Petco Health and Wellness Company, Inc. (NASDAQ:WOOF) Q2 2023 Earnings Call Transcript

Petco Health and Wellness Company, Inc. (NASDAQ:WOOF) Q2 2023 Earnings Call Transcript August 24, 2023

Petco Health and Wellness Company, Inc. misses on earnings expectations. Reported EPS is $0.06 EPS, expectations were $0.07.

Operator: Good morning, everyone, and welcome to Petco’s Second Quarter 2023 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please also note, today’s event is being recorded. At this time, I’d like to turn the floor over to Cathy Yao, Vice President of Investor Relations. Cathy, you may begin.

Cathy Yao: Good morning, and thank you for joining Petco’s second quarter 2023 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 results. On the call with me today are Ron Coughlin, Petco’s Chief Executive Officer, and Brian LaRose, Petco’s Chief Financial Officer. Before they begin, I would like to remind everyone that on this call, we will make certain forward-looking statements, which are subject to a number of risks and uncertainties that could cause actual results to differ materially from such statements. These risks and uncertainties include those set out in our earnings materials and our SEC filings.

In addition, on today’s call, we will refer to certain non-GAAP financial measures. Reconciliations of these measures can be found in our earnings release, presentation, and our SEC filings. And finally, during the Q&A portion of today’s call, we ask that you please keep to one question and one follow-up. With that, let me turn it over to Ron.

Ron Coughlin: Thank you, Cathy, and welcome, everyone. Before I begin, I want to thank our 29,000 Petco partners for their enduring commitment to providing the very best for pets and pet parents. I’m proud of the work our teams deliver every single day. This morning, I’d like to focus my remarks on three key topics. First, I’ll briefly review our Q2 results. Second, I’ll discuss actions that will generate approximately $150 million in savings, from a combination of run rate cost efficiencies and productivity enhancements by the end of fiscal 2025. These will help drive both gross margin and OpEx with a greater weighting to gross margin. And finally, I’ll outline the continued progress we’re making on our roadmap for accelerated profitable growth.

For the quarter, we delivered solid top line growth. Net revenue was up 3% year-over-year at $1.5 billion. Comparable sales driven by standout results in services and sustained momentum in average basket trends also grew 3%. This translated to 7% growth on a two-year stack. Our services business once again delivered exceptional performance, growing 17% and is now over a $700 million run rate business. Our veterinary business continues to scale and both vet and grooming are capturing more market share. And our consumables business continues its solid growth trajectory. We believe the strength of our differentiated pet health and wellness offering and the value proposition of our unique 360-degree ecosystem and omnichannel delivery model is the right one to capture the long-term megatrends of humanization and premiumization and are fundamental pillars of our long-term strategy.

While we demonstrated our ability to grow, we recognize that we’re operating in a tougher consumer discretionary environment than we forecasted as we entered the year. And as a result, we’re not yet where I want us to be in translating top line growth to the bottom line. Our supply and companion animals businesses remain more pressured than anticipated, impacting our profitability for the year relative to our expectations. With food, we also continue to see a bifurcation among pet parents, with ongoing migration to more premium foods on the one hand and an uptick in value seeking behaviors amongst the second cohort. Due to the broader discretionary environment and its associated impact on our supplies and companion animals businesses, as well as the pricing actions we’re undertaking to ensure we’re price competitive on key products and SKUs, we are revising our adjusted EBITDA and adjusted EPS guide for the year.

Brian will provide more color on our expectations shortly. We remain relentlessly focused on controlling our controllables to optimally navigate today’s consumer dynamic. We have a focused plan to deliver our revised targets while we continue to make progress against our long-term strategic priorities. First, we’re taking additional actions to protect profitability. We are implementing tight cost controls, and programmatic initiatives across the business. Through a comprehensive cost and efficiency program, we’ve identified and are actively working multiple areas to unlock $150 million in run rate cost savings by the end of fiscal 2025, of which we project $40 million in savings by the end of year one. Specifically, over the last year, including in Q2, we adjusted our workforce, reducing our corporate and field leadership headcount by a cumulative total of approximately 25%, including the closure of open roles.

As a leadership team, we are acutely aware of the impact these actions have on colleagues that we care deeply about. We did not take these decisions lightly. While difficult, they are best for our business, ensures our workforce matches the capability needed to support our long-term strategy. These actions position us as a leaner and more effective organization. Beyond this year, we’ve identified broader programmatic initiatives to further enhance profitability. These include refinements to our supply chain, including shipping and distribution enhancements, such as automation, meaningful G&A efficiencies, and improvements in merchandise operations. Brian will elaborate further. We’re confident these actions will better position us for the short, medium, and long term while enabling us to prioritize capital allocation on our key initiatives of vet, digital and debt reduction.

Turning to the second component of our strategic actions. We’ll strengthen our positioning with pet parents with the surgical use of assortment, value, in-store experience, and marketing. We are actively evolving our assortment to align with the trends that we’re seeing, supplementing our rapidly growing premium offerings with more value-based options. This includes reintroducing the number one selling cat food brand, Fancy Feast, this week, something both our customers, and pet care center teams are very excited about, as well as Diamond Naturals. Both will drive incremental customers to the franchise. More to come here. We will complement the product moves with targeted pricing actions to address competitive gaps in key traffic driving brands and SKUs. We’ve taken similar actions several times throughout my tenure here, and they have delivered customers, unit, and revenue growth with breakeven impact to margin within a year and accretion thereafter.

Additionally, once again, we delivered margin expansion within services and digital, and we expect those to continue to help offset mix pressures. As we ensure we have the right products at the right price for the right customer, we’ll also lean into seasonal programs like Halloween and holiday. And we recently brought back our popular Supplies Perks program to stimulate additional supplies purchases and will continue to enhance the customer experience, whether it’s online, on the app, or in-store. Our investments into labor continue to pay off, with partner retention up nearly 800 basis points year-over-year. Combined, we believe these actions should meaningfully accelerate our capability to drive profitable growth and deliver for our customers.

And we’ll do this without compromising on progress against our differentiating, long-term strategic priorities. Now, turning to the results of the quarter across services, our differentiated merchandise mix, and omnichannel. In the quarter, our total pets seen in vet increased 26% year-over-year. We ended Q2 with 269 hospitals and are on track to approach 300 hospitals by year end. We as our hospitals mature, our economics become increasingly attractive. Petco clinics continue to outperform our expectations and remain complimentary to our hospital business. These mobile clinics up 23% year-over-year to a total of 1,400 clinics a week, support routine wellness visits in an affordable way. They also remain a source of talent for our full-time vets, with 21% of our full-time vet recruits this year coming from our clinic pool.

In total, we brought 364 vets into our ecosystem in Q2, up 59% year-over-year, including vets available for our clinic business. In grooming, revenue growth was strong and we continue to gain market share in a fragmented market, up nearly 100 basis points year-over-year, growing basket, transactions, and center store sales. Grooming’s continued momentum has been accelerated by a clean grooming launch earlier this year, with services and products free of parabens, phthalates and chemical dies, as well as a nearly 500 basis point year-over-year improvement in groomer retention. In merchandise, our key challenge is in the supplies business, which was down 9% in the quarter. Categories like apparel, crates and toys remain soft as consumers slowed spending in these products.

We are taking targeted actions in this area to drive performance, including improving price competitiveness, screening the offering to more value-oriented initiatives, and expect stabilization over time. We remain nimble in our response to capturing opportunities when they arise. As a result of the extreme heat, we were able to drive our flea and tick business leading to RX sales up nearly 20% year-over-year. As we look to the back half of the year, our supplies offerings will benefit from lower input costs and lower freight expense, particularly in Q4. Looking beyond this, consumables remain solid. In the quarter, consumables grew 7% with strength in both premium up 8% year-over-year and non-premium up 4% year-over-year. Specifically, we continue to see strong Fresh Frozen growth with 10% revenue growth and 12% customer growth year-over-year and these are some of our highest value customers.

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Our delivery model continues to be a differentiator for Petco, meeting the needs of pet parents who prefer to shop in an omnichannel fashion. Across the business, we saw a 2% brick and mortar growth and 9% digital growth, driven by strength in basket trends and Nest Pac growth. Our repeat delivery and BOPIS revenue continued to grow as did same-day delivery orders, supporting our value proposition as an integrated omnichannel player. Looking ahead, we will continue to optimize investments across all our marketing channels, in-store and online. Specifically, we will tighten the focus of our marketing dollars on driving traffic to capture share and propel profitable growth. This will include deepening our relationships with our existing 25 million customers so that we are well positioned for the eventual recovery in discretionary.

A key lever here is our valuable Vital Care Premier program where members grew 75,000 to 660,000 in the quarter. These high value customers spend more than triple what non-members spend. Lab supplies trips contributed to a modest 60,000 total customer decline. And finally, as we think about increasing customer touch points, we were proud to announce the expansion of our Lowe’s shop-in-shop partnership this quarter, expanding to 300 locations, including 75 of Vetco Clinics, this furthers our footprint in rural markets, at zero capital outlay from Petco. These locations are already performing ahead of expectations. We expect the partnership to be incrementally positive to our top line, dollar accretive to our profit, and will enable us to capture new customers.

As I close, I’m proud of the progress Petco has made over the last five years, including our vet build-out and the evolution of our 360-degree omnichannel model. That said, I am not satisfied with where we are, and we have an aggressive plan across product, price competitiveness, marketing, and store and digital experience to ensure we deliver. I’m confident that we have the right blue-chip team to execute this plan since the actions we outlined today will forge an even stronger business. Thank you. And with that, I’ll hand it over to Brian.

Brian LaRose: Thanks, Ron, and good morning, everyone. To build on Ron’s remarks, I also want to extend my thanks to our Petco partners and their continued dedication to the health and wellness of pets. For the quarter, net revenue was $1.5 billion, an increase of 3% year-over-year. Comparable sales, driven by sustained strength in average basket trends grew 3% year-over-year and 7% on a two-year stack. Our digital business showed strength with 9% year-over-year growth in the quarter. Total services grew 17% year-over-year, driven by strength in vet and grooming under the leadership of our exceptional services team and is now a $700 million plus run rate business. In merchandise, consumables were up 7% year-over-year in the quarter, while our discretionary supplies and companion animals businesses experienced ongoing softness, down 9% year-over-year.

Moving down the P&L, gross profit was roughly flat year-over-year in the second quarter at $593 million. Q2 gross margin of 38.7% was down 140 basis points year-over-year. The decline was primarily attributable to business mix shift with strength in services and digital and continued softness in discretionary categories. As a reminder, in services, our labor sits in cost of sales, so while services has a lower gross margin than enterprise, in the long term, it’s helpful to adjusted EBITDA. In Q2, SG&A as a percentage of revenue increased 40 basis points year-over-year to 37.2%, driven primarily by an increase in stock-based compensation and one-time costs primarily related to headcount reduction. Excluding stock-based compensation and one-time costs this quarter, our SG and A as a percentage of revenue would have decreased 50 basis points year-over-year.

We also had a tangible increase in payroll expense from the one-time step-up we made to a $15 per hour minimum wage last December as we continue to invest in our partners, a move that is increasing retention. Q2 adjusted EBITDA was $113 million down 15.7% from prior year with an adjusted EBITDA margin rate of 7.4%, down 170 basis points year-over-year. Q2 adjusted EPS was $0.06, a decrease of $0.10 from the prior year, driven in part by a $0.04 year-over-year increase in interest expense, based on 267 million weighted average fully diluted shares and a normalized effective tax rate of 26%. Turning to our balance sheet. Our liquidity position remains strong. We ended the quarter with $619 million inclusive of $173 million in cash and cash equivalents and $446 million of availability on our revolving credit facility.

In Q2, we paid down $25 million in principal and another $15 million last week. Year to date, we have now paid down $75 million toward our target debt paydown of $100 million for the year. Our CapEx of $52 million was down 26% year-over-year as we lapped last year’s freezer build-out. I also want to touch on inventory briefly. Overall, we remain pleased with our inventory performance with in-stock improvements for the quarter and inventory turnover cycle remaining strong. Our inventory dollars are down 7% year-over-year. We generated free cash flow of $45 million in the quarter, up $72 million year-over-year, underscoring our enduring focus on steering this business strategically through this environment. Year to date, we’ve generated a total of $20 million in free cash flow, a $56 million improvement to a loss of $36 million in the first six months of 2022.

As I turn to our outlook, although our long-term strategy focused on the megatrends of humanization and premiumization remains, we also acknowledge that discretionary pressures remain and consumers are more value sensitive during this environment. To address this, we are implementing strategic actions that will better position us for profitable growth in 2024 and beyond. Given the current consumer dynamics outlined above, and the expected timing of benefits from our strategic cost actions, which will primarily start to benefit in 2024, we are lowering our adjusted EBITDA, adjusted EPS, and capital expenditures outlook for fiscal 2023. We’ve updated our guidance to revenue of $6.15 billion to $6.275 billion, which is unchanged. Adjusted EBITDA of $460 million to $480 million.

Interest expense of $145 million to $155 million, which is unchanged. Adjusted EPS of $0.24 to $0.30 on 269 million weighted average fully diluted shares, $215 million to $225 million of capital expenditures, and we continue to expect to add a total of 50 to 55 owned vet hospitals in 2023 in approximately 10 rural locations. Our updated adjusted EBITDA guide anticipates continued pressure on gross margins. Given continued mix pressures away from discretionary, along with strategic pricing actions we are undertaking to accelerate growth and retention, which we have seen positive returns on in prior iterations. When the discretionary environment stabilizes, coupled with the outcome of our cost actions and productivity, we expect our gross margins will stabilize.

Importantly, we’ve seen continued improvement in services and e-com gross margins. As a reminder, on services, the P&L geography of [labor sits] (ph) and cost of sales, which means the business has a lower gross margin than enterprise. Our lower CapEx guide still anticipates the build out of our vet in rural locations as provided in the updated guidance. Beyond this year, we have identified additional programmatic initiatives to drive efficiencies and further reduce costs, which includes merchandize, supply chain and broader G&A opportunities. These sum to an estimated $150 million on a run rate basis by the end of fiscal 2025 and an estimated $40 million run rate savings in year one, split across the following. In supply chain, we expect to further streamline our DCs and optimize our network on the first leg of our long-term distribution strategy.

We are working to further optimize our roots and automate our DCs so that we can ship more efficiently from DCs to stores. We also have additional opportunities to further drive down e-com shipping costs. In merchandise, we plan to extract additional savings by rightsizing input costs from our vendors. In G&A, we will continue to optimize labor within our PCCs through leveraging technologies such as our handheld Zebra devices to assist in tasking and inventory management. Additionally, for certain roles, we are shifting our resources to lower cost locations. And of course, we plan to remain tactical across real estate, marketing and other opportunities. We’re confident these actions better position us for the short, medium and long term, while allowing us to prioritize capital allocation on our key initiatives of vet, digital, and debt reduction.

To conclude, the entire Petco leadership team and I remain focused on navigating the short term through disciplined execution in this environment. We are committed to adapting and evolving our business thoughtfully to meet the current cyclical impacts to pet parents and our business, while remaining well positioned for the long term and delivering profitable growth as a leader in the resilient and secularly favorable pet category Thank you for you time. And with that, we’d be happy to take your questions.

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Q&A Session

Operator: Ladies and gentlemen, at this time, we’ll begin the question-and-answer session. [Operator Instructions] Our first question today comes from Oliver Wintermantel from Evercore ISI. Please go ahead with your question.

Oliver Wintermantel: Great, thanks. Brian, maybe that’s — the first question for you. Looking like the decrease in just EBITDA margin, EPS but top line stays the same. So is that just a continued mix shift to more of the consumables away from supplies in the second half? If you could maybe talk a little bit about the seasonality in that? And then the second part is, is the reduction in EBITDA just based on gross margin? Or do you see also SG&A pressures? Thank you.

Brian LaRose: Hi, Ollie. Thanks for the question. Let me start on a macro basis. We continue to see consumers’ wallets shift towards services with some uncertainty moving forward. Specific to us, our initial full year guidance assumed a modest stabilization in discretionary spend on a dollar basis in the back half of the year and we have not seen that discretionary spend stabilize. And as a result, these factors continue to further pressure gross margin. So specific to your question, yes, the reduction in the EBITDA guide is directly related to the change in our outlook for the discretionary categories, companion animal and supplies and the vast majority of that reduction is related to gross margin. Now we do have cost actions in place. The team is energized. We’re already getting some quick wins from those cost actions. While they will primarily benefit 2024 and 2025, there will be some modest benefit in 2023.

Ron Coughlin: And the majority of those actions impact gross margin.

Brian LaRose: Correct.

Oliver Wintermantel: Thanks very much. Good luck.

Ron Coughlin: Thanks, Oliver.

Operator: Our next question comes from Zach Fadem from Wells Fargo. Please go ahead with your question.

David Lance: Hey, guys. This is David Lance on for Zach. Thanks for taking our questions. You noted that you’re taking price increases to be more or excuse me, price actions to be more competitive. Curious if you could talk about what side of the business that’s coming on and how your discretionary pricing stacks up this year?

Ron Coughlin: Yeah. Thanks, David. From a competitive standpoint, we can’t really elaborate from a pricing standpoint. We can say the consumers today are looking for value. We’re taking actions to drive that value, customer engagement, drive units. Historically, when we’ve taken these actions, as Brian cited, we’ve seen a breakeven within the year. But it’s really to address gaps in key product categories that drive both traffic and pricing perception.

David Lance: That’s helpful. And then the guide implies flat to down comps in 2H. So just curious if you could talk through the rationale there and maybe the trajectory of the business as we exited the quarter.

Brian LaRose: Yeah. You’re right. If you look at the overall revenue guidance. I’ll go back to macro. We continue to see pressure on consumers’ wallets, especially in discretionary. And overall, we did see growth in the first half with continued momentum in services and consumables primarily but that discretionary category remains pressured. So given that environment, we felt like maintaining our revenue that was most appropriate.

David Lance: Got it. Thanks.

Operator: Our next question comes from Simeon Gutman from Morgan Stanley. Please go ahead with your question.

Simeon Gutman: Good morning. I wanted to ask what’s assumed for discretionary companion for rest of the year if there’s a mix percentage? And as you plan for ’24, are you just taking the tact of being extra conservative or should that category flatten out and grow for next year?