Thank you, everybody, for coming, sticking around. It's gonna be worth the wait. Such 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.
Yeah. Any updates on your pet?
Yogi, 65 lbs, 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 gonna be a taco for Halloween.
Oh, 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-
Yep.
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-
Yeah
... Is more on the finer point. But if you had to rank the magnitude of headwinds on that, on this category, is it macro? Is it pull forward? Is it share of wallet? Is it losing share due to pricing?
Yeah, 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 three. First, it's the macro and consumer wallet, right?
If you look at food and beverage, human food, food and beverage, that's had heavy inflation. If you think of shift towards services, that's impinged upon wallets. There's 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 one to year 8-ish is basically flat in terms of total spend. However, year one and year two 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 under-penetrated 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?
Yeah. 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 2024, 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're—we announced a $150 million cost out program. That is $40 million in year one. The majority of that is gross margin impacting. So we're not sitting, we're being... We're controlling our controllables.
Mm-hmm. Then, if we could maybe talk about pricing a little bit, and maybe I should segment it into two parts. You talked about value, and I think you wanna start addressing value maybe a little bit more. But when I think of Petco, I do think kind of better, best-
Yep.
-More premium.
Yep.
So how do you reconcile the... and the bigger emphasis on value?
Yep. 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, they're greater humanizers, if you will. So if you look at my grandfather, the dog was in, you know, the backyard and had Alpo. My mother, the dog was in the house, and it was Iams. With me, the dog's in my bed, and he's getting, you know, fresh, frozen, and science-type 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.
So, in terms of just what you're introducing, I know you made the announcement about-
Yeah
... Fancy Feast as an example of where you're... How much should we expect the mix to change?
Yeah
At Petco as a result of this?
Our number one focus is winning the premiumization play, right? If you look at the top end, super premium and fresh frozen, whether it is ORIJEN at $100 a bag, Taste of the Wild, Honest Kitchen, we just brought in Ollie. 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 two-thirds 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, you know, we're three weeks into the Fancy Feast expansion, but strong double-digit % 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 treat, cat treats and cat toys grow, so it drags attachment that's very favorable. So it's getting more at bats with those customers.
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-
Yeah
... entry point or value proposition?
Yeah, actually, our WholeHearted, which is, you know, when I came in, it was about 1.6% of the mix, now it's close to 10% of the mix, is mid-tier.
Mid-tier.
So it's high-end quality for mid-tier pricing. So again, it's a 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 the 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 Nestlé 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, 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?
Yeah, the thing I would say is, you wanna be real-time aligned with where the customer is looking, but keep your North store in your-- North Star in your strategy.
So our North Star is humanization and premiumization. The customer is looking for more value. Now, we wanna make sure that we're providing that and getting those footsteps. You know, will we adjust as we go out? Yes. But having, having those customers and providing for that need, I think makes us a stronger franchise.
Does this, the value proposition, have any impact on margins?
So, initially, those products will have less gross margin, but you gotta think about it in a couple 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 secondly, 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?
Yeah. I can't give specifics for competitive reasons on that. Again, I'll break it into three 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, that continues, and that shift towards more premium continues. 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 three 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 quarters for break even, and then roughly just a little over a year for payback. But again, the first quarter is where you see, you see the biggest hit on that.
And that, you know, I know you're talking in terms of, you know, customer response or where you start to, you know, start to benefit from some of these changes. But in terms of the customer response to pricing, is that something they notice right away, or are you seeing elasticity impact from right away?
So basically, the line goes like this.
... on these KVI pricing actions. Again, we've done three of them, two quarters towards break even. And, you know, 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, 'cause there's two components, right? 1 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, you know, to the store?
Yeah, 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 cat customers and said, "Hey, we now have Fancy Feast," to make sure we're communicating to them. We have 25 million customers, so our ability to go contact them is powerful. And then same thing on the pricing changes. Again, there is 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.
Now, we talked about the gross margin impact from the value introduction. And obviously, there's gonna 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/or gross margins?
Yeah, so if you think about it, it's the number one 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.
That impact is a P&L geography versus a real profitability dynamic. As we see outsized growth on services, you know, I would encourage all of 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-
Yeah
piece. And it probably lends itself to what you just... That bucket you said before, where the people are aging out of certain things with their, with their pets. But are you surprised at 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?
You know, what's interesting is it's a mirror of the consumer space.
Yeah.
Right?
Yeah.
People aren't cutting back on these things in their personal lives, and they're not cutting back on services. I had an 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%. We'll get into vet shortly, but we had 26% increase in number of pets seen in our veterinary. Now, part of that is the consumer, and part of that is our ecosystem working.
Right. Yeah, and I do have a couple of questions on vet, 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.
That's right.
Could you maybe talk us through the evolution of vet, and where you plan to go with it?
Yeah
-Over time?
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, you know, 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, Yeah, I came in in 2018. In 2019, we launched our first own vet, so we did it in Las Vegas, and we did four or five, and we liked that model better.
We liked the financials, we liked the customer experience better, we liked the sharing of the data across an enterprise. That gave us confidence, and from there, we pursued an owned vet strategy, and then we purchased the joint venture, half of the joint venture from Pathway, and that's worked, served us very well. If you look at our vet business, you know, year one is dilutive, year two is break even, year five is a 20% four-wall margin. And then on top of that, we get the center store lift of 4-5 points. We've talked about it since minute one, and we continue to validate that number. From an enterprise standpoint, it's very attractive. From a competitive moat standpoint, it's very attractive.
Then that capability allows us to do things like our Vital Care Premier program, which is for $24.99, you get a free checkup, 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 going to one place for grooming, one place for vet, and one place for food or supplies.
Can you maybe talk about, from an offerings standpoint, what you're not offering today that you can do in the future, and maybe how prescriptions and insurance come into play?
Yeah. Our Rx business is growing strong double digits. We're really happy about that. We were under-penetrated, and we continue to scale that business, and it's just a natural... And then we want to drive more of that on a Repeat Delivery, which is highly sticky. From an insurance standpoint, we announced a partnership with Nationwide. They're the number one player in insurance. They have 1.2 million pets, but there's 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 you know, there'll be an announcement in the near future on the joint offering with Nationwide.
Then, just feedback that we hear or questions that we get is your ability to hire vets. That it is pretty tight capacity.
Yep.
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 vet practices?
Yeah. 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 that at scale to do both of those. So we have 268 vet hospitals, and we have over a thousand vet clinic, or vet clinics in over a thousand 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, I'm not— 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 years, 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 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're focused on debt first.
Right. Maybe I can ask, since we just mentioned it, we go to debt for a second. Year to date, you've paid down $75 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-
Yeah
... in the quarter. What's being done to try and free up some of the cash when the bottom line is under more pressure?
Yeah
... 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 free cash flow was up $72 million last quarter, which is in our view very good performance. We are committed to a $100 million paydown, $75 million through Q2, so that's good progress against that $100 million. So we're gonna continue to focus on things like cash conversion. We're gonna focus on terms with our vendors. We're gonna focus on smart capital allocation as well. You know, we'll be more conservative as we head into 2024 based upon where we are, and again, debt will be the number one 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
Yep
... Omni-channel.
Yep.
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 omni-channel actually helps you with selling that.
I have a personal soft spot because my dog, Yummy, was overweight, and the owner of JustFoodForDogs said, "Your dog's 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 him over to that, which was everything to me. So you know, roughly about a $1.5 billion business today, projected to get to $6 billion by 2025. We're very well-positioned with JustFoodForDogs, which has been a fantastic partnership. We just added Ollie's. We have Instinct. We have Freshpet. So we have a good array, and we also have a WholeHearted Fresh now.
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 a 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. You know, we plan on continuing to drive it and to win in that category. It's super strategic for us. As part of the pet category, you know, 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, like, the added ingredients and the, the freezer cost-
Yeah
... And things like that, is it as profitable as?
Profit dollar positive, slightly dollar profit margin. But again, you have to think about it detractive, but you have to think about it as a full enterprise. And the other thing I, 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 our BOPUS or you do it via same day, like when my fresh frozen comes, it comes in a Petco paper bag.
It doesn't have, you know, freezing and that type of material. If you're shipping it from a distribution center, you're having to add all that extra cost.
We have a cost competitive advantage on that category, not to mention a freshness competitive advantage versus online-only players.
Then another initiative, we had Lowe's here earlier, before, and obviously you're in partnership with them to do-
Yeah
... Shop in shops, which is exciting. But I think you also have a plan to build out your own standalone stores. So you're gonna be in 300 stores with Lowe's in rural markets, and then you have a plan to build out your standalone stores. I think there's a long-standing established player in the farm and feed,
You think?
... Space. Has been in the more rural markets for quite some time. How different do you envision the Petco standalone-
Yeah
... Concept versus other competitors?
Let me start with those.
Yeah.
We started in a pilot. The pilot. We liked the results. Both sides liked the results. We expanded that to roughly 300 locations. We're pleased with it, with the results so far. If you think about it from our standpoint, zero capital outlay-
... Accessing the rural pet market is predicted to be a $6 billion market, so it gives us a foothold in accessing that market. From our rural play, well, we'll have 15 stores by the end of this year. We like what's happening. It's either on or above our, our projections. But again, if I look at 2024, we're gonna 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 spears 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, these stores are doing well.
There's also a companion animal customer that is not served by existing players.
Okay, we've been asking four questions of every company-
Yep.
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 2024?
Yeah, I'm not gonna prognosticate. I mean, this morning we wake up with fluid data. So, what I can tell you about our categories, 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, you know, if you look at what I said about supplies, supplies are projected to grow 3% in 2024 at the category level. And we still have, you know, strong services growth at the same time. But, you know, we'll see. The consumer is gonna stabilize, the question is when, in the discretionary space.
Right. Part B of the question is on trade down. You know, obviously you're introducing more value, so I think you're thinking you can capture maybe some more trade down in 2024. But how do you think about, you know, the trade down-
Yeah.
2023 versus 2024?
It's a bifurcation. We're gonna have more customers. I talked about 12% growth on fresh frozen. We're gonna have more customers buying fresh frozen. ORIJEN was a $100 bag growing double digits, so we're gonna 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 and companion animals could drive better trends?
Yeah, we're not sitting on our hands. We have a supplies perks program that incentivizes folks to buy, buy more. I go back to the footsteps point, right?
Yeah.
If I get more footsteps, I'm gonna get more attach on the supplies, but there also is newness. Actually, if you go into our PCCs, otherwise known as stores today, you'll see two things. First of all, is 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, you know, in-store 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, you know, 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 environments. 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, you know, sitting in Texas in 110 degrees, you needed that. So making sure we're on point for those buying opportunities, whether that be those or whether that be seasonal-type opportunities.
And that kind of leads to our last question, just on inventory. Can you, you know, maybe talk to how you're feeling about in stocks, how much flexibility you do have to chase, you know, certain trends?
Yeah
Or certain things that you think are changing with the consumer?
Yeah, 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.
Right. Right. 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 streams.
Yep.
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?
Yeah. So, we're driving double-digit growth on our recurring revenue. It's been an explicit strategy since, you know, we started talking in 2018, 2019, 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 upfront. And so those customers are spending 3 times 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 2 times more with us. And then the last thing would be, that I would cite, is insurance.
And as we get into, you know, more, 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 'cause it gives us predictability.
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.