Petco Health and Wellness Company, Inc. (NASDAQ:WOOF) Q3 2022 Earnings Call Transcript

Petco Health and Wellness Company, Inc. (NASDAQ:WOOF) Q3 2022 Earnings Call Transcript November 30, 2022

Petco Health and Wellness Company, Inc. reports earnings inline with expectations. Reported EPS is $0.16 EPS, expectations were $0.16.

Operator: Good morning and welcome to the Petco’s Third Quarter 2022 Earnings Conference Call. Please note this event is being recorded. I would now like to turn the conference over to Benjamin Thiele-Long, Petco’s Director of Executive and Business Communications. Please go ahead.

Benjamin Thiele-Long: 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 Coughlin, Petco’s Chief Executive Officer; and Brian LaRose, Petco’s Chief Financial Officer. In a few moments, I will invite Ron and Brian to provide their perspective on Petco’s financial and operating performance for the quarter and the 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 will be grateful if you could keep to one question and one follow-up.

With that, let me turn it over to Ron.

Photo by James Lacy on Unsplash

Ron Coughlin: 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, continue to see product mix shift towards premium and launch landmark partnerships 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 defense growth category. Capabilities that have generated revenue growth enabled us to navigate mix pressures and continue to deliver enhanced value to a growing customer base. In the third quarter, comparable sales were up 4%, equating to 20% and 36% on a 2 and 3-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 remained 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 will touch on more later, followed by an innovative new collaboration with Marriott to facilitate traveling with pets.

All while our rapidly growing advertising network continues to be a draw for well-loved brands like Nestle and Colgate-Palmolive’s Hill’s. 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 Vital Care 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 Vital Care members, an increase of 42% quarter-over-quarter and over 200% year-over-year, we are even more confident that we have designed the right offering for pet parents sitting at the intersection of value and loyalty.

Vital Care members continue to bring a 3.5x 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 pets’ 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 are focused on successfully integrating the Thrive business after which we have returned to our previous run-rate of new hospital openings. This quarter exemplified our execution against both. With the 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 in 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 Solensia 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 are 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 VAME 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 bookings supplement sales while negating the impact of last-minute cancellations. From new pets that need vaccinations to older pets that want to look at 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 ensuring 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 multiyear 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 are even better positioned to capture share in this high value 2.6 billion and growing addressable market. With the ability to cross-promote and market to each other’s customers, we are excited about bringing Nationwide’s growing number of pet families into our Petco Ecosphere, including our veterinary and grooming services, merchandise and memberships, with the 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 2-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. Consumables 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 3-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 are seeing in the category.

Our owned exclusive premium mix grew in the quarter. Sales in our own brands Reddy 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 Antoni. And earlier today, we announced that we are 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 Stella & 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 BOPIS and loyalty program conversion. Our digital channels continued to build on the profitable double-digit growth in the first half of this year, with Q3 total digital sales up 10% year-over-year, 42% over 2 years.

Key drivers of growth included an increase in average basket, growth in repeat delivery, including RX, and continued innovation. We also saw strong gross margin improvement with particular efficiencies in cost per order. Specifically, the addition of multiple same-day delivery windows through our partners 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 tenth consecutive quarter of positive comp sales and ninth consecutive double-digit comp growth quarter on a 2-year stack. Basket remained elevated driven by strength in 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 are also excited about our fantastic holiday theme 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 have also now opened our third neighborhood farm in pet supply with locations in Texas and North Carolina and putting us on track for our target of 6% to 7% 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 2 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 continues 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 or 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 lifesaving 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 am 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 4 years, it brings home the value of our purpose-led transformation. It’s a transformation that has 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.

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Brian LaRose: 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 and 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 2-year stack. Total services grew 14% year-over-year, translating to 38% over a 2-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 2-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 mix impact of consumable strength and transitory supplies pressure combined with elevated supply chain and associated capitalized freight 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 and 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 and 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 facility. 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 million to $275 million of capital expenditures. For adjusted EPS, we now expect between $0.75 and $0.79, 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.

Operator: Our first question comes from Liz Suzuki from Bank of America. Please go ahead.

Liz Suzuki: Great. Thank you. And Ron, my condolences to you and your family on the loss of Yummy. He was a great dog.

Ron Coughlin: Thank you.

Liz Suzuki: So just a question on the gross margin headwind and when you expect that to abate, I mean I would imagine that there’s €“ just with the cost of food for humans and for pets, food inflation is probably a pretty big driver of 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 mix headwind would likely continue?

Brian LaRose: 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. Digital, we’re driving distribution savings through limiting split shipments and also scaling ad work. 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 freight costs impacted gross margin this quarter sequentially as they begin 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 case in point, our discretionary categories are up more than 20% from pre-pandemic levels. And we would expect those to return as the economic environment stabilizes and help gross margins.

Ron Coughlin: I would just build on that, that in addition to strength in 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.

Liz Suzuki: Great. Alright. Thank you.

Ron Coughlin: Thank you, Liz.

Brian LaRose: Thanks, Liz.

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

Simeon Gutman: 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?

Brian LaRose: 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, on mix, 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 supply 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 with those categories return that will be very beneficial to gross margin.

Simeon Gutman: Okay. And a follow up €“ I’m sorry, Ron.