Petco Health & Wellness Company, Inc. (WOOF) Q4 2022 Earnings Call Transcript

Good morning and welcome to Petco’s Fourth Quarter 2022 Earnings Conference Call. All participants will be in listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Cathy Yao, Vice President of Investor Relations. Cathy, you may begin.

Good morning, everyone, and thank you for joining Petco’s fourth quarter 2022 earnings conference call. In addition to the earnings release, there is a presentation, infographic and earnings supplement available to download on our website at ir.petco.com, summarizing our fourth quarter and full-year 2022 results. On the call with me today are Ron Coughlin, Petco’s Chief Executive Officer; and Brian LaRose, Petco’s Chief Financial Officer. Before they begin, I would like to remind you that on this call, we will make certain forward-looking statements which are subject to a number of risks and uncertainties that could cause actual results to differ materially from such forward-looking statements. These risks and uncertainties include those set out in our earnings materials and SEC filings. In addition, on today's call, we will refer to our non-GAAP financial measures. Reconciliations of these measures can be found in our earnings release and our presentation, as well as in our SEC filings. And finally, during the Q&A portion of today's call, we ask that you please keep to one question and one follow-up. With that, let me turn it over to Ron.

Thank you, Cathy, and good morning, everyone. Before we start, I'd like to officially welcome Cathy Yao as our new Vice President of Investor Relations. Cathy has a remarkable and varied background in both the buy and sell sides, along with experience in telecommunications and healthcare. Many of you may already be familiar with her; she has quickly become a valuable member of our team and is the proud owner of two Pomeranians, Loki and Freya. We’re thrilled to have her and her pets as part of Petco. Now, regarding our results, I want to express my gratitude to our amazing Petco partners for their outstanding efforts in achieving record sales in Q4. We marked our 17th consecutive quarter of comparable growth, our 16th consecutive quarter of increasing customer numbers, and achieved cash flow performance that exceeded expectations, all while navigating a challenging macroeconomic environment. Our partners exemplify our mission of purpose-driven performance, combining robust operational results with real improvements in the lives of pets, pet owners, and Petco employees. Petco's performance was enhanced by a pet category that once again showed solid growth, proving its resilience amid economic fluctuations. In 2022, the demand for pet products remained elevated compared to the previous year. Gen Z and Millennials emerged as the largest group of new pet adopters in 2022, along with being our highest spenders, contributing to increased spending per pet. We achieved 5% comparable sales growth for both the quarter and the full year, while net revenue growth was 4% during the same periods. This momentum carries into Q1, reflecting the ongoing appeal of our unique ecosystem. Critically, our full-year performance has strengthened our balance sheet and generated strong operating cash flow. Combined with the advantages of our cash management initiatives, we've recently paid down an additional $35 million in principal on our debt and are taking measures to manage our floating rate exposure. We remain committed to reducing debt while continuing to invest in our long-term growth strategy. Brian will provide more details shortly. At our inaugural Investor Day last year, we established three key growth pillars: first, the rapid expansion of services; second, enhancing the uniqueness of our merchandise; and lastly, using data and membership to cultivate loyalty and increase share of wallet. Let me update you on our progress in these areas. Services saw an impressive 14% comparable growth this quarter and a 36% increase over a two-year period. In veterinary services, we've established a presence in 90% of our pet care centers. Our veterinary hospitals and clinics treated nearly 1.9 million pets in 2022, positioning us among the leading veterinary service providers in the U.S. Record hiring of veterinarians, improvements in online booking, and innovation in medical technology have significantly increased transaction volume, resulting in double-digit sales growth year-over-year. We welcomed over 1,100 new veterinarians to our team in 2022, a 40% increase from the previous year, and added 50 new full-service veterinary hospitals, totaling 247 nationwide. This is a remarkable achievement considering we had just 10 hospitals at the beginning of 2018, placing us in the top 10 based on hospital units. Petco continues to provide a trustworthy ecosystem for pet wellness, unparalleled in the industry. Pet Care Centers with veterinary hospitals see mid-single-digit growth in center store sales, are growing faster, and generate higher profits than those without hospitals. In addition, veterinary customers display a lifetime value 2.3 times greater than non-veterinary customers. Last year, we conducted over 58,000 veterinary co-clinics across 46 states, significantly enhancing access to affordable preventative care for pets. Our veterinary clinic services are meeting a critical need for many pet owners. Beyond our unique veterinary offerings, we are redefining veterinary networks through innovative partnerships, trading programs, and advancements in medical technology, including AI radiology and diagnostics. This positions our veterinary business as a crucial growth driver, providing an attractive environment for veterinary professionals and enhancing pet health outcomes. Regarding our distinct merchandise, 2022 was another successful year. The inclusion of exclusive, independently branded store offerings like Backcountry and Stella & Chewy’s has been instrumental in boosting our premium product mix and attracting new customers. Our popular owned brands, such as Reddy and WholeHearted, have also seen revenue growth while catering to various customer budgets. Overall, our differentiated product assortment fosters customer retention by offering health-focused items that are not available through mass merchants or many online channels, reducing the intensity of competitive promotions. Total merchandise sales increased for both the quarter and the full year, with noteworthy double-digit growth in consumables, particularly from our WholeHearted brand. We also experienced continued growth in Fresh Frozen revenue and customers and saw double-digit growth in RX, making strides in this $12 billion market. While discretionary supplies in companion animal categories declined year-over-year, we improved our growth rate significantly in Q4 compared to Q3. In the high-value Fresh Frozen category, we have maintained a competitive edge over online-only retailers. Over 90% of our e-commerce customers opt for same-day delivery or Buy Online Pick Up in Store when available, allowing us to utilize our Pet Care Centers as micro-distribution hubs, delivering products more quickly and often at lower costs. Today, we announced an industry first: an exclusive partnership with Freshpet, the leading brand in Fresh Frozen pet food. This partnership makes Petco the first national omnichannel pet retailer to offer customized fresh pet food subscriptions directly to customers' homes. As the Fresh Frozen category is projected to reach $6 billion in the next four years, this move positions Petco to capitalize on the growing direct-to-consumer pet market, aligning with trends in personalization and humanization of pet care. Our omnichannel delivery capabilities are another key differentiator. Our digital platforms continue to grow, with app and website sales showing double-digit growth for both the quarter and the full year, resulting in a remarkable 32% increase over two years and 138% over three years for the full year. Additionally, we reached a significant milestone this year by exceeding $1 billion in recurring customer revenue from sources such as repeat delivery, Vital Care, and insurance, ensuring predictable and retaining revenue streams. In our Pet Care Centers, we’ve achieved 11 consecutive quarters of comparable growth in brick-and-mortar sales. Furthermore, we have implemented a base wage of at least $15 per hour for all non-trainee employees at Petco, leading to strong year-over-year partner retention rates and a rewarding work environment that benefits our business in both the short and long term. On the international front, our operations in Mexico have shown impressive revenue growth, with the addition of 12 new locations this year, bringing our total to 120. Our pilot program also continues to grow profitably, targeting the $7 billion addressable market, and is performing above expectations, trending towards cash flow positivity within the first year. Our Canadian Tire partnership pilot is also thriving and holds significant growth potential. Lastly, regarding customer loyalty and share of wallet, our data-driven approach to marketing and customer experience enhancements brought us 1 million new customers in the last year, including over 70,000 in the recent quarter. Our total active customer count now exceeds 25 million. In January, we combined all memberships under the Vital Care program, transitioning Pals program members to Vital Care Corp, and existing paid Vital Care members to Vital Care Premier. This unified approach has simplified our loyalty system and is already yielding positive results, reflected in membership upgrades. In February, we reached a notable milestone with 500,000 active Vital Care Premier plans. This program not only offers tailored benefits and savings to pet parents but also drives loyalty and integration into our ecosystem. Premier members enjoy a lifetime value 3.6 times higher than non-members, frequenting our stores more often and generating greater spending across categories, which translates to increased margins over non-members, especially among newly acquired members. Before I wrap up, I'd like to touch upon Petco Love. In Q4, we saved over 97,000 pet lives and reunited over 17,000 pets through our Petco Love Lost initiative. Partnering with Merck, we administered 172,000 free vaccines in the quarter, making significant strides toward our goal of providing our second million free vaccines, protecting pets from preventable diseases. These initiatives exemplify our commitment to purpose-driven performance. I’d like to extend my gratitude to Blue Buffalo for their support of the Yummy Memorial Cancer Fund, which provides essential financial assistance for Petco partners needing pet cancer treatment. On a personal note, I want to thank the teams at Petco Love and Priceless Pets Rescue for assisting me in finding our newest family member, a chocolate lab named Yogi, who is now happily adjusting to his role and keeping up with his vaccinations at our local Vetco Hospital. In closing, I am excited about the strength of the pet market and our distinctive strategy. While we have much work ahead, we are executing effectively in this environment, and our long-term growth strategy is both unique and effective. The pet category continues to thrive, and we have one of the best retail teams dedicated to delivering excellence day in and day out. Now, I'll hand it over to Brian.

Thanks, Ron and good morning, everyone. Building on Ron's remarks, we delivered against our strategic objectives throughout a challenging macroeconomic background, and I too want to extend my thanks to the thousands of Petco partners across our pet care centers, distribution centers, and support centers for their dedication to delivering the very best for pets. Looking at the quarter, net revenue was $1.6 billion, an increase of 4% year-over-year. Total revenue of $6 billion for the full-year was also up 4% year-over-year, and our cash flow came in significantly above our expectations, allowing us to take further actions to reduce principal on our debt, which I'll elaborate on more. In the fourth quarter, comparable sales driven by sustained strength in average basket trends grew 5% year-over-year and 19% on a two-year stack. For the full-year, comparable sales also grew 5% and 24% on a two-year stack. For the quarter, total services grew 14% year-over-year translating to 15% for the full-year, driven by strength in vet and grooming and further enhancements in our booking systems. In merchandise, strength in consumables, which grew 12% in the quarter year-over-year and 13% for the full-year, continued to offset the anticipated transitory impact of discretionary purchasing in supplies and companion animals, which were down 9% for the full-year. As Ron said, we did see a 100 basis point improvement in Q4. Our digital business also showed strength with double-digit sales growth in both the fourth quarter and the full-year and expanded gross margin in the fourth quarter, buoyed by strength in our digital pharmacy, repeat customers, and the continued growth of our rapidly scaling ad network. Moving down the P&L, gross profit was down 1% in the fourth quarter at $627 million and flat for the full-year at $2.4 billion. Q4 gross margin of 39.8% was down 220 basis points year-over-year, and gross margin for the full-year of 40.2% was down 160 basis points. The decline for both the fourth quarter and the full-year was driven primarily by the mix impact of consumable strength and transitory supplies pressure combined with elevated supply chain and associated capitalized rate costs, which, as for many, brought headwinds on a year-over-year basis. Our team has worked tirelessly to improve operating leverage by focusing on strategic cost initiatives and have picked up momentum throughout the year. As a result, I'm pleased to report that in the fourth quarter, SG&A as a percentage of revenue improved from 36.5% to 34.8% year-over-year, down 170 basis points. For the full-year, SG&A as a percentage of revenue was 36.5%, down 70 basis points. On an absolute basis, the fourth quarter SG&A expense was $550 million, down $3 million from the prior year, inclusive of continued investment in our pet care center partners. This demonstrates our cost discipline in a balanced approach to managing the short term while making strategic long-term investments. For the full-year, SG&A was $2.2 billion, up 2% from 2021. Q4 adjusted EBITDA was $170 million, down 1% from the prior year, with an adjusted EBITDA margin rate of 10.8%, compared to 11.4% in the prior year. For the full-year, adjusted EBITDA of $582 million was down 1.5%, with an adjusted EBITDA margin rate of 9.6%, compared to 10.2% in the prior year. Q4 adjusted EPS was $0.23, a decrease of $0.05 from the prior year based on $266 million weighted average fully diluted shares and a normalized effective tax rate of 26%. Full-year adjusted EPS was $0.75, a decrease of $0.16 from the prior year. I now want to take a moment to provide an update on changes to our going-forward adjusted EBITDA, adjusted net income, and adjusted EPS definitions. To date, we've been reporting these metrics consistent with the approach taken by other newly public companies. Following a period of evaluation and review over the last few months, along with feedback from investors and to remain in line with evolving best practices, we are updating the treatment of certain adjustments on a prospective basis. While our fourth quarter adjusted non-GAAP results reflect our prior definitions, future results will be based on these updated definitions. To be clear, none of these changes will have an impact on Petco's cash flow or affect the company's operations and strategic priorities. We will no longer include store pre-opening, store closing, and non-cash occupancy expenses in our adjustments and will limit non-recurring costs to restructuring charges, one-time material legal reserves, and significant one-time transaction related charges. We believe these updated definitions will create more clarity and insight into Petco operating results. To assist investors in this transition, we've provided reconciliations between our prior and new non-GAAP definitions. Moving beyond the P&L, our liquidity position remains strong. We ended the quarter with $646 million inclusive of $202 million in cash and cash equivalents and $444 million of availability on our revolving credit facility. We've continued to make meaningful improvements in our cash flow performance with a 96% increase in Q4 operating cash flow over the prior year, and free cash flow of $71 million, up $76 million over the prior year. The way the team managed the inventory was a key contributor to our strong free cash flow, an outcome of our investments in strategic supply chain enhancements, as well as operational discipline. In-stocks were up tangibly year-over-year and we continue to work actively with our vendors to position us well while we navigate this environment. Last quarter, we said we expected to be free cash flow positive for the year while still investing in pillars of future growth, including veterinary hospitals and cooling infrastructure to accelerate our Fresh Frozen business. With exceptional cash flow performance in the fourth quarter, free cash flow for the full-year was $68 million. We continue to see opportunities to further improve our working capital moving forward. Given our strong cash position, as Ron noted, last week we paid down $35 million principal on our debt, $31 million more than the required quarterly payment, indicating our strengthening balance sheet and commitment to reduce overall debt levels. Additionally, to take further actions to manage our interest rate exposure, we implemented callers on a portion of our floating rate debt. Combined with the caps we implemented last quarter, we have significantly mitigated our interest rate exposure. Now shifting to 2023, as we plan for the year, we remain confident in the strength of our unique health and wellness ecosystem that continues to set Petco apart and in our ability to deliver against our strategic priorities, including vet digital and owned and exclusive brand differentiation. We fully expect the pet category to remain resilient with overall growth, as seen in past economic downturns, with notable strength in consumables and services. While discretionary categories remain pressured, and while we anticipate the macro environment to remain fluid, we expect our supplies and companion animal businesses to work their way toward normalization. In the meantime, we are focused on programmatic cost initiatives to mitigate against mix pressure to manage our business in the short-term while reinvesting in the business to improve long-term profitability and create additional shareholder value. We're confident in our ability to continue to improve free cash flow in 2023, and to do so without sacrificing ongoing investment in our strategic long term growth initiatives. Turning to guidance, I'd like to remind you that our outlook reflects our new updated non-GAAP definitions. Additionally, fiscal 2023 will be a 53-week year for Petco, leading to an incremental week of operations relative to fiscal 2022. Our guidance reflects the extra week. In fiscal 2023, we expect revenue of $6.15 billion to $6.275 billion. Adjusted EBITDA of $520 million to $540 million to be roughly flat. Adjusted EPS of $0.40 to $0.48, including an incremental $0.12 to $0.15 in expected interest expense since fiscal 2023. Approximately $273 million of shares outstanding and an effective tax rate of 26% and $225 million to $250 million of capital expenditures. The expected reduction in capital spend in 2023 reflects the completion of one-time investments in high ROI initiatives such as freezer build-outs for Fresh Frozen and the retirement of some technical debt in IT. Importantly, we will continue to invest in our long-term growth drivers. Additionally, we are targeting principal debt payments of approximately $100 million as a commitment to further strengthening our balance sheet. Our guidance is based on the current economic outlook and represents a one-time forward-looking comment on our debt paydown in light of this unique environment. We expect to open 50 to 55 owned veterinary hospitals in 2023 and 10 to 15 rural locations, both of which are reflected in our guidance. When thinking about our guidance, there are a few things to keep in mind: in light of our expectations of the macro evolution and the transitory softness in the discretionary categories, we anticipate adjusted EBITDA to be down in the first half, with Q1 being a low watermark, and flat to up in the second half. As we start to see normalization in discretionary trends, we expect improvement in the revenue and gross margin trajectory that we are currently anticipating for the year and correspondingly an enhanced EBITDA rate. We saw modest improvements in freight costs in the back half of 2022 and we expect to see further improvements in our freight costs in 2023 as the overhang on freight alleviates, which will be increasingly realized as we progress through the year. And finally, I'd like to reiterate our emphasis on investing for long-term growth and our continued execution against our working capital optimization provides us confidence to support our balance sheet while also making high ROI capital investments. To conclude, we remain committed to delivering against our short, medium, and long-term goals to provide the best and only full-service health and wellness ecosystem for pets and to deliver sustainable profitable growth. We remain focused on what's in our control and on our structural investments in services, differentiated merchandise, and data and memberships continue to be the drivers for growth in a resilient category, while making us well positioned for consumers in any economic environment. Thank you for your time. And with that, we’d be happy to take your questions.

We will now begin the question-and-answer session. Our first question comes from Kate McShane from Goldman Sachs. Please go ahead.

Hi, thank you. Good morning. We wanted to ask around consumables and supplies. Thanks for the color that you've given so far. You had noted more normalization in the supply category as we go into the back half. Should we be assuming that it inflects? And just what is being incorporated into your guidance for this category when it comes to the potential for a tougher macro backdrop or recession?

Hi, Kate. I'll start; it’s Ron. If you look at the segments from a consumable standpoint, consumables remain strong. And we predict they will continue to be strong, particularly with the addition of our Freshpet announcement this morning. Services remain strong. We continue to see strong growth in grooming and double-digit growth in veterinary services. So we’re very pleased with that segment. As we cited, we saw a 100 basis point improvement in Q4 to Q3; there were macro dynamics, as well as we took some initiatives like our supplies perks program, which we launched this quarter, and we're already seeing 300,000-plus customers in that program. If you look at past recessions, it's actually playing out exactly the way it is now. Consumables and services stay strong, while discretionary spend gets impacted for five to six quarters, if you recall, it started last year. So we would anticipate that normalization along that similar timeline. I’ll let Brian add in terms of assumptions.

Yes. In terms of assumptions for the guide, Kate, piggybacking on Ron's remarks, we expect consumables to continue to grow, and we expect services to continue to grow. Part of our guidance implies that if you look at the first half, as I mentioned in the prepared remarks, we would expect EBITDA to be down in the first half; that's primarily due to mix shift pressure with consumable strength away from discretionary categories. As that normalizes, we would expect that to sort of come back in the second half.

Thank you. And then just a quick follow-up question on Freshpet. Is there any margin differential with Freshpet within the consumables category?

We couldn't be more excited about Freshpet. First, if you look at Fresh Frozen, Fresh Food, customized, delivered to customers. Most of the offers that are customized are coming to the customer's frozen. So it is a game changer from that standpoint; the margin is accretive to our current Fresh Frozen offering for the most part.

Yes, good morning. And first of all thank you for changing the adjusted EBITDA calculations. So my questions are about the slowdown in the fourth-quarter net adds; if you could maybe comment on that, what drove it and what do you expect in 2023 for net adds? And then my follow-up would be to the adjusted debt-to-EBITDA ratio, if you have a new goal there for this year or going forward? I think last time you spoke about maybe buybacks by the end of 2023 when you reached your former adjusted debt-to-EBITDA ratio; if you could update us on that as well? Thank you.

Hi, Oli. Thanks for the question. We've grown our active customer base for 16 consecutive quarters. We reached 1 million net new this past year. So we now today have over 25 million customers, which is a lot more than you and I started talking several years ago. Importantly, over 24 million of those are members of our loyalty programs, formerly Pals in our Vital Care. Our ability to interact with those customers and provide enhanced services is very strong. We like many of the dynamics within our customer base. We're growing multi-category customers. We're growing recurring revenue. Actually, recurring revenue customer revenue is over $1 billion in ‘22, which is a big deal if you think about predictability and stickiness. We have over 0.5 million Vital Care members, and we're growing penetration with the higher spending millennials in midyears; all that is good. While Q4 adds were below expectations, it was primarily driven by churn among lower spending customers. But we're also not going to sit on that; we've enhanced our OPP offerings, profitable OPP offerings, and we'll continue to do that and then get those customers into loyalty programs. So we're focused on it and continuing to add, as I said, we've had 16 consecutive quarters of net adds.

Yes, let me take the second one, Oli, in terms of debt. I'm not going to comment on any kind of target today in terms of ratio. We would expect to update on the future Analyst Day, the way we’d expect to do in the coming month. We did a couple of things this quarter; we put callers in place, which combined with the caps that we did last quarter significantly mitigates our interest rate risk and also allows us to capture the length of an interest rate. We've paid $35 million down on our principal debt last week and then we would target for the year $100 million for debt reduction. We're committed to deleveraging.

Great. Thank you. Could you just elaborate a little bit on what some of the principal drivers were offsetting better-than-expected free cash flow? And then your expectations for 2023?

Yes. Let me start by saying the right way to think about 2023 is higher free cash flow than in 2022. In terms of the drivers, Kate, we've been talking for a while now about opportunities in working capital. I think the team did an exceptional job this quarter in managing inventories. If you look at our overall inventory management, in-stocks were up tangibly at the same time, inventory on the balance sheet was down in dollars and more meaningfully down in units. So we managed our in-stocks better; we managed our balance sheet better. There's more opportunity for us in terms of working capital, and that's what translates to expectations of higher free cash flow in 2023.

Hey, thanks for taking my question. I was wondering if you can provide a little bit more color on what you're seeing in the vet labor market. You've been very successful at hiring vets this year. So curious how you're seeing that market evolve in Q4 and into Q1? Thanks.

Thanks for the question, Corey. In a nutshell, we're very pleased with our performance to date. That market, while it remains tight, we're very pleased with our ability to bring in high-quality vets into our network. We brought in a record 1,100 vets into our ecosystem - 40% more vets in Q4 than the prior year, and our time to fill and our attention are above industry benchmarks. Clearly, our strategy is working; it's clear that our value proposition is working, whether you look at we allow vets to practice medicine as they see fit and we provide vets with stock. There are a lot of unique attributes of our offering that just is ahead of what competitors are offering. We've also established a strategic pipeline with our Vet Tech program, which is one of my personal favorites. What that means is, if you're a center store partner of Petco and you have an interest in being a Vet Tech, we’ll send you to Vet Tech school and you'll be a feeder into our system. The Vet Tech market is tight as well, and actually, our first graduates are going to happen in 2023, and I'm really excited about that. So net-net, it’s a tight market, but we're outperforming in a tight market.

Thanks. And then just as a follow-up on the outlook for 50 to 55 vet centers this year. Is that reflective of the tight market? And is that the rate we should think about you adding vet centers going forward, or do you expect to get back to the long-term 70-year model maybe in 2024? Thanks.

Yes, Corey, that's more reflective of a balance. As we look at our total CapEx spend for the year, as I guided, $225 million to $250 million. Part of that decrease was the rollover of some one-time high ROI investments we made last year in freezers. The retirement of some technical debt, but we're taking a balanced approach to CapEx. We have 50 to 55 vet hospitals; we’re still committed to that for long-term growth. It's one of our number one priorities in terms of long-term strategic growth. We have 10 to 15 of our small-town rural build-outs on top of the 50 to 55. So in total, when you think about units, you're still about 70 units roughly if you take the vets combined with the STRs. We feel like the guidance we put out with CapEx, the balanced approach to short-term versus long-term investments is the right approach.

Great. Thanks so much and good morning, guys. Thanks for taking our question. I wanted to ask about gross margins; I think they're about 300 basis points below the pre-pandemic levels for the business. Can you talk about what's implied in the guide for gross margins for the year? Should we expect the declines there to begin to moderate here in the first half on freight normalizing, or is that mostly dependent on the supplies category stabilizing? And then secondly, I'm connected to that. Ron, you had mentioned for a number of quarters now promotional activity in this space being pretty rational. Can you talk about what you saw in the fourth quarter and what are you seeing to start 2023 so far? Thank you so much.

Yes, let me take the first one, Anna. So the vast majority of our margin pressure on the business is driven by that transitory mix shift headwinds. In prior economic cycles, as Ron mentioned, the discretionary categories have been impacted for about five or six quarters. We expect that to follow a somewhat similar pattern. Our guidance for the year implied EBITDA down in the first half, flat to up in the second half, primarily due to that transitory mix shift. Now underneath the businesses, we continue to make operational improvements. If you look at our services business, we grew margin year-over-year. If you look at our digital business, we grew margin year-over-year. That includes rapid scaling of our ad network. So taking all that in, we're taking a somewhat cautious view and we're focused on executing as we navigate through that environment. And I'll flip it to Ron for the second question.

Yes. Hi, Anna. Thanks for the question. Overall, the pet market does continue to be fairly rational; one of the dynamics in the industry is demand continues to exceed supply. That gap is narrowing, but at the same time, we're getting cost concessions with some favorability in freight, which gives us more leeway. From our standpoint, we focus on delivering value. That includes great products for great prices, so we're seeing significant growth in WholeHearted as an example, which is more of a mid-tier price but great value for a great product. Where we promote, we focus on being strategic in search surgical, we've talked in the past about leveraging promotions to drive outcomes like BOPUS where we have favorable profitability and loyalty program adoption like Vital Care. Speaking of Vital Care, customers save $400 a year in Vital Care. We're thrilled to get over 0.5 million customers. So we see the market as rational, and there’s a fundamental reason for that and that’s kind of demand continues to exceed supply.

Good morning, everyone. I wanted to follow-up please on the guidance. So the down $10 million that sounds like some buffer in case the first half or second-half, I guess mix doesn't pan out? And then just to confirm the right interpretation?

Yes, I'd say we're taking a prudent view, Simeon, when we look at the year, and that's why we kind of gave a little bit more color on the half versus half. If you think about the half guide with EBITDA down in the first half, flat to up in the second half, that is an expectation around sort of the pattern of the supplies and CA categories.

So the comments on Q4 versus Q3 was a sequential improvement in the growth rate versus year ago. So sequential improvement in the growth rate versus year ago. In terms of Q1, we're not going to break down at the segment level. What we said at the macro level is our momentum on the total business has continued into Q1. We see both category strength as well as we're happy with what we're seeing in the five or six weeks into Q1.

Good morning, Ron, Brian. I wanted to follow-up or start with ROIC, return on invested capital. I think Brian you mentioned some high ROIC investments like coolers this year. So hoping maybe if you could just take a step back given the guidance for 2023 and speak to your ROIC targets and our hurdle rates. And just comment on whether the current environment is impacting your willingness or ability to spend on non-strategic initiatives or if you're still, sort of, achieving those hurdles and targets as you would expect?

Yes, I actually love this question, so thanks for it. If I think about our CapEx investments, if you think about where we guided on vet hospitals and small-town rural locations, those are both meaningfully above any hurdle rate that we put out in terms of ROIC. Those small-town rural locations are cash flow positive generally in the first year. In aggregate, those locations are performing above our expectations for the ones that we've actually rolled out. So 10 to 15 is a slight further step into that scale pilot in year two. That remains a priority for us, and that 50 to 55 hospitals continue to track for the 247 we have in place, in line or above our historical IPO model for vets. So those are tangibly above any kind of hurdle rate for ROIC. What we are doing, if you look at the step down in CapEx from 2022 levels to 2023, we did have some sort of one-time-ish investments last year; freezers is the big one that we've referenced. We have freezers in over 1,000 locations now in our PCCs, that's a return on investment that doesn't take a whole lot to compute. We look at the fresh market as a slightly below $1 billion market growing to $4 billion in the next three years. We think we have a competitive advantage in that market. So the investment was something that we felt really good about making.

Let me build on that. That does not imply we won't increase the number of coolers. It was a unique deal with a certain vendor where the financial terms were. In that instance, we put in the coolers. There are other instances where the vendors and the majority of instances where the vendors fund the coolers, so we don't anticipate not putting in more coolers, because the category is growing. It's just where those dollars get paid for, and in most instances it's vendor funded.

Appreciate the color. And then just a quick follow-up, more of a clarification question around the share count. It looks like the guidance implies 2.5% growth. So maybe just help us understand what's driving this on a year-over-year basis and what's the right burn rate to think about as the business stands today as it pertains to the share count?

Yes, I think all you have to think about there, Steven, is we went public two years ago. We started issuing equity as a company two years ago, and there's a slight increase in share count associated with that.

Thanks a lot, and good morning. My question is around inflation; if you could give us some color on how much inflation-driven pricing benefited your comps in the fourth quarter and what your outlook is for 2023? That would be helpful.

Hey, Seth. I'll talk broadly about 2023 and then Brian can talk about impact into Q4. The pricing we took in 2021 and 2022 is sticky. Demand continues to exceed supply, particularly with consumables. We believe the vast majority of vendor pricing has come through, and while there may be pockets, we don't anticipate significant further vendor pricing actions in 2023. The way I think about 2023 is there'll be a balance of some areas where there's disinflation and some areas where there's slight inflation. So I'd call it an even year in terms of how to think about it at the category level and our level. I'll let Brian talk about that for Q4.

Yes. I would just add that Amy College and our Merch Team, they really do a tremendous job managing cost inputs and pricing actions. And I also had that freight costs have improved modestly in the second half. We expect that to continue into 2023. One of the benefits of having a differentiated portfolio is the strength of our relationship with vendors. So we typically have long lead time to evaluate any inflationary inputs, analyze the pricing elasticity, and then respond in a way that's in the best interest of customers and the company.

That's helpful. And just a follow-up, so flattish in terms of 2023, but there should be some wrap-around benefits from the price we took in 2022. Is that a low-single-digit contribution to your comps in ‘23?

Yes, we're not going to get into specifics. What I will tell you is that when you look at our basket, we've been really pleased with our basket performance, not just in Q4, but for the balance of the whole year in 2022; we're about that in '23, and that is much more than pricing; it has to do with a lot of the hard work that the team is driving.

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

Good morning. Thanks a lot for taking my question. There's a lot to unpack with the guidance given the extra week and the adjustments you made to the definition of adjusted EBITDA. So on that, can you give us more of an explicit sense on how you're thinking the comp is going to unfold through the course of the year? You expect the supply business to improve in the back half. Does that mean the overall comp is going to improve in the back half? And then what is the year-over-year change in margin that's assumed at the midpoint of the guidance?

Yes. Thanks for the question, Michael. I'm not going to get into any kind of quarterly guidance. I will tell you, yes, I'll reiterate some of the points we made in the guidance that we expect consumables to remain strong, and services to remain strong. We've talked about a five to six-quarter cycle in the discretionary categories. We're somewhat in the middle of that, so we expect that to normalize as we get into the back half; with that, certainly would come enhanced revenue and enhanced margin. Ron, can I add one comment? The fourth quarter’s prior year results are also elevated. You have to keep that in mind.

And my follow-up question is on the long-term margin outlook. So your operating margin for this year is going to be slightly above where it was in 2019. What's the path to getting to the long-term goals that you had outlined at your Analyst Meeting a year ago? Is it simply seeing an improvement in the supplies business as a way to improve the overall profitability of the enterprise from you?

Yes, a couple of points, Michael. Number one, you hit on it. The impact of the business from mix shift is cyclical. This is something that we would expect to normalize over time. I would remind you too that in the fourth quarter, we deleveraged on an SG&A rate by 170 basis points in the fourth quarter, 70 basis points for the full-year. So we have cost actions in place to make sure that we are deleveraging. What that does for us is it protects us in any kind of a downside scenario in '23, and then an upside scenario provides us significant leverage to enhance that EBITDA rate. I will also tell you when you look at the long-term, we're excited about our positioning in the market. We continue to invest in vets. As that vet model matures, we would expect improvements in various gross margins. We talked last year at Analyst Day about having about 500 basis points of room to go in our digital margin. We continue to make progress against that, so there's a lot of room for us underneath the businesses and as that mix shift normalizes, we'd expect that to improve.

Hi, everyone. Thanks for the question. I'm going to ask a similar question as Michael, but in a different way. Looking at the guidance, it seems to suggest about 2.9% year-on-year revenue growth. If you exclude the extra week, it comes down to 1.5%. Considering the base effects from Q4 compared to Q1 and Q2, that's added another point to revenue. My question is, it seems there isn't much in terms of comparable growth for '23. Are there any store closures or factors that might impact revenue next year? I'm wondering if there's something that could be affecting the revenue guidance for '23 that we should be aware of.

Yes, no, no, Chris. I think the way you think about revenue versus comp is relatively similar. There's not a whole lot of difference between comp and revenue. So I think the numbers you were quoting are probably at the midpoint of our guide, 1.5% and 3%, but that should roughly translate to comp, so there is comp growth implied in the guide.

Got it. That's really helpful. Just an overall question: it seems like you're anticipating that the consumables and hard goods will start to grow again in the second half. Is the consumer healthy? Are you noticing people trading down in the stores? Is this trend consistent across different demographics? What gives you the confidence that as the comparisons on hard goods supplies become easier, things will improve in the latter half?

Yes. Hey, Chris. Thanks for the question. So let me segment it. First, to be clear, consumables continue to be strong; we're talking about double-digit growth. There was just a piece of research that said that pet parents are twice as likely to come back on their own food as they are their pet's food. So we don't see any change, and in fact, we continue to pre-immunize within our portfolio. So in general, within our portfolio, we continue to pre-immunize tied to the humanization trend that's a decade-long trend. It continues today, so we see strength on that. We see strength on services. From a supply standpoint, you see the discretionary spend; you're seeing it across different categories. We did see a sequential improvement this quarter. We have gone back and analyzed prior recessionary times, and the behavior looks pretty similar. We saw an improvement when gas prices backed off. So there are lots of different dynamics in it. But if you look at past recessions, it's about a five to six-quarter dynamic. But overall, pet demand remains strong. As I said, it remains above supply, so that's the dynamics are positive; it’s just the discretionary piece that is cyclical.

This concludes our question-and-answer session. I would like to turn the conference back over to Ron Coughlin for any closing remarks.

Thank you, operator. To our analysts and our investors, as always, we're grateful for your time and your support. The pet category remains resilient, and it's a growth category. We remain committed to executing throughout this environment, while simultaneously making progress against our long-term strategic growth priorities. We look forward to updating you throughout the year on our continued progress.

That concludes Petco's fourth quarter 2022 earnings conference call. The team will be available after the call if you have any follow-up. Thank you.

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