroom for growth, and we're getting after it with 50% plus growth momentum. Scaling veterinary capability coupled with our data on pet parents gives us confidence that we can gain significant share in this market. In prescription food, we're delivering exceptionally high double-digit growth with strong sales online, and in every location where we put a vet hospital, we can now sell prescription food. This will be a predictable and steady growth driver for years to come. In prescription drugs, we're thrilled to have formed a relationship with a best-in-class fulfillment partner in Vetsource, and the early results are promising. In the $2 billion insurance market, where we similarly have immense headroom, it's early innings, but we've doubled our business off a small base. We've built domain expertise and developed a compelling offering aimed at both direct-to-consumer and through employee health plans. We've more than doubled our policies since the beginning of the year. This includes signing on Salesforce and Cognizant, bringing us to a total of 22 companies offering Petco insurance through their employee benefit plans. The pet health space is large and growing, and we're encouraged by the capability and momentum that we've built. Our integrated multi-channel ecosystem is the only offering able to meet all of a pet's needs, something 50% of customers say they want. As a result, pet parents are voting with their wallets. I'm pleased to report that over the last quarter, we continue to acquire significant net new customers. Our successful customer acquisition efforts over the last 12 months have been driven by the strength of our model, our marketing muscle that gets more and more powerful, and tailwinds from an exceptional category that is large and growing, especially as the demand for new pets has continued into 2021. We have been aggressively driving customers into our recurring revenue and loyalty programs, and it's working, with revenue from recurring revenue customers up 60% and recurring revenue customers up 50% year over year. Vital care subscriptions were up to more than 100,000 members since launching at the end of last year, and these customers are spending over three times as much as an average customer, with 25% of them new to food and 36% new to services with Petco. And nutrition and grooming perks loyalty programs have reached over 700,000 members, almost doubling from last quarter and again exhibiting significantly higher spend versus an average customer. Once again, we grew our multi-channel, multi-category customer base double digits, ending the quarter with approximately 4 million multi-channel customers. These customers spend up to seven times as much as single-channel, single-category customers. And the demographics of our customer base are improving as well. Our sales for millennials and Gen Zers continue to grow and have reached what we believe is the highest proportion of a customer base in the pet specialty industry. This is important. as they are major drivers of the humanization trend and therefore shop more frequently and spend more than older demographics. Earlier this month, we were excited to announce the launch of a partnership with Klarna to become the first in the pet industry to provide buy now, pay later options for our customers. This new payment option resonates strongly with millennials and Gen Zers who prefer more flexible payment options versus traditional credit products. Historically, the addition of the Klarna payment option has helped raise average order value by 20% to 80% and improved conversion by 20% on average. We believe this will open up opportunity in higher AOV products like vacuums. We're excited to be a first mover with this payment option for both our customers and the 18.5 million Klarna app customers in North America. Now looking more closely across the business, We're driving tangible growth across our services and vet businesses with revenue growth of 49% versus a year ago and consistent with Q1 and almost 36% growth on a two-year stack. And it continues to be a significant differentiator for us. Our goal is straightforward, to be the leading services and vet provider across an over $45 billion addressable market. We are taking share and driving sales momentum across services by leveraging our pet care center assets and unique capabilities in marketing, technology, and customer engagement in a way that local, smaller, brick and mortar, and online-only competitors just cannot match. We are becoming an employer of choice for vets, trainers, and groomers. We've built out compelling employer value propositions and recruiting core competency that is delivering impressive recruiting and retention results. We now have the highest number of groomers that we've ever had with significant room for additional growth across our salons to meet rising demand. Additionally, we recently launched and funded a scholarship program for high potential partners in our pet care centers to become veterinary technicians with an inaugural class of 100 partners. I'm very proud of this effort. Services and vet are a cornerstone of our pet care center transformation, which we believe is the most compelling per unit productivity enhancement effort in retail. A proven step and repeat formula that represents a strong organic growth runway for years to come. Remember, when we transform a pet care center, we achieve a mid-single digit merchandise lift that is additive to the attractive economics within the four walls of the vet. Combined, This creates a dramatic lift in incremental market share. The return of retail traffic continues to drive strength in our brick-and-mortar merchandise, with revenue up 17 percent year-over-year and 21 percent on a two-year stack, with double-digit growth in all of our major categories, including consumables, supplies, and companion animals. There was particular overperformance in consumables. We saw strong results across owned and exclusive brands, which were up double digits. as well as premium and super premium brands, which were up over 20% versus last year, driven by outsized growth of our best premium food and treats brands, our customer analytics, an exceptional experience within our pet care centers, and tailwinds from pet humanization. Fresh and frozen, which was up more than 50% year over year, and today we are the number one pet specialty retailer in the fresh and frozen category, supported by our unique omni-channel fulfillment strategy, including same-day delivery. We're focused on continuing to be a market maker in the more human-like fresh, refrigerated, and frozen space with a full spectrum of exceptional brands like Just Food for Dogs, Fresh Pet, and Instinct. Our Just Food for Dogs kitchens and pantries are now in 468 pet care centers, and we're expecting to end the year with roughly 700 locations, complementing our nationwide fresh and refrigerated footprint. Impressively, we have more than doubled our revenue in this category over the last year. Our digital business just posted what we believe is one of the highest two-year revenue growth rates for any business in the category at 138% or 150%, excluding the sale of our live Aquaria business we exited a year ago. We've made significant improvements in customer experience, expanded our brand assortment, gotten our pricing where we want it, and driven tremendous growth in app downloads. Suffice it to say, our omnichannel model is working. App downloads were up over 100% versus last year to 4.4 million, and our care reminders are driving stickiness and spend. We're the only pet specialty player providing 360-degree reminders for all of a pet's health and wellness needs, including grooming, flea, tick, vaccinations, and merchandise. And we believe that will drive meaningful growth and customer engagement over time. Further, our app serves as the hub of our ecosystem where pet parents can purchase, schedule a groom, schedule vaccinations, and receive personalized care reminders. Just last week, a push notification reminded me that I was six weeks out from my last groom from iLab Yummy, a great reminder for me and a driver of increased frequency for Petco. Additionally, a growing international business continues to be a bright spot. Through our joint venture with Grupo Gigante, Petco Mexico, the on and offline leader in Mexico, grew double digits year over year. And with Canada's reopening, we're excited to see our business with Canadian Tire resume its growth trajectory. With the Delta variant driving increased case counts across the country, the health and safety of our partners, guests, and animals in our care remains our number one priority. Our business has benefited from both the stay-at-home and reopening environments, but we remain diligent in our health and safety protocols and continue to encourage our partners to get vaccinated, providing incentives and time to get vaccinated. Overall, we feel confident in our ability to manage the current market environment as we have over the last 16 months. On inventory, yes, things have been tight. Not one of our vendors could have reasonably planned their capacity for this many more new pets to households. We've been wholly focused and successful working with our vendors to get available inventory and converting customers to the products that are in stock. Our digital and PCC teams are so trusted and adept at directing demand that they create a competitive advantage, enabling us to gain share and deliver strong comps in this tight environment. Similarly, as vendors have passed through higher costs, we've seen early success at passing through these costs. And in aggregate, we have not seen impact on unit volumes, which is great to see. Additionally, the promotional environment has remained very rational, with promotional activity down a point or two versus last year. As I mentioned earlier, purpose-driven performance combines our operational excellence and strong financial results with an unwavering commitment to improving the lives of pet, pet parents, and our own Petco partners. In terms of purpose, we're progressing on our mission to save pet lives. Earlier this week, the Petco Love Foundation announced a significant partnership with Merck to make over 1 million life-saving vaccinations available to pets. Petco Love is working with community-based animal welfare partners across the country to distribute these much-needed vaccinations, something we believe gives all pets the best chance to live long and healthy lives. And as a native New Yorker, we've been partnering with the City of New York to help provide a safe place for pets and pet parents to escape the extreme heat by opening pet care centers as pet-friendly cooling stations. We are also investing to improve the lives of those who work at Petco, and these investments in areas like pay raises, bonuses, enhanced benefits, and career development opportunities are paying off in a tight labor market, delivering on our partner promise that as Petco does better, so will our partners. As a result, hiring and retention are above 2019, and we saw a more than 70 percent increase in pet care center applications in the second quarter versus the beginning of the year. In line with our commitment to improve racial equity, diversity, inclusion, and belonging, year to date, over 50 percent of our director and above new hires and promotions have come from underrepresented populations. This will continue to be a strategic focus. And to protect the planet, we are executing against our commitment to increase our assortment of sustainable products to 50% by 2025, an area where Petco is leading. As part of this initiative, we recently announced our first-ever Sustainability Vendors Summit to be held on September 22nd. To close, we are keeping Petco's terrific people, customers, and the animals in our care as safe as possible. Our category is growing rapidly, and our obsessive execution against our unique model is enabling us to gain share. This, in turn, is enabling us to deliver outstanding results. Importantly, we are just getting started. Our transformation towards the only digitally-led services and differentiated merchandise one-stop ecosystem will drive strong growth, not only in the second half, but long into the future. Now, before I turn it over to Mike to walk you through the CFO portion of our quarterly results, I'm pleased to announce a career progression for Mike and promotion for Brian LaRose. Mike has been wearing many hats for us as we navigated our turnaround, refinancing an IPO. Three hats, to be precise, CFO, COO, and President of Petco Services. With our tremendous progress against those, Mike wanted to focus 100% of his time on being an operator. With our accelerating shift towards services, including the scaling of a major vet network and expansion at-home services, as well as reshaping our supply chain to meet the needs of the larger, faster-growing company that we are today, Mike's complete focus on these areas will be invaluable. Mike has been and will continue to be an important partner to me, the CFO, and the business overall. Correspondingly, Brian LaRose, who has run Petco's finance and IR functions for the last year and who many of you have met, will become chief financial officer of Petco, reporting to me. We're so fortunate to have a leader of Brian's caliber taking on this role. Brian brings a wealth of expertise across operations, accounting, M&A, and investor relations from Deloitte and HP, where we work together. Brian has led our financial planning and played an integral role in our refinancing and IPO, with an end result being a dramatically improved balance sheet and fantastic roster of investors. I want to express my deepest gratitude to Mike on behalf of both the Board of Directors and the leadership team at Petco for carrying such a broad portfolio for the last year. We are so fortunate to have both of these leaders on our team, and I'm pleased with the smooth and planned transition. With that, I will turn it over to Mike.

Thanks, Ron, for the kind words. Good morning, everyone. The first half of 2021 was a great start to the year. Building on the strong business momentum and strategic execution that Ron discussed, I am pleased to share with you how these efforts are translating into strong financial and operational results. Q2 was yet another quarter of record revenue of $1.43 billion, up 19% year over year, with comparable sales of 20% or 30% on a two-year stack, reflecting the strategic competitive advantage and the traction on our transformation that Ron outlined. Diving one level deeper for Q2, services and vet revenue was up over 49% and 36% on a two-year stack that was consistent with the Q1 two-year revenue growth trend. Our veterinary grooming and training businesses continued to show strong momentum, We opened 18 full-service vet hospitals in the quarter, including closing on our second acquisition, as we mentioned on our Q1 call, and remain on track for 72 total openings this year. Hospital performance continues to outpace expectations, with our Petco fully-owned and operated units showing the strongest revenue productivity. Consumer demand for grooming and training remains robust, and we continue to see success in recruiting and staff retention across all our services businesses. And even with continued COVID-related safety accommodations, we are well positioned to continue outsized core services and vet sales trends in 2021. Digital revenue grew 14% on a one-year and 150% on a two-year basis, excluding the sale of live aquaria, while digital revenue increased 11% on a one-year and 138% on a two-year basis. And brick-and-mortar merchandise revenue was up 17% and 21% on a two-year stack, reflecting both the stickiness of the return of retail demand and our strategic initiatives. Also, on both a one- and two-year basis, transactions and average basket trends were positive for the quarter. We continue to deliver these results through a dynamic market and retail environment, as Ron referenced. While the number of new pets caused some vendors to struggle to keep up, and this has provided challenges, I am proud of our team's agility and tireless work, and we continue to leverage our omnichannel fulfillment differentiation. Importantly, vendor supply and our overall in-stock improved as we navigated Q2. and we expect continued progress in Q3 and Q4. In Q2, we also opened two new distribution facilities in Dallas and Columbus that will support our expected revenue growth into 2022. Our continued strong financial results also enable us to incrementally invest in distribution partner recruiting, retention, and compensation to ensure our supply chain remains healthy. Like the broader marketplace, we saw some inflation on vendor product that we passed along in price increases implemented in the latter part of the quarter. Historically, inflation has been beneficial for Petco, and so far it looks like outsized demand will accommodate inflation-related higher prices. We believe our price moves will more than offset both domestic and import-based input cost increases for the rest of 2021. While we believe some of these factors will persist in the second half of the year, We are confident we are taking the right steps to maximize our performance and ensure our supply chain remains a competitive advantage. Moving down the P&L, gross profit increased 70 million, or 13%, to 599 million. Gross profit as a percentage of sales was 41.8%, down 203 basis points from Q2 2020. In line with our expectations, and driven by the mixed impact of exceptionally strong consumable product sales and a modest sales channel impact driven by the increased relative strength of our digital, services, and vet businesses, as we forecasted on our first quarter earnings call. Over time, we continue to see opportunity to drive gross profit rate improvement across our business areas as an offset. SG&A as a percent of revenue improved from 38.4% in Q2 2020 to 36.7% in Q2 2021, demonstrating leverage across our model. On an absolute basis, SG&A expense was $526 million, up $61 million or 13% from prior year. As we continue to lean into investments in our marketing, infrastructure, and people to support sustained future growth all while reducing SG&A percentage. SG&A also includes a legal accrual that is excluded from adjusted EBITDA, which reflects in part a settlement for class action which we were able to opportunistically resolve. Further, we do not anticipate settlements of this magnitude or scale for similar cases in the near term based on regular updates and changes to our practice. Q2 adjusted EBITDA was $155 million, an increase of 19% from prior year, in line with revenue growth. This excludes a $45 million gain from mark-to-market on our investment in Rover upon Rover's successful SPAC transaction. Q2 adjusted EPS improved by 14 cents, or 127% to 25 cents, based on 265 million weighted average fully diluted shares as well as a normalized effective tax rate of 26%. Turning to our pet care center base, we ended Q2 with 1,451 pet care centers in the United States, down two from the first quarter. Our Mexico joint venture ended the quarter with 101 pet care centers, up one from the first quarter. Shifting to customers, in Q2, we added approximately 1 million net new customers. In June, we implemented a new POS, that improves customer engagement and utilizes more effective data requirements for PAL signups. This further enhances our CRM and analytics capabilities. We leveraged this POS change to evolve how we define and report our active customer base. As you know, our active customer base includes recurring, PAL, and e-comm customers where we are driving deeper engagement. To maximize outreach impact, we analyzed our active customer base to ensure we had complete current contact information. In this process, we both added PUPBOX active customers not previously captured and moved roughly 2 million PALS members with incomplete or outdated contact information to transactional status. These customers represented only 3% of revenue. Importantly, these transactional customers continued to drive sales and are a valuable source for continued conversion. Under the prior methodology, our net new customer ads in the quarter were roughly in line with the 1 million net new customers under this revised methodology. As a result of these changes, our active customer base at the end of Q2 was 22.5 million and will be the basis for go-forward reporting. These changes do not impact our remarkable sales performance or the overall number of customers shopping with Petco. This will simply enhance the impact of our marketing and CRM efforts over time. Moving to cash flow, we continue to have strong liquidity, ending the quarter with $645 million, inclusive of $203 million in cash and cash equivalents, and $441 million of availability on our revolving credit facility. Looking at cash flow, we generated strong cash from operations of $87 million and had $53 million in capital expenses. Year-to-date, we generated robust free cash flow of $103 million, up 142% versus prior year. Our net leverage ratio reduced by 16%, or 0.5 times to 2.7 times in Q2 of 2021. And I want to congratulate Brian LaRose on his new role. I am pleased to pass the CFO baton to him. He's been a great thought partner to me over the last year, and I look forward to continuing to partner with him to drive our strategic priorities forward. I could not be more confident in Petco's financial management with Brian as Chief Financial Officer.

Thank you so much, Mike and Ron. I am truly honored and humbled to be part of Petco and assume the role of Chief Financial Officer. Working in partnership with Ron, Mike, the rest of the leadership team, and our board over the past year, I have seen firsthand the power of our unique multi-channel model, and I could not be more excited about our strategic positioning for the future. Talking about the future, given our strong performance in the first half of the year and our increased confidence in second half performance, we are now expecting the following for full year 2021. Total revenue of $5.6 to $5.7 billion or a 14% to 16% increase from 2020. Adjusted EBITDA between $565 and $575 million or a 17% to 19% increase from 2020. Adjusted EPS between $0.81 and $0.85 based on $80 million of net interest expense excluding loss on debt extinguishment 266 million shares outstanding, and an effective tax rate of 26%. And we expect capital expenditures to be near the top end of our original guidance range of between 185 and 235 million, inclusive of incremental investments in digital, the build-out of our vet hospitals, innovation, and enhanced supply chain capacity in response to sales growth. Our guidance raised reflects strong Q2 performance, initial revenue trends in Q3, and mid-20s percent range two-year comp assumption for the balance of 2021. Our confidence in the performance of our business areas results from the build-out of our services and digital businesses, the positive customer dynamics, our executional excellence, and the ongoing strength and resiliency of the pet space. All of these factors point to a strong second half and a phenomenal 2021 for Petco. With that, Ron, Mike, and I will now take your questions.

Thank you. We will now begin the question and answer session. To ask a question, you may press star then one on your touch-tone phone. If you're using a speakerphone, we ask that you please pick up your handset before pressing the keys. To withdraw your question, please press star then two. And as a reminder, we do ask that you limit yourself to one question in a single follow-up. Today's first question comes from Michael Laster with UBS. Please go ahead.

Good morning. Thanks a lot for taking my question, Ronnie. In your remarks, you mentioned that you're seeing benefits of both stay-at-home and reopening in your financial performance. Stay-at-home is probably pet parents are at home with their pets, and they're rewarding their companionship with more treats. So presumably that's helping the consumable business. So A, is that right? And B, where are you seeing the benefits of the reopening, and do you expect that to accelerate over the next several quarters as the reopening continues?

Hi, Michael. Thanks for the question. Absolutely. So in the stay at home, you know, I have this theory that pets helped America psychologically get through this pandemic and they bonded and they took better care of their pets. They were more frequent in terms of rooms, more frequent in terms of checkups, et cetera. With reopening, what you see is purchases of collars, purchases of leads, but you also see returns to our pet care centers. which is good for our business because the more our customers omni-channel, the higher revenue we have from them and, frankly, the higher margin we have from them. So both sides have been beneficial to us. And I will tell you, you know, I looked at this a couple days ago. You know, we've seen no correlation between rising COVID penetration and business. If you look at the biggest hotspot today, which is Florida, our Florida business is stronger than overall change. So we're not seeing a negative impact of COVID penetration.

That's helpful. My follow-up question is on the gross margin. You attributed the degradation to mix from strengthening the consumer business. Was there also a piece Because of the offers for auto-ship or where you're giving 35% off and 5% off recurring orders, it seems like there's a lot of competitive intensity within that element of the pet specialty market where a lot of players are going after customers on this repeat order activity.

Hey, Michael. It's Brian. Let me start on the second point. Let me circle back to the first point. On the second point, no. Actually, we've taken a look at this, and revenue from promotional activity for us is down year over year. So the revenue associated with promotional activity is down. Let me go back to the first point then on consumables. We had an exceptional consumables It was stronger than we expected, and it was exceptional. And let me just take you back a little bit. We were a little worried about this a couple of years ago, and we did a lot of work on it. We did a lot of work on our customer acquisition, retention strategy, assortment. our strategic focus on own brands, premium and super premium. And then we had the launch of the Food Perks program recently, which enabled us to pick up more share than we expected. These are sticky, sticky customers that have more frequency in terms of traffic. We feel really good about this dynamic. And that did have some impact on gross margin for us. However, we'll take that all day long because of the customers that we're bringing in. And what I would say is the strength in consumables this of our strategy. And it didn't mean that supplies had a bad quarter. Supplies had a really strong quarter. Consumables was just stronger. And just as a reminder, last quarter, We said that we expected gross margin to have a modest impact quarter on quarter due to some mixed dynamics, and that's what played out this quarter. We still see plenty of opportunity to offset mixed dynamics on gross margin. We've gotten really, really good at looking at cost efficiencies across our entire model. So we feel good about where we landed the quarter in line with what we thought and on the back of a super strong consumables quarter.

Thank you. And our next question today comes from Stephanie Wissink with Jefferies. Please go ahead.

Hi. Good morning. It's Blake. I'm for Steph. I just wanted to follow up on the consumables question. Was that due to a comparison at all in the Q2 last year? And then can you talk about maybe how much that has sustained quarter to date? And maybe I don't know if you can give any commentary on the size and the margin. Was that kind of a leading factor? driver of the gross margin decline year over year, or is it more digital or services?

No, it was. So just to go back to what I just said, the consumables margin impact year over year, the biggest driver was consumables growth on gross margin. That was the biggest impact. There was some channel mix dynamic impact year on year. However, the biggest driver was consumables growth. When it comes to comp, the only thing I take you back to in comp is remember in Q2 last year, you had a unique quarter with the onset of the pandemic, the beginning of a pet boom, and a higher supplies mix last quarter. So I wouldn't take you back to a weak comp in consumables, but rather strength in mix and supplies last year. You flip that around this year. You had a question in there about what this means for kind of consumables gross margin or quarter to date. We don't want to talk about quarter to date in terms of subcategory. I will tell you that we like what we're seeing so far in the quarter overall and the trends that we had in Q2 have continued. And then for gross margin on consumables are very good gross margins. They're just supplies and companion animal happen to have better gross margins. And so when we have a mixed dynamic that flips around either year on year on quarter on quarter, it can impact the rate. But we're really happy with the performance this quarter across the category within brick and mortar and exceptional performance in consumables.

I would just build this, Ron. You asked about consumables performance a year ago. When Brian talked about what we were concerned about, we were concerned about some customer leakage on consumables. for our business. As he said, it's a very sticky customer. And quite frankly, it's the highest frequency part of being a pet parent. So it's good for our business and it has full enterprise benefits of keeping those customers and bringing those customers into the franchise.

That's encouraging to hear. Appreciate that. Last one would be on the, just the pandemic, if you will, the customer cohort over the last year, year and a half. Can you talk about that The behavior of that specific cohort and the retention, any behaviors you want to call out in terms of omnichannel retention, things like that. Thank you.

Yeah, the retention has been equivalent to past cohorts, so that's good. We were worried about it. Kind of they came in and went, so the retention has been consistent with past cohorts. And they're flowing like past cohorts in terms of with reopening, we had a bunch of the new cohort going back into the pet care centers. And again, the more of our customers that are omni-channel customers, the more of our customers that are multi-channel customers. the higher value customer that they are. So we're not seeing significant differentials in the new cohort. The one thing I will say is that the newly acquired customers tend to be more Gen Z and millennials, which means they're bigger into humanization, which means they spend more than prior age groupings.

Thank you. Our next question today comes from Oliver Wintermantle with Evercore ISI. Please go ahead.

Yeah, good morning. I just had a question also on gross margins with the flow through for the rest of the year. So it looks like, you know, this quarter, consumers were very strong. Do you expect that to continue for the rest of the year, and how should we think about the gross margin performance? Is that magnitude in the second quarter that you expect for the rest of the year, or should that get better?

Yeah, Oliver, I don't want to get into specific gross margin guidance. main factor on our gross margin, and there are multiple layers of that. There's channel mix. We continue to expect digital and services to scale. Those are our two primary strategic investment areas, and we expect those businesses to continue to scale. The second thing I would say is there's mix within the mix, as we talked about this quarter. So for the balance of the year, you know, we would not give specific guidance other than the repeat what we said about, you know, modest mixed impacts for the balance. I would also tell you that, you know, look at the guidance that we gave on EBITDA. So our expectations around gross margin are baked into our second half EBITDA guidance. We feel good about the guidance that we just put out there. You know, we raised full year by 125 on the top, 15 on the bottom with 12% flow through. And our EBITDA reflects our expectations around gross margin.

Got it. Thank you. And I think, Ron, you said traffic and ticket were balanced for the quarter. Is that Does that mean it was about half when the comp was traffic, half was ticket? Because I assume consumable, there's more traffic, it's a bigger traffic driver. So a little bit more detail would be great. Thank you.

All the fundamentals are positive. So traffic, basket, AOV, we're pleased with all the fundamentals across the enterprise.

Thank you very much. Our next question today comes from Kate McShane at Goldman Sachs. Please go ahead.

Hi, good morning. Thanks for taking our question. You had mentioned, Ron, in your prepared remarks about being successful in converting customers to those items that are in stock. I wondered if there was a way to quantify what you might be leaving on the table just with the state of the supply chain the way it is, where your biggest out-of-stocks are, and When you've been able to convert customers, has it been to higher price point items?

Yeah, we haven't spent a lot of time looking at what was left on the table. Quite frankly, we've been focused on driving our business and driving demand into where we have supply. And I'll be honest, that's been a moving target. This is where the power of our pet care center partners is. and the digital platform that we've built really comes to bear. It is amazing how influential our pet care center partners are in directing purchase. So if you can't get Royal Canin, there's a great product in Hills. If you can't find Taste of the Wild, well, Origin is a similar and great product. And they're able to direct those customers. Our pet care center partners in particular, but I think our digital approach as well, is we start with the best products that we have, and then we work our way down based upon affordability. So there would be an inherent shift towards higher quality, higher priced products in that process. But again, I think the proof of the pudding is in the fact that we put up a 20% comp, And a lot of the shortages was in consumables. And, you know, Brian just talked about how strong we were in consumables. So it has been really surprising to me how they can direct that demand to where we have supply.

Thank you.

Thank you.

And our next question today comes from Stephen Zacon with Citigroup. Please go ahead.

Okay, good morning, guys. Thanks for taking my question, and congrats to Mike and Brian on the new roles. I was curious if we could start off, could you just elaborate a little bit more what you're seeing thus far in the third quarter? I know it's a small period, but what's really driving the increased confidence in the Ray's second half comp outlook? I know the industry is doing well overall, but when you look at your business, what are some of the main factors that's giving the increased confidence for the back half?

I'll start with two comments, and then I'll pass it over to Brian. First, This category is thriving, right? The call for the category for the year is a 9% growth category. And on top of that, we're gaining share. So the category dynamics and the furry annuity that I talked about are there and they're showing up in the business. For me, July was a major litmus test, as is the early Q3 in terms of how we were going to lap H2. We got many questions for you guys from, you know, from the investors and the sell side earlier in the year. Are you guys going to be able to lap the second half? That was the biggest question that was out there. And if you look at July and if you look at early Q3, the overlap looks pretty similar to H2 in terms of what we need to lap. And we are very pleased with how we're lapping double digit with double digit. So I'll stop there and I'll pass it over to...

Yeah, I'll just add on, Steven, and reiterate the confidence that we see in updating our guidance is based on what we saw in the first half and what we're seeing so far in Q3. And to some of the points that you raised, the midpoint of the guidance that we gave, the midpoint in the second half reflects a mid-20s percent two-year stack. And just a couple of things on quarters, too. I don't want to get into quarterly guidance, but Q4 is typically a little stronger on the top line and bottom line rates than Q3. And we feel good about our ability to deliver that. So in addition to the top line mid-20s, bottom line flow through looks good. The customers that we picked up in the first half, the consumables growth that we saw in Q2, again, more customers coming in, more traffic. you look at the vet filled out is on track. We added 18 hospitals in the second quarter. The performance of those hospitals is in line and, in fact, ahead of the expectations that we have for the hospitals. The return of the grooming and training business, if you remember last year, that was a business that really got whacked by some of the restrictions throughout the pandemic, and it has bounced back really nicely in the back half of last year and through the first half of this year, and we see runway in the second half. And then the last thing I'd point to is the progress we've made in recurring revenue. Ron talked about recurring revenue customers and the growth there. Vital care, although it's early days, is an important vehicle for us to bring more and more stickiness in terms of recurring. So I would say all those variables add up to what we believe is an important raise and confidence in it.

That's very helpful detail. Thank you. Just a follow-up on capital allocation. So with debt levels coming down, you know, what do you see as the right level of leverage to operate the business? And how do you kind of rank order the priorities for capital allocation going forward?

Yeah, we haven't given a specific target, Steve. What I can tell you is, you know, we're happy with, you know, where we actually queue to. We're down at kind of a 2-7 leverage ratio and we see room to go beyond that. However, I would put that second behind reinvestments in the business. You know, hopefully you caught us that we raised our CapEx guidance to the top end of the prior range. So we were at 185 to 235. We've moved that to the upper end of that. And that's because we like the ROI that we're seeing on our CapEx investments. Beyond just VET and the build-out in VET, investments in digital, Mike mentioned investments in two new supply chain hubs in Dallas and Columbus that we opened this quarter. So we are investing in supply chain to make sure that we keep up ahead of demand. So I'd say investments in the business first, debt pay down second, and we see room to go below two-step.

Thank you. Our next question today comes from LaVesh Hemnani with Credit Suisse. Please go ahead.

Hey, thank you for taking my questions, and congratulations on the new rules. A quick follow-up on just the spend per pet. I mean, I'm just trying to understand, how has that evolved over the last year, and if there is any way to sort of parse out the various components between digital and services, et cetera?

Yeah, as I said, you know, our basket is going up. Our AOV is going up. So we feel good about the trends in that space. You know, When we bring in more millennials, we bring in more Gen Zers, the humanization trend is there, and they spend more on their pets. The other thing that's happening is as we shift folks to multi-channel, we're over 4 million customers now. We've been double-digit on multi-channel growth for three-quarters in a row. Those customers spend up to seven times more. So in many ways, our whole strategy and our whole model is to drive spend per pet, is to drive share of wallet. And it's working because we get people to use more pieces of our ecosystem. And a great microcosm of that is our vital care program. As Brian said, we came above 100,000, and we've had more vital care ads every quarter, and we would anticipate that continuing. So when we get somebody into our vital care program, they have between 2.5 and 3 times more spent. They have roughly 20% of those customers weren't buying food from us before. Now they are. Over 30% of those customers weren't getting services from us. Now they are. So most of the initiatives that we have are all about driving spend per pet, and we're moving that in the right direction.

Got it. One quick question on guidance. This is for you, Brian. So when I look at the EBITDA guidance for the back half, what's baked in for the marketing expense side of the piece? I know earlier in the year there was a big focus on driving customer acquisition. So how do we think about that? Thank you.

Yeah, I'm not going to get into specific guidance on a line item basis. I can tell you that what you've seen us do in the first half of the year is continue to lean into marketing investments. We continue to like the ROI. We like the customers that we're acquiring through those investments. We've baked in our own marketing plan in the second half. And as long as we continue to see good ROI, which right now is kind of running at 2x plus industry benchmarks, we'll continue to invest. And so we've got investments baked in. I just don't want to get into the specific line item detail. Thanks, LaVesh. Thanks, LaVesh.

And our next question today comes from Chris Battiglieri with Exane BNP Parabox. Please go ahead.

Hey, guys. Thanks for taking the question. So hoping you could elaborate on the two new supply chain hubs you referenced. Are these full distribution centers or like micro-fulfillment centers, just kind of like some clarity what those are, then holistically, like how are you thinking about your overall distribution network as you pivot more of the business online? Like, do you feel pretty comfortable where you are? And like, how do you think about the investment path over there?

Yeah, Chris, thanks for the question. The one distribution center in Dallas is a full distribution center, so we'll be doing both supplies and non-con, which is mainly consumables, out of that distribution center, in addition to e-com orders. The distribution center in Columbus is focused on non-con only, and we talked about the strength of the consumables business, so that's obviously a good focus point there. We feel really good about where our distribution center network is today. We're investing in some upgraded technology in our Dallas center, which we think will help with productivity there. And so it's really, we made some of these decisions back last year, and I think they have really helped us to get ahead of the volume that we're seeing right now.

The thing I would build on what Mike said is, Our micro distribution center strategy is the pet care center stores, right? And so 87% of e-commerce orders are fulfilled through our pet care centers, which means we are faster to the customer and lower cost than our online competitors, and we can do things like same-day delivery that they can't do. So in addition to the macro network that he's building out, this micro distribution center strategy is a winner for us.

Gotcha. That's really helpful. Then just one quick question on the micro center strategy. Can you talk about the DoorDash kind of Dash Cash program and kind of how that's evolving? Is there a way you frame what percentage of kind of like online sales are shipped from there? And then two, it seems like there's been a lot of wage investments in the kind of ride sharing industry. Like is your arrangement then more like a fixed cost basis? Do you see that kind of cost pressure? Does anything you share there be helpful?

Yeah, I won't get into specifics about the DoorDash arrangement, but I will just tell you that having DoorDash and same-day delivery gives us yet another important tool to deliver to customers however they want it, whenever they want their products. So you combine same-day with focus, with ship from store, it's a very powerful proposition for the customer. And same-day will also... be a really, really important dynamic around the fresh and frozen space. So the idea of getting your product not wrapped in all kinds of ice and packets, but actually freshly delivered to you is a really, really important advantage for us when it comes to that same day delivery fulfillment. So we'll continue to drive that part of the business. Our contract with DoorDash is very attractive and has incentives for our growing volume with it, and we feel just really, really good about how we're setting up for customer distribution going forward.

Thank you. And our next question today comes from Zach Spadam with Wells Fargo. Please go ahead.

Hey, good morning, guys. Thanks for fitting me in, and congrats to Mike and Brian. Can you talk about the segment of your sales that you qualify as repeat or recurring and how that's been trending as a percent of your total business? And then given the outside strength in consumables and food you're calling out, is it fair to say there's been softening and more discretionary or bigger ticket items as the impact of stimulus rolled off, or does that business remain strong as well?

Hitting the second piece of it, we've seen – Quite frankly, we've seen no part of our business that hasn't seen strength, so we haven't seen a fall-off with stimulus, with stimulus roll-off on any part of our business. In terms of recurring, what's in recurring is repeat delivery, vital care, pup box, and insurance. As I said, our customer base there was up 50 percent, and the revenue from recurring In terms of percent of total, the one number we've said is it's more than 50% of our e-commerce revenue is from recurring revenue customers.

Thank you. And our next question today comes from Seth Basham with Wedbush Securities. Please go ahead.

Thanks a lot, and good morning, and thanks for squeezing me in. My question is around the consumable strength that surprised the upside. Did you see that surprise in the stores as well as the online channel?

Yeah. Thanks for the question. It's both. I would say that it was pivoted a little bit more, and I believe we mentioned this in the prepare marks, toward brick-and-mortar, but it was holistic across the channels. However, a little bit more in brick-and-mortar, and that was in line with what you saw in the brick-and-mortar total growth 17 points.

Jared, that's what I assumed. But to follow up on that, in terms of the drivers behind that, you mentioned a few, but how did pricing play into the strength there? Did you guys get any more aggressive on pricing to be able to drive some of that?

No. You know, the only thing that we mentioned in pricing, Seth, is that from some of the cost increases that we saw, that we took pricing actions on roughly 20% of SKUs, and the impact of that pricing was nominal in the quarter. And I would tell you that it actually was more than offset by some of the year-over-year impact from stimulus. So we had a bigger impact from stimulus last year than we did by any like benefits this year. So it was more than a push across those two, but modest impact from pricing, 20% of SKUs, and it wasn't pricing-driven in terms of the elasticity on the score.

Thank you. And our final question today comes from Justin Kleber with VAERS. Please go ahead.

Hey, guys, it's Justin Claver. Thanks for sneaking me in here. Just wanted to ask kind of a related follow-up to the pandemic cohort question, but more so focusing on new pet parents. And any sense for how new pet parents are comping in year two as you lap, you know, some of the initial spend associated with a new pet? Are those customers still growing, or do you see them take a step, you know, just a bit of a step back in year two?

Yeah, great question, Justin. Thanks for it. I'll say a few things. First, we're seeing data that says that we got more than our fair share of new pet owners, which is great. We do a lot of work on, it's called Welcome to the Family, amongst other initiatives to help new pet parents and to capture those customers. So we're seeing signs that we got more than our fair share on new pet customers, which is great for our business. And needless to say, our work in companion animals Inherently, they come into our ecosystem. In terms of spend kind of according to the life stage, we've done a bunch of work, a bunch of analytics. There really isn't a difference between year one and year two. The dynamic is you buy a lot of supplies to set up the crane, the collars, the leashes in year one, but then in year two, Not only is the pet larger, so you need new collars, et cetera, but the second thing is the pet eats a lot more. So therefore, the customer probably has more frequency coming back as well. So we don't see a difference in terms of spend per pet in year one versus year two. The only time you really have a difference in spend per pet is in the later age years where health care costs go up. But that's the only difference that we see. Thanks for the question, Justin.

If I could just ask one last follow-up, unrelated on Just Food for Dogs. Ron, just curious how those stores and what those pantries are comping relative to the rest of the chain. And then what type of halo effect do you guys see on the rest of the business, just given the trip frequency associated with fresh food? Thank you.

Yeah, it's a great question. We see this category quadrupling. I've said all along I want to be a market maker in this category, and that's what we're doing. You know, if you look at our fresh business, Fresh Frozen was up 50% year over year. We believe that we're the number one retailer of Fresh Frozen. And our JFFD customers are among our highest spending customers with twice the trip frequency. So not only do we get the JFFD sale, which is obviously a high ring, but the basket that comes along with that higher trip frequency is really, really good for us. We do also have Fresh Pet and Instinct nationally. But we increased our footprint of JFFD. We'll be in over 700 by the end of the year. So, we're highly dedicated to that. And we announced last quarter expansion into the same day offering there. So, you know, the one thing I'd add to Mike's earlier comments on frozen is it, fresh frozen, it is very difficult to make money on a DC model in fresh frozen. We know it. It's very difficult because you are shipping with, you think about the cardboard, think about the chilling that you have to put into that box. Very difficult to make money. That's why we think that our buy online, pick up in store, as well as our same day is an advantage model, particularly in fresh frozen.

Thank you. And ladies and gentlemen, this concludes today's question and answer session. I'd like to turn it back to Ron Coughlin for final remarks.

Thank you. It's an exciting time for Petco. We're delivering purpose-driven performance with strong year-to-date results. Our entire organization is relentlessly executing against our strategic priorities, and we've built an exceptionally unique offering in a market exhibiting incredible growth. Our revised guidance reflects the strength of our unique health and wellness ecosystem that continues to set Petco apart, and our confidence in our ability to deliver against our strategic areas like vet, digital, and owned and exclusive brands. And while we're focused on delivering results through operational excellence, we remain steadfast in our mission of saving and improving lives of pets, pet parents, and our own petco partners every single day. Together, we believe that our focus on purpose-driven performance and our unique position will drive results and create long-term value for all of our stakeholders. And we appreciate the confidence that they show in us every single day. Thank you very much.

That concludes PECO's second quarter 2021 earnings conference call. Investor relations will be available after the call if you have any follow-up questions.

And ladies and gentlemen, that concludes today's conference call. Thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day.