Earnings Call Transcript - CHWY Q3 2021

Operator, Operator

Good day, and welcome to the Chewy Third 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 of Investor Relations. Please go ahead.

Robert LaFleur, Vice President of Investor Relations

Thank you for joining us on the call today to discuss our third quarter 2021 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 earlier today, have been posted to the Investor Relations section of our website, investor.chewy.com. 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. 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 financial measures to the most directly comparable GAAP financial measures are provided on our Investor Relations website and in today's SEC filings. These non-GAAP measures are not intended as substitutes for GAAP results. Additionally, unless otherwise noted, results discussed today refer to third quarter 2021, and all comparisons are accordingly against the third 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.

Sumit Singh, CEO

Thanks, Bob, and thanks to all of you for joining us on the call. Demand and customer engagement remained strong throughout the third quarter. Q3 net sales were $2.21 billion, adding 24% growth on top of strong comps last year. These top line results and our continued growth this year demonstrate the durability of our business model and the overall strength of the pet category. Our metrics, measuring demand and customer engagement, such as site traffic, new customer acquisition, order volume, order size, purchase frequency and net sales per active customer or NSPAC were strong throughout the quarter. We ended Q3 with 20.4 million customers, a year-over-year increase of 15%. Consistent with the trends we have seen throughout 2021, gross customer adds continue to exceed pre-pandemic levels and retention rates continue to track in line with historical levels. More importantly, the strength and quality of our new and active customers continues to improve. For example, we estimate that the expected lifetime values of the Q3 2021 new customer cohort is 12% higher than the pre-pandemic counterpart. Additionally, third quarter Autoship customer sales as a percent of net sales increased 140 basis points to 70.6%, reaching a new company high. And last, but not least, the average order value for new to Chewy customers was 6% and 13% higher than the Q3 2020 and Q3 2019 cohorts, respectively. These positive new customer behaviors flow through to NSPAC, which is an important gauge of overall customer engagement and lifetime customer contribution. Here, we are pleased to share that the third quarter NSPAC increased 15% to $419. This reflects year-over-year growth of $56, which is a record increase for us. It is exciting for us to see NSPAC growth accelerate as a large 2020 cohort matures and our expanded customer choices and increased discoverability expedite share of wallet gains. Even with these gains, we are still only capturing a fraction of the average U.S. pet spend per household from the over 20 million loyal customers who deemed Chewy their preferred destination for everything pet. And so further expanding NSPAC is an important piece of our growth and profitability flywheel. We are encouraged to see our efforts bear fruit in this area, and at the same time, we are highly motivated and remain focused on driving additional NSPAC growth. Moving on to gross margins. Third quarter gross margin expanded 90 basis points year-over-year to 26.4%. This is something we're proud of achieving when operating in the present challenging environment. As we executed Q3, we observed two factors that affected gross margin that had been largely absent through the first half of the year, elevated inbound freight costs and product cost inflation. Together, these two factors, net of a favorable mix shift and pricing adjustment muted gross margin expansion in the quarter by approximately 100 basis points. The elevated inbound freight costs reflect macro trends that are impacting imports and the flow of shipments across the country. And we believe these costs will remain elevated in the near term until the global supply chain disruptions begin to abate. On product costs, we saw inflation ramp up on an expanded assortment of inventory items throughout the quarter. In consumables-led categories, many large national brand suppliers have raised MAP to pass through the higher product costs, and we are adjusting our prices accordingly. In hardgood-led categories, which are typically not governed by MAP pricing, we have seen a greater delta between cost and price, which is primarily driven by higher demand elasticity of products in these categories. Given the inherent price transparency across online channels, this lag between higher cost inputs and the eventual rationalization of consumer-facing prices creates a short-term drag on profitability. Over time, we expect increased prices to offset higher product costs and negate any long-term negative impact to gross margin without impacting customer demand. On the advertising and marketing front, we reversed the sequential spike that we saw last quarter and delivered higher marketing efficiency even as customer acquisitions remained steady and NSPAC ramped nicely. Q3 marketing expenses scaled to 6.8% of net sales. The drivers of improved efficiency in Q3 are a combination of ad costs correcting from their Q2 high and sharper, more targeted execution from our team across channels and across customer segments. Our efforts, which included predictive propensity modeling, while taking macro conditions into account proved effective in aligning customer segments and maximizing acquisition LTV. The results of this approach were twofold. First, we saw a strengthening of traffic or sessions to our website, which we converted at a higher rate, both sequentially and year-over-year. Second, we also improved efficiency across various channels and reduced CPA in the quarter by 12% sequentially. Moving on to SG&A. The higher labor costs and related costs we saw in SG&A during Q3 essentially offset our gross margin improvement and marketing efficiencies, leading to Q3 adjusted EBITDA margin that was flat compared to last year. Shifting gears from in-quarter performance to innovations across Chewy, I'd like to share some of the latest developments in our growing Chewy Health franchise. First, I'm pleased to announce that we have expanded access to our popular connect with a vet telehealth service to our entire base of 20 million active customers plus any new to Chewy customers on a pay per consult basis across chat and video. Access for Autoship customers remains free of charge, and now non-Autoship customers can also enjoy the peace of mind that comes from having nationwide access to professional veterinarian care 15 hours a day, 365 days a year. Continuing our innovation streak in Chewy Health, we recently announced that we will offer an exclusive suite of pet health insurance and wellness and preventative plans in partnership with Trupanion starting in spring 2022. Since its inception, the mission of Chewy Health has been making pet health care more accessible and affordable. And these insurance and wellness plans were designed to do both. In designing them, we wanted to give pet parents the peace of mind to always say, yes, when it comes to taking the best possible care of their pets. We will share more details on future earnings calls. Finally, in Chewy Health, our rollout of Practice Hub is continuing to generate buzz and interest in the industry. As a reminder, with Practice Hub, we have designed a complete e-commerce solution for veterinarians that can be integrated with their existing practice management software. Using our proprietary app, vets can easily create preapproved and manage prescription medications, all in one place. Then they can earn revenue as a seller on our marketplace when customers place an order in clinic or purchase their items at home on chewy.com, with Chewy handling all inventory, fulfillment, shipping, and customer service. Our managed initial rollout of Practice Hub continues with over 50 clinics participating on an invitation-only basis and we continue to receive positive feedback from veterinarians and staff using the product. We have a healthy pipeline of hundreds of interested users, ranging from independently operated practices to multi-clinic veterinary groups. We are excited about the initial success of Practice Hub and look forward to expanding the rollout to the broader vet community. When evaluating the potential contribution of Chewy Health to our long-term objectives and within the $35 billion pet health TAM, it is worth emphasizing that presently less than 15% of Chewy customers are Chewy Health customers. So the opportunity within our base of 20 million customers is meaningful, not to mention the opportunity from pet parents who are not yet Chewy customers. Integrating new health care services like insurance, wellness plans, connect with a vet, and Practice Hub with our existing pharmacy operations, where we have nearly tripled our run rate pharmacy revenue over the short 10-quarter period since our IPO will help us drive deeper penetration into this vertical with our customers and vet partners. I'd also like to take a moment to reiterate that we continue to manage Chewy for the long term by looking beyond the near-term noise in the macro environment today and instead by sticking to the strategic roadmap, which has been Chewy's north star since our IPO. Key components of that roadmap include customer life cycle management, which includes both acquiring customers and expanding their share of wallet. It also includes growing our private label brands and expanding our health care offerings. Since 2018, we've nearly doubled our customer base and increased NSPAC by 30%. Our private label catalog has more than quadrupled and its penetration in the hard goods business has increased to nearly 20%. Additionally, I just outlined the progress we are making in Chewy Health with our B2C and B2B offerings to customers and veterinarians. Overall, when evaluating Chewy's progress from a customer's lens, we now offer a rapidly growing multidimensional customer experience that spans consumables, hard goods, private label brands, and an emerging full ecosystem of health offerings. This makes our customers stickier and gives them an opportunity to strengthen their engagement and spending with us. And finally, while we have not made any announcements yet on our last two roadmap components, non-vet services and international expansion, both remain questions of when and not if. So looking back, we have accomplished a lot and have much to be proud of. But looking forward, tremendous opportunity still lies ahead. And in so many ways, we are just getting started. With that, I will wrap up by reiterating that we are pleased with our Q3 performance and our ability to deliver strong results in the face of disruptions and challenging macro conditions. Looking beyond these near-term challenges, there is plenty of reason for optimism. Consumer engagement is high, business momentum is strong, and we believe the long-term positive trends of more pet ownership, higher per pet spending, and increased e-commerce penetration are as strong as ever. Amidst this, our ability to retain the significant revenue gains we recorded last year during the height of the pandemic and then adding meaningful growth on top of that this year clearly reflects the soundness of our long-term strategy and our efforts to build an enduring franchise to serve millions of loyal pets and pet parents. In short, we are bullish about Chewy's future. And with that, I'll turn the call over to Mario.

Mario Marte, CFO

Thank you, Sumit. Our third quarter net sales were $2.21 billion, representing 24.1% growth. On a 2-year stack basis, year-to-date net sales through the third quarter grew by more than $3 billion or 80% versus the same period in 2019. As Sumit mentioned in his remarks, demand remained strong throughout the quarter, while inflationary pressures, product shortages, and labor constraints made execution challenging. Shortages of wet dog food persisted, while out-of-stock levels in areas like third-party and proprietary branded hard goods also increased. As a result of these, the negative impact of supply shortages in Q3 net sales was approximately $15 million more than our internal expectations. Third quarter Autoship customer sales increased 26.7% to $1.56 billion, faster than overall net sales growth and up 80% on a 2-year stack basis. Third quarter Autoship customer sales as a percentage of net sales increased 140 basis points to 70.6%. This improvement in Autoship penetration rate reflects the maturation of the 2020 customer cohort in Autoship's unmatched value proposition, including free access to Connect to the Vet. Third quarter net sales per active customer, or NSPAC, increased $56 or 15.4% to $419. On an absolute dollar and percentage basis, the year-over-year NSPAC improvements were the largest in the company's history. We expect NSPAC growth to remain strong for the balance of 2021 as we continue to successfully grow customer share of wallet across all cohorts. Our strong NSPAC performance is a clear indication of the health of the underlying customer demand that continues to drive our top line results. We had 20.4 million active customers at the end of Q3, an increase of 14.7% year-over-year. As a reminder, net customer adds are a function of new customers added in the period and the retention of customers acquired in prior periods. Consistent with our year-to-date trends, our gross customer adds continue to run above the pre-pandemic levels of 2019 and below the elevated levels we saw in 2020 during the peak of the pandemic and quarantine. Retention rates for customers heading from their first year into their second year remained within the historic range as do retention rates for our more mature cohorts. Moving down the income statement, third quarter gross margin increased 90 basis points to 26.4%. Our ability to expand gross margin 90 basis points against the backdrop of higher inbound freight costs and accelerating product cost inflation reflects our ability to navigate a challenging operating environment while still making solid progress towards our long-term targets, protecting customer experience and remaining competitive in the market. On the SG&A front, we entered Q3 expecting to see improvement in labor markets. That has not materialized to the extent we expected, and labor shortages continue to hinder our efforts to fully staff our fulfillment centers. This affects our ability to process both inbound and outbound shipments and achieve optimal levels of operational productivity. In the face of these macro-driven challenges, we spent more to maintain customer experience and business continuity, which was a drag on Q3 profitability. Third quarter operating expenses, which include SG&A and advertising and marketing, were $616.8 million or 27.9% of net sales compared to 27.3% in the third quarter of 2020. The 60 basis points of OpEx deleveraging reflects significant labor cost pressure in SG&A, offset by positive operating leverage in advertising and marketing. Let's go through the OpEx details. SG&A, which includes all fulfillment and customer service costs, credit card processing fees, corporate overhead, and share-based compensation totaled $466.4 million in the third quarter, or 21.1% of net sales compared to 19.8% in the third quarter of 2020. Excluding share-based compensation, SG&A totaled $447.3 million or 20.2% of net sales, an increase of 180 basis points versus the third quarter of 2020. This deleveraging of SG&A net of share-based compensation is largely driven by ongoing increases in labor costs. As has been widely reported across the country, demand for labor continues to outpace supply. And as a result, labor costs have yet to stabilize. In the face of these ongoing labor shortages, we spent an incremental $30 million on higher wages, benefits, recruiting, and hiring incentives in the third quarter, which was in line with the expectations we laid out in our previous earnings call. Q3 SG&A expenses also included approximately $10 million in cloud computing and software costs related to our build-out efforts as we upgrade our technology infrastructure to meet the needs of growing customer demand and increased work-from-home capabilities. These investments provide us with a solid tech platform on which to grow the business, which, over time, allows us to focus more of our CapEx on building out our fulfillment capacity. Net of the $40 million attributable to incremental labor costs and the computing and remote work infrastructure expenses, which would not have been in SG&A expenses last year, Q3 SG&A, excluding share-based compensation would represent 18.4% of net sales, which is flat compared to Q3 last year. As we have shared previously, our ability to scale costs in our existing network and corporate functions enables us to fund new initiatives, technology, and incremental fulfillment capacity. Over time, we expect the deployment of automation combined with the revenue growth and margin-accretive businesses to drive improvements in this line. As Sumit elaborated on earlier, third quarter advertising and marketing expense was $150.3 million or 6.8% of net sales, an 80 basis point improvement over third quarter 2020. Third quarter net loss was $32.2 million, improving $0.6 million versus the third quarter of 2020 and net margin improved 30 basis points to negative 1.5%. Adjusted EBITDA was $6 million, improving $0.5 million versus the third quarter of 2020, and adjusted EBITDA margin was flat at 0.3% as gross margin improvement and greater marketing efficiencies were offset by cost pressures in SG&A. Moving on to free cash flow. Third quarter free cash flow was $2.3 million, reflecting $74.3 million in cash flow from operating activities and $72 million of capital expenditures. Operating cash in Q3 reflects a nearly $100 million increase in inventory since the start of the year as we took action to protect against further supply chain deterioration and prepared for holiday sales. Capital investments include initial spend related to our new fulfillment centers in Reno and Nashville, which are projected to launch in 2022. Our most recent FC opening in Kansas City and capitalized labor for software development. In line with historical trends, over 80% of our capital spend this quarter was focused on building capacity for growth. We finished the quarter with $727 million of cash and cash equivalents on the balance sheet and no debt. This cash, combined with available capacity on our ABL provides us with nearly $1.2 billion of available liquidity. That concludes my third quarter recap. So now let's discuss our fourth quarter and full year 2021 guidance. As Sumit also articulated in his remarks, we have plenty of reasons to be optimistic about the pet industry, e-commerce in general and our business in particular. The overarching positive trends of more pet ownership, higher spending per pet, and the secular shift to online are as strong as they've ever been. Balancing the strength of these underlying demand trends against the expected sales impact of ongoing supply shortages, our current revenue outlook is as follows: We expect fourth quarter net sales to be between $2.40 billion and $2.44 billion, representing 17% to 19% year-over-year growth. This brings our full year outlook for 2021 net sales to between $8.90 billion and $8.94 billion, representing year-over-year growth of 25% or approximately $1.8 billion. At the same time, macro uncertainty remains elevated, and we expect supply chain disruptions, labor shortages, and product and inbound freight cost inflation will continue to weigh on near-term profitability. Additionally, we will start to absorb higher shipping costs in January when our outbound freight and logistic contract renews. Reflecting these factors, we now expect our full year 2021 adjusted EBITDA margin to be in line with full year 2020. With these net sales and adjusted EBITDA margin ranges, 2021 adjusted EBITDA would increase 26% year-over-year. Here at Chewy, we continue to execute and follow our long-term growth and margin expansion roadmap. Even as consumer demand patterns shift from a pandemic to post-pandemic footing, we will add significant growth on top of the record growth we achieved in 2020. This is a testament to the strength and durability of demand in the pet category and of Chewy's ability to attract new customers, expand share of wallet, and gain market share. Moreover, during a period of unprecedented cost pressures on multiple fronts, including inventory, labor, and freight, we still expect to expand gross margins and grow adjusted EBITDA on a full year basis. As we continue to execute our long-term strategic plan, we remain optimistic about the future and the progress we are making in our journey to be the most trusted and convenient destination for pet parents and partners everywhere. And with that, I'll turn the call over to the operator.

Operator, Operator

Our first question will come from Doug Anmuth with JPMorgan.

Douglas Anmuth, Analyst

Sumit, maybe you could just talk about customer acquisitions a little bit. I know you said they remain above pre-pandemic levels. I'm not sure if you quantified perhaps at all relative to the 20% growth that you talked about in the first half of the year. And then related to that is your view on the higher LTV for the current cohort, is that essentially just driven by the higher NSPAC that you're seeing early on for that cohort? And then just perhaps on the cost side, any sense of visibility or how you're thinking about timing around easing of freight cost and product cost inflation, labor and I suppose the competitor pricing dynamics as well?

Sumit Singh, CEO

Sure, Doug. We have three questions here. Regarding the volume of acquisitions, they remain consistent with what we've previously reported, so there's not much new to share. The positive trend continues on the NSPAC front, and we didn't have any concerns about acquisitions during the third quarter. For the LTV, we're estimating this based on customer interactions with NSPAC. For instance, the customer cohort that we've had for a full year is now spending around $420 in NSPAC, which is higher than the three-quarter cohorts when compared to 2019. This serves as a useful data point. Additionally, we’re observing how customers engage with Autoship and how they are building their baskets while interacting with our new verticals. Altogether, this helps us project LTV. Typically, we’re accurate in this area as it informs our marketing investments, which subsequently influences our LTV to CAC ratios and enhances our marketing effectiveness and customer acquisition efforts. Now on to costs and timing. We're seeing three main types of costs. First, the flow of materials, both domestically and internationally, was affected in Q3, primarily due to port congestion and spikes in container rates. We experienced a threefold inflation increase in spot rates compared to Q1. Q3 also usually involves ramping up for the holiday season, which, combined with inflation, significantly impacted costs. We do see signs of improvement, and we expect to recover any expenses related to increased import freight management in the coming quarters. The second type of cost relates to product inflation, which we've discussed before; we saw an increase in both the rate and the volume affected by inflation. Given the price transparency in e-commerce, prices tend to catch up to costs gradually, and we need to manage this carefully to avoid impacting customer demand in the short term. We anticipate that it will take a few quarters for prices to adjust in the marketplace, depending on how competitors react to demand and set their prices. Therefore, we are cautiously observing the situation, and it’s challenging to provide a definitive timeline, but we don’t anticipate this being a long-term issue. Lastly, we are experiencing labor costs that are in line with industry trends. Our fill rates saw improvement after September as we expected, but we are still below the rates needed for optimal network operation. Currently, we do not foresee any near-term recovery in labor rates, and we will continue to monitor market signals as we move into 2022. More updates will follow as the situation evolves.

Operator, Operator

Our next question will come from Steph Wissink with Jefferies.

Steph Wissink, Analyst

Can we have two rated questions about marketing. The first is just on your marketing efficiency. It seemed like there was a nice step-up in efficiency in the quarter. I'm wondering how sustainable you think that is. Is that related to ad rates or just better precision around the money you're spending? And then related to that, I think you mentioned in your prepared remarks, there were some shortages that accounted for about $50 million of maybe missed revenue in the third quarter. Did you pull back on marketing because of shortages? Or was there an opportunity maybe to lean a little bit more heavily into marketing or can you in the coming quarter to try to drive either actives or NSPAC?

Sumit Singh, CEO

Steph, it's Sumit. I'll take that one. So your read on marketing in Q3 is exactly right. It was a combination of both ad costs reverting from their Q2 highs as well as the team executing just on a more targeted and just executing sharp. And we provided the details in the script around the way that we demand-generated across certain audiences and the way that our propensity modeling kicked in to be able to generate greater efficiency, which we also saw when customers came through our website. If you were to quantify the two, I would say, likely a 65-35 sort of ratio where ad costs probably were responsible for 60% of the improvement, 60%, 65%. And then the rest was our own efforts. In terms of sustainability, so far, Q4 is coming in line with our expectation. So we'll continue to monitor this. And any investments that we've baked in are already reflected in the way that we were providing guidance today. And yes, of course, when out-of-stocks escalate, it does reflect directly in the way that we go to market and spend marketing towards that particular set of assortment that then drives customer acquisition. So there was definitely opportunity, probably a few more million dollars that we could have spent in marketing. But outside of that, we optimized marketing to the full extent.

Operator, Operator

Our next question will come from Mark Mahaney with Evercore ISI.

Mark Mahaney, Analyst

I apologize for coming in late and I hope my questions aren't repetitive. At the end, you mentioned a new road involving the last two components of the roadmap, one being non-vet services. Can you remind us what would be included in that? Also, regarding the Trupanion deal, are you able to share any details about the economics? How should we interpret that? Our expectation from Evercore's side is that it could provide a significant boost over time in terms of gross margin for you. If you could discuss that and clarify who will own the customer relationship or who will record the revenue, it would help us understand the gross margin impact of the deal better.

Sumit Singh, CEO

Sure, Mark, this is Sumit. Your first question was about non-vet services. We see that market as encompassing everything outside of health care services, including boarding, grooming, and puppy training. We estimate this to be around $10 billion to $14 billion in total addressable market. Our approach won't require us to start from scratch to enter this vertical, thanks to the investments we've made in our architecture and technology for health care solutions. Essentially, we are building a scalable and dynamic platform that allows us to reach customers. Currently, you can think of our service providers as veterinarians, but in the future, we could easily extend that same service to providers like groomers. Thus, it’s not a completely new initiative for us; it’s more about focus and prioritization, which is why we believe it’s a matter of when, not if. Now, regarding the second part of your question about insurance, we haven't shared the full deal structure yet, but we’ll provide more details as we approach the launch in the spring. What I can share is that the deal involves a mix of cash and equity. We’ll make sure to adhere to Trupanion's internal rate of return guidelines, maximizing value while keeping within those bounds, with some compensation in cash and some in equity. The cash can be seen as a marketing or acquisition cost to support business growth and enhance customer conversion, education, and awareness. We’re essentially providing the customer base and platform, while Trupanion will handle the underwriting of the policies.

Operator, Operator

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

Brian Fitzgerald, Analyst

You kind of talked to us a little bit, but I wanted to ask about the reduction of the high end of the annual revenue guidance range. Could you walk us through the key factors influencing your thinking there? Is that supply chain issues and stock-outs or the need to get a little slower in marketing despite the improved efficiencies you're seeing given the various supply chain issues, cost pressures, SG&A and so forth? I want to drill down a little bit on the key drivers there.

Mario Marte, CFO

Sure. Brian, it's Mario. I'll address that question. As mentioned in the opening remarks, the consumer remains healthy and demand is strong. We are seeing positive trends in site traffic, conversion, customer acquisition, order volume, basket size, and purchasing frequency in the third quarter. Our updated guidance reflects what we're observing in the market, particularly as out-of-stock issues persist in some areas of our catalog. We anticipated additional capacity in the wet food category coming online by the third quarter, but that has not yet materialized, and supply has actually become more constrained than in the second quarter. So, the updated guidance simply reflects the current reality. It's important to note that we have consistently provided top line guidance throughout the pandemic, and despite the macro uncertainties related to supply chain and labor, we have been very accurate. Since going public, our net sales guidance has either hit or exceeded expectations, and in the last two quarters, we've stayed right in the middle of a very tight guidance range. Thus, we are reflecting the current reality concerning supply.

Operator, Operator

Our next question will come from Deepak Mathivanan with Wolfe Research.

Deepak Mathivanan, Analyst

Just a couple of ones from us. So first, on the NSPAC side, you're seeing nice benefits from the maturation of large COVID cohorts this year. But as we go into next year, what will be the main drivers of sustained NSPAC growth? I mean can NSPAC continue to grow at these rates as some of the larger cohorts mature further? And then the second question on the cost side, thanks for all the color on the cost side, in response to Doug's question. Could you elaborate on two areas? One is the aggressive competitor pricing that you noted in the prepared remarks. And then the second, the increase in freight cost that's kicking off in January. Maybe some color on how much they contributed to gross margin and how we should think about some preliminary expectations for gross margin trends for next year.

Mario Marte, CFO

It's Mario. I'll start off and maybe Sumit can address the second part of your question. Regarding NSPAC, I won't comment on 2022 just yet. However, looking at this year's developments, Sumit mentioned earlier that our 2020 cohort, which is substantial, has matured and is more engaged than previous cohorts, particularly compared to 2019. Their first-year revenue and purchases with us have exceeded those of the 2019 cohort. Additionally, the cohorts we acquired in 2021 are showing even higher first order values than last year, which had already outperformed 2019. Specifically, this year’s first orders are about 6% higher than the initial orders in 2020 and 13% higher than in 2019. Several factors contribute to this growth, including our expanded catalog and improved selection for customers. We've broadened our categories and developed our proprietary brand catalog, targeting products that previously weren't available in the market. Our pharmacy business is also performing well, and as more customers utilize this service, NSPAC increases. This growth is reflected in our revenue breakdown in the 10-Q. Our other category, which includes proprietary brands and pharmacy, is growing nearly twice as fast as the rest of the business. So, there’s catalog expansion, category expansion, and we are enhancing our ability to present customers with what they want when they want it, allowing us to keep expanding NSPAC. Sumit, do you want to talk about the contract?

Sumit Singh, CEO

Deepak, you had two questions in your second question. I'm not sure I fully followed the competitive pricing comments, I'll have you repeat that, but let me offer you the FedEx answer first. So logistics companies, as you know, were very clear in their recent earnings calls that they were looking to raise rates in 2022. And we recently completed negotiations on a new contract that goes into effect in January, and we will see outbound shipping rates in 2022 go up under this calendar. That said, we're pleased with our new contract, as pleased as we can be, and believe that our new rate card, while higher, remains favorable relative to the broader market. It's too early to quantify the impact of gross margin, impact of these higher rates, given the many factors that will ultimately drive our outbound freight costs in '22 including volume, average shipping distance and others, plus we're very actively still dealing with many macro uncertainties and constraints. So we'll have more details to share with you in the next quarter when we provide 2022 guidance.

Deepak Mathivanan, Analyst

Got it. Yes. Sumit, the first part was, basically, you noted one of the factors of gross margin that impacted gross margins were aggressive competitive pricing. Is that just related to the product inflation that you're not seeing some competitors kind of follow in the marketplace? Or is there something else, maybe one competitor is being aggressive with prices more broadly?

Sumit Singh, CEO

Is that a Q3 question you're asking? Or is that a carryover from Q2 that you're asking about?

Deepak Mathivanan, Analyst

Q3 question.

Sumit Singh, CEO

What we're essentially stating is that there is a delay between MAP and the increases in cost inflation because it takes some time for the MAP pricing, which sets the market floor, to be reflected in the online channels. Additionally, the range of cost inflation that has emerged usually needs to be gradually integrated back into the market to avoid affecting demand or momentum. Any past comments on pricing have been related to a subdued pricing environment and the absence of promotions and discounts due to supply chain issues. We have observed some easing of these constraints, particularly as we transition from Q3 to Q4, which typically sees a more seasonal and demand-sensitive period. However, this phenomenon has not completely dissipated yet.

Operator, Operator

Our next question will come from Dylan Carden with William Blair.

Dylan Carden, Analyst

Just curious the comments about stable NSPAC fourth quarter to third quarter. Was that meant to be in dollar terms or sequential or annual growth? I'm just curious when the sort of churn overhang eases. Should we start seeing that by the fourth quarter? Or do we really need to get into 2022? And then finally, related on the gross adds running higher than sort of pre-pandemic levels. Do you attribute that to still some benefit in that there's some broader sort of consumer anxiety and being in stores? Or do you think that's actually now at this point, more organic online migration?

Mario Marte, CFO

Dylan, this is Mario. I'll start, and then Sumit can add to my response. Regarding the stable NSPAC, I am not sure, and I don't think I mentioned it. So, I would appreciate clarification on that. Let's begin with that.

Dylan Carden, Analyst

Yes. Sorry, that might have just been me being distracted. I thought the comment was that NSPAC growth would be stable 3Q versus 4Q. And I was just wondering if that was in dollar terms or if you think maybe you'll get 15% sort of steady-state growth into the next quarter?

Mario Marte, CFO

So actually, I would maybe flip that, Dylan, and say that we expect NSPAC growth to continue to be strong through the rest of the year. That's maybe more of the takeaway there. You can see that in our sales guidance and obviously where we're trending in terms of active customers for the year. In terms of the overhang, you really have to get into 2022. And the reason being is that when we look at the 2020 cohort, very large cohort like we talked about before, it was pretty evenly spaced throughout the year. And so any first-year into second-year attrition that we normally see with every cohort from the beginning of the company, we're going to see that happen throughout this year. So the impact will continue to be through 2021, and we should work through that as we enter 2022. Yes, I'll address this and then Sumit can add anything if needed. We're increasing our investments, which is evident in our financials, to help more people discover us. We're not only benefiting from the shift to online, but we're also assisting customers in finding us and locating the products and services they need online.

Sumit Singh, CEO

Yes, Dylan, I believe we are not comparing apples and oranges here. We are strictly looking at the organic state that existed until 2019 and comparing that to the same organic state now. I don't think we're deriving any advantage from the pandemic or its ongoing effects in this particular situation.

Operator, Operator

Our next question will come from Nathaniel Feather with Morgan Stanley.

Nathaniel Feather, Analyst

This is Nathan Feather on for Lauren Schenk. I know in the past, you guys have talked about being more of a price taker in the market. Given the inflationary environment, is there any change in your price strategy? Or is that broadly similar? And then are you able to quantify to what extent you're flowing through this increased cost and prices? Or how much that delay between the change in MAP pricing and the actualization within prices affects revenue?

Sumit Singh, CEO

Sure. There's not much more to add beyond what I've already shared. To avoid being repetitive, we are ensuring that our pricing remains competitive, typically in accordance with MAP guidelines. We believe this is essential for maintaining customer trust in the marketplace and supporting our brand. Regarding MAP and the alignment of costs and prices, we aren't yet estimating how many quarters this might take. For some large consumable brands, MAP has already adjusted and fully aligned. Therefore, we will need to monitor this on an individual basis and across different portfolios. This will also depend on the balance of demand and supply as inventory moves through the market and how quickly this situation resolves. As we progress through Q4, we will provide further updates in the March earnings call.

Operator, Operator

Our next question will come from Eric Sheridan with Goldman Sachs.

Eric Sheridan, Analyst

Maybe just one question on the health side of the equation. You gave the stat around 15% as the overlap between core customers and health customers. Can you give us a little bit sense of how you want to align investments, especially on the marketing side to drive adoption of the health initiatives and create a sort of larger Venn diagram between the customer sets as we look out to 2022 and beyond?

Sumit Singh, CEO

Eric, this is Sumit. Our approach involves investing as much as possible until we achieve a return. As you know, this is a legacy category, and the shift to online has been gradual until we significantly enhance the customer experience online. This improvement is driving a different online migration rate compared to what consumers are accustomed to, particularly in buying dog food and accessories. This affects the conversion we are working on. We are balancing our investments, conversion efforts, and the returns we see. We have noted that healthcare customers tend to be more profitable and have a higher lifetime value due to their ongoing needs. Consequently, this allows us to accept higher marketing costs per healthcare customer. Our strategy revolves around the lifetime value compared to customer acquisition cost, and we don’t adhere to a strict budget; we invest as long as we see a return. This remains a high priority for us. You will notice that we are offering a variety of choices. If you're looking for insurance, we provide that. If you need telehealth services, we can facilitate that. For pharmacy prescriptions, we offer an exceptional customer experience. If you need subscriptions for veterinary diets, we can assist with that, too. Overall, think of us as building an ecosystem with multiple facets that attracts customers in various ways, keeps them engaged, and connects them within the veterinary community to drive growth in healthcare.

Mario Marte, CFO

And Eric, this is Mario. It's good to hear your voice. Last time we discussed the overlap, it was about 10%. You can see the progress we're making in getting more of our customers to shop across various categories on our platform.

Operator, Operator

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

Seth Basham, Analyst

My first question is just around the gross adds that you mentioned. So you said that they're higher than 2019. Last quarter, you said that the first half was up about 20% versus 2019. Year-to-date now, are they still up 20% versus 2019?

Mario Marte, CFO

Yes. I think Sumit answered that question a few minutes ago, noting that they are still roughly in line with what we had shared with you previously.

Seth Basham, Analyst

So in line with the rate of the second quarter or 20% versus 2019?

Sumit Singh, CEO

It's not a metric that we're planning on repeating every quarter. I think the perspective was important and slightly different when we shared it last time, but mostly customer adds continue to run above 2019 and very much in line with what we've seen so far throughout the rest of the year as well throughout the preceding year as well.

Operator, Operator

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

Peter Keith, Analyst

Looking at the guidance for EBITDA margin to remain flat, we anticipate Q4 EBITDA margin will decrease by about 300 basis points compared to last year. I wonder if this marks the lowest point for margin decline, considering potential factors in Q4 like hardgoods or freight wages. Could you provide some clarity on this? Or is it likely that this pressure will persist into next year?

Sumit Singh, CEO

The answer essentially lies in a combination of how we see Chewy's progress. Since our IPO, gross margin has expanded by 700 basis points, and marketing has scaled by roughly 400 basis points. SG&A was on track to scale until we began absorbing the costs resulting from the pandemic. Moving forward, we still have room to expand gross margin while also addressing the challenges of rising freight costs and the inflation we discussed today. We continue to maintain marketing efficiency, which leads us back to EBITDA and SG&A. We incurred about $100 million in investments in 2020, and until the labor markets stabilize or imports improve, it's challenging to assess the current state of SG&A. All of this is factored into our EBITDA guidance for the year. If you have a more specific question, I would be happy to address it.

Peter Keith, Analyst

Sure. Maybe I'll just focus specifically on gross margin. You're not guiding for gross margin. But it seems like what you're talking about with ocean freight pressure in the competitive environment that gross margin is going to be abnormally pressured in the fourth quarter. So can you confirm that? And then are these pressures peaking in the fourth quarter? Maybe hardgood mix come down a little bit as we get into the early part of next year, and so the overall gross margin pressure abates somewhat.

Mario Marte, CFO

Certainly, this is Mario. I won't comment on 2022 just yet, but as we discussed in relation to the Q3 results, some cost challenges are persisting into the fourth quarter. We expect these issues to continue affecting gross margin. When comparing to last year, in Q4 we had a one-time $16 million reserve release that impacted EBITDA, so we need to consider that. This year, we are also facing higher labor costs that are expected to persist into the fourth quarter, and unlike the second half of last year, these costs did not decrease in Q3. For Q4, we now anticipate labor costs to be around $13 million, down from the $15 million we had previously projected during the second quarter call. Thus, excluding the one-time item, gross margin will remain under pressure in the near term due to these higher labor costs, which lays out the situation for the fourth quarter.

Operator, Operator

Our next question will come from Rick Patel with Credit Suisse.

Rakesh Patel, Analyst

I'm hoping we can zoom out and we can talk about how you see NSPAC trending in the future relative to your IPO plan. So historically, I believe when you acquire a new customer, year one spend is between $150 to $200, jumps to $300 in year two and so on. But the curve has obviously shifted higher. So just curious what's the right way to think about spend for newer cohorts as we think about their multiyear journey with you?

Mario Marte, CFO

Spend to acquire those customers? Or you mean their spend? Yes, the NSPAC. Yes. So I answered this question a few minutes ago. I won't comment on 2022 and beyond at this point. But I can tell you that what we're seeing from customers that we acquired last year and that we acquired this year is that their NSPAC curves are shifting up. One of the things that we talked about before is that the way we improve LTV to CAC for our customers over time or accelerated payback period is by acquiring more of the share of wallet earlier, moving up the NSPAC and making every order more profitable. We're doing exactly that. Over the last two years, you've seen us expand gross margin by 300 basis points roughly. And year-over-year, we're looking to increase gross margin. You've seen us also increase NSPAC. And we've talked about specifically for cohorts in 2020 and 2021 and how their NSPAC is moving up. So normally, we are grabbing more of the share of wallet from those customers, then also moving out the overall curve and we're making those orders or those dollars more profitable. All of that helps us in the payback period. All of that helps us in improving the LTV to CAC. And so these are very good indicators for us this early on in their journey.

Operator, Operator

Our next question will come from Chris Bottiglieri with BNP Paribas Exane.

Christopher Bottiglieri, Analyst

So first one is just more high level on the Trupanion partnership. Should we view this as an isolated high-margin revenue stream? Or are there meaningful synergies with your broader health offering? Trying to understand if there's incentives in place for insurance to use telehealth, Rx drugs, or even to refer some of these pet insurance customers towards Practice Hub. Can you give us any sense of the strategic view there that would be helpful?

Sumit Singh, CEO

We believe the value of insurance is twofold. Currently, pet insurance penetration in the U.S. is between 2% and 3%, while in the U.K. it exceeds 25%. This represents a significant opportunity for expanding our total addressable market. We anticipate that insurance will not only become a profit center on its own but will also enhance customer engagement, brand loyalty, and lead to increased consideration for healthcare purchases made through our platforms. We still have a lot of innovation ahead, with plans to launch in the spring and expand on a state-by-state basis. There will be many chances for us to discuss our plans, the value proposition, and our marketing strategies as we talk to both customers and veterinarians. Overall, it's important to understand that this will be a long-term strategy aimed at boosting engagement and consideration for healthcare purchases through our platforms.

Christopher Bottiglieri, Analyst

Got you. That's really helpful. And then just the last one, I'm not sure if you can answer this or willing to answer it. But can you give us a sort of sense that there's obviously a difference between MAP pricing and the hardgood side. Can you give us a sense of either cost inflation or price inflation, how that compares between the two and overall, I think just throughout retail, we're seeing somewhere between 4% and 7% inflation in a lot of our categories. Just trying to get a sense of where that stands for pet and how that's impacting NSPAC.

Sumit Singh, CEO

That's actually a pretty good range. Our upper end of the range goes up to 9%, but that's been fairly well organized.

Operator, Operator

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

Sumit Singh, CEO

Thank you very much. We hope you have a happy, healthy and safe holidays. Thank you.

Operator, Operator

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