Good day. Welcome to the Chewy Q3 2020 earnings conference call. All participants will be in a listen only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, please press star then one on your touchtone phone. To withdraw your question, please press star then two. Please note that this event is being recorded. I would now like to turn the conference over to Mr. Robert LaFleur, Vice President of Investor Relations and Capital Markets. Please go ahead, sir.
Thank you for joining us on the call today to discuss our Q3 fiscal 2020 results. Joining me today are Chewy CEO, Sumit Singh, and CFO, Mario Marte. Our earnings release and letter to shareholders, which were filed with the SEC on Form 8-K earlier today, have been posted to the investor relations section of our website, investor.chewy.com. A link to the webcast of today's conference call is also available on our site. On our call today, we will be making forward-looking statements, including statements concerning Chewy's future prospects, financial results, business strategies, industry trends, and our ability to successfully respond to business risks, including those related to the spread of COVID-19, including any adverse impacts on our supply chain, workforce, fulfillment centers, other facilities, customer service operations, and future plans.
Such statements are considered forward-looking statements under the Private Securities Litigation Reform Act of 1995 and are subject to certain risks and uncertainties, which could cause actual results to differ materially from those contemplated by our forward-looking statements. Reported results should not be considered an indication of future performance. Note that the forward-looking statements on this call are based on information available to us as of today's date. We disclaim any obligation to update any forward-looking statements, except as required by law. For further information, please refer to the risk factors and other information in Chewy's 10-Q and 8-K filed earlier today, and in our other filings with the SEC. During this call, we will discuss certain non-GAAP financial measures.
Reconciliations of these non-GAAP items to the most directly comparable GAAP financial measures are provided on our investor relations website, in our earnings release, and letter to shareholders, which were filed with the SEC on Form 8-K earlier today, and in our 10-Q. These non-GAAP measures are not intended as a substitute for GAAP results. Finally, this call in its entirety is being webcast on our investor relations website. A replay of this call will also be available on our IR website shortly. I'd now like to turn the call over to Sumit.
Thanks, Bob. Thanks to all of you for joining us on the call. Our Q3 results reflect Chewy's relentless focus on execution and customer experience, coupled with the positive macro trends of accelerated e-commerce migration and increased pet ownership. These forces came together yet again to produce another quarter of strong net sales growth. Volume in the back half of the quarter outperformed our expectations as traffic, conversion, orders, and customer retention all strengthened from September into October as customers shifted their shopping behavior this year to shopping earlier, responding favorably to thoughtful additions in our assortment and innovative product and service launches, such as personalization and gifting. Coming into the Q3, we expected an early kickoff to the holiday season, and the Chewy team was prepared and ready to shift into high gear when it came.
This summer, we began optimizing our inventory and preparing our fulfillment centers, knowing that the holiday spike would add to the elevated demand tempo that has been in place since March. The teams responded and executed to plan. Over the next few minutes, I will discuss our Q3 results and share some insights as to how the quarter unfolded. I will use the balance of my remarks to talk through our exciting new healthcare launches and how those fit into the broader Chewy story as we prepare to celebrate our 10th anniversary next year and carry our mission into the second decade just as eagerly and enthusiastically as we approached its first. After that, I will turn the call over to Mario to discuss our Q3 results and guidance in more details.
Q3 net sales increased 45% year-over-year to $1.78 billion, with Autoship net sales representing 69.2% of total net sales. We added 1.2 million net active customers in the quarter, ending Q3 with 17.8 million active customers. Q3 net sales per active customers, or NSPAC, was $363, an increase of 2.8% year-over-year when adjusting for the extra week in 2018. We delivered Q3 gross margins of 25.5%, 180 basis point increase year-over-year, and consistent with our gross margin last quarter. The promotional environment was muted throughout most of the quarter before picking up in mid-October with the early launch of the holiday season. As such, promotional discounts were less of a gross margin headwind than forecasted. Shipping costs were also in line as we worked closely with our freight partners to uphold customer delivery experience.
Private label remained a strong contributor this quarter, with Q3 private label hard goods penetration reaching 16%. Our seasonal businesses, such as Halloween, were also strong in the quarter. Here, we improved our private label merchandise mix by 20 points to over 70%, showcasing the quality and appeal of our newly launched proprietary assortment. This helped grow total Q3 hard goods sales, including third party and private label, by more than 70% year-over-year. Over the past few quarters, our team has been hard at work to reformat our proprietary brand strategy by introducing compelling merchandise, many at expanded price points, improving discoverability and delivering an overall tremendous value proposition for our customers. This strategy is creating a positive, consistent, and sustainable momentum and driving incremental profitability in our portfolio.
Moving on to Q3 adjusted EBITDA, we produced another positive quarter, generating $5.5 million of adjusted EBITDA at a margin rate of 0.3%, representing 280 basis points of improvement year-over-year. While gross margins were strong in the quarter, several of the short-term operating cost headwinds we detailed on our last call materialized as anticipated and impacted our ability to translate our top-line momentum into bottom-line results as efficiently as we did in the Q1 and the Q2. These elevated costs were related to investments in labor and benefits as we ramped up our fulfillment centers and customer service sites to deliver a successful holiday amidst increasingly constrained labor markets and residual COVID-19 costs. Additionally, as anticipated, we saw marketing costs increase in Q3, normalizing from the hyper-efficient run rates we saw in Q1 and Q2. Mario will provide more details on these components in just a moment.
We continue to be laser-focused on executing against our commitment to pets and pet parents to deliver exceptional customer experiences by offering a broad assortment of brands and products with the convenience of e-commerce. That commitment extends to pet health and wellness. As part of our goal to make pet healthcare more affordable and accessible, we recently launched medication compounding and Connect with a Vet, our proprietary telehealth platform. These two innovative businesses are valuable additions to the growing healthcare business and represent our first service-based offerings for pet parents. Before I discuss these new businesses in greater detail, I would like to share some insight into our pharmacy Rx business, which anchors our broader healthcare strategy. For clarity, when I refer to Chewy Pharmacy, I am referring to the business that we own and operate under our own licenses.
Total pharmacy includes Chewy Pharmacy, plus the pharmacy that we operate that generates third-party management fees. Total pharmacy operations are expected to generate over $500 million of gross revenue this year, which we believe makes us the largest e-commerce pet pharmacy in the U.S. To achieve this milestone just over two years after our launch is a remarkable achievement for which we, as a team, are proud. Chewy Pharmacy, on a reported basis, is expected to generate over $350 million of net sales this year, which would equate to 5% of total net sales based on our current guidance. Given the scale, pharmacy is now contributing positively to the year-over-year expansion in Chewy's total gross margins. As we have noted on previous earnings calls, we believe that we are still in the early innings regarding our pharmacy business, and we remain focused on growing this vertical in a disciplined manner.
Now let me tell you a little bit more about our recent compounding and telehealth launches. Let's start with compounding. Compounding is a service offered through our pharmacy where we customize medications to the specific needs of individual pets, as some pets can't take medications in their commercially available forms. They may need a liquid instead of a tablet or a specialized dosage or formula. To enable these requirements, our licensed pharmacists use ingredients sourced from FDA-registered manufacturers to custom prepare medications in our labs to the specifications provided by the veterinarians. Today, we offer this service exclusively to pets and pet parents. In the future, we plan to extend this service to the vets so vets can offer compounded medications directly to their in-clinic patients. In both these use cases, we seek to pioneer bar-raising customer experiences across this billion-dollar fragmented market.
We are just as excited about our new telehealth service, Connect with a Vet, which connects Chewy pet parents directly to a contracted licensed veterinarian using our proprietary tele-triage platform, where vets answer questions, offer advice, and discuss pet health concerns without diagnosing medical conditions or recommending treatments. Instead, they make referrals to local vets or emergency clinics if needed, which drives customer traffic back into these veterinarian clinics for medical diagnosis and treatment. We offer this service free of charge to Autoship customers from 8:00 A.M. to 8:00 P.M. Eastern Time, Monday through Friday. We launched the program in 35 states in October, and starting today, I am happy to announce that we are rolling it out to another 12, which brings our total coverage up to 47 states. Program utilization rates to date are encouraging, as is the customer feedback we are receiving.
Connect with a Vet is clearly a first-of-its-kind service. We are still in early days and have a lot more to learn. At the same time, we have taken an important first step towards building a telehealth platform that can evolve and expand over time as our culture of innovation advances the technology platform and as the regulatory environments modernize to meet the needs of today's pet patients and providers. 2020 has been an unbelievably busy year so far, and I'm proud of the way every member of the Chewy team across our fulfillment centers, customer service sites, and corporate offices has stepped up to meet both the challenge and the opportunity.
Not only do we continue to optimize our day-to-day operations, we are always looking for ways to enhance customer assortment, service, and experience as we welcome a record number of new customers and offer current customers a safe and reliable way to care for their pets. The bond between pets and their pet parents has never been stronger. We look forward to a robust holiday season and close to the year. I will now turn the call over to Mario, who will provide the details on our Q3 results and financial outlook. Mario?
Thank you, Sumit. Q3 net sales reached $1.78 billion, increasing by $552.2 million, or 44.9% year-over-year. In absolute dollar terms, Q3 growth marked the biggest increase we have reported in the company's history. Year to date, net sales are up 46% on accelerated customer growth and solid increases in per-customer spending. Q3 sales from Autoship customers total $1.23 billion, representing 69.2% of total net sales for the quarter. Customer acquisition rate remains healthy and continues to run above pre-pandemic levels. In Q3, we added 1.2 million net active customers and ended the quarter with 17.8 million active customers. Year to date, we have added 5.1 million active customers, an increase of nearly 40%. We continue to monitor and be pleased with the purchasing behavior of our 2020 customer cohorts.
The first and Q2 cohorts remain engaged, and the initial engagement levels of the Q3 cohort is consistent with their peers from earlier in the year. Trends in basket size, reorder rates, and Autoship sign-up all remain favorable, reflecting the continued success of our assortment and merchandising strategies. Net Sales Per Active Customer, or NSPAC, increased to $363 in the Q3, $7 or 2% higher versus the Q2, and 2.8% higher year-over-year when adjusting Q3 2019 NSPAC to exclude the benefit from the extra week in the Q4 of 2018. As a reminder, Net Sales Per Active Customer reflects trailing four-quarter net sales divided by the number of active customers at the end of the quarter. This is the last quarter we will have to adjust for the extra week in Q4 2018 in our year-over-year comps.
We should note that the quarter-over-quarter increase is a reversal from recent quarters when NSPAC remained relatively flat. This is what we would expect as the mechanics of the NSPAC calculation begin to more fully reflect the positive revenue impact of the large customer cohorts that we acquired earlier this year, and as our pace of quarterly active customer adds moderates from its peak lockdown highs. Moving to the income statement. Q3 gross margin was 25.5%, a year-over-year increase of 180 basis points as we again surpassed the low end of our long-term target range. In the Q3, we benefited from strong execution as hard goods, private label, and healthcare collectively contributed 110 of the 180 basis points of year-over-year gross margin expansion.
Q3 operating expenses, which include SG&A and advertising and marketing, were $486.9 million, or 27.3% of net sales, scaling 280 basis points year-over-year. SG&A, which includes all fulfillment, customer service, credit card processing fees, corporate G&A, corporate payroll, and share-based compensation, totaled $352.3 million in the Q3, or 19.8% of net sales. This improved 120 basis points year-over-year, which on a fully loaded basis, again scaled versus 2019 as our share-based compensation declined versus our prior period run rate. Factors affecting Q3 SG&A expenses include the launch of two fulfillment centers, investments in bonuses and other incentives for our fulfillment and customer service team members, and absorption of some residual costs related to COVID-19. Q3 advertising and marketing was $134.6 million, or 7.6% of net sales, scaling 150 basis points year-over-year.
As previewed on our Q2 call in September, as the economy reopened in Q3, organic acquisition rates as a percent of total acquisitions began to normalize after running at elevated levels through the H1 of 2020. Likewise, the stronger economy and increased political advertising around the election helped drive a surge in digital advertising during Q3, which led to channel input costs rising from the depressed rates we saw in Q1 and Q2. In response, we adjusted our acquisition marketing efforts accordingly and continued to acquire customers smartly, while still delivering year-over-year marketing efficiencies and progressing towards our long-term target of 6% to 7% of net sales. Q3 net loss was $32.8 million, and net margin improved 460 basis points year-over-year to -1.8%. Q3 net income, excluding share-based compensation of $25.1 million, was -$7.8 million.
Net margin excluding share-based compensation improved 280 basis points to -0.4%. Q3 adjusted EBITDA was $5.5 million, and adjusted EBITDA margin improved 280 basis points year-over-year to 0.3%, again exceeding break even. While gross margins were solid this quarter, the operating cost headwinds that we faced in SG&A and marketing that I detailed earlier affected our ability to convert gross profit into adjusted EBITDA as efficiently as we did the first two quarters of the year. In our view, several of these headwinds are not systemic and simply reflect short-term issues related to new FC ramp-up and residual costs related to COVID-19. Turning now to free cash flow. Q3 free cash flow was positive $32.9 million, reflecting $63.4 million in positive cash flow from operating activities and $30.5 million of capital expenditures.
The positive operating cash in Q3 was primarily a function of the strong sales momentum we saw in the latter half of the quarter. Capital investments continue to be focused on capacity build, including cash outlays for our new automated fulfillment center in Archbald, Pennsylvania, and our new limited catalog fulfillment center in Kansas City, Missouri. We finished the quarter with over half a billion dollars of cash on the balance sheet. Which is a function of the $154 million we started the quarter with, combined with the $318 million we raised through our September follow-on offering, and the $33 million of free cash flow we generated during the quarter. This level of liquidity gives us tremendous flexibility. First, to support our growth, and second, it gives us the ability to evaluate internal and external opportunities to expand our addressable market. Now to guidance.
Based on strong early quarter results and accelerated customer demand and spending, we are increasing our guidance ranges as follows. Q4 net sales to between $1.94 billion and $1.96 billion, representing year-over-year growth of 43%-45%. Full year 2020 net sales to between $7.04 billion and $7.06 billion, representing year-over-year growth of 45%-46% and reflecting over $2.2 billion of incremental net sales added in 2020. We now expect to be profitable on a full year adjusted EBITDA basis, and we are increasing our full year 2020 adjusted EBITDA margin guidance range to between 0.2% and 0.4%. While some potential cost headwinds remain, these mostly reflect short-term impacts directly related to COVID or its temporary effects on areas like labor and logistics.
I will conclude by saying that our Q3 results demonstrate the appeal and resilience of the value proposition we offer pet parents and our ability to grow and scale the business profitably. We remain optimistic about our future and look forward to wrapping up a successful 2020 and building on this momentum in 2021, for which we plan to provide you more details on our next earnings call. With that, I'll turn the call over to the operator. Operator?
Thank you. We will now begin the question and answer session. To ask a question, you may press star then one on your touch-tone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then two. Please limit yourself to one question and one follow-up. If you have further questions, you may reenter the question queue. At this time, we'll pause momentarily to assemble our roster. Our first question will come from Steph Wissink with Jefferies. Please go ahead.
Thank you. Good afternoon, everyone, and Sumit, congratulations on your Bloomberg Businessweek recognition. Our question actually is twofold. If we could just start with some of the private label penetration. You're seeing good success there, but maybe give us a pathway to what you think that penetration rate could be over the course of the next 12 to 24 months. Then how does that influence the way you're thinking about gross margin advancement over that same timeframe? Thank you.
Hi, Steph. Thank you. Private label is a strategic vector for us. It's a little bit over a three-year-old business, and we have been ramping assortment in private label both across our consumables and hard goods portfolio. While we haven't broken out the specific size of private label, it can be inferred to be between somewhere around the mid to high single-digit % of net sales. We aspire to grow private label to become between 15% and 30% of net sales. The comment that we shared today on the call was particularly giving private label penetration for our hard goods portfolio that has now reached 16% of overall hard goods sales.
In hard goods, where we believe product lines are commoditized and customer loyalty isn't indexed to a particular brand, we believe we can reach north of 30%, somewhere around 40%, 45%, perhaps even 50% penetration for private label goods. For consumables, we will keep the context of our customers' loyalty towards their brands and our strategic nature of relationship with our suppliers in mind as we grow the private label portfolio there. Overall, as we get to ranges between 15% and 30% over time for overall private label business, we expect this business to generate 800 to 1,000 basis points higher gross profit than our base business. From the progress that we're making, we're pleased with it.
Not only have we added assortment within private label, effectively doubling assortment over the last 18-month period, we've also increased price points as we've added newer assortment across newer subcategories and higher price point products that are driving tremendous engagement and tremendous response from customers, particularly given the quality of these products remain four, 4.2, 4.4 star rated products at a minimum.
Thank you.
Sure.
Our next question will come from Cory Carpenter with JPMorgan. Please go ahead.
About sales accelerating in October, it seemed like you called out early holiday demand. Hoping you could expand a bit more on some of the dynamics you saw that month, also how you're thinking about the potential pull-forward of demand that maybe typically would've come later. As a second question, just curious, over the past month or so, what type of impact you've seen, if any, from the second wave virus on consumer demand or any evidence of pantry loading. Thank you.
Hey, Cory. This is Sumit. I'll take it. Two-part question. I'll answer them collectively because we believe they're connected and related. Let's start with when we provided Q3 guidance in early September, we shared that sales pace coming into the Q3 was strong. We saw, as anticipated, trends start to accelerate in October as the holiday season kicked off earlier this year. That momentum built through November and has carried through Black Friday and Cyber Week, with those two days being the highest net sales days in the company's history.
As we've examined the drivers of this momentum across traffic and conversion patterns, Cory, we don't believe that this is a simple pull forward or a COVID-induced second wave phenomenon. In fact, we believe that the demand that we're seeing is primarily organic and structural in nature. Let me sort of expand on that a little bit. First of all, we haven't found evidence within our internal data to suggest the same type of COVID-induced customer purchase behaviors as we observed in spring. For example, we aren't seeing a material variance in metrics such as units per order, or a disruption or a change in order frequency to suggest any kind of panic buying that we saw in March, April timeframes or the early onset of the pandemic. As we look to the balance of the Q4, we remain optimistic that these demand trends will continue.
Underneath of the organic volume, when we analyze the data here, we're seeing a couple of things. First, we are retaining a larger portion of our cohorts. Overall customer retention for our active customer base is up more than 600 basis points year to date, which also, by the way, helps address the question that we've all been wondering about through the onset of this year as to, are we going to be able to retain the cohort of customers that we are acquiring during the pandemic? We believe that sort of hits on that. Second, we're attracting larger, newer cohorts, and we're seeing higher engagement from these active customers, especially where we're garnering a larger share of wallet from new cohorts earlier in their life cycle.
For example, if you use Q2 of this year cohort as an example, this cohort was 50% larger than the Q2 2019 cohort. The initial net sales per active customer or share of wallet for this cohort, this Q2 2020 cohort, was 10% higher than the Q2 2019 cohort. When you put it all together, it sort of nets out to be, we're attracting more new customers, we're keeping more of our established customers, and more and more of these customers are building larger and more profitable baskets early on. That's sort of the summary of what we're seeing right now in terms of demand patterns.
Thank you. That's very helpful.
Our next question will come from Mark Mahaney with RBC Capital Markets. Please go ahead.
Thanks. I guess I'll just ask two specific P&L questions. Were there specific drag factors on gross margins? I know they were up nicely year-over-year. There was nice revenue growth sequentially, but the gross margin was the same. Is that where the build-out of the new fulfillment center cost kind of came in and limited the sequential gross margin expansion? Then secondly, you talked about this rising competitiveness for online ad spend. Do you feel like where you ended a quarter, is that back to kind of par, based on your historical experience? To get back to par, would you expect advertising costs, advertising intensity to continue to rise? Just put that in context. Where are you now versus where you think you normally would run the business? Thanks a lot.
Okay. Hey, Mark, this is Sumit. I'll take them. From a gross margin point of view, we saw a drag in two places. One was a natural drag as we came into the holiday season. There's obviously a higher degree of promotability, particularly as the holiday season arrived earlier in October. On a year-over-year comparative basis, the promotions environment was relatively muted. On an absolute basis, we obviously did see promotions kick in. That's kind of one. Number two, when you look at our supply chain, our supply chain's healthy from an in-stock level point of view, but the placement of inventory could be suboptimal in places as we're still adjusting and balancing out value chains as we work closely with our suppliers to get product into the warehouses.
From that standpoint, there's still a little bit of an effect of us either shipping products over longer zones, which generally shows up in freight costs that generally is a drag to gross margin. That's sort of the first part of the question. Overall, must be said, 180 basis points improvement year-over-year, and the fact that our newer strategic pillars are driving positive incremental gross margin into the portfolio is something that we're tremendously proud of and satisfied with. Moving on to marketing.
Marketing, as expected, as we came out of Q2, when we talked to you in September, we said, "Hey, marketing costs are starting to rise because inputs are starting to rise as the economy opens up, as more advertisers come in and the demand supply ratio offsets to be able to raise kind of bid costs in the market environment." What we saw was essentially exactly that happen. On the back of that, we also saw opportunities where we could efficiently spend money and acquire customers, which our team continued to do. Overall, due to the shifting in holiday, we observed a pull forward trend in new customers that were acquired kind of pre-Cyber period starting from late October into mid-November. That growth was built on strong shopper demand that reflected across the digital network.
On the television side, obviously, this is pre-bought inventory given everybody anticipated sort of the political campaigning advertisement spend. There we pulled in our spend a little bit to the left and spent money efficiently. Overall marketing costs, as you know, and as you've seen in the P&L, continues to trend below from a year-over-year point of view. It's obviously higher than the hyper-efficient periods that we saw in the early onset of the pandemic. Yes, we do believe that marketing costs will continue to be pressured as we execute the rest of Q4, perhaps even into next year.
Mark, if I can add one more thing, because I think what you're referring to, a couple of points are on gross margin. One is, obviously, we've stated that we did increase gross margin 180 basis points year-over-year.
If you're looking at quarter-over-quarter, you're right, they were 25% in both quarters. If you look at the mix of sales in the Q2 versus the Q3, you see that in the Q3, we had an increase in the percent of sales that went to consumables. We've talked about the relative margin performance of different components of revenue. When you go from a 69.4%, or rather 68.2% of sales being consumables in the Q2, and that increased to over 69%, it is those mix between the sales, the components of net revenue, that would have an impact on gross margin.
Okay. Thank you for the clarification. Thank you, Mario. Thank you, Sumit.
Thanks, Mark.
Our next question will come from Brian Fitzgerald with Wells Fargo. Please go ahead.
Hi, thanks, guys, and Sumit, congrats also. Could you guys talk to the opportunity to monetize Connect with a Vet, the referrals to local vets? Is that really monetized today? What is the monetization mechanism there? Seems like there's a lot of new pandemic parents, and this is a good way to drive Autoship for the uninitiated. Similar topic on Connect with a Vet. Can you talk about how you're growing awareness of this offering with your current Autoship customers? It's very early, but do you have any sense of how much awareness you have been able to drive already? Maybe how you think about how that can help drive Autoship retention. Last point, the path to availability of that service in all 50 states. Thanks.
Hey, Brian. Thank you. As of this morning, the service is available across 47 of the 50 states. We have rapidly expanded it from the 35, four or five weeks ago, to the 47 as of this morning. As of this morning, it is available coast to coast across our base of Autoship customers, which we're happy and proud of. Number two, of course, us starting the opportunity with Autoship customers is strategic in my mind as what we expect to do there is to observe. We believe this will help both fuel acquisition into the Autoship program, or stronger acquisition, and also help with retention of Autoship members, which is obviously both of them are incremental to the portfolio in driving top line and bottom line to the portfolio.
Over time, as you pointed out, the opportunity, these are early innings, and as we develop the product, we will obviously seek opportunities to embed it or offer it to our entire base of customers. There we have several ideas in the way that we can monetize this product over time. So far, we're focused on Autoship customers and learning how the service does there. Did I miss a part of your question? I don't believe so.
No, I think you got it all. Thanks, guys.
Yep, thanks.
Our next question will come from Lauren Schenk with Morgan Stanley. Please go ahead.
Great, thanks for taking the question. I guess following up a little bit on an earlier question, thinking about marketing spending into next year. Obviously, I think we're hearing about CPCs largely going to be higher to next year. From a sort of retention of new buyers perspective, is there anything that you think you need to invest in from that perspective? Is it really going to be sort of continued new customer growth and to that effect, how should we think about new customer growth next year given the really strong growth that you've seen this year?
Sure. Hi, Lauren. We'll stay away from speculating on numbers for next year. We'll talk to you more about 2021 on our Q4 call, I'll generally answer the question. First of all, no, we do not expect to spend incremental dollars on retention. In fact, as we have seen or as we have shared on this earnings call, customer retention year to date is up more than 600 basis points. That obviously includes the cohort of customers that we acquired this year, who continue to engage with us in a positive manner with higher AOVs driven by ASP and mix, not actually driven by higher UPO, therefore not indicating any kind of pandemic buying behavior there. Number two, we expect to continue to broaden or open up more marketing channels as we step out from 2020 into 2021.
You should expect us to broaden our range, our reach, our frequency. Overall, we are a strong direct response performance marketing engine, and you should expect us to hold ourselves disciplined and accountable in the way that we spend money and acquire customers. Last but not least, I will remind the audience that we've enhanced the value proposition of products and services that we bring to Chewy customers. In that way, not only are we seeing customers spend more early on, we believe the overall potential of net customer spend and LTV is greater. Therefore, generating higher LTV to CAC ratios, which has been our North Star as we think about marketing, and we will continue to do so as we move from this year into next.
Great. Thank you.
Our next question will come from Seth Basham with Wedbush Securities. Please go ahead.
Thanks a lot, and good afternoon. My question's around sales per active customer. We saw that metric increase, but it slowed a little bit sequentially in terms of year-over-year growth. Is there anything to think about as it relates to that metric here?
Hi, Seth, this is Mario. You're referring to NSPAC, and so the mechanics of NSPAC, if you remember, is that we take all the revenue in the last four quarters and divide by the active customers at the end of the quarter. Now we're seeing that number move up again. You would expect that, we would expect that NSPAC should continue to improve over the balance of the year and into next year as the revenue from those cohorts continues to be realized for the full trailing four quarters of having acquired the cohort itself. I think what you have to do for the last year is, you still have to adjust for the extra week in the Q4 of 2018.
If we do that, our NSPAC is up almost 3%. You can see how many new active customers we added in the quarter, which obviously has a temporary drag on that number from moving up.
Understood. Thank you.
Our next question will come from Oliver Wintermantel with Evercore ISI. Please go ahead.
Yeah. Hi, thanks. I just had a question regarding the cost headwinds that you mentioned in Q3. I think in your prepared remarks, you said they should shift into Q4, and then maybe into next year as well. While overall, you said they should be not permanent in nature, but you mentioned labor and logistics as well as COVID-19. Maybe a little bit more information of what you expect in Q4 and what part of these cost headwinds should fall off in next year.
Yeah, certainly. Hey, Oli, it's Mario. I'll answer that one. You've heard us say that unlike the Q1, COVID did not have a material impact to our gross margin in the Q3. We did see an impact in SG&A. We had approximately $8 million of expenses that were either directly or indirectly related to COVID in the Q3, which is about in line with what we shared with you for Q1 and Q2. We said $11 million in the Q1, rather $11 million in the Q2, $10 million in the Q1. For the Q4, we do expect somewhere between $15 million and $20 million of incremental SG&A, and again, directly or indirectly related to COVID. That's partially due to higher wages and benefits for our fulfillment center team members. We do believe these are temporary in nature.
[crosstalk]Oli, I'll add a couple of things. As you know, we're also ramping up two fulfillment centers along the way that kind of go into that SG&A number. We've just talked about marketing, where input costs are increasing, and it's a bit of an open playing field of marketing. There, we will continue to remain disciplined and also opportunistic, so that depending upon how the market behaves, our team can respond accordingly to drive both yield as well as net customer adds to the portfolio.
Got it. Just if I may, the $15 million-$20 million incremental SG&A, does that compare to the $8 million COVID cost, or was that a total number?
It's a total number.
Got it. Thanks very much.
Our next question will come from Erin Wright with Credit Suisse. Please go ahead.
Great. Thanks. On pharmacy, how much do you think you are taking share from other e-commerce players versus veterinary practices? Then more broadly on the pharmacy business, do you anticipate this will be a largely organic approach over time or down the road? Do you see the opportunity to bolster your pharmacy business more rapidly through acquisitions or just potentially highly synergistic pharmacy file buys, which could be an opportunity for you? Or will this be a more organic approach?
Hi, Erin, I'll take the question. First of all, the first question on share. Let's start from the top. We view healthcare as a $35 billion market. Of that $35 billion, approximately $7 billion in our research is RX medication, which is growing at 10% CAGR. We believe, if you do that math, then we're roughly 7% of the overall total available market share in that category. 70% or higher is still owned within the veterinarian channel. E-commerce, in our opinion, is approximately between $1 billion-$1.3 billion for total RX medication, which gives us a segment share of somewhere around 40%-45%. That's the first part of that question. With the market growing at 10% and the vet channel owning over 70%, I mean, at these dynamics, the category, in our opinion, has room for multiple simultaneous winners.
Our job is to ensure that Chewy is one of them. In terms of our strategy, in terms of the growth, we're clearly focused on organic growth at this point. As that strategy evolves, we are first focused on making sure that we have value-added services and products both for our customers and the veterinarian space, where we can keep the veterinarians in the center of the equation as we go make healthcare more affordable and accessible. That will be our primary focus over the next nine to 12 to 15 months as we grow the category and the space overall.
Okay. That's helpful. Just a related question on the triage offering, how do the economics work with the veterinary referral partners? Presumably, these clinics would in turn partner with you on the prescription management side. Will this be material near term, and are these exclusive relationships with these practices? How does that essentially work?
Sure. Thus far, there are no exclusive relationships. The referrals are, essentially, we are providing a service to the customer in identifying the type of veterinarian that might be suited to be able to appropriately diagnose the medical condition or the level of urgency with which the diagnosis might be required. In that way, Chewy partner veterinarians are redirecting customers to either neighborhood veterinarians, the customer's own veterinarian, or to emergency clinics.
If you've gone through the experience, what you will find is that we provide a full diagnosis summary or a full summary of the conversation, and some specific notes for the veterinarian in clinic to take a look at. In this way, what we are essentially doing is driving what we call high-quality traffic into the veterinarian's office, where the opportunity for conversion or offering that service or treatment and receptiveness for the customer is the greatest and the highest. That's one way to think about it. The other way that we're thinking about it, which we're excited about, is we believe that services like these can help solve challenges like compliance and also grow TAM for the healthcare space, which is obviously a vested interest and a joint mission that the veterinarians have. How?
Well, we believe that, and I've shared this data point earlier on this call, we believe that a third of pet parents in the U.S. either do not take their pets to vet or don't do so routinely. The barriers to doing so, in our opinion, is either the cost of vet care, the barriers or friction in the process itself, or just a lack of awareness around preventative healthcare in the minds of the pet parents. By offering or by bringing triage services like Connect with a Vet, we can offer the service to that type of pet parent from the convenience of their home and essentially earn their trust to be able to educate them and therefore drive that traffic into the veterinarian clinics.
In doing so, both increase compliance as well as open up the entire TAM for that particular customer segment that's not touched or not fully unleashed on opportunity from a veterinarian side standpoint. Those are two different ways of thinking about it.
That makes a lot of sense. Thanks.
Our next question will come from Rick Patel with Needham & Company. Please go ahead.
Thank you, good afternoon. Earlier, you touched on how newer cohorts are spending more earlier on compared to prior cohorts. I believe that historically, revenue per active customer has been in the $150-$200 ballpark for year one. If this has in fact ticked higher, do you see upside to NSPAC in the out years as well, or does this mean that lifetime value is consistent, but the ability to capture revenues earlier on has improved?
Rick, this is Mario. I think I understood your question. I think the answer to that question is both. Not only are we capturing more revenue earlier, which impacts LTV to CAC, and therefore we would expect that behavior to continue going forward, continuing to improve the LTV to CAC versus prior cohorts. An uptick in the first-year revenue per active customer could be a good indicator of future year NSPAC also being higher than prior customer cohorts. That doesn't just happen, right? We've been doing that actively by expanding the catalog, expanding the categories. The fact that two years ago, we did not have a pharmacy, that meant that a customer could spend potentially $700, $800 with us on their products and being consumables or hard goods, but they couldn't buy their medicine. They can do that today.
Our hard goods catalog itself was much smaller two years ago. As we continue to expand not only the product selection, but also the price points, that means that the customer now has an opportunity to buy their food and their dog bed, cat tree, et cetera, from us. We've expanded the product selection of non-dog, non-cat pets at home. Again, that customer may have had to split their purchases with us in another channel, and now they can consolidate all their spend on chewy.com. Therefore, the answer is, not only can we capture more of the revenue earlier, but also the LTV to CAC for those customers should improve, not only with higher revenue but also more profitable orders for those customers.
Very helpful. Thank you.
Our next question will come from Peter Keith with Piper Sandler. Please go ahead.
Hi. Thanks. Good afternoon. Maybe as a quick follow-up to Rick's question on the cohort spending, you have had this impressive 150% increase in cohort spend from year one to year two historically. So maybe with a higher starting point in year one, do you still see that type of increase for all these customers moving into next year? Or do you think maybe that growth moderates somewhat?
Peter, this is Mario. The cohort spend increasing from year one to year two. Look, without speaking to 2021, because we will do that on the Q4 call, nothing that we're seeing from the customers that we acquired this year would have us believe that they're going to behave any different than prior-year customers. I think that's the short answer, without me getting into 2021, any guidance discussion.
That's fair enough. If I can ask maybe a simplistic big picture follow-up. Impressive numbers that you're giving out on the higher retention rate this year. I think there's some views out there that maybe your churn rate would actually be higher, your retention would be lower because you've acquired a lot of customers when brick and mortar stores were closed. Simplistically, could you just maybe give us an overview of why you think the retention rates this year in particular are trending so much stronger?
Hey, Peter, this is Sumit. I'll take that. Well, I think it goes back to the entire value proposition, right? First of all, we seek to deliver a high bar, credible experience from the get-go. We aim to repeat that with every interaction that a pet parent has with us. So much so that, we build relationships, not acquire mere transactions. In some way, the relationships that we acquire fuels long-term loyalty and evangelism towards the brand. That has a lot of value in a category like pet, where customers refer to themselves as pet parents. It's an emotive category.
Underneath of that, when you layer on the core tenets of e-commerce on offering competitive pricing, broad assortment, and reliable and convenient delivery services, and you complement that with an expanded portfolio of products and services, it allows us to inch closer every month, every quarter, to our mission statement of being the most trusted, convenient destination for pet parents everywhere. We believe that it's reflected in the numbers that we're sharing today, including retention-type statistics or spend-per-cohort statistics that we've shared, or numbers that we've shared on the call today, both up more than 600 basis points on the retention basis, and cohorts on a year-over-year basis, spending 10% higher in quarter, as I kind of shared earlier on the call. You should expect us to continue to operate in a high discipline and high customer experience, high bar manner.
Okay. Very helpful. Thank you.
Our next question will come from Deepak Mathivanan with Barclays. Please go ahead.
Hey, guys. Thanks for taking the question. The first one on Autoship. You've had the first order discount on Autoship program at around 40% for a few months now. What are the benefits you're seeing from this change, and how do you think about the ROIs at these levels? Also, is the Autoship penetration currently the same on more recent cohorts, maybe on a monthly basis? Because of the pandemic, there's been some fluctuation there, just curious on how that adoption has been. Thank you.
Sure. Hey, Deepak. I'll take the second one. Mario will take the first one. The Autoship penetration is same or better on customer cohorts that we are acquiring.
I think your first part of your question was about the discount. I think the simple answer is, you're right, the Autoship penetration is increasing, or it's higher at this higher level. The other side is, what is the cost to us, right? The cost is minimal. You have the benefit of having more sign-up rate, a higher sign-up rate net, of any cancellations, and a lower cost, which leads to an improved LTV to CAC for these customers.
Deepak, these are transient, seasonal promotions that we do. We're not seeking to disrupt the value proposition in the program driven by deep discounting or any such sort. These are seasonal, holiday-driven promotions, where we are particularly sensitive and data-driven in understanding what our gross customer adds would be in Autoship, and also understanding the cancellation rate post-event, therefore, arriving at net adds that form the basis of the payback calculation, given that we understand how long the customers are going to stay with us, what their spend patterns are going to be, and how we can develop them from one category into purchasing multiple categories over time. That's how we think about it.
Got it. No, that's very helpful. Thanks, guys.
Sure.
This concludes our question and answer session. I would like to turn the conference back over to Sumit Singh for any closing remarks. Please go ahead, sir.
Thank you, everyone. Have a good night.
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.