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

Okay. Last session of the day. We have a good turnout. This is great. Thank you, everybody, for coming, sticking around. It's going to be worth the wait. So it's a good conversation always with Ron Coughlin, President and Chief Executive Officer of Petco. Thank you so much for joining us today.

No problem. Pets bring the fun.

Yes. Any updates on your pets?

Yogi. 65 pounds. And for the record, I'm not a Yankee fan, I'm a Mets fan, but he's doing great. He's doing absolutely great, and he's going to be a taco for Halloween.

Excellent. So we wanted to maybe start the conversation in talking about what you announced during Q2. We learned that the discretionary category has remained challenged maybe got a little bit worse and that you were going to refine your pricing in order to be more competitive. So maybe we can start with the discretionary piece first. Supplies and companion animals. I think its more on the finer point. But if you had to rank the magnitude of headwinds on this category, is it macro? Is it pull forward? Is it share of wallet? Is it losing share due to pricing?

Yes. There's a combination of those factors. The discretionary impact across categories is seen across the consumer space. We're not immune to that. If I take our factors, there's really 3. First, the macro and consumer wallet, right? And if you look at food and beverage, human food and beverage, that's had heavy inflation. If you think of shift towards services, that's impinged upon wallet. So there has been that factor. The second thing is the life cycle of a pet, right? So if you take the life cycle of a pet, year 1 to year 8-ish is basically flat in terms of total spend. However, your 1 and year 2 are higher supply spend. And then as dogs like Yogi get bigger, they have more food. So we have the COVID puppy boom and then the supplies that came along with that exacerbated by stimulus. So we have a dynamic of life cycle, which we're getting towards the back end of but there's a life cycle component. And the third is there's been growth in the value segment, and we were underpenetrated in the value segment. The good news is we work with vendors to cover more of those segments and those products are feathering in as we speak.

So how should we think then about your outlook for the discretionary category. How should we think about it in the back half? And do you see it stabilizing maybe in 2024?

Yes. What we said is we're not counting on a stabilization in the second half, which is what drove our guidance change. In terms of '24, I can cite the category call. The category call is a 3% growth on supplies, but we're not counting on that. We're taking actions to stimulate that whether that be our supplies perks program, whether that's taking cost out to make sure we're more competitive in value or, quite frankly, the discretionary business, given our high -- it's our highest profit area. We announced a $150 million cost out program that is $40 million in year 1, the majority of that is gross margin impacting. So we're not sitting -- we're controlling our controllables.

And then if we could maybe talk about pricing a little bit and maybe I should segment it into 2 parts. You talk about value. And I think you want to start addressing value maybe a little bit more. But when I think of Petco, I do think kind of better, best, more premium. So how do you reconcile the bigger emphasis on value.

Yes. Make no mistake about it. The mega trend in the category is about premiumization, humanization. The driver of that is millennials and Gen-Zers are adopting more of the pets. They spend more, they're greater humanizers, if you will. So if you look at my grandfather, the dog was in the backyard and had APO. My mother, the dog was in the house and it was [indiscernible]. With me, the dog's in my bed and he's getting fresh frozen and science type of products, and it goes on and on. And for the millennials, they're probably getting custom food at this point. So you see a continuum there in terms of value.

And so in terms of just what you're introducing, I know you made the announcement about Fancy Feast as an example of where you are. How much should we expect the mix to change at Petco as a result of this?

So our #1 focus is winning the premiumization play, right? So if you look at the top end, super premium and fresh frozen, whether it is origin at $100 a bag, Taste of the Wild, Honest Kitchen. We just brought in Oli. Those are all national retail exclusive to Petco. And we are set up to win. There's no company better positioned to win that move towards more premium products. That said, in today's environment, there is more demand for value. You saw that article in the Wall Street Journal yesterday. We need to supplement our strategy with more value products. The first one that we talked about on the earnings call was Fancy Feast, which we brought in, about half to 2/3 of their portfolio. And if you think about it, it's not just to get the volume on those products. It's to get the customers and to get the attach. So we're 3 weeks into the Fancy Feast expansion, but strong double-digit percent of those customers are new to Petco. And then when you bring in these products, guess what, if you bring in Fancy Feast, your litter business grows, your cat treats and cat toys grow. So it drags attachment that's very favorable. So it's getting more at-bats with those customers. And why is going with a national brand like Fancy Feast the right move versus maybe doubling down on your private label, which has always been more of your entry point or value proposition. Actually, our WholeHearted which is when I came in, it was about 1.6% of the mix. Now it's close to 10% of the mix, is mid-tier. So it's high-end quality for mid-tier pricing. So again, it's the value. But the power of these value brands is footsteps, right? And getting footsteps. And if the customer is migrating and looking for those products, you want those footsteps to get the at-bats for supplies to get the at-bats for things like litter. And one of the other things that happens is we're very good at trading up. So even within the Nestle portfolio, we could take someone from Fancy Feast to a pro plan [ cat ] as well. And our team is very good at that.

So do you think part of this has to do with the amount of inflation that we've seen in food, in particular, whether it's human food or pet food. And does the prospect of maybe moderating inflation mean that value in pet food might not necessarily be where the consumer goes next year?

Yes. The thing I would say is you want to be real time aligned with where the customer is looking, but keep your North Star in your strategy. So our North Star is humanization and premiumization, the customer is looking for more value. Now we want to make sure that we're providing that and getting those footsteps. Will we adjust as we go out? Yes. But having those customers and providing for that need, I think, makes us a stronger franchise.

And does this -- does the value proposition have any impact on margins?

So initially, those products will have less gross margin, but you got to think about it in a couple of points. First of all, these big companies, they not only margin, but they do a different trade spend versus the smaller, more premium. So there's pieces in how the margin works out with them that's different. But second, I go back to the attach piece, right? You want the footsteps to sell the supplies. You want the footsteps to sell the litter. So you have to think about it as an ecosystem benefit. In the short term, on a product-by-product basis, there will be some, but we see it as an ecosystem benefit.

Okay. So we talked about the introduction of some more value. Maybe now we can talk about pricing because I do think that you're adjusting your pricing as well. We wondered if you could talk about if this was more in consumables or discretionary, where are the prices being adjusted? And are you adjusting it to a particular gap?

I can't give specifics for competitive reasons on that. Again, I'll break it into 3 tiers. On the high end, which is our meat and potatoes, if you will, we don't see pricing. We don't see a lot of these products are unique to us, exclusive to us. So the need to be hypercompetitive on pricing is not there, right? And that continues and that shift towards more premium continued. In the middle range is where you need to be more price competitive when the products are more mass. And those are the adjustments. Now the impact will be more pronounced in the near term and then obviously alleviate over time. Historically, we've done 3 of these since I've been at Petco in different segments, and they've been beneficial from a customer standpoint. Historically, it takes a couple of quarters for breakeven and then roughly just a little over a year for payback. But again, the first quarter is where you see the biggest hit on that.

I know you're talking in terms of customer response or where you start to start to benefit from some of these changes. But in terms of the customer response to pricing, is that something they noticed right away? Or are you seeing elasticity impact from right away?

The base of the line goes like this. On these KVI pricing actions, again, we've done 3 of them, 2 quarters towards breakeven and so that's what we expect to see. From a customer standpoint, it's our job to build awareness. It's our job to make sure that they see it because there's 2 components, right? One is price competitiveness and the second is price perception. If the consumer in their mind is more value-centric, then you want to be seen as a company that provides fair prices and fair value. So there's -- those 2 components that we wanted to move the needle on.

Is there anything aside from just adjusting the prices in terms of how you're speaking to the customer about some of the changes that you're making to the store?

Yes. We're making sure we communicate. So we made sure we communicate, for example, that we now carry Fancy Feast. We made sure we went out to lapsed customers, lapsed cat customers and said, hey, we now have Fancy Feast to make sure we're communicating to that. We have 25 million customers. So our ability to go contact them is powerful. And then same thing on the pricing changes. Again, there's both the price on the individual SKU but there's the price perception that, that's a place that I can find adequate value, and that's important.

So we talked about the gross margin impact from the value introduction. And obviously, there's going to be a gross margin impact from the pricing action that you take as well. But as we look into next year, how should we think about gross margin dollar growth and our dollar gross margins?

Yes. So if you think about it, it's -- the #1 lever is discretionary spend and what happens with discretionary spend. I shared the projection for 2024. When exactly that breaks, we will see as this year evolves and we get into 2024, but we're not passengers on the bus. So if you look at our digital business, we're growing gross margin. If you look at our services business, we're growing gross margin. Now services is very important. Our services business last quarter grew 17%. It's been a consistent double-digit grower. But from a P&L geography standpoint, because labor sits in cost of sales, the gross margin looks adverse, but at the EBITDA level, it is projected to be relatively neutral versus total enterprise. So that impact is a P&L geography versus a real profitability dynamic. And as we see outsized growth on services, I would encourage all our investors to look at it at the EBITDA line, not at the gross margin line.

It's interesting to, in my opinion, to see how strong services are in contrast with the discretionary piece. And it probably aligns itself to what you just said before, where the people are aging out of certain things with their pets, but are you surprised that the resiliency and the strength of services just in the macro environment we're currently in and how that comes into play for the customer.

What's interesting is it's a mirror of the consumer space, right? People aren't cutting back on these things in their personal lives, and they're not cutting back on services -- I had investor earlier really shocked that people weren't cutting back on grooming. Our grooming business has been very, very strong. So it's really a mirror of the consumer market. Our veterinary business is growing strongly. If you look at our service business, it grew 17%. If you look at our -- we'll get into that shortly. But we had a 26% increase in the number of pets seen in our veterinary. Now part of that is the consumer and part of that is our ecosystem working.

Right. And I do have a couple of questions on that because I know it's an important initiative for you, Ron. And maybe we can start all the way back to when you thought of the idea of vet because how vet is today, which is fully company-owned is not exactly how you started. So could you maybe talk us through the evolution of vet and where you plan to go with it over time?

And by the way, I wouldn't take credit for thinking of it, but I would take credit with the team on how we've executed it. So when we started, we didn't have a lot of confidence of getting into vet. It was a new business to us, so we started with a joint venture with a veterinary network operator. And we got to over 100 locations with that. But as many relationships, it was time to move on from the joint venture, partially because of the dynamics there and partially because we had concurrently, I think when I came in at '18 and '19, we launched our first owned vet. So we did it in Las Vegas and we did 4 or 5. And we like that model better. We like the financials. We like the customer experience better. We liked the sharing of the data across the enterprise. And that gave us confidence. And from there, we pursued and owned vet strategy, and then we purchased the joint venture -- half of the joint venture from Pathway, and that's [indiscernible] served us very well. If you look at our vet business, year one is dilutive. Year 2 is breakeven. Year 5 is a 20% [indiscernible] margin. And then on top of that, we get the center store lift of 4 to 5 points. We've talked about [indiscernible], and we continue to validate that number. So from an enterprise standpoint, it's very attractive. From a competitive moat standpoint, it's very attractive. And then that capability allows us to do things like our Vital Care Premier program, which is for $24.99, you get a free check up, you get discounts on grooming, discounts on food, and it really brings to life our strategy of a full ecosystem for customers, which no other company can do. And 54% of pet parents say they want a one-stop shop, rather than going to one place for grooming, one place for vet and one place for food or supplies.

Can you maybe talk about from an offering standpoint, what you're not offering today that you can do in the future? And maybe how prescriptions and insurance come into play?

Yes. Our Rx business is growing strong double digits. We're really happy about that. We were underpenetrated, and we continue to scale that business. And it's just a natural and then we want to drive more of that on our repeat delivery, which is highly sticky. From an insurance standpoint, we announced a partnership with Nationwide. They're the #1 player in insurance. They have 1.2 million pets, but there is also a component of their human health program, and they're driving customers to our veterinary hospitals as part of that. And if you think about it in terms of their actuarial, they're very interested in having healthier pets. So they're partnering with us on the veterinary piece, but there'll be an announcement in the near future on the joint offering with Nationwide.

And then just feedback that we hear, questions that we get is your ability to hire that it is pretty tight capacity. But it sounds like you haven't had too many issues there. So could you maybe talk about your recruiting efforts, your retention efforts when it comes to that? And is there any way you can move maybe a little bit quicker with opening more of vet practices?

Yes. The vet hospital hiring, we were up -- I think the number was 58% in terms of hiring into our ecosystem. Now we have vet hospitals and we have vet clinics. And we're the only player at scale to do both of those. So we have 268 vet hospitals, and we have over 1,000 vet clinics, or vet clinics in over 1,000 of our locations. And that business has been going gangbusters because it's the right offer at the right time for immunizations and things like flea and tick. In terms of hiring, listen, it's a very tight market. But within that tightness, we do well. And the reason is the following. First, we allow vets to practice medicine as they see fit. A lot of the vet networks have been roll-ups. So there'll be deals with pharma type companies, and they dictate what they prescribe, we don't do that. Second, we offer flexibility in hours. So you can go from 20 hours to 40 hours, a lot of vets are of child, either bearing or child raising year, so that's effective. We also allow them to go back and forth between our clinic, 1099, and hospitals. So if you're at a life stage where you only want to work one day a week, you can work our clinics, then you say, I want to go back to full time. We obviously tend to get first dibs on that. So it's a nice feeder system that's completely unique to us. Again, we sprint to get there, but we get there.

And then just growing faster, is that a possibility or something you think about just given the -- the success and the lift you get from.

Long term, I think the answer is yes. I think if you look at our capital allocation priorities for 2024, we're focused on debt first, then vet, then digital, but 2024, we are focused on debt first.

Right. Maybe I can ask since you just mentioned it, will go to debt for a second. Year-to-date, you've paid down [ $35 ] million towards your target debt paydown of $100 million. I think that's for this year. How do we think about capital allocation going into next year? And when it comes to cash flow, I think you generated free cash flow of about $45 million in the quarter. What's being done to try and free up some of the cash when the bottom line is under more pressure like it is now.

So we're very focused on generating cash flow. I think Brian and his team did an excellent job, whether it's the cash conversion cycle being smart with capital allocation et cetera. Our year-on-year capital -- I'm sorry, our year-on-year free cash flow was up $72 million last quarter, which is, in our view, very good performance. We are committed to $100 million pay down, $75 million through Q2. So that's good progress against that $100 million. So we're going to continue to focus on things like cash conversion. We're going to focus on terms with our vendors. We're going to focus on smart capital allocation as well. We'll be more conservative as we head into 2024 based upon where we are. And again, debt will be the #1 priority.

Maybe if I can just turn to a couple of initiatives that I think are really interesting. First is the fresh food, which we've talked a little bit about earlier, but I always thought it was a very interesting dynamic when it came to competing with online, fresh and omnichannel. And so maybe you could talk to us a little bit about how much you're emphasizing fresh food, how differentiated it is and just how the omnichannel actually helps you with.

I have a personal soft spot because my dog, Yumi was overweight and the owner of JustFoodForDogs said, "Your dog is fat" He needs to go on my fish and sweet potatoes and he definitely got a couple more years out of his life when I shifted them over to that, which was everything to me. So roughly about $1.5 billion business today, projected to get to $6 billion by 2025. And we're very well positioned with JustFoodForDogs, which has been a fantastic partnership. We just added [ Olis ]. We have Instinct, we have [ Freshpet ]. So we have a good array. We also have a WholeHearted fresh now. So we have a good array of product. It's a high-growth category. We did 10% growth last quarter, 12% customer growth on that. One of the interesting dynamics of Fresh is it has higher trip frequency. So you drag more attach and things like that. So it's actually the only food that we really constantly look at from an enterprise value standpoint because of that higher trip frequency on that product. We plan on continuing to drive it and to win in that category, it's super strategic for us. And it's part of the pet category shift towards premium, super premium, and it's kind of the tip of the spear, if you will.

And from a profitability standpoint, just with the added ingredients and the freezer cost and things like that. Is it as profitable?

Profit dollar positive, slightly dollar profit margin. But again, you have to think about [ accretive ]. You have to think about it as a full enterprise and the other thing I would say, and you hit on this earlier, is if you look at shipping, if you look at getting fresh frozen product to a consumer, right? If you do it via [indiscernible] or you do it via the same day, like when my fresh frozen comes, it comes in a Petco paper bag. It doesn't have freezing and that type of material. If you're shipping it from a distribution center, you're having to add all that extra cost. And so we have a cost competitive advantage on that category, not to mention freshness, competitive advantage versus online-only players.

And then another initiative we had Lowe's here earlier before, and obviously, you're in partnership with them to do stop-and-shops, which is exciting. But I think you also have a plan to build out your own stand-alone stores. So you're going to be in 300 stores with Lowe's in rural markets and then you have a plan to build out your stand-alone stores. I think there is a long-standing established player in the farm and feed space and has been in the more rural markets for quite some time. How different do you envision the Petco stand-alone concept versus [indiscernible]?

Yes. We started in a pilot. The pilot -- we like the results, both sides like the results. We expanded that to roughly 300 locations. We're pleased with the results so far. If you think about it from our standpoint, the 0 capital outlay accessing the rural pet market is predicted to a $6 billion market. So it gives us a foothold in accessing that market. From our world play, we'll have 15 stores by the end of this year, we like what's happening. It's either on or above our projections. But again, if I look at 2024, we're going to be conservative, debt first, then vet, et cetera. So we're in the middle of our capital allocation. But right now, Lowe's is our bigger tip of the spear into the rural market. That said, when we do our research, there is a customer that absolutely wants pet centric products, which is why these stores are doing well. And there's also a companion animal customer that is not served by existing players.

We've been asking for questions of every company that's presented with us today. Again, we always touch a little bit on each of these questions in our earlier discussions. But with regards to your consumer, do you think they're going to be facing more headwinds, less headwinds, or about the same as we go into '24?

Yes. I'm not going to prognosticate. I mean this morning, we wake up with fluid data. So what I can tell you about our category is our category is one of the highest growth categories there is. Our category is projected to grow between 5% to 6% to 7% growth on an ongoing basis. And if you look at what I said about supplies, supplies are projected to go 3% in 2024 at the category level. And we still have strong services growth same time, but we'll see. The consumer is going to stabilize, the question is when in the discretionary space.

Right. And part B of the question is on trade down. Obviously, you're introducing more value. So I think you're thinking you can capture maybe some more trade down in '24, but how do you think about the trade down '23 versus '24.

It's a bifurcation. We're going to have more customers. I talked about 12% growth on Fresh Frozen. We're going to have more customers buying Fresh Frozen. Origin was a $100 bag growing double digits. So we're going to have continued growth on the high end, but we need to participate more aggressively on the value side of the house as well and that's where those products that we are bringing in and will bring in will make a difference. So it's kind of a bifurcated dynamic.

We've talked about share of wallet. I mean, you're seeing it firsthand, discretionary versus consumables. And it sounds like, again, it's a little bit more macro before we see some stabilization in discretionary. But is there anything else that could maybe flip discretionary to positive territory? Is it innovation? Is it newness, what else in that specific supplies in companion animals could drive better trends?

Yes. We're not sitting on our hands. We have a supplies perks program that [indiscernible] folks to buy more. I go back to the footsteps point, if I get more footsteps, I'm going to get more attached on the supplies. But there also is newness. Actually, if you go into our PCC, otherwise known as stores today, you'll see 2 things. First of all, it has great Halloween outfits, so anybody who has a dog, I would encourage you to go get those. But one of my favorites is that right now is Doggy Parton, and it's Dolly Parton's dog and it's selling really well. So bringing those types of innovations, and we have more in the pipeline in sight purchases if you go talk to the NPD/Circana people, innovation is generating benefits in the market. The last thing I'd cite, though, is being on point when there's an opportunity. So we all know that there was high heat this summer. Well, when there's high heat, where there's high heat, we really push forward on flea because fleas are a bigger problem in high heat environment. So making sure we go after those opportunities as they arise to drive that type of business. Similarly, we brought in a range of cooling products and cooling beds. Because if you're sitting in Texas in 110 degrees, you needed that. So making sure we're on point for those buying opportunities, whether that be those, whether that be seasonal type opportunities.

And that kind of leads to our last question just on inventory. Can you maybe talk to how you're feeling about [ in stocks ], how much flexibility you do have to chase certain trends or things that you think are changing with the consumer?

Yes. We didn't have the inventory build that others do actually or did. Our inventory last quarter, inventory dollars were down 7%. So we feel pretty good about where our inventory is right now. It's up slightly versus a year ago in a good way. What I would say is when we bring this value assortment, there might be a small bump as we load in the DCs and the stores. But other than that, there's no stochastic change in inventory plan, we're pretty well positioned, and our inventory management has helped contribute to our cash flow performance.

Okay. Just in the last couple of minutes here. One thing I didn't get to ask you about that I really wanted to ask you about was your recurring revenue stream. So can you talk about how much of your revenue growth has been driven by recurring revenue streams and just how much that customer has grown this year?

Yes. So we're driving double-digit growth on our recurring revenue. It's been an explicit strategy since we started talking in '18, '19. And I'm pleased with the progress. If you look at Vital Care Premier, which is for $24.99, you get the checkup, grooming discounts and product discounts. We went from roughly [ 220 ], I think, a year ago to 660,000 customers in the Vital Care Premier paying that $24.99 or less if you pay up front and so those customers are spending 3x more than our average customer. So it's very positive. Similarly, our repeat delivery customers, which has been a growth driver for us are spending 2x more with us. And then the last thing would be that I would cite is insurance. And as we get into more aggressive in the insurance space, that's a recurring revenue type program as well. So we're pleased with it. It's very important because it gives us predictability, and we want to drive more of our revenue into recurring revenue, made good progress, but I'd like to go even faster.

Okay. That's all the time we have. Thank you so much. Thanks for joining us.

Thank you very much. Appreciate it.