Earnings Call Transcript - CHWY Q2 2021

Operator, Operator

Good afternoon, and welcome to the Chewy Second Quarter 2021 Earnings Conference Call. All participants will be in listen-only mode. Please note, this event is being recorded. I would now like to turn the conference over to Bob LaFleur, Vice President of Investor Relations. Please go ahead.

Bob LaFleur, Vice President of Investor Relations

Thank you for joining us on the call today to discuss our second 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 items 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 a substitute for GAAP results. Additionally, unless otherwise noted, results discussed today refer to second quarter 2021, and all comparisons are accordingly against the second 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. We have now crossed the halfway point of 2021, and our results once again demonstrate the strength of our business model and the incredible bond between pets and pet parents. Our business remains healthy, customer engagement continues to grow, and we are confident in our ability to build upon the strong results we delivered last year, while navigating the uncertain market conditions due to the ever-evolving COVID-19 pandemic. Let's start with our second quarter results. Q2 net sales rose 27% to $2.16 billion. To gain an even greater appreciation of our top line momentum, we believe it is also insightful to look at our net sales growth on a two-year stack basis. Through this view, Q2 2021 net sales grew at a two-year CAGR of 37%. We ended Q2 with 20.1 million customers, a year-over-year increase of 21% or 29% on a two-year CAGR. Gross customer adds are running higher than pre-pandemic levels, but below the record levels we saw last year during the peak of the pandemic-driven lockdowns. In fact, year-to-date, we have acquired approximately 20% more new customers than we did in the first half of 2019 prior to the pandemic. Our retention rates remained stable as well. In addition to the number of customers we add, customer spending is equally as important to our growth equation. Second quarter net sales per active customer or NSPAC increased 14% to $404. This is a meaningful acceleration over the growth we reported in the first quarter and the first time in the Company's history that NSPAC has surpassed $400. We have increased share of wallet from every cohort we've added to our platform over the past 10 years, and our long-term revenue retention levels from each cohort remain well above 100%. As a result, our base of recurring revenues grows over time as the revenue produced by each cohort stacks on top of one another, like the layers of a cake. Because revenue retention is above 100%, each new cohort's contribution to net sales is completely incremental to the base. This dynamic, combined with our ability to consistently improve margins, creates a powerful long-term growth and profitability flywheel. Returning to our second quarter results. Gross margin expanded 200 basis points to 27.5%. Driving 200 basis points of gross margin improvement in this difficult operating environment reflects our focused execution across multiple customer offerings and the strong and recurring purchase behaviors of our customers over time, combined with the benefits of our scale. The pricing and promotion environment remained stable throughout Q2, and we estimated that this benefited gross margins by approximately 50 basis points. As was the case across much of the economy, labor market challenges persisted throughout Q2. This impeded our ability to staff our fulfillment centers at desired levels and achieve optimal productivity. Aligned with the expectations we shared with you on previous earnings calls, we increased our investments in wages, benefits, and hiring incentives across our fulfillment network in order to maintain customer experience and business continuity. As a result of these increased investments, Q2 SG&A leverage was minimal. Marketing is an area where the landscape evolved rapidly in Q2. The 80 basis point increase in advertising and marketing expenses as a percent of net sales in Q2 is the result of two main drivers. The first is the sharp recovery of input costs across advertising platforms. While this was expected to some degree, the magnitude of increase in Q2 was unprecedented. And second, seeing early signs of benefits from our continuous learning approach, we invested dollars into the opening of new marketing channels, which we believe will drive incremental long-term customer acquisition and build brand awareness. Usually, we see a couple of quarters lag between the initial investment in a new marketing channel and the realization of returns as those channels scale. The Q2 gross margin gains that were driven by our strong operating performance more than offset the environmental challenges from higher fulfillment center labor costs and elevated marketing expenses, and Q2 adjusted EBITDA margin expanded 20 basis points to 1.1%, and adjusted EBITDA increased 51% to $23.3 million. Mario will provide more color to this line item. Next, I'm excited to share some of the many innovations we've been working on at Chewy. These initiatives are improving operational efficiency, driving higher customer engagement, and advancing sustainability. Collectively, we believe these efforts will unlock additional top line growth and support long-term profitability. Let me start by updating you on the latest developments across our fulfillment network. We recently announced that our 14th fulfillment center and fourth automated fulfillment center will open near Nashville, Tennessee, in the fall of 2022. Nashville now joins Kansas City and Reno in the pipeline of fulfillment centers that we will open over the next 12 to 14 months. Additional efficiency-driving measures include technology, which custom makes boxes based on the size of the contents. This process is not only faster than manual pack-and-ship, but it also reduces the amount of corrugate and packaging materials used per order, which then reduces costs and is better for the environment. We are also refining our pick, pack, and ship processes to reduce the time spent configuring box content, which helps expedite how quickly packages leave our fulfillment centers. Collectively, once these three automated facilities and efficiency measures are fully ramped, we expect that increased fulfillment productivity will produce 40 to 60 basis points of incremental SG&A operating leverage and reduce our future exposure to labor market volatility. We are also deploying new software across our fulfillment center network to improve productivity, reduce per unit fulfillment costs, and positively impact sustainability. For example, in the second quarter, we launched proprietary machine learning-driven software, which streamlines order routing and allocation across our growing fulfillment center network to optimize shipment volume, customer promise, and cost to fulfill. At our current scale, the fully realized benefits from this proprietary software are expected to be between 30 and 50 basis points of margin improvement. Once fully ramped across our fulfillment center network, we expect these initiatives to contribute a combined 70 to 110 basis points of incremental adjusted EBITDA margin. Moreover, these efforts have become increasingly relevant as labor markets remain challenged, transportation networks become capacity constrained, and inflationary pressures on freight costs begin to rise. Moving on to Chewy Health, we continue to think big and innovate rapidly to serve our growing base of customers and veterinarian partners. First, we are very excited to launch a marketplace for veterinarians directly on chewy.com to help them grow clinic revenues and improve experiences for pet parents. This revolutionary free service enables veterinarians to choose items to list on chewy.com, set prices, create preapproved prescriptions, and earn revenue when customers place an order in clinic or purchase from them via Chewy. Moreover, the service allows millions of Chewy customers to purchase pet medications directly from their veterinarian while shopping on chewy.com with fast, free shipping directly from our nationwide network of fulfillment centers. What is even more exciting is that the back-end prescription management capability of this platform is powered by a Petscriptions product, which is currently in use at more than 8,000 clinics across the country. Collectively, we are branding this innovative new platform as Practice Hub, through which we are offering veterinarians a complete e-commerce solution for their customers. Practice Hub leverages the benefits of our quick and reliable delivery, unparalleled customer care, and convenient Autoship subscription service. We look forward to sharing more details with you in our future earnings calls. Second, we are pleased to announce that our third Chewy Pharmacy will open later this year. This new facility located in Pittston, Pennsylvania, will provide fulfillment services for pet medications and special dietary food, providing Chewy Health customers in the Northeast and Mid-Atlantic with even faster delivery of pet prescriptions and other health and wellness products. Last but not least, we continue to be pleased with the ramp of our Compounding Pharmacy service since its launch last fall. It is still early days, but the results thus far are confirming our investment thesis. Compounding net sales increased by almost 50% sequentially between Q1 and Q2 on increased order volume and larger basket sizes. And Autoship penetration increased over 250 basis points over the same period. More importantly, Compounding is attracting new customers to Chewy Health, with 65% of new Compounding customers either being new to Chewy entirely or existing Chewy customers who are first-time healthcare consumers. Services like Compounding, which at the present moment, are available only to our end customers, show how Chewy is uniquely positioned to assist pet parents who need customized solutions in an otherwise limited marketplace. Here at Chewy, we are pleased with and proud of our progress in the pet healthcare space. With every innovation that proves customer or vet experience, we progress one step closer to fulfilling our mission to make pet healthcare more affordable and accessible for every pet parent in the country, and we are doing so by keeping veterinarians at the center of the equation. Further, each new product or service that we launch to benefit our customers or vet partners further positions us as the only player in the pet industry building out a full pet healthcare ecosystem that effectively services both pet parents and veterinarians. In doing so, we are positioning ourselves to assume market leadership in the $35 billion TAM. Our pet health and wellness offerings from Chewy Health include OTC medicines, veterinary diet, pharmacy, Compounding medication, telehealth, Petscriptions, and now Practice Hub, a unique and innovative marketplace that provides the vet community a complete e-commerce solution that leverages all the strengths of chewy.com. More importantly, we are just getting started. In addition to what we have shared today, we are working on multiple new initiatives across Chewy Health, and we look forward to sharing these with you in the not-too-distant future. Let's exit these innovation updates with a brief check-in on our newest launch of fresh prepared foods. Our expansion in the fresh and prepared food space continues as planned. The launch is still in early days, and we are refining the product and service offerings based on customer feedback, keeping food safety and customer experience top of mind. Here are a few data points to apprise you of the ramp. We can now successfully ship product in custom designed sustainable packaging to customers across 25 states, covering 56% of the U.S. population. Overall customer feedback is positive, and we continue to fine-tune our product and service offering based on this feedback. Fresh and prepared Autoship sales as a percent of net sales are already approaching 50%. With fresh and prepared foods, we intend to deliver a customer experience that will rival how pet parents shop today by offering them a broad selection, great prices, and the unparalleled convenience and customer service that are Chewy's hallmarks. I will conclude my remarks by reiterating my confidence in our second half outlook. Despite the uncertainty of the current operating environment, we continue to execute our business plan with rigor and enthusiasm. Our fundamental growth drivers, expanding our customer base, increasing share of wallet, and building out our highly profitable verticals remain intact. We continue to drive year-over-year improvements in key metrics like net sales, gross margin, adjusted EBITDA margin, NSPAC, and free cash flow. And finally, amidst all the ongoing uncertainty, the Chewy team remains as relentless and customer-obsessed as ever, delivering new and exciting experiences to our pet parents and delivering top and bottom line growth for our shareholders. With that, I will now turn the call over to Mario.

Mario Marte, CFO

Thank you, Sumit. I am happy to share our results as the execution of our long-term growth strategy continues to bear fruit. Beginning with our top line results, second quarter net sales were $2.16 billion, representing 26.8% growth. On a two-year stack basis, Q2 2021 sales were $1 billion higher than the second quarter of 2019. Out of stock levels remained elevated in the second quarter, but they improved modestly versus the first quarter, resulting in a smaller drag on net sales in Q2. This is a result of supply chain conditions improving in some areas as certain vendors reduced backlogs. However, other areas like wet dog food are still being affected by industry-wide production capacity limitations. Second quarter Autoship customer sales increased 30.3% to $1.51 billion or a 37.6% CAGR over the last two years. Second quarter Autoship customer sales as a percentage of net sales increased 200 basis points to 70.3%. This improvement in Autoship penetration rate reflects the maturation of the 2020 customer cohort in Autoship's growing value proposition. Active customers were 20.1 million at the end of Q2, an increase of 21.1% 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. As Sumit mentioned, year-to-date gross customer adds are running 20% above the comparable pre-pandemic period in 2019, and retention rates are stable. To better demonstrate the dynamics of new customer adds and retention as they relate to net active customer adds, we have included a supplemental section on this topic in our shareholder letter this quarter. Second quarter net sales per active customer or NSPAC increased $48 or 13.5% to $404. This was a $16 sequential increase over Q1. On an absolute dollar basis, both the year-over-year and sequential NSPAC increases were the largest in the Company's history. We expect that NSPAC growth will remain strong for the balance of the year as the 2020 cohort continues to mature, and we expand our customer offerings. Moving down to the income statement, second quarter gross margin increased 200 basis points to 27.5%. Delivering 200 basis points of gross margin expansion in the current environment is a strong testament to our ability to scale our operations, increase share of wallet, and build a strong recurring revenue base by delivering best-in-class customer service to each and every pet parent. Second quarter operating expenses, which include SG&A and advertising and marketing, were $609.6 million or 28.3% of net sales compared to 27.4% in the second quarter 2020. The increase reflects the incremental investments we made in both SG&A to overcome the current demand and supply imbalance in labor markets, and in marketing. I will expand on both of these areas next. SG&A, which includes all fulfillment and customer service costs, credit card processing fees, corporate overhead, and share-based compensation, totaled $437.7 million in the second quarter or 20.3% of net sales compared to 20.2% in the second quarter of 2020. SG&A, excluding share-based compensation, totaled $412.1 million in the second quarter of 2021 or 19.1% of net sales, an increase of 110 basis points. This increase reflects the incremental $30 million we invested in wages, hiring incentives, and recruiting in the second quarter. Not only was it budget that's been in line with the Q2 expectations we outlined on our last earnings call, but it is also approximately twice as much as we spent on these items in the first quarter. Without this $30 million of additional labor expenses, second quarter SG&A, excluding share-based compensation, would have scaled 30 basis points year-over-year to 17.7% of net sales. Said differently, the permanent leverage in SG&A that we have delivered and expect to deliver in the future is being offset by temporary macro factors that are driving incremental costs. This demonstrates our ability to fund needed fulfillment capacity and still leverage operating expenses. We believe that the investments we are making in our team members, automation, and technology will drive higher engagement, retention, and productivity, enabling us to effectively scale SG&A over the long term. Second quarter advertising and marketing was $172 million or 8% of net sales, an 80 basis point increase versus second quarter 2020. While we expected an increase in this line item as ad rates have been on an upward trend since bottoming out in early 2020, and organic customer growth rates have returned to pre-pandemic levels, the rate of increase we saw in Q2 was unprecedented, even for the seasonally strong quarter. As we enter the third quarter, ad rates have moderated somewhat, but still remain above Q1 levels. It is worth noting that even with these two factors at play, when we take a two-year view, marketing spend in the second quarter scaled 160 basis points, while at the same time, we acquired more customers in the second quarter of this year than we did in second quarter 2019. What this reflects is the efficacy of our marketing spend, which primarily focuses on acquiring and then developing customers to produce higher levels of profitable sales that increase the longer they stay with us. As a result, marketing scales as we grow. This, combined with improvements in gross margin, drives our LTV to DPAC ratios over time. Second quarter net loss was $16.7 million, improving $16.1 million versus the second quarter of 2020, and net margin improved 110 basis points to a negative 0.8%. Adjusted EBITDA was $23.3 million, improving $7.8 million versus the second quarter of 2020, and adjusted EBITDA margin improved 20 basis points to 1.1%. As we have previously shared, we expect to make gradual and incremental improvements in profitability on an annual basis while retaining the flexibility to make short-term investments in a given quarter for the long-term benefit of the Company and our shareholders. Moving on to free cash flow. Second quarter free cash flow was $60.3 million, reflecting $85.1 million in positive cash flow from operating activities and $24.8 million of capital expenditures. The positive operating cash in Q2 was primarily a function of favorable working capital, only partially offset by growth in our inventory levels as we work to protect our supply chain. Capital investments included additions to our fulfillment network, including cash outlays for our new fulfillment centers in Pennsylvania and Kansas City, as well as ongoing IT projects. We finished the quarter with $725 million of cash and cash equivalents on the balance sheet and no debt. In addition, we recently upsized our ABL facility to $500 million. This facility remains undrawn, and combined with our cash on hand, provides us over $1.2 billion in available liquidity. That concludes my second quarter recap. So now let's discuss our third quarter and full-year guidance. Environmental crosscurrents continue to make precision forecasting difficult. Macro conditions seem to be improving as vaccination levels increased, although the Delta variant is clouding that picture. At the same time, supply chain and labor market challenges remain, and no one really knows how long or to what extent these might prevail. Still, there's a lot to be bullish about as the trends toward increased pet ownership, higher per pet spending, and a category shift towards online all remain positive. Consumers may have started redirecting some of their discretionary spending back to areas like travel or dining out, but on the whole, spending on the family pet isn't really discretionary. While there may be a few less indulgences on treats and toys as we return to the office and some consumers might cross-shop more as they venture out and about, we don't believe that it's going to alter the long-term trajectory of the pet category's ongoing shift towards greater online penetration. In fact, Chewy's growing product and service offerings, compelling value proposition, and unparalleled customer service have positioned us well to capitalize on the industry's expected growth and to keep gaining market share as sales continue to migrate online. Despite the elevated opacity of the current operating environment, we remain confident in our ability to deliver another year of strong top line growth and adjusted EBITDA margin expansion. With that, we are reiterating our full-year top and bottom line outlook as follows. We expect third quarter net sales to be between $2.20 billion and $2.22 billion, representing 23% to 25% year-over-year growth. We expect our full-year 2021 net sales to be between $8.9 billion and $9.0 billion, representing 25% to 26% year-over-year growth. And finally, we expect our full-year 2021 adjusted EBITDA margin to expand between 80 and 120 basis points. As you update your models, please keep the following in mind. We still expect to add more new customers this year than we did in 2019, but not as many as we did during the pandemic last year. Normal attrition rates for a cohort as large as 2020 create a meaningful headwind against net active customer adds this year. We expect this to be a one-year phenomenon and the delta between gross and net adds is anticipated to normalize next year. As I mentioned, we added a supplemental section on this topic to our shareholder letter this quarter. So please check that out for more details on the mechanics and math behind net active customer adds. Additionally, if the current labor shortages persist, they may lead to delays in orders leaving our fulfillment centers, similar to what we saw in the second quarter of last year, as demand surged and shipments lagged. This could affect reported net sales because we do not book the revenue from an order until it ships. To be clear, this simply affects the timing of when sales are recognized, as reported revenue shifts from one quarter into the next. Any potential inter-quarter revenue facing is not incorporated into our current guidance, and improvements in the labor market could reduce or fully mitigate any risk. As we continue to execute against our strategic plan of increasing scale, growing share of wallet, and expanding our product and service offerings, we remain focused on operational discipline and on driving meaningful margin expansion. Our 2021 guidance reflects net sales growth of 25% or better and adjusted EBITDA that is approximately 2x what we generated last year. We are delivering incremental profitability; at the same time, we are making meaningful investments in the infrastructure that will support our growth as evidenced by the fact that we will nearly double our fulfillment footprint in two years. In short, we are bullish about Chewy's future.

Operator, Operator

We will now begin the question-and-answer session. Our first question today comes from Steph Wissink with Jefferies.

Steph Wissink, Analyst

Thank you. Good afternoon everyone. We have two questions. One is more of a technical question just on your comments on the wet food still being limited. If you could just talk a little bit about what you think that might have been as an impact to Q2 sales? And then maybe if you could talk a little bit about the NSPAC, it seems like it's coming in much stronger than we would have expected even at this point in your maturation. So talk a little bit about how you're thinking about NSPAC contribution? I think you mentioned balance across net adds and NSPAC. But how are you thinking about NSPAC over the back half of the year and then maybe as we think about 2022?

Sumit Singh, CEO

Hi, Steph, this is Sumit. I'll take the first one. Mario will take the second one. We estimate the impact to be lower than Q1 and in the range of $25 million to $30 million for wet food production.

Mario Marte, CFO

Steph, this is Mario. I'll address the second part. You're correct that the strength in NSPAC is significant. The $404 we reported in the second quarter represents the fastest growth we've seen in that metric, both sequentially and year-over-year. To provide more context on NSPAC, let's look at the cohort that joined us in the first half of 2020, which we've discussed previously. We now have a full year of data for that cohort, and their NSPAC over the past four quarters is over $400. This figure surpasses that of the cohorts from 2019 in their first year following acquisition. This supports our hypothesis that these customers would spend more upfront and that their future spending would also be higher. If we consider the NSPAC curve we've shared before, we believe it has shifted upwards for this cohort, which is a positive sign. We also posited that the 2020 cohort would achieve lifetime value profiles as strong as, or stronger than, previous cohorts, and thus far, this appears to be true. Looking at customer behavior overall, the average spend per new customer in the second quarter was higher than last year, indicating that this average continues to rise year-over-year, a trend we've observed in recent quarters. Autoship sign-up rates remain strong and exceed last year's levels, and the average basket size is above pre-pandemic levels. The sales mix within our basket size is contributing to gross margin expansion, with all these metrics positively impacting various line items. Additionally, if we examine customer behavior over a longer trend, it's clear that customers tend to spend more the longer they remain with us, a pattern we've seen consistently since our inception. For instance, every cohort acquired in 2015 and prior has an NSPAC exceeding $800 in the last 12 months. All indicators and metrics we are observing continue to demonstrate positive trends.

Operator, Operator

Our next question comes from Mark Mahaney with Evercore ISI.

Mark Mahaney, Analyst

Thanks. I have a couple of questions. First, you mentioned exploring new marketing channels, but you didn't specify what those are. Can you provide more details on that?

Sumit Singh, CEO

Hey, Mark, this is Sumit. No, we haven't provided color on those, Mark. Just on the basis of sensitivity and information that we're still kind of experimenting and don't want to reveal publicly at this point.

Mark Mahaney, Analyst

Okay. Understood. Then let me switch. These elevated costs you're seeing in labor and marketing, there's no particular reason why you have visibility as to when those would change. Like as you think about it, to the extent to which they're temporary or permanent, I don't think there's a way to answer that, but do you have a strong point of view as to whether those elevated costs in both of those areas are things that are they permanent? Or is it after three or four quarters those should abate, any opinion on that?

Sumit Singh, CEO

When you say both areas, you mean labor and which one is the second area?

Mark Mahaney, Analyst

And Mario, you talked about rising ad costs, price per ad.

Sumit Singh, CEO

Sure. Let me explain both aspects. Regarding labor, we don't have complete visibility. We're analyzing data from markets with fulfillment centers and comparing it to our forecasts and the incoming fill rates, both short and long-term. We've examined how the expiration of pandemic or federal benefits has affected our labor inflow on an index basis. So far, we've noticed that states where these benefits have ended have shown an improvement of approximately 25% to 35% in labor fill rates. However, this data is empirical, and we are gathering it from various sources while closely monitoring the situation. We lack full confidence in how it will change but expect labor markets to clarify over the next few weeks, allowing us to progress into Q3 optimally. For now, we're maintaining our investment levels to ensure business continuity and customer experience in managing shipments. Turning to marketing, the landscape changed rapidly in Q2, particularly in terms of ad cost recovery and improving participation rates from all online and retail players. The rate of change was unprecedented, and I will provide more details shortly. Overall, shopper demand in the online pet category in Q2 was relatively flat to slightly down compared to last year, but it began to improve in late July and has continued into August. Despite the overall industry facing flat to declining traffic, Chewy's traffic increased by about 20 percentage points more than the overall industry, which shows a healthy influx of customers and indicates we are gaining market share as the year progresses. In Q2, the softness in the online segment coincided with May and June, during which searches for travel, restaurants, and local retailers peaked, as customers began to venture out leading up to the Delta variant. To address this online traffic decline and encourage consumers to return to pre-pandemic shopping habits, both retailers and e-tailers increased their marketing expenditures on paid channels and engaged in promotional events throughout Q2. Consequently, we observed rising costs across the board. For context, Google cost-per-click in the pet supplies category increased by 51% year-to-date, and Facebook's average ad prices rose by 47% year-over-year. In the pet sector, we estimate that cost per thousand impressions increased by over 80% year-over-year during these months, marking the highest annual increases we've seen in this area. To conclude, we don't adhere to a predetermined marketing budget; instead, we allow returns and the ratios of customer lifetime value to customer acquisition cost to dictate our payback strategies. Overall, we spent about 50 basis points or $11 million more than our internal forecast primarily due to rising ad costs. As we transition from Q2 to Q3, ad costs have decreased, now below Q2's peak but still above Q1 levels. This summarizes our outlook as we enter Q2.

Mark Mahaney, Analyst

And sorry, one last quick question. Thanks a ton for that page, that's Slide 17. I appreciate the simple math behind that. In your press release and shareholder letter, when you mentioned that retention rates are consistent, does that mean the churn rates are also relatively consistent, and are you using the same terminology there?

Sumit Singh, CEO

Yes. Yes, we're.

Operator, Operator

Our next question comes from Doug Anmuth with JP Morgan.

Doug Anmuth, Analyst

Thanks for taking the question. I have two. First, just on customer additions, would you still expect 2021 to return to pre-COVID or 2019 type of levels, which would suggest bigger sequential pickup in the back half? Or is the composition of how you get that revenue a little bit different with customers somewhat below that and then just the higher NSPAC that you're seeing? And then secondly, Sumit, if you can talk a little bit about Chewy Practice Hub for vets, curious on your view of how that opens up the addressable market for prescriptions? Any early feedback you can provide from vet partners and just what you've learned from the 8,000 clinics that you've been working with on the back end so far? Thanks.

Mario Marte, CFO

I will start with the first part of your question, and then Sumit will respond to your second part. Regarding the active customer additions this year, we included a supplemental in the shareholder letter to illustrate the calculations behind it. I anticipate that the impact of the very large, record-size cohort from 2020 will continue to moderate the number of additions we see this year. In simpler terms, I expect our net active additions this year to remain at a lower rate compared to 2019. This situation is expected to be temporary. By next year, in 2022, we foresee this large cohort along with the natural attrition to play out within the cycle. On the other hand, we are experiencing rapid growth in NSPAC. This means that both the customers we are retaining and those we are acquiring are spending increasingly more on our platform, which is encouraging. Not only have we retained and added a significant number of customers, surpassing our gross additions in 2019, but these customers are also spending more with us over time. These positive dynamics contribute to an expanding top line and growing gross margin, as repeat orders prove to be more profitable than initial orders. Additionally, they lead to greater efficiencies in the supply chain, resulting in an expanding bottom line as well. These factors represent favorable trends in terms of netback and active customer additions.

Sumit Singh, CEO

I'm excited to talk about the Practice Hub. In previous earnings calls, I mentioned that research shows one-third of pet parents do not regularly visit the vet, which limits industry compliance and affects overall market potential. This initiative enables us to collaborate more closely with veterinarians as direct partners. We're focused on creating an ecosystem where pets, vets, and pet parents are central, with Chewy facilitating an enhanced experience throughout that journey. The Practice Hub is designed to support veterinarians by listing their offers directly on our website. This provides them access to over 20 million Chewy customers and benefits from our strong Autoship program, allowing them to earn revenue on repeat orders. This encourages veterinarians to improve compliance, and partnering with us helps them build customer relationships through education and consistent traffic. Overall, this approach establishes a beneficial cycle for veterinarians to engage effectively, broadening the marketplace for both vets and consumers while enhancing compliance. Regarding your second question about exposure, we are currently collaborating with several independent clinics and a nationally recognized vet group. They are helping us refine the product, which is currently available on a selective, invite-only basis. As the year progresses, we look forward to working with the 8,000 clinics partnered with us that already use Petscriptions. We're excited about what’s coming next.

Brian Fitzgerald, Analyst

I wanted to follow up on Doug's question regarding the mechanics of the Practice Hub marketplace. It seems that it could potentially develop into a lead generation platform for veterinarians in the future. Sumit, you mentioned a few days ago on CNBC that the tele-vet is functioning as a triage, and vets are currently facing a demand that exceeds their capacity. This creates a triage situation. Is there a possibility that this could eventually turn into a paid product for veterinarians, helping them generate leads, manage and triage cases, and enhance their productivity in addressing the essential work they need to do instead of handling issues that don't require a visit?

Sumit Singh, CEO

Brian, yes, in short, we have a big bold vision for what we can do with Practice Hub as we continue to develop and improve the product. We're starting out with the concept of a curated marketplace, supported by the power of Petscriptions. Your intuition aligns with our ambitious thinking, and there are many possibilities for expanding the product and service in the future.

Brian Fitzgerald, Analyst

And then if I could ask a quick question. Do you have a rough figure for what percentage of the pharma business or the healthcare business is really akin to subscriptions like antiparasiticals that heartworm pills show up every so often, you have to keep giving them to the pet?

Sumit Singh, CEO

Our Autoship subscriber rate is comparable or better in the pharma sector. Is that what you were asking, or did I misunderstand your question?

Mario Marte, CFO

I see between heart and preventatives, it makes up 80% of the total $12 billion TAM that exists between OTC and pharma medication today. So, extreme pain medication and such makes up roughly 15% to 20% of pharma.

Seth Basham, Analyst

Good luck and good afternoon. My question is on your gross add commentary. You talked about being up 20% year-to-date versus 2019. What's your expectation for the full year 2021 versus 2019?

Mario Marte, CFO

Yes, Seth, this is Mario. We do not provide guidance on active customer additions for the year. The best way to understand the pacing is that the impact of the very large cohort from 2020 will continue to influence our gross additions this year. However, we do not break down gross and active additions for 2021.

Seth Basham, Analyst

Okay. That's fair enough. And then secondly, as it relates to the customers acquired in this second quarter, what type of LTV do you expect to add as those customers versus the customers acquired in the last year, given the record high CAC that I think that you guys are incurring this quarter?

Mario Marte, CFO

I'll start again and Sumit may add something to it. When considering the lifetime value to customer acquisition cost, it's important to look at both aspects. There were possibly some higher input costs in the second quarter, which could have resulted in increased customer acquisition costs during that period. However, the margin we recorded was among the highest at 27.5%. Additionally, customers are spending more from the outset. They joined the platform and began spending more immediately, and this spending is yielding a higher margin. Therefore, it suggests that the lifetime value to customer acquisition cost should align with historical levels. That's what I would say.

Sumit Singh, CEO

The customer of today in the way that they're exposed to expanding and broad choices and offerings from us, which we've incredibly expanded over the last three years, LTV expands by several hundred dollars on an annual basis. We haven't yet put a number to it, and it's hard because we're still graduating customers through different offerings that we've developed. And some of these offerings are early stages that we're actually maturing into. But when you look at it from a maturity point of view, there are several hundred dollars of LTV to be added up top, which actually provides us a nice cushion at the expanding contribution margin to be able to tolerate CAC and to be able to participate very effectively in the marketing environment, whether it be the marketing environment of today or the future, as we continue to acquire more customers and add them to our platform.

Lauren Schenk, Analyst

This is Nathan Feather on for Lauren. Can you just talk through a little bit more some of the puts and takes on gross margin expansion in the quarter? And where do you think that could have ended up without the short-term impact in terms of discounting and other?

Sumit Singh, CEO

Sure. Mario mentioned the expansion of our gross margin, and we've included the details in the script. There's not much more to add on that front. Our customers are actively engaging with the various verticals we've developed. We are seeing the results of our efforts in enhancing search discovery and encouraging customers to purchase more across different categories, as well as higher-margin verticals. This, combined with the advantages of our scale, is what is driving the improvements in gross margin. We estimate that the current muted pricing and promotional environment have contributed an additional 50 basis points to our gross margin.

Mario Marte, CFO

And Nathan, I would add that back to the point that Sumit made in the opening remarks, but we are implementing this technology, what we call the ORS 2.0, our order routing system, that we estimate could lead to another 30 to 50 basis points of gross margin expansion. So there are puts and takes to gross margin expansion. We see the results in the second quarter. There are some initiatives that are in place that should expand that. And also, if you look at the mix of sales, consumable versus hard goods and other, there is opportunity to continue to move some of those sales to some of the more profitable mix in the future.

Nathan Feather, Analyst

Okay. Great. Thank you. And then on top of that, on the marketing side, did you see any shift in channels within the quarter in terms of where you're marketing outside of the introduction of some of those new channels? And was there any potential impact from IDFA in the quarter? Thank you.

Sumit Singh, CEO

Our marketing mix is dynamic, and we spend relative to the returns that we're getting. So we don't have a predefined budget for a predefined channel or a fixed go-to-market strategy. So it's a bit of a hard question to answer because depending upon the dynamic nature and the volatility that we saw in Q2, we reacted accordingly. And then what was the second part of your question?

Nathan Feather, Analyst

Just did you see any impact from the Apple App Store or the Apple fee changes IDFA?

Sumit Singh, CEO

Yes. No. We've been actually working to sort of mitigate that from the beginning in the way that our architecture is built. So no, we didn't see a material impact on that so far.

Peter Keith, Analyst

Thanks and good afternoon. Maybe a follow-up on the gross margin. It looks like you're seeing continued healthy mix shift. So with all of the new engagement with pet health, I think in the past, you've talked about health running about 500 to 800 basis points above your core business. When we think about like Practice Hub and Compounding rolling in and presumably growing very quickly, does that gross margin lift change in any way for better or for worse?

Sumit Singh, CEO

Sure. It's Sumit, I'll take it. So we've said at scale, we expect healthcare to be 300 to 800 basis points higher gross margin than the base business. And we're on track to deliver that. And you can see some of that starting to come through in the gross margin uplift that we've continued to deliver on a year-over-year basis. And then from here on out, as I've said in the past, we have many initiatives that we're working on to complete the road map that builds out towards our long-term guide of 25% to 28%. And so far, we've reserved the right to update that guidance, because there's so much more interesting stuff for us to work on and reinvest dollars in where we see the long-term return taking place. So in terms of building out our road map, we still have a full non-health care. We have healthcare to build out that we are starting to open up more and be more candid with here and starting to share with all of you. We still have non-healthcare services to build out, and we still have a lot of work to do in connecting the dots to be able to engage the customer holistically across these three or four verticals that connect the pet life cycle. And at the same time, we're thinking boldly about not just end consumers in the space, but also about the community that services pets, which is also embedded in our mission statement of being the destination for pet parents but also partners. And a few of the examples that you've seen us bring to life so far are Compounding medications, which are today a B2C offering; and now with our telehealth, where we're working with veterinarians collectively and now with Practice Hub that we've actually opened up to veterinarians. So you should continue to expect us to innovate robustly and at pace and keep you apprised of gross margin expansion in the future.

Peter Keith, Analyst

Okay. Very helpful. Separately, I was wondering if you could address the growth for small animals. I know dogs and cats get a lot of attention, but we've been hearing rumblings out there that it's actually small animal adoption that remains white-hot. I was wondering, if you're seeing that in your business? And maybe is it too small to matter, or any quantification of sort of the ex-dog and cat business as a percent of sales would be helpful.

Sumit Singh, CEO

Yes. Your long-term trend is correct. Overall, in the United States, we believe somewhere between 30% and 40% of pets are small pets, and they are growing at a slightly higher rate than large pets. It actually makes sense as a lot of Gen Ys, Zs, and millennials adopt pets and at least pre-pandemic, city living and dwelling was a much more or continuing to become a popular option. And when you look at the density of space and the pet type that might be more suitable, it does give a little bit of a tailwind to the small pet data point. But it's not materially shifting or has shifted to the point where we need to update our planning assumptions or educate customers in a different way so far.

Operator, Operator

Our next question comes from Chris Bottiglieri with Exane BNP Paribas.

Chris Bottiglieri, Analyst

It was helpful to see the illustrative curves. I wanted to drill a little bit deeper. I think your overall consolidated attrition rate just naturally benefits from cohort maturation, as you have more overall customers. So it just naturally blends down at least historically anyway. If we look at your two attrition rates in '21 versus 2019, were the attrition rates better in '21 than '19? If you can comment there would be helpful.

Mario Marte, CFO

Mario here. The attrition rate has consistently stayed at historical levels, regardless of the perspectives we consider. Whether we examine the 2020, 2018, or 2015 cohorts, the strong retention rates for these groups, irrespective of their size, have remained stable. That's the most straightforward way to address your question.

Chris Bottiglieri, Analyst

Got you. Okay. That's helpful. I wanted to check in on the Freshpet offering, specifically regarding your private label product and Freshpet's products. Can you provide insight into the early growth rates? Are your existing customers transitioning from wet and dry food to this offering, or are you attracting new customers from other channels with this initiative? Finally, there's a market perception that this might have a lower contribution margin due to higher shipping costs. What has been your experience so far regarding contribution margins? Are they similar to other consumables at comparable price points, or have they been diluted?

Sumit Singh, CEO

The business is still in its early stages, and we are gradually expanding our offerings. The customer base is not yet large enough for significant insights. However, we are experiencing rapid growth with many customers transitioning from existing Chewy products, either fully migrating or using them as add-ons. Additionally, we are acquiring a good number of new customers directly tied to this vertical, which supports our strategy for both existing and new customer acquisition. Regarding shipping, using dry ice or cold chain does result in higher shipping supply costs. However, we excel at creating bundled purchases for our customers and encouraging repeat sales through our Autoship program, which improves our planning and operational efficiency. Overall, we anticipate that, once scaled, this business will contribute positively to profits and benefit the overall business.

Operator, Operator

Our next question comes from Justin Kleber with Baird.

Justin Kleber, Analyst

Thanks everyone. Good afternoon. Just wanted to follow up on the active customer add questions. Can you give us a sense how those gross customer adds flowed across the quarters in 2020? Were they meaningfully different than the net adds that you reported? Just trying to understand if you've already cycled over the peak period of gross adds and how that might influence the pace of net adds as we look to the back half of this year?

Mario Marte, CFO

Justin, it's Mario. The gross adds last year were even throughout the year, almost the same number of gross adds in Q1 versus Q4, Q3, Q2. So you won't find any discernible pattern there.

Justin Kleber, Analyst

Okay. Lastly, regarding your outlook, what are you assuming from a promotional perspective in your guidance? Are you anticipating a gradual return to a more normalized promotional environment, especially as we approach the fourth quarter and the holiday season?

Sumit Singh, CEO

So far, yes, this is actually directly correlated to the way supply chain and out-of-stock issues and overall freight conditions improve. And so, so far, we are continuing to assume a stable and relatively muted promotional environment as we move into the back half of the year.

Justin Kleber, Analyst

Okay. And if I could just sneak one more in. Just wanted to ask about new pet parents and the maturation of their spending, particularly how it evolves in year two as you cycle some of those initial purchases associated with the new pet, picking things like a crate or a catcher? If you look at spending on an annualized basis, do those new pet parents grow in year two in terms of overall spend? Or do you see them take a bit of a step back?

Sumit Singh, CEO

No. On a customer basis or on a cohort basis, revenue retention improves year-over-year. Unlike a traditional e-tailer or retailer where revenue declines from year one to year two, we experience a steady, predictable increase from year one to year two. We provided the shapes back in the S-1 document in 2019. When examining eight years of cohorts, we see that the first year averages between $150 to $200, while the second year increases to $350. Additionally, with Mario's recent comments, we are noticing that consumer spending is higher earlier. Therefore, we do not observe a compression. If customers are buying full baskets, generally, hard goods purchases are discretionary and have a longer buying cycle. However, for consumables, we can accurately forecast repeat purchases and frequency. Overall, spending increases from year one to year two.

Operator, Operator

And our final question today comes from Steven Forbes with Guggenheim.

Steven Forbes, Analyst

Good evening. Sumit, I wanted to follow up on Chewy Health. You mentioned in the release that veterinarians can now earn revenue when a customer places an order. I was curious if you could provide any context around how this revenue share compares to other options that may have today and/or whether you think the improved value proposition has now neutralized the fulfillment preference, enabling the customer to truly drive the decision process as we think about the potential for market share gains into the future?

Sumit Singh, CEO

Our offering is very competitive, and we believe it will allow veterinarians to have control over how they price products with us. We may charge a small fulfillment fee, which is lower than what we currently see in the marketplace. From this perspective, we believe this should be beneficial and that veterinarians will be pleased with the overall arrangement when they engage with Chewy and our customers in a comprehensive way. I apologize for not catching the second part of your question. Could you please repeat it for me?

Steven Forbes, Analyst

I think you answered. I was just curious whether you think the offering, right, that you're putting forth here really neutralizes the fulfillment preference among the vets enabling your customers, right, to really drive the decision process.

Sumit Singh, CEO

Practice Hub is completely different from any other product or service currently available in the marketplace. First, it operates on chewy.com with 20 million active customers who can immediately buy from their vet. Second, Chewy manages the entire customer experience. We offer free shipping on orders over $49 and do not charge for essential items like insulin, which typically incur fees from other services. You could expect to pay over $30 for a single order elsewhere. We also ensure fast shipping, delivering within one to two days, while other services take between four and six days, based on our benchmarks. Chewy's customer care team is available 24/7, which adds to the tremendous value we provide both financially and in terms of customer engagement. In my opinion, this offering is a highly compelling and superior product that is set to redefine the industry. We take great pride in what we are bringing to market.

Mario Marte, CFO

For the software, S-1 is fully deployed and operating at full capacity. I can't provide a specific timeline, but we have started to roll it out through the network. Your second question was about additional scaling benefits. Continued sales, as we shift our sales mix into the higher-margin verticals, along with the simple math of increasing our repeat order base—because repeat orders are generally more profitable than initial orders—will provide us additional benefits over time through supply chain efficiencies.

Sumit Singh, CEO

What we find very encouraging is that we continue to improve customer engagement and develop our customers. Achieving this, combined with the benefits of our scale, allows us to deliver incremental gross margin, which is tremendous. The work we are doing is structural, customer-centric, and focused on profit and loss. At the same time, there are currently macroeconomic environments that are hopefully temporary and affecting the flow-through from gross margin to EBITDA. Despite these constraints, we have generated roughly $300 million on a stack basis over the last two years in our profit and loss. Year-over-year, we expect to deliver double the EBITDA this year compared to last year. We believe that our scale, efficiency, and ongoing customer work mean we are on the right path and that our strategy remains intact.

Operator, Operator

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

Sumit Singh, CEO

Thank you very much. Stay safe. Have a great evening.

Operator, Operator

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