Petco Health & Wellness Company, Inc. Q2 FY2022 Earnings Call

Good morning, everyone, and thank you for joining Petco's Second Quarter 2022 Earnings Conference Call. In addition to the earnings release, there is a presentation infographic available to download on our website at ir.petco.com, summarizing our second quarter 2020 results. On the call with me today are Mr. Ron Coughlin, Petco's Chief Executive Officer; Mr. Brian LaRose, Petco's Chief Financial Officer. In a few moments, I will invite Ron and Brian to provide their perspective on Petco's financial and operating performance for the quarter and our outlook and priorities for the quarters and year ahead. Before they begin, I would like to remind you that on this call, we will make forward-looking statements regarding our current plans, beliefs and expectations which are not guarantees of future performance and are subject to a number of risks and uncertainties and other factors that could cause actual results and events to differ materially from results and events contemplated by such forward-looking statements. These risks and uncertainties include those set out in our earnings release and our filings with the Securities and Exchange Commission. These forward-looking statements are made only as of the date marked and except as required by law, we undertake no obligation to update or revise any of them, whether as a result of new information, future events or otherwise. In addition, today's presentation contains references to non-GAAP financial measures. Reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures are included in our earnings release and our presentation as well as in our filings with the Securities and Exchange Commission. And finally, during the question-and-answer portion of today's call and to allow us time for questions from as many participants as possible, we'd be grateful if you could keep to one question and one follow-up. With that, let me turn it over to Ron.

Good morning, everyone, and welcome. As always, I'd like to begin my remarks clearly and simply. The Pet category continues to grow. Petco's business continues to grow. Our customer base continues to grow, and our unique competitive moats continue to deepen. Despite the current economic environment, the Pet category is once again proving its unique defensive growth characteristics, and the focused execution of our 29,000 Petco partners, both improve the lives of countless pets and pet parents and delivered tangible progress against our strategic priorities. Including further expansion of our Vet network and capabilities, continued mix shift towards premium products, the addition of over 100 experiential fresh frozen pantries in pet care centers, and double-digit growth in recurring and loyalty customers. Importantly, our nondiscretionary categories of consumables and services continue their strong upward trajectory. As expected and similar to other consumer categories, inflationary pressures have softened the discretionary areas of our business. This transitory response is consistent behavior during previous recessions and past experience indicates a return to growth with economic improvement and the passing of the stimulus overlap period. Additionally, our team has done a nice job managing supply chain challenges and their impacts while maximizing sustainable customer and business growth. Importantly, in aggregate, we feel comfortable with our inventory position, both in quantity and makeup. Having operated in the current economic environment for several months now, we have greater clarity in terms of consumer and cost dynamics and have adjusted our assumptions for the full year. Brian will share these shortly. Turning to key members. Comparable sales were up 4%, equating to 23% and 34% on a 2- and 3-year stack. Net revenues grew by 3%. Our unique model and powerful marketing continued to win new customers. Our active customer base grew by double digits year-over-year, and we added 325,000 net new customers in the quarter. This is our 14th consecutive quarter of growth in our customer base. Recurring customer revenue grew by 54% year-over-year driven by repeat delivery, insurance, top box and Vital Care members. Total active Vital Care customers reached 282,000 in the quarter, including customers we've converted into Vital Care with the acquisition of Thrive. Customers joining Vital Care have been increasing their visits and spend by double digits, with a lift in spending across all categories and delivering a 3.5x higher LTV in an average customer. This is up 10% from last quarter. The additions we made with Vital Care in March have resonated with pet parents who clearly see the value in this program, especially in the current economic climate. The average pet parent can save over $300 annually and from Petco's standpoint, we capture a far greater share of wallet with around 30% of Vital Care customers due to their loyalty and 40% new to services, both up versus Vital Care 1.0. We have a robust roadmap of enhancements to come, allowing us to add many more members and capture further share of wallet. We look forward to sharing more details soon. The value of loyalty membership is significant, especially when combining Vital Care with our existing 1.6 million booming and nutrition Perks members, we continue to increase visits and spend by almost 50% and 40%, respectively, year-over-year, and they have over two times higher LTV than average customers. Demand for services has proved resilient delivering 13% year-over-year growth, translating to a robust 62% growth on a two-year basis, driven by strength in both Grooming and our Veterinary business. Services are such a differentiator versus online and competitors and pet parents, who see the value in our training, veterinary services and grooming. They also act as a feeder for Petco into a broader health and wellness ecosystem, including OTC solutions, Rx food, Rx medicines and insurance. Specifically, our Veterinary services, a strategic long-term growth driver and competitive moat for Petco. This has been a quarter with exceptional progress. We closed the Thrive acquisition in May, and integration is going ahead of our plans. We've now added over 600 veterinarians to our network in the last 6 months alone. We opened 11 new vet hospitals in the quarter and remain on track for a target of 50 new hospitals for the full year. We also made significant enhancements to our online booking systems allowing customers to seamlessly view deployment availability across multiple locations and driving a 30% increase in online hospital bookings. Every day becomes more obvious that our vet model positions Petco to win customers. Not only does our full-service hospital mix of preventative diagnostic and treatment give pets the best possible care, but our ecosystem of mobile in-store clinics provides the cost and convenience to fit every pet parent’s needs. And we are rapidly becoming a disruptive innovator in the vet space, evidenced by our collaboration with Butterfly IQ+ that technology bringing their cutting-edge handheld ultrasound system to all of our hospitals by the end of the third quarter. This not only allows us to provide pet parents peace of mind with on-site diagnostics, it also removes the need for referrals out of our hospitals and enables us to capture that high-margin revenue. It's also a talent magnet, being 1 of the most sought-after technologies veterinary professionals asked for before choosing which hospital to join. In merchandise, as in Q1, consumables continue to surge, demonstrating the recession-proof nature. Sales grew 12% year-over-year and 37% on a 2-year stack. This strength is great for the long-term health of our business as consumable customers have a higher retention rate and bring a 30% higher LTV than customers who don't buy consumables. Our over-index to the pet parents to take the best care of their pets and who are the highest spending customers continues to power a multiyear shift to healthier premium food even in this hyperinflationary environment. These include high-end kibble brands like Origin, Royal Canine and Hills. Kitchen that can't be found in the mass or grocery channel. And pet parents are continuing to migrate to more premium, fresh frozen brands like JustFoodForDogs, and Freshpet. We opened our second JustFoodForDogs kitchen where we actually make the food in our sports arena Pet Care Center in San Diego. These kitchens really bring the fresh food experience to life creating a unique brand-building experience at Halos, an entire market to drive awareness and trial. To summarize, make no mistake about it. We continue to drive a positive mix shift towards more premium and super premium foods. We're also mix shifting towards our own brand consumables. Our WholeHearted brand took more share from lower quality, more broadly distributed brands with over 30% growth year-over-year. When you combine the growing strength of our WholeHearted brand, with the macro trends of premiumization and fresh frozen, the future is clear to us. That's why today, we're delighted to announce the launch of WholeHearted Fresh Recipes as a pull of next step in our nutrition leadership. In collaboration with JustFoodForDogs, we're launching exclusive new human-grade fresh and frozen owned brand pet food as part of the WholeHearted line, available Pet Care Centers and online beginning this month. I was thrilled to see a brand new WholeHearted cooler in our Carmel Valley location near the office 2 weeks ago. Overall, our owned and exclusive brands continue to strengthen our business against our competitors. Our supplies remain a cornerstone of Petco's offering, including our owned and exclusive ready brand, which even now offers cooling beds and clothing to help pups keep cool in these record-setting temperatures. Structurally, our suppliers are highly profitable, extremely well-positioned and at scale, providing significant financial advantages versus online-only competitors. The lapping of year-ago stimulus and the current inflationary environment does create transitory pressure on the supplies business growth, but it's a pressure which history has shown dissipates as lapping dynamics and inflation moderates. Importantly, our customer insight grounded innovation engine continues to be a core competence. In the quarter, we launched an exclusive partnership with Clif with plant-based jerky, a smart crossover from human food. If you're grabbing a Clif bar on a hike, why can't your pet have one too? We also exclusively launched back country recreational gear, meeting pet parent's desire to spend more time outdoors with their pets with fun floating, stay-dry rain gear and even a doggy tent. The brand is off to a super strong start. Our Pet Care Centers delivered their ninth consecutive quarter of positive comp sales, fueled by growth in basket via continued mix shift towards premium merchandise and our ability to pass through pricing. Result of both the uniqueness of our offering and the incredible capabilities of our Petco partners to connect on a highly personalized level. This past quarter, I visited Pet Care Centers in Arizona, Idaho, Washington State, Texas, California and New York. In each case, I met passionate Petco partners focused on improving the health of pets. Keeping each other safe in a pandemic environment and building a stronger Petco business. I am in awe of the spirit of the Petco partners across our network. In the labor market that remains competitive, Petco stands out as a caring, fun, purpose-driven environment for our partners, helping pets and pet parents on a daily basis. Correspondingly, in the last quarter, we saw applications to work at Petco increase 16% over the prior year. Our Mexico business continued its upward trajectory with sales up double digits year-to-date. I'm very excited to share that our neighborhood farm and pet supply strategy is now live and resonating with the local community. Early indications from our first location in Floresville, Texas, which opened in June are exceptional. Financial performance and customer engagement are exceeding our expectations, with particular strength in supplies for companion animals, meeting an unmet need in this market. During the grand opening, multiple customers came up to me and said, "Thank you. Thank you. Thank you. We needed a pet-focused retailer here, and I no longer need to drive to San Antonio all the time." It was also the first opening we remember having horses in attendance. We're excited about what we're learning in the now addressable multi-billion-dollar farm and feed market across segments like equine, chicks and bovine. We're looking forward to the multiple planned additional openings for Q3 and Q4. Our Digital business continued to drive powerful profitable growth through innovations, including in-app repeat delivery sign-ups and multi-location fulfillment for same-day delivery. In Q2, total digital sales were up 10% or 143% on a three-year stack. We've more than doubled our Digital business over the last 3 years. Our digital customer spend is now up over 20% year-over-year, continuing to outpace our key online competitors' recent trends. We also expanded digital margins year-over-year through distribution efficiencies, including our renewed DoorDash contract and the rapid acceleration in our Ad Network revenues. But it's a role that a digital plus brick-and-mortar play in our ecosystem that is more significant. The deployment of our Pet Care Centers as micro-distribution centers creates an unmatched competitive advantage and agility. We continue to not only fulfill nearly 80% of the digital orders through our Pet Care Centers, but delivered a record number of same-day delivery orders in the quarter, a 60% increase year-over-year. Needless to say, same-day delivery provides a competitive moat versus our key online competitor. Now stopping there. We added 75 new brands to our online assortment so far this year, including much-loved brands like DANIE-PET, a digitally native and science-backed multivitamin supplement and tech-focused offerings like WinWebcam and iRobot vacuums. Finally, on digital, our advertising network is now firmly a jewel in Petco's crown with over 200% growth year-over-year, our platform and bespoke data capabilities provide a compelling offering for vendors, connecting pet parents and converting them down the marketing funnel. We're confident our pipeline of in-flight enhancements will support projected triple-digit growth year-over-year for the full year 2022. Before I hand it over to Brian, I'd like to take a moment to focus on our North Star, our purpose, and it starts with our partners. We've been focused on improving wages for the last 4 years. As a result, our average total hourly compensation is currently over $17 per hour. This month, we announced we're lifting the floor with every non-training of Petco either brand-new or tenured will make $15 base wage per hour or more by the end of the year. We believe this is the right thing to do, particularly given cost of living increases, and it recognizes the extraordinary contributions our Petco partners make every single day. It will enhance retention and make us an even more attractive destination for talent. Petco Partners also celebrated our community at pride events across the country, joining virtual events from happy hours and panel discussions on LGBTQIA+ communities in the veterinary field, joining the Annual Pride parade in our hometown of San Diego and even joining a pride-themed spin class led and DJ'd by our very own, Brian LaRose. In June, we published our environmental, social and governance report for fiscal year 2021, giving an in-depth look at our sustainability progress. In it, we outlined the proactive steps we're taking as a leader in our category for finding sustainable solutions that positively impact the well-being of pets, people, and the planet we share. Of particular note, over the last year, we've engaged with over 350 product vendors as part of our efforts to increase our sustainable product mix to 50% by the year 2025. We eliminated nearly 8 million pounds of cardboard and 66,000 pounds of plastic through digital fulfillment, and we also published our first EPA Scope 3 carbon footprint. Together with Petco Love, we continue our mission to help and save pet lives. We've now delivered over 917,000 free vaccines to date to under-resourced communities putting us in arm's reach of our one million vaccine commitment in partnership with Merck. We also saved over 95,000 pet lives in the quarter alone and have reunited over 10,000 pets with our loving families to date through Petco Love Lost. In closing, our ecosystem and results-driven orientation is enabling growth, and we continue to make a difference in lives every single day. With our recently evolved leadership structure, we're laser-focused on putting customer centricity and operational excellence at the center, meeting the customer need of a one-stop experience for pet health and wellness. As always, thank you to all our amazing Petco partners and customers. Despite the environment, this is an exciting time for Petco and we remain grateful to our partners who are on the journey with us to deliver purpose-driven performance every day. With that, let me hand it over to Brian.

Thanks, Ron. At the halfway mark for the year, we remain confident in our position as the leader in pet health and wellness and are proactively managing the macroeconomic environment. Across the entire business, teams have done an amazing job at remaining laser-focused on driving performance every day and controlling our controllables while delivering against our strategic priorities and making investment decisions with a long-term perspective. Looking at the quarter specifically, we delivered yet another quarter of strong net revenue at $1.48 billion, up 3% year-over-year with comparable sales of 4% or 23% on a 2-year stack with continued strength in average basket trends. Total Services grew 13% year-over-year and 62% on a 2-year stack across Vet, grooming and training. Momentum in consumables continued up 12% year-over-year and 37% on a 2-year stack and delivering a 30% higher LTV over our other customers. It's clear our team is executing extremely well, and we were able to leverage our structural advantages versus our competitors, including the ability to offer BOPUS, same-day delivery and ship from store by leveraging our Pet Care Centers as micro-distribution centers. You'll remember in our last couple of earnings calls, we outlined that supplies in companion animals will be lapping a stimulus-driven elevated prior year comparable. Like others, we've seen some softening in discretionary spend with supplies in companion animals down 9% year-over-year. Finally, before we move down the P&L, we closed on the purchase of the remaining stake in our Thrive joint venture in May at a cash price of $35 million. This is a real accelerant in our vet business, bringing approximately 800 veterinary professionals to Petco, combining the hospitals under a single brand, delivering an improved ROI. In addition, during the second quarter, we incurred approximately $11 million of acquisition-related integration costs, bringing total year-to-date spend to $13 million representing the majority of the $15 million to $20 million total estimate communicated last quarter. Although early stages, we're pleased with what we're seeing on integration and return on investment. Moving down the P&L. Gross profit decreased $5 million or 1% to $594 million. Gross margin was 40.1%, down 170 basis points year-over-year and 110 basis points on a quarter-over-quarter basis driven by the mix impact of consumables, onetime Thrive integration-related costs and elevated freight costs. Gross margin when adjusted for the Thrive cost was 40.6%. SG&A as a percent of revenue improved from 37.8% in Q1 to 36.8% in Q2, down 100 basis points, demonstrating our cost discipline. Thrive transaction and integration-related charges included in SG&A accounted for approximately 30 basis points, translating to an adjusted SG&A rate of 36.5%. On an absolute basis, SG&A expense was $545 million, up $19 million or 3.5% from prior year. Excluding Thrive, SG&A would have been $540 million, up $14 million or 2.7% from prior year as we remain adept in managing costs while continuing to invest for sustained future growth through infrastructure and our people. While there will always be puts and takes in aggregate, our network inventory levels remain well managed and in line with demand. Q2 adjusted EBITDA was $142 million, a decrease of 8.5% from prior year, with an adjusted EBITDA margin rate of 9.6% compared to 10.8% in the prior year, a decline of 120 basis points. Quarter-over-quarter, adjusted EBITDA was up 60 basis points. Q2 adjusted EPS was $0.19, a decrease of $0.06 from the prior year and up $0.02 quarter-over-quarter. Based on 266 million weighted average fully diluted shares as well as a normalized effective tax rate of 26%. We continue to have strong liquidity, ending the quarter with $569 million, inclusive of $125 million cash and cash equivalents and $444 million of availability on our revolving credit facility. Looking at cash flow for the first half of the year, we generated strong cash from operations of $100 million and had $136 million in capital expenditures which increased 36% year-over-year as we continue to reinvest in future sustainable growth across vet, fresh frozen and digital infrastructure. To echo Ron's remarks, the halfway point of our fiscal year provides a distinct opportunity to both reflect and examine the balance of the year ahead. Today, we have greater clarity of the extent of the incremental headwinds likely to impact our business and our customers, which means we also have greater clarity on how to stay ahead of them. Looking ahead, the current economic environment necessitates that we be pragmatic while also ensuring we can still make long-term investments essential to our future success. Specifically, while momentum has continued into Q3, we believe it is prudent to adopt an appropriately cautious outlook for the full year. We, therefore, are making the following adjustments to align with our current expectations as follows: revenue of $5.975 billion to $6.05 billion; adjusted EBITDA between $580 million and $595 million; $250 million to $275 million of capital expenditures; adjusted EPS between $0.77 and $0.81, assuming $90 million of interest expense, 26% tax rate and a $267 million weighted average diluted share count. When thinking about our guidance, there are a few things to keep in mind. Our ongoing ability to proactively manage the dual vectors of inflation, both in terms of impact to shipping and to the customer through efficiencies in our Pet Care Centers, same-day delivery and membership offerings. Our consumables and services businesses continue to be nondiscretionary with strong growth expected to continue. We believe the current pressures on supplies in companion animals are transitory in nature and anticipate an improving trajectory as inflation and other economic pressures dissipate. While in-stocks continue to improve as vendors are scaling to meet the demand, our in-stock position is currently slightly better than where we started the year. We fully anticipate the typical seasonal uplift of the holidays from Q3 to Q4. Above all, Petco remains a strong, profitable growth company with a unique and innovative ecosystem in a resilient category that remains highly relevant for consumers over the long term. In short, we remain focused on our goals and will never stop pushing ourselves to succeed. This continued drive for operational excellence and sustained profitable growth wouldn't be possible without our Petco partners. Their unwavering optimism and attention to detail and their ability to help pet parents maximize the health and wellness of their pets. Thank you for your time. And with that, we'll move to questions.

Our first question comes from Kate McShane with Goldman Sachs. Please go ahead.

I wondered if I could just focus on traffic versus ticket during the quarter and the cadence of same-store sales throughout the quarter. I know you mentioned you have momentum going into Q3, but I wondered if you could give a little bit more context around that.

Thanks, Kate. So this marks the ninth consecutive quarter of comp growth was in brick-and-mortar. So we've continued to show momentum in brick-and-mortar. And that's due to our unique portfolio, our partners in the aisle, e-commerce assets and the pricing leverage. Our basket has continued to increase, ticket size has increased. We also have a healthy and growing services business, which creates a unique ecosystem, as you know. And we have differentiation versus mass and grocery. We continue to see great engagement in the Pet Care Centers. There is trip consolidation, largely driven by gas prices. But all in all, between the basket and the ticket size, we continue to drive positive revenue growth and increase efficiency because we're getting more sales with lower trips, so that's an efficiency driver for us.

And as a follow-up question, we just wondered if you could talk about some of your strategies around pricing just given the amount of inflation that we've seen, particularly in consumables, just how pricing has changed for you maybe quarter-on-quarter? And if there's been any change in the promotional environment given the softness in some of the discretionary?

Yes. No, thanks for the question, Kate. So we took pretty holistic pricing actions in the second half of last year, which we've talked about. Since then, we just spend more moderated. We have taken some pricing actions. Whenever we do that, we do deep analytics on a SKU-by-SKU basis, analyzing the elasticity of that pricing model to make sure that we're actually not at the table. So we've taken selective pricing actions in the first half of the year, not like we did in the second half of last year. Consumables remain strong. So we have not seen a trade-down impact. We've not seen any sort of elasticity impact from pricing actions we've taken to consumables. So we feel really good about where we're positioned from a pricing standpoint. In terms of promotional activity, we've not seen a dramatic change there. The market remains strong. Consumables remain strong, and the market overall, including our competitors, remains very balanced.

I would just add, you still have more demand than supply. So from a fundamental standpoint that drives pricing rationality. And then the other piece of your question, Kate, was around Q3. And as Brian said, we're pleased with the momentum that has continued into Q3 on both total revenue as well as traffic trends.

Our next question comes from Steph Wissink with Jefferies. Please go ahead.

I want to follow up on Kate's question and your response, just with respect to in-stock levels. Any sense of when you might be back at grade in terms of matching supply and demand?

So it's a dynamic we've been talking about. There is not one of our vendors that planned for the millions of new pets that happened in 2021 and there continues to be more adoptions versus pre-pandemic into this year. So that's the bad news. The good news is that it is all scaling. I was at a brand-new plant for kitchen in Dallas several months ago. I met with the host team. They just announced big investments. So capacity is coming on real time and correspondingly, we're seeing improvements in our in-stocks and enhancements to our ability to match supply to demand every week. So it's all getting better. A lot of that capacity got approved in '20, early '21, and that's now starting to come on. So it will get better and better as we progress through the second half of the year and into '23.

Okay. That's helpful. And Brian, one for you. I'm just trying to square up the guidance in terms of the revision to earnings versus the revision to sales? It doesn't look like a significant revision to revenues. So just trying to kind of back into what you're assuming in the middle of the P&L for the back half that's lending to a more significant profitability cut?

Thank you for the question. To begin, as you mentioned regarding revenue, we saw growth this quarter and are positioning ourselves for continued growth in the future. Our guidance reflects a balanced strategy; we're managing short-term needs while reinvesting for long-term success. We currently have a $40 billion incremental total addressable market opportunity in front of us, and we are committed to investing in that. The guidance includes various factors at play. Our consumables business is very strong and continues to grow at double-digit rates, and we expect that trend to persist. Our services business remains resilient without impact from demand elasticity, which we anticipate will continue as well. However, we are observing some softening in discretionary spending specifically in supplies for companion animals, so we are adjusting our approach accordingly. The positive aspect is that this category has historically returned to profitable growth as economic conditions improve. Therefore, we are not remaining idle; we have proactive strategies to drive growth in those discretionary areas, such as Vital Care and nutrition perks. Our guidance is shaped by our current understanding of the economic environment, which has changed from 90 days ago, and we believe it accurately reflects the market conditions we are seeing.

Okay. Brian, just to clarify. So would you like us to more heavily impact the gross margins based on mix? Just given that you saw some nice SG&A progress in the quarter, you want us to continue to carry that forward into the back half?

Yes, that's correct. The team did an excellent job with SG&A. When looking at the figures quarter-on-quarter, we saw a 100 basis points improvement in SG&A leverage. Regarding gross margin, there are three main factors. Firstly, there was a one-time impact from Thrive amounting to 50 basis points. Secondly, there's a temporary mix pressure related to the growth of consumables affecting gross margin. Additionally, certain supply chain issues, particularly freight costs, have influenced gross margin. However, we have achieved structural enhancements in our gross margin profile through improvements in the mix of consumables as we transition to premium products. We've also seen improvements in our digital gross margin due to distribution savings and ad networks. Looking ahead to the mid to long term, we anticipate some of these challenges will ease, but we are adopting a more cautious and conservative approach in our bottom line guidance.

Our next question comes from Anna Andreeva with Needham & Company. Please go ahead.

Great. Thank you so much, and good morning guys. Two quick follow-ups from us. Can you talk about the gross margin puts and takes as we go through the year? You called out freight as one of the pressure points during the quarter. Are you seeing freight costs moderate as oil prices have been coming down here? And then secondly, on supplies, you mentioned strong trends quarter-to-date. Has that category improved at all? And what are you implying for supplies for the year?

Yes, let me take the first one, Anna. Regarding the inflationary pressures, it's important to note that we don't have real-time adjustments for some freight charges. For instance, the cost inputs we recorded in Q2 are largely capitalized in inventory and only impact the profit and loss statement as we sell that inventory. Therefore, as inflationary pressures ease and inventory turns over in the midterm, we anticipate some relief in those costs, but it won't be immediate. To clarify, while we will see more favorable costs, they won't show up in Q3. I expect that gross margin and EBITDA will improve seasonally in Q4 compared to Q3 due to the seasonal uplift we typically experience in the fourth quarter. Now, could you please repeat the second part of your question?

It was supplies.

I want to emphasize that a strong consumables business is excellent for us. It's a reliable source of revenue, and the lifetime value of these customers is significantly higher than that of non-consumables customers. Over the past three years, our supplies business has grown by nearly 30%. We've been successfully expanding this segment and it's very profitable, giving us a competitive edge against our main rival. However, inflation is putting pressure on this business. This is due to both inflation itself and the decrease in year-over-year stimulus. We expect to see recovery in this area as these factors lessen. Consumer research indicates that 40% of people not purchasing these products have simply postponed their purchases rather than canceled them, so we believe that demand will return. As we approach the holiday season, we are enthusiastic; we perform well during Halloween, Christmas, and Hanukkah, and our team is prepared with excellent merchandise. We are actively driving initiatives to stimulate purchasing in these categories. That said, we are being cautious in our projections due to the current economic uncertainties.

Okay. That's helpful. I appreciate it. Can I squeeze another one in? What are you guys seeing in terms of the overall growth in the pet space? There's been some chatter about higher relinquishments coming in. Just curious what your view is.

Yes. This is something that we both track closely, and quite frankly, I care a lot about. The fantastic news is relinquishments are below pre-pandemic levels. So there's the episodic new story on this, but through Petco Love, we're in touch with the majority of rescue scale rescues around the country and relinquishments are below '19 levels, which is great news.

Next question comes from Seth Basham with Wedbush Securities. Please go ahead.

My first question is just a little bit more clarity on the outlook from the margin pressure standpoint. The biggest factors pressuring your margin outlook for the balance of the year are those from mix or supply chain or investments in loyalty programs or otherwise?

Yes, I think you made a great point, Seth. The primary issue is the temporary mix pressure, which we anticipate will improve as the economy recovers in the medium to long term. The next significant factor is the freight and distribution costs; as I mentioned earlier, we have capitalized some of those costs in our inventory, and we expect improvements as those costs turn around. Your third observation is accurate as well. We are carefully balancing our strategy, managing short-term challenges while still investing. We have a substantial opportunity ahead of us – a $40 billion incremental total addressable market. We will keep investing in this opportunity to emerge from this economic cycle in a stronger position and well-prepared for the future.

That's helpful. And then my follow-up question is just looking at the Hard Goods category. Where do you see inventory levels being right now for the industry? And do you think that area of the industry gets more promotional in the back half of the year and could impact margin rate for you guys?

No, we feel very confident about our inventory levels. While there is a lot of market noise concerning this sector and inventory challenges, we are not facing those issues. The team has successfully managed our inventory levels. The year-over-year increase was largely due to costs, and from a unit perspective, our units have increased slightly more than revenue on a year-over-year basis and have remained relatively stable quarter-on-quarter. I am very pleased with our inventory position. Regarding the promotional environment, we have observed rational behavior in promotions across consumables and supplies, and we do not expect that to change.

That's helpful. And if I could just throw in one more follow-up for Ron. Just thinking about Vital Care and how the sign-ups there are trending helped to your expectations and the spend per customer. Are those on track and you think that creates more opportunity in this higher inflationary environment for your customers?

Yes. Thanks for the question, Seth. So I'll take the latter part first. Absolutely, Vital Care provides opportunity in this economic environment. Customers can save over $300 annually. So it is the right program at the right time, and it's differentiated. Nobody has anything like it. In terms of sign-ups, we are ahead of our internal plan, and there will be news in the coming months in terms of ways we're going to catalyze even further sign-ups and accelerate sign-ups. So we're very excited about Vital Care in terms of where we are. 2.0 is outperforming 1.0, and there will be more news shortly that will further accelerate Vital Care and it's right on trend right now in terms of customers. For that mid to lower-end customer, it is absolutely the right program to help them save money. And for the high-end customer, it really helps us to gain more of their share wallet.

Our next question comes from Zack Fadem with Wells Fargo. Please go ahead.

This is David Lance on for Zack. I guess the first one for me would be how your expectations for the category have changed in the second half of the year with the lower top-line outlook?

Yes. Look, David, our expectations for the category haven't changed. We still believe this category is a great opportunity for us, 7% long-term expected growth. If you look at our long-term algorithm, we still expect to gain share in that category over the long term. What we're seeing in terms of the second half outlook is transitory. Those discretionary categories are pressured. What we've seen in prior economic cycles if those categories are temporarily impacted, they do respond well as the economy improves, and we would have no different expectations this time around.

Great. And then just one follow-up. Can you talk about what you're seeing with some of the recent initiatives with the shop-in-shop with Lowe's and Rover?

Yes. We're really happy with the shop-in-shop with Lowe's. It's going well. To give proof of our ecosystem coming to life, we're actually now running Petco clinics in the parking lots of those locations as well. So we're excited about that. It's a great complement actually to our small town rural initiatives as well. So it's going well.

Our next question comes from Steven Zaccone with Citi. Please go ahead.

So maybe to follow up on the revision to EBITDA guidance. So the new guidance calls for EBITDA down 2% to up 1% on revenue growth of up 3% to 4%. The Analyst Day earlier this year, you talked about EBITDA growth tracking faster than revenue as a framework. So as you take a look at the year, do you see the primary drag to EBITDA this year as one-time in nature? I guess if consumables strength continues into next year, would this be an ongoing drag to EBITDA margins?

No, thanks for the question, Steve. We do believe it's one-time in nature. So we are still really confident in the long-term algorithm that we laid out at Investor Day, where, as you said, we expect EBITDA to grow faster than sales growth. What you are seeing this year is transitory in nature that mix shift from supplies and companion animals into consumables. Look, the good news about that is consumables customers. If you look on a long-term basis, have 30% higher LTV than a typical customer. So that's good news for us. Looking back at past economic cycles, the impact on supplies and companion animals are transitory, they are temporary. We expect that to rebound. Also, as we look to '23 and beyond, we expect EBITDA to return to our long-term output.

And we're already seeing improvements in freight costs.

Great. The follow-up I had was regarding your statement that you haven't observed any trade-down in the business. I'm curious because the pet category has been experiencing premiumization as a long-term trend. What leads you to believe that this won't be threatened by consumers opting to purchase more premium food?

Well, the first thing to note is that this represents a long-term trend that has been unfolding over the past decade. At its core is a strong consumer insight and segmentation, which highlights the humanization trend that has been robust for the last ten years. This trend is evident across all segments, especially among Gen Zs and Millennials. As these groups become a larger share of pet owners, there is increasing demand for premium products. This trend is ongoing, particularly in the fresh frozen category, which is expected to grow from over $1 billion currently to $4 billion to $5 billion in the next three years. The momentum is significant, and this represents a clear shift towards more premium offerings. We are not experiencing any slowdown; in fact, our ready business continues to see double-digit growth. Therefore, premiumization is also occurring in supplies.

Thanks for the detail. Best of luck in the second half.

Our next question comes from Simeon Gutman with Morgan Stanley. Please go ahead.

I wanted to talk about services for a minute. You mentioned that consumer discretionary, there was some weakness. Is there any overlap or a line of sight into either the vet spending or the grooming side? Have you seen anything change in frequency? And then how are you thinking about it for the second half?

Yes. Both businesses are strong. Trips are up, revenues up double digits and our vet business continues to have a positive impact on Pet Care Center store sales. So similar to my commentary on premiumization, people aren't cutting back on grooming or vet visits, and that's providing us with strength and buttressing our trips. There's a demand part of that equation and a supply part. One of the things that makes us excited is we added 600 veterinary professionals to our network in the first half of the year. 800 veterinary professionals via Thrive when you include the tax. So our capacity has seen a significant increase, which will continue the momentum that we're seeing.

The follow-up is on the supplies and companion animal. Can you take us through the sequential change over the last couple of quarters in this? I'm trying to zero in on the impact of gas prices that it had on this versus normalization against COVID trends versus industry trends. Is there any light that you can shed or the way you assess it? Because we've seen some gas prices let up, did the business improve a little from that or is it not that we're normalizing against COVID, and it's not about the near-term fluctuation in, let's say, gas prices?

Yes. Let me take a couple of steps back, Simeon. First, we look at it a couple of different ways. One of the things we've taken a look at is on a 3-year trend because you have to normalize some of the dynamics over the last couple of years on a 3-year trend, the supplies and companion business is very strong, up over 20%. If you look at Q1 to Q2, we saw consistency in the business is what I would say. If you look at what we published in the presentation on the site, minus 9 in Q1, minus 9 in Q2 on a year-over-year basis, again, 3 years strong, over 20%. In terms of gas prices, as I said earlier, while some of those have started to come down in terms of our P&L and how that impacts consumers, our P&L, we'll see some of that flush through later in the back half of the year as inventory turns. We have seen some trip consolidation in terms of our consumer behavior as gas prices have sort of stayed elevated despite some little bit of decrease. Again, going back to where this category is resilient, we have seen time to time again through prior economic cycles that this category responds. As Ron said earlier, 40% of some of these - of the purchases in supplies and companion animal are delayed, not canceled. We would expect that to come back.

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

Just wanted to follow up on your last comment. It looks like the hard goods mix was flat quarter-on-quarter. What drove the gross margin decline ex of that acquisition? It looks like it was down 60 basis points. Is that all transportation? Or was it like the mix within hard goods or mix to consumables weaker this quarter?

Yes, you're correct, Chris. It was a combination of factors including hard goods and transportation costs. There is some noise in the market suggesting that transportation costs are beginning to decrease, and that's accurate. However, real-time adjustments won't reflect this immediately since some of those costs become part of capitalized inventory. Therefore, on a quarter-to-quarter basis, transportation costs posed a challenge. As you noted, the mix impact was mostly unchanged year-over-year, but there were variations within that mix.

Got you. Okay, that's helpful. And then on SG&A, it looks like you're looking to raise the kind of base wage to $15 an hour. I guess how far are you off that level today in Q2? What does that mean for spend in the back half? And then just a broader question. Maybe speak more of the labor environment, what you're seeing if that's flattening up a bit? It sounds like your applications are up pretty enormously. I kind of just want to hear your perspective on each of those.

Yes. Thanks, Chris. So first, our total wage is up above $17. We've been working on this for a multiyear journey to get this to a good place. It's been a personal objective of mine to get every single partner at Petco above $15, which is why we feel great about making the move. It was already baked into our long-term model to get over $15 as kind of the base in light of inflation and the impact that's having on people. We felt like now is the right time. In terms of the labor environment, Petco is a great place to work. You get to leverage your passion for pets. We're a mission-based company. We take good care of our people. As a result, our applications, as I said, are up double digits and actually up 30% on a quarter-over-quarter basis. So we're able to attract talent, and these moves we're making on compensation will make us even more attractive.

Our next question comes from Elizabeth Suzuki with Bank of America. Please go ahead.

Just wondering if you could go through capital allocation priorities, just given that you took down the CapEx guidance a little bit, but you also took up your interest expense assumption for the year. So presumably as rates are rising, and that cost is going up. So how are you thinking about where you want to deploy cash going forward and thinking about your leverage?

Yes, that's a great question. We have maintained our long-term leverage guidance as outlined at Analyst Day. In terms of prioritization, we still have numerous high ROI investments that we are excited about. In the first half of the year, we focused heavily on those. We also made significant investments in fresh frozen products, and we expect to be in over 1,000 locations for JFFD by the end of the year. As we announced today, we are eager about our WholeHearted Fresh Frozen launch in the second half, which is a key focus for us. Balancing our capital expenditures for the year involves being practical about our cash flow. We have increased our interest expense guidance from $76 million to $90 million for the year, so we deemed it wise to reduce our capital expenditure range to $250 million to $275 million. However, we are not sacrificing our long-term investments. We will continue to invest in Fresh Frozen and enhance our digital assets to improve our capabilities.

Our next question comes from Michael Lasser with UBS. Please go ahead.

Brian, it appears you are incorporating a fairly consistent comparison into your projections for the latter half of the year, both on a one-year and three-year geometric basis. This is despite the fact that a significant portion, if not the majority, of the comparison is being influenced by inflation, and you will encounter some of the price increases implemented in the second half of last year starting this year. Do you anticipate that your units will gain momentum as inflation begins to ease? If so, do you also foresee a corresponding enhancement in our supplies business in the upcoming quarters?

Yes. No, thanks for the question, Michael. Look, I mean, you hit it. If you look at our 3-year stack, we actually see on a 3-year basis, a slight acceleration in the second half. So mid-30s on a 3-year stack with a little bit better in that second half. We do expect more vet builds in the second half. So if you look at what we said, we said 50 to 60 beds for the year. We did 15% in the first half. We would expect the vast majority of those to be in the second half. We have about 15 net PCC store adds in the second half of mix of small town rural and traditional PCCs. From a supply and NCA basis, look, we're being pragmatic about our approach to guidance in the second half. We do expect this category to return. But I think we're in a different spot than we were 90 days ago. As we look at the second half of the year, we felt it was appropriate to guide as we did to be pragmatic about how that category returns.

Also, we have an improving inventory situation. So that helps us in the second half as well.

That's helpful. And then my follow-up question is understanding that you're running the business for the long term, how would you expect free cash flow to unfold over the next couple of quarters given that it was under pressure year-over-year in the first half of the year?

Yes, I'd expect it to get better in Q4, Michael. Q4 is a seasonally strong quarter. As we look at free cash flow, we look at it obviously on a couple of vectors. I was really pleased with the operating cash flow in the quarter that the team generated particularly around the way they manage inventory levels. We will continue to lean into CapEx, although we've brought the guidance down. It is still a significant investment in CapEx for the year, which we feel really good about that long-term ROI. As we cadence through the balance of the year, I would expect free cash flow to improve in Q4.

Our next question comes from Peter Benedict with Baird. Please go ahead.

Okay. Maybe we don't have Peter. Maybe let's go to the next one, operator. We can come back.

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

A question regarding your net adds. Can you maybe tell us a little bit more about which areas were the most important to add to the net adds? Was it more the consumable customer or services? That would be helpful.

Yes, there was strength in both areas. This marks the 14th consecutive quarter of customer growth, highlighting the effectiveness of our marketing, the support of our partners in stores, and the appeal of our digital offerings. We are very pleased with this consistent increase. Both consumables and services showed strong performance. With our expansion to 200 vet hospitals, we're attracting new customers to our locations. Our Perks programs, which offer unique discounts on food and vet visits, stand out especially in the current inflationary climate, making them appealing to customers. Overall, we've maintained 14 consecutive quarters of growth.

Got it. Maybe this one is for Brian. Regarding the question about leverage, you mentioned that if we reach the leverage target set for the end of 2023, we might consider some buybacks. Has there been any change in that perspective?

No, nothing's changed there, Oliver. We remain committed to what we laid out at Analyst Day. Although the current year guidance has changed, we have levers to actually do that. Whether it be working capital improvements, earnings as I said a little bit earlier, we still believe the long-term algorithm and that return to EBITDA growing faster than revenue as we head into '23.

We are focused on getting to that destination.

Our next question comes from Peter Benedict with Baird. Please go ahead.

Can you hear me now?

We thought we lost you, Peter.

I’m unsure about what occurred earlier, and I apologize for that. I have a quick question regarding the momentum you mentioned continuing into the third quarter. Could you clarify what you mean by that? Are you saying that comparisons in July were better than for the entire quarter, and that trend has continued? What’s the reasoning behind that comment? That’s my first question.

Yes. What we'd say is our growth has continued into the third quarter. I think we're going to expand beyond that. We see transactions heading in a better direction. Overall, we're seeing continued growth momentum, we're seeing transactions heading in the right direction. From a mix standpoint, we're not seeing a dramatic change at this point.

That concludes the question-and-answer session of today's call. I would now like to pass it over to Mr. Ron Coughlin for closing remarks.

Thank you, operator. To our analysts, we appreciate your time and your questions. To our investors, thank you for showing faith in us every single day. Petco continues to grow in a category that remains strong and resilient even in times of economic headwinds. Above all else, our teams remain committed to driving operational excellence while putting the customer at the heart of everything we do and delivering against our long-term priorities with purpose-driven performance. Thank you for your time.

That concludes Petco's Second Quarter 2022 Earnings Conference call. The team will be available after the call if you have follow-up questions. Thank you.

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