Chewy, Inc. (CHWY) Q4 2020 Earnings Call Transcript

Good afternoon, and welcome to the Chewy Fourth Quarter and Full Year 2020 Results Call. All participants will be in listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note, this event is being recorded. I would now like to turn the conference over to Robert LaFleur, President of Investor Relations. Please go ahead.

Thank you for joining us on the call today to discuss our fourth quarter and full year results for fiscal 2020. Joining me today are Chewy’s CEO, Sumit Singh; and CFO, Mario Marte. Our earnings release and letter to shareholders, which were filed with the SEC on Form 8-K earlier today, have been posted to the Investor Relations section of our website, investor.chewy.com. A link to the webcast of today’s conference call is also available on our site. On our call today, we will be making forward-looking statements, including statements concerning Chewy’s future prospects, financial results, business strategies, industry trends and our ability to successfully respond to business risks, including those related to the spread of COVID-19, including any adverse impacts on our supply chain, workforce, fulfillment centers, other facilities, customer service operations and future plans. Such statements are considered forward-looking statements under the Private Securities Litigation Reform Act of 1995 and are subject to certain risks and uncertainties, which could cause actual results to differ materially from those contemplated by our forward-looking statements. Reported results should not be considered an indication of future performance. Also note that the forward-looking statements on this call are based on information available to us as of today’s date. We disclaim any obligation to update any forward-looking statements, except as required by law. For further information, please refer to the risk factors and other information in Chewy’s 10-K and 8-K filed earlier today and in our other filings with the SEC. Also during this call, we will discuss certain non-GAAP financial measures. Reconciliations of these non-GAAP items to the most directly comparable GAAP financial measurements are provided on our Investor Relations website, and in our earnings release and letter to shareholders, which were filed with the SEC on Form 8-K earlier today and in our 10-K. These non-GAAP measures are not intended as a substitute for GAAP results. Finally, this call in its entirety is being webcast on our Investor Relations website. A replay of this call will also be included on our IR website shortly. I’d now like to turn the call over to Sumit.

Thanks, Bob. And thanks to all of you for joining us on the call. As we gathered for this call a year ago, we were just beginning to realize the scope of the COVID pandemic. Looking back, I’m incredibly proud of the way Chewtopians came together to execute through this incredibly challenging year. As a leadership team, we communicated frequently and honestly about how we would navigate the pandemic with our team member safety at the forefront. We made sure our teams had safe and healthy workspaces and implemented new team member friendly policies and benefits. In response, our teams redoubled their dedication to our customers and made sure that their pets received the vital products and care that they needed. In the face of a surge in volume, we kept our supply chains operating and our fulfillment centers open. Our corporate staff and customer service teams quickly adapted to working from home, and our tech and product teams solved challenges to seamlessly foster that transition. Despite the disruptions caused by COVID and, in some cases, because of them, we accelerated the rollout of several strategic initiatives, including the launch of eGift cards and personalized products, the introduction of service innovations like our telehealth offering, Connect with a Vet, and compounding services, and the opening of our first automated and first high-velocity fulfillment centers. These accelerated rollouts speak to the adaptability and the innovative spirit of our entire Chewy team. And even with the COVID backdrop, our teams remain relentlessly focused on the strong execution required to deliver a superior customer experience to over 19 million pet parents who trust us to deliver on that promise. It is for all these reasons that 2020 will go down as a landmark year in Chewy’s history. Over the next few minutes, I will briefly discuss our Q4 and FY 2020 results. I will then use the balance of my remarks to outline our long-term vision for Chewy and why we believe this vision leaves us well positioned for long-term sales and profitability growth. After that, I will turn the call over to Mario to discuss our fourth quarter and full year 2020 results in greater detail as well as our first quarter and full year 2021 guidance. Q4 net sales increased 50.8% year-over-year to $2.04 billion, bringing 2020 full year net sales to $7.15 billion or 47.4% annual growth. Exceeding $2 billion of quarterly net sales is another milestone for us. It took us 7.5 years to reach our first $1 billion quarter and only 2 years to reach the $2 billion quarterly sales mark. Active customer growth and continued strength in purchasing behavior were key drivers of Q4 and full year 2020 momentum. During Q4, our new customer acquisition pace accelerated relative to Q3. Customer reactivations increased by 40% and customer retention improved by 240 basis points. As a result, we added 1.4 million net active customers in the fourth quarter and ended the year with 19.2 million active customers. As we have shared with you in the past, efficiently adding new customers to our platform and then growing their share of wallet is a key part of our growth strategy. For the full year, we added 5.7 million net active customers, reflecting a 42.7% annual growth. The customer cohorts we acquired in 2020 were highly engaged and displayed similar and, in some cases, stronger purchase and repurchase behavior compared to legacy cohorts. These positive behaviors were driven by a wider product assortment and by a growing set of customer offerings, such as gift cards, personalized products, compounding services, and Connect with a Vet. Assessing our progress by business vertical, we are pleased to note that our core consumables business remains strong. And we continue to gain traction in hardgoods, healthcare, and proprietary brands. Looking at the Q4 trends within our key verticals, third-party hardgoods sales grew 40% faster than the business overall, and proprietary brand hardgoods sales more than doubled year-over-year. Further, within hardgoods, our proprietary brand penetration increased 570 basis points year-over-year to reach 21%, continuing the share gains we have reported throughout the year. These results provide us confidence that we are on the right track and that there is a lot of opportunity in front of us to continue winning customers’ hearts and minds in these areas. Now, let’s review our margin performance. We are encouraged to see our effort to increase customer lifetime value drive higher margins. Fourth quarter gross margin expanded 300 basis points year-over-year to 27.1%. Full year 2020 gross margin was 25.5%, up 190 basis points versus 2019 and a record high on a full year basis. Approximately half of our Q4 gross margin improvement came from structural and sustainable drivers, like higher penetration rates into higher margin verticals like hardgoods, proprietary brands, and healthcare. Notably, on a year-over-year basis, we executed a 510 basis-point mix shift out of lower margin consumables and into higher margin verticals like healthcare and hardgoods. Higher gross margins and a rigorous focus on bottom line execution translated into another quarter of positive EBITDA. Fourth quarter adjusted EBITDA was $60.8 million, translating to an adjusted EBITDA margin of 3%, a 340 basis-point improvement year-over-year. For the full year, adjusted EBITDA was $85.2 million, and adjusted EBITDA margin improved 290 basis points to 1.2%. Both Q4 and full year 2020 adjusted EBITDA includes a $15.9 million benefit from releasing a prior tax reserve. And even if we back out this onetime tailwind, we generated $150 million more in adjusted EBITDA in 2020 than we did in 2019, demonstrating our ability to successfully scale the business and drive incremental profitability. Our performance and dynamics of this past year have provided us with an advanced look at Chewy’s future. We believe that our future is bright, given the size of the opportunity in front of us and our relentless focus. Moving forward, we plan on executing against this opportunity in order to realize even greater scale and improved profitability. I will focus the balance of my remarks today outlining the scale of the large and growing opportunity in front of us, and in sharing with you the ways we intend to meet the challenge of realizing it. Let’s start with three important trends and why we believe Chewy is well prepared to capitalize on them. First is the increase in the number of pet owning households. Pet adoption surged in 2020 as millions of people sought out comfort, companionship, and the joy of pet parenthood. According to industry analysts, the number of pet owning households increased by 5.7% in 2020, a significant acceleration from the pre-pandemic 5-year CAGR of 0.6%. Looking at our own data, it is clear to us that these new pet parents are joining us early in their journey. For example, in 2020, we observed a 35% year-over-year increase in the creation of pet profiles for puppies and kittens, and a 40% increase in the creation of profiles for newly adopted pets. We get excited about these insights because that newly adopted Chewy puppy is going to grow up, eat more food, and shred more toys, leading to a long-lasting relationship with us, resulting in a stream of recurring revenues for years to come. Understanding our customers and anticipating their wants and needs helps us create sustainable advantages to win in the pet space. The second trend is the size of the U.S. pet market opportunity, and our ability to expand the competitive playing field. Today, we compete in roughly 70% of the $100 billion U.S. pet market, and we do so primarily in the areas of food supplies and prescription drugs and diet. That leaves us with an additional $30 billion opportunity in healthcare and services to grow into, and we are confident in our vision and our ability to do so. Equally exciting to note is that we are continuing to increase our penetration into a growing U.S. pet market that is expected to reach $120 billion by 2024. At $7 billion in net sales, Chewy is clearly only at the beginning. And finally, the third trend is growing e-commerce penetration within the U.S. pet market. Online penetration rates in the retail food and supplies category are estimated to have grown from 7% in 2015 to 30% in 2020, and are expected to reach 53% by 2025, which is in line with the current online penetration rates of categories like books and electronics. Further, as we are observing, healthcare and services have already begun to shift online, and we believe this trend will continue and accelerate. Equally importantly, we believe these shifts in favor of e-commerce channels are durable and largely permanent. This is where we believe Chewy has won and will continue to win for years to come. Years of preparation and focus have positioned us as the internet's preeminent neighborhood pet store and a leading pure-play e-commerce company in the pet space. We look forward to a future marked by ongoing innovation, winning customer hearts and minds, and growing market share. Overall, we see 2020 and the impact of COVID as much more than a one-time growth accelerator. We see the past year as a catalyst that sped up a secular shift towards e-commerce that was already underway. There are multiple growth vectors ahead of us, which make the market opportunity so compelling, and moving forward, we plan to continue following the growth and margin expansion roadmap that we have used since our IPO. That roadmap consists of the following: Acquire new customers, increase share of wallet for existing customers, expand assortment, grow proprietary brands and health care offerings, launch services, and when the time is right, expand the business outside of the U.S. As we continue to successfully execute in each of these areas, we will also continue to invest wisely to grow our base of recurring revenues, scale our operating expenses, and drive profitable growth over the long term. Let’s look at how our efforts are translating into tangible results. Increased wallet share is a truly powerful growth catalyst. We captured 12% more initial wallet share from our 2020 new customer cohort than we did from their 2019 predecessors, and we accomplished this while absorbing our largest new customer cohorts ever. An additional data point, which leaves us confident that our efforts are delivering results, is the fact that year one contribution profit per customer, which we calculate as gross profit less variable costs, has increased at an average annual rate of 16% over the past two years. Reiterating what I mentioned earlier in my comments, these gains across share of wallet and profitability are being realized as a direct result of our efforts and reflect the impact of catalog extension, improved discoverability, and the incremental contribution from high-margin verticals like healthcare, hardgoods, and proprietary brands. In the past three years, we have nearly doubled our total SKU count, including executing a sevenfold increase in higher-margin proprietary brand SKUs. Within healthcare, we are unlocking value for ourselves, our customers, and our partners in this large and growing $35 billion market opportunity. You will likely recall that we recently launched two services in the healthcare space, Connect with a Vet and Compounding. In 2020, these services were live just for a few months. But in 2021, we will get a full 12 months of financial benefits these services provide as well as vital knowledge that we continue to accumulate as we operate and refine these businesses. In the year ahead and beyond, we will remain focused on expanding our customer base. Sustained improvements in customer lifetime value continue to support our strategy of disciplined investing in advertising and marketing. As we quickly and efficiently convert new customers into engaged active customers, our growing customer base, in turn, generates the profit that we then reinvest into acquiring even more customers, thereby completing the flywheel effect that drive both top line and bottom line growth. Additionally, we expect to continue leveraging SG&A. Along the way, we may choose to make incremental investments to strengthen our employee value proposition. However, our playbook shows us offsetting these investments over time with efficiencies from the technology and productivity enhancements that we began implementing in 2020. We are confident that these investments will drive long-term growth and profitability. More specifically, in 2021, we will invest approximately $60 million in higher wages and benefits, the bulk of which will be directed to our fulfillment and customer service team. This investment is necessary to help us attract and retain team members, drive higher employee engagement, and increase productivity over time. At the same time, we expect to see productivity gains accelerate in 2021 from the technology and automation investments we have made in our fulfillment center network. You may recall that in October 2020, we opened our first fully automated fulfillment center. A month earlier than that, we began realizing a different style of efficiency when we opened our first limited catalog, high velocity fulfillment center. Given their launch timing, these fulfillment centers provided only modest ramp benefit to us in fiscal 2020. In 2021, we expect to realize accelerated productivity gains from their full year operations. We also expect to open our second automated fulfillment center in Q2 2021 in Kansas City, and another limited catalog facility in Q3 2021. Additionally, in 2022, we will begin automation retrofits at select fulfillment centers. We will keep you apprised of the specific timing of these events on our upcoming calls. We believe these investments in our people and automation are not only prudent, but they also have the potential to drive step function changes in our variable cost structure and contribute meaningfully to effective SG&A leverage. Finally, I would like to share that having achieved our first full year of positive adjusted EBITDA in 2020 and our first quarter of positive net income in Q4, we have taken a meaningful step forward on our path to profitability and in demonstrating our ability to get big fast and get fit costs. Going forward, our margins may fluctuate quarter-to-quarter, but we believe our profit trajectory is clear and positive. I will end my comments by reiterating that 2020 was an incredibly challenging and unpredictable year for all of us. During this time, Chewy performed exceptionally well and made significant strategic and operational progress. We navigated the safety concerns of the pandemic and kept delivering for our pet parents and business partners. We proactively grew our market share by offering a wide level of service to the millions of new customers who adopted pets during the pandemic. Further, we capitalized on the accelerated and sustainable shift of consumers to e-commerce channels. As a result, we grew our customer base by 43% and ended the year with 19.2 million active customers. Perhaps most importantly, we dramatically increased our market size by launching new services in the pet health and wellness space. These expanded offerings helped us reach additional customers and improve our ability to increase wallet share with our existing customers. We are entering 2021 with significant momentum, and we are confident in our ability to deliver. With that, I will turn the call over to Mario.

Thank you, Sumit. We knew the 2020 holiday season would be unprecedented, and we prepared for a range of outcomes. The season got off to an early and strong start, and market conditions remained favorable throughout the balance of the quarter. Fourth quarter net sales were $2.04 billion, reflecting 50.8% year-over-year growth. This brought full year 2020 net sales to $7.15 billion, a $2.3 billion or 47.4% increase year-over-year. Along with accelerated customer growth, we also saw sustained high levels of customer engagement as traffic and conversion metrics improved from December into January, reversing their typical seasonal pattern. Pricing and promotions are usually a reflection of the broader market environment, and both remained balanced and stable throughout the quarter. This allowed us to maintain pricing integrity and lower the volume of promotional discounts offered. Looking at customer cohort behavior, the positive trends we saw earlier in 2020 continued through the fourth quarter. Engagement levels remained high, and basket size and reorder trends remained favorable, which led to a 12% increase in Q4 average spend per new customer versus the Q4 2019 cohort. Closing out the fourth quarter top line discussion, Autoship net sales represented 68.2% of total net sales, and net sales per active customer, or NSPAC, increased to $372. This represented sequential growth of $9 or 2.5% and year-over-year growth of $12 or 3.3%. NSPAC growth accelerated this quarter as the mechanics of the NSPAC calculation began to reflect the positive revenue impact of the millions of customers who joined the platform in 2020. As is our usual reminder, net sales per active customer reflect trailing four-quarter net sales divided by the number of active customers at the end of the quarter. It’s also worth noting that we no longer need to adjust our year-over-year NSPAC comparisons for the extra week in 2018, as Q4 2018 has now aged out of the comp period. Moving on to financials, fourth quarter gross margin was 27.1%, a year-over-year increase of 300 basis points, and a high watermark for the company to date. For the full year, gross margin came in at 25.5%, up 190 basis points versus 2019, continuing to our drive towards incremental annual gross margin improvement. As Sumit mentioned, approximately half of the 300 basis-point improvement in gross margin came from sustainable, structural drivers like the improved mix into higher-margin verticals like hardgoods, proprietary brands, and healthcare, as well as increased scale benefits. The remainder came from pricing stability and the more restrained promotional environment. Turning now to operating expenses, fourth quarter operating expenses, which include SG&A and advertising and marketing, were $532.6 million or 26.1% of net sales, scaling 250 basis points year-over-year. For the full year, operating expenses were $1.91 billion or 26.7% of net sales, scaling 210 basis points versus full year 2019. SG&A, which includes all fulfillment, customer service, credit card processing fees, corporate G&A, corporate payroll, and share-based compensation, was 18.7% of net sales, a 230 basis points year-over-year improvement. SG&A expenses in the quarter include a $15.9 million benefit from the release of a non-income tax reserve and approximately $13 million of COVID-related expenses. Excluding these two items, SG&A as a percentage of net sales was 18.9%, a 210 basis-point improvement year-over-year. For the full year, SG&A was $1.40 billion or 19.6% of net sales and scaled 40 basis points year-over-year. Excluding the $15.9 million non-income tax benefit in the fourth quarter and approximately $42 million of COVID-related expenses incurred throughout the year, SG&A scaled 80 basis points year-over-year. Fourth quarter advertising and marketing was $150.1 million or 7.3% of net sales, scaling 20 basis points year-over-year. As we discussed last quarter, the elevated organic acquisition rates we saw in the first half of 2020 began normalizing in the third quarter, and that trend carried through to the fourth quarter. As expected, we also saw channel input costs recover from the lower rates we saw in the first half of the year. We adapted to these changes, adjusted our acquisition marketing efforts, and drove accelerated customer acquisition in the fourth quarter while still improving our year-over-year efficiency. On a full year basis, advertising and marketing represented 7.2% of net sales, scaling 160 basis points versus 2019. We estimate that roughly half of the marketing efficiency in 2020 was a result of the pandemic-driven boost to traffic and conversion. In Q4, we delivered our first quarter of positive net income. Net income was $21 million, and net margin was 1%, a 550 basis points improvement year-over-year. Excluding share-based compensation expense of $24 million, fourth quarter net income was $45 million, with net margin excluding share-based compensation improving 330 basis points to 2.2%. On a full year basis, our 2020 net loss improved by $92.5 million from $252.4 million in the prior year, and our net margin improved 390 basis points to negative 1.3%. Full year net income, excluding share-based compensation, was $36.7 million compared to a loss of $116.1 million last year, and the net margin, excluding share-based compensation, improved 290 basis points to 0.5%. Fourth quarter adjusted EBITDA was $60.8 million, and adjusted EBITDA margin improved 340 basis points to 3%. For the full year, adjusted EBITDA was $85.2 million, and adjusted EBITDA margin improved 290 basis points year-over-year to 1.2%. Turning now to free cash flow, fourth quarter free cash flow was $47 million, reflecting $77.5 million in positive cash flow from operating activities and $30.5 million of capital expenditures. The positive operating cash in Q4 was primarily a function of Q4 profitability in our favorable working capital strategy. Capital investments continue to be focused on capacity build, including cash outlays for our new automated fulfillment centers in Archbald, Pennsylvania, and Kansas City and our next limited catalog, high velocity fulfillment center. We finished the year with $563 million of cash and cash equivalents on the balance sheet and free cash flow was essentially breakeven for the year. Let me highlight two points regarding our free cash flow. First, in 2020, we invested in higher inventory levels to protect our supply chain and to ensure that we could meet our customers’ needs, especially during peak holiday season. Second, note that we have continued to execute on our strategy to reinvest excess cash flow to grow the business and improve the bottom line. This is evident by the fact that in the last two years, we consumed no cash while at the same time, we more than doubled our top line, launched four fulfillment centers, and improved our adjusted EBITDA margin by 770 basis points. Our strategy remains intact. And we remain committed to execution and results in 2021. That concludes my fourth quarter and 2020 recap. So, now, let’s discuss our first quarter and full year 2021 outlook. In 2020, we benefited from many tailwinds, some of which we expect to continue into 2021 and some of which may not. On balance, while we believe that consumer behavior post pandemic is still somewhat challenging to predict, we also believe that our strong value proposition, which includes expanding customer choices, provides us real and tangible advantages as we execute on our mission. To start, the positive demand trends we saw in Q4 have carried over into the New Year. Customer spending on our platform remains strong and business vertical mix remains structurally sound. Additionally, the pricing and promotional environment has thus far remained stable and in line with our expectations. On the other hand, there are certain headwinds that we continue to navigate through the first quarter. We expect some of these to be temporary in nature, while others are likely to remain active hotspots for us to manage throughout the year. For example, we are observing an industry-wide disruption in the availability and supply of wet canned food, which is driving elevated out of stock levels and suboptimal inventory positioning across our network. Thus far, this has not had a material impact on our business, but it is an area where we intend to remain vigilant. In advertising and marketing, we intend to remain disciplined in our marketing spend while balancing external variables across advertising platforms and the normalization of market conditions in a post-pandemic world. At the same time, we don’t intend to leave any opportunities on the table and reserve the option of making investments that produce long-term customer acquisition benefits, even as they affect short-term profitability. We expect to continue scaling SG&A in 2021. The labor market continues to remain pressured driven by strong e-commerce demand and in certain geographies, persistent competition against extended unemployment benefits. We believe that our investments in automation and productivity gains will continue to help us manage these headwinds. Further, while we will make bold investments, like the $60 million of spending on higher wages and benefits that we outlined earlier, we continue to believe that improvements in turnover, productivity, and engagement, when combined with the efficiencies we expect to realize from the other investments that we’ve made in tech capabilities in machine learning will yield even larger long-term benefits. With the above perspective in mind, our 2021 guidance balances the opportunities we see with potential headwinds that may arise. We are establishing guidance as follows: First quarter net sales of between $2.11 billion and $2.13 billion, representing year-over-year growth of 36% to 37% when adjusting for the $70 million of estimated pantry stocking benefit we identified in Q1 2020; full year 2021 net sales of between $8.85 billion and $8.95 billion, representing year-over-year growth of 25% to 26% when adjusting for the Q1 2020 pantry stocking benefit; and finally, full year 2021 adjusted EBITDA margin expansion of 50 to 100 basis points. As you update your models for 2021, here are a few other things to keep in mind. You should expect to see our net active customer apps in 2021 returning to something closer to their pre-COVID levels, reflecting the normal retention patterns we see from any given cohort from the first year into the second year, and this will be especially pronounced this year given the size of the 2020 cohort. At the same time, we expect NSPAC to increase in 2021 versus 2020 as pre-2020 customer cohorts continue to mature, and we capture a greater share of wallet from the 2020 cohort. And one final note. With the PetSmart separation complete, we will bring a limited number of administrative functions like tax and insurance in-house that were previously run under a shared services agreement with PetSmart. Even with this change, the operational and financial impact of the separation is minimal. 2020 presented us with many challenges, but it also brought about many beneficial changes in our marketplace. We were well positioned to meet these challenges and were flexible enough operationally to take advantage of the opportunities. As a result, our 2020 performance was strong across the board. We added a record number of new active customers, produced strong revenue growth, and generated four quarters of positive adjusted EBITDA, all of which demonstrates the clear progress we’re making on our path to profitability. Looking ahead to 2021, we will continue to benefit from the evolving marketplace and our strategic execution should enable us to generate 25% revenue growth or more and further expand our adjusted EBITDA margins.

Our first question today will come from Nat Schindler with Bank of America.

I just really wanted to get a little bit more into deceleration you’re baking into guidance. I understand it was a pretty radical year this year in how things change. But obviously, all those customers who got pets and all that new customer growth that occurred all throughout this year is going to be additive to growth for the bulk of next year at least, well, on average half of the year. So, shouldn’t the deceleration curves, barring the 3 percentage point hit roughly that the pantry stocking did in 1Q of last year, barring that, shouldn’t be a much smoother slower deceleration in the subscription model like yours?

Hey Nat, this is Sumit. I’ll take that one. Our guidance indicates that we expect to add $1.8 billion in top line sales this year, building on a record year in 2020. It's important to emphasize that we remain confident in our ability to navigate the current challenging environment. Providing guidance involves reflecting on various headwinds and tailwinds while balancing risk and opportunity to give a perspective early in the year, even as consumer behavior and the environment continue to evolve. Overall, we feel good about these numbers and our capacity to meet them. Additionally, we believe this guidance for $1.8 billion in incremental growth means we will capture over 50% of the growth occurring in online channels in 2021, which is a significant assertion. We will keep evaluating this and will update you when we adjust our internal models as needed.

Just a quick follow-up on that. How much of the incremental growth in the online channel in 2020 do you think you captured?

If you do the math, we believe that online grew roughly $6.2 billion year-over-year. And this year, buy online, pickup in store, which was a popular kind of mechanism, is rolled up under online. And if you back that out, pure e-commerce, pure-play e-commerce grew roughly $4 billion. And Chewy grew $2.3 billion off that $4 billion, so capturing 57% of pure-play e-commerce growth.

Our next question will come from Brian Fitzgerald with Wells Fargo.

Thanks, guys. A great quarter. The average annual increase in year one of the contribution profit at 60% over the past three years. Could you tell us what that was in 2020 and in ‘19, maybe more specifically? And then any thoughts on how that might continue to trend over the next three years? And then, I got one quick follow-up.

Hey Brian, it’s Sumit. I’ll take it. So, we haven’t broken down numbers. As you know, we don’t provide contribution profit level detail. What we are observing and why we wanted to come out and share this is because it was indicative of the results that we’re observing as a result of the direct efforts that we’re putting into drive consumer lifetime value and profitability in the portfolio. And so, when you sort of roll these back, they answer the second part of your question on a longer-term basis. These gains across wallet share and profitability as we evaluate them internally are being realized and reflect the impact of catalog expansion, improved discoverability, and the incremental contributions from higher-margin verticals such as healthcare, hardgoods, and proprietary brands. As we mentioned in our remarks, we’ve nearly doubled our total SKU count in the last three years, including executing a sevenfold increase in higher margin proprietary brand SKUs. So, when you look at sort of margin growth from here on out, we believe we’re still sort of in the early innings of what remains a really focused roadmap on how we plan to execute our playbook and grow margins moving forward. Less than a third or approximately a third of our total customer base is today buying a proprietary-branded product, which leaves an opportunity for two-thirds of roughly 20 million customers to be exposed to higher margin proprietary brands. When you look at healthcare being a newer vertical, that number is far less than the one-third that I mentioned, providing us even more headroom to grow. So, as we sort of continue to play out our playbook on putting more focus on innovation around products and services and the complementarity between them, you should expect us to drive incremental gradual profit from here on out. That’s how we think about that.

Great. I'm curious about the increase in wallet share you've seen during the pandemic. Can you discuss how many new pet adoptions and purchases might be affecting this? Specifically, I'm interested in how a higher proportion of new pet parents influences wallet share and spending on items like kennels and bedding. To put it another way, considering the life cycle of a pet, newborns often receive everything new and fresh, but as they age and you have multiple pets, you may start to recycle clothes. Are you noticing any effects from this dynamic on wallet share?

I think that's a great question. As we mentioned in our script, we’ve seen a 35% increase in the creation of pet profiles for puppies and kittens, as well as a 40% increase in pet profiles for adoption. For example, with a Chewy puppy, you might not need to replace the crate right away. Puppies do outgrow their crates, so you might have to adjust based on the size of the puppy you brought home. Even if that weren't the case, the appeal of this category to us lies in the fact that pet sales are largely recurring in consumables and healthcare. As puppies grow, they will require more food, destroy more toys, and have increased healthcare needs, all of which we are prepared to meet. Any impacts we are experiencing currently lead us to believe that there is sustainable momentum behind these profiles and the data we are collecting. Recently, we reviewed our database and found over 170 million data points from these pet profiles. This wealth of information supports our recommendation and personalization services, enhancing our ability to engage with customers moving forward. We are committed to continuing to engage customers and increasing our share of their spending.

Our next question will come from Steph Wissink with Jefferies.

Thanks. Good afternoon, everyone. Congrats on a great year. Sumit, I have a question for you just on the multiyear. If you look back at the IPO model, it looks like you’re running more than 2 years ahead of your EBITDA target at that time. So, I’m curious if you can contextualize for us how much of that is leverage related to the underlying gains of the food and supplies business? And how much of that is kind of the pull forward of some of the strategic initiatives that you listed in your script, like health and compounding and other things? And how should we think about the leverage in the model?

Great question. I would say that we are executing exactly the roadmap we outlined. The scale benefits allow us to leverage fixed costs in our investments and achieve higher variable cost efficiencies in our fulfillment center network due to the volume we handle. The change in gross margins you've noticed, on top of the SG&A leverage, is mainly driven by our efforts to increase the assortment and choices in proprietary brands, healthcare, and hardgoods, which accounts for about 60%. The remaining roughly 40% is attributed to the overall increment in scale and the leverage we gain from the Autoship channel as we increase sales through it. Mario, do you have anything to add?

I would add to the point on Autoship. If you look at the sales for Autoship last year, it was about $4.9 billion, which is greater than the total sales in the previous year. This shows how that portion is also driving leverage. It impacts our ability to better plan within our warehouses, as well as with our incoming vendors, OEMs, and logistics partners. Therefore, it contributes to leverage in our gross margin as well.

We believe that food is a basic necessity, which explains why customers are likely to visit Chewy. However, we are also transforming that experience. If we adhere to the traditional view, it highlights the customer service excellence that attracts customers, alongside our enhanced ability to create a comprehensive shopping experience. Additionally, we’ve expanded our offerings and improved how customers discover them. Now, customers are not just finding food; they are also engaging with us through content and learning about our Connect with a Vet service, which they may have heard about through others. We also have a unique Disney collection that is exclusive to us. We think these differentiators create advantages that not only enhance the shopping experience but also provide benefits across our offerings, ultimately contributing to the efficiency of our fixed cost structure.

Our next question comes from Doug Anmuth with JP Morgan.

Hi. Thanks. This is Katie on for Doug. So, hoping you can provide an update on your Connect with a Vet initiative. What have the early learnings been thus far? And how does this shape your expectations around monetization this year? And then, on pharmacy, last quarter, you laid out a target for $500 million of GMV in fiscal ‘20. Curious where you came in relative to your expectation? And then, also how your thinking about the growth potential of pharma this year? Thanks.

We are pleased with the progress of Connect with a Vet, which is a telehealth service we launched in Q3. It focuses primarily on tele-triage and connects customers with licensed veterinarians to address common questions or health and wellness-related concerns. So far, we have completed over 30,000 sessions with customers and gained a lot of insights. Our Net Promoter Score is high, above 85, and 70% of customers who have interacted with the service rated it 10 out of 10, which is encouraging. Recently, we expanded Connect with a Vet from just chat functionality to include video capability, which we are actively developing. In about two weeks, we plan to extend our hours of operation from 8:00 p.m. to 11:00 p.m. to increase availability for West Coast customers. Currently, the service is still free for Autoship customers. We believe in the monetization of the service and plan to make it available to our entire customer base, which I will update you on when the time is right. Regarding pharmacy, we achieved the previously shared goal of $500 million in net sales overall. Pharmacy remains an area of excitement for us, with the prescription vertical estimated at around $7 billion to $10 billion in market size, growing at a 10% compound annual growth rate. This growth rate even exceeds that of food and supplies during a pandemic year, and we see ourselves in the early stages of this opportunity with significant upside potential.

And Katie, this is Mario. Just to add one more data point to that. You’re right that we said about $0.5 billion gross revenue. But of course, not all that flow through our financials, about $360 million did.

Our next question will come from Oliver Wintermantel with Evercore ISI.

Mario, you just mentioned ownership and as a percent of sales, it looks like that continued to decline for the third quarter in a row. Is that just because people didn’t have yet the chance to sign up for Autoship, or is that the expansion of more verticals and more hard goods? If you could give us a little bit more details on that, please?

Yes. So, you’re right, there was a small change, but that’s all within the variance that we would expect any given quarter. If you look at for the full year, it was a 100 basis-point difference between last year and this year. But remember, this year, we also had a record number of active customers. And as you pointed out, that is more about timing and when we expect those customers to sign up to Autoship to discover the benefits there. But that is certainly within range of what we’d expect.

Got it. I have a quick follow-up regarding the gross margin. You mentioned that half of it is structural and sustainable, while the other half is due to fewer promotions. Looking ahead to 2021, if the structural factors continue to play out and we return to more promotions, should we expect to see another half of that gross margin expansion in 2021, or are there other factors we should consider?

So, I’ll start and maybe, Sumit, if you want to add something to it. But, we have said that the improvement that we saw in the fourth quarter, half of it was structural. None of that is any different than 2021. When we think about the vectors that we’re firing against right now, continuing to grow our hardgoods catalog, healthcare proprietary brands, expanding share of wallet, and increasing what we sell to our customers, all those things are in place. What you may find is quarter-to-quarter, there may be some fluctuations in gross margin, and that’s simply because we do see some activity in certain times of the year in terms of promotions and maybe some more advertising in the marketplace. But the reality is, structurally, those things we don’t expect to change.

The only thing I would add is, at this time, we’re not baking in any top line or bottom line impact related to any material disruptions in supply chain or logistics networks. So far, we’re assuming recovery, and we’re assuming a quality of recovery that does not impede the momentum of the business. And everything that we’re hearing right now seems to be an assumption that we’re comfortable with. In some instances, we have the proper amount of inventory and the inventory might be unevenly distributed through our fulfillment network. And while that does not result in any out of stock situation, it does lead to higher levels of cross shipment or split orders that result in suboptimal shipping costs that roll up to gross margin. So, I think there are some pluses and minuses. But on the balance, we do expect customers to continue to engage and discover the higher margin verticals that we continue to focus on, and therefore provide gradual structural changes to gross margin.

Our next question comes from Seth Basham with Wedbush Securities.

My question is around your fulfillment expense outlook. For 2020, with some of the additional costs that you called out, seems like you did deleverage your fulfillment expenses. Should we think about the outlook for 2021 and the moving pieces with additional investment in wages, et cetera, would you expect us to leverage fulfillment expenses or not?

Yes, this is Mario. I'll answer that. In our prepared remarks and earlier discussions, we mentioned that we are investing $60 million in wages and benefits, primarily in fulfillment and customer service. We also noted that we are launching two new fulfillment centers this year. You can expect similar investments to those we made last year, particularly since one of the centers will be a high-velocity, limited catalog fulfillment center, similar to the one we opened in Kansas City last year. The other will be an automated facility like the one we launched in October in Archibald, Pennsylvania. So, if your question is whether we expect those investments to affect our SG&A this year, the answer is yes.

Got you. Well, when we think about the composition of your margin expansion for 2021, are you expecting both gross margin and SG&A leverage?

I think, Seth, we just provided guidance, and the checks and balances so far flow through the guidance that we provided for the full year. And as the quarter progresses, I think we’ll keep you updated and share more information on a granular basis.

Our next question comes from Peter Keith with Piper Sandler.

It’s Bobby Friedner on for Peter. Thanks for taking my question. I wonder if you could discuss what you’re seeing and how you’re thinking about price inflation of pet food in 2021. And how should we think about retail pricing across the entire portfolio of products in an inflationary environment?

Your question is quite broad, Bobby. I'll do my best to answer it, and please clarify if needed. As we've indicated, the pricing environment has been fairly stable, with discount levels remaining low for this season. This situation has led to some increased prices and inflation in the market. However, we believe that the pet category is resilient when it comes to recession or inflation. Currently, we haven't observed any obstacles to demand or momentum in the business, and we expect that trend to persist. As supply chains begin to recover and inventory levels improve, we anticipate a return to the pre-pandemic pricing environment.

Our next question comes from Lauren Schenk with Morgan Stanley.

Great. I guess, marrying a few of the previous questions. When we look at your guidance for the 50 to 100 basis points of margin improvement versus the revenue guidance, I think it implies a flow-through rate of around 6%, understanding the $16 million in wages, which brings you closer to 9.5%. But can you just help us think about if there’s any other sort of onetime investment, maybe the second automated DC that is holding back flow through or potentially offsetting some of the COVID costs that I would have thought would have sort of benefited flow through this year? And then, as a follow-up, maybe this is a piece of it, but we’re hearing from a variety of different retailers about shipping delays, freight cost increases, anything that you’re seeing there on sort of a like-for-like basis heading into 2021? Thanks.

Sure. When considering our guidance, there are several factors at play. We're basing this on the balance of risks and opportunities for the year. Regarding revenue, we noted positive demand trends extending into the first quarter. Pricing promotions are stable, which positively influences the guidance range. However, customer behavior continues to evolve post-pandemic, and there are some industry-wide supply chain challenges affecting certain products, which are seen as obstacles. In terms of adjusted EBITDA, we've identified several factors that we anticipate will impact this year, including our marketing investments, the opening of two new fulfillment centers, and an additional $16 million in wages and benefits for our team members. These elements will influence our position within the guidance range and the eventual impact on EBITDA. As we've mentioned earlier, we prioritize long-term business operations. This year, we may opt for short-term investments in marketing and additional capacity, which could affect our short-term profitability but lead to long-term advantages. All these factors are factored into the guidance range we've provided.

Lauren, advertising and marketing is a complex topic for 2021, and it's difficult to forecast how this will unfold as we are still early in the year. It's beneficial to take a step back and view the situation from a broader perspective. We believe that spending 6% to 7% of net sales on advertising and marketing is appropriate for our business. Over the past few years, particularly the last three, we have increased our marketing expenses from 11% of revenue in 2018 to 8.8% in 2019, then to 7.2% and 7.3% in 2020. The improvement of 160 basis points, as we highlighted earlier, was largely attributed to organic-driven efficiency, which means we have effectively positioned our marketing spending around 8%. As we consider our current marketing strategies, understand emerging trends, and assess how advertising platforms are developing, we will also seize opportunities to invest in marketing to achieve growth. This remains a challenging area to discuss at the moment. We will likely provide more updates regarding our long-term and yearly outlook as the quarters progress.

And let me just add one more item because I want to make sure that it’s clear how we think about the EBITDA for the year. But the guidance we provided would have us adding over $100 million of EBITDA to the bottom line, even while we grow $1.8 billion, both at midpoint of the guidance. So, this is a pretty significant increase, both top line and bottom line.

Your second question was about shipping. The variability and unpredictability in demand and forecasting can be challenging compared to planning a supply chain or transportation network. We are proud of our teams for collaborating on our forecasts and achieving a high level of forecast accuracy. This is supported by the fact that approximately 70% of our sales go through the Autoship model. This allows us to provide a consistent and stable forecast to our suppliers and transportation partners, enabling them to optimize their asset utilization. Additionally, the strategic nature of our partnerships has protected us from significant changes in rate structure during the holiday season or current fleet.

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

Thank you very much for the questions, everybody. Thank you.

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.