Good morning and welcome to Petco’s Fourth Quarter 2022 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] 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 Cathy Yao, Vice President of Investor Relations. Cathy, you may begin.

Good morning, everyone, and thank you for joining Petco’s fourth quarter 2022 earnings conference call. In addition to the earnings release, there is a presentation, infographic and earnings supplement available to download on our website at ir.petco.com, summarizing our fourth quarter and full-year 2022 results. On the call with me today are Ron Coughlin, Petco’s Chief Executive Officer; and Brian LaRose, Petco’s Chief Financial Officer. Before they begin, I would like to remind you that on this call, we will make certain forward-looking statements which are subject to a number of risks and uncertainties that could cause actual results to differ materially from such forward-looking statements. These risks and uncertainties include those set out in our earnings materials and SEC filings. In addition, on today's call, we will refer to our non-GAAP financial measures. Reconciliations of these measures can be found in our earnings release and our presentation, as well as in our SEC filings. And finally, during the Q&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 Ron.

Thank you, Cathy, and good morning, all. Before we begin, I want to take a moment to formally welcome Cathy Yao, who joins Petco as our new Vice President of Investor Relations. Cathy has an impressive and diverse background, spanning both buy and sell side and telecommunications and healthcare. Many on this call will know her, she has already become a great addition to the team and is proud pet parent of two Pomeranians, Loki and Freya, we’re delighted to have her and her pets at Petco. Turning to results. I want to start by thanking our incredible Petco partners for their excellent work in delivering record quarterly sales in Q4. We achieved our 17th consecutive quarter of comp growth, 16th consecutive quarter of customer growth and delivered cash flow performance significantly higher than expectations, all through an uncertain macro environment. Our partners continue to embody the mission of purpose-driven performance combining strong operating performance with tangible improvements to the lives of pets, pet parents and the partners, who work at Pepco. Petco’s performance was bolstered by a pet category that once again delivered solid growth, proving its resilience regardless of the economic environment. Pet options in 2022 remained elevated above prior year. Gen Z and Millennials continued to be the largest cohort of adopting new pets in 2022 and the highest spending, bringing elevated and accretive spend per pet. Comp sales growth was 5% for the quarter, as well as the full-year. Net revenue growth was 4% for both the quarter and full-year, momentum that continues into Q1, demonstrating the enduring appeal of our one of a kind ecosystem. Importantly, our performance for the full-year has strengthened our balance sheet and brought strong operating cash flow performance. This, combined with the benefits from our cash management initiatives, meant that…

Thanks Ron and good morning, everyone. Building on Ron's remarks, we delivered against our strategic objectives throughout a challenging macroeconomic background and I too want to extend my thanks to the 1,000s of Petco partners across our pet care centers, distribution centers and support centers for their dedication to delivering the very best for pets. Looking at the quarter, net revenue was $1.6 billion, an increase of 4% year-over-year. Total revenue of $6 billion for the full-year was also up 4% year-over-year and our cash flow came in significantly above our expectations, allowing us to take further actions to reduce principal on our debt, which I'll elaborate on more. In the fourth quarter, comparable sales driven by sustained strength and average basket trends grew 5% year-over-year and 19% on a two-year stack. For the full-year, comparable sales also grew 5% and 24% on a two-year stack. For the quarter, total services grew 14% year-over-year translating to 15% for the full-year, driven by strength in vet and grooming and further enhancements in our booking systems. In merchandise, strength and consumables, which grew 12% in the quarter year-over-year and 13% for the full-year, continued to offset the anticipated transitory impact of discretionary purchasing in supplies and companion animals, which were down 9% for the full-year. And as Ron said, we did see a 100 basis point improvement in Q4. Our digital business also showed strength with double-digit sales growth in both the fourth quarter and the full-year and expanded gross margin in the fourth quarter, buoyed by strength in our digital pharmacy and repeat customers and the continued growth of our rapidly scaling ad network. Moving down the P&L, gross profit was down 1% in the fourth quarter at $627 million and flat for the full-year at $2.4 billion. Q4 gross margin…

We will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Kate McShane from Goldman Sachs. Please go ahead.

Hi, thank you. Good morning. We wanted to ask around consumables and supplies. Thanks for the color that you've given so far. You had noted more normalization in the supply category as we go into the back-half, should we be assuming that, that inflects? And just what is being incorporated in your guidance for this category when it comes to the potential for a tougher macro backdrop or recession?

Hi, Kate. I'll start, it’s Ron. If you look at the segments from a consumable standpoint, consumables remain strong. And we predict they will continue to be strong, particularly with the addition of our Freshpet announcement this morning. Services remained strong. We continue to see strong growth in grooming and double-digit growth in vet. So we’re very pleased with that segment. As we cited, we saw 100 basis point improvement in Q4 to Q3, there were macro dynamics, as well as we took some initiatives like our supplies, Perks program, which we launched this quarter and we're already seeing 300,000 plus customers in that program. So if you look in past recessions, it's actually playing out exactly the way it is now. Consumables and services stay strong and discretionary spend gets impacted for five to six quarters, if you recall, it started last year. So we would anticipate that normalization along that similar timeline. I’ll let Brian add in terms of assumptions.

Yes. In terms of assumptions for the guide, Kate, piggybacking on-site, we expect consumables to continue to grow, we expect services to continue to grow. Part of our guide implied that if you look at the first-half, as I mentioned in the prepared remarks, we would expect EBITDA to be down in the first-half, that's primarily due to that mix shift pressure with consumable strength away from discretionary categories. As that normalizes, we would expect that to sort of come back in the second-half.

Thank you. And then just a quick follow-up question on Freshpet. Is there any margin differential with Freshpet within the consumables category?

We couldn't be more excited about Freshpet. First, if you look at Fresh Frozen, Fresh Food, customized, delivered to customers. Most of the offers that are customized are coming to the customer's frozen. So it is a game changer from that standpoint, the margin is accretive to our current Fresh Frozen offering for the most part.

Our next question comes from Oliver Wintermantel from Evercore. Please go ahead.

Yes, good morning. And first of all thank you for changing the adjusted EBITDA calculations. So my questions are the slowdown in the 4Q net adds, if you could maybe comment on that, what drove it and what do you expect in 2023 for net adds? And then my follow-up would be to the adjusted debt-to-EBITDA ratio, if you have a new goal there for this year or going forward and I think last time you spoke about maybe buybacks by the end of 2023 when you reached your former adjusted debt-to-EBITDA ratio, if you could update us on that as well? Thank you.

Hi, Oli. Thanks for the question. We've grown our active customer base for 16 consecutive quarters. We reached 1 million net new this past year. So we now today have over 25 million customers, which is a lot more than you and I started talking several years ago. Importantly, over 24 million of those are members of our loyalty programs, formerly Pals in our Vital Care, so our ability to interact with those customers, provide enhanced services is very strong. We like many of the dynamics within our customer base. We're growing multi category customers. We're growing recurring revenue. Actually, recurring revenue, customer revenue is over $1 billion in ‘22, which is a big deal, if you think about predictability and stickiness. We have over 0.5 million Vital Care members and we're growing penetration with the higher spending millennials in midyears, all that is good. While Q4 adds were below orders, it was primarily driven by churn amongst lower spending customers. But we're also not going to sit on that, we've enhanced our OPP offerings, profitable OPP offerings, and we'll continue to do that and then get those customers into loyalty programs. So we're focused on it and continuing to add, as I said, we've had 16 consecutive quarters of net adds.

Yes, let me take the second one, Oli, in terms of debt, I'm not going to comment on any kind of target today in terms of ratio. We would expect to update on the future Analyst Day, the way we'd expect to do in the coming month. We did a couple of things this quarter, we put callers in place, which combined with the caps that we did last quarter significantly [Technical Difficulty] and also allows us to capture the length of an interest rate. We've paid $35 million down on our principal debt last week and then we would target for the year of $100 million [Technical Difficulty] won't get into a specific [Technical Difficulty] we're committed to deleveraging.

[Operator Instructions] Our next question comes from Elizabeth Suzuki from Bank of America. Please go ahead.

Great. Thank you. Could you just elaborate a little bit on what some of the principal drivers were offset better-than-expected free cash flow? And then your expectations for 2023?

Yes. Let me start by saying the right way to think about ‘23 as higher free cash flow in 2022. In terms of the drivers, Kate, we've been talking a while - for a while now about opportunities in working capital. I think the team did an exceptional job this quarter in managing inventories. If you look at our overall inventory management, in-stocks were up tangibly at the same time, inventory on balance sheet was down in dollars and more meaningfully down in unit. So we managed our in-stocks better, we managed our balance sheet better. There's more opportunity for us in terms of working capital and that's what translates to expectations of higher free cash flow in 2023.

Great. Thank you.

Thanks, Liz.

Our next question comes from Corey Grady from Jefferies. Please go ahead.

Hey, thanks for taking my question. I was wondering if you can provide a little bit more color on what you're seeing in the vet labor market. You've been very successful at hiring vets this year. So curious how you're seeing that market evolve in Q4 and into Q1? Thanks.

Thanks for the question, Corey. In a nutshell, we're very pleased with our performance to date. That market, while it remains tight, we're very pleased with our ability to bring in high quality vets into our network. We brought in a record 1,100 vets into our ecosystem 40% more vets in Q4 than the prior year and our time to fill and our attention are above industry benchmarks. Clear that our strategy is working, it's clear that our value proposition is working, whether you look at we allow vets to practice medicine as they see fit, we provide vets with stock, there's a lot of unique attributes of our offering that just is ahead of what competitors are offering. We've also established a strategic pipeline with our Vet Tech program, which is one of my personal favorites. What that means is if you're a center store partner of Petco, and you have interest in being a Vet Tech, we'll send you to Vet Tech school, and you'll be a feeder into our system. And the Vet Tech market is tight as well, and actually, our first graduates are going to happen in 2023, and I'm really excited about that. So net-net is a tight market, but we're outperforming in a tight market.

Thanks. And then just as a follow-up on the outlook for 50 to 55 vet centers this year. Is that reflective of the tight market? And is that the rate we should think about you adding vet centers going forward? Or do you expect to get back to the long-term 70-year model maybe in 2024? Thanks.

Yes, Corey, that's more reflective of a balance. As we look at our total CapEx spend for the year as I guided $225 million to $250 million. Part of that decrease was the rollover of some one-time high ROI investments we made last year in freezers. The retirement of some technical debt, but we're taking a balanced approach to CapEx. We have 50 to 55 vet hospitals, we’re still committed to that for long-term growth. It's one of our number one priorities in terms of long-term strategic growth. We have 10 to 15 of our small town rural build outs on top of the 50 to 55. So in total, when you think about units, you're still about 70 units roughly if you take that the vets combined with the STRs. And so we feel like the guidance we put out with CapEx, the balanced approach to short-term versus long-term investments is the right approach.

Not to mention the debt paydown.

Not to mention the debt paydown.

Our next question comes from Anna Andreeva from Needham & Company. Please go ahead.

Great. Thanks so much and good morning, guys. Thanks for taking our question. I wanted to ask about gross margins, I think they're about 300 basis points below the pre-pandemic levels for the business. Can you talk about what's implied in the guide for gross margins for the year? Should we expect the declines there to begin to moderate here in the first-half on freight normalizing or is that mostly dependent on the supplies category stabilizing? And then secondly, I'm connected to that. Ron, you had mentioned for a number of quarters now promotional activity in this space being pretty rational. Can you talk about what you saw in the fourth quarter and what are you seeing to start ‘23 so far? Thank you so much.

Yes, let me take the first one, Anna. So the vast majority of the margin pressure on the business is driven by that transitory mix shift headwinds. In prior economic cycles, as Ron mentioned, the discretionary categories have been impacted for about five or six quarters. We expect that to follow a somewhat similar pattern. Our guide for the year implied EBITDA down in the first-half, flat to up in the second-half primarily due to that transitory mix shift. Now underneath the businesses, we continue to make operational improvements. If you look at our services business, we grew margin year-over-year. If you look at our digital business, we grew margin year-over-year. That includes a rapid scaling of our ad network. So taking all that in, we're taking a somewhat cautious view and we're focused on executing as we navigate through that environment. And I'll flip it to Ron for the second question.

Yes. Hi, Anna. Thanks for the question. Overall, the pet market does continue to be fairly rational, one of the dynamics in the industry is demand continues to exceed supply. That gap is narrowing, but at the same time, we're getting cost concessions with some favorability and freight, which gives us more leeway. From our standpoint, we focus on delivering value. That includes great products for great prices, so we're seeing significant growth in Wholehearted as an example, which is more of a mid-tier price, but great value for a great product. Where we promote, we focus on being strategic in search surgical’s, we've talked in the past about leveraging promotions to drive outcomes like BOPUS where we have favorable profitability and loyalty program adoption like Vital Care. And speaking of Vital Care, customers save $400 a year in Vital Care, we're thrilled to get over 0.5 million customers. So we see the market rational and there's a fundamental reason for that and that's kind of demand continues to exceed supply.

The next question comes from Simeon Gutman from Morgan Stanley. Please go ahead.

Good morning, everyone. I wanted to follow-up please on the guidance. So the down $10 million that is -- sounds like some buffer in case the first-half or second-half, I guess mix doesn't pan out? And then just to confirm the right interpretation?

Yes, I'd say we're taking a prudent view Simeon when we look at the year and that's why we kind of gave a little bit more color on the half versus half. If you think about the half guide with EBITDA down in the first-half, flat to up in the second-half, that is an expectation around sort of the pattern of the supplies and CA categories.

Okay. And the comment around 100 basis points improvement in supplies, has that flowed through to the first-half? And then I guess is that a one-year number? Is it a stack that's an underlying like how should we interpret, that would suggest things are getting better sequentially? Or do you not run rate that into your first-half guide?

So the comments on Q4 versus Q3 was a sequential improvement in the growth rate versus year ago. So sequential improvement in the growth rate versus year ago. In terms of Q1, we're not going to break down at the segment level. What we said at the macro level is our momentum on the total business has continued into Q1. We see both category strength, as well as we're happy with what we're seeing in the -- I guess, not early days anymore, but five or six weeks into our Q1.

Our next question comes from Steven Forbes from Guggenheim Securities. Please go ahead.

Good morning, Ron, Brian. I wanted to follow-up or start with ROIC return on invested capital. I think Brian you mentioned some high ROIC investments like coolers this year. So hoping maybe if you could just take a step back given the guidance for 2023 and speak to your ROIC targets and our hurdle rates? And just comment on whether the current environment is impacting your willingness or ability to spend non-strategic initiatives or if you're still, sort of, achieving those hurdles and targets as you would expect?

Yes, I actually love this question, so thanks for it. If I think about our CapEx investments, if you think about where we guided on vet hospitals and small town rural locations, those are both meaningfully above any hurdle rate that we put out in terms of ROIC. Those small town rural locations are cash flow positive generally in the first year. In aggregate, those locations are performing above our expectations for the ones that we've actually rolled out. So 10 to 15 is a slight further step in to that scale pilot in year two. That remains a priority for us and that 50 to 55 hospitals continues to track for the 247 we have in place. In line or above our historical IPO model for vets. So those are tangibly above any kind of hurdle rate for ROIC. What we are doing, if you look at the step down in CapEx from 2022 levels to 2023, we did have some sort of one-time-ish investments last year, freezers is the big one that we've referenced. We have freezers in over 1,000 locations now in our PCCs, that's a return on investment, that doesn't take a whole lot to compute. We look at the fresh market as a slightly below $1 billion market growing to $4 billion in the next three years. We think we have a competitive advantage in that market. So the investment was something that we felt really good about making.

Let me build on that. That does not imply we won't increase the number of coolers. It was a unique deal with a certain vendor where the financial terms were. In that instance, we put in the coolers. There are other instances where the vendors and the majority of instances where the vendors fund the coolers, so we don't anticipate not putting in more coolers, because the category is growing. It's just where those dollars get paid for and in most instances its vendor funded.

Appreciate the color. And then just a quick follow-up, more of a clarification question around the share count. It looks like the guidance implies 2.5% growth. So maybe just help us understand what's driving this on a year-over-year basis and what's the right burn rate to think about as the business stands today as it pertains to the share count?

Yes, I think all you have to think about there, Steven is we went public two years ago. We started issuing equity as a company two years ago and there's a slight increase in share count associated with that.

Our next question comes from Seth Basham from Wedbush Securities. Please go ahead.

Thanks a lot and good morning. My question is around inflation, if you could give us some color on how much inflation driven pricing benefited your comps in the fourth quarter and what your outlook is for 2023? That would be helpful.

Hey, Seth. I'll talk broadly about ‘23 and then Brian can talk about impact into Q4. The pricing we took in ‘21 and ‘22 is sticky. Demand continues to exceed supply, particularly with consumables. We believe the vast majority of vendor pricing has come through and while there may be pockets, we don't anticipate significant further vendor pricing actions in ‘23. The way I think about ‘23 is there'll be a balance of some areas where there's disinflation and some areas where there's slight inflation. So I'd call it an even year in terms of how to think about it category level and our level. I'll let Brian talk about that for Q4.

Yes. I would just add that Amy College and our Merch Team, they really do a tremendous job managing cost inputs and pricing actions. And I also had that freight costs have improved modestly in the second-half. We expect that to continue into ‘23. One of the benefits of having a differentiated portfolio is the strength of our relationship with vendors. So we typically have long lead time to evaluate any inflationary inputs, analyze the pricing elasticity and then respond in a way that's in the best interest of customers and the company.

That's helpful. And just a follow-up, so flattish in terms of 2023, but there should be some wrap around benefits from the price took in 2022. Is that a low-single-digit contribution to your comps in ‘23?

Yes, we're not going to get into specifics. What I will tell you is that when you look at our basket, we've been really pleased with our basket performance, not just in Q4, but for the balance of the whole year in ‘22, we're about that in ’23, and that is much more than pricing, it has to do with a lot of the hard work that the team is driving.

[Operator Instructions] Our next question comes from Michael Lasser from UBS. Please go ahead.

Good morning. Thanks a lot for taking my question. There's a lot to unpack with the guidance given the extra week the adjustments you made to the definition of adjusted EBITDA. So on that, can you give us more of an explicit sense on how you're thinking the comp is going to unfold through the course of the year? You expect the supply business to improve in the back half. Does that mean the overall comp is going to improve in the back-half? And then what is the year-over-year change in margin that's assumed in -- at the midpoint of the guidance?

Yes. Thanks for the question, Michael. I'm not going to get into any kind of quarterly guide. I will tell you, yes, I'll reiterate some of the points we made in the guidance we expect consumables to remain strong, services to remain strong. We've talked about a five to six quarter cycle in the discretionary categories. We're somewhat in the middle of that, so we'd expect that to normalize as we get into the back-half, with that certainly would come enhanced revenue and enhanced margin.

And my follow-up question is on the long-term margin outlook. So your operating margin for this year is going to be slightly above where it was in 2019. What's the path to getting to the long-term goals that you had outlined at your Analyst Meeting a year ago. Is it simply seeing an improvement in the supplies business is a way to improve the overall profitability of the enterprise from you?

Yes, a couple of points, Michael. Number one, you hit on it. The impact of the business from mix shift is cyclical. This is something that we would expect to normalize over time. I would remind you too that in the fourth quarter, we deleveraged on an SG&A rate by 170 basis points in the fourth quarter, 70 basis points for the full-year. So we have cost actions in place to make sure that we are deleveraging. What that does for us is it protects us in any kind of a downside scenario in ‘23 and then an upside scenario provides us significant leverage to enhance that EBITDA rate. I will also tell you when you look at the long-term, we're excited about our positioning in the market. We continue to invest in vets. As that vet model matures, we would expect improvements in versus gross margin. We talked last year at Analyst Day about having about 500 basis points of room to go in our digital margin. We continue to make progress against that, so there's a lot of room for us underneath the businesses and as that mix shift normalizes, we'd expect that to improve.

Our next question comes from Chris Bottiglieri from BNP Paribas. Please go ahead.

Hi, guys. Thanks for taking the question. I’m going to ask a similar question as Michael, I'm just going to cut it differently. The -- if I look at the guide, it seems to imply about 2.9% year-on-year growth on revenue. If you back out, kind of, the extra week, you're at 1.5%, you're going to take base effects from Q4 versus Q1 and Q 2, that's added about another point to revenue. So I guess my question is it doesn't sound like there's a lot of comp embedded in for ‘23. Is there any like store closures or anything like that, that actually revenue next year? I think if you think about that could be weighing on the revenue guide for ‘23 that we should be mindful of or?

Yes. No, no, Chris. I think the way you think about revenue versus comp is relatively similar. There's not a whole lot of difference between comp and revenue. So I think the numbers you were quoting are probably at the midpoint of our guide, 1.5% and 3%, but that should roughly translate to comp, so there is comp growth implied in the guide.

Got it. It’s okay, that's really helpful. And then just like overall question, it sounds like you're betting that the consumables hard goods, kind of, starts growing again back half like [Technical Difficulty] consumer -- is consumer like healthy? Like are you seeing people trade down from the [Indiscernible] in the stores? Is it similar across demographics? Like kind of what gives you that confidence that as you get easier compares on hard good supplies if things get better in the back-half?

Yes. Hey, Chris. Thanks for the question. So let me segment it. First, to be clear, consumables continues to be strong, we're talking about double-digit growth. There was just a piece of research that said that pet parents are twice as likely to come back on their own food as they are their pet's food. So we don't see any change and in fact, we continue to preimmunize within our portfolio. So in general, within our portfolio, we continue to preimmunize tied to the humanization trend that's a decade long trend. It continues today, so we see strength on that. We see strength on services. From a supply standpoint, you see the discretionary spend, you're seeing it across different categories. We did see a sequential improvement this quarter. We have gone back and analyzed prior recessionary times and the behavior looks pretty similar. We saw an improvement when gas prices backed off. So there's lots of different dynamics in it. But if you look at past recessions, it's about a five to six quarter dynamic. But overall, pet demand remains strong. As I said, it remains above supply, so that's -- the dynamics are positive, it’s just the discretionary piece that is cyclical.

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

Thank you, operator. To our analysts and our investors, as always, we're [grateful] (ph) for your time and your support. Pet category remains resilient and it's a growth category. We remain committed to executing throughout this environment, while simultaneously making progress against our long-term strategic growth priorities. We look forward to updating you throughout the year on our continued progress.

That concludes Petco's fourth quarter ‘22 earnings conference call. The team will be available after the call if you have any follow-up. Thank you.

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