Good morning, everyone. Thanks so much for joining us. My name is Nathan Feather. I'm Morgan Stanley's small and mid-cap internet analyst. Pleased to be joined by David Reeder , Chewy CFO. Thanks so much for joining us today.
Thanks for having me. Really appreciate it.
Before we begin, a few quick housekeeping items 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. And with that, let's kick it off. Dave, you just finished your first full year at Chewy. What, if anything, has deviated from your expectations coming in? And how do you feel about the state of the business today and its positioning within the pet industry?
Sure. Number one, it doesn't feel like it's been a year. It went by incredibly quickly. Part of the reason why it went by so quickly is because there have been some deviations from what I expected. If you go back in time and you think through what I was expecting at that point in time, I would say we're probably a year ahead of where I thought we would be on the Chewy journey. Specifically, the way I would define that is we started fiscal year 2024. We were talking about active customers being roughly flat.
We went through the course of the year, and ultimately, we guided flat to up. Then we kind of had momentum occurring throughout the remainder of the year. For note, we have not reported Q4 results yet. That will be in a couple of weeks. We're on a fiscal calendar that ended essentially at the end of January. So we saw this active customer growth progress throughout the year, giving us more confidence and momentum as we entered Q4 with the appropriate commentary that we added at that point in time.
Revenue, we took up to the high end of the range as we progressed throughout the course of the year. So not only did we feel good about the active customer growth, but we felt good about the net sales or net sales per average customer, that growth as well, which is kind of share of wallet is the way you should think about that. And then finally, we took up profitability on a year-over-year basis. At midpoint, it was up more than 40% year-over-year, of course, with the corresponding free cash flow.
So you stand back, you kind of look at what I expected coming into the year, kind of all green across the financial metrics, which is one measure. The other measure that I would mention is I would highlight that across our strategic initiatives, we made tremendous progress last year. So we opened eight vet clinics in Georgia, Florida, Texas, and Colorado. We expanded our health care and health services offerings correspondingly.
We continued to build upon our pharmacy success in the U.S., the largest online pet pharmacy in the U.S. by far. So we extended our leadership position there. And then perhaps most importantly, we continued to wow our customers with the customer-first foundation that we've continued to build upon. So for all those reasons, I feel like we're about a year ahead of where I expected. It's been a wonderful year in reflection. There's still a lot of work to do, but great progress.
OK, great. Well, a lot I want to dig into there. But first, let's start off a little bit more macro. And I think the big question has been how far the pet industry is from a level of normal. First off, what do you see as normalized long-term and online industry growth? And how are you thinking about the 2025 outlook, especially as it compares to coming off a roughly flat pricing environment in 2024?
Sure, so normal for the pet industry. The pet industry, if you were to go back and look at kind of a 50-year type timeline, there are some companies that go back even further than that in pet. It's been an industry that's been incredibly recession resilient. It's been a very stable industry, and it's been an industry kind of characterized as an industry by kind of mid-ish single-digit growth with low single-digit pricing inflation across that kind of 50-year period.
Obviously, during the COVID years, we had some disruption, and that led to some pretty significant increases in inflation across pet. That put kind of a dampener on some of the pet household formation that you would also typically see across that kind of 50-year period. You'd see kind of low single-digit pet household formation in addition to some low single-digit inflation.
And that's how you'd get mid-single digits overall. And so I would say that largely that has normalized. So if you look back over the last four quarters or so, pricing has very much moderated. There are encouraging signs because pricing has moderated about the continued growth now, perhaps a return to growth, I should say, in pet household formation. So there are some encouraging signs there. I would say that there are two trends that continue. And I would say both of those are tailwinds for Chewy.
Number one, as we talked about, Capital Markets Day in December. About 30% of the industry was kind of online at that point in time. Those were the rough estimates. And it continues to move online. So more than 45% of the industry, perhaps even well north of 45% of the industry, will continue to move online. And over time, it will become an even more significant contributor to the total channel of sales. And so that's a tailwind for Chewy. We're getting perhaps even more than our fair share of the migration online.
That's number one. And then number two, the humanization of pets. So pets, it's one of the only categories. The only category besides kids that I can think of are perhaps relatives. That's just incredibly emotive. People talk about themselves as being pet parents. I have three pets, two dogs, and a cat. And they have a lot more in terms of luxury than the farm I grew up on. And so that humanization has led to premiumization.
That trend has not only continued, but perhaps even accelerated in recent years, which is also a tailwind for Chewy. So the industry appears to be normalizing. I think it's going to ultimately normalize to kind of this 50-year average. I think there are trends that will grow, that will accelerate Chewy's growth, both the movement online as well as the humanization of pets so that we can achieve more than that.
Now, talking about some of that volatility, COVID certainly led to a lot of ups and downs in pet ownership. Where do you think pet ownership stands now relative to 2019? And as we look ahead to 2025, how are you thinking about the shape of household formations through the year?
Sure. So number one, there is no perfect data with respect to pet household formation. You have some households that have multiple pets. You have some categories of pets that historically you wouldn't think of in terms of your standard pets, if you will, amphibians and birds. And most people think dogs and cats. But there's this incredible category of pets that for us fall under kind of a specialty category that's everything from chickens to equine all the way through the lizards and amphibians and other pets.
And so when you step back and you think about what is happening across the pet industry, the most important metric that we look at is we look at the shelter data. And we are about 50% integrated into shelters in the U.S. in terms of collecting data. Those are kind of the single biggest source of pet data in the U.S. in terms of it's not actually breeders that provide the majority of pet adoption in the U.S. and household formation. It's actually shelters, and so when you look at that data, and we've quoted some of that data throughout 2024, when you look at that data, it has continued to improve throughout the course of the year.
In fact, in Q3, we had kind of mid-teens growth in year-over-year pet adoption from shelters. We also had kind of low single-digit reduction in the relinquishment, so this is kind of the, I don't want to say abandonment, but it's the pets going back into the shelter, not being adopted. Those trends have been pretty positive now for the last several quarters, which is different than what we saw in kind of 2021, 2022, 2023, et c.
OK, great. Now, over the past few years, and I think on the back of some of that pet macro, you had seen some annualized customer declines, of course, with sequential growth over the past two quarters. How much of the weakness over the past few years would you attribute to that macro dynamics versus micro? And do you think we've reached the inflection point back to positive territory?
The very short answer is yes. I think we have reached the inflection point with respect to active customer growth. We talked about in our Q3 call, Q4 guidance, about how we were carrying momentum into the Q4 of the year, and we talked about how we were going to lean into that momentum. So yes, I do believe we have reached the inflection point on active customer growth. And specifically, what I would cite is we had improvements in new customer additions in the Q3.
We had a reduction in churn. And we had improvements in reactivations as well. Those are kind of the three elements. So it's new customers to Chewy. It's reactivating lapsed customers for whatever reason. And then it's reducing that churn. We had improvements in all three of those variables that ultimately create the outcome of active customer growth. We were quite pleased by those results.
Now, on the flip side of that coin is net sales per active customer and NESPAC. How should we think about the relationship between customer growth and NESPAC?
Sure. So first, let me just kind of describe NESPAC for those of you that perhaps are not as familiar with the Chewy thesis. Net sales per active customer, or the acronym NESPAC for us, think of it as the consolidation of wallet share for a customer. So a customer, an average pet owner, will spend somewhere between kind of $1,200 to $2,500 annually on their pet. And more recently, in the Q3, we reported net sales per active customer of about $567.
And so that kind of represents our portion of what a pet parent would spend on their pet in that annualized period. The elements that go into net sales per active customers in terms of what drives it, well, number one, Autoship growth. That's our subscription service. It represents about 80% of our revenue on a quarterly basis. [It] is Autoship, very highly predictable, recurring, strong relationship with customers. Autoship goes into NESPAC cross-category selling.
These are customers that perhaps come into Chewy to buy a dog bed and then ultimately buy a consumable, and they buy food, and then ultimately perhaps they buy pharmacy or some health care supplements. It is also cross-category selling that goes into it. Of course, the final portion of NESPAC is just it is the frequency. It is the frequency of how often that customer will order that particular item. Those are kind of the elements of NESPAC. When you think about active customer growth and how it impacts NESPAC, our oldest cohorts of customers spend well north of $1,000 with Chewy.
And so over time, as we build trust, they continue to consolidate their baskets, build baskets. We consolidate their share of wallet. And so as cohorts age, we start to see significant growth in NESPAC. Now, when you add new customers to that, you're adding customers as the denominator. But the newest customers in the first year, they spend the least compared to the oldest cohorts. And so as those customers come in, you're adding to the denominator with not proportionally adding the same kind of average amount to the numerator.
And so when you get to active customer growth, you tend to see NESPAC kind of compress a little bit. Those older cohorts are still ordering. In fact, those cohort shapes are very similar to pre-COVID shapes. They've been very consistent and durable, I think, throughout Chewy's entire history, actually. And so active customer growth, you get those corresponding incremental sales.
It does create a denominator mathematical headwind, quote unquote, if you will, to NESPAC. But ultimately, those two added together and our continued expansion in terms of our offerings and services and products continues to drive not only active customer growth now, but also continue to drive NESPAC.
Very helpful. Switching gears a little bit. Chewy launched its first vet clinic last year, and by now, by my count, you're out to eight clinics. You can correct me if I'm wrong. What are the early learnings from the clinics open so far? How should we think about the long-term potential for this segment? And what are the near-term limitations to scale?
So first, let me take a step back and just talk about the ecosystem that we're building for Chewy. So the market that we play in the U.S. is about $150 billion. Rough and tough numbers, it's about $90 billion on the retail categories. It's about $50 billion on the health care side, which includes health care services like vet clinics. And then finally, it's about $10 billion on services. And so what you've seen Chewy do over time is you've seen us really try to create this ecosystem for pets and pet parents built on a foundation of customer-first experience.
With the customer-first experience and a tech-forward approach, we've been able to expand into these categories to essentially create an ecosystem where these happy customers, active customers that continue to consolidate their wallet, they don't have to leave the Chewy ecosystem because of the incredible service and support and trust that we've built. When you think about now expanding into vet care services or vet clinics and health care services, you're right. We are up to eight. Well done on the research.
We're incredibly excited about these clinics. Specifically, let me tell you why we're excited. Number one, new customers that are coming into Chewy through the vet clinic channel is significantly higher than what we originally modeled. We're getting more new customers. The utilization is high, number one. Utilization of the clinics is high. That utilization is being increasingly driven not by current Chewy customers, which they, of course, those customers are coming to visit, but we're getting even more new customers through this channel than we originally modeled.
So that's incredibly positive, not only for the vet clinic services, but number two, it's positive because more than half of those new customers to Chewy, within 30 days of visiting that vet clinic, they're going to chewy.com and purchasing products from our retail platform. So we're able to engage with the customer where they are as a trusted partner to provide health care services. Then those customers are so pleased with the service and the level of transparency and trust that we build in that initial visit that more than half of them are then going back and participating in the Chewy platform by purchasing online.
And so those are just two incredible things, two incredible statistics. And I could cite numerous others, but in the essence of time, I won't. But we are excited about vet clinics. We're excited about rolling out more vet clinics in the future. But to your question with respect to kind of the rate and pace of expansion, there are kind of like upper limits on how many vet clinics you could open in kind of a 12-month period. And vets are in short supply in the U.S. So there are a shortage of vets.
So when you open kind of a standard clinic, you tend to hire somewhere between kind of two and four vets, depending on the format and size and the metro in which you're opening that clinic. So you have to find the vet, the physical DVMs in that market. You have to secure them. You also have to find some technicians in that market, and then, of course, the real estate.
So what you tend to see is kind of a dampener on the rate and pace of expansion, is you rarely see someone roll out or an entity roll out more than maybe 30 clinics a year. That would be just an unbelievable year if something like that was to occur. I would say it's much more likely when you look at everyone that participates in the market that it's 20 clinics or less.
OK. Now, one of the hallmarks of 2024 was your meaningful profitability inflection, EBITDA margins tracking to 4.6%-4.8% for the year. Can you break down the key pieces behind that improvement and whether they can lead to additional leverage from here?
Sure. The reason why I'm smiling a little bit with this question is because this was one of investors' largest areas of feedback with respect to the long-term model that we posted at Capital Markets Day. So at Capital Markets in December of 2023, we put together a long-term model that had EBITDA margins at 10 points or more, 10% or more EBITDA margin as part of our long-term model.
And at the time, we were sitting at roughly 3.3% EBITDA margin for the year, though we hadn't reported Q4 2023 results at that time. And so here we are, 12 months later, the midpoint of guidance is 4.7% at midpoint, up 140 basis points on a year-over-year basis. And that EBITDA high quality, converting more than 80% of EBITDA to free cash flow. So here we are, 12 months later, and we've made tremendous progress on that particular metric.
Specifically, what I'm quite pleased about is we didn't just make it geographically in one area of the P&L. If you look at gross margin, we have improved gross margin, biggest drivers of gross margin, sponsored ads. If you recall, we said the sponsored ads could be 1%-3% of net sales, flowing through at roughly 70 basis points of gross margin. We said that we would be at the low end of that 1%-3% range in 2024.
That was our guidance at our Q3 earnings call with Q4 guidance. We're quite pleased on how that business is performing. We've continued to expand into health care. Specifically, we've highlighted that the health care portion category of kind of the market has about 1,000 basis points of accretion to gross margin. We've continued to grow faster in that segment. We're product mixing up.
Then, of course, we're at scale. So when you think about kind of freight and packaging and things like that, we continue to perform at scale there, third largest direct-to-consumer shipper in the U.S. So gross margin, we've made tremendous progress. But it hasn't just been gross margin. When you go down and you look at OPEX and you look at the leverage that we have on OPEX as well, at the high end of our revenue range, we're approaching $12 billion.
So you think about at-scale revenue, we've got at-scale fixed cost infrastructure. And I would characterize that and I'd break it down into three particular fixed cost infrastructures that we have that are at scale. Number one is our fulfillment centers. We've got 18 fulfillment centers. We've got five of them that are fully automated.
We've got our pharmacies kind of embedded or next to many of those fulfillment centers so you can fulfill the pharmacy, do the compounding, as well as ship it out in an efficient way, and so that's about 70% utilized, our fulfillment center network, which is the third largest fulfillment center network direct-to-consumer in the U.S., and so each incremental dollar is going to flow through at a higher rate, so that's number one in terms of fixed cost infrastructure.
Number two, our human capital. We're kind of at scale with respect to human capital and payroll, and you've seen payroll growth really flatten out, if not decline in some instances, and so we're getting a lot of leverage out of our human capital. We're at scale there, and then finally, we develop most of our own software, so most of our software is first-party software.
And so we're at scale on our digital infrastructure as well. And so we're getting leverage in the gross margin line. We're getting leverage in the OPEX line. And then each incremental dollar of revenue growth is not only coming with either additional margin, gross margin from sponsored ads or product mixing up, but it's also flowing through that fixed infrastructure where you get this fixed cost absorption, such that we're then able to increase profitability.
Let's talk about that incremental dollar. In 2024, incremental margins are running well ahead of your 15% long-term target. One, how should we think about the rationale behind that 15%? What led you there, and why was 2024 running so far above, even with the headwind from the extra week?
Sure. Number one, the 15% flow-through is a long-term model. And so on any particular year, you can have more or less when you think about a long-term model. But first, I'd start with that kind of 10% EBITDA margin that we put out there as a long-term goal. We've made 140 basis points of improvement this year. If you were to say long-term is kind of five years, getting to that 10% would be about 100 basis points of EBITDA margin a year.
We kind of have outperformed in 2024. We're excited about the progress we made. We think the areas that I've highlighted, we think those areas continue to have leverage in the future. So we'll leave our kind of longer-term 10% margin with 15% flow-through. We'll kind of leave that in place for now. But obviously, we're quite pleased with how we performed against it.
OK, great. But let's dig into some of the expense lines you mentioned there. And let's kick it off with gross margin. Over the long run, seen tremendous improvement here, going from around 17% in 2017, around 29% this year. Looking backwards, what have been the primary ingredients driving that expansion? And then looking forwards, what opportunities remain to further improve gross margin? And how do you think about the relative difficulty of those opportunities?
Sure. If you look backwards, I think some of the biggest things that you would look at is you would look at our product mixing up. Not only do you have your normal retail business, but now you've got a pharmacy that we disclosed was more than $1 billion of revenue and growing significantly faster than the corporate average.
You've got kind of health care categories that are kind of $3 billion+ , right, all of which kind of carry accretive margin to the enterprise, and many of which are growing faster than the enterprise. Probably one of the single biggest contributors, if looking backwards, is the growth of the health care categories within Chewy.
It's been one of the product mixing up has been one of the single biggest contributors to our growth in profitability, and then followed by a lot of the scale that I've kind of discussed previously. On a go-forward basis, on a prospective basis, and obviously, sponsored ads is an area that we continue to be incredibly excited about. In fact, our vendors are incredibly excited about what we've been able to do so far with sponsored ads.
In 2024, the first percent is the hardest percent to get. So if you go back, and again, I'll go back in time just a little before I talk prospectively, we essentially had an immaterial amount of sponsored ads with respect to full year 2023. And then you roll into full year 2024, where we had built a little bit of momentum.
We were using a third-party system to engage with our vendors to bring their collateral and their content and their media onto our platform, but the system that we were using was, for us, very manual, and so we had to take content that our vendors had developed, perhaps for other venues, and we had to kind of manually take that and then layer it on to the system that we've built, whether that's the mobile app or the web storefront, and so it was incredibly inefficient, and there was just some content that we couldn't deliver in an effective way.
A nd so what we're incredibly excited about is that when you think about 2025, we've rolled out our own first-party software, and this was something that we built, we concepted, built, and delivered. It's already been launched in 2024, less than 12 months. I mean, that should speak to the power and the number, quite frankly, of software engineers that we have in the company. And now when you think about engaging with vendors, vendors can self-service. We go out, we do our bidding as you traditionally would do. We can self-service a lot of their content onto our platform.
And also for 2025, we can also, in a very efficient way, we can utilize the content of video, which we were not able to do in an efficient way in 2024. So sponsored ads is an area that we're excited about. We remain excited about it. We've built some capabilities for 2025 and beyond that we didn't have in 2024. And so we like our approach there. Also, areas in which we're excited about 2025, we continue to build on our online pharmacy.
We're excited about that continued growth into 2025, which is accretive to gross margin. In fact, all the health care merch categories, we're excited about that growth into 2025. And then finally, while it's kind of immaterial to the P&L right now, vet clinics, perhaps on a longer-term arc, we're excited about how they contribute to profitability as well.
Right. A lot of really encouraging stuff in there. I want to dig in just a touch more on sponsored ads. Mentioned tracking around 1% of revenue exiting 2024. How should we think about the pacing of expansion over the years or the next few years, especially given a lot of the improvements you've made in the switch to first-party tooling?
Yeah. So if you've spent any time with Chewy, you probably know that the customer experience is something that we talk about daily. In fact, I'd say it's the foundation. The customer experience is the foundation of Chewy. Everything else has really been built upon that foundation.
And so one of the things that we think about deeply is what does the customer experience look like when they go to either our web storefront or increasingly the mobile app? And what experience do they get? And how do they get to either the query or the selection that they want? And what does that journey look like?
And so as we think about rolling out sponsored ads, which we're incredibly excited about, we're also cognizant of how do we introduce the right content to the right customer at the right time, such that they don't feel like some of perhaps the other sites that you go to, where you get bombarded with multiple adverts, sometimes for not even things that you're even searching for.
And so as we think about the rollout of sponsored ads, now that we have some of the infrastructure in place, I would say the emphasis and the constraining factors is really around that experience. Because we have, I mean, as it stands, we have more demand than we have supply. As we turn on supply, which is gated by this experience, we want to make sure that that experience, given that we have more than demand, we want to make sure that experience is what we would want ourselves to have as customers.
Another longstanding pillar of margin improvement has been automation in the fulfillment network to level set. What's the latest on utilization, the portion of orders that go through automated fulfillment centers? And long-term, how much cost reduction can you achieve through the fulfillment center network? And what are the key gating factors to unlock that?
Sure. So as I mentioned, we have 18 fulfillment centers today. All of them have some amount of automation in them. We have five that are kind of Gen 2, which we think of as being almost fully automated. The remainders, as I mentioned, have various degrees of automation. And we have the ability to unlock incremental capacity by automating individual lines. So you don't have to think of, if I want to continue to automate a facility, you don't have to think of it in terms of I got to go build a new facility that's fully automated.
You can provide automation and get incremental output by automating certain things within, even facilities today that are not fully automated as we quantify them. So the network in total utilization is about 70%. And so we've got some incredible room for expansion with very minimal incremental investment. Then about 40% of our volume is running through the automated facilities.
In terms of efficiencies, you get about 30% more sales out of the same square feet for expansion there. We’ve got plenty of opportunity with very discreet, small, manageable CapEx projects to increase efficiencies. So I feel like we’re very well situated from a fulfillment center network for the foreseeable future.
OK, great. Now, another expense I want to touch on is marketing. You talked about leaning in there in Q4, given some of the momentum you were seeing in the business. Can you provide some more color on how you manage the marketing budget and priorities more holistically? And then for 2025, what's the right range to think about for marketing as a portion of revenue?
Sure. So we've been pretty consistent for a long period of time, well before I joined the company, that advertising and marketing as a percentage of net sales would kind of average between 6%-7% as kind of upper and lower control limits, if you will, and then if you were to look over the most recent periods, be those quarters or years, you see that we tend to spend around 6.7%, 6.8% of net sales into advertising and marketing or A&M, as we've shortened the name, so as we spoke about in Q4 guidance, Q3 results, we talked about the fact that we saw some momentum in the market.
We saw some Chewy-specific momentum even, and that we wanted to lean into that. I think when you think about and you model the future, I think you can kind of look at the past, and you can see kind of that 6.7%, 6.8% type of levels. Those are numbers we're very comfortable with. That's for an annual period. On any given quarter, given either opportunities that you see or campaign timing, you may have higher or lower on any specific quarter.
For an annual period, we've been running at kind of this 6.7% or 6.8% for a while. We feel good about that. Ultimately, there's leverage in that model as you continue to get bigger and you scale net sales over time. I would expect that there would be leverage in that model. For the near term, I would say where we've been historically is probably a good place to forecast future.
OK, great. Now, before we wrap, I'd be remiss not to ask about tariffs. So how should we think about your exposure to currently proposed actions, particularly as it relates to China? And what steps have you or can you take to mitigate any potential impacts?
Sure. Number one, I'd start by just saying that we have a phenomenal supply chain team that constantly manages inventory, and they're very on top of the most recent changes and any impacts they would have to us. Tariffs, in general, have very little impact, very limited impact on Chewy. We do have a small presence in China, primarily related to hard goods and perhaps more specifically to private brand hard goods.
We would characterize tariffs as being single-digit millions, perhaps low teens, kind of millions impact, and then I think perhaps most importantly, we wouldn't be disadvantaged, right, so if you think about our business, about 85% of our business is consumables. The majority of those consumables are sourced in regions where there's not meaningful tariffs, many of them in the United States, so we feel pretty good about where we're situated, and particularly with respect to tariffs.
We've covered a lot of ground here. I want to bring that all together. As you look across the business, what do you see as the primary competitive advantages that have enabled Chewy's success?
I would kind of end where I started. Number one, we have built Chewy on a customer-first foundation, and so everything that we have built sits on that foundation of trust and customer experience. We have built an ecosystem so that most of the pet parents and pets' needs can be fulfilled now within the Chewy network. There are different degrees of maturity, but they can be fulfilled within the Chewy network.
We have about 80% of our revenue. We haven't talked about Autoship much, but about 80% of our revenue is subscription-based through our Autoship program. It's an incredible loyalty program, and customers continue to be amazed and wowed by not only their service, but our ability to fulfill their needs through their subscription Autoship service, and so you put it together, and you've got a customer-first foundation.
You've got a tech-forward company with incredible capability on the technology side. You've got best-in-class offerings across the entire pet ecosphere, whether it's retail, whether it's health care, whether it's hard goods, whether it's increasingly in the future private brands and vet clinics and health care services. And so we've got foundation of trust, tech approach, forward approach, followed by best-in-class selection, at-scale revenue with at-scale infrastructure. Each incremental dollar that comes in flowing through at a higher rate leading to profitability. It's a great mathematical formula for success.
I think that's a perfect place to leave it, Dave. Thanks so much for being here.
Thanks, Dave.