Chewy, Inc. Q1 FY2021 Earnings Call

Good day, and welcome to the Chewy First Quarter 2021 Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Robert LaFleur, Vice President, Investor Relations. Please go ahead.

Thank you for joining us on the call today to discuss our first quarter 2021 results. Joining me today on the call 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, investments, 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-Q 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 measures 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-Q. These non-GAAP measures are not intended as a substitute for GAAP results. Additionally, unless otherwise noted, results discussed today refer to first quarter 2021, and all comparisons are accordingly against the first quarter of 2020. Finally, this call in its entirety is being webcast on our Investor Relations website. A replay of this call will also be available on our IR website shortly. I'd now like to turn the call over to Sumit.

Thanks, Bob, and thanks to all of you for joining us on the call. 2021 is already turning out to be an exciting and busy year for us at Chewy. Our business momentum and strong customer engagement continue, and that gives us the confidence to raise our full year 2021 guidance for net sales and adjusted EBITDA margin expansion. Along with our financial results, today, I will share with you some exciting new launches that highlight our ongoing pace of innovation and further strengthen our customer value proposition. I will also share with you some of the headwinds we are facing and update you on the actions we are taking to protect customer experience and business continuity. After that, I will turn the call over to Mario to discuss our first quarter results in greater detail and share our updated guidance. Let's start with our Q1 results. Q1 net sales increased 32% to $2.14 billion. Continued growth in our active customer base and strength in purchasing behavior drove our top line results. While we are pleased with our net sales in the quarter, elevated out-of-stock levels were a persistent headwind throughout the quarter and reduced our Q1 net sales by an estimated $40 million. This is clearly a supply-driven situation, which we expect to abate in the second half of this year as additional production capacity comes online. Until then, we will keep actively managing our inventory and using our recommendation engines to help customers find attractive alternatives. Efficiently adding new customers to our platform and then growing their share of wallet remains a key part of our growth strategy. Active customers increased by 4.7 million or 31.6% to end the first quarter at 19.8 million customers. New customer additions remained above pre-pandemic levels and, as anticipated, moderated against the peak pandemic levels of this past year. Further, retention rates remained steady as the 2020 cohort matures into their second year on our platform. Taking a broader view, over the past 2 years, we have increased our active customer base by 8.4 million or 75%. The practical effect of this is that the weighted average tenure of our active customer base is just under 2 years. In other words, our average active customer is still squarely on the left side of their lifetime spending curve with us. For context, our customers historically spend over $400 with us in their second year compared to approximately $700 in their fifth year and almost $900 in their ninth year. As such, we believe that we still have significant future share of wallet gains left to realize from a substantial component of our customer base. First quarter net sales per active customer, or NSPAC, increased $31 or 8.7% to reach $388, a meaningful acceleration over our 2020 growth rate. In reviewing the purchase behavior of the Q1 customer cohort, we saw the same kind of positive engagement levels and basket size trends that we saw throughout 2020, which helped drive a 13% year-over-year increase in Q1 average spend per new customer. Top line momentum translated into improved margin performance. Q1 gross margin was 27.6%, reflecting a 420-basis-point increase, approximately half of which is the result of our efforts to improve customer engagement and drive structural growth in our hard goods, proprietary brands, specialty and health care verticals. The remainder came from normalizing freight costs against the COVID-related spike last year and the muted pricing and promotional environment. As we executed Q1 with rigor, we faced labor shortages in our fulfillment centers, or FCs, similar to those being faced by many companies nationwide. To offset these headwinds, we did a few things concurrently. We invested in higher wages and short-term incentives, which to some degree helped overcome FC staffing constraints. We also implemented other operating cost disciplines. For example, we developed algorithms which enabled real-time improvements in inventory receipts and order allocation, leading to increased density in pick and pack across our FC network. We introduced part-time shifts to better optimize interval-level labor forecasting and provide more flexible options to our team members. These activities helped keep operating expenses in check. And this operating discipline, when combined with our strong gross margin performance, drove meaningful improvements in flow-through as Q1 adjusted EBITDA came in at $77.4 million and adjusted EBITDA margin increased 340 basis points to 3.6%. In addition to these strong financial results, I am also tremendously proud of the broader transformations underway at Chewy. In 2018, we were mostly a provider of food and treats. Today, just 3 years later, we are delivering a multidimensional customer experience that spans food, treats, personalized accessories, health care, and most recently, services. And our pace of innovation and quality of execution has never been stronger. With that in mind, I'd now like to spend a few minutes sharing some of the many things that are going on inside Chewy today. We are excited about these because they represent continued progress in our effort to improve experience for our pet parents and partners and drive higher engagement with them. Additionally, they position us well to capture the large and growing opportunity in front of us. First, we continue to make meaningful strides in upgrading our technology stack and architecture. In Q1 2021, we relaunched the chewy.com homepage and other stops in the shopping funnel as a single-page application. This enhancement allows us to offer a more targeted and customized shopping experience to our customers, which we are already starting to take advantage of. Once fully implemented across our website, these features will unlock hyperlocal and enhanced personalized recommendations that will improve the shopping experience and, through their revenue-enhancing functionality, support our efforts to increase customer share of wallet. We are also excited to announce our entry into the fresh and prepared pet food space with new selections from the segment's leading brand, Freshpet; and our premium proprietary brand, Tylee's. Our highly trained and best-in-class customer service team, coupled with our personalized search and discovery features, make Chewy the right platform to drive customer adoption in this category, given the increased level of education and awareness pet parents need when deciding among the many pet food options that are available today. To date, we have already developed and patented new sustainable packaging that allows us to preserve product quality throughout the customer delivery process. We are currently in beta mode and will soon launch our initial distribution in 3 geographies, covering approximately 60% of Chewy's customer base. And we intend to grow both our fresh catalog and expand geographic distribution as we scale this business. We are enthusiastic about the fresh and prepared foods categories and the opportunity to serve new customers and expand assortment choices for our existing ones. With this launch, Fresh joins Connect with a Vet and our compounding pharmacy on the growing list of recently launched offerings that expand our TAM. Over the past few years, we have expanded our pet health and wellness offerings to include a wide spectrum of products and services, which now include OTC medicine, vet diet, pharmacy, and most recently, Petscriptions, Compounding, and telehealth. Collectively, we now call this still expanding effort Chewy Health, which consumers and veterinarians are starting to recognize as a brand that delivers innovative solutions designed to improve the health of every pet and empower those who care for them. We continue to gain traction with our recently launched innovations, Connect with a Vet, Compounding Pharmacy, and Petscriptions, which is our proprietary prescription management system for veterinarians. Recently, we enabled the video chat functionality for our proprietary telehealth solution and expanded its reach. Connect with a Vet is now available via text or video chat 7 days a week until 11:00 p.m. East Coast time, 365 days a year, which provides important coverage on nights, weekends, and holidays when care is often difficult to find. These upgrades have significantly improved customer experience and are driving higher customer adoption of this service. Net Promoter Scores for Connect with a Vet remained strong, and over 85% of customers who rated the service in Q1 gave us perfect 10 out of 10 scores. Our Compounding Pharmacy business continues to expand. We now publish 1,800 compounding SKUs, servicing dogs, cats, and, as of April, horses. We also achieved a major milestone recently by earning our PCAB accreditation, which is the gold standard for quality and safety compliance in the compounding industry. As planned, our entrance into Compounding is improving customer access to pet health and wellness services and growing our customer base. Approximately 2/3 of our compounding customers are new to Chewy Health, including over 20% that are new to Chewy overall. As anticipated, compounding is also emerging as a strong recurring revenue driver, with over 60% of outbound shipments already going through Autoship. And on Petscriptions, I am pleased to share that close to 7,000 clinics and veterinarian partners are now utilizing this product to simplify and automate all prescription management tasks with an intuitive, easy-to-use digital solution. This helps to reduce friction, improve veterinarian efficiency, reduce in-clinic costs, and enhance customer experience for both the veterinarian and the patient. We will share more about our ongoing work in this space in our Q2 call in September. Chewy Health is the only brand that blends technology and consumer innovation in pioneering modern pet health solutions for everyone. Our mission within Chewy Health is to make pet health care more affordable and accessible by developing value-added services and products that keep pet parents and veterinarians at the center of the equation. We are just getting started, and we'll keep you updated on our progress. The same spirit that animates our quest to make pet health care more affordable and accessible also drives our charitable efforts through a program we call Chewy Gives Back. Chewy Gives Back operates under a mission to make the world a better place for pets and the communities that serve them. To this end, last year, we made approximately $35 million in in-kind donations to shelters and rescues, providing them with the critical supplies they needed to perform their important work on the front lines. Additionally, I am excited to share with you that last week, we launched our nationwide Pet Adoption Services that enable millions of Chewy customers and not-yet Chewy customers to discover and adopt a pet directly through Chewy's website. As with everything we do, we believe that customers will find this new service to be an engaging and bar-raising experience. Over 6,000 shelters and rescues have already signed up, and the list continues to grow rapidly. The launch is supported with full Wish List integration, which enables shelters and rescues to list their needed supplies on chewy.com for our customers to conveniently discover, donate, and have them shipped directly to the shelter. Our launch of the Pet Adoption Service and features such as Wish List, again, shows how our innovation with customers continues to extend to our partners and service community and is in complete harmony with our mission of being the most trusted and convenient destination for pet parents and partners everywhere. Now before I wrap up, let's quickly visit growth across our fulfillment center networks. As our top line momentum continues, we are investing in our distribution network to stay ahead of the growth curve and enhance customer experience. At the end of Q1, we opened our 12th fulfillment center located in Lewisberry, Pennsylvania. This facility primarily specializes in carrying our bulky assortment items like cat trees and dog crates and/or items that ship in their original containers. I'm also pleased to share the news that we are expanding the capacity of our Phoenix, Arizona fulfillment center this summer and also that we will open our third automated FC and 13th FC overall in Reno, Nevada next year. This new facility, along with the Phoenix expansion, will further reduce ship times, improve customer experience and help reduce costs. I will end my comments by reiterating my optimistic outlook for the balance of 2021. We continue to execute against our growth road map by expanding our customer base, increasing share of wallet, growing our TAM-expanding verticals and launching new ones. While supply chain and labor market conditions remain challenging, we are successfully managing through these headwinds and still driving significant year-over-year improvements in gross margin, adjusted EBITDA, and free cash flow. I am incredibly proud of the determination and focus of our teams and their ability to accelerate our pace of innovation while consistently delivering strong top line and bottom line results for our shareholders. With that, I will turn the call over to Mario.

Thank you, Sumit. We continue to execute on our long-term strategy, and momentum remains healthy. First quarter net sales were $2.14 billion, representing 31.7% growth. First quarter Autoship customer sales increased 34.4% to $1.48 billion. And Autoship sales as a percentage of net sales increased 140 basis points to 69.3%, which approaches the high watermark we reached in the fourth quarter of 2019. These results reflect the maturation of the 2020 customer cohort and the growing appeal of the Autoship program's benefits, which include complementary access to our first-in-the-industry telehealth offering, Connect with a Vet. Autoship is a powerful tool for reinforcing the customer value proposition and strengthening loyalty bonds with pet parents. Net sales per active customer, or NSPAC, increased $31 or 8.7% to reach $388 in the first quarter. Compared to the fourth quarter of 2020, NSPAC increased $16 sequentially and marks the largest absolute single quarter NSPAC increase in the company's history. Improved discoverability and merchandising, growth in our newest verticals, and more spending from the 2020 customer cohort are the primary drivers behind the acceleration in NSPAC growth. Moving down the income statement, first quarter gross margin was 27.6%, an increase of 420 basis points. As Sumit mentioned, approximately half of the increase came from structural business improvements, and the remainder reflects normalized freight and logistics costs compared to the elevated investments we made during the peak of the pandemic last year to protect customer experience and the muted price competition and promotional activity that we saw in the first quarter this year. First quarter operating expenses, which include SG&A and advertising and marketing, were $550.7 million or 25.8% of net sales, scaling 50 basis points. SG&A, which includes all fulfillment and customer service costs, credit card processing fees, corporate overhead, and share-based compensation, totaled $406.2 million in the first quarter or 19% of net sales, scaling 70 basis points. SG&A, excluding share-based compensation, totaled $381.4 million in the first quarter of 2021 or 17.9% of net sales, an increase of 80 basis points. This reflects the additional investments we made in wages and benefits for our fulfillment and customer service teams that we outlined on our last earnings call as well as the impact of the higher recruiting and hiring incentives that have been necessary to address persistent labor shortages. Absent the incremental wage benefit and recruiting costs related to the current disruptions in the labor market, our SG&A expense, excluding share-based compensation, would have been flat year-over-year as a percentage of net sales. Launching four new FCs in 12 months while keeping SG&A flat as a percentage of net sales, aside from incremental expenses related to current labor markets, demonstrates our ability to fund incremental investments in capacity by efficiently leveraging operating expenses across the network. First quarter advertising and marketing was $144.4 million or 6.8% of net sales, a 30-basis-point increase versus first quarter 2020. We expected this line to increase year-over-year on a percentage of net sales basis as input costs recovered from the artificial lows we saw early in the pandemic. Adjusted EBITDA reached a new high this quarter, totaling $77.4 million, improving $73.9 million versus the first quarter of 2020 for a net sales to adjusted EBITDA flow-through of 10.5% excluding the estimated $20 million negative impact that COVID-19 had on freight costs in the first quarter of 2020. Adjusted EBITDA margin improved 340 basis points to 3.6%. In Q1, we also delivered our second quarter of positive net income, reaching $38.7 million, improving $86.6 million versus the first quarter of 2020. Our net margin was 1.8%, a 480 basis point improvement. As we have shared in the past, we expect our expanding and profitable repeat business, coupled with the benefits of scale, to drive increasing profitability over the long term. Moving on to free cash flow. First quarter free cash flow was $59.5 million, reflecting $98.4 million in positive cash flow from operating activities and $38.9 million of capital expenditures. The positive operating cash in Q1 was primarily a function of Q1 profitability and favorable working capital, which mostly reflects a temporary reduction in inventory levels due to the ongoing supply chain situation. Capital investments include ongoing additions to our fulfillment network, including cash outlays for our recently opened limited catalog facility in Pennsylvania and our second automated fulfillment center in Kansas City. We finished the quarter with $638 million of cash and cash equivalents on the balance sheet, which is our highest ever level of cash on hand. That concludes my first quarter recap. So now let's discuss our second quarter and full year guidance. We are raising our full year top line and profitability outlook, but before I discuss the details, I'd like to spend a few moments on how we formulated this guidance. As Sumit mentioned at the beginning of the call, 2021 continues to be a busy and exciting year for us. Our strategy remains intact, demand remains strong, and we remain bullish about our future and our ability to maintain pace of execution. At the same time, as we prepare and ramp our network to handle the current and future momentum in our business, we are not immune to the labor shortages currently being faced across the country. Even with the $60 million of enhanced wages and benefits that we committed to last quarter, labor markets remain constrained, and it remains difficult to attract workers. In an attempt to fill job vacancies, companies across the U.S. continue to invest in higher wages and benefits. As these conditions persist, we may choose to commit an additional $30 million to recruiting and hiring incentives over the next 2 quarters. Although we expect these types of expenses to be temporary in nature, that ultimately depends on how labor markets respond to the end of extended unemployment benefits in September. While these higher costs may put near-term pressure on our ability to scale SG&A, we are increasingly confident that these investments in our workforce and automation will increase engagement, retention, and productivity over the long run. When we net these headwinds and tailwinds, we are more positive in our outlook than we were just 9 weeks ago when we issued our initial 2021 guidance. So with that in mind, we expect second quarter net sales to be between $2.15 billion and $2.17 billion, representing 26% to 28% year-over-year growth. We are raising our full year 2021 net sales guidance to between $8.9 billion and $9.0 billion, representing 25% to 26% year-over-year growth. And finally, we are raising our full year 2021 guidance for year-over-year adjusted EBITDA margin expansion to between 80 and 120 basis points. As you update your models for 2021, please keep the following in mind. First, elevated out-of-stock levels are a stronger headwind this year than they were in 2020, and we have not yet seen signs of this abating. While macro conditions are clearly improving on the pandemic front as vaccination levels increase, predicting how exactly consumers will behave post-pandemic is not yet fully clear. What is clear to us is that our compelling value proposition and the predictable and recurring nature of nearly 70% of our business provides us real and tangible advantages in today's marketplace. Second, as you saw in the first quarter, our advertising and marketing spend remains disciplined as we adjust in real-time to rapid changes in the advertising landscape. As always, we remain vigilant and ready to make additional investments to achieve long-term benefits, even if they come at the expense of short-term results. And third, as we have shared before, net customer assets here should look more like they did in 2019, prior to the epidemic, which reflects the normal retention patterns we expect to see from the 2020 cohort as it moves from its first to its second year. NSPAC is expected to accelerate in 2021 as we annualize the 2020 cohort and as the many initiatives that we have launched over the past 2 years continue to expand customer share of wallet. 2021 is off to a great start. We grew first quarter net sales by 32%, and our growing scale and operating discipline drove 420 basis points of gross margin expansion. We also delivered our highest quarterly adjusted EBITDA ever. By increasing our net sales and adjusted EBITDA guidance, we are reiterating our bullish view on Chewy's market position and how we see the balance of 2021 playing out. And with that, I'll turn the call over to the operator.

Our first question will come from Mark Mahaney with Evercore.

I have two questions. First, it seems the out-of-stock issue is still ongoing. Can you share your confidence level regarding its resolution in the latter half of this year and what measures you can take to address it? Is this situation completely out of your control? Second, regarding your statement about new customer acquisitions remaining above pre-pandemic levels, the net additions in this April quarter were actually lower than those in the first quarter of 2019. Does this indicate that you are experiencing higher churn related to the new customers acquired during the COVID year, or am I misunderstanding the situation? I want to clarify whether your net customer additions this year can match those of 2019.

This is Sumit. I will take the first question, and Mario will take the second one. On out-of-stocks, we believe, as we've indicated in the Q4 earnings call, that production capacity constraints primarily remain in the vet canned food category. Any other out-of-stocks that we're facing, we're actually able to mitigate fairly well, given the extensive size of our catalog and the substitutability within discretionary categories such as hard goods or supplies. The primary area that out-of-stock issues are being felt industry-wide is consumables. Health care is also not as deeply impacted. While we don't have perfect visibility, we have confidence from our strategic suppliers and vendors and partners that incremental investment is going in and capacity is being unlocked, which should be available in the back half of this year. The rate of improvement is somewhat unclear right now, which is why we've consistently stated that this out-of-stock issue is a headwind that we will continue to monitor. But yes, we do expect it to abate in the back half of this year.

And I'll answer the second part of your question. You're right, we added 600,000 net active customers in the first quarter, ending with 19.8 million active customers in Q1. That was right in line with our expectations for the quarter and what we've mentioned over the last couple of earnings calls. First, our retention rates are multiple times higher than traditional e-commerce platforms. Any attrition that we see happens from year 1 into year 2. Customers that stay with us after 2 years remain with us for a very long time. So let's talk about the Q1 '20 cohort because that's what's going to drive some of the year-over-year impact here. First, the retention rate for that cohort is higher than the average retention rate over the last couple of years. Even with higher retention, that cohort was so large that the normal attrition we saw created a headwind to net customer adds this quarter. If we look at the new customer adds this past quarter for Q1 '21, it was not only higher than pre-pandemic but also higher than what we expected for this year just 18 months ago. So dial it back 18 months, our pace of new adds was higher than our expectations. We're still acquiring customers at a very fast clip, and we do not believe that the demand we saw in 2020 was a pull-forward from future years. Ultimately, we expect the 2020 cohort to generate more revenue this year than they did last year.

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

I'm actually wondering about some more of your longer-term plans on your growth and international expansion and what conditions and what areas would you look to go to and how you would enter new markets, particularly Europe, where similar size to the U.S.

This is Sumit. I will take that question. Our plans, first of all, are squarely centered on achieving our mission statement to be the most trusted, convenient destination for pet parents everywhere. We've gone back and added the word 'partners' because we believe that we are effectively servicing communities in pet that have not been serviced in a high-quality manner in the past. Given that, we have focused on the United States, and we believe there is a ton of online growth being driven and will continue in the United States. We fully plan to capitalize on that growth through our investments in the multidimensional experience that we've discussed, covering food, treats, personalized accessories, health care, and services. For international expansion, we believe pet parents are more the same than different, and our brand and capability is extensible outside the United States. That said, focus has been important to us; we’ve concentrated on the U.S. International plans are roughly between 1 and 5 years, and that statement remains true. When we explore international opportunities, we will keep our options open and research how customers behave, market dynamics, how to do marketing, supply chain, infrastructure availability, and customer behavior. We'll work backward from that to figure out which markets to enter. But rest assured, we're going to be thoughtful, diligent, and disciplined about the investments we make in our international approach.

Our next question will come from Erin Wright with Crédit Suisse.

Can you speak to the traction you're seeing across the pharmacy business? Is the stickiness across that business playing out according to plan as we lap some of the COVID dynamics from last year, returning some volume back to the vet clinic? And you mentioned you're working with 7,000 vet clinics now. What sort of share do you have in terms of the percent of scripts that you're having filled through Chewy?

Sure. We believe a couple of things to be true. First, our data indicates that retention into our pharmacy and other health care verticals remains strong. Autoship subscription rates in these verticals remain stronger than in the core business, which is a net positive. Our work with veterinarians and connecting customers with their vets continues to establish trust and credibility in this space. Recent independent research revealed that 86% of the veterinarian community would be open and favorable to working with Chewy. These are encouraging data points for us. As I mentioned, Petscriptions is present in 7,000 clinics, which is roughly equivalent to about 30% of the veterinarian clinic penetration in the U.S., and we're very proud of that.

And, Erin, let me add one more thing. If you refer to our 10-Q, you will see that the other segment of our revenue, which includes all proprietary brands, pharmacy, and specialty, is growing twice as fast as the overall business. So that should give you an indication of how we view these newer verticals.

Okay. Great. And one just quick follow-up just on the incremental spending associated with higher labor incentives, the $30 million. So that's not, or is that embedded in your guidance at this point, or is that an incremental expense?

It is fully embedded in our guidance.

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

We want to ask about the entry into the fresh market. Could you provide us with some context around the opportunity, the current size of the Freshpet food market? And maybe what happens with consumable spend as you move from traditional to fresh? What is the margin uplift there? And then really quickly on the adoption service. It sounds like you stood that up pretty rapidly. You've already done a really nice job there integrating with shelters. We know it's early on, but what's the opportunity to build awareness there? Are you investing behind that? Any early learnings with kind of the attach rates and what those cohorts look like, or how the adoption cohorts maybe differ from traditional cohorts?

Okay. There's a lot in there, so let's try to unpack this. On fresh and packaged foods, we believe that as customers become more aware of their options due to humanization and premiumization of pet food, the categories such as fresh and prepared foods will present an attractive opportunity for us. This category requires education, and customers need to be engaged. We believe that our customer care model, along with personalized care and experience building, will allow us to effectively educate customers and drive adoption in this category. The size of the market is currently estimated to be between $600 million to $1 billion, and growth rates are hard to predict as we expect challenges to drive adoption. Investments are already factored into our guidance, and we expect the business will scale as we drive growth. As for the Pet Adoption Services, we are proud to work with the shelter community to bring this to life. This initiative connects pet parents, many of whom are Chewy customers, with opportunities to adopt pets. Over 55% to 60% of pets in the U.S. are adopted from shelters and rescues, and this is our way of connecting with those communities to build brand awareness and consideration towards Chewy, fostering loyalty moving forward. We will continue enhancing our work in this space and look forward to sharing more as the program evolves.

Our next question will come from Steph Wissink with Jefferies.

Mario, these might be best suited for you, but Sumit, please jump in. I want to talk a little bit about gross margin advancement, because it is running several hundred basis points ahead of where we would have expected the model at this stage. So I'm curious if you can talk about what opportunities still exist to further enhance the margin, whether that's through mix or leverage. And then, Mario, a question for you on cash. I mean, the cash flow in the quarter was outstanding. I know that some of that was a benefit of working capital. But how should we think about cash flow for the year? And how should we also think about your cash priorities, therefore, as the cash continues to build on the balance sheet?

All great questions. I will take the first one on gross margins. Mario will take the second one on cash. On gross margins, I would like to point you back to the roadmap I have often shared on these calls: three buckets of gross margin improvement. First, acquiring customers and growing share of wallet; second, investing in improved discoverability, merchandising, and growing our under-penetrated newer verticals like proprietary health care; third, connecting our destination with services. We believe we are making incremental progress in our gross margin. We are now, net of the pricing muted environments, slightly above the low end of our long-range guide. Our goal remains 28% margin, and we are continually focused on improving customer engagement to achieve that. We still have less than one-third of Chewy customers today exposed to proprietary brands, and there's ample opportunity for improvement. We've also expanded our addressable market through new categories like fresh and packaged foods. So there's a lot of innovation happening at the company, and we're disciplined in our approach. We'll share updates about our progress on future calls.

This is Mario. We've seen very rapid growth without consuming cash, and if you consider the guidance for net sales and adjusted EBITDA margin, we anticipate over $200 million of adjusted EBITDA at the high end. This supports your assessment of cash generation for the year. I agree that we benefited from working capital due to reduced inventory levels, but we intend to build that back up to meet customer demand. We finished the quarter with our highest cash level ever at $638 million. We also have an untapped facility of $300 million, giving us about $1 billion of available liquidity. This ensures balance sheet strength and flexibility for potential investments in technology, automation, M&A, and expanding new verticals.

Our next question will come from Doug Anmuth with JPMorgan.

First, just on profitability. I know you raised the margin expansion, obviously, for the full year outlook. Just thinking about the $60 million potentially in the back half, is that essentially the reason for not seeing more flow-through on a full year basis? Or is there something else or additional that we should be thinking about just on the EBITDA for '21? And then secondly, just on private label, I think you said about one-third of customers are exposed there. Just curious if you can help frame that in terms of where you are as a percentage of net sales and in relation to perhaps your ambitions that you've mentioned in the past toward a 15% to 30% over time?

Sure. This is Sumit. I'll take the second question, and Mario will address the first one. Regarding private brands, one-third of our nearly 20 million customers have purchased private or proprietary brands. This means that two-thirds haven't yet shopped proprietary brands. Our focus on improvement in search and discoverability and newer launches will aim to increase exposure further. We've doubled the overall number of assortments over the last 2.5 years. We've seen significant progress in hard goods, gaining 500 basis points share year-over-year, reaching 18% penetration and bringing us closer to our goals of 15% to 30% we discussed previously. The gross margin for proprietary brands is favorable to the core business, reflected in our overall gross margin improvement. More customers will be exposed to more proprietary options over time.

I'll take the first part of your question. To level set, in Q1, we added half a billion year-over-year in net sales and increased gross margin while maintaining expense discipline. We reported record adjusted EBITDA of $77 million. For the full year, we guided adjusted EBITDA margin increases of 80 to 100 basis points, combined with our net sales projection, which implies tripling EBITDA for the full year. If you factor in the wages and benefits we outlined in our previous calls, you arrive at approximately 9% to 11% flow-through for the year, which aligns with what we saw in Q1.

Our next question will come from Seth Basham with Wedbush Securities.

My question is around advertising. How do we think about advertising as a percentage of sales this year? And I think you were commenting previously around 7% to 8%. You did better than that in the first quarter. Do you expect to move to that range and have the opportunity to grow your gross adds even more aggressively?

We believe advertising and marketing will likely remain in line with the levels we saw in 2020, around 7%, plus/minus. The plus or minus is driven by efficiencies, similar to how we saw a 20-basis-point improvement in Q1. We came in at 6.8%. If we uncover more opportunities to acquire customers or input costs decline further, that might push us higher. Overall, we believe we've been spending appropriately to acquire customers efficiently.

Relative to 2019, are you expecting customer acquisition costs in 2021 to be higher?

This is a tough question to answer as it requires predicting outcomes in an uncertain market. Many platforms have experienced changes, making it hard to anticipate a full year's marketing expenses. Our guidance does factor in current uncertainties, but we believe spending should be flattish compared to 2020 levels.

Our next question will come from Peter Keith with Piper Sandler.

I was hoping you could just discuss a little bit more around the new homepage launch and the customization and localization features that you have. Maybe just provide some specific examples on how you think that can improve the customer experience.

Sure, Peter. This new functionality improves our ability to target and personalize the experience by presenting content that resonates with pet parents based upon their individual needs and emotive states in their journey with their pets. This taxonomy will provide an interactive digital experience, yielding better conversion rates and enhancing customer development. When you visit the homepage, we have the ability to target based on the type of pet you have, leading to dynamic recommendations aligned with your needs. Think of it as a combination of behavior-driven experiences rather than an unauthenticated one.

That's very interesting. The follow-up and unrelated question I had was just around the net customer adds. I know this was asked earlier in the call, but referencing back to the 2019 levels, and you did come in below that for Q1. I would think that the net customer adds moderate as the year progresses just from maybe gross add slowing or the 2020 cohort churn picking up in sheer magnitude. Is my thinking incorrect, or is 560,000 kind of a good level to think about on a run rate basis?

Yes, Peter, I’ll answer that. The dynamics of net active adds is exactly what I had mentioned before. We do have a headwind from a very large customer cohort we acquired last year. So even with high retention levels, we still face a net headwind. To understand net active adds, it's essential to consider the longer time frame rather than just year-over-year. The very large cohort we acquired last year will create attrition this year. We expect continuous gross additions, and despite some attrition, we are optimistic about the growth in our customer base. Therefore, rather than thinking about short-term numbers, we should view these trends over time.

Our next question will come from Lauren Schenk with Morgan Stanley.

I just wanted to ask about what you're seeing from a COVID cohort spending perspective. If here in sort of year one, they were already spending over that $400 that you typically see in a second-year customer, and if that is the case, what kind of gives you the confidence that the COVID cohort will continue to expand spend at the same rate as previous cohorts?

This is Sumit. We continue to see positive and engaged behavior from the cohort in terms of purchase frequency, subscription rates to Autoship, and basket sizes. These metrics indicate momentum. The uptick is driven by improved discoverability, merchandising, and growth in our new verticals. We aren’t planning on deploying marketing spend to retain customers, which is important if we believe we're at risk of losing them. We don’t think so. If this doesn’t clarify your question or if you have follow-ups, please let me know.

If I'm understanding your question correctly, Lauren, I would expect this cohort to follow the same pattern as previous cohorts, where first-year spending is X and second-year spending exceeds that. We're already seeing positive engagement from the first quarter cohort, with their spending 13% above the previous first quarter cohort. Considering that there was pantry loading last year, we're seeing appropriate behavior from this year's cohort, with spending predictions that exceed last year.

Our next question will come from Nick Bacchus with Raymond James.

So you talked a lot about new customer acquisition continuing to be strong but at a moderating pace, some headwinds from year one retention, but NSPAC continues to accelerate. How do you think about these drivers longer-term? So kind of in the 5-year-plus plan, how much of your top-line growth is going to come from each of those drivers? How do you think about that?

Yes, I think the key to net active adds is to think about them over a longer time period than just year-over-year so you can observe the trends over time. The very large cohort we acquired last year is going to impact this year. It's important to view our customer base as blooming over time, growing and maturing over time, spending more. We anticipate that as we attract more customers to the platform, the average spend by these cohorts will increase significantly as they stick with us longer and longer. This dual tailwind will drive our growth. Therefore, we believe we can effectively capitalize on our expansion efforts and increase market share.