Earnings Call Transcript - CHWY Q3 2020

Operator, Operator

Good day, and welcome to the Chewy Third Quarter 2020 Earnings Conference Call. All participants will be in a listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note that this event is being recorded. I would now like to turn the conference over to Mr. Robert LaFleur, Vice President of Investor Relations and Capital Markets. Please go ahead, sir.

Robert LaFleur, Vice President of Investor Relations

Thank you for joining us on the call today to discuss our third quarter fiscal 2020 results. 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-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, 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. 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.

Sumit Singh, CEO

Thanks, Bob, and thanks to all of you for joining us on the call. Our Q3 results reflect Chewy's relentless focus on execution and customer experience, coupled with the positive macro trends of accelerated e-commerce migration and increased pet ownership. These forces came together yet again to produce another quarter of strong net sales growth. Volume in the back half of the quarter outperformed our expectations, as traffic, conversion, orders and customer retention all strengthened from September into October, as customers shifted their shopping behavior this year and started shopping earlier, responding favorably to thoughtful additions in our assortment and innovative product and service launches such as personalization and gifting. Coming into the third quarter, we expected an early kickoff to the holiday season and the Chewy team was prepared and ready to shift into high gear when it came. This summer, we began optimizing our inventory and preparing our fulfillment centers, knowing that the holiday spike would add to the elevated demand tempo that has been in place since March. The teams responded and executed to plan. Over the next few minutes, I will discuss our Q3 results and share some insights into how the quarter unfolded. I will then use the balance of my remarks to talk through our exciting new healthcare launches and how those fit into the broader Chewy story, as we prepare to celebrate our 10th anniversary next year and carry our mission into the second decade, just as eagerly and enthusiastically as we approached its first. After that, I will turn the call over to Mario to discuss our third quarter results and guidance in more detail. Q3 net sales increased 45% year-over-year to $1.78 billion, with Autoship net sales representing 69.2% of total net sales. We added 1.2 million net active customers in the quarter, ending Q3 with 17.8 million active customers. Q3 net sales per active customer, or NSPAC, was $363, an increase of 2.8% year-over-year when adjusting for the extra week in 2018. We delivered Q3 gross margins of 25.5%, a 180 basis point increase year-over-year and consistent with our gross margin last quarter. The promotional environment was muted throughout most of the quarter before picking up in mid-October with the early launch of the holiday season. As such, promotional discounts were less of a gross margin headwind than forecasted. Shipping costs were also in line, as we worked closely with our freight partners to uphold the customer delivery experience. Private label remained a strong contributor this quarter, with Q3 private label hard goods penetration reaching 16%. Our seasonal businesses, such as Halloween, were also strong in the quarter. Here, we improved our private label merchandise mix by 20 points to over 70%, showcasing the quality and appeal of our newly launched proprietary assortment. This helped grow total Q3 hard goods sales, including third-party and private label, by more than 70% year-over-year. Over the past few quarters, our team has been hard at work to reformat our proprietary brand strategy by introducing compelling merchandise at expanded price points, improving discoverability and delivering an overall tremendous value proposition for our customers. This strategy is creating a positive, consistent and sustainable momentum, and driving incremental profitability in our portfolio. Moving on to Q3 adjusted EBITDA. We produced another positive quarter, generating $5.5 million of adjusted EBITDA at a margin rate of 0.3%, representing 280 basis points of improvement year-over-year. While gross margins were strong in the quarter, several of the short-term operating cost headwinds we detailed on our last call materialized as anticipated and impacted our ability to translate our top line momentum into bottom line results as efficiently as we did in the first and second quarters. These elevated costs were related to investments in labor and benefits, as we ramped up our fulfillment centers and customer service sites to deliver a successful holiday, amidst increasingly constrained labor markets and residual COVID-19 costs. Additionally, as anticipated, we saw marketing costs increase in Q3, normalizing from the hyper-efficient run rates we saw in Q1 and Q2. Mario will provide more details on these components in just a moment. We continue to be laser-focused on executing against our commitment to pets and pet parents to deliver exceptional customer experiences by offering a broad assortment of brands and products with the convenience of e-commerce. That commitment extends to pet health and wellness. As part of our goal to make pet healthcare more affordable and accessible, we recently launched Medication Compounding and Connect with the Vet, our proprietary telehealth platform. These two innovative businesses are valuable additions to the growing healthcare business and represent our first service-based offerings for pet parents. But before I discuss these new businesses in greater detail, I would like to share some insight into our Pharmacy Rx business, which anchors our broader healthcare strategy. For clarity, when I refer to Chewy Pharmacy, I am referring to the business that we own and operate under our own licenses. Total pharmacy includes Chewy Pharmacy, plus the pharmacy that we operate that generates third-party management fees. Total pharmacy operations are expected to generate over $500 million of gross revenue this year, which we believe makes us the largest e-commerce pet pharmacy in the U.S. To achieve this milestone just over two years after our launch is a remarkable achievement for which we, as a team, are proud. Chewy Pharmacy, on a reported basis, is expected to generate over $350 million of net sales this year, which would equate to 5% of total net sales based on our current guidance. Given the scale, Pharmacy is now contributing positively to the year-over-year expansion in Chewy's total gross margins. As we have noted on previous earnings calls, we believe that we are still in the early innings regarding our Pharmacy business and we remain focused on growing this vertical in a disciplined manner. Now let me tell you a little bit more about our recent compounding and telehealth launches. Let's start with compounding. Compounding is a service offered through our pharmacy where we customize medications to the specific needs of individual pets, as some pets can't take medications in their commercially available forms. They may need a liquid instead of a tablet or a specialized dosage or formula. To enable these requirements, our licensed pharmacists use ingredients sourced from FDA-registered manufacturers to custom-prepare medications in our labs to the specifications provided by the veterinarians. Today, we offer this service exclusively to pets and pet parents. In the future, we plan to extend this service to the vets, so vets can offer compounded medications directly to their in-clinic patients. In both these use cases, we seek to pioneer bar-raising customer experiences across this $1 billion fragmented market. We are just as excited about our new telehealth service, Connect with a Vet, which connects Chewy pet parents directly to a contracted licensed veterinarian using our proprietary tele-triage platform, where vets answer questions, offer advice and discuss pet health concerns without diagnosing medical conditions or recommending treatments. Instead, they make referrals to local vets or emergency clinics if needed, which drives customer traffic back into these veterinarian clinics for medical diagnosis and treatment. We offer the service free of charge to Autoship customers from 8 a.m. to 8 p.m. Eastern Time Monday through Friday. We launched the program in 35 states in October. Starting today, I am happy to announce that we are rolling it out to another 12, which brings our total coverage up to 47 states. Program utilization rates to date are encouraging as is the customer feedback we are receiving. Connect With a Vet is clearly a first-of-its-kind service. We are still in the early days and have a lot more to learn. At the same time, we have taken an important first step towards building a telehealth platform that can evolve and expand over time as our culture of innovation advances the technology platform and as the regulatory environments modernize to meet the needs of today's pet patients and providers. 2020 has been an unbelievably busy year so far, and I'm proud of the way every member of the Chewy team across our fulfillment centers, customer service sites and corporate offices has stepped up to meet both the challenge and the opportunity. Not only do we continue to optimize our day-to-day operations, we are always looking for ways to enhance customer assortment, service and experience, as we welcome a record number of new customers and offer current customers a safe and reliable way to care for their pets. The bond between pets and their pet parents has never been stronger and we look forward to a robust holiday season and a strong finish to the year. I will now turn the call over to Mario, who will provide the details on our third quarter results and financial outlook.

Mario Marte, CFO

Thank you, Sumit. Third quarter net sales reached $1.78 billion, increasing $552.2 million or 44.9% year-over-year. In absolute dollar terms, third quarter growth marked the biggest increase we have reported in the company's history. Year-to-date, net sales are up 46% on accelerated customer growth and solid increases in per customer spending. Q3 sales from Autoship customers totaled $1.23 billion, representing 69.2% of total net sales for the quarter. Customer acquisition rates remain healthy and continue to run above pre-pandemic levels. In Q3, we added 1.2 million net active customers and ended the quarter with 17.8 million active customers. Year-to-date, we have added 5.1 million active customers, an increase of nearly 40%. We continue to monitor and are pleased with the purchasing behavior of our 2020 customer cohorts. The first and second quarter cohorts remain engaged and the initial engagement levels of the Q3 cohort are consistent with their peers from earlier in the year. Trends in basket size, reorder rates and Autoship sign-up all remain favorable, reflecting the continued success of our assortment and merchandising strategies. Net sales per active customer or NSPAC increased to $363 in the third quarter, $7 or 2% higher versus the second quarter and 2.8% higher year-over-year when adjusting Q3 2019 NSPAC to exclude the benefit from the extra week in the fourth quarter of 2018. As a reminder, net sales per active customer reflects trailing four-quarter net sales, divided by the number of active customers at the end of the quarter. This is the last quarter we will have to adjust for the extra week in Q4 2018 in our year-over-year comps. We should note that the quarter-over-quarter increase is a reversal from recent quarters when NSPAC remained relatively flat. This is what we would expect as the mechanics of the NSPAC calculation begin to fully reflect the positive revenue impact of the large customer cohorts that we acquired earlier this year and as our pace of quarterly active customer adds moderates from its peak lockdown highs. Moving to the income statement. Third quarter gross margin was 25.5%, a year-over-year increase of 180 basis points, as we again surpassed the low end of our long-term target range. In the third quarter, we benefited from strong execution, as hardgoods, private label, and healthcare collectively contributed 110 of the 180 basis points of year-over-year gross margin expansion. Q3 operating expenses, which include SG&A and advertising and marketing, were $486.9 million or 27.3% of net sales, scaling 280 basis points year-over-year. SG&A, which includes all fulfillment, customer service, credit card processing fees, corporate G&A, corporate payroll, and share-based compensation, totaled $352.3 million in the third quarter or 19.8% of net sales. This improved 120 basis points year-over-year, which on a fully-loaded basis again scaled versus 2019 as our share-based compensation declined versus our prior period run rate. Factors affecting third quarter SG&A expenses include the launch of two fulfillment centers, investments, and bonuses and other incentives for our fulfillment and customer service team members as well as the absorption of some residual costs related to COVID-19. Q3 advertising and marketing was $134.6 million or 7.6% of net sales, scaling 150 basis points year-over-year. As previewed in our Q2 call in September, as the economy reopened in Q3, organic acquisition rates as a percent of total acquisitions began to normalize after running at elevated levels through the first half of 2020. Likewise, the stronger economy and increased political advertising around the election helped drive search and digital advertising costs during Q3, which led to channel input costs rising from the depressed rates we saw in Q1 and Q2. In response, we adjusted our acquisition marketing efforts accordingly and continue to acquire customers smartly while still delivering year-over-year marketing efficiencies and progressing towards our long-term target of 6% to 7% of net sales. Third quarter net loss was $32.8 million and net margin improved 460 basis points year-over-year to negative 1.8%. Third quarter net income excluding share-based compensation of $25.1 million was negative $7.8 million. Net margin excluding share-based compensation improved 280 basis points to negative 0.4%. Third quarter adjusted EBITDA was $5.5 million, and adjusted EBITDA margin improved 280 basis points year-over-year to 0.3%, again exceeding breakeven. While gross margins were solid this quarter, the operating cost headwinds that we faced in SG&A and marketing that I detailed earlier affected our ability to convert gross profit into adjusted EBITDA as efficiently as we did in the first two quarters of the year. In our view, several of these headwinds are not systemic and simply reflect short-term issues related to new fulfillment center ramp-up and residual costs related to COVID-19. Turning now to free cash flow. Third quarter free cash flow was positive $32.9 million reflecting $63.4 million in process cash flow from operating activities and $30.5 million of capital expenditures. Positive operating cash in Q3 was primarily a function of the strong sales momentum we saw in the latter half of the quarter. Capital investments continue to be focused on capacity build, including cash outlays for our new automated fulfillment center in Archbald, Pennsylvania and our new limited catalog fulfillment center in Kansas City, Missouri. We finished the quarter with over $0.5 billion of cash on the balance sheet, which is a function of the $154 million we started the quarter with combined with the $318 million we raised through our September follow-on offering and the $33 million of free cash flow we generated during the quarter. This level of liquidity gives us tremendous flexibility, first to support our growth, and second, it gives us the ability to evaluate internal and external opportunities to expand our addressable market. Now to guidance. Based on strong early quarter results and accelerated customer demand spending, we are increasing our guidance ranges as follows: fourth quarter net sales to between $1.94 billion and $1.96 billion, representing year-over-year growth of 43% to 45%; full-year 2020 net sales to between $7.04 billion and $7.06 billion, representing year-over-year growth of 45% to 46% and reflecting over $2.2 billion of incremental net sales added in 2020. We now expect to be profitable on a full-year adjusted EBITDA basis and we are increasing our full-year 2020 adjusted EBITDA margin guidance range to between 0.2% and 0.4%. While some potential cost headwinds remain, these mostly reflect short-term impacts directly related to COVID or its temporary effects on areas like labor and logistics. I will conclude by saying that our third-quarter results demonstrate the appeal and resilience of the value proposition we offer pet parents and our ability to grow and scale the business profitably. We remain optimistic about our future and look forward to wrapping up a successful 2020 and building on this momentum in 2021, for which we plan to provide you more details on our next earnings call. With that, I'll turn the call over to the operator.

Operator, Operator

Thank you. We will now begin the question-and-answer session. Our first question will come from Steph Wissink with Jefferies. Please go ahead.

Steph Wissink, Analyst

Thank you. Good afternoon, everyone. And Sumit, congratulations on your Business Week recognition. Our question actually is twofold. If we could just start with some of the private label penetration, you're seeing good success there. But maybe give us a pathway to what you think that penetration rate could be over the course of the next 12 to 24 months? And then how does that influence the way you're thinking about gross margin advancement over that same timeframe? Thank you.

Sumit Singh, CEO

Hi, Steph. Thank you. Private label is a key focus for us and has been in operation for just over three years. We have been expanding our private label offerings in both consumables and hardgoods. While we haven't disclosed the exact size of private label, it is estimated to account for mid to high single-digit percentages of our net sales. Our goal is to increase private label to represent between 15% and 30% of net sales. The specific comment we made today was about the private label penetration in our hardgoods, which has reached 16% of total hardgoods sales. In hardgoods, where we see product lines becoming more standardized and customer loyalty isn't tied to a specific brand, we believe we can exceed a penetration of 30%, potentially reaching around 40%, 45%, or even 50% for private label items. For consumables, we remain mindful of our customers' loyalty to their brands and our strategic relationships with suppliers as we expand our private label offerings. Overall, we anticipate that as we approach the 15% to 30% range for the private label segment, it will generate 800 to 1,000 basis points higher gross profit compared to our core business. We are pleased with our progress. Not only have we effectively doubled our private label assortment in the last 18 months, but we have also increased price points as we introduced new products in various subcategories, which have generated significant customer engagement and positive reactions, particularly given that these products maintain a minimum rating of 4, 4.2, or 4.4 stars.

Operator, Operator

And our next question will come from Cory Carpenter with JPMorgan. Please go ahead.

Cory Carpenter, Analyst

Sales accelerated in October. It appeared that you mentioned early holiday demand, but could you elaborate on the dynamics you observed that month and your thoughts on the potential pull-forward of demand that would typically arrive later? Additionally, over the past month, what impact have you noticed, if any, from the second wave of the virus on consumer demand or evidence of pantry loading? Thank you.

Sumit Singh, CEO

Hey, Cory, this is Sumit. I'll take it. It's a two-part question, and I'll answer them together because we think they're connected. Let's start with our Q3 guidance from early September, where we noted that the sales pace entering the third quarter was strong. As expected, we saw trends begin to accelerate in October with an earlier holiday season this year. That momentum continued through November and into Black Friday and Cyber Week, making those two days the highest net sales days in the company's history. As we analyzed the reasons behind this momentum in terms of traffic and conversion patterns, we don't think this is simply a pull-forward effect or a consequence of a second wave of COVID. We believe the current demand is largely organic and structural. To elaborate, we haven’t found indications in our internal data to suggest the same COVID-induced purchasing behaviors we noticed in the spring. For instance, we are not observing significant changes in metrics like units per order or order frequency that would indicate panic buying as seen in March and April at the start of the pandemic. Looking ahead to the remainder of Q4, we remain optimistic that these demand trends will persist. Delving into the organic volume, our data indicates a few key points. First, we are retaining a greater share of our customer cohorts. Customer retention for our active base has increased by over 600 basis points year-to-date, addressing our earlier concerns about retaining customers acquired during the pandemic. Secondly, we are attracting larger new cohorts and seeing higher engagement from active customers, particularly where we capture a greater share of wallet from new cohorts earlier in their life cycle. For instance, the Q2 cohort of this year was 50% larger than the Q2 2019 cohort, and their initial net sales per active customer was 10% higher compared to the Q2 2019 cohort. In summary, we are bringing in more new customers, retaining more established ones, and these customers are increasingly building larger, more profitable baskets early on. That's what we're currently observing in terms of demand patterns.

Cory Carpenter, Analyst

Thank you. It’s very helpful.

Operator, Operator

Our next question will come from Mark Mahaney with RBC Capital Markets. Please go ahead.

Mark Mahaney, Analyst

Thanks. I have two specific questions regarding the P&L. First, were there any particular factors that negatively impacted gross margins? I understand they improved significantly year-over-year, and while revenue grew sequentially, the gross margin remained unchanged. Did the costs associated with the new fulfillment center contribute to limiting the sequential gross margin expansion? Secondly, you mentioned increasing competition for online advertising spending. Do you believe the position you've reached by the end of the quarter aligns with your historical performance? Are you expecting advertising costs to continue rising in order to return to your typical operational levels? Please provide some context on where you currently stand compared to where you would ideally like to be. Thank you.

Sumit Singh, CEO

Okay. Hey, Mark. This is Sumit. I'll take them. From a gross margin perspective, we experienced some pressure in two areas. Firstly, this was partly expected as we entered the holiday season, which saw an increase in promotional activity, particularly since the holiday season started earlier in October. Compared to the previous year, the promotions environment was relatively subdued, but in absolute terms, we did notice an uptick in promotions. Secondly, regarding our supply chain, it remains healthy in terms of available stock, but the inventory placement could be better in certain areas as we continue to adjust and balance our supply chains while collaborating closely with our suppliers to get products into the warehouses. Consequently, there is some impact from shipping products over longer distances, which typically leads to higher freight costs that negatively affect gross margin. On a positive note, we achieved a 180 basis points improvement year-over-year, and we are proud that our new strategic initiatives are contributing positively to incremental gross margin in our portfolio. Moving to marketing, as we expected after Q2, we mentioned in September that marketing costs were starting to rise due to increasing inputs as the economy reopened and more advertisers entered the market, affecting the demand/supply ratio and leading to higher bid costs. This is precisely what we observed. We also saw opportunities to spend efficiently to acquire customers, which our team pursued effectively. Due to the shift in the holiday schedule, we noticed a trend of acquiring new customers earlier than usual, starting from late October to mid-November, driven by strong shopper demand visible across our digital network. On the television side, we had pre-purchased inventory in anticipation of political advertising spending, which allowed us to allocate our budget effectively. Overall, marketing costs have remained lower year-over-year, though they are higher than the extremely efficient levels witnessed during the early stages of the pandemic. We expect marketing costs to continue facing pressure as we move through Q4 and potentially into next year.

Mario Marte, CFO

And Mark, if I can add one more thing because I think what you're referring to a couple of points on gross margin. One is, obviously, we've stated that we did increase gross margin 180 basis points year-over-year. But if you're looking at quarter-over-quarter, you're right they were 25% in both quarters. If you look at the mix of sales in the second quarter versus the third quarter, you see that in the third quarter we had an increase as a percent of sales that went to consumables. We've talked about the relative margin performance of different components of revenue. So when you go from a 69.4% or rather 68.2% of sales being consumables in the second quarter and that increased to over 69%, it is those mix between the sales components of net revenue that would have an impact on gross margin.

Mark Mahaney, Analyst

Okay. Thank you. Thank you for the clarification. Thank you, Mario. Thank you, Sumit.

Sumit Singh, CEO

Thanks, Mark.

Operator, Operator

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

Brian Fitzgerald, Analyst

Thanks, guys and Sumit congrats also. Could you guys talk to the opportunity to monetize Connect with a Vet, the referrals to local vets? Is that really monetized today? What is the monetization mechanism there? It seems like there's a lot of new pandemic parents and this is a good way to drive Autoship for the uninitiated. And then, similar topic on Connect with a Vet, can you talk about how you're growing awareness of this offering with your current Autoship customers? It's very early, but do you have any sense of how much awareness you have been able to drive already? And maybe how you think about how that can help drive Autoship retention? And last point, the path to availability of that service in all 50 states. Thanks.

Sumit Singh, CEO

Hi, Brian. Thank you. Let’s start with the availability. As of this morning, the service is offered in 47 of the 50 states. We have quickly grown from 35 states about four or five weeks ago to 47 today. Secondly, focusing on Autoship customers is a strategic move for us because we expect to learn from this experience. We believe it will help enhance our acquisition into the Autoship program and improve retention of Autoship members, which is important for both our revenue and profits. Over time, as you mentioned, we’re still in the early stages. As we refine the product, we will look for ways to integrate it and offer it to our entire customer base. We have several ideas to monetize this product eventually. Currently, we're concentrating on Autoship customers to see how the service performs for them. Did I overlook any part of your question? I don’t think so.

Brian Fitzgerald, Analyst

No, I think you got it off. Thanks, guys.

Sumit Singh, CEO

Yep. Thanks.

Operator, Operator

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

Lauren Schenk, Analyst

Thanks for taking the question. I guess following up a little bit on an earlier question, thinking about marketing spending into next year. Obviously, I think, we're hearing about CPC being largely higher next year. But from a sort of retention of new buyers perspective, is there anything that you think you need to invest in from that perspective? Or is it really going to be continued new customer growth? And to that effect, how should we think about new customer growth next year given the really strong growth that you've seen this year?

Sumit Singh, CEO

Sure. Hi, Lauren. We won't speculate on numbers for next year right now. We'll provide more details about 2021 during our Q4 call. To address your question, we do not anticipate increasing our spending on retention. As we've mentioned during this earnings call, customer retention has improved more than 600 basis points year-to-date. This includes the cohort of customers we acquired this year, who are engaging positively with higher average order values driven by average selling price and mix, rather than an increase in units per order, indicating no pandemic-related buying behavior. Additionally, we plan to expand our marketing channels as we transition from 2020 to 2021. You can expect us to enhance our range, reach, and frequency. We are a robust direct response performance marketing engine and will remain disciplined and accountable in our customer acquisition spending. Lastly, we have improved the value proposition of the products and services we offer Chewy customers, leading to increased early spending from them. We believe the overall potential for net customer spending and lifetime value is substantial, resulting in better lifetime value-to-customer acquisition cost ratios, which is a key focus for us in our marketing strategy as we move forward into next year.

Lauren Schenk, Analyst

Thank you.

Operator, Operator

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

Seth Basham, Analyst

Thanks a lot and good afternoon. My question is around sales per active customer. We saw a metric increase, but it slowed a little bit sequentially in terms of year-over-year growth. Is there anything to think about as it relates to that metric here?

Mario Marte, CFO

Yes. Seth, this is Mario. You're referring to NSPAC. The mechanics of NSPAC, if you remember, is that we take all the revenue in the last four quarters and divide it by the active customers at the end of the quarter. We're starting to see the sequential increase is the positive revenue impact of the large customer cohorts that we acquired earlier this year. So now we're seeing that number move up again. You would expect that NSPAC should continue to improve over the balance of the year and into next year as the revenue from those cohorts continues to be realized for the full trailing four quarters of I think acquired the cohort itself. I think what you have to do for the last years, you still have to adjust for the extra week in the fourth quarter of 2018. If we do that, then our NSPAC is up almost 3% and you can see how many new active customers we added in the quarter, which obviously has a temporary drag on that number from moving up.

Seth Basham, Analyst

Understood. Thank you.

Operator, Operator

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

Oliver Wintermantel, Analyst

Yeah. Hi, thanks. I just had a question regarding the cost headwinds that you mentioned in Q3. In your prepared remarks, you said they should shift into Q4 and then maybe into next year as well. While overall, you said they shouldn't be permanent in nature, but you mentioned labor and logistics as well as COVID. So maybe a little bit more information on what you expect in Q4, and what part of these cost headwinds should fall off in next year?

Mario Marte, CFO

Yes. Certainly. Oli, it's Mario. I'll answer that one. You've heard us say that unlike the first quarter, COVID did not have a material impact on our gross margin in the third quarter, but we did see an impact in SG&A. We had approximately $8 million of expenses that were either directly or indirectly related to COVID in the third quarter, which is about in line with what we shared with you for the first and second quarters, where we said $11 million in the first quarter and $10 million in the second quarter. For the fourth quarter, we do expect somewhere between $15 million and $20 million of incremental SG&A, again directly or indirectly related to COVID, and that's partially due to higher wages and benefits for our fulfillment center team members, but we believe these are temporary in nature.

Sumit Singh, CEO

I'll add a couple of things. As you know we're also ramping up two fulfillment centers along the way that go into that SG&A number. We've just talked about marketing where input costs are increasing, and it's an open playing field on marketing. We will continue to remain disciplined and opportunistic. Depending on how the market behaves, our team can respond accordingly to drive both yield as well as new customer additions to the portfolio.

Oliver Wintermantel, Analyst

Got it. And just, if I may, the $15 million to $20 million incremental SG&A, does that compare to the $8 million COVID cost or was that a total number?

Mario Marte, CFO

It's a total number.

Oliver Wintermantel, Analyst

Got it. Thanks very much.

Operator, Operator

Our next question will come from Erin Wright with Credit Suisse. Please go ahead.

Erin Wright, Analyst

Great. Thanks. On Pharmacy, how much do you think you are taking share from other e-commerce players versus veterinary practices? And then more broadly on the Pharmacy business, do you anticipate this will be a large new organic approach over time, or down the road? Do you see the opportunity to bolster your Pharmacy business more rapidly through acquisitions, or just potentially the highly synergistic Pharmacy file buy which could be an opportunity for you? Or will this be a more organic approach?

Sumit Singh, CEO

Hi, Erin. I'll take the question. So first of all, on share. Let's start from the top. We view healthcare as a $35 billion market. Of that $35 billion, approximately $7 billion in our research is Rx medication, which is growing at a 10% CAGR. We believe, if you do that math, then we're roughly 7% of the overall total available market share in that category. Seventy percent or higher is still owned within the veterinarian channel. E-commerce in our opinion is approximately between $1 billion to $1.3 billion for total Rx medication, which gives us a segment share of somewhere around 40% to 45%. So that's the first part of that question. With the market growing at 10%, and the vet channel owning over 70%, I mean, in this dynamic, the category in our opinion has room for multiple simultaneous winners. Our job is to ensure that Chewy is one of them. In terms of strategy and growth, we're clearly focused on organic growth at this point. As that strategy evolves, we are primarily focused on making sure that we have value-added services and products for both our customers and the veterinarian space, where we can keep the veterinarians in the center of the equation to make healthcare more affordable and accessible. That will be our primary focus over the next nine to 12 to 15 months as we grow the category and the space overall.

Erin Wright, Analyst

Okay. That's helpful. And just a related question on the triage offering, how do the economics work with the veterinary referral partners? Would you agree these clinics would in turn partner with you on the prescription management side? Will this be material near term? And are these exclusive relationships with these practices? How does that essentially work?

Sumit Singh, CEO

Sure. So far, there are no exclusive relationships. The referrals consist of providing a service to customers to help them identify the right veterinarian for diagnosing a medical condition or determining the urgency of the diagnosis. In this way, Chewy partner veterinarians guide customers to local veterinarians, their own veterinarian, or emergency clinics. Customers experience a full diagnosis summary or conversation overview with specific notes for the veterinarian to review, which can create high-quality traffic to the veterinarian's office where the chances of conversion or offering treatment are the highest. We are also excited about how services like these can address compliance challenges and expand the total addressable market in the healthcare sector, which is a common objective for veterinarians. We believe that one-third of pet owners in the U.S. either do not take their pets to a vet or do not do so regularly. The barriers include the cost of veterinary care, friction in the process, and a lack of awareness about preventative healthcare among pet owners. By offering triage services like Connect with a Vet, we can provide support from the convenience of home, build trust, and drive traffic to veterinary clinics, thereby increasing compliance and broadening the total addressable market for that customer segment.

Erin Wright, Analyst

And Sumit, thanks.

Operator, Operator

Our next question will come from Rick Patel with Needham & Company. Please go ahead.

Rick Patel, Analyst

Thank you and good afternoon. Earlier you touched on how newer cohorts are spending more earlier on compared to prior cohorts. I believe historically revenue per active customer has been in the $150 to $200 ballpark for year one. If this has in fact ticked higher, do you see upside to NSPAC in the out years as well? Or does this mean that lifetime value is consistent, but the ability to capture revenues earlier on has improved?

Mario Marte, CFO

Rick, this is Mario. I think I understood your question. The answer to that question is both. Not only are we capturing more revenue earlier, which impacts the LTV to CAC. Therefore, we would expect that behavior to continue going forward, continuing to improve the LTV to CAC versus prior cohorts. But also, an uptick in the first-year revenue per active customer could be a good indicator of future year NSPAC also being higher than prior customer cohorts. That doesn't just happen, right? We've been doing that actively by expanding the catalog and categories. The fact that two years ago we did not have a pharmacy meant that a customer could spend potentially $700 to $800 with us on products being consumables or hard goods, but they couldn't buy their medicine. Well, they can do that today. Our hard goods catalog itself was much smaller two years ago. As we continue to expand not only the product selection but also the price point, it means that customer now has an opportunity to buy their food, their dog bed, cat tree, etc. from us. We’ve expanded the product selection of non-dog, non-cat pets at home. Therefore, the answer is not only can we capture more of the revenue earlier, but also the LTV to CAC for those customers should improve with higher revenue as well as more profitable orders for each of those customers.

Rick Patel, Analyst

Very helpful. Thank you.

Operator, Operator

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

Peter Keith, Analyst

Good afternoon. Maybe as a quick follow-up to Rick's question on cohort spending, you have had this impressive 150% increase in cohort spend from year one to year two historically. So maybe with a higher starting point in year one, do you still see that type of increase for all these customers moving into next year? Or do you think maybe that growth moderates somewhat?

Mario Marte, CFO

Peter, this is Mario. The cohort spend increasing from year one to year two. Look, without speaking to 2021 because we will do that on the fourth-quarter call, nothing that we're seeing from the customers that we acquired this year would have us believe that they're going to behave any differently than prior year customers. So I think that's the short answer without me getting into 2021 any guidance discussion.

Peter Keith, Analyst

Okay, that's fair enough. And if I can ask maybe a simplistic big picture follow-up. Impressive numbers that you're giving around the higher retention rate this year. I think there are some views out there that maybe your churn rate would actually be higher or that your retention will be lower, because you've acquired a lot of customers when brick-and-mortar stores were closed. So simplistically, could you just give an overview of why you think the retention rates this year, in particular, are trending so much stronger?

Sumit Singh, CEO

Hey, Peter, this is Sumit. I'll take that. It goes back to the entire value proposition, right? We seek to deliver a high-bar credible experience from the get-go and aim to repeat that with every interaction that a pet parent has with us so much so that we build relationships, not merely acquire transactions. The relationships we acquire fuel long-term loyalty and evangelism towards the brand and that has substantial value in a category like pets, where customers refer to themselves as pet parents. It's an emotive category. Underneath that, when you layer on the core tenets of e-commerce, such as offering competitive pricing, a broad assortment and reliable, convenient delivery services, and complement that with an expanded portfolio of products and services, it allows us to inch closer every month, every quarter to our mission statement of being the most trusted convenient destination for pet parents everywhere. We believe this is reflected in the numbers we're sharing today, including retention statistics and spend per cohort statistics we've shared or noted on this call today both up more than 600 basis points on retention basis and cohorts on a year-over-year basis spending 10% higher in quarter. You should expect us to continue operating in a highly disciplined manner with an elevated focus on customer experience.

Peter Keith, Analyst

Okay, very helpful. Thank you.

Operator, Operator

Our next question will come from Deepak Mathivanan with Barclays. Please go ahead.

Deepak Mathivanan, Analyst

Hey, guys. Thanks for taking the questions. So the first one on Autoship. You've had the first order discount on the Autoship program at around 40% for a few months now. What benefits are you seeing from this change? And how do you think about the ROIs at these levels? Also, is the Autoship penetration currently the same on more recent cohorts, maybe on a monthly basis? Because of the pandemic, there's been some fluctuation there. So just curious on how that adoption has been. Thank you.

Sumit Singh, CEO

Sure. Hey, Deepak, I'll take the second one. Mario will take the first one. The Autoship penetration is the same or better on customer cohorts that we are acquiring.

Mario Marte, CFO

Yes. I think your first part of your question was about the discount and the simple answer is, you're right, the Autoship penetration is increasing or is higher at this higher level. The cost to us is minimal. You have the benefit of having a higher sign-up rate net of any cancellations and a lower cost, which leads to an improved LTV to CAC for these customers.

Sumit Singh, CEO

And Deepak, these are transient seasonal promotions that we do. We're not seeking to disrupt the value proposition in the program driven by deep discounting or any such sort. These are seasonal holiday-driven promotions where we are particularly sensitive and data-driven in understanding what our gross customer adds would be in Autoship and also understanding the cancellation rate post event, therefore arriving at net adds that form the basis of the payback calculation given that we understand how long the customers will stay with us, what their spend patterns will be, and how we can develop them from one category into purchasing multiple categories over time. That's how we think about it.

Deepak Mathivanan, Analyst

Got it. Now that's very helpful. Thanks, guys.

Sumit Singh, CEO

Sure.

Operator, Operator

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

Sumit Singh, CEO

Thank you, everyone. Have a good night.

Operator, Operator

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