Petco Health and Wellness Q2 2025 Earnings Call Transcript

Quartr
Provided by Quartr
September 10, 2024

There are 10 speakers on the call.

Operator

Good day, and welcome to the Petco Second Quarter 2024 Earnings Conference Call. All participants will be in a listen only mode. After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Benjamin Tiolong.

Operator

Please go ahead.

Speaker 1

Good afternoon, and thank you for joining Petco's Q2 2024 Earnings Conference Call. In addition, on today's call, we will refer to certain non GAAP financial measures. Reconciliations of those measures can be found in our earnings release, presentation and SEC filings. And finally, during the Q

Speaker 2

and A portion of today's call, we ask that you please keep to one question and one follow-up. With that, let me turn it over to Joel. Good afternoon, everyone, and thank you for joining us today. I could not be more excited to lead Petco through this pivotal time for the company and shape the next chapter of its extraordinary mission driven approach of improving the lives of pets and pet parents. First, on behalf of the Petco Board, I'd like to thank Mike Mohan for stepping in as Interim CEO and for his tireless work to stabilize our operations and drive continued improvements in performance over the last 6 months.

Speaker 2

His passion for our business, his focus on strengthening our retail fundamentals and his work to realign our cost structure has set us on a path for improved profitability. We will continue to build on this going forward. Before giving a brief overview of our priorities for the remainder of the year, I'd like to spend a few moments on why I came to Petco. I believe in Petco's deep rooted mission to improve lives for pets and their parents. Pets have always been a central part of my life.

Speaker 2

Having grown up with dogs and seeing my children do the same, I've experienced firsthand the immense joy pets bring to a family, including mine. Today, Petco is an incredible brand, which sits at a critical juncture. While we maintain a differentiated proposition within the resilient pet category, a category which is expected to reach $200,000,000,000 in sales within 5 years, there are clear opportunities to significantly improve our operating and financial performance. Specifically, there are 3 things about Petco that excite me. Number 1, our integrated store and digital footprint, which if positioned effectively can create an incredible customer experience brought to life across multiple channels.

Speaker 2

My initial visits have already exposed me to some of the most knowledgeable and enthusiastic people I've met in retail. I must say, our partners in the pet care centers truly care about our customers' pets. I've been impressed. Number 2, delivering a differentiated offering that can bring and make Petco a destination for pets and pet parents. It's a truism I've seen through my decades in retail that if we present our customers with unique and trend right product, will accelerate our return to retail excellence, meeting pet parent needs and getting back to the heart and soul of pet parenting.

Speaker 2

Number 3, our breadth of services offering, including our vet platform. This is our biggest competitive distinction from online only and mass players and has the potential to power our business as a significant long term growth driver. In addition to these 3, I also want to share my observations in my 1st few weeks at Petco. I believe in and I'm fully committed to what the team and the Board have been working on over the last 6 months and the path it is set for us to continue. I also believe as we maintain this disciplined and holistic approach to retail execution and do so with a focus on fewer and clearer priorities, we can better leverage Petco's unique strengths.

Speaker 2

In doing so, we'll not only capture greater share of the category that we currently command, but deliver tangible and sustained profit improvement and significant long term shareholder value. Simply put, I love pets and I love retail. And although I've only been at Petco a very short while, I'm filled with optimism for the opportunities we have to reestablish trust in our financial discipline and grow the Petco brand. Before I hand it over to Brian to review the quarter, I wanted to share how we're approaching the rest of this year. Our top priority is to improve profitability, focusing specifically on things that will have the greatest impact to our business.

Speaker 2

The entire company is aligned on 4 key initiatives, namely: number 1, returning to retail fundamentals number 2, meeting and exceeding customer expectations number 3, capturing market share through improved basket and number 4, delivering meaningful improvement to the bottom line through a disciplined approach to costs. If the first half of this year was about setting the trajectory of our transformation, the back half is about executing against it and setting the stage for future profitable growth. Let me be clear on where we are today. We are not starting over. I'll be working hand in hand with the leadership team to build on the momentum of the last 6 months and move with urgency to fix what needs fixing at the foundational level for our long term success.

Speaker 2

In doing so, we'll be working diligently and with speed to provide that every part of our business is operating efficiently and effectively, delivering meaningful near term improvements to cash flow and enhanced EBITDA performance. Moreover, our approach will embed these changes into the DNA of how we operate every day, delivering accretive run rate savings in fiscal 2025 and setting a solid financial and operating foundation to facilitate Petco's return to profitable growth. We have much work to do and I look forward to sharing an update on our 2024 progress on our Q3 earnings call. I'd like to close by extending my thanks to the nearly 30,000 Petco partners across the stores, distribution centers and support centers. Without doubt, this business has been through significant change over the last 6 months.

Speaker 2

Through it all though, their hard work, their faith in the future of this brand and their proactive approach to supporting each other has meant Petco has continued to deliver for pets and pet parenting during this time. Everything I've seen since joining mirrored what I was told during my hiring process. This gives me confidence we are on the right path to return to retail excellence and restore the underlying fundamentals of this business. We will continue to build on our mission and return this iconic brand to its winning ways. Thank you.

Speaker 2

And with that, I'll pass it on to Brian. Thanks,

Speaker 3

Joel, and good afternoon, everyone. Before I begin, I would also like to take this opportunity to thank Mike for his leadership over the past two quarters and to formally welcome Joel to the Petco team. We're delighted to have you and can already feel the impact of your energy and enthusiasm for the brand and the category. For the quarter, net revenue was 1,520,000,000 dollars down 50 basis points year over year with comparable sales up 30 basis points year over year. Across our business, consumables grew 1%, while discretionary categories remained soft at negative 5%.

Speaker 3

Services and other, which is comprised of services, wholesale and recently disposed non core businesses delivered 3% revenue growth. Services specifically were up 10% driven by ongoing strength in our vet hospitals, mobile clinics and grooming. Moving down the P and L, gross profit was $581,000,000 down 2 10 basis points from prior year. Gross margin for the quarter was 38.1 percent, down 60 basis points from prior year, driven by softness in our discretionary categories and up 30 basis points from Q1, driven by a combination of cost savings initiatives and operational efficiencies. SG and A as a percentage of revenue increased by 80 basis points year over year to 37.9%, which as we anticipated was driven predominantly by planned one time investments needed in store labor.

Speaker 3

Looking ahead, we continue to streamline non essential tasking to allow partners more time to focus on improving the in store customer experience through selling and interacting with customers and over time yield efficiencies in our labor model. Q2 adjusted EBITDA was $83,500,000 with an adjusted EBITDA margin rate of 5.5%. Adjusted EPS was negative $0.02 compared to $0.06 per share in the prior year. Turning to cost transformation and takeout, we continue to make progress against key work streams including merchandising as we continue to review and rationalize our assortment to better align in store and online merchandising with the needs of pet parents. Operational efficiencies in our supply chain, which include renegotiation of multiyear contracts with shipping partners, reducing split shipments and incremental improvements in distribution center labor recalibrating marketing at both the top and bottom of the funnel so that we attract and retain the highest lifetime value customers possible, and instituting a more holistic process with indirect procurement across the business.

Speaker 3

Turning to the balance sheet, liquidity remains strong at $655,000,000 inclusive of $128,000,000 in cash and cash equivalents and $528,000,000 of availability on our revolving credit facility. Free cash flow was $42,000,000 driven by lower inventory levels achieved as part of our ongoing approach to disciplined inventory management. And while modestly down from $45,000,000 in the prior year, this keeps us firmly on track to meet our expectations to be free cash flow positive for fiscal 2024. I'll now turn to outlook. For the Q3, we expect revenue of approximately 1,500,000,000 dollars adjusted EBITDA between $76,000,000 to $80,000,000 and adjusted EPS between negative $0.03 and negative $0.04 Additionally, for the full year, we continue to expect net interest expense of approximately $145,000,000 inclusive of the estimated impacts of our hedges against the forward rate curve and $272,000,000 weighted average fully diluted shares, which is unchanged and $140,000,000 of capital expenditures for the full year, which is also unchanged.

Speaker 3

To echo Joel's remarks, the entire Petco team is focused on controlling what we can to deliver structural improvements to our underlying financials and work towards clear and achievable targets on the path to sustained and profitable growth. The first half of this year has brought meaningful change in the way we operate our business and combined with Joel's energy and expertise, I'm confident we've set the right foundation for sustained progress in our business for the full year and beyond. Thank you for your time. And with that, we'll be happy to take your questions.

Operator

And our first question today comes from Zach Fadem with Wells Fargo. Please go ahead.

Speaker 4

Hey, good afternoon. First of all, congrats to you, Joel. And I'd love to dig in more on your initial impressions as this is a business that I think many would say had perhaps too many growth drivers in the air over time and maybe lost sight of the core. So as you think about strategic direction going forward, curious how you think about the balance of investing in growth pillars like that and your stores, but also simplifying the business and perhaps taking costs out of the system?

Speaker 2

Yes. Hey, thanks, Zach. I appreciate the support. Look, I think where we got to start on that one is, our focus right now and number one priority is on improving profitability. And that's what we've got to do first.

Speaker 2

And as I said in my prepared remarks, I believe in what Mike was working on, what the management team was working on, and we've put together a great strategy on how to return this company to great fundamentals around EBITDA performance. The second half of this year is now about executing. Having said that, what I would really focus on in relation to your question is we've got to strengthen retail fundamentals. And I think everybody defines retail fundamentals differently. And I think for the stage and where we're at, at Petco, three things come to mind, Zach.

Speaker 2

First is merchandise excellence. And this is a unique business. It's comprised of probably about 2 thirds consumable, 1 third discretionary. My life at Walmart was all about consumables. We simply got to be in stock on consumables.

Speaker 2

And that's what we're working on to improve our consumable business. Discretionary, that's about delivering unique trend right product. And that's what I spent 10 years at 5 working on. And we're going to get great at that. The second area is this is a service business driven business and we got to get that right.

Speaker 2

And as I think about the fundamentals around service, it's about staffing right. Companion animals, we got to be knowledgeable. The vets got to be open. The groomers got to be trained. It's about clean, well merchandised stores.

Speaker 2

Our digital offerings got to be easy and efficient and so on and so forth. And finally, Zach, we got to be masters of efficiency. Retail is not a high margin game. And so therefore, we've got to have strict discipline around inventory, tight expense control, supply chain management, leverage. And so long answer to your question, but we've got to get those retail fundamentals in order before we start to focus on growth again.

Speaker 2

But I've been a growth guy for a long time. We're going to pivot to offense, but right now it's focused on profitability first. Thanks, Zach.

Speaker 4

Got it. Appreciate the time, Joel. And just for Brian, thanks for the Q3 guide. It looks like you expect Q3 to look pretty similar to Q2 from a top line perspective. But as we look at the puts and takes around margins, you're either expecting a really nice inflection on the gross margin line as you lap the year ago price actions or you're taking SG and A dollars quite a bit down on a year over year basis or maybe a combination of both.

Speaker 4

So any clarity you can offer on those points? Thanks.

Speaker 3

Yes. Thanks Zach. I would just echo Joel's comments that our number one priority and focus is improving profitability in the business in the near term and the long term and also driving free cash flow improvement. Look, this remains, Zach, as you know, a dynamic retail environment. So our Q3 guide offers us the best view of what we know today and our focus is on executing against that.

Speaker 3

In terms of the balance between gross margin and SG and A, what I'll tell you is let me start with SG and A. In the Q2, you saw SG and A up roughly $9,000,000 total year over year. That was driven by planned one time investments in store labor, very consistent with Q1. We're committed to solid retail execution as Joel said, and that means meeting the customer where they are

Speaker 2

and allowing our pet care center partners

Speaker 3

the opportunity to do so. Quarter.

Operator

And our next question comes from Peter Benedict with Baird. Please go ahead.

Speaker 5

Hey, guys. Thanks for taking the question. Joel, welcome. Brian, I guess my first question is just around the EBITDA, the adjusted EBITDA view. I think you guys were expecting kind of sequential improvement across the year.

Speaker 5

Obviously, the outlook for 3Q is a little below what you just did. I'm not sure if 2Q came in better than expected. You just leaving yourself some room to operate. Just kind of curious what's changed versus your thought process 90 days ago? That's my first question.

Speaker 3

Yes. Thanks for the question, Peter. And not much else to add. Q2 did come in a little bit better than expected. I would tell you gross margin for the Q2 came in better than our expectations, driven by a couple of things.

Speaker 3

I think you're seeing some of the benefit of the cost initiatives that we have in place taking shape. We also saw some good improvement in the services business sequentially and year over year for that matter. So those things held up. I will tell you, as you know, just as well as Zach, Peter, it's a dynamic retail environment and our guide for Q3 reflects what we expect for the quarter.

Speaker 5

That makes sense. I guess my other question would just be around kind of what you are kind of seeing in the business in terms of not just consumer behavior, but the really what's going on with pet food pricing and how the vendors are kind of behaving here. Anything you could share in terms of views on how pricing may be trending, particularly around dog food space as we look out in your outlook for the balance of the year? Thank you.

Speaker 3

Yes. Thanks, Peter. I would say we've seen relative consistency across the board. I'll start with the customer. The customer remains choiceful and is seeking value, and we need to make sure that our assortment meets the customer where they need and we have the breadth of offerings to satisfy that customer desire.

Speaker 3

We continue to see strength in our services business. It was up 10% this quarter with notable strength in vet, both owned vet hospitals and the vet go business. Consumables was positive for the quarter at 1%, 8% on a 2 year. So we continue to see some of the similar strength in pockets of our business and we saw a bit of modest improvement in the discretionary categories. So all in all, I would wrap it up and say there hasn't been that much change in both the behavior of the consumer and or pricing relative to what we saw last quarter.

Operator

And our next question comes from Stephen Forbes with Guggenheim. Please go ahead.

Speaker 6

Good evening, Joel, Brian. Congrats Joel as well. Joel, maybe just to start, you talk about profit improvement. I think many of us here are just trying to gauge where you see the opportunity. So anyway to rank order sort of the profit improvement opportunities as you see them today?

Speaker 6

Is it first costing? Is it distribution efficiencies, assortment evolution you mentioned in stocks? And what is the current timeframe you are speaking about internally to execute against those profit improvement agendas?

Speaker 2

Thanks, Steve. It's been a while since I've seen you. Look, the in terms of rank order, merchandising is by far and away our greatest opportunity to deliver profitability. We've simply got to get more discipline there. We've got to improve our vendor partnerships.

Speaker 2

And with the due diligence we're putting into merchandising, we're going to make a lot of progress in that. Look, in terms of timing and Brian you lean in, but we committed to $150,000,000 and I believe we're still on track on that.

Speaker 3

Yes, dollars 150,000,000 run rate savings exiting 2025 as you know Steve and we're on track for that. We continue to look for opportunities to both augment those savings and accelerate those savings where possible. Joel is right, the biggest opportunity is in merchandising. We see additional opportunities in areas like marketing where you can get return in 1 of 2 ways. One is how much you spend and the second is how you spend it.

Speaker 3

So making sure that we're fully optimized in the top and bottom of funnel across marketing. I mentioned investments in store labor. While we're making those investments, we're simultaneously looking for opportunities to take task out of our store labor model, which provides 2 things, both of which are good. Number 1, you help simplify the operations for that pet care center partner who's employed by us. And number 2, you give more opportunities to meet the customer.

Speaker 6

And then just a quick follow-up for Brian. You mentioned the improvement in services gross margin as reported. Any contextualization on what's driving that? Is it a function of a reduction in the growth burden, right, as you pull back on best stores? Or is there something more structural occurring within that margin profile?

Speaker 6

Thank you.

Speaker 3

Yes. Thanks, Steve. Number of different things. Let me start with grooming. Grooming continues to be a business that operates at scale and it's a productivity based model.

Speaker 3

So as long as you remain highly productive in grooming, the gross margin flows through nicely and we saw that. Q2 is a good quarter for us grooming wise, just based on the seasonality of that business. Secondly, yes, the maturation of the vet model, a combination of the growth algo being lower, so less, hospitals being added at the front end does help. That said, underneath that, our leadership team on services has done a really terrific job in making sure that we're, 1st of all, providing the best care for pet parents and their pets, but secondly, doing it in a way that's highly efficient for us to help improve the structural margin underneath those vet hospitals. The last area I'd say is the VEKO mobile clinics continue to be terrific for us.

Speaker 3

High growth, not a large capital investment, very quick return on that investment and when operating at scale that model really works.

Operator

And our next question comes from Seth Basham with Wedbush. Please go ahead.

Speaker 2

Thanks a lot. Good afternoon and a lot of my congratulations, Joel. If we could just double click on something you mentioned earlier with one of the biggest opportunities being in merchandising. Can you just peel back the layers for us and tell us exactly where you see the biggest opportunities? Is it getting more margin from vendors?

Speaker 2

Is it consolidating vendors? Is it changing the assortment dramatically? Is it the supply chain of the vendors? Just give us a little bit more insight as to where you see the

Speaker 1

biggest opportunities, please?

Speaker 2

Yes. Thanks, Seth. And quite honestly, it's everything you just outlined. But to be specific and put it in my words, we've got more work to do on the assortment. And so we're in the process of an end to end review of our total assortment.

Speaker 2

And that's looking at specifically looking at how we're priced so that not only do we remain competitive, but that it generates a reasonable margin. Our in stock metrics, as I mentioned earlier, are really important, especially in our consumable business. And I think we've got a ways to go on improving our in stock on our consumable business. You mentioned vendor partner performance that is equally as important to us. We have a unique profile with some categories that only Petco carries.

Speaker 2

And so we've got to work on enhancing that relationship with our vendors and getting the maximum and maximizing the leverage there so that we can continue to grow some of these specially unique categories. And so we're really kind of looking up and down the entire thing from both the consumable side as well as the discretionary side. And both of those are really leveraging my experience both from Walmart as well as at 5, so that we can get better across all areas. But I am confident that Petco has a great merchandising assortment. It just needs a little tweaking to better leverage it and deliver EBITDA performance.

Speaker 2

That's helpful. And then as a follow-up question, if you guys could provide any perspective on where you think the industry is, are we bottoming, are we seeing pet adoption on net basis improve at household formation starting to improve?

Speaker 7

When do you think we'll see

Speaker 2

a turn in those metrics if they haven't improved yet? Thank you.

Speaker 3

Yes. Let me start with the second part of your question. In terms of adoptions, adoptions have slowed. The good news is that intakes are actually lower than last year and materially lower than 2019. And when you think of intakes, you don't just think of relinquishments.

Speaker 3

In fact, relinquishments is not the biggest driver of intakes, lost pets are. Almost 50% of all incoming pets into shelters and we have data from thousands of shelters through Petco Love, almost 50% of intakes are actually lost pets. So it's critically important for pet parents to make sure they take the appropriate controls, whether that be chips or other means to track their pets, so that we can slow down the intakes into shelters. Adoptions have slowed a bit. Those are down from last year as our intakes.

Speaker 3

In terms of the broader industry, we're focused on what we control right now. And controlling what we can with a focus on improving profitability and cash flow of the business, offering pet parents the products they need with an exceptional shopping experience while simultaneously addressing our cost structure, All of that will help improve our position in the current environment and help set us up to win as the industry returns to its historical levels of mid single digit growth. I don't want to prognosticate on when that would be, but I would tell you it's in the not too distant future.

Operator

And our next question will come from Michael Lasser with UBS. Please go ahead.

Speaker 2

Good evening. Thank you so much for taking my question. Jewel, as you have observed the organization during your early part of your tenure, what is your diagnosis for what caused Petco to lose its way? And how do the elements of your plan address those shortcomings? Thank you.

Speaker 2

Thanks, Michael. Good to hear from you. I'll be honest, Michael, my focus hasn't been on what caused us to lose our way. It's been focused on what are we doing about fixing it and do I believe in the work that's been done. And I said it on my prepared remarks, I'll say it again, Michael.

Speaker 2

My assessment is we are completely on the right track. We've got the right strategy. There's been a complete dedication from Mike, from the management team, from everybody, all the partners, and now we just got to go execute, Mike, and that's really where the focus has been. I can't speak for the past. I wasn't here.

Speaker 2

But what got me excited about joining Petco is that what's not broken is the brand. What's not broken is the passion our partners have out in the field for our customers and for our pet parents. And so everything that we've got to fix is in our control and we are well on the way to starting to make progress against that. And I believe in the strategy that's been outlined and now we just got to go make it happen, Michael. My follow-up question is, how does the company's financial leverage position influence your strategy?

Speaker 2

And do you think there could be a store portfolio review that would lead to some significant amount of store closures on Horizon? Yes. Good question, Michael. And what I would tell you is, I've looked at the entire plan, the entire strategic plan and a mass closing is not one of them. I do not see that as something we need to do.

Speaker 2

But having said that, Michael, look, we're looking under every rock, everything's on the table. And if a store isn't profitable, we'll close it. But it's more of a fluid rolling situation as stores come up for lease. But we do not have a large group of stores that are EBITDA negative. They're going to result in us having to do a math set of closing.

Speaker 2

That's for sure.

Operator

And our next question comes from Kamil Gajrawala with Jefferies. Please go ahead.

Speaker 2

Hey, guys. So a couple of questions. I guess the first is, Joe, you've been there for such a short period of time. Keeping with the current strategy obviously makes sense. But are there any kind of notable refinements in that strategy or areas that you really want to press forward or press ahead and other things that maybe are less important than they might have been before?

Speaker 2

I guess where I'll press ahead is going to be, we just got to move faster, right? And I think about wanting to get back to playing offense and for those of you that follow me at 5 for a number of years before we could play offense at 5, we had to get our people, systems and infrastructure in place. And as I think about Petco, what we've got to do right now is cut costs, run to red, which means have urgency and be decisive, and we got to prioritize projects. We got to reduce the number of projects we're doing, so that what we're focused on is meaningful and has a significant difference in impact for both our partners and our customers. So, I think if anything, it's just about speed and execution than it is about changing the strategy here in the short term.

Speaker 2

Okay, got it. And then any thoughts on the current format of the store and if there's any refinements that need to be there? Well, look, I think we've got opportunities in our current stores and I think the first phase though is we've got to get profitability back in course so that we can focus on our debt leverage, we can focus on returning to increasing our EBITDA and then we'll turn to the portfolio of stores. What I can tell you I've been encouraged about is we know how to do a store right if we put our mind to it. And I was recently in our Union Square store.

Speaker 2

I think that's a phenomenal store. It shows you what our Petco team can do when we put our best foot forward. And that's the type of image I want for us to our brand long term. But right now, we got to stay focused on near term profitability.

Operator

And our next question comes from Steven Zaccone with Citi. Please go ahead.

Speaker 7

Great. Thanks very much for taking my question. Congrats, Joel, on the new role.

Speaker 4

I wanted to ask a question just going back to

Speaker 7

this discussion around market share. You referenced trying to capture more market share and Petco has some really large competitors, right? So when you've been in stores and you've done your initial assessment of the business, do you see a bigger opportunity to gain more market share with those existing customers that are coming in to kind of increase their basket? Or is there a bigger opportunity here to drive new customer growth and maybe get some lapsed customers to return to the store?

Speaker 2

Yes. Stephen, great question. And ultimately, we got to get back to growth. And I'm not afraid of the competition. Retail is a competitive game.

Speaker 2

I believe that Petco can compete with anybody. What we need to do though is we got to firmly articulate our points of differentiation and then go deliver them. And what's been great in my short time being here is how aligned the organization is, how much everybody here wants to win. And so as we move from the strategy phase to this execution phase around profitability, that's really going to open up some opportunities to then go focus on market share. And so, while our first signs of market share gain aren't going to necessarily be about unit store growth, I think it's about truly leveraging our current store base.

Speaker 2

We can grow services and Brian talked a lot about that and how we're already winning there. We can continue to improve the in store experience. You've got some ideas on entering new categories and you put that all together, it really helps improve the four wall EBITDA of our existing fleet. That will be the first phase and where you'll start to see growth out of this company. But let's stay focused on the profitability piece and we've got to deliver that for all of you and earn the respect back here in the second half of 'twenty four.

Speaker 7

Okay, understood. And then, Brian, a question for you just on the driver of the comp. How should we think about that slightly positive comp? Was it driven by a little bit more by ticket? Was there improvement in transactions?

Speaker 7

And then how should we think about the back half of the year or at least the third quarter since you've given guidance there?

Speaker 3

Yes. Thanks, Steve. Without getting into too much detail, it was more driven by ticket than it was by traffic.

Operator

And our next question comes from Oliver Wintermantel with Evercore ISI. Please go ahead.

Speaker 8

Yes. Thank you and welcome, Joel. My first question is, you mentioned a focus on profitability. Looking at the gross margin rate of above 42% when at the time of IPO dropped below 38 Is there anything that you can help us with how you envision the profitability of the business to improve over the next few years? And what are the drivers?

Speaker 8

Is it more gross margin? Is it SG and A? Is it merch margin? A little bit more details would be helpful.

Speaker 3

Yes. Thanks, Oliver. Let me start with that one. You mentioned back to gross margin levels of 42%. That was at a time when we had discretionary categories growing in some quarters in excess of 30%.

Speaker 3

I will tell you that the biggest driver of gross margin deterioration over the past several years has been the decline in those categories, which as you know, prior to this quarter, we're down 8% or 9% per quarter for a few years. They're at not minus 5% today. We've seen modest improvement there. We do expect those categories to return to growth. We're not we have not baked that into our guide in the Q3.

Speaker 3

However, we do expect that to occur. That said, we are focused on controlling what we can. What you saw show up in the Q2 with the sequential gross margin improvement was some of the operational efficiencies starting to take hold. We saw a good improvement in supply chain. We saw good improvement in services gross margin quarter on quarter.

Speaker 3

That was coming off of improving from Q4 to Q1. So we do see opportunity in gross margin. We've got a lot of initiatives, a lot of major things in flight isolated in a couple of initiatives that we talked about, merchandising across the board, taking a holistic approach. As Joel touched on, there's opportunity for it there for us. There's opportunity within our OpEx structure once we get past some of these investments needed to make sure that the customer experience is right in store.

Speaker 8

Got it. Thank you. And then the follow-up is on free cash flow. I think first half is breakeven, but then you're expecting a growth in 2024. So maybe can you point to some drivers of free cash flow growth in the second half?

Speaker 8

Thank you.

Speaker 3

Yes. Thanks, Oliver. There's 4 major levers that drive free cash flow for this company that matter, profitability, accounts payable, inventory and CapEx. We've taken a disciplined approach to CapEx for the year and we've held that guide at $140,000,000 We are supporting the business appropriately with that level and also investing in several high ROI projects to help drive the future growth of the business. Team did a great job on accounts payable last year, and we've held where we kind of exited last year.

Speaker 3

And then what you saw in Q2 was some of our disciplined inventory management show up in free cash flow. The biggest driver though and the biggest lever for us is to improve profitability and that's our primary focus.

Operator

And our next question comes from Simeon Gutman with Morgan Stanley. Please go ahead.

Speaker 9

Hi, This is Lauren Ng on for Simeon. I guess just following up on prior questions regarding strategies. I think you mentioned like merchandising, improving vendor partnerships, investments in store labor. Can you just give any color on maybe how you plan to fund these strategic initiatives?

Speaker 3

Yes. I mean these are initiatives that fund themselves. When we talk about initiatives, we're not talking about major investments back into the business. I mentioned the store labor investment, but those show up in the P and L fairly transparently in Q1 and Q2. That was the driver of SG and A improvement.

Speaker 3

But more if you think about the whole bucket of initiatives, we're targeting $150,000,000 of run rate savings exiting 2025. So I would not think of these initiatives as investments into the business, but opportunities to free up capacity inside the business to A, reinvest in the business B, drop some of that profitability to the bottom line and C, mitigate against any unforeseen headwinds.

Speaker 9

Got it. That's helpful. And then I guess our follow-up is just we're wondering what is the attach rate of service and that among pet owners and how can this improve?

Speaker 3

I'm not sure I'm going to be able to give you the attach rate you're looking for. What I will tell you is, the services business is strong. So if I look at the buckets of our business where we're leveraging strengths as opposed to trying to fix something that's broken services is one of those areas. Grooming remains a very resilient strong business operating at high capacity. The vet business is growing at a multiple of the services business both in hospitals and Arbecco mobile clinics.

Speaker 3

So I think we're meeting pet parents' needs across services. And as Joel mentioned in his introductory comments, it's a key differentiator for us against both mass retail and online only competitors.

Operator

And our next question comes from Kendall Toscano with Bank of America. Please go ahead. Hi.

Speaker 9

Thanks for taking my question. And Joel, congrats on the new role. So my first question was just on, Brian, I know you mentioned that overall the comp was more ticket than traffic driven, but curious if you zoom in on the services business and particularly that where you had some pretty nice growth during the quarter. Was that also the case there?

Speaker 3

Yes, Kendall, that's both. The vet business is maturing for us. So although we have slowed down the growth of new vet adds this year, we added a meaningful amount of vets over the past two and a half years. Those vets take up to 5 years to mature fully. So we still have vets ramping in capacity in line with the economic model that we laid out.

Speaker 3

So that would be different the overall business because we're actually improving both transactions and basket in that business.

Speaker 9

Got it. Okay. That's helpful. And then my next question was just in terms of the product category margins. It looks like in services, you had some pretty nice year over year gross margin expansion, but then in the products business, you the margins actually got a little bit worse compared to the Q1.

Speaker 9

Just wondering if that was in line with expectations and what drove that? And also how we should think about the products business into 3Q as you're lapping assortment changes from last year? Thanks.

Speaker 3

Yes. Let me start with services. Each of our services business businesses, major businesses, grooming and vet improved their gross margin rate sequentially and year over year. Now vet has because of the nature of it being a maturing business, has a lower gross margin rate than grooming, as it grew faster than grooming. The fact that the overall services business improved the gross margin rate speaks to the strength of what's happening underneath that model.

Speaker 3

Within product, year over year, the biggest change in product gross margin is actually the discretionary weakness where you still saw minus 5% relative to 1% consumables growth and you have fundamentally materially different margin profiles between those 2. The change quarter on quarter just has to do with kind of mix within the mix. It's not a meaningful change in that product margin, Kendall. So I would say it's we continue to ramp some of our newly introduced brands. We did see particular strength in Fresh Frozen.

Speaker 3

So from a lifetime value standpoint, that is a very, very attractive category where we think we're uniquely positioned to take share over time. However, the margin profile is a little bit different. So it's kind of mixed within there.

Operator

This concludes our question and answer session. I would like to turn the conference back over to Benjamin Theolog for any closing remarks.

Speaker 1

Thank you, everyone. And again, Joel, welcome to PECO. We're delighted to have you here. That concludes today's earnings call. The team will be available after to answer further questions later today.

Speaker 1

Thank you so much.

Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.

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Earnings Conference Call
Petco Health and Wellness Q2 2025
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