Petco Health and Wellness Company, Inc.

Good morning, and welcome to the Petco's third quarter 2022 earnings conference call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Benjamin Thiel-Long, Petco's Director of Executive and Business Communications. Please go ahead.

Good morning, everyone, and thank you for joining Petco's third quarter 2022 earnings conference call. In addition to the earnings release, there is a presentation and infographic available to download on our website at ir.petco.com, summarizing our third quarter 2022 results. On the call with me today are Ron Coghlan, Petco's Chief Executive Officer, and Brian LaRose, Petco's Chief Financial Officer. In a few moments, I would invite Ron and Brian to provide their perspective on Petco's financial and operating performance for the quarter and their outlook and priorities for the remainder of the year. Before they begin, I would like to remind you that on this call, we will make forward-looking statements regarding our current plans, beliefs, 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 and events to deliver materially from results and events contemplated by such forward-looking statements. These risks and uncertainties include those set out in our earnings materials and our filings with the Securities and Exchange Commission. These forward-looking statements are made only as of the date marked and, 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 presentation. as well as in our filings with the Securities and Exchange Commission. And finally, during the question and answer portion of today's call, and to allow us time for questions from as many participants as possible and finish the call on time, we would be grateful if you could keep to one question and one follow-up. With that, let me turn it over to Ron.

Thank you, Benjamin. Good morning, everyone. Our third quarter results demonstrate the resilience of our category, the strength of our unique model, and dedication of our incredible Petco team members. In a challenging macroeconomic environment, we delivered our 16th consecutive quarter of comp sales growth, added customers for the 15th consecutive quarter, accelerated our vital care member sign-up rate, made progress in scaling our growth drivers of vet and digital, continued to see product mix shift towards premium, and launched landmark partnerships at leading brands. all strategic initiatives that secure Petco's ability to deliver sustained future growth while capturing category megatrends. Financially, on EBITDA, we did what we said we would do. And we also made tangible progress on strategic cash flow enhancing initiatives. Our consistent delivery of growth despite macro disruptions exemplifies our nimbleness, our execution capabilities, and the strength of our one-of-a-kind ecosystem in a defensive growth category. Capabilities that have generated revenue growth enable us to navigate mixed pressures and continue to deliver enhanced value to a growing customer base. In the third quarter, comparable sales were up 4%, according to 20% and 36% on a two- and three-year stack. Net revenue grew by 4%. The appeal of our unique model and power of our marketing engine enable us to add over 325,000 net new customers in the quarter, bringing our total active customer base above 25 million. Recurring customer revenue driven by repeat delivery, insurance, and vital care grew by 56% year-over-year. High-value multi-category customers also grew in the quarter. Contextualize, our sales and customer growth is driven by high-value customers returning to shop for premium food and supplies, who, like our value-oriented customers, are also leaning into our loyalty and membership programs. Additionally, the drivers of future category growth remain positive, including adoption levels, which continue to increase year over year, and relinquishments trending below pre-pandemic levels. The category resiliency and uniqueness of our health and wellness ecosystem makes Petco a powerful partner for brands wanting access to these deeply engaged, high-value customers. In the quarter, we announced a new partnership with Nationwide Insurance, which I'll touch on more later, followed by an innovative new collaboration with Marriott to facilitate traveling with pets, all while our rapidly growing advertising network expands. continues to be a draw for well-loved brands like Nestle and Colgate-Palmolive's Hills. Taken together, it's clear that in addition to selling products and services, Petco is driving innovation and becoming a pet platform company. A key component of our platform capabilities is our industry-leading membership offerings. This quarter, our flagship VitalCare saw an acceleration in weekly sign-ups of over 50%. fueled by addition of companion animals and enhancements to in-store registration at point of sale. Now with over 400,000 active VitalCare members, an increase of 42% quarter over quarter, and over 200% year over year, we're even more confident that we've designed the right offering for pet parents sitting at the intersection of value and loyalty. VitalCare members continue to bring a 3.5 times higher LTV, over average customers, with over a third of members new to food and new to services with Petco, driving our share of wallet expansion. Combined with nutrition and grooming perks members, now over 1.7 million, our loyalty programs make it easier and more affordable for pet parents to care for all their pet's needs in one place, especially during these inflationary times. They provide a tool for selling engagement in pet care centers, with perks members increasing their visits by roughly 50% and spend by over 40%. These programs have been so successful that at the end of the quarter, we also launched supplies perks, which is showing early positive signs. Critically, a key contributor of expanding our customer membership base was marketing. with targeted impactful messaging focused on healthier pet, healthier budget, proving powerful in driving upper funnel demand generation. Turning to the core pillars of our business, services continued its double-digit growth driven by accelerated sales momentum in vet and grooming. Across both businesses, the teams continue to make progress on building capacity and streamlining the booking process for customers. On VET, earlier this year, we said we were focused on successfully integrating the Thrive business, after which we've returned to our previous run rate of new hospital openings. This quarter exemplified our execution against both, with a Thrive integration not only complete, but now delivering tangible operational synergies and new vital care members. We also accelerated hospital openings with 17 new hospitals, and from a veterinarian standpoint, We signed on more vets this quarter than any previous quarter. Our vet hospital growth is bucking industry trends, contributing to in-store vet prescribed food sales that are at an all-time high. In addition to our 229 full-service hospitals, our Vetco clinics create a highly appealing offering for customers in these cost-conscious times. A record number of in-store and mobile clinics delivered our highest ever quarterly sales while providing access to vaccinations and healthcare at the right place, time, and cost for pets and their parents. 90% of our pet care centers now offer some form of veterinary care, and we continue to add capacity to meet growing demand. These vet additions continue to be strong center store sales drivers. Between our full-service hospitals and mobile clinics, we added over 350 full-time and contract veterinarians, representing a record number of doctors in the Petco ecosystem for the quarter, with referrals from our own veterinarians being the primary driver of new hires. The technological sophistication, competitive compensation package, and autonomous medicine approach of our full-service hospitals offer an appealing home for veterinary professionals, wanting to focus on the practice of medicine without the stress of managing a business, especially in these uncertain economic times. Treatment advances included the addition of Silencia to our solution suite produced by Zoetis. It is the first and only antibody therapy in the market that treats feline osteoarthritis pain and mobility. We're already receiving testimonials of the life-changing impact this treatment has had for cats, who regain mobility and return to their mischievous and playful selves. We also partner with Petco Love as trailblazers in the AVMA and VMAE Journey for Teams program, a comprehensive national initiative that provides support and training for veterinary professionals to advance diversity, equity, and inclusion in the industry. In grooming, full-service bookings remain strong. Platform optimizations have increased ease of booking, and the introduction of same-day booking supplements sales while negating the impact of last-minute cancellations. From new pets that need vaccinations to older pets that want to look their best for the holidays and need ongoing care through end-of-life, services remain an unequivocal growth driver for us and a highly personalized differentiator from online and mass competitors. And to further our mission of insuring as many pets as possible, get the best care available, this quarter we announced our ability to build on our existing double-digit growth insurance business with a new multi-year partnership with the number one player in pet insurance nationwide. With over 90 million pet families in the U.S., but only 2.5% of them estimated to be insured, compared to 25% in parts of Europe, we're even better positioned to capture share in this high-value $2.6 billion investment and growing addressable market. With the ability to cross-promote and market to each other's customers, we're excited about bringing Nationwide's growing number of pet families into our Petco ecosphere, including our veterinary and grooming services, merchandise, and memberships, with a combined whole health and wellness approach that can give them longer and healthier lives together. Turning to merchandise. Consumables continue to surge, growing 12% year-over-year and 33% over a two-year stack. Consumables customers also continue to deliver an elevated LTV over other customers. The key driver of growth in consumables remains our differentiated assortment. Sales in both RX and fresh frozen grew year-over-year. Specifically, RX, including prescriptions and food, grew almost 50% year-over-year, driven largely by repeat customers. Consuelo's strength continues to offset the transitory pressure on supplies, the combination of which weighs on gross margin. Importantly, supplies remain elevated since pre-pandemic levels, up over 20% on a three-year stack. Our teams continue to do a fantastic job in managing inventory, And we expect discretionary sales to normalize as the economic environment improves, the overlap dynamics pass, and the sales impact of supplies, perks, sign-ups are realized. Premium-owned brands continue to be a unique draw, aligning with the long-term macro trends we're seeing in the category. Our owned exclusive and premium mix grew in the quarter. Sales in our own brands ready and wholehearted both grew year over year. Two things are clear. The premiumization trend continues, and Petco is firmly a retailer of choice for health-focused and premium brands. In September, we launched an exclusive partnership with Yummers, the pet lifestyle brand created by Queer Eye's JVN and Anthony. And earlier today, we announced that we're adding the fantastic premium brand, Stella & Chewy's, becoming the first and only national retailer to offer their raw and natural food products both online and in brick-and-mortar locations. as well as bringing in selling Chewy's customers who are high value health and wellness focused pet parents. Experience shows us that when we bring in highly popular, narrowly distributed brands into our ecosystem, we see an incremental lift in sales. Importantly, although the macro environment remains challenging, we continue to maintain great brand partnerships and are working closely with our vendors to control cost and maintain inventory. While our premium mix differentiates Petco from mass and grocery players, our agility also means we can drive affordability through vital care and our perks programs. And with demand continuing to outstrip supply in many parts of the category, the promotional environment remains rational, where we use promotions surgically not only to remain competitive but to drive specific outcomes such as BOPUS and loyalty program conversions. Our digital channels continued to build on the profitable double-digit growth of the first half of this year, with Q3 total digital sales up 10% year-over-year, 42% over two years. Key drivers of growth included an increase in average basket, growth in repeat delivery, including Rx, and continued innovation. We also saw a strong gross margin improvement with particular efficiencies in cost per order. Specifically, the addition of multiple same-day delivery windows through our partnership with DoorDash have extended the time in which orders can be placed and increased appeal. Innovations like these continue to deepen our competitive moat versus online-only players and reinforce our retail 3.0 strategy. Our advertising network is a growing powerhouse for Petco, delivering double-digit growth quarter-over-quarter and triple-digit growth year-over-year. Household brands continue to be drawn to our digital channels as a platform for awareness, traffic, and revenue generation with our high-value and health-conscious customer base, both online and in-store. We expect continued strong growth for the balance of the year and into 2023. Our pet care centers delivered their 10th consecutive quarter of positive comp sales and 9th consecutive double-digit comp growth quarter on a two-year stack. Baskett remained elevated, driven by strength and consumables, with both new and repeat customers drawn to fresh frozen offerings in store, as well as own brand consumables and supplies. Across the business, we positively lapped Black Friday and Cyber Monday year over year. We're also excited about our fantastic holiday-themed treats, toys, and supplies, including our famous dill pickle and our fabulous Hanukkah range for dogs and cats. Additionally, our number one in the market Mexico business continued its strong growth, now up almost triple digits since 2019, and our Lowe's pilot stores are exciting both sides of the partnership. We've also now opened our third neighborhood farm and pet supply with locations in Texas and North Carolina and putting us on track for our target of six to seven by the end of the fiscal year. Overall, early results are ahead of our expectations, underscoring Petco's ability to serve unmet pet-specific needs in these markets, to quickly scale profitably, and to capture meaningful share of this significant and rapidly growing addressable market. Whenever I spend time with our Pet Care Center partners, like I did two weeks ago in Oregon and Nevada, it brings home the unequivocal truth that we have the most knowledgeable and enthusiastic team in retail. Simply put, Petco is what it is because of our partners. The energy and insights that they bring remains pivotal in shaping Petco into the leading pet health and wellness company that it is. Their passion continue to be a key driver of growth while connecting deeply with our customers. I am so grateful for the work our partners do every single day. Before I close, I'd like to focus on a personal note. As some of you may know, in October, the Coughlin family and Petco as a whole lost our beloved lab, Yummy. Yummy was so much more than just a pet. For almost 15 years, he was a companion that made every aspect of my family's life better. As chief dog officer, he reminded us of the pivotal role pets play in our lives, the impact our health and wellness ecosystem has on pet lives, and the thing that makes Petco so special, our purpose of improving lives. Nowhere is our purpose more evident than the incredible work of the Petco Love team. In the third quarter alone, together with Petco Love, we saved over 98,000 pet lives and have reunited over 13,000 pets to date through Petco Love Lost. And in October, Petco Love hit the 1 million free vaccines goal in partnership with Merck and recommitted to another 1 million vaccines to save pets from preventable deadly diseases in addition to all the other incredible life-saving work that they do. As many of you will know, Yummy was treated successfully for cancer twice, diagnosed and supported by our Petco veterinary teams. But for many pet parents, the cost of this treatment is beyond reach. That is why for years, Petco Love has invested millions in helping pet parents obtain treatment by establishing funds nationwide to subsidize pet cancer care. Now, in his memory, I'm delighted to share that Petco Love intends to establish a Yummy Memorial Pet Cancer Fund to support our own Petco partners who are unable to afford this costly treatment for their pets with cancer. This is just another way that Petco cares for the needs of our partners by caring for those they love and who bring so much joy to their lives. When I think of this and the other landmarks Petco has reached over the last four years, it brings home the value of our purpose-led transformation. It's a transformation that's seen us make bold moves in pet health and wellness, elevate nutrition standards, push the possibilities of innovation, and evolve our ecosystem to meet customer needs in changing environments. Bold moves we will continue to make. To be clear, Petco is a growth business with distinct competitive advantages within a defensive growth category. As we set ourselves up to continue driving profitable growth into 2023, we will be both relentless in driving efficiencies and continue to scale our growth initiatives. We will be agile and align our offering to the needs of our high-value pet parents as they navigate changing economic conditions. With that, let me hand it over to Brian.

Thanks, Ron. Petco and the pet category remain incredibly resilient. We continue to build a business to meet the needs of the growing number of pet parents throughout economic cycles with continued revenue growth, ongoing discipline and cost management, and strategic investment in initiatives for long-term growth. Looking at the quarter specifically, net revenue was $1.5 billion, an increase of 4% year-over-year. Comparable sales, driven by sustained strength in average basket trends, grew 4% year-over-year and 20% on a two-year stack. Total services grew 14% year-over-year, translating to 38% over a two-year stack, driven by strength in vet and grooming, and buoyed by operational synergies and enhancements in our online and in-store booking systems. In merchandise, strength in consumables, which were up 12% year-over-year and 33% over a two-year stack, offset the transitory impact of discretionary purchasing in supplies and companion animals. Consumables customers, including fresh frozen, continue to be among our highest value customers in terms of both spend and trips. Regarding mix, our focus on delivering the healthiest merchandise and services for pets remains both a cornerstone of our differentiated offering and continues to prove compelling with both new and repeat health-conscious pet parents. Due to the ongoing demand for these products and astute planning by the team, we've remained largely insulated from the inventory challenges faced by the broader retail sector. Moving down the P&L, gross profit increased $3 million to $598 million. Gross margin was 39.8%, down 139 basis points year-over-year, and 34 basis points quarter-over-quarter, driven primarily by the mixed impact of consumable strength and transitory supplies pressure, combined with elevated supply chain and associated capitalized rate costs from the first half that are cycling through the P&L. As stated in Q1 this year, we've been building our executional muscle since the fall of 2021 in anticipation of economic headwinds. As we have done for the last year, we continue to proactively carry out programmatic cost initiatives that allow us to mitigate headwinds while also staying ahead of consumer reaction to the macroeconomic environment in the short and long term. These initiatives range from strategic investments such as our recently opened distribution center that will serve as a hub for internationally sourced inventory and generate efficiencies over time, to more tactical improvements, including limiting split shipments and weight overages in shipments from store, enabled by alerts through partners' handheld Zebra devices. SG&A as a percent of revenue improved from 36.9% to 36.6% year over year, down 30 basis points. On an absolute basis, SG&A expense was $550 million, up $17 million, or 3.1% from prior year, including continued investments in our pet care center partners as we continue to take both a short and long-term view of managing costs, enabling us to improve retention and positioning us to invest strategically in sustained future growth. Q3 adjusted EBITDA was $138 million, a decrease of 70 basis points from prior year, with an adjusted EBITDA margin rate of 9.2% compared to 9.6% in the prior year, a decline of 40 basis points. Q3 adjusted EPS was $0.16, a decrease of $0.04 from the prior year based on 266 million weighted average fully diluted shares and a normalized effective tax rate of 26%. We continue to have strong liquidity, ending the quarter with $593 million, inclusive of $149 million cash and cash equivalents, and $444 million of availability on our revolving credit facilities. Thinking about Q4 and 2023 more generally, operational excellence and agility sit at the bedrock of our approach. Specifically, when thinking about cash and liquidity, we've made meaningful improvements in our cash flow performance with a 55% increase in free cash flow over the prior year and year-to-date free cash flow at a near break-even level as we enter what is historically a strong cash flow quarter. We've also made meaningful progress in our ability to get further leverage out of our balance sheet. As a result of cash flow trending positive and continued efforts to improve working capital, we expect to be free cash flow positive for the full year, while still investing in pillars of future growth, including VET, fresh frozen, and neighborhood farm and pet supply. Additionally, we've taken actions through financial instruments, including interest rate caps on portions of our variable rate debt, to minimize impacts of future rate increases. As a result of these actions, we feel extremely confident in our ability to continue to incrementally generate free cash flow in 2023 and to do so without sacrificing ongoing investment in our strategic long-term growth initiatives. Finally, turning to guidance, we are reaffirming guidance for the full year on revenue, adjusted EBITDA, and capital expenditures, With revenue of 5.975 billion to 6.05 billion, adjusted EBITDA between 580 million and 595 million, and 250 to 275 million of capital expenditures. For adjusted EPS, we now expect between 75 and 79 cents, assuming 100 million of interest expense, which is 10 million higher than our prior guidance. 26% tax rate, and a $267 million weighted average diluted share count. When thinking about our guidance, there are a few things to keep in mind. Our consumables and services businesses continue to be largely non-discretionary with strong growth expected to continue. While we fully expect the typical seasonal uplift of the holidays from Q3 to Q4, given the current broader uncertainty in consumer dynamics and spending behaviors, it's prudent to anticipate EBITDA may be in the lower end of the range, and our interest expense guidance is based upon the forward yield curve, which is reflected in our updated interest and adjusted EPS guidance. To conclude, while the current environment creates some cyclical pressures, the more enduring aspect is Petco's ability to meet changing consumer dynamics while leading the evolution into the structural megatrends in the pet category. To ensure that we capitalize on these trends, we will remain relentless in our focus on cash generation, inclusive of cost management across supply chain, our pet care centers, and infrastructure, in addition to driving meaningful improvements in our working capital. These cost and balance sheet actions will enable us to maintain our capital priorities, which include, one, reinvesting in our business through significant high ROI opportunities to fuel future growth, and two, managing our overall debt position. This approach, combined with the sustained appeal of our product and services portfolio throughout the entirety of their pets' lives, makes us confident in our ability to not only grow today, but to come out of the current economic cycle stronger and even better positioned to drive profitable growth long term. Thank you for your time, and with that, we'd be happy to take your questions.

We will now begin the question and answer session. To ask a question, you may press star then 1 on your touchtone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then 2. In the interest of time, please limit yourself to one question and one follow-up. At this time, we'll pause momentarily to assemble our roster. Our first question comes from Liz Suzuki from Bank of America. Please go ahead.

Great, thank you. And Ron, my condolences to you and your family on the loss of Yummy. He was a great dog. So just a question on the gross margin headwind and when you expect that to abate. I mean, I would imagine that there's, you know, just with the cost of food and, you know, for humans and for pets, food inflation is probably a pretty big driver of, you know, the increase in consumables as a percentage of sales. Do you expect that to continue to be the case as we go into 2023 on a year over year basis, just that some of that mixed headwind would likely continue?

Let me first start with the gross margin question, Liz, and thanks for the question. As I mentioned on the call, the margin pressure in the business is primarily due to the transitory mix pressures. And in fact, mix alone accounted for more than the year-over-year decline in gross margin, which was partially mitigated by improvements in underlying aspects of the business. In digital, we're driving distribution savings through limiting split shipments and also scaling ad works. We've also opened a distribution center that will serve as a hub for internationally sourced inventory and get us efficiencies over time. I'd also say for this quarter, and as we discussed last quarter, previously capitalized rate costs impacted gross margin this quarter sequentially as they began to cycle through the P&L. And then the consumables business is really strong, as you touched on. And while we've seen softness in those discretionary categories, through prior economic downturns, those categories experienced softness, but rebounded as the economy improved with strong growth. And just, you know, case in point, our discretionary categories are up more than 20% from pre-pandemic levels, and we'd expect those to return as the economic environment stabilizes and health growth margins.

I would just build on that, that in addition to strength and consumables, which is only going to be buttressed by the Stella & Chewy announcement that we made today, which is a really strong brand, but the services, we've had consistent double-digit growth on services, and we see no reason why that strong growth doesn't continue.

Great. All right. Thank you.

Thank you, Liz. Thanks, Liz. Our next question comes from Simeon Gutman from Morgan Stanley. Please go ahead.

Hey, good morning, Ron. Good morning, Brian. I want to follow up on this gross margin question. The third quarter grows at 39.8. It looks like the lowest in the public company history. And I wanted to ask how much, you kind of said it, Brian, that most of it was mix shift. I wanted to ask about how much VET investments could weigh on that. And then in light of, I guess, both of these factors, I don't know if you've looked at the street gross margin for next year. I think it's 40.5. I wanted to see what your thoughts about that are relative to what the trends in the business look like today.

Thanks for the question, Simeon. I'm not going to talk about 2023 guidance today. What I will tell you in relation to your first point is, yes, I'm mixed. more than 100% of the decline in gross margin. So we're down 139 basis points year over year. The mix impact was more than that. If you look historically in this business and go back to when the supplies mix was at a more elevated and normalized level, you had a very different gross margin profile. We fully expect those categories to return. And when those categories return, it will be very beneficial to gross margin.

Okay. And a quick follow-up. Oh, sorry, Ron.

I mean, if you go back to the Great Recession, you look at what happened to supplies, as Brian said earlier, it was very similar. But a year later, it was back to being a robust category and back to where it was in the mix. So I've looked at the growth rates for each of those businesses. I've looked at the gross margin back then, but I would anticipate it would look pretty similarly with what happened in the Great Recession when supplies took a kind of one-year softness due to the recessionary, discretionary impact.

And a quick follow-up, the percentage of the business that you would define or classify as discretionary and is the underlying run rate stable or are those products decelerating?

Let me get into the mix first. If you look at the presentation that we post online, you can see that combined between the services and the consumables categories, that's about 60% of our mix. And within that, those are largely non-discretionary. If you look at the growth rates, this quarter, 12% consumables, double digits, and services, those remain very strong. Within the remaining 40%, not all of it is discretionary. And what we believe is that a lot of the purchases today are being delayed. And some of those purchases are going to come back. So not entirely that 40% category is discretionary. A portion of it is. And we fully expect that growth to return.

And with regards to stable, I would call it stable with hopeful signs, with green shoots. meaning we launched a supplies perks program. We're very happy with the sign-ups on the supplies perks program. It takes a little while on our perks programs. We know that from food and grooming for those customers to come back and redeem, but we're very happy with the sign-ups there. And then secondly, we've taken some actions on companion animals that are showing early signs. So stable with green shoots.

Our next question comes from Peter Benedict from Baird. Please go ahead.

Oh, hey, guys. Thanks for taking the question. One kind of model question. Just on the interest expense, Brian, you said you put some caps in place here. $32 million, I think, is the implied fourth quarter interest expense. Is that a good base rate to assume as we run through next year? Do we lock that in? So $125, $130 for next year? Is that how we should think about this?

Let me try and help Peter. I would remind you that we base our interest expense guidance on the forward yield curve, which is expected to continue to increase through the first half of 2023. So I'd say you factor that into the current run rate that that yield curve is expected to increase. On the caps, yeah, we're looking at all ways to sort of mitigate risk here. We put some financial instruments in place and caps to protect a variable part of our debt. And then we're going to remain, as I said on the call, relentless on cash flow. We made good improvements this quarter, 55% improvement in free cash flow year over year. We made meaningful progress in our ability to get leverage out of the balance sheet. And we feel confident in our ability to continue to incrementally drive free cash flow in 23 to both reinvest in the business and manage overall debt.

Got it. That's helpful. And then I guess just a question on inventory, and nice to see it managed well, but certainly in an environment where a lot of people have way too much. But let me flip that a minute. How do you know you're not running too lean on inventory? I know we've been in some stores, and we see the out-of-stocks in certain areas. Just talk to us about just break down that inventory a little better. Do you feel like you're too lean in certain areas? What are you doing to make sure you're servicing the customer? Thanks.

I would say we are in the strongest inventory position that we've been in in a few years. We have a great leader we brought in who has Best Buy experience under Amy College, and they've done a great job managing inventory. We have favorable in stocks versus a year ago that are tangible right now that turned green probably six to eight weeks ago. Um, and so, um, our inventory position should be a contributor to growth and is a contributor to growth, um, are already. Um, and as Brian cited, we don't feel like we're, um, over inventory in any places or any tangible places, but we feel like we have the right inventory in the right places. You know, you always have episodic vendor type issues. But in just getting ahead of kind of a current conversation, our exposure to China is very low. We actually moved a lot of our sourcing away from China on supplies several years ago, and that is serving us well, should China have any issues with a kind of relapse of COVID.

Our next question comes from Oliver Wintermantle from Evercore ISI. Please go ahead.

Yeah, good morning. I had a question regarding the comp and the ticket versus traffic. I think, Brian, you said mostly was basket. Is it fair to assume that transactions were negative and ticket was all the offset?

Yeah, it was driven by basket, Oliver. We did see some trip consolidation on the transaction side, but I would say, look, the team's done a tremendous job in consolidating. to drive Baskin, not all price driven, by the way. That was the question prior on price. Most of our pricing actions, if you recall, holistic pricing actions took place in the second half of last year, which we're starting to lapse. So Baskin drove it. We did see some consolidation on transactions.

Got it. And then a quick follow up.

I would also build on that. We are not your traditional purely merchandise retailer. Our services are tangible. So as we get this significant increase in visits for vets, visits for grooming, training, et cetera, that drives trips for us. So that is a tangible lever, which is why we're so intent on continuing to build out our vet network. So that's another trip driver for us. Sorry to interrupt.

No, perfect. Thank you for that. I just had a follow-up question on the gross margins. Can you... Can you just explain again the freight component of gross margins? How did that trend in the quarter versus the first half and how do you expect that to play out in the fourth quarter?

Yeah, so in the first half, we had more elevated rate and broader supply chain costs. And those get, I think as we touched on last quarter, capitalized on the balance sheet and started to cycle through the P&L. So we signaled we expected the P&L impact from those to get worse quarter on quarter, Q2 to Q3. Now, taking a step back from what's on the balance sheet, in terms of base rates, overall supply chain costs, those are starting to improve. a bit in the second half, we expect to see more tangible improvement into 2023.

Our next question comes from Michael Lasser from UBS. Please go ahead.

Good morning. Thanks a lot for taking my question. Did traffic get worse from the second to the third quarter? It looks like the consumables growth on a multi-year basis has decelerated a bit. So why would that be the case? Are pet parents feeding their animals less? Or your growth in new customer additions did moderate from up 6% in the second quarter to only being up 0.8% year over year in the third quarter. So is that having an influence on traffic as well?

Thanks for the question, Michael.

Traffic was relatively stable in the dynamic that Brian talked about in terms of some trip consolidation happening, which actually makes us more efficient. And as I said, services traffic continues to continue to grow. If you look at our tools for driving traffic, they're tangible. I talked about the vet piece. The nice thing about getting the growth we're seeing in vital care is that the trip frequency visits are up by 60% pre-post on the vital care customers. Similarly, on the perks programs, visits are up 50% on those. So while there is a natural in a recessionary or hyperinflationary environment, you have some purchasing cutbacks happen. Those programs are helping us maintain stability in our traffic trends.

Yeah, and I just add on consumables, Michael. Look, we were up 33% on a two-year stack. And just as a reminder, consumables customers are the most valuable customers we have from an LTP standpoint. So we're really happy with that performance.

Yeah, another contributor to that action, as you mentioned, is we're selling more mega pack type offers. which inherently then you reduce your number of frequency, your number of trips behind those types of products.

Thank you very much. My follow-up question is on the benefit you're going to get from the reduction in freight costs, can you quantify it? And is there a point at which if the discretionary sales remain weak like they've been in the last couple of quarters, Will the freight benefit that you see at some point be enough to offset the gross margin drag that you've been experiencing from the shift away from discretionary?

Yeah, I'd say on the mix impact, Michael, that's much larger than the freight dynamics. And I tried to hit that hard. If you look year over year, again, 139 basis points, gross margin, more than that in the impact from mix. So the return of the discretionary categories, which we fully expect to happen, will be the biggest driver in terms of gross margin. In terms of the freight, I'm not going to quantify it specifically for you. I would tell you we will see some benefit in Q4. We'll see more of a benefit as we head into 2023.

Our next question comes from Chris Bottiglieri from BNP Paribas. Please go ahead.

Hey, everybody. Thanks for taking the questions. Can you speak to the implied Q4 gross margin guide? It looks like it's probably flat to down slightly, depending on where you are in that EBITDA range. I guess in a normal pre-COVID year, like typically how much higher is gross margin in Q4 than Q3? And then I guess what are you assuming in terms of mix and promotional environment for Q4? I think in the past you were, I think being a little bit conservative and thinking that maybe the promotional environment picks up a bit in Q4. I just want to see how you're thinking about that today.

Hey, Chris. It's Ron. Let me take the promotional environment, and Brian can walk you through any view on gross margin. So from a promotional environment standpoint, the market remains rational. and part of that is the fact that for a long time now, aggregate supply has lagged, aggregate demand. It's gotten better, but the market continues to be rational in terms of pricing. If you look at what happened over Black Friday weekend, the promotions were similar to pre-pandemic levels, and actually, if you look at our promotional depth, Our promotional depth was 300 points below a year ago, so the promotional environment seems rational. We anticipated continuing through the holidays. Obviously, you have episodic type things, but over the period, we anticipate rationality from a promotional standpoint. and that's what you've seen all along. I'll pass it on to Brian.

Yeah, and I would just say on the discretionary categories, Chris, look, we're not passengers on the bus here. We saw great success when we launched our grooming perks program. We saw great success when that led into launching the food perks program, which is why we launched the supplies perks program. We're encouraged by the early sign-ups there. We're excited about our holiday lineup, but in reference to the guide, until we see a tangible improvement in the trajectory of those discretionary categories, we think the guidance that we gave, which gross margins implied in there and the commentary around it is appropriate.

Gotcha. Okay. That's very helpful. Thank you.

Thanks, Chris. The next question comes from Stephen Zacon from Citi. Please go ahead.

Great. Good morning, guys. Thanks for taking my question. Our condolences also for the loss of Yemi. Sorry, Ron. Could you talk about the implied fourth quarter outlook in a bit more detail? It's a wide range of same-store sales. I think you cited Black Friday and Cyber Monday comp positive. Maybe how has the business trended overall thus far in November? What are the swing factors to get you to the high end versus the low end of the range?

Maybe we'll tag team again.

So One of the remarkable things about this business is there is very low variability. If you look on week to week, we have not had the significant swings that you see in some of the other retailers. I look at the NPD data, and I'll see weeks when it's up 2 and then weeks when it's down 11. We don't see that. We've been very consistent through Q3, consistent through the Black Friday period. We had a great Cyber Monday. And we're tracking in November relatively consistently. So we have not seen big swings on our business, which is why that's feeding into the guide that Brian is providing. As Brian said, we have initiatives we put in place like the Supplies Perks Program. I would add to that, we're seeing early traction on Klarna, particularly for our companion animal. If you're setting up a companion animal, you're getting a tank, you're getting an animal, you're getting a bunch of accessories as well. So we're seeing early traction with that as well on our companion animal business. But our business has been relatively consistent. and which is feeding into the guide, but I'll let Brian add anything to that.

I would just add that, you know, to build on Ron's point, we continue to see solid growth. We saw growth Black Friday and Cyber Monday, but given the consumer dynamics, Steve, and the fact that it is still early, you know, while we're past Black Friday, we're past Cyber Monday, but we still have the vast majority of the holiday season remaining. We feel like the range that we gave and the guidance is appropriate.

Okay, great. Follow-up question just on farm and pet supply. Could you talk a little bit more detail about the early learnings from the concept? Maybe what's the potential sales productivity of these boxes? How do we think about four-wall profitability relative to your existing stores? And then relative to the six to seven openings by year end, what's an appropriate level of openings for 2023?

Yeah, thanks for the question.

We're fired up about the farm and neighborhood farm and pet supply. If you look at rural markets today, it's roughly a $7 billion TAM. We have not had our fair share of that, and that TAM is growing rapidly. So then there was a question, can we compete with our brand? We did the research. The research says absolutely. People are looking for a pet specialty player in these markets. Then we launched our first, our second, and now our third. And the performance is ahead of our expectations, proving that people are looking for that pet specialty player. You know, I cited before what I heard in the aisle when I go to these locations is, well, I don't have to drive an hour anymore to San Antonio to get my pet specialty products, or I'm so glad that I could get these products. So it's valuable. TAB, Mark McIntyre, very, very encouraging, as I said, we're going to get to separate by the end of the year. TAB, Mark McIntyre, We are in the process of finalizing capital allocations for 2023 but we would anticipate building out at a more rapid rate for 2023 because it is so promising, the other thing I would say is. It extends our merchandise portfolio into these products, so we're seeing some really nice sales in new products. for chickens, new products, for other breeds as well that adds to our portfolio.

The last thing I would add to you, the great thing about these pet care centers is they turn positive in year one, which is a little bit anomalistic from the way we manage sort of a traditional pet care center. So that gives us a lot of positive momentum in the early signs from the three stores we have open and promising.

Our next question comes from Seth Basham from Wedbush. Please go ahead.

Thanks a lot, and good morning. Since you brought it up, Ron, just regarding the near-term Black Friday and Cyber Monday periods where you grew sales, you also mentioned that promo debt declined 300 basis points over this period. So does that mean that merchandise growth, profit, dollar growth meaningfully increased year-over-year during this period?

That would be dependent on mix.

So quite frankly, we've been here prepping for earnings, so we haven't dug into some of the mix dynamics there, but that would be dependent on mix. So we're pleased with the sales that we generated. We're pleased with the response to our promotional activity. We're also pleased, by the way, with week over week our holiday merchandise sales have increased. but I think it's premature to get into the mix of what we sold over Black Friday and Cyber Monday.

Yeah, and I think the other thing I'd mention on promotions is if you look at some of the promotions that we did, some of those were comeback promotions, right? So think about the ones that we did. You can think about, you know, $30 off 100, that is on your next visit into the pet care center. So some of the promotions that we did are not impactful from a gross margin standpoint around Black Friday, and they bring that customer back into our pet care center in the holiday season.

Got it. Fair enough. Secondly, could you expand on the insurance offering and the nationwide agreement that you signed? Is that the tip of the iceberg in terms of a more pronounced offering that you'll have for pet insurance?

You said it very well. Yes, what we've said so far is the start of it.

Let me start by saying this is a partnership with the number one player in insurance. So we're talking scale right from the get-go, number one. Number two, Nationwide came to us. In our prepared mark, I talked about Petco becoming a platform company. Companies are coming to us to partner with us, whether that be Nationwide, whether that be Marriott, whether that be even Klarna, to partner with us because we're increasingly giving them access and data against a very valuable customer base. We see insurance as a significant upside. If you look at it today, it's about a $2.6 billion market, but penetration in the United States is relatively low vis-a-vis Europe. This is a big upside market. Europe has roughly 25% penetration. U.S. is a fraction of that. So big upside. We will be developing or we are developing a customized offering with Nationwide. It's very easy to imagine bundling of insurance and veterinary care, bundling of insurance and things like vital care, which is great because it's a win-win, right? Because if the pets are healthier, Nationwide costs are going to be lower. So a lot of exciting things that can come of this. The other thing is they have a significant customer base that we can now market to. So they might sell insurance to their existing customer base, but we can provide them with veterinary services. We can provide them with grooming services. We can provide them with merchandise. So very excited about this partnership.

Our next question comes from Stephen Forbes from Guggenheim. Please go ahead.

Hey, guys. This is Julio Marquez for Stephen Forbes this morning. Just very quickly, congratulations on the quarter, and on behalf of the Guggenheim team, our condolences to Yumi, and kudos to you guys for setting up a fund in memory. Thank you. So in terms of vital care members, you mentioned an increase in POS conversions, I think, if I heard that correctly. You know, what exactly has changed here? And if you could, any color on demographics and new members and, you know, membership overall, specifically across generations and, you know, maybe color on how you guys think about advertising across different cohorts there. Thank you.

Sure. So the fact that we accelerated our sign-up rate to 40% is really exciting for us. The fact that we're now at 400,000, I think at analyst slash investor day, I said we're going to get to a million. It's not a matter of if it's when. That timetable got accelerated with the success of some of the things we rolled out. One was companion animal, and we find companion animal customers really, really interested in leaning into vital care, which is great to move that business. But the second thing, as you cited, is sign up at point of sale. So before we enabled that, a customer would have to go on their phone and go through the whole registration process on their phone. Obviously, in some instances, that's contingent on Wi-Fi, et cetera. Now, the Petco partner at the register at checkout can add on a vital care membership onto that purchase while they're having their credit card there for purchasing whatever they were there to purchase. So we saw a tangible increase in sign-ups. With that, we also, needless to say, have more interactions from our Petco partners with customers because of that ability. So it's been a real win. And then back to vital care, in terms of the vital care benefit to us, we get tangibly more traffic. 30% of these vital care customers are new to food with us. 30% are new to services with us. So that means that we're getting more share of wallet of these customers. So it's been really, really effective. And I think there's a broader theme there, which is Petco shifting more of its revenue base to recurring revenue, which makes us more predictable. So our revenue from recurring customers is up over 50%. And we're going to continue to drive into those recurring revenue programs like VitalCare and like insurance, like PubBox, et cetera.

The last thing I would add is just the point of sale underscores what an asset our pet care center partners are. To give them that capability at point of sale and give them the ability to connect with a customer is such an advantage for us.

Great.

Thank you.

Appreciate the call. Thank you. The next question comes from Corey Grady from Jefferies. Please go ahead.

Hey, thank you very much for taking my questions. I wanted to follow up on your comment on in-stock rates turning favorable. Can you give us an update on where your Petco care centers are in terms of in-stock rates and when you expect to be back to grade?

We won't give a specific percentage there, but I will tell you we're in the best shape we've been in in a while. We're up year over year. We're up quarter over quarter. We continue to see improvements across the portfolio, and we're really happy with our in-stock levels today.

Okay, great. And then for my follow up, I just wanted to get more color on your priorities for cash or capital going forward. Can you talk about like the balance between, you know, thinking about like store upgrades that rollout and then, you know, the neighborhood farm and pet supply rollout?

Great question. First, I would tell you that we're focused on generating cash in multiple ways, through driving the P&L and also through continuing to get leverage out of our balance sheet to make good progress this quarter, up 55% in free cash flow on a year-over-year basis and near break-even in a year where we're investing in our long-term growth initiative. You mentioned a couple of different things. I would tell you those growth barriers are not binary investments for us, so we will continue to invest in that. We're excited about Farm to Feed, and we think there's an incremental opportunity there for us. I would tell you that we've retired a bunch of the technical debt that we had on the IT side, which historically has sort of dogged us a little bit. We are investing primarily in innovation, in IT, and we've gotten rid of some of that technical debt. So it's across all of those areas that you mentioned. I would tell you that if you think about capex in 23 well i'm not going to give a specific number i would not expect 23 capex to be above 22 levels in total while we continue to invest in those areas our next question comes from anna andriva from needham please go ahead um great uh thank you and good morning guys and ron our condolences on uh yummy as well

Two questions. So first, I guess to Ron, on net ads, pretty strong results and nice to see that consistency sequentially. And I know vital care is a really big part of that. Just curious, can you talk about where you're seeing those customers come from? And secondly, I guess this is to Brian, good to see the company make progress on inventories Can you talk about where we should expect inventories to end the year, and at which point should inventories be more in line with sales in 23? And thank you so much.

Thanks, Anna.

Yeah, we were very pleased with the net ads, and I should say that we continue to add customers into Q4. So the momentum, we continue to see momentum into Q4. In terms of where we're sourcing them, We have consistently been able to source customers from the independent channel as we have a broader offering, as our service offering comes. We're sourcing customers who are new coming for veterinary services. That's part of the power of that, where they're coming because they want to consolidate their purchases with us. They were going to another veterinary provider before. We're sourcing customers from e-comm customers who are looking for things like same-day delivery, things like BOPIS that the online, pure online players can't provide. So those are the main two sources of it. Or three, independent veterinary customers and e-comm customers looking for, you know, fulfillment options that aren't available from other online players.

And then on inventory, let me just hit a couple of things. I was really pleased with the way the team managed inventory this quarter. How to balance these plans where it did while improving in stocks quarter on quarter year over year was really an exceptional job. I would tell you that historically, I'm not going to give a number for Q4, but typically what you would see, Q3 to Q4, is a bit of an inventory decline. As you build up inventory going into the strong holiday season, sales are typically elevated Q3 to Q4 and that inventory normalizes. When you think forward looking on 23, I would tell you that throughout 22, Our units in inventory have remained relatively in line with revenue growth. The increase in dollars is driven by inflation. So as inflation normalizes on the balance sheet and units stay in line with sales, I think that's when you'd start to see things converge a little bit closer.

This concludes our question and answer session. I would like to turn the conference back over to Ron Coughlin for any closing remarks.

Thank you, operator.

To our analysts and our investors, thank you as always for your time and your support. Petco is a growth company which continues to build momentum in an exceptional category with tangible competitive advantages. We remain committed to delivering against our long-term strategic priorities with purpose-driven performance. Thank you and happy holidays from all of us at Petco.

That concludes Petco's third quarter 2022 earnings conference call. The team will be available after the call if you have follow-up questions. Thank you. Happy holidays.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.