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?

Brian LaRose: Yeah. Let me start, Simeon and then I’ll turn it over to Ron to talk about 2024. So as I said earlier, our initial guide assumes some stabilization in that discretionary category. If you look at Q2, we declined 9%. If you look at Q1, we were down 8%. Obviously, our expectations in Q2 weren’t in line with what we previously assumed. While I won’t get into a specific number, I think if you look at the minus 9% in Q2 we have not assumed much recovery from that for the balance of the year. And I’ll turn it over to Ron to talk about ’24.

Ron Coughlin: Yeah. Hi, Simeon. The current projections for the overall category for ’24 are mid-single digit with a stabilization of supplies. When in ’24 that happens, we will see, but we’re not waiting. We’re going to take actions. We’re taking actions on our Supplies Perks, which actually — enrollments were up 11% versus when we ran that before. We’re taking action on costs. We have favorable cost progress on our supplies. We have favorable freight, which allows us to have more flexibility in terms of providing value to customers. So we’re taking actions. Category call for ’24 at this point is mid-single digits with a stabilization in supplies.

Simeon Gutman: Thanks. If I can ask one follow-up, I don’t know if I can. On the promotionality of the industry, it seems like it’s ticking up. I’m curious how you describe it. And as you plan second half, is that — I guess, I don’t know, pricing actions is discounting or promotions or it’s price optimization?

Ron Coughlin: Yeah. Good question. Supply and demand have rebalanced versus a year ago. So the industry is returning to pre-pandemic promotional levels. There’s a consumer who’s looking for more value, and we’re making sure that we provide it and the promotions that we run are traffic positive, revenue driving and for the most part, profit dollar neutral. So it is an effective tool in generating customers. We’ve seen positive reactions to them, but it’s really a return to pre-pandemic promotional levels based upon supply now being more in balance with demand.

Simeon Gutman: Okay. Thanks guys. Good luck.

Ron Coughlin: Thanks, Simeon.

Operator: Our next question comes from Anna Andreeva from Needham & Company. Please go ahead with your question.

Anna Andreeva: Great. Thanks so much. Good morning, guys. I wanted to follow up on the sales cadence that you saw during the quarter. I think you had said previously that May was more in line with 1Q. So that’s mid-single digits. So should we think both June and July slowed? And what are you seeing in the business so far in August? And then I had a follow-up as well.

Ron Coughlin: Hi, Anna. thanks for the question. In terms of linearity, we had non-comp noise with events shifting from month-to-month versus a year ago. What I can say is we weren’t happy with supplies in May, June or July, which is driving our guidance change. Services remains strong across all three months and food showed solid growth across the quarter. In terms of August, we haven’t seen a significant change in our trend line, but we’re taking action, and we’re seeing some initial green shoots on some of those actions.

Anna Andreeva: Okay. Great. That’s helpful. And just as a follow-up on gross margins. Did that come in line with your expectations for the quarter? And just any color that you could share on the puts and takes on the gross margin line as implied by the annual guide. I think, Ron, you had mentioned some of the benefits from the cost actions on gross margin are starting to trickle in this year as well?

Brian LaRose: Yeah, I can take that one, Anna. So in terms of gross margin, relatively in line with our expectations overall and that was despite the discretionary category not coming in line with our expectations. So the change of the guide, as we mentioned, is primarily related to our renewed expectations on that supplies and discretionary category. On the cost actions, Ron did mention that they are heavily weighted towards gross margin, but the benefits of those cost actions will mostly benefit 2024 and 2025. Some of the benefits in 2023 are more in the SG&A line from some of the headcount actions that we’ve taken.

Anna Andreeva: All right. Fair enough. Thanks so much, guys.

Ron Coughlin: Thanks, Anna.

Operator: Our next question comes from Steven Forbes from Guggenheim. Please go ahead with your question.

Steven Forbes: Good morning, Ron, Brian. Ron, you mentioned premium receivables up 8%, and I think, non-premium up 4%. But given some of the comments you made about assortment and just the consumer in general, curious if you provide unit volume color between those two subcategories and how you’re thinking about the current mix of the business from a go-to-market strategy?

Ron Coughlin: Thanks for the question. We continue to see a bifurcation in demand. We’re still seeing strong growth on premium offerings like Fresh Frozen, Orijen, Acana, which continue to be outperforming. That said, at the category level, we do see an increase in value-seeking behaviors amongst the subsegment. We’ve supplemented our value offers like our launch of Fancy Feast and Diamond Naturals with price points that are appealing to our customers. And additionally, the cost enhancements on supplies and related freight will be weaved in, in the second half to allow us to be more cost competitive on those products as well. So it’s really a story of bifurcation, strong demand on the high end and increased demand on the value side as well.

Steven Forbes: Thank you. Maybe just a quick follow-up for Brian. To level set the capital spending expectations, can you expand on where you’re deprioritizing capital spending this year with the most recent change? And then any comment on sort of initial 2024 plans as it pertains to balancing through your strategic growth initiatives with other investment needs like automation, to capture some of the savings that you noted?

Brian LaRose: Yeah. Good question, Steve. First, let me address 2023. So we’ve maintained our — that target of 50 to 55 hospitals in 2023 and our small town rural build out of about 10. And we’ve also maintained our commitment to pay down $100 million of debt this year in terms of our capital allocation priorities. We’re already at $75 million, we did $25 million in Q2. We did another $15 million last week. So already $15 million in Q3 gets us to $75 million. In terms of 2024, I don’t expect those capital allocation priorities to change dramatically. We will continue to focus on debt paydown. We will continue to lean into areas like that and other strategic priorities with high ROI. The adjustment of the CapEx guide for this year did not trade off any of those strategic priorities. It was in other ancillary areas where we were able to make some trade-offs to maintain our cash balance and make sure we were managing our working capital appropriately.

Steven Forbes: Thank you.

Ron Coughlin: Thank you.

Operator: Our next question comes from Seth Basham from Wedbush Securities. Please go ahead with your question.

Seth Basham: Thanks a lot and good morning. My question is just trying to better understand some of the merchandising and price changes that you’re making. Now first, supplies typically aren’t traffic driving. So what’s leading you to the decision to have to invest in price and supplies? And then secondly, bringing back things like Fancy Feast and the Supplies Perks program, why were those removed in the first place?

Ron Coughlin: Thanks for the question, Seth. So let me bifurcate. We didn’t provide indication of where we’re taking pricing. What we find is food is a traffic driver, similar to the grocery model and that can drag supplies. There are certain categories that are price perception defining within supplies, which is why we’re encouraged by the fact that we have lower costs flowing through and lower freight costs coming through. And those categories are strategic in terms of creating a price perception which then contribute to traffic.

Seth Basham: Okay. That’s helpful. And then the decision to remove Fancy Feast previously and the Supplies Perk program, can you give us some context there?

Ron Coughlin: On Fancy Feast, we took a decision back in 2018 around artificial ingredients, the Fancy Feast products that are brought into our stores today have been reformulated and have eliminated all artificials, which is a really positive thing. It’s a win for Nestle, it’s a win for us and a win for our customers. We’re really excited about it. And Fancy Feast is absolutely a great traffic driver.

Brian LaRose: Yeah. And on the Supplies Perk program, Seth, we tend to pulse in and out of those programs based on our expectations for elasticity and demand. And so that was not dormant for very long, and we tend — we just made the decision to pulse back in.

Seth Basham: Thank you.

Ron Coughlin: Thanks, Seth.

Operator: Our next question comes from Michael Lasser from UBS. Please go ahead with your question.

Michael Lasser: Good morning. Thanks a lot for taking my question. So Petco’s adjusted EBITDA margin for this year is now expected to be around 200 basis points below the level it was in 2019. As you diagnose why that is, what’s changed though at the business to drive such significant margin compression? How much of it relates to external factors like increased competition? And how does all of this inform your view of what the company’s long-term EBITDA margin outlook is?

Brian LaRose: Yeah. Thanks for the question, Michael. So the change from 2019 is primarily related to the cyclical pressure that we have in the discretionary business. That pressure has a direct impact on gross margin, that gross margin impact has a direct impact on adjusted EBITDA. We’re confident that, that cyclical impact will stabilize. When that stabilizes, coupled with our cost actions, we’re confident that gross margin will stabilize. We do have $150 million of cost actions in play to help return EBITDA to profitable growth in the future. If you look at the impact on gross margin as well, I’ll remind you that services sits — labor for services sits in cost of sales. If you take services out of our model in the quarter, our gross margin would actually have been a little bit over 41%. So as services has grown materially from 2019, up 17% again in Q2, that has an impact on rate on the gross margin line.

Ron Coughlin: It’s really a story of discretionary. And given that’s our highest profit category, the cyclical pressure of discretionary on the P&L.

Michael Lasser: Okay. My follow-up question is on the comp outlook, especially as you head into the holiday. What are you assuming as your base case for 3Q, 4Q comps, especially given the uncertain macroeconomic environment, and what would drive upside and what would drive downside to those comp expectations?

Brian LaRose: Yeah, I’m not going to get into the quarters, Michael, but I’ll tell you that we felt like the revenue — maintaining the revenue guide was the most appropriate thing to do given some of that uncertainty. We’d expect that services would continue to be strong. We’re happy with our consumables performance this quarter, up 7%, but that discretionary category remains under pressure. So if you look at the back half of the year, that would imply, as somebody asked earlier is somewhat of a deceleration in comp. We felt like that was the best guide based on what we know today.

Michael Lasser: Thank you very much and good luck.

Ron Coughlin: Thank you.

Operator: Our next question comes from Steven Zaccone from Citi. Please go ahead with your question.

Steven Zaccone: Great. Good morning. Thanks for taking my question. So to follow up on Michael’s question, what do you think is the optimal mix of discretionary for this business? Because on the one hand, yes, it’s challenging from a cyclical perspective. But on the other hand, some of your growth drivers in the business since you’ve come public, right, are premiumization in food and then services, which are lower gross margin rate businesses. So I’m curious for what’s the optimal mix of discretionary over time and if it continues to trend lower, how do you think about the margin drivers to improve EBITDA margin rate over the next couple of years?

Ron Coughlin: Thanks for the question. We like our discretionary business, our supplies business, companion animal business, they are high-margin businesses. So outside of an economic cycle like the one we’re in, they help drive our strong profitability and our customer delighters, and we have differentiation from our own brands. And in that category, actually roughly 50% plus is own brands. So it is a very attractive profit driver for us on a timeless basis. As you cited, things like digital, things like services are gross margin dilutive. But in both those cases, we are driving margin enhancements within those silos, which help offset that. And as Brian has cited, from a services standpoint, gross margin is impacted by the labor. If you look at it on an EBITDA basis in the mid to long term, it’s equivalent to — roughly equivalent to our total enterprise.

Steven Zaccone: Okay. But to follow up on that then. So if we think about the vet hospital side of the business right now, which is getting some scale, can you say whether that’s EBITDA margin accretive to the business today? Will it be EBITDA margin accretive in the next couple of years? Thank you.

Brian LaRose: Yeah, Steve, thanks for the question. Today, it is not. So if you think about the vet model, the great news about the vet model is the unit economics continue to track along with or ahead of our model depending on the cohort. Our most recent cohorts are ahead of model. That model has EBITDA dollars and gross margin dollars as dilutive in the first year, roughly breakeven in year two on a path to 20% EBITDA in year five. We’re on track with that. If you look at our overall cohorts with 269 hospitals, we’ve added roughly 150 to 175 of those in the last two-plus years, which means the average age of our hospital is just over two years, meaning the average EBITDA rate of those hospitals is just over that breakeven amount. Now the good news with that is they are maturing. As those hospitals mature, the cost that model will be accretive to our overall model. And at that inflection point become actually accretive to the overall enterprise EBITDA rate.

Steven Zaccone: Okay. Thanks very much.

Ron Coughlin: Thank you.

Operator: [Operator Instructions] Our next question comes from Greg Sommer from Gordon Haskett. Please go ahead with your question.

Greg Sommer: I just wanted to follow up on the vets. I was wondering if you’re still seeing in store, like center store lit from the vet that’s similar to past quarters? And then is that mainly traffic driven? And then just a follow-up. What was the biggest bucket out of that [$150] (ph) million savings of the various buckets that you laid out? Thank you.

Ron Coughlin: Thanks for the question, Greg. So from a vet standpoint, we really like the impact it has on the rest of the store. So from a center store lift standpoint, we’ve revalidated the four to five point lift on center store when we put in a vet, which is a great impact. Our locations with vets are growing tangibly faster than the locations without vets. And in terms of traffic, yes, is a very effective traffic driver for us. In fact, 15% of the vet customers are new to Petco. So that’s one of the advantages from that model.

Brian LaRose: Yeah. And on the cost actions, the larger buckets of the cost actions are in merchandise and supply chain, which will impact the gross margin line on an overweight basis. While there’s opportunities in SG&A, we have more opportunities in cost of sales.

Operator: And ladies and gentlemen, with that, we’ll be concluding our question-and-answer session. I’d like to turn the conference back over to Ron Coughlin for any closing remarks.

Ron Coughlin: Thank you for your time and questions. As we close, I want to reiterate that we’re confident in our plan to navigate the current environment, and we remain resolute that we are well positioned to capture the long-term megatrends of the growing and resilient pet category. Thank you.

Cathy Yao: That concludes Petco’s second quarter 2023 earnings conference call. Thank you.

Operator: And ladies and gentlemen, with that, we will conclude today’s conference call and presentation. You may now disconnect your lines.

Cathy Yao: Goodbye.