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

Good morning, everyone. Welcome to day 2 of our Baird's 2023 Consumer Services -- Technology and Services Conference. I'm Peter Benedict, senior research analyst covering consumer retail -- consumer products and services and retail. Really pleased to have -- to kick off the day with the folks from Petco all the way in from Southern California. So there's going to be a breakout session after this Q&A in as for Room B. So if you'd like to join us for that. We'd love to have you. To my left is Brian LaRose, Chief Financial Officer. Brian joined Petco in 2020, previously at HP. And then to his left, Jason Heffelfinger, who is the Chief Services Officer at Petco. Jason has been with Petco since 2015. And as his title suggests, he's responsible for all things services related, including the companies that hospital initiative, which I'm sure we're going to get into today. Cathy Yao is here as well, Vice President of Investor Relations. I'm going to start off just kind of a high level. There's no prepared remarks from the company. We're just going to kick right into Q&A. I'm going to start at a high level, maybe some sector stuff, the pet category. It's a big category as we know, depending on who you ask, $135 million to $140 billion, probably grew double digits last year. I think historically, it's a mid-single-digit type growth industry, one that's very attractive, resilient. That buildup to growth has historically been about 1% kind of pets, 4% this kind of up trade up humanization trend spend per pet growth. So a great category. Just maybe, Brian, I'll start with you. How are you thinking about just the sector broadly speaking, in 2023, as you see things?

Yes. I think those long-term historical trends continue. And you're right. If you look over the last 3 decades in this category, it's been resilient through any economic cycle with kind of that 1% pet growth, 4% spend per pet. We expect that to continue. There are different estimates for pet growth this year, some are calling it at 1, some are calling it 1.5 or 2. But somewhere in that range, I think, for '23 and beyond, if you look forward out for the next 5, 7 years, you'd still see mid-single digits or better. The better could come in where a greater weight of new pet households are with Gen Zs and millennials as they reach their peak earning years. And as they have a propensity to follow some of the humanization and premiumization trends of pet, we expect that spend per pet to continue in that kind of 4-ish percent range.

Yes, makes sense. Thinking about current conditions, you guys stood at a 5% comp in the first quarter, a good number. You did speak to a slowing demand trend that you kind of exited the quarter. Certainly, that's a common theme, I think, across a lot of retail. Can you maybe elaborate on what you saw more tactically here? Category, customer segments, just what's going on with that?

Yes. Well, I mean you gave me the nice tee up. So we did a 5.4% revenue in Q1, 5.1% comp. Those are good numbers. Those speak for the resiliency, I think, of the category and our business and how we're positioned. We made some commentary about the Q1 exit. We had seen other retail peers talk about exiting into May with maybe a negative comp. We felt like it was the appropriate thing to signal if that wasn't the case. I'll elaborate a little bit more. I'll tell you that what we saw in April and May was closer to our Q1 growth rate than or slightly positive. So we -- our outlook for the year remains largely unchanged from when we started the year. I think we -- if you look at some of the key data points in Q1, we reached 580,000 Vital Care members. Jason's business, we had an increase at 20% year-over-year in terms of pets seen. Our digital business grew double digits, consumables grew double digits. So those are good indicators of how we're positioned in terms of the Omni. I would add 1 thing on the second half, too, Peter just as a reminder, when we guided for the full year, we were pretty over that -- it included a 53rd week. So this is a 53-week year and that will be an extra week in the fourth quarter. So I think good to remind folks of that as well.

Sure. No, that's helpful perspective. Let's -- we'll get Jason involved here and return to kind of the Petco ecosystem. I think over the past several years, Petco has been kind of repositioning itself to be more kind of a holistic health and wellness company as the company's name now shows. Services, I think, are around 10% to 11% of sales. Maybe let's start by just a little bit of your background because I think most people in this room are familiar with you. Talk about your background, how do you end up here, and then we'll get into services a little bit.

Yes. No. Thanks, Peter. So I've been in retail for 20 years, and I've been with Petco since 2015, as you stated. Had a lot of opportunities in the company to do a number of different things from operations, both field and corporate and then had the opportunity to roll over to lead services about 5 years ago and then started up with our new vet program about 4 years -- 4.5 years ago, in earnest, and I have the opportunity to lead all of our services. So we have our vet hospital business, our mobile vaccination clinic business, which we can talk about as well. Grooming, which has performed incredibly well post pandemic into Q1, and then our Dog Training business also.

Let's say before we get into the vet side, maybe talk a little bit about grooming an important business, one you've been in for a long time. What are the trends you're seeing there? What types of improvements have you made to the services? I mean, that was a business I think that got a lot of attention a few years ago and it has done well. But help us understand what's happening there?

Yes. No, look, I would say, 5 years ago, we really set out to reimagine our grooming business. And we've made incredible changes and progress over those 5 years. So starting -- 1 of the things about a services business that I'm sure everybody is aware of our product is our people. And our people in the hours work are capacity or inventory. And so we spend a tremendous amount of time really focused on our partners and our people that are in the salons every day. We spent about 4.5 years ago when we revamped our compensation program. So we made it so when we win our groomers win, and that really helped enable our kind of transformation with our salons. And then I would just tell you, we've also done really smart investments around technology. So whether it be online booking flows, paid media, search tools to really drive traffic to our salons. It's been actually an incredible story. And I would tell you, and you kind of said it in the intro, we've seen great growth. And so we have the largest number of groomers we've ever had in the history of the organization, which creates the most capacity we've ever had in the history of the organization. And we have demand in the marketplace. It's an incredibly fragmented market. And so during COVID, we had the opportunity to take advantage of our essential status and bringing in new clients and new partners. And that's really snowballed into the growth that we've seen post pandemic through Q1.

And I'd add that this is not a business that is absent some of the premiumization trends. Just last quarter, Jason and his team launched a clean grooming initiative, something that was very compelling for customers who are interested in that type of solution and it drove an actually increase in AOV in the first quarter.

Yes.

Let's pivot to the vet story. Maybe just size up the vet kind of market, the services opportunity that you see from Petco and then we'll start to drill down into what you're doing.

Similar to the pet market, there's -- I would say there's a $35 billion TAM, give or take, as you know, how we triangulate it. It's incredibly fragmented as well. There are some big corporate players, but there is definitely room for us, and we have a right to play in that space. When we think about our business, we started this in earnest 4.5 years ago-ish as we started some pilot hospitals in San Diego. And in just short 4 years, we're a top 10 player from a unit perspective in the vet hospital space. And so we're continuing to rapidly grow that, and we'll add another 50 to 55 hospitals this year, and we'll exit '23 with 300 hospitals. And so we have a lot of momentum behind us on the hospital space, and we see a path to -- as we look at our store portfolio to about 900 hospitals within our pet care centers. And so again, we've done a lot of work behind us. We've earned a right to be in the space, and we see a long path forward for growth.

I think a lot of people certainly remember when PetSmart was involved with Banfield, maybe just benefited helping people understand how what you're doing is different from that and how you're positioned kind of in the market?

Yes. No, great question. So the PetSmart Banfield relationship is very different than what we do. So Banfield actually operates the hospitals within PetSmarts, and it's a tenant lease relationship. And so a couple of things, nuances that I'd like to call out on that. The first off is they do not share customer data. And so a Banfield is a Banfield that's just located within a PetSmart. And so 1 of the things that they've decided to do as an organization is when their leases expire within their PetSmart buildings, they're, for the most part, exiting those leases and building their own stand-alone hospitals, whether it be across the street or to a more opportune spot within the DMA. And so what we can tell from a PetSmart perspective is they had about 800 Banfields at 1 point. We see about 200 to 250 dark Banfield locations now within their stores. And they've tried to dabble in a couple of different opportunities to fill and engage those hospitals again with doctors and whether be different types of franchises, things like that. But it's been very slow progress. Whereas our hospitals and our pet care centers are completely owned by Petco. We are Petco -- they are Petco employees. In some of the most important parts of that are being 1 company, we share data. Our customers, our pet care center customers are hospital customers. We have customers in grooming that go to our vet hospitals. Our doctors refer pet parents back into our center store. And when we get into the economics piece of the units, we can kind of talk about how that works together. But we are a fully owned and operated hospital unit.

And then recently, you used to have a joint venture relationship, which you bought out. Can you talk about the rationale behind that.

Yes. So when we started the hospital business, we partnered with Thrive Pathways is a joint venture. They ran hospitals, and so we wanted to learn how they did it. We opened 98 total hospitals with Thrive. Alongside our openings with Thrive, we were building our own vet model, our Vetco Total Care model, and we were implementing those in our stores as well in different markets. And what we found is we really liked our model better. We liked how we ran hospitals, we liked employing our doctors. And then what I talked about from a data standpoint, we like the data that we were getting from our customers and our hospitals that we didn't have access to in the Thrive joint venture is easily as we did in our own system. And so look, we made the decision. We liked how we did our business. We're our financial model, we were performing better than our Thrive partners. And so we made the decision to buy out the joint venture last year. We spent the summer integrating and converting those 98 hospitals into Vetco Total Care changing the practice management system, changing the online booking flow, bringing the partners over. So just there was a lot of cultural and operational aspects that we had to implement. We finished in Q3 last year. And we're really excited to have 1 brand. From a marketing standpoint, it makes a ton of sense. And from a customer confusion standpoint, having 1 banner to be able to talk to is really simplified the message for our customers. And as we converted those hospitals, we had the opportunity to go look at the financial model in them as well and get them back on track to where we were executing from a Vetco Total Care standpoint. And once we got through the integration, we're back to being on to -- we're back to where the Thrive's were pre-acquisition. And so we're in really good shape with those hospitals.

Yes. I mean any acquisition, whether it be a buyout or a joint venture as to make sense strategically, financially, this was both. I mean it was not a -- I just heard so it was not a very difficult financial decision to actually execute that.

One of the things with vet as long as we've covered pet, we always hear like, "Oh, it's so hard to get vets and the shortage and things like that." So talk about maybe how you're going to market your access to vets, how you've been successful in pulling that up?

Yes. No, look, it's a truism of the market. There's a limited number of veterinarians. And I would say we're tackling it just a little bit differently than anybody else in the industry. So I'll take you back a little bit. So we had acquired a company called Vetco 10 or 11 years ago, and they were a mobile vaccination service, they contracted with 1099 doctors. So we've always ran that vertical, and it's been very successful, and we love the financial model behind it. But what that does is it gives us an introduction to all of our 1099 doctors as well. So when we think about hiring doctors. In Q1, we onboarded 375 new doctors to our ecosystem. There's a mix of W-2 and 1099 within that population set, but that's a 60% growth year-on-year. So we have a value proposition that's resonating. And I'll get back to the 1099s in a second. So we went out and built an employee value proposition with our Chief Veterinarian to really change how veterinarians are compensated and how they're -- and the ability for them to have flexibility within their schedules. So as we did that, we started to prove out the value proposition through our owned vet and we took a ton of feedback, and we continue to iterate on that model. So we have a unique compensation structure for our doctors. And then we have a 1099 population set that we recruit from. So we engage with over 2,000 1099 doctors nearly every week for our clinics. So when we think about our W2 doctor base, about 40% of our hires are from referrals. So we know the value proposition is working. And about 10% of our hires in Q1 were actually conversions of 1099s who we're working within our ecosystem already, saw the value proposition and the work environment and wanted to come over. So it gives us an inherent advantage because of all the doctors we engage with every day. And so I think that's 1 of the things that gives us confidence in our ability to staff and grow this business to 900 hospitals.

Perfect. Brian, let's get back to maybe the -- some of the financials on the broader business. Can you talk about the outlook for gross margin this year? I think gross margins were down around a little over 200 basis points in the first quarter. Maybe talk about freight, category mix? How you're thinking about the second half of the year and the trajectory of gross margin?

Yes, good question. The impact on gross margin year-over-year was primarily due to mix, and I'll break mix into 2 components, but the largest piece of that had to do with the mix shift where consumables is strong and the discretionary categories are seeing some weakness. That is the primary driver of the impact on gross margin. We know that will revert. It always has historically. We've built our model for the rest of the year, not assuming a recovery in that category. Now you do get an improvement in comp just by math, if you take kind of the run rate business in dollars for discretionary and drag it out, you get a different comp structure in the back half, but there's not an assumption of recovery. There's a second piece of mix that impacts gross margin that, quite frankly, we're -- we believe it's the right thing to do. Jason's business and services, all of the labor sits in cost of sales. So as you grow your services business at a multiple of your company growth rate, you're going to have a gross margin impact that is largely ineffectual to the total company because if you look at the EBITDA for the services business, it's very attractive. So you've got a gross margin just from P&L geography and services. Freight, we would expect Q2 to Q4 to start to be modestly beneficial for the balance of the year. And then again, as I go back in terms of overall dollars, we do have a 53rd week in the fourth quarter.

And then just maybe honing in on the digital side of your business. We talk about more of it later if you have time, but I think at your investor meeting that you had laid out a 500 basis point, I think, opportunity for digital margin improvement. Just help us understand maybe your positioning in digital and how you're going to achieve that?

Yes. I think our digital business is on the right path. There's this 3 big buckets if I think about that 500 basis points. The first is an expansion of our ad network. And it's pretty remarkable what Darren and the team have done. If you go back to this company when Ron came in to be CEO in 2018, we didn't have an app, it's 2018. Here we are today, where our digital assets are so far into best-in-class that we can monetize those assets through an ad network. So you know how those models work. You actually work with vendors and non-vendors and you monetize the site. That will impact gross margin. Favorably, it's almost 100% flow-through. The second 2 things are somewhat related. You have to reduce your number of split shipments and get efficiency out of your DC network. And that leads to the third piece, 70% to 80% of our digital orders on any given quarter are fulfilled through our pet care centers. That allows us leverage, that allows the model to be attractive from an EBITDA standpoint. Within that 70% to 80%, there are 3 components. There's buy online, pick up in store, which, of course, we love you're driving to the store, paying for the logistics. Second piece is our same-day delivery with our relationship with DoorDash. And the third is ship from store. In that same-day delivery where that gets really compelling is as the fresh frozen market continues to expand. If you think about shipping a fresh frozen product from a DC, it's going to cost you $10, $11 of cooled packaging. It'd be the same delivery direct from a PCC or a store to the end customer, you maybe have $0.75 of a cooled envelope. So a big difference in terms of overall impact on gross margins. So those would be kind of the 3 buckets.

No. I mean the Fresh Frozen category 1 we're very familiar with, well Freshpet here tomorrow. Yes, maybe expand a little bit on what you're doing in that category, who you've partnered with. You've done some merchandising. Look, it takes an investment by the retailer to kind of -- this is different space, right? This is a dry shelf place that you can just flip things over. You can put a fridge, freezers. Talk about that initiative. And maybe what you guys see in terms of the opportunity just broadly speaking in terms of the Fresh Frozen?

Yes, we have a great relationship with Freshpet. We have a great relationship with Just Food For Dogs. We also have our own brand Wholehearted that kind of sits in the middle of those 2. It does take some investment last year. We had kind of a onetime investment in CapEx to put coolers in over 1,000 locations. That was something where the ROI made perfect sense to me. Again, it wasn't a very difficult math, but it did take a lean into capital last year that's passed. And so part of the step function decline you saw in CapEx from '22 to the guide in '23 is the fact that we've gotten over the hurdle of that freezer investment. This is a market that different estimates have it at $900 million today. I think Freshpet even in their last Analyst Day, called the market at $5 billion in 3 years. We've got estimates at, say, it's $4 billion, whether it's 4 or 5 , it's a big market. And so I think there are opportunities for us to continue to expand. We just last quarter, launched an initiative with Freshpet for customizable food where that's a process you go in, you enter all your vitals for your pet, whether that be [indiscernible] dietary restrictions or preferences, and it actually kicks out a customizable SKU for you that we carry in the store. So we're excited about fresh. I mean, we think the market is going to continue to grow, be a much bigger piece. It is the next leg of that humanization and premiumization trends much akin to what you saw 10, 15 years ago as people moved up the stack and premium kibble. Same thing is going to happen at Fresh Frozen.

I couldn't agree more. That's good stuff. Jason, back to you. Let's talk about that vet hospital rollout and its impact kind of more broadly on the P&L. Maybe talk about incremental flow through, I'm sure you're early, you're building these out. So they're not terribly additive today, but at some point, they're going to be. And maybe help us understand how you think about the economics flow-through on incremental [indiscernible] such things.

So we'll start with the model and then we'll get to how it's impacting the P&L. So from a model standpoint, we built a 5-year plan around each unit of hospital that we add. First year, we lose a little bit of money. Second year, we break even to make money. And then 3, 4, 5, up to the fifth year, we run at 20% EBITDA margin. If you want to put that in dollars, it's about $1.5 million in revenue, $300,000 in EBITDA and 4-wall EBITDA for the hospital. And then you also get year 1 about a mid-single-digit lift in the center store sales and then that kind of has a tail to it as you go through the 5-year model. So when you think about where we're at today on the time line, we've opened about 176 hospitals in the last, call it, 3 -- 2.5, 3 years. So our average vintage of our owned hospitals is about 2, 2.5 years old right now when you think about that. So when you think about where we're at on the financial curve, our hospitals today are margin-dollar accretive is a total cohort. So we are adding to the P&L now, which is great to see. In the long run, we'll be at 300 hospitals by the end of the year. And if you were to just take that cohort of 300 hospitals, move them over here and say their average vintage is about 2 years right now. If you were to fast forward 3 years to where their average vintage is 5 years, what we would see to the P&L is about $450 million in revenue at about $90 million in EBITDA. So that's just that cohort of 300 hospitals, and we're going to continue to add up to 900 hospitals. So the runway and the opportunity we have from a P&L perspective is huge. The other thing I would tell you is that does not include the center store lift. Brian doesn't let me take credit for that. So we're talking capital. So you have that add-on effect as well. And then the last thing I would say from a financial standpoint, 20% of the customers that come into our vet hospitals are new to our ecosystem in its entirety. And so from an entry point to our PCCs, the vet hospitals have been fantastic in driving new customers. And those customers, our hospital customers, once they've been with us for a year and they're an existing customer, they have a 3x [indiscernible] of our normal Petco customer. So they're most valuable customers they're new to Petco, and we're going to continue to grow that base as we get up to 900 hospitals.

That's compelling. You're growing, I think 50% to 55% this year. How do we think about that cadence going forward? Can you do more? Like what are the gating factors? How do we think about the pace of growth?

Yes. So when we think about pace of growth, the first thing we did was we looked at our portfolio. So we have about 900 PCCs. We want to put hospitals in that makes sense. And then when we peel that back, what our strategy around implementation of hospitals in a year is we try to hit 2 or 3 new markets a year. It's expensive to go into a new market. You have to build a new brand, you don't have leverage from a ton of hospitals in a market. So as an example, this year, we're going into Minneapolis and Seattle. So we're making those market entry investments. And when you think about the remainder of the hospitals, we'll do 60%, 70% of the remainder of our hospitals as infill. And what we really like about infill opportunities is as we start to get density in saturation, it creates productivity and efficiencies from a marketing, from a staffing, from a customer communication perspective. And so from a responsibility standpoint, we think 50% to 55% is the number right now, doesn't mean that won't change down the road. But that's how we look at the business and the portfolio and the rate of growth that we really want to go at. I don't know, Brian, if you...

Yes. And I said -- I mean, capital is a consideration. So this year, we wanted to make sure we took a fairly balanced approach. We've got 50 to 55 at hospitals, 10 to 15 of our small town rural concept. To Jason's point, though, we've proven in the past, if you go back 2 years ago, we added 72 hospitals. So we've demonstrated the ability to pulse in, in the right opportunistic market.

Leveraging off of that, just help us understand kind of the broader CapEx plan? I think $225 million to $250 million this year. Maybe talk about maintenance versus growth? And how we kind of think about the run rate going forward?

Yes. Good question. So in our 10-K, we break out CapEx into a couple of different components. If you look at the 10-K filed last year, you'll see 1 of those components is IT. IT a year ago was $60 million, last year, it was $80 million. So if you think about IT in that range, maybe closer to lower end of that. There's some level of IT investment you need to make, whether that's in infrastructure, security, app enhancements, personalization, et cetera. On top of that, you have some level of maintenance CapEx in your PCC. If you have a 15 year old aquatic tank that breaks, you got to fix it. If you have an HVAC system that goes down, you got to replace it, right? So there's some level of that. So you start to build not quite up to half or so of the CapEx guide for the year. On top of that, you pick your most strategic investments with the best ROI. For us, it's vet. We look at 50 to 55 vets. When you put in a vet, it's about $600,000 to actually have the vet itself. There's another $600,000 when you do reflow the center store, call it $1.2 million, if you do 50 to 55, you've added about $60 million in CapEx. Then on top of that, you've got sometimes there are years when you have one-timers. I mentioned last year, you had a larger investment in freezers. That went away. Last year, we did $278 million at CapEx. Our guidance this year is $225 million to $250 million. That step function decline normalizes for some of those onetime investments last year. So I think right now, the guide we gave for the year, I think, is the right balance, we are very mindful of making our commitment to our debt pay down. We made a commitment in the year to pay down $100 million of principal in debt. We've already done $60 million against that $100 million. That's part of that capital consideration as well.

Yes. That was going to be my next question, which is just what your use of free cash flow and the debt is -- I mean, is there a leverage target that you're kind of targeting? And where do you think you want to land this business from a leverage standpoint?

Yes. We haven't updated it since our last Analyst Day. I will tell you though, we're focused on paying down debt this year. And that is -- there are 2 sort of call them 1A or 1B or depending on the day 1B and 1A priorities for our capital. And the first is reinvesting in the business where we have high ROI. The second is paying down debt or in reverse order. But those are the 2 things that we're focused on right now.

Got it. So there's 3 questions we're asking kind of all of our companies. So some of that's been addressed here, but just to have it on -- put it in front of you. So 1 is just on the health of your consumer and your view in the back half of this year where that will be relative to where it's been so far this year. Better or worse? The same?

Yes. I would say largely unchanged. If you think about our business, we would expect food, consumables and services to remain strong. We've not assumed any recovery in the discretionary category. I think the category itself remains resilient, and we would expect that to continue.

Got it. Second was just on retail price inflation. It's been a tailwind in your business along with a number of others. How do you see inflation in the back half of this year relative to what is running?

Yes. I would say inflation will be modestly better. I don't see the same level of price increases that we saw in the back half of '21 in particular and throughout '22.

Got it. And then lastly, just around inventory. How are you thinking about your inventory levels, maybe at the end of this year relative to where you started?

Yes, you probably saw we already start to smile. I think our team has done an exceptional job here, an exceptional job. If you look at our balance sheet last quarter, our -- we did a 5% comp, improved our in-stocks and inventory dollars went down year-over-year. I think the team has done remarkable work in getting much more efficient in terms of supply-demand matching, everyone was in a different spot 24 months ago. And I think the fact that the team navigated through that got us back to a very comfortable level on in-stocks and brought inventory balance sheet dollars down. It's a big deal.

Great. Well, listen, I think we're out of time, but we appreciate it. Help join me in thanking Brian and Jason.

Thank you.