Chewy, Inc. (NYSE:CHWY) Q3 2022 Earnings Call Transcript

Chewy, Inc. (NYSE:CHWY) Q3 2022 Earnings Call Transcript December 8, 2022

Chewy, Inc. beats earnings expectations. Reported EPS is $0.01, expectations were $-0.09.

Operator: Good evening, everyone and thank you for joining today’s Chewy Third Quarter Fiscal Year 2022 Earnings Call. My name is Don Tanami, the operator of today’s call. I would now like to pass the conference over to our host, Mr. Robert LaFleur, Vice President of Investor Relations. Sir, the floor is now yours.

Robert LaFleur: Thank you for joining us on the call today to discuss our third quarter 2022 results. Joining me today are Chewy’s CEO, Sumit Singh; and CFO, Mario Marte. Our earnings release and letter to shareholders, which were filed with the SEC earlier today, have been posted to the Investor Relations section of our website, investor.chewy.com. On our call today, we will be making forward-looking statements, including statements concerning Chewy’s future prospects, financial results, business strategies, investments, industry trends and our ability to successfully respond to business risks, including those related to inflation and its effect on the economy and our industry. Such statements are considered forward-looking statements under the Private Securities Litigation Reform Act of 1995 and are subject to certain risks and uncertainties, which could cause actual results to differ materially from those contemplated by our forward-looking statements.

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Reported results should not be considered an indication of future performance. Also note that the forward looking statements on this call are based on information available to us as of today’s date. We disclaim any obligation to update any forward-looking statements, except as required by law. For further information, please refer to the risk factors and other information in Chewy’s 10-Q and 8-K filed earlier today and in our other filings with the SEC, including our annual report on Form 10-K. Also, during this call, we will discuss certain non-GAAP financial measures. Reconciliations of these non-GAAP items to the most directly comparable GAAP financial measures are provided on our Investor Relations website and in today’s SEC filings. These non-GAAP measures are not intended as a substitute for GAAP results.

Additionally, unless otherwise noted, results discussed today refer to the third quarter of 2022 and all comparisons are accordingly against the third quarter of 2021. Finally, this call in its entirety is being webcast on our Investor Relations website. A replay of this call will also be available on our IR website shortly. I’d now like to turn the call over to Sumit.

Sumit Singh: Thanks, Bob and thank you all for joining us on the call today. Building on the momentum we reported in the second quarter, Chewy’s Q3 results showed accelerating double-digit top line growth, a sequential increase in active customers, sustained gross margin expansion and solid free cash flow generation. We experienced strong demand throughout the third quarter, especially across our non-discretionary categories, which provided a solid foundation for our growth. The resilience of the underlying demand in these categories, coupled with our ability to grow customer share of wallet, again enable Chewy to outperform broader industry trends and take incremental market share. Q3 net sales were $2.53 billion, a year-over-year increase of 14.5% and a sequential acceleration from the 12.8% growth in the second quarter.

Our top line results were anchored by the predictable nature of our Autoship customer sales, which grew nearly 19% to 73.3% of net sales and by rising customer engagement as measured by net sales per active customer, or NSPAC, which grew nearly 14% to $477. Digging a little deeper into our Q3 net sales, non-discretionary categories like core food and healthcare collectively made up over 83% of our net sales and were the primary growth drivers, reflecting healthy unit demand and improved in-stock levels. Within discretionary categories, hard goods showed relative improvement in Q3 with sales declining 5% year-over-year, which is a 400 basis point improvement versus the second quarter year-over-year performance. We remain confident that hard good sales will return to their growth path as the economic environment improves.

Taking a longer term view, over the last 3 years, our third quarter hard good sales are up 70%, gross profit has nearly doubled and gross margin has expanded by over 400 basis points. Shifting to overall company profitability, Q3 gross margin expanded 200 basis points year-over-year to 28.4%, which is a new quarterly high. Our gross margin performance this quarter reflects the favorable comps from Q3 last year, the continuation of strong pricing trends without any noticeable impact on demand and the incremental benefits we realized from our ongoing supply chain and logistics transformation. Q3 adjusted EBITDA was $70.4 million and adjusted EBITDA margin was 2.8%, an increase of $64 million and 250 basis points respectively. The primary drivers of adjusted EBITDA growth were higher gross margins and accelerated scaling of SG&A results that showcase our ability to get big fast and get fit fast as we simultaneously drive top line growth and expand margins.

Moving on to customers, we ended Q3 with 20.5 million active customers. Gross customer additions accelerated 6% sequentially and are up 9% compared to Q3 2019. Consistent with recent quarters, customer retention rates remained stable as we continue to work through the initial attrition phases of our pandemic era cohorts. In the third quarter, as consumers shifted their focus away from summertime pursuits like travel towards the upcoming holiday season, we saw opportunities to increase our level of marketing investment compared to recent quarters. While ad supply remained tight, we found ROI-positive opportunities consistent with our philosophy to maximize LTV payback and we invested accordingly. Now, let me update you on some of our latest innovations as we continue to build out the Chewy Health ecosystem, expand into new and exciting high-margin verticals, and make meaningful strides in our supply chain transformation.

Starting with Chewy Health, we recently announced the expansion of CarePlus, our exclusive suite of insurance and wellness offerings with plans provided by Lemonade. Combining the products from Lemonade and Trupanion under the CarePlus banner enables us to diversify our product offerings across the full spectrum of price points and coverage options in order to meet the needs of a wider range of pet parents. We are targeting a nationwide launch of our Lemonade offerings beginning in spring 2023. We remain bullish on the pet insurance space and our ability to drive customer acquisition and deepen customer engagement. Elsewhere in Chewy Health, we recently launched Wipeful , our first private brand in the pet wellness category. Wipeful is a line of supplements featuring products from multivitamins to hip and joint supplements.

The non-prescription pet health and wellness category has an estimated 2022 TAM of over $2.4 billion. And given the increased consumer focus on wellness and the ongoing trend towards pet humanization, we believe this launch gives us another opportunity to strengthen our connection with customers and to drive top and bottom line results. Moving to new lines of growth, we recently launched the beta version of our sponsored ads program, several months ahead of schedule. Sponsored ads are dedicated product placements on chewy.com that promote specific products from select vendors. With these ads, our suppliers can seamlessly advertise to our 20 plus million active customers. We believe sponsored ads will enable us to scale contextual advertisements, which in turn should deliver highly relevant products to customers and high margin revenue to our business.

The full launch is on track for 2023. And last but not least, we continue to make excellent progress transforming our supply chain and logistics operations and developing world class capabilities across our organization. More importantly, these efforts produced meaningful operational and financial benefits throughout the company in Q3. First, our automated FC network is handling an increasingly larger portion of our outbound shipping volume at progressively lower variable cost per order. In Q3, we shipped nearly 30% of our volume through our automated FC network, up from 10% in Q3 last year. Second, our inventory rebalancing efforts through enhanced software and planning capabilities have improved in-stock levels across our network, which has lowered costs by reducing average shipping distances by 25% compared to last year and announced customer experience by reducing click-to-deliver times and improving order accuracy.

These efforts have been complemented by our middle-mile initiative, which also cuts average shipping distance and reduces costs. Finally, our two new import routing facilities are on pace to handle 90% of our import volume by the end of 2022, which further enhances our ability to optimize inventory distribution across our FC network and reduce inbound freight costs. Collectively, these supply chain and logistics efforts have allowed us to mitigate freight costs, begin leveraging our SG&A expenses a quarter ahead of schedule, and improve customer experience on multiple fronts. Let me conclude with the following. The operating environment remains dynamic and evolving. What hasn’t changed is how much pet parents value the enduring companionship of their pets and it is this emotional bond that sustains the pet category through all phases of the economic cycle.

Chewy’s compelling value proposition backed by low prices, personalized service and delivery convenience across a broad selection of products continues to resonate with our customers. This enables us to build the long-term trust that in our view allows us to outgrow our competitors and take market share. Concurrently and unequivocally, our team’s relentless focus on execution and operational excellence allows us to take this growing market share and transform it into incrementally higher profitability and in growing free cash flow. Before I turn the call over to Mario, I would like to share an important development with you. After nearly 8 years at Chewy, Mario has decided to retire from the company. Now it’s too soon to plan his retirement party or order the proverbial gold watch, although those things will be appropriate sometime next year.

As of today, we have no specific date in mind for Mario’s departure and our intent right now is simply to inform you of our transition plans. We have begun a search for top-tier internal or external candidates for this important and strategic position. In the meantime, it’s business as usual and we are grateful to have Mario’s services for as long as necessary to find and ramp a worthy successor. Please understand that this is not a matter about which we will provide regular updates and we don’t plan to comment about this until we have a successor in place. With that, I will turn the call over to Mario. Mario?

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Mario Marte: Thank you, Sumit. Appreciate the kind words and I am looking forward to a little R&R when the time comes. But until then, it is business as usual. Now, let’s talk about our third quarter results. Net sales increased 14.5% or $320 million to $2.53 billion. Growth was led by our non-discretionary consumables and healthcare categories, which collectively represented over 83% of our Q3 net sales. Driving our third quarter net sales growth was an 18.8% increase in Autoship customer sales, which reached a new high of 73.3% of net sales, a 13.8% increase in NSPAC, also a new high for the company and an active customer base of just over 20.5 million, increasing approximately 30,000 versus the second quarter and 100,000 versus last year.

Moving to profitability, our third quarter gross margin expanded 200 basis points year-over-year to 28.4%. Approximately 100 basis points of the year-over-year improvement is a result of favorable comps against Q3 last year when global supply chain disruptions and product cost inflation adversely affected our gross margin. The balance came from continuation of the strong pricing trends that emerged last quarter and greater efficiency in outbound shipping costs, which resulted from bigger basket sizes and the favorable progress we have made in our supply chain and logistics initiatives. Continuing on to OpEx, SG&A, which includes all fulfillment and customer service costs, credit card processing fees, corporate overhead and share-based compensation, totaled $543.5 million in the third quarter or 21.5% of net sales compared to 21.1% in the third quarter of 2021.

Excluding share-based compensation, SG&A totaled $497.4 million or 19.6% of net sales. This is an improvement of 60 basis points compared to the third quarter of 2021 and was flat on a sequential basis. As we shared previously, we expected to begin leveraging SG&A expenses, excluding share-based comp as we exited 2022 and we are pleased to be a quarter ahead of schedule in delivering on this expectation. I will now take a moment to elaborate on how our efforts to leverage these costs are paying off. First, greater efficiency and variable fulfillment costs provided 120 basis points of leverage in the quarter, led by ongoing improvements in fulfillment center productivity from our expanded network of automated FCs. As Sumit shared in his remarks, nearly 30% of our Q3 volume shipped from automated FCs compared to 10% last year.

This helped drive down variable fulfillment costs per order, which provided about half of the Q3 year-over-year cost leverage in this area with the remainder coming from an increase in average order size. We also gained an additional 20 basis points of SG&A leverage as the incremental volume shipped through our automated FCs absorbed more of the incremental fixed carry cost of those facilities. In addition to these gains, corporate overhead scaled by 40 basis points year-over-year as a result of our disciplined management of G&A spend and tight cost controls. At the same time that we are scaling our base costs, we continue to invest in the future. This includes the upfront investments we began making in the second half of 2021 and the personnel and technology needed to support the growth and profitability initiatives that we have detailed for you on this and prior calls.

This contributed approximately 90 basis points of deleveraging in Q3, which is a 20 basis point sequential improvement from the deleveraging that we saw in the second quarter. As a reminder, while the growth-driving investments we make show up in our SG&A expenses today, the benefits will be realized over time through incremental top line growth and gross margin expansion. Third quarter advertising and marketing expense was $177.1 million or 7% of net sales, a 20 basis point increase over the third quarter of 2021 and a 110 basis point sequential increase compared to the second quarter of 2022. As we have said before, our marketing investments are ROI driven and may fluctuate from quarter-to-quarter depending on market conditions. In Q3, we saw the opportunity to make incremental investments across a full spectrum of marketing channels and we lean into those opportunities to maximize long-term gains in terms of active customers and top line growth.

Overall, our marketing spend remained within the 5% to 7% of net sales range that we articulated on our last call. Wrapping up the income statement, third quarter net income was $2.3 million, a year-over-year increase of $34.6 million. Net margin expanded 160 basis points to 0.1%. Third quarter adjusted EBITDA increased to $70.4 million and our adjusted EBITDA margin expanded 250 basis points to 2.8%, which we believe clearly demonstrates the operating leverage that we are unlocking as we realized the benefits of higher gross margin and accelerated scaling of SG&A expenses. Moving on to free cash flow. Third quarter free cash flow was $69.8 million, reflecting $117.4 million in cash flow from operating activities and $47.6 million of capital expenditures.

Capital investments were primarily comprised of investments in our automated FC and Reno and ongoing technology projects. We finished the quarter with $675 million in cash and cash equivalents and marketable securities, which is $68 million higher than our cash and cash equivalents balance at the end of last quarter. This quarter, you will notice that our balance sheet includes $297 million of marketable securities. Starting in Q3, we took advantage of rising short-term interest rates to redeploy excess cash from overnight deposits into highly liquid commercial paper and short-term treasury bills. At the end of Q3, we remain debt-free and between cash on hand, marketable securities and our availability on our ABL our liquidity currently stands at over $1.1 billion.

That concludes my third quarter recap. So, now let me cover our fourth quarter and full year 2022 guidance. As 2022 winds down, the resilience of consumer spending in the pet category continues and Chewy’s value proposition remain as compelling as ever. Our current outlook for the balance of 2022 assumes no material change from current trends in the macro environment. We are increasing our full year 2022 guidance to incorporate our Q3 results and a tighter range of expectations for Q4. We are also raising our full year adjusted EBITDA guidance to reflect our gross margin and leverage in SG&A as reported through the third quarter. We expect fourth quarter net sales to be between $2.63 billion and $2.65 billion representing year-over-year growth of approximately 10% to 11%.

We are raising our full year 2022 net sales outlook to a range of $10.02 billion to $10.04 billion representing year-over-year growth of approximately 13% and over $11 billion in absolute dollar growth compared to 2021. We are also raising our full year 2022 adjusted EBITDA margin outlook to a range of 2.3% to 2.4%, up from our prior range of 1.75% to 2%. As you update your models, here are a few housekeeping items to keep in mind. We now expect full year 2022 gross margin to expand by approximately 90 to 100 basis points from our full year 2021 gross margin of 26.7%. While we expect Q4 gross margin to improve year-over-year, it is likely to come in somewhat below Q3 due to seasonal factors like higher promotional activity and fewer opportunities to achieve freight and shipping efficiencies amid higher holiday volumes and peak season surcharges.

In terms of CapEx, year-to-date CapEx is running at 2.3% of net sales. As we articulated on prior calls, the higher CapEx this year reflects a pull forward of payments on our next round of FC projects given longer project lead times. We now expect full year 2022 CapEx will come in slightly below our previous expectation of 2.5% of net sales as some anticipated spending shifts into 2023. We now expect to generate approximately $50 million to $100 million of positive free cash flow in 2022, given our revised profitability and CapEx outlook. Q3 results demonstrate Chewy’s ability to expand margins in growth profitability in the current macro environment. This is a direct result of our sustained track record of making targeted investments in areas that enhance customer experience, grow our top line, expand margins and improve free cash flow.

We believe our unwavering customer centricity, combined with our sharp operational execution will enable us to continue extending our industry-leading position in pet. And with that, I’ll turn the call over to the operator for questions.

Q&A Session

Operator: Thank you, sir. Our first question comes from the line of Doug Anmuth with JPMorgan. Sir, the floor is yours.

Doug Anmuth: Thank you. Thank you for taking the questions. I have two. Just I guess, first on the 4Q revenue. Can you just talk about the deceleration versus 3Q and if there is anything in particular driving that or anything that you’re seeing in terms of trends quarter-to-date or during the holidays? And then second, the accelerated scaling of SG&A expenses. Where do you think you’re seeing the biggest gains across warehouses and automation and just overall logistics? Thank you.

Mario Marte: Hey, Doug, it’s Mario. I’ll start off with the Q4 guidance. So as you’ve heard us say before, our guidance doesn’t anticipate to take into consideration all the data that we have as of right now, when we look at the fourth quarter, we’re considering the fact that hard goods seem to make a bigger piece of the €“ of sales usually in the fourth quarter. Seasonally, Q4 tends to show a little more heavily towards hard goods given the holidays. And while we saw some demand firming up in the €“ between Q2 and Q3 generally speaking, demand for that category remains relatively soft compared to non-discretionary demand in things like consumables and healthcare. And it’s those headwinds produced by that softer discretionary demand that’s likely to keep net sales growth rates below what we saw, for example, in Q3.

Also recall that last year, Q4, we had a bit of a boost from the Omicron search in December and January. So that’s an impact of higher comps last year regarding Omicron. Now that all said, look, the midpoint of the fourth quarter guidance is still it suggests over $250 million increase year-over-year and the quarter is off to a good start. And if you look at the full year, you see that our guidance now for full year 2022 is about 13% growth over $1.1 billion growth in dollar terms year-over-year and more than double the revenue over the last 3 years.

Sumit Singh: Hey, Doug, this is Sumit. I’ll take the second part of the question. You said what’s contributing to accelerated SG&A. You also said logistics. I’ll take both logistics initiatives are rolling up through gross margin, but I’ll explain as I kind of go through. On the SG&A scaling, so things that are in play here. One, the benefits that we’re getting from automation, which we rolled out a couple of years ago are really starting to come through now. So if you heard me talk about kind of a physics analogy in the past where I said there is a lot of potential energy conserved in the system, which once we start unlocking turns into kinetic energy and that’s kind of what you’re seeing flow through. So basically, the two fulfillment tenders that we launched last year are fully ramped.

We pushed nearly third of our volume or just a little under 30% of our volume through that network. We know the third one is still ramping and we realized half of our 120 basis point leverage to the accelerated ramp of the fulfillment centers. The ramp is also helped by the fact that our inventory positioning is improving both as a result of our work and as a result of improved in-stock levels. And so when you do that, you actually create density in the fulfillment centers that allows you to be more productive and the labor situation has been fairly stable. So when you put all of that together, it allows us to leverage our network in a manner that we essentially planned it or built it to begin with. So that’s the fulfillment center portion.