Great. Welcome everyone to the 25th Annual Needham Growth Conference. My name is Anna Andreeva, I cover consumer e-commerce for the firm. Next up, we have management team from Petco Health and Services. From the company, we have Brian LaRose, who is the CFO. Welcome, Brian.
Hey, Anna. Thanks for having me.
Okay, absolutely. We are rated buy on Petco. We really like the resilient nature of the pet space. We think the company has done a really great job growing top line via consumables and also services, especially healthcare and vet. We think the stock is pretty attractively priced. Let's kick this off. Brian, I guess first off, just starting with the big picture, it's been a kind of a tale of two cities in 2022. Your performance in consumables that has been very strong, growing double digits, e-com up in the double-digit range as well, and underperformance in hard goods and companion animal. Hard goods seems like it's an industry issue overall. Maybe talk about how that has compared to your expectations, as we went through the year, any green shoots that you're seeing in the hard goods category.
Yeah. Thanks for the question. Again, thanks for having me. Let me take a step back and say, I think if you went back a year ago, I'm not sure in any industry that anybody could have predicted we'd be where we are today in terms of the overall market. They're sort of unprecedented times. Now, the good news in that is where you started, Anna, that we've continued to grow. Petco is a growth company. We're gonna continue to be a growth company. You said it was a tale of sort of, of two companies here. Consumables has been really strong, very resilient, growing double digits all year. We actually, I'd be remiss if I didn't mention services. I think Jason would be upset with me. Services has also been very resilient, services would be grooming, training, as well as Vetco.
That was up 14% in the third quarter, up 38% on a two-year stack. We've had a lot of resiliency in services as well. The hard goods category or what we call supplies and companion animal, the more discretionary category. It's about 40%-ish of our business, and that's been down, you know, about 9% for the year. We've gone back and looked at prior economic cycles in terms of how these categories typically behave through the great financial crisis and prior downturns. They behave somewhat similarly. You have, you know, consumer pullback in certain categories. Overall, the company's been growing, we would fully expect those categories to come back as the economy improves.
Okay. Within hard goods, if you were to slice and dice, you know, a bit further, how are the non new pet formation categories doing within that? I would think within hard goods, anything related to healthcare, I think has been more resilient.
Mm-hmm.
With that, what are you seeing in terms of pet ownership? I know it's really difficult to get the accurate stats on those, you know, haven't been super reliable. Just curious if there's any color there?
Yeah. 'Cause also in the prior question, you talked about green shoots. You know, one of the things that we did last quarter, we launched a supplies perks program. Think of that as, you know, kind of the old school punch card program where you buy more products, you get one for free. We launched supplies perks off of the basis of success we saw in grooming perks and nutrition perks, where for every bag of dog food you buy, you get the 10th one free. As we looked at the discretionary categories while we've looked at the prior economic cycle data, we're not passengers on the bus here. We continue to take action to stimulate the category. Supplies perks was one of the things that we put in place to try and stimulate growth there.
In terms of the overall pet adoption cycle in the category, kind of, you know, going back to what I said earlier, this is a resilient category. It was resilient before the pandemic. It was resilient through the pandemic. It's been resilient since. It's a category that over the last 30 years has had a mid-single-digit CAGR through all economic cycles. Obviously grew a little faster during COVID, but we've continued to see the category grow this year. Pet ownership is up this year. Relinquishments are down from pre-pandemic levels. Overall, that's good news. That means there's more pets in the ecosystem. That means there's more pet parents spending time with their pets, and that means there's more pet parents spending money on their pets. The category remains strong and continues to grow.
Okay. Okay, that's great. Any, just to follow up on my previous question, any non-new pet formation categories within the supplies-
Yeah.
category that you could call out?
Yeah. You mentioned, you know, healthcare products, you know, under our own brand's name. All our Well & Good products continue to perform well. The discretionary or hard goods category isn't sort of a one-size-fits-all. You have items that are truly discretionary in nature, whether that be toys or things of that nature. You also have pockets of that category that are less discretionary, where you take collars or leashes. If my pet grows out of a collar, I'm going to get a new one. If I have a leash that's fraying, I'm going to get a new one. You have pockets of the category that have been more resilient than others.
Okay. Okay. That's perfect. You mentioned own brands, at my household, we are a fan of your Well & Good brand. That's great. I know exclusives, as well as own brands, are a big differentiator of the Petco model. Just curious if you could remind us about the penetration there.
Yeah.
How has growth trended so far in 2022? Those are more profitable categories for Petco. Just any additional color on profitability?
Yeah. I can't probably get into the profitability as much as you would like, but I'll tell you, they are accretive to our model. Very important part of our model is own brands, we see a long trajectory of growth for it and to continue to increase penetration, coupled with our premium assortment across different vendors. If you take own brands in total, obviously we have brands like Reddy and WholeHearted, which have continued to grow very, very well for us. You couple that with exclusive relationships in products like Backcountry, new partnerships with companies like Stella & Chewy's, you have an overall premium assortment of category that is has positioned us very, very well in the overall market. Against competition, you know, about 60% of our assortment is exclusive to our own brands, not available at mass.
Mm-hmm.
It allows us to position ourselves against a certain demographic in the category, that is advantageous to us.
Are you seeing any trade down within any of the parts of your portfolio either towards your own brands or from more premium brands to more of a price, a mass price point?
No, in aggregate, we haven't seen that. If you think about, let me talk about food, for example. The consumables category growing double digits. The fact that we're so overweight in a premium assortment suggests that there could not be a mass trade down within that category, otherwise we wouldn't have shown up with double-digit growth in consumables. What we have done is, you know, I think WholeHearted, our own brands, gives us a great opportunity to position ourselves against those customers who are maybe more value-conscious for a premium product.
We've come up with new bundles in Wholehearted for those customers who are looking for that value entry price point. We've also continued to lean into our perks program, so there's you know, an inherent benefit whenever you participate in nutrition perks. You get that 10th bag of dog food free. You sign up for Vital Care, the benefits that you get from Vital Care across nutrition services as well as well as vet allows you to get greater benefit as a customer.
Okay. As you talk about the premium trend, which has been the case across the industry, for a few years now, it would be remiss not to mention the fresh and frozen.
Mm-hmm.
That's a pretty exciting TAM. Has been growing really nicely. Maybe talk about that. What kind of education do you think is still necessary for the consumer to really see acceleration, like bigger acceleration?
Yeah.
-in that area?
It's a great question. You're right, Anna. When we look at the market, you know, it's, you know, call it, you know, somewhere, $800 billion-$900 billion worth of market today. We think it grows to $4 billion-$5 billion over the next three years. There are different data points out there on the size of the market, but it's large and growing, and growing very fast. We believe enough in the market, we made a significant CapEx investment this year to make sure that we have freezers available in over 1,000 locations within our pet care centers to be able to provide fresh and frozen products. We believe we have an advantage as this market continues to grow in terms of the way we fulfill.
Fresh and frozen is a difficult economic model to ship direct from DC and Mass. We have, you know, roughly 80% of our e-com orders are fulfilled through our pet care centers, through buy online, pickup in store, same-day delivery, and ship from store. That allows us to get the fresh product to a customer faster at better economics for us, there continues to be sort of an advantage for us from a fulfillment standpoint. We have one other question in there that I missed.
I guess, general education-
General education, that was it.
of the customer.
We continue to, you know, lean into our marketing efforts around fresh frozen. Our partnerships with our vendors are core to that. You know, we obviously have a good relationship with JustFoodForDogs, with Freshpet, you know, with other vendors within the fresh space, so we continue to partner with them to educate. I also think this, there's a natural humanization trend that follows what you saw in premium kibble, where you just continue to see customers migrate.
There's an overall wellness umbrella that fresh fits into, and I think as you look at the demographics of new pet ownership, we're over-indexed in certain areas like in Gen Z and Millennials, where 66% of Gen Z and Millennial customers wanna do what's best for their pets. They spend more on their pets. They are more invested in the overall humanization and wellness of their pets. Fresh fits under the umbrella of that education as well.
Okay. That's actually a perfect segue into my next question. As you think about the spend per pet, so we talked about one component, right? The number of pets, which is growing slightly more modestly right this year, but it sounds like it's still growing slightly. Spend per pet, just given the demo that you just described, and the propensity to spend on services, especially, talk about what inning are we in in terms of the growth there, and what is Petco doing specifically to accelerate that further?
That's a great question. Let me take a step back first and think about historically. Historically, when I talked earlier about, you know, the resiliency of the category being kind of mid-single digits growth, if you break that apart, traditionally, it's been kind of 1% pet growth, 4% spend per pet. You know, we talked in our last Analyst Day about longer term, the category growing from, you know, from a 5% category to a 6%-7% category, driven by an increase in spend per pet. That spend per pet will come from the increasing humanization of pets and the fact that people are looking for the overall wellness of their pets, investing more in premium food, inclusive of fresh. Expansion into grooming services and making sure that you're getting regular, wellness checkups as well as RX and insurance.
How do you bundle all that together? One of the things that we've done one of our major investments to scale spend per pet across our own ecosystem is Vital Care.
Mm-hmm.
It is the most comprehensive offering for a pet parent in the industry. For a $20 fee per month, you get rewards back to the tune of $15. You get free vet visits within our four-wall vets. You get discounts on nutrition. You get discounts on grooming. All in, what that allows from a customer standpoint is about $200 a year of savings from a customer standpoint. For us, a Vital Care customer spends about 60% more than a analogous non-Vital Care customer and has 3.5 x higher LTV. Perhaps the biggest vehicle we have to drive spend per pet across our ecosystem-
Mm-hmm.
is Vital Care. We're up to 400,000 members today and growing nicely.
Okay. Yeah, Vital Care is definitely pretty unique in the industry, and I know as you rolled out that sign-up capability at the registers this fall, you really saw a pretty nice acceleration there. You know, maybe talk about what are some of the other ways, you know, to really monetize and advertise this program?
Yeah. Yeah, great, good question. There are a couple of things we did for Vital Care this year. The first thing was we actually rolled out Vital Care for cats. Initially, it was a dog-only product. We then had a partnership with Rover, and we enhanced the Pals Rewards associated with the program. We then, right before we did the POS sign-up, launched Vital Care for companion animals, so different price point, different economics, but same value proposition, and we saw a lift from that. The big unlock was sign up at point of sale. Before that, we were scaling nicely where you actually had to enable sign-up through the app, even if you were in store.
Having that at point of sale gives us a quicker transition for the customer. It also leverages what's one of the best assets we have in the company. It's our pet care center partners, our employees in store. Highly educated employees, very good at making sure that our customers understand what's available to them. To have them with that tool set at register is a big unlock for us.
Okay. Okay. That's great. Just taking a step, a step back, maybe talk about what you're seeing with a competitive set. You and your other publicly traded competitor in this space have talked about a very rational environment across this ecosystem and really for some time. Maybe talk about what are you seeing from that regard, and how would you categorize your performance year-to-date versus some of the others in the industry?
Yeah. Let me start with, you know, maybe for those of you who are less familiar, we compete against obviously, pet specialty retailers in brick-and-mortar. We compete against online-only players, and we compete against, you know, what is a fragmented overall vet market. We have competition across different pockets of our business. That said, there's not a single company who has the end-to-end ecosystem that we offer, where you have vets inside of our stores, augmented by Vetco mobile vaccination clinics, where you have grooming capabilities, training capabilities, brick-and-mortar with fulfillment for e-com orders at 80% of the e-com orders that come in. When we look at our competitive set, we're uniquely positioned to have all of those offerings. For some of our competition, you can't actually do some of the things that we do.
You can't have hands-on pet unless you have a vet. You can't actually administer an X-ray if you don't have that capability in store. You can't do dog training in person if you don't have that capability in store. We're leveraging our physical footprint and augmenting that with the services and digital capabilities around it. You know, I think if you look at what's happened in the industry, you've continued to see, you know, where we started, you know, inclusive of us, very strong growth in services, very strong growth in the food categories, a category that continues to grow through this economic cycle en masse, and then you have some pockets that we believe will return.
Okay. You had mentioned vet and that's definitely one of the areas that we're especially excited about. You'll end the year with, I think, about 250. You've talked about 900 locations over time. Talk about how you approach the thinking about opening your own -
Yeah.
versus being acquisitive. Any updates how the Thrive acquisition and integration is progressing? As you look out and the vet locations mature, any additional color that you can provide about that customer and what you're seeing to the center store as a result?
Sure, yeah. Vet is so core to our growth strategy. It has been, and it will be. We started investing in this business about four years ago. We initially started with a joint venture partnership, where it's 50/50 owned. We started opening our own vet hospitals about three years ago. Started to scale those own vet hospitals, we like that model a lot better for us in terms of the overall economics. For those of you less familiar with the vet model, typically, when we put in a vet, you have about a, you know, call it a $600,000 capital investment for the vet itself. The four-wall vet economics are where you're sort of loss-making in year one, getting to positive in year three with a long-term EBITDA that is well above company average at 20%.
You know, as we've continued to scale vets, we've continued to see ourselves positioned well against that model. We measure that return on capital investment on the four-wall economics itself. Apart from that, the center store. Whenever we put in a vet, we get a center store lift of kind of mid-single digits in year one. We revalidated that. Anna mentioned, you know, that we're, you know, we're ending the year at 250 vets. We've gone through the work to look at all of our cohorts on a month-by-month, year-by-year basis, does that center store lift hold now that we're 200+ vets in? The good news is it does. The model itself is super attractive to us in terms of how it ties together the ecosystem, as well as what it means for four-wall vet economics and, you know, overall company return.
It also gives us a nice on-ramp for customer acquisition, so we've continued to acquire customers at the enterprise level. Vet is a great on-ramp for that, and it's a great on-ramp into vet for customers who walk through our doors in brick-and-mortar. In terms of acquisitions, you know, we've typically done kinda onesie-twosie acquisitions of vet practices. Most of our vets continue to be organic vet adds, where we build them out ourselves. When we do acquire a standalone vet, they would move into our center store, either day one or in short proximity.
We might do that in a market where we just find a vet that fits well in our ecosystem, and we find the opportunity to bring them in. Mostly builds, highly attractive model, and something that we remain committed to.
Okay. It's been an incredibly tight labor supply type of a industry. Yet, you know, Petco has done a very good job, I think attracting and retaining. Maybe talk about that, if you're seeing any improvement from the specifically labor standpoint. Just curious what other challenges or conversely opportunities, surprises to the upside have you seen with the rollout?
Yeah. I think the recruiting market is largely unchanged. You know, it's a competitive market to recruit vets in. We've done really well against it. Last quarter, we brought in more vets than we ever have in any quarter. It was a highly positive quarter for us in terms of vet recruiting. We attack it in multiple fronts. You know, first of all, from an overall compensation standpoint, you know, we're able to offer wages, bonus, and equity, something that, you know, a lot of the larger fragmented players in the market can't offer. Secondly, our value proposition more is centered around what we can give from a lifestyle of a vet. You know, if you think about the vet professional, they get into this business to actually practice medicine.
We allow them the opportunity to do that. To come into our four walls in a, you know, a brand-new facility with the equipment provided, the staffing provided, the ordering system provided, the relationship with the general manager that allows them access to customers walking through the doors, and to do so where you allow them to practice autonomous medicine, is a very different pitch than some of the other players in the market. It remains competitive, but I think our recruiting team has done a really, really good job. In terms of where you say surprises or maybe newness, I think, you know, going back to part of your prior question, the Thrive acquisition's been good for us.
You know, we retained almost all of the vet professionals above our model in terms of retention of professionals coming over from Thrive. There were 800 vet professionals inclusive of vets, vet techs, staff, et cetera, within Thrive. We had a retention target for that acquisition. We exceeded that target.
Mm.
That validates our value proposition in terms of the vet space and the vet profession. Also gives us a nice on-ramp in terms of referrals. The last thing I'd say is, you know, in addition to our own vets, we have these Vetco mobile vaccination clinics, where we hit about 1,200 of our locations last quarter, and there's about 1,100 professionals, 1099 professionals within that ecosystem.
Mm.
Gives us access to bring vets in to either fill in shifts or perhaps have an on-ramp to become a full-time professional with us. I think our overall ecosystem for vet is strategically important.
Mm-hmm.
Performing very well.
I personally think Vetco is a really interesting opportunity for the company. How does that tie in overall with the vet initiative? I know you've said it hasn't been as much crossover necessarily in terms of selling. I would imagine it brings in a new customer to the role.
Absolutely. Yeah, absolutely. It brings in new customers into our ecosystem. We make sure that we cross-sell and cross-market.
Mm-hmm.
We're now four Vetco-only customers. I think as you see this thing scale over time, it's not necessarily binary, where it's either a Vetco-owned facility or a Vetco clinic. We will deploy the Vetco mobile clinic wherever we think we're getting the best return. As I mentioned last quarter, that meant 1,200 locations actually had visits from a Vetco mobile clinic, so highly scalable.
Okay. All right. Terrific. Moving on to some of the KPIs, Petco discloses the net adds, and that has been pretty strong for the company for a number of quarters now. Maybe talk about where do you think that consumer is coming from? We've done our work on the independent channel and the mass and grocery, I think those are still donating share.
Mm-hmm.
Just curious on your thoughts there.
Yeah. I think it's coming from all sorts of different sources. If you think about the fact that, you know, 60% of our assortment isn't available in mass channels, the fact that we have vets inside of our four walls. We offer grooming and training services, so we have hands-on pet in many different means. It's highly attractive and overlaps well with a demographic who is looking for the best overall wellness for their pet. I mentioned earlier we're higher indexed towards Millennial and Gen Z-ers. That has been a nice part of that customer acquisition on-ramp for us, because those are customers who are looking to spend end-to-end in a one-stop shop. How we position in the market, we've done a lot of work around this too. You have...
If you think about where customers wanna shop, you know, 29% of customers wanna shop online only. 32% of customers wanna shop in store. 39% of customers wanna shop omni. We hit all of those different buckets.
Okay. One of the metrics you provide, revenues for active customer, and we've talked about that has seen some decline. Talk about that and specifically, what is the company doing?
Yeah.
-improve that metric?
Yeah, great question. In key areas like digital and services, our net spend per average customer is actually up. If you look at the overall company level, there is a nuance underneath there, where we continue to acquire new customers. Whenever you continue to acquire new customers, they're obviously sitting in your denominator. You do not have the full breadth of their spend in the numerator as of yet, there's some pressure on the net spend per average customer. As you mature those customers over time, you scale that net spend per that individual customer. As long as you're adding, there's some pressure on that arithmetic. If we were to not add customers, you'd see an increase in net spend for average customer, we're in the business of continuing to try and add new customers.
Okay. Okay. Okay, great. I guess, moving on, I wanted to ask about the small town concept.
Yeah.
I think there are three currently. You've talked about pretty sizable TAM in the small town area. Maybe talk about to those unfamiliar with that opportunity, how exactly do you approach that? How is Petco differentiating themselves in some of those areas, and how should we think about the growth there?
Yeah. I'm, you know, I get excited about this opportunity. We are still in the pilot stage. Neighborhood Farm & Pet Supply is the official name of this product. We talked in our Analyst Day about identifying a $7 billion TAM that is large and rapidly growing. Within that, we, you know, there's 100 or 200 locations that we've identified as potential locations. Now, we're still in pilot stage. You mentioned we have three locations.
Mm-hmm.
Floresville, Texas, Early, Texas, and one in North Carolina. We opened the first one in June. Early innings, but things are going well in terms of that concept. You know, the idea there is there is an untapped and underserved market for pet specialty in those locations. While there are other players who provide some services in those markets, you still have customers. Take Floresville, for example. Floresville sits outside of San Antonio. You had a large demographic that was driving into San Antonio to get the full needs of their pet specialty met. We put a store in Floresville, and suddenly they have an opportunity to get what they need right there. We think there's more of these locations available. Cost us about $650,000 of capital to put in a location.
They are profitable in year 1 in terms of the model. We're holding to that model in terms of the locations that we've launched. You know, we wanna make sure that we're responsible about the way we're investing here. We've said we'll do a handful more this year and evaluate our 2023 projection as we give out guidance in March. It's a big opportunity for us, and I think the way we're positioned from an overall ecosystem fits very well in those markets.
Okay. How do you think about balancing that growth as you look out between small town and vet? What are some of the KPIs that you look for specifically within small town to make you think to accelerate this?
You know, I wish it was more sophisticated than good old-fashioned ROI. It's good old-fashioned ROI.
Okay.
The good news is the ROI on both of those investments is very, very strong, well above any hurdle rate that we would look for. I would say they're non-binary decisions in terms of-
Mm-hmm
how we make those. You know, we like the investment in vet. We like what we've seen for small town rural. Make no mistake, that is core to what we're doing and what we continue to do. It is not a question of not doing that. It is a question of investing in something incremental that we believe is-
Mm-hmm
you know, very attractive from an ROI standpoint.
How does the assortment differ in a small town concept versus your average store, and where are you with the services opportunity there?
We've expanded our assortment into new areas. In a typical, if I were to go to, you know, 92nd Street in New York here, I doubt you would see four different species of chicks.
Mm-hmm.
You would see that in some of the small town areas. We've expanded into equine and bovine. We provide things in an outdoor barn area such as hay. Those are things that are necessary and very attractive to that market. We've, we've developed new expertise in those areas and expanded the assortment, as well as our traditional assortment across dog, cat, and companion animal. That's some of the sort of assortment standpoint. The second part of your question was?
Services.
Services.
How do services come into that?
Great. For the first part, for the first location in Floresville, we did not have an embedded vet or grooming services, but as we continue to launch these, we will test services in these markets, whether that be grooming, training, or other.
Okay. Okay, perfect. Just moving on, I wanted to discuss pricing versus cost-
Sure
relationship. You've started taking prices up already in 2021. They've been pretty sticky. Just talk about what you're seeing out there in terms of cost increases?
Mm-hmm
If any, coming ahead for 2023. You know, how do you think about the price elasticity?
Yeah. As you said, in the second half of 2021 is when we saw more of the holistic cost input increases and the associated price increases on our side was in the second half. Since then, it's been more episodic. There have been some. I think the good news for us here is we have really fantastic relationships with our vendors, our Chief Merchant, Amy College, does a tremendous job of working with them to have the appropriate lead time as we see cost input increases coming in, where we can evaluate what that pricing elasticity is. You know, I used to have a boss that said, you know, "Interrogate the data until it confesses." We go interrogate the data when we get the cost input in and see what it confesses in terms of what we can price. We have.
You know, as we've continued to take price, we'll continue to evaluate. Again, holistic actions in the second half of 2021, more episodic since.
Okay. Okay, sounds good. That's a perfect segue into margins. Gross margins of the business have seen some declines on the negative mix shift-
Mm-hmm.
away from hard goods. Talk about some of the puts and takes, maybe some of the good news versus bad news as we think about the gross margins in the near to the medium term. What are you guys doing to offset some of that negative mix shift?
Yeah. If you look at Q3 as an example, gross margin was down about 140 basis points year-over-year. I made a comment on the call that greater than 100% of that gross margin decline was due to the transitory mix from, you know, heavy and consumables and a little bit lighter in the discretionary category. That's where the pressure on gross margin came from, which implies that underneath, if greater than 100% is from mix, that we've had some improvements underneath. There are a couple areas to call out. You know, in the analyst day last year, we talked about the digital business having 500 basis points of room to grow in terms of gross margin. We've made good progress against that. There've been a couple things within digital.
We continue to scale our ad networks, which we've talked a lot about, which is highly accretive in terms of a margin standpoint. That's number one. Number two, we've done a good job of eliminating split shipments in digital, which again, is accretive to the model when you eliminate those, that level of split shipments. That, while a lot of our cohorts are in those early stages, as they continue to mature, that model continues to improve.
Mm-hmm.
Within the food space, we've continued to over-index into the premium and super premium space. In Q3, and then more into Q4, we've started to see some of the benefit of some of the freight headwinds that we saw last year.
Yeah. How significant do you think that benefit could be to the business? There have been some pretty nice improvement sequentially and year-over-year in freight.
We haven't sized that. What I would tell you is there's a timing factor on two fronts. There was, you know, freight costs were up this year. Typically, particularly for ocean-bound freight, when we bring that in, we capitalize a lot of those costs on the balance sheet. They cycle through the P&L as you roll your inventory. In Q2, for instance, when you started to see spot rates declined, we signaled that we would still have some pressure in Q3 because we knew what was on the balance sheet at the end of Q2, and that's what occurred. You're starting to see underneath that spot rates change. From a timing standpoint, the balance sheet, the second timing aspect is when you're in contract with some of these carriers.
They would typically roll every year at different times, depending on the carrier. As your spot rates continue to decline, as you roll over into new contracts with carriers, that would be reflected.
Okay. Okay, perfect. Let's pause here and see if there are any questions in the room. Okay. I'm happy.
Can we just talk about the competitive landscape with digital and how, you know, just having brick-and-mortar might be able to help you going forward with as you're building, you know, your online presence?
Yeah. I think I don't know if everybody could hear that, but the other question was around the competitive landscape, particularly in e-com and how having a physical footprint might benefit us going forward. I think on multiple fronts. The fact that we have different fulfillment options for customers, BOPIS, same-day delivery, ship from store, and ship from DC in a traditional e-com sense, means we can get product to a customer when, how they want it depending on where they are in that cycle. It gives us the fulfillment advantage using our physical footprint. It also allows us to leverage our e-com asset, the website, and the app to drive folks into brick and mortar.
The fact that you go on the app, and you can actually schedule your grooming appointment, your vet appointment, you can sign up for Vital Care, you can look at the history of everything that you purchased for your pet within that ecosystem, is a way to incent those digital customers to actually explore other services for us. As I had mentioned earlier, if you have that physical footprint, you have hands-on pet and vet, you have hands-on pet and training, you have hands-on pet and grooming within the same ecosystem using that digital asset as a portal.
As a follow on to leverage, since you have the physical asset and have all these, vets, you know, I'm sure you've thought about it, but why did you come up and not offer an insurance-based product for your customers?
Yeah. The question was why haven't we offered an insurance-based product? We've had an insurance-based product available, you know, where it was, we were not the underwriters for that product. We've entered into a new relationship with Nationwide that we just announced. Our partnership with Nationwide allows us to offer a larger breadth of insurance offerings for customers. That was something that just launched, and we would expect to scale.
Because you have the physical assets and you have the vets, why wouldn't you underwrite that yourself?
The question was why would. I again, I'm repeating it 'cause I'm not sure if they can hear.
Yeah.
The question was why wouldn't we underwrite that ourselves? We looked at the economics on it. I think for us, partnership made a lot of sense with a company like Nationwide that has specialty there. It also, if you think about what that gives us in terms of capabilities, let's use Vital Care as an example, right? Vital Care right now is one offering, very compelling offering with an offer to the customer. As that continues to evolve, you could, you know, you may see other opportunities for us to offshoot from Vital Care. We did the math. We looked at the economics. We felt like the partnership with Nationwide was the right path for us.
That is a good question. Insurance is a huge opportunity for the company. Penetration of insurance in the U.S. is still so low compared to other developed countries. Why do you think that is, and what are you guys doing specifically to educate the consumer about the benefits there?
I think it's early days for us in terms of this partnership with Nationwide. I think there's an opportunity for us to increase penetration. I also think there's an opportunity for us to bolt on insurance as part of our broader offering.
Okay. Just to follow up on profitability, we touched upon some of that already. Your EBITDA margins are roughly in line with pre-pandemic levels for 2022, down year-over-year slightly on a negative mix shift. How do you think about the longer-term profitability in the business, especially if you think about the money-losing vet hospitals currently beginning to scale up?
I think if I look at the EBITDA rate this year, the biggest impact on that has been that transitory mix shift on gross margin. If I look underneath that, you know, we touched on some of the gross margin improvements within the business to help mitigate. We've also continued to demonstrate leverage in our OpEx model. If I look back over the last 11 quarters, and I look year-over-year, we've continued to show leverage on a quarter-on-quarter basis year-over-year in terms of that OpEx ratio. That's while making investments in certain key areas in OpEx, like investments in our labor force in terms of minimum wage. We're getting leverage while making investments.
Mm-hmm.
As I look out into, you know, beyond the current economic environment, as I said earlier, we would expect that transitory mix in terms of hard goods and consumables to normalize over time.
Okay. Okay, sounds good. Moving on to free cash flow.
Yeah.
You've talked about doing a deep dive in working capital and specifically with your payables. Inventories have been well managed for the business. Maybe update us where you are with that.
Yeah. I'll start with inventory. I think if I had to list the bright spots of the company this year, inventory would be top of the list or near the top of the list. We've done a really good job as a company managing. If you look, each quarter, inventory units have been roughly in line with revenue. Balance sheet's been up a little bit more due to the inflationary impact on, you know, on the value of inventory. Our team has done a really good job. We have not put ourselves in any position of having an in-scale inventory issue in terms of abundance of inventory. I think the inventory's been well managed. If I look at payables, there's an opportunity there for us.
You know, we, you know, we believe as we look out past this year, there's an opportunity to incrementally grow free cash flow because we have working capital, availability for us.
Okay. Okay, sounds great. Finally, the debt is a floating rate.
Mm-hmm.
As a result, you know, variable expense is a little bit higher, I think in 2022 and potentially into 2023. Maybe talk about some of the factors to mitigate that.
If you look at our debt structure, it is a variable rate interest structure. I think the Street has largely reflected what interest will be for next year for us. To mitigate against that, we put some caps in place, so those caps protect us in terms of further increases in interest rates over time against what the Fed is planning to do. We continue to look at different vehicles to help protect us against that. I think the good news is that what's out there in the market is reflective of what the interest expectation is for next year. I'll tie that back to the prior conversation on free cash flow. With the interest expense, we do expect that there to be opportunity to incrementally grow free cash flow in spite of what's happening in interest expense.
Okay. Well, I think that's a great place to end. Thank you to Brian. Thank you to everybody that listened in.
Yeah. Thanks so much. Thanks, Anna. Thanks, everyone.