Petco Health and Wellness Company, Inc. (WOOF) Earnings Call Transcript & Summary

Good afternoon, everyone. Sorry for the quick delay. I'm Simeon Gutman, Morgan Stanley's hardline, broadline and food retail analyst. It is our pleasure to welcome Petco to this event, inaugural visit. I don't think they've ever been to our conference, even as an older public company. Represented by CEO, President -- Chairman and CEO, Ron Coughlin. I'm going to read a quick disclosure, sit down and have a conversation, and then we'll leave some time at the end for questions. For important disclosures, please see the Morgan Stanley Research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. Thanks for being here.

Of course.

All right. First question. So I've admired your tenure as CEO, even when it was private because the business started to go under a pretty big transformation. There haven't been many -- there's not a lot of retail turnaround stories that have endured, for whatever reason. And the things that you've changed: culture, product, I guess service, holistic approach, now into vet. Anyway, I wanted to start with those elements and maybe just frame it for people because I think the business went through more significant change then the market sort of gives it credit for and open it.

Yes. I appreciate the question. Thanks for having me. I mean first, the market backdrop, a $100 billion business, growing -- or category growing healthily, 5% to 6%. So we are in a fantastic category. When I came in, it was June of 2018, declining business, 5% to 6% decline in business. The first thing was to fix the operational integrity of the business, how it was operating. And I brought in a lot of blue-chip talent, talent from Best Buy, talent from HP, talent from Walmart, talent from Target, PepsiCo and people who know how to run companies in a very disciplined way, and that worked. Take Justin Tichy, he was Walmart, Target and Best Buy, and he's my head of stores and he knows how to operate, he simplified things down to kind of 4 metrics, that'd be number one. Number 2 is we had a highly underdeveloped digital business, and it was very promotional. And so we kind of addressed the technical debt there, number one, and then brought in Darren MacDonald from Jet, Walmart.com, and our digital business is now up 140% over the last 3 years. And it's not kind of one-off, it's building out capabilities like repeat delivery, same-day delivery, et cetera, would be the second one. And then third was the services business. Our services business was a 7% decliner. And quite frankly, it was kind of where careers went to die inside Petco. We put some of our best people on services, got the Grooming business growing double digits. And then we started a buildout of the Vet business. And if you look at the Vet business, we started with a joint venture because we didn't have confidence that we knew the Vet business, which is probably sound. But the more we looked at it, the more we liked our own model. We launched our own model 3 years ago in Las Vegas, and the financials were superior, the control of the integration, rest of store. And we're now over 200 vets and that's been very favorable to us. So those are kind of a true first-class digital business, a true services leg, in addition to a lot of changes we did on the merchandise side. The biggest of which is we got rid of artificial ingredients. We got rid of things like shock collars and really dedicated ourself to the wellness of pets, and a health and wellness positioning. It worked.

What don't we see?

What don't you see? Some of the things I cited, like the people, right? It's not as evident that the class of people that we brought into Petco, they're Fortune 50 level type of people. The hard work to build the vet business and the fact that we liked our business better than the joint venture partner, even though they'd been in the business a decade prior. The operational integrity. And then lastly I'd say, and we'll probably get to this in a later question, is we unlock the passion of our team. If you go into one of our stores, for the most part people are there because they love pets, and they want to take better care of pets. And they've been at disconnect with corporate and making kind of more kind of financial decisions. And what we said was what's right -- best for the pet is right for Petco. And when we got rid of our artificial ingredients, when we got rid of shock collars, it just unlocked the hearts of our employees and that made all the difference.

And that's what I was going to get to next. And you said a nice phrase, unlocked the passion of the team. This is a skeptical question, but the skeptic in it is you've reinvigorated organizational momentum, culture within the store, and it's done around pets. How do you maintain that? And even if sales slow a little, how do you maintain that confidence even in tougher times?

Yes. So when I go visit a pet care center or Justin goes visit a pet care center, we do 2 things. The first thing we say is we work for you, and we truly turned the company upside down. I'd go into stores and people would say, well, my register is down for hours, and then I'd go to the IT department. Well, why didn't -- well, I didn't have time. And we turned all that upside down. IT works for the stores. Real estate works for the stores, I work for the stores. And when you turn that upside down, it's amazing what happens. You start getting e-mails that say, hey, we're a pet company, why don't we have bereavement, and we launched bereavement. I can't afford to work at Petco because you don't have parental leave. Well I didn't know we didn't have parental leave until I got that e-mail. So when you open the door, all of a sudden, you find out all the things you could do better. And when you turn things upside down, you hear. Well, the real estate team isn't fixing the drain in the groomer. You hear that the register's there. So that was a second big part of it. And the last was taking care of employees. We just announced we're going to $15. One of the first things we did was we pushed data down to the store level, right? It used to be, I'd go to a store and I'd say, how is your premium mix doing? They didn't know -- they didn't have data. The data was kept in San Diego. We [ stated ] down to the general managers, made them call them general managers. They weren't general managers before. We give them bonuses on their store, but so every general manager has a bonus, which I don't think is common in the retail industry, and then we gave them stock. When we did the IPO, I got lots of questions, but we pushed stock down to every general manager, which I don't think is common, and created -- so give them the data, the accountability and then the reward.

So this business was very primed for what happened around the pandemic organizationally, technically, right? All of these investments were just put in place and then the pandemic happened. So bad pun, but you were like a coiled up companion animal. And then you've had this massive growth in pet ownership. So you had the best of both worlds, but this is going into more of a skeptical question, which is how do we know we're through the digestion, whatever reversion is happening? I know we're seeing some in discretionary spend. How do you feel that it could take a long period of time to adjust to this as opposed to growing right past it.

Yes. One of the biggest questions I got in the IPO when the COVID pet boom happened was, is this really a pull forward, and is there going to be a hangover. The good news is you get to go to Vegas and not be hung over the next day in this instance because of the -- what I call the furry annuity. You only get 1 set of patio furniture. Most people only get 1 set of patio furniture. You only get a couple of TVs, but the reality of it is that pet's there for the next 10, 12, 15 years. And so you're going to be spending on that pet. And guess what? Because millennials and Gen Z'ers are adopting the majority of pets, they're spending more. So there was not a hangover. Pet adoptions are actually up above prepandemic levels. Relinquishments are down below pre-pandemic levels. So if you look at the category, there's 2 dynamics that drive the category. The first dynamic is number of pets. The second dynamic is spend per pet. Both of those are ahead of prepandemic despite the COVID pet boom, which lifted our business.

By the way, I forgot to say sorry for your loss of Yummy, a big advocate for the industry.

It was Petco's loss. He was the Chief Dog Officer, my yellow lab I lost 6 weeks ago.

The competitive landscape. This has been 1 of the more dynamic among all of retail, because you've had this pure-play e-commerce company come in, plus the other prevailing one at Amazon. So can you talk about how the landscape has changed. Petco's position has been stabilized, secured fortressed in a way, it came from a position of weakness now to arguably a position of strength. How does it evolve? And do we see a reacceleration back towards e-commerce? You'll be part of that story now, but any thoughts, yes.

So if you look at customers and you ask them, how do you want to shop -- pet parents, rather. How do they want to shop? 29% say they want to be digital only, 39% omnichannel, the rest brick and mortar. So I'll be honest with you, when I first got in the job and we had all that technical debt, I said, oh, I'm just going to stay out of Chewy's way. And then what COVID taught me is we can compete for that 29 too, because there's a portion of that 29 that one repeat delivery, one same day, want a BOPUS pickup that they can't do. So 29 is where I compete with Amazon and Chewy and we've proven we have competitive assets that they don't have. The 39 for omnichannel, that's mine. And I go after that 39 in a big way, nobody else can offer the array. From an operational standpoint, 70% to 80% of our e-commerce orders get fulfilled through our pet care centers. We use them as forward-deployed inventory. So that's ship from store, same-day delivery, BOPUS and curbside. And that gives us advantage, particularly in an environment where UPS and FedEx rates are going up. So that is a fortress. Right now, we have a particular advantage because we locked in, if you recall, on our earnings -- our Analyst Day, we locked in DoorDash in March, right prior to gas prices going through. So we have a locked-in contractual rate on same-day delivery that gives us real advantage.

Is the customer acquisition cost for the incremental e-commerce -- I don't want to say omnichannel, but e-commerce customer -- is it getting higher, or it's been the same. It's always been competitive, that initial offer.

Yes. We've had advantage versus online on customer acquisition for a while, and the bundling really serves us very well, in my view.

Discretionary, you're seeing some pressure. We've talked ...

I should say Cyber Monday was fantastic, by the way. Cyber Monday was very strong.

Good. So discretionary seeing some pressure in this environment outside of Cyber Monday. I guess, when do you expect it to inflect? And maybe a better question is, are you seeing the underlying unit deterioration? Is it stable? Is it getting worse? Or is it actually getting better?

Yes. So let me break down the business. Analogize with '08 recession. So food and services, rock solid, right? Marginal impact -- no impact on food, marginal impact on services. That's exactly what happened in the Great Recession. Supplies, because of discretionary, got hit. I saw Doug McMillon on Squawk this morning. He was saying the same thing, right? His food business is great, toys more challenging. So discretionary spend hit our supplies. Tennis balls are lasting longer, leads are getting frayed before replacement. So you go back to '08 and if you plot it, Lehman went down in December of '08. It took about 12 months for supplies to start reversing that trend, and it took 15 to 18 months for them to turn positive. Whether we're precisely on that same trajectory, I don't know, but kind of -- that's kind of the path that's happened in the last recessions. So we were March, April of last year is what I would call it, maybe April, May, but that's kind of -- could have come -- now we're not passengers on that bus. We have launched Supplies Perks. We've [ relaunched ] companion animal programs. The lapping factor on stimulus and child tax credit has been something we've dealt with all year. Obviously, that dissipates after December. So there's a lot of initiatives going in place, but until we see it, we're not calling it.

And this is the spend per pet and the discretionary spend per pet, not the food.

And spend per pet continues to go up structurally. This is structurally, this is spend on supplies, and companion animals specifically.

Got it. Okay. Talking about margin or by product category, the mix shift has been margin-dilutive. And like you said, you're not a passenger on a bus here. Are you happy with the consumable margin by itself? Are there things that could happen to the consumable margin to offset some of the discretionary side?

Yes. Well, the mix shift towards -- the mix shift towards premium, and we continue to premiumize, there's all this talk about down-trading, our down trading is favorable. We're premiumizing. The mix shift is positive from a gross margin dollar standpoint. There is more we can do from a rate standpoint. When I came in, our WholeHearted, which is our own brand mix, was 1.6%. Today, it's over 10% of our mix, and that's favorable margin. So there's things we can do there. There's also some deflationary dynamics at hand that I'm hoping will wash through, right? You have reductions in things like meat costs right now. So as we get deflation on some of the input costs, we'll be talking to vendors about how does that get reflected.

I don't think you're providing an outlook on that deflation of price, the price component for '23 or how...

Price to us, you mean?

Price to the consumer and what that could look like. So there's been a ticket benefit from inflation. I don't think we've talked or quantified that's fine, but how does that play out? The question of whether we actually see disinflation or outright deflation in out-year.

Yes. I mean, we have dueling dynamics, right? So in a recessionary [ year ], you tend to see some deflation. However, the premiumization trend is a decade-plus trend. So -- and we announced bringing in Stella & Chewy on our -- the day of our earnings. Every time we brought in one of these premium brands that heretofore were only sold in independents, that's been a real positive for both our total consumable sales and our premium mix shift. We put in 1,000 coolers of just -- we just reached 1,000 coolers for just food for dogs. That's a positive on our mix shift. So I think there'll be both dynamics. We haven't called it yet in terms of what the guidance would be on there. But the macro, macro dynamic is premiumization.

When do the Stella & Chewy hit the shelves, or do they...

Next month, I believe. Don't quote me on that, but next month.

Are there any other products within the independent channel that's breakout or transcendent, like Stella & Chewy?

One other scaled one.

Right. Got it. And they're scaled. They're not nascent that's beginning to grow and take shape.

There's probably a lot, there's a lot of those. There's always been -- for those of you who aren't familiar with the pet industry because this has been -- it was new to me when I came. There's always been these brands that grow in independent and then they cross over, and we're actually the first place they go. So for example, Taste of the Wild, Stella & Chewy, Honest Kitchen, they only are distributed. They -- national expansion with us. They don't go to PetSmart when they do that because of our Health and Wellness and our nutrition standards. So yes, there's -- but there's 1 scale name, Fromm is the other scale one.

Where on a pricing perspective, where do your own brands sit relative to pricing on the like item? And then is there -- can you just remind us of the margin profile on the same item?

Take the last first. Margin is higher. We like the margin a lot on those products. Let me break it into 2. On consumables, we have WholeHearted. As I said, it went from 1.6% to over 10% of our mix and it's growing. We just launched WholeHearted Fresh Frozen, which we're really excited about. And so on WholeHearted, our price point is above commodity and below super premium. So what we see is a trade-up from commodity products, the Pedigree level of type products, even though we don't carry Pedigree, and a value for a high-quality product for those who can't afford an Orijen, [ a can or just ] food for dogs and favorable margin dynamics on the rate side of the house. On supplies, we will go from a super premium puffer vest that could have been sold at Louis Vuitton, if you will, down to relatively lower price points and we have multiple brands that hit each price tier. That is an area that we're doing 2 things on. We're both driving out costs on supplies to allow us to have a sharper price point, as well as supplementing our line to make sure that if someone wants a $29, $39 dog bed, we can provide for that. We've been very focused on premium. It's worked for us. In this economy, we need to supplement a little bit, and that work is underway.

Can I ask about inventory demand has outstripped supply, and we've had a few conference calls, I think, among the grocers still talking about some sporadic out-of-stocks in the mass category. Are you seeing proper replenishment? Have the vendors caught up?

We are much, much better than we were. I would say at the macro level, you still have demand exceeding supply. But it is not of significance. And I will tell you about 6 weeks ago, we shifted from a negative year-on-year in stock level to a positive year-on-year. So that is a tailwind for us. So the industry in stock level is much better. And we have a lot of capacity coming online at the major food manufacturers, in particular. And then obviously getting stuff out of Asia has gotten easier, hopefully it will stay that way.

Pet ownership. You mentioned a few facts. I think you may have covered it, I wanted to ask because of this perception that there would be a slowing off the boom, if not, I think you said the word relinquishments. Can you talk about, I guess, the full picture. Is there risk that we've pulled forward pet ownership and we won't see the same growth going forward?

Yes. People said that from '20 to '21 and '21 was still heightened versus prepandemic. '22, the call, I think Euromonitor is the one who does the call, it's continued growth in '22. And then one of the kind of -- one of the -- there was a [ citing ] most recently of taking pet growth up to 2%. So it's somewhere in there. Historic was 1. So somewhere in there, and relinquishments are below pre-pandemic levels. So that part of what drives the category looks healthy.

I was going to ask a specific question about vet centers. It seems like it's the most opportunistic initiative. Maybe -- well, that's a good question. What's the most opportunistic initiative that the company is working on for future growth, and then we'll talk...

No, that is the transformative, where there's other things we like a lot, but that is the transformative dynamic. You look at the Vet financials alone, you look at the 5- to 6-point center store lift that we get when we put a vet in. You look at what it does for our image, for traffic, it's transformative.

Can you set up for us, what this will look like in 5 years? What the footprint of vet centers will...

Yes. So we went from basically 0 in 2017, let's call it, to today we're kind of 240-ish. We'll get to 800, 900 vet. Now these are vet hospitals. We also run vet clinics, and I'll come back to that in a second. What we're saying is 5 years to maturation, 2 years to pay back the newer cohorts, which I know we're going to get to, are favorable to that. In terms of the center store, year 1, 5 to 6-point lift, and that's despite taking 2,500 square foot of merch out of that store footprint. One of the real gems, which I didn't realize earlier on, is the vet clinic business, for a variety of reasons. Number one, in this type of economy, the vet clinics that we run for, say, for example, like 3 hours on a Saturday and Sunday in one of our stores, it gives a more -- lower cost entry for that vaccination. But the other thing it does is it gives us flex veterinarian capacity. So there's the 1099 doctors, they bid on those shifts. And so if we had a call out in one of our hospitals, that gives us access to a pool of doctors that other companies would not have. That vet clinic business is growing double digits, and it's highly strategic in terms of our staffing model as well.

And then an update on how the initiatives are progressing. Are you integrating at the pace that you plan to, the revenue ramp?

[ This is by ] Thrive integration?

No, I'm sorry, I'm going yes, Thrive plus your own vet centers.

So Thrive integration is done. We're getting the operational efficiencies, we held onto more doctors than we expected, which is a great sign. And the biggest way you get more doctors is by having more doctors to refer, and giving them a great experience. So that's really positive. We -- what we said at the beginning of the year when we did the Thrive acquisitions, we're going to focus on the Thrive acquisitions, slow down the build-out and then we'd return to the 70 a year rate, and that's what -- we did 17 last quarter. We're on track for the year in terms of our numbers. So we're 100% on track on that.

Are there any constraints to growth, availability of vets, meaning you're having to hire from or there's enough coming through graduation that you can be a big source.

That market is tight, right? It's one of the tightest labor markets there are. Our time to fill a job is below industry benchmarks. Our retention is better than industry benchmarks. As I said, the best way to get more vets is to have more vets and our referral rate is really, really good right now. So I get asked a lot of questions: why don't you build out vet hospitals faster. If I could hire more vets faster, I would do more. But in terms of our commitments, we feel good about our ability to deliver against that.

At Investor Day, did you frame when there should be a positive both on top and bottom line margin impact to the P&L from vet centers?

I don't know if we did. So I don't want to be out of school, but Brian can follow up on that with you.

Fair enough. Vital Care, another powerful initiative. You've said 2x spending multiplier when you get customers who...

2.5.

I said 2x plus, so... 3.5x spending multiplier when you have customers who convert. What level of Vital Care penetration would you target? I'll just leave it at that, and I'll keep going.

So for those of you who don't know, Vital Care is the industry's first full membership program. For $19.99/month you get checkups, discounts on grooming, discounts on products. The whole idea is to have healthier pets as well as to capture more share of wallet. 30% of those customers are new to food with Petco, 30% are new to -- or 30 plus are new to services with us. So the share of wallet play is playing out. At Investor Day, I said we were going to get to 1 million, that kind of freaked out my Vital Care team. We announced 400,000 this past quarter. Our sign-up rate was up by 40%. So the $1 million is pretty clear in line of sight. I see no reason why we couldn't get to 10% of our customer base in Vital Care at some point, long term, I'm not calling it when. But long term because now the $1 million is starting to get more into the line of sight.

And what are some of the other behaviors you're seeing with Vital care? Are they omnichannel, other categories? What are you...

Yes. I mean the share of wallet piece I cited, their LTV is 3.5x. And let me ladder that up. If you take repeat delivery, which is where we automatically ship you your food on a set time period, Vital Care insurance and PupBox, we now have almost 20% of our revenue in recurring revenue, which gives us predictability. And I think that's contributing. I don't know if you look at the NPD data, I look at the NPD data every week. If you go back 8 weeks ago, NPD would be -- or maybe 10 weeks ago, plus 3% to 5% for the retail industry. If you look at the last few weeks, it was negative 10-ish, right? These big swings. We haven't seen those big swings. We've been stable. And I think a big part of that has been the recurring revenue base. If you add on top of that, the $1.7 billion, which is what we reported in the quarter of the Perks program, which is basically a loyalty program for food and grooming, that gives us stability in our numbers that we've invested a lot of effort and sweat to get to, and it's helping us.

I have a couple more. If folks in the audience would like to ask, just let us know, and we'll get the mic runner. We do have one. Okay. Yes. We just get you the mic, sorry.

Yes, it's really compelling to see everything you're doing. How would you speak to from a market share perspective, one big player in the space, who Simeon alluded to, looks like they're gaining meaningful share versus you and potentially everyone else. What do you think is contributing to that? And is that something that -- how should we think about that as investors? Because clearly, people think when you're losing share, is that going to suggest that there could be declines to come or weaker trends for your business?

Yes. I assume you're not talking about Seattle.

Exactly.

You're talking about Miami.

Yes.

Yes. Okay. That dynamic slipped in more recent time periods. Actually, it's Seattle who's doing better in a low-cost environment in the online space than Miami. And so the rate of share gain has slowed significantly for Miami in that dynamic. And we've kind of steadily gained share over the last year. Our e-commerce business is up 140% on a 3-year basis. We play to our strengths, right? If you want same-day delivery of if you want BOPUS, if you want curbside, they can't do those things. So we have a customer base in that 39% of omnichannel customers that we get a kind of free rein on. They have their customers, and they do a nice job on that, but we think we can be competitive there. Our portfolio and our services gives us a tie-in that, that competitor doesn't have as well. They don't have veterinary services. Televet is $200 million out of a $30 billion vet business. So the 98% of the vet business is hands on pets. Grooming, all those services gives us traffic. And if you go to what is the -- probably the most profound insight in the pet industry, it's that 54% of pet parents want to consolidate with one-stop shop, right? Take [ Ron Coughlin ] before I worked at Petco I went one place for a vet. I never saw my vet. And I went another place for grooming and another place for food -- and the ability to consolidate that with 1 partner is very powerful, and that's our differentiation.

Just I'll ask about San Antonio, went to see a rural market store. Its physical expansion. Usually, that's a caution sign, but you're going after this market. So what makes it attractive and that it's proper use of capital?

Yes. So rural markets for pet spend are $2 billion plus and growing double digits. We all know the population dynamics. Even if you look at base retail, rural versus urban, rural is growing faster. There is another competitor somewhere in, I think, Nashville that does very well in that space. And so the question was, is there room for a pet specialty player and can our brand hunt in these markets? We went and did some consumer research. And the answer was resoundingly yes, there's customers who want a focused pet specialty player to meet their needs. So then we launched our first pilot. And I will tell you I had multiple people come up to me and say, thank you. I no longer have to go to San Antonio to get product X or product Y. We launched our second one, both of which are significantly ahead of our financial model. We launched our third more recently in North Carolina. So in aggregate, these are performing ahead of our expectations. The IRR is well ahead of cost of capital. So we're excited. It's a new TAM and -- that we can tap into with less competition and people are saying they want that focus. We're getting into categories we hadn't been in before. Equine, bovine, we have hay out on the dock, as you saw. So it's exciting. We're still -- we haven't called it, not a pilot anymore, but we are planning for a more rapid expansion in '23. We will get to 7 or 8 of these by the end of the year, and they're doing well.

Great. and you have full access to the Equine product assortment?

Yes. The product assortment has been great. And actually, there's some product that those competitors don't have as well.

Very good. Well, if there are no other questions, we'll end it there. Thank you very much, Ron, for sharing your story. Congratulations on your success and happy holidays.

Appreciate it. Happy holidays to you as well.