Good day, and welcome to the Chewy Third Quarter 2020 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions]

I would now like to turn the conference over to Mr. Robert LaFleur, Vice President of Investor Relations and Capital Markets. Please go ahead, sir.

Robert LaFleur - Vice President of Investor Relations and Capital Markets

Thank you for joining us on the call today to discuss our third quarter fiscal 2020 results. Joining me today are Chewy's CEO, Sumit Singh; and CFO, Mario Marte. Our earnings release and letter to shareholders, which were filed with the SEC on Form 8-K earlier today, have been posted to the Investor Relations section of our website, investor.chewy.com. A link to the webcast of today's conference call is also available on our site.

On our call today, we will be making forward-looking statements, including statements concerning Chewy's future prospects, financial results, business strategies, industry trends and our ability to successfully respond to business risks, including those related to the spread of COVID-19, including any adverse impacts on our supply chain, workforce, fulfillment centers, other facilities, customer service operations and future plans. Such statements are considered forward-looking statements under the Private Securities Litigation Reform Act of 1995 and are subject to certain risks and uncertainties, which could cause actual results to differ materially from those contemplated by our forward-looking statements. Reported results should not be considered an indication of future performance.

Also note that the forward-looking statements on this call are based on information available to us as of today's date. We disclaim any obligation to update any forward-looking statements, except as required by law. For further information, please refer to the risk factors and other information in Chewy's 10-Q and 8-K filed earlier today and in our other filings with the SEC.

Also during this call, we will discuss certain non-GAAP financial measures. Reconciliations of these non-GAAP items to the most directly comparable GAAP financial measures are provided on our Investor Relations website in our earnings release and letter to shareholders, which were filed with the SEC on Form 8-K earlier today, and in our 10-Q. These non-GAAP measures are not intended as a substitute for GAAP results.

Finally, this call in its entirety is being webcast on our investor relations website. A replay of this call will also be available on our IR website shortly. I'd now like to turn the call over to Sumit.

Sumit Singh - Chief Executive Officer and Director

Thanks, Bob, and thanks to all of you for joining us on the call. Our Q3 results reflect Chewy's relentless focus on execution and customer experience, coupled with the positive macro-trends of accelerated e-commerce migration and increased pet ownership. These forces came together yet again to produce another quarter of strong net sales growth. Volume in the back half of the quarter outperformed our expectations, as traffic, conversion, orders and customer retention all strengthened from September into October, as customers shifted their shopping behavior this year and shopping earlier, responding favorably to thoughtful additions in our assortment and innovative product and service launches, such as personalization and gifting.

Coming into the third quarter, we expected an early takeoff to the holiday season, and the Chewy team was prepared and ready to shift into high gear when it came. This summer, we began optimizing our inventory and preparing our fulfillment centers, knowing that the holiday spike would add to the elevated demand tempo that has been in place since March. Team has responded and executed to plan.

Over the next few minutes, I will discuss our Q3 results and share some insights as to how the quarter unfolded. I will then use the balance of my remarks to talk through our exciting new healthcare launches and how those fit into the broader Chewy story, as we prepare to celebrate our 10th anniversary next year and carry our mission into the second decade, just as eagerly and enthusiastically as we approached it first. After that I will turn the call over to Mario to discuss our third quarter results and guidance in more details.

Q3 net sales increased 45% year-over-year to $1.78 billion dollars, with Autoship net sales representing 69.2% of total net sales. We added 1.2 million net active customers in the quarter, ending Q3 with 17.8 million active customers. Q3 net sales per active customers or NSPAC was $363, an increase of 2.8% year-over-year when adjusting for the extra week in 2018. We delivered Q3 gross margins of 25.5%, a 180 basis point increase year-over-year and consistent with our gross margin last quarter.

The promotional environment was muted throughout most of the quarter before picking up in mid-October with the early launch of the holiday season. As such, promotional discounts were less of a gross margin headwind than forecasted. Shipping costs were also in line as we worked closely with our freight partners to uphold customer delivery experience.

Private label remains a strong contributor this quarter, with Q3 private label hard goods penetration reaching 16%. Our seasonal businesses, such as Halloween, were also strong in the quarter. And here, we improved our private label merchandise mix by 20 points to over 70% showcasing the quality and appeal of our newly launched proprietary assortment. This helped grow total Q3 hard goods sales, including third party and private label by more than 70% year-over-year.

Over the past few quarters, our team has been hard at work to reformat our proprietary brand strategy by introducing compelling merchandise, many at expanded price points, improving discoverability and delivering an overall tremendous value proposition for our customers. This strategy is creating a positive, consistent and sustainable momentum and driving incremental profitability in our portfolio.

Moving onto Q3 adjusted EBITDA. We produced another positive quarter generating $5.5 million of adjusted EBITDA, at a margin rate of 0.3%, representing 280 basis points of improvement year-over-year. While gross margins were strong in the quarter, several of the short-term operating cost headwinds, we detailed on our last call, materialized as anticipated and impacted our ability to translate our top line momentum into bottom line results, as efficiently as we did in the first and the second quarters. These elevated costs were related to investments in labor and benefits as we ramped up our fulfillment centers and customer service sites to deliver a successful holiday amidst increasingly constrained labor markets and residual COVID-19 costs.

Additionally, as anticipated, we saw marketing cost increase in Q3, normalizing from the hyper-efficient run rates we saw in Q1 and Q2. Mario will provide more details on these components in just a moment. We continued to be laser-focused on executing against our commitment to pets and pet parents to deliver exceptional customer experiences by offering a broad assortment of brands and products with the convenience of e-commerce. That commitment extends to pet health and wellness.

As part of our goal to make better healthcare more affordable and accessible, we recently launched medication compounding and Connect with a Vet, our proprietary telehealth platform. These two innovative businesses are valuable additions to the growing healthcare business and represent our first service-based offerings for pet parents. But before I discuss these new businesses in greater detail, I would like to share some insight into our pharmacy Rx business, which anchors our broader healthcare strategy.

For clarity, when I refer to Chewy Pharmacy, I am referring to the business that we own and operate under our own licenses. Total pharmacy includes Chewy Pharmacy plus the pharmacy that we operate that generates third-party management fees. Total pharmacy operations are expected to generate over $500 million of gross revenue this year, which we believe makes us the largest e-commerce pet pharmacy in the U.S. To achieve this milestone, just over two years after our launch is a remarkable achievement for which we as a team are proud.

Chewy Pharmacy, on a reported basis, is expected to generate over $350 million of net sales this year, which would equate to 5% of total net sales based on our current guidance. Given the scale, pharmacy is now contributing positively to the year-over-year expansion in Chewy's total gross margins. As we have noted on previous earnings calls, we believe that we are still in the early innings regarding our pharmacy business, and we remain focused on growing this vertical in a disciplined manner.

Now, let me tell you a little bit more about our recent compounding and telehealth launches. Let's start with the[Phonetic] compounding. Compounding is a service offered through our pharmacy, where we customize medications to the specific needs of individual pets, as some pets can't take medications in their commercially available forms. They may need a liquid instead of a tablet, or a specialized dosage or formula. To enable these requirements, our licensed pharmacists use ingredients sourced from FDA-registered manufacturers to custom-prepare medications in our labs to the specifications provided by veterinarians.

Today, we offer this service exclusively to pets and pet parents. In the future, we plan to extend this service to the vets, so vets can offer compound medications directly to their in-clinic patients. In both these use cases, we seek to pioneer bar-raising customer experiences across this billion dollar fragmented market.

We are just as excited about our new telehealth service, Connect With a Vet, which connects Chewy pet parents directly to a contracted licensed veterinarian using our proprietary tele-triage platform, where vets answer questions, offer advice, and discuss pet health concerns without diagnosing medical conditions or recommending treatments. Instead, they make referrals to local vets or emergency clinics, if needed, which drives customer traffic back into these veterinarian clinics for medical diagnosis and treatment. We offer this service free of charge to Autoship customers from 8 a.m. to 8 p.m. eastern time, Monday to Friday.

We launched the program in 35 states in October, and starting today, I'm happy to announce that we are rolling it out to another 12, which brings our total coverage up to 47 states. Program utilization rates to date are encouraging, as is the customer feedback we are receiving. Connect With a Vet is clearly a first of its kind service. We are still in early days and have a lot more to learn. At the same time, we have taken an important first step towards building a telehealth platform that can evolve and expand over time as our culture of innovation advances the technology platform, and as the regulatory environments modernize to meet the needs of today's pet patients and providers.

2020 has been an unbelievably busy year so far. And I'm proud of the way every member of the Chewy team across our fulfillment centers, customer service site and corporate offices has stepped up to meet both the challenge and the opportunity. Not only do we continue to optimize our day-to-day operations, we are always looking for ways to enhance customer assortment, service and experience, as we welcome a record number of new customers and offer current customers a safe and reliable way to careful their pets. The bond between pets and their pet parents has never been stronger, and we look forward to a robust holiday season and close to the year.

I will now turn the call over to Mario, who will provide the details on our third quarter results and financial outlook. Mario?

Mario Marte - Chief Financial Officer

Thank you, Sumit. Third quarter net sales reached $1.78 billion, increasing $552.2 million or 44.9% year-over-year. In absolute dollar terms, third quarter growth marked the biggest increase we have reported in the Company's history. Year-to-date, net sales were up 46% on accelerated customer growth and solid increases in per customer spending. Q3 sales from Autoship customers totaled $1.23 billion, representing 69.2% of total net sales for the quarter. Customer acquisition rate remains healthy and continues to run above pre-pandemic levels.

In Q3, we had a 1.2 million net active customers and ended the quarter with 17.8 million active customers. Year to date, we have added 5.1 million active customers, an increase of nearly 40%. We continued to monitor and be pleased with the purchasing behavior of our 2020 customer cohorts. The first and second quarter cohorts remain engaged, and the initial engagement levels of the Q3 cohort is consistent with our peers from earlier in the year. Trends and basket size, reorder rate and Autoship sign up, all remain favorable, reflecting the continued success of our assortment and merchandising strategies.

Net sales per active customer or NSPAC increased to $363 in the third quarter, $7 or 2% higher versus the second quarter and 2.8% higher year-over-year, when adjusting Q3 2019 NSPAC to exclude the benefit from the extra week in the fourth quarter of 2018. As a reminder, net sales per active customer reflects trailing four quarter net sales, divided by the number of active customers of the end of the quarter. This is the last quarter we will have to adjust for the extra week in Q4 2018 in our year-over-year comps, which should note that the quarter-over-quarter increase is a reversal from recent quarters when NSPAC remained relatively flat. This is what we would expect as the mechanics of the NSPAC calculation begins to more fully reflect the positive revenue impact of the large customer cohorts that we acquired earlier this year, and as our pace of quarterly active customer adds, moderates from its peak lockdown highs.

Moving to the income statement. Third quarter gross margin was 25.5%, a year-over-year increase of 180 basis points as we again surpassed the low end of our long-term target range. In the third quarter, we benefited from strong execution as hard goods, private label and healthcare collectively contributed 110 of the 180 basis points of year-over-year gross margin expansion. Q3 operating expenses, which include SG&A and advertising and marketing were $486.9 million or 27.3% of net sales, scaling 280 basis points year-over-year.

SG&A, which includes all fulfillments, customer service, credit card processing fees, corporate G&A, corporate payroll and share-based compensation, totaled $352.3 million in the third quarter or 19.8% of net sales. This improved 120 basis points year-over-year, which on a fully loaded basis again scaled versus 2019, as our share-based compensation declined versus our prior period run rate. Factors affecting third quarter SG&A expenses include the launch of two fulfillment centers, investments and bonuses and other incentives for our fulfillment and customer service team members and absorption of some residual costs related to COVID-19.

Q3 advertising and marketing was $134.6 million or 7.6% of net sales, scaling 150 basis points year-over-year. As previewed on our Q2 call in September, as the economy reopen in Q3, organic acquisition rates, as a percent of total acquisitions, began to normalize after running at elevated levels through the first half of 2020. Likewise, the stronger economy and increased political advertising around the election helped drive a search in digital advertising during Q3, which led to channel input costs, rising from the depressed rates we saw in Q1 and Q2. In response, we adjusted our acquisition marketing efforts accordingly and continued to acquire customers smartly, while still delivering year-over-year marketing efficiencies and progressing towards our long-term target of 6% to 7% for net sales.

Third quarter net loss was $32.8 million and net margin improved 460 basis points year-over-year to negative 1.8%. Third quarter net income, excluding share-based compensation of $25.1 million, was negative $7.8 million. Net margin, excluding share-based compensation, improved 280 basis points to negative 0.4%.

Third quarter adjusted EBITDA was $5.5 million and adjusted EBITDA margin improved 280 basis points year-over-year to 0.3%, again exceeding breakeven. While gross margins were solid this quarter, the operating cost headwinds that we face in SG&A and marketing that I detailed earlier affected our ability to convert gross profit into adjusted EBITDA as efficiently as we did in the first two quarters of the year. In our view, several of these headwinds are not systemic and simply reflects short-term issues related to new FC, ramp up and residual costs related to COVID-19.

Turning now to free cash flow. Third quarter free cash flow was positive $32.9 million, reflecting $63.4 million in positive cash flow from operating activities and $30.5 million of capital expenditures. And positive operating cash in Q3 was primarily a function of the strong sales momentum we saw in the latter half of the quarter. Capital investments continue to be focus on capacity build, including cash outlays for our new automated fulfillment center in Archbald, Pennsylvania and our limited catalog fulfillment center in Kansas City, Missouri.

We finished the quarter with over $0.5 billion of cash in the balance sheet, which is a function of the $154 million we started the quarter with, combined with a $318 million we raised through our September follow-on offering and the $33 million of free cash flow we generated during the quarter. This level of liquidity gives us tremendous flexibility; first to support our growth, and second, it gives us the ability to evaluate internal and external opportunities to expand our addressable market.

Now to guidance. Based on strong early quarter results and accelerated customer demand and spending, we are increasing our guidance ranges as follows. Fourth quarter net sales to between $1.94 billion and $1.96 billion, representing year-over-year growth of 43% to 45%. Full year 2020 Net Sales to between $7.04 billion to $7.06 billion dollars, representing year-over-year growth of 45% to 46% and reflecting over $2.2 billion of incremental net sales added in 2020. We now expect to be profitable on a full-year adjusted EBITDA basis, and we are increasing our full-year 2020 adjusted EBITDA margin guidance range to between 0.2% and 0.4%. While some potential cost headwinds remain, these mostly reflects short-term impacts directly related to COVID or it's temporary effects on areas like labor and logistics.

I will conclude by saying that our third quarter results demonstrate the appeal and resilience of the value proposition we offer pet parents and our ability to grow and scale the business profitably. We remain optimistic about our future and look forward to wrapping up a successful 2020 and building on this momentum in 2021 for which we plan to provide you more details on our next earnings call.

With that, I'll turn the call over to the operator. Operator?

Question & Answers

Operator

Thank you. We will now begin the question-and-answer session. [Operator Instructions] And our first question will come from Steph Wissink with Jefferies. Please go ahead.

Stephanie Wissink - Jefferies - Analyst

Thank you. Good afternoon, everyone, and Sumit, congratulations on your business week recognition. Our question actually two-fold. If we could just start with some of the private label penetration, you're seeing good success there, but maybe give us a pathway to what you think that penetration rate could be over the course of the next 12 months to 24 months, and then how does that influence the way you're thinking about gross margin advancement over that same timeframe? Thank you.

Sumit Singh - Chief Executive Officer and Director

Hi Steph. Thank you. Private label is a strategic vector for us. It's a three - a little bit over a three-year-old business, and we have been ramping assortment in private label both across our consumables and hard goods portfolio. While we haven't broken out the specific size of private label, it can be inferred to be between somewhere around the mid-to-high single digit percentage of net sales, and we aspire to grow private label to become between 15% and 30% of net sales. The comment that we shared today on the call was particularly giving private label penetration for our hard goods portfolio that has now reached 16% of overall hard goods sales.

In hard goods, where we believe product lines are commoditized and customer loyalty is an index to a particular brand, we believe we can reach north of 30%, somewhere around 40%, 45%, perhaps even 50% penetration for private label goods. For consumables, it is obviously, we are - we will keep the context of our customers as loyalty towards their brands and our strategic nature of relationship with our suppliers in mind, as we grow the private label portfolio there.

Overall, as we get to ranges between 15% and 30% over time for overall private label business, we expect this business to generate 800 basis points to 1,000 basis points higher gross profit than our base business. From the progress that we're making, we're pleased with it. Not only have we added assortment within private label, effectively doubling assortment over the last 18 month period, we've also increased price points as we've added newer assortment across newer subcategories and higher price point products that are driving tremendous engagement and tremendous response from customers, particularly given the quality of these products remain 4, 4.2, 4.4 star rated products at a minimum.

Operator

Thank you. And our next question will come from Cory Carpenter with JP Morgan. Please go ahead.

Cory Carpenter - JP Morgan - Analyst

[Technical Issues] sales accelerating in October. It seemed like you called that early holiday demand, but hoping you could expand a bit more on some of the dynamics you saw that month, and then also how you are thinking about the potential pull forward to demand that may be typically would have come later?

And then as a second question, just curious over the past month or so, what type of impact you've seen if any from the second wave virus on consumer demand or any evidence of pantry loading? Thank you.

Sumit Singh - Chief Executive Officer and Director

Hey, Cory. This is Sumit. I'll take it. Two-part question. I'll answer them collectively, because we believe they're connected and related. Let's start with, when we provided Q3 guidance in early September, we shared that sales pace coming into the third quarter was strong. We saw, as anticipated, trends start to accelerate in October as the holiday season kicked off earlier this year. That momentum built through November and has carried through Black Friday and Cyber Week with those two days being the highest days - highest net sales days in the Company's history.

As we have examined the drivers of this momentum across traffic and conversion patterns, Cory, we don't believe that this is a simple pull forward or a COVID induced second wave phenomena. In fact, we believe that the demand that we're seeing is primarily organic and structural in nature. So let me sort of expand on that a little bit. First of all, we haven't found evidence within our internal data to suggest the same type of COVID induced customer purchase behaviors as we observed in spring. For example, we aren't seeing a material variance in metrics such as units per order or disruption or a change in order frequency to suggest any kind of panic buying that we saw in kind of March-April time frames or the early onset of the pandemic.

As we look to the balance of the Q4, so we remain optimistic that these demand trends will continue. Underneath of the organic volume, when we analyze the data here, we're seeing a couple of things. First we are retaining a larger portion of our cohorts. Overall customer retention for our active customer base is up more than 600 basis points year-to-date, which also by the way helps address the question that we've all been wondering about through the onset of this year as to, are we going to be able to retain the cohort of customers that we are acquiring during the pandemic? And we believe that sort of hits on that.

Second, we're attracting larger, newer cohorts, and we're seeing higher engagement from these active customers. Especially, where we are garnering our larger share of wallet from new cohorts, earlier in their life cycle. So for example, if you use Q2 of this year cohort as an example, this cohort was 50% larger than the Q2 2019 cohort, and the initial net sales per active customer or share of wallet for this cohort, this Q2 2020 cohort was 10% higher than the Q2 2019 cohort. So when you put it altogether, it's sort of nets out to be, were attracting more new customers, we're keeping more of our established customers, and more and more of these customers are building larger and more profitable baskets early on. That's sort of the summary of what we're seeing right now in terms of demand patterns.

Cory Carpenter - JP Morgan - Analyst

Thank you. That's very helpful.

Operator

Our next question will come from Mark Mahaney with RBC Capital Markets. Please go ahead.

Mark Mahaney - RBC - Analyst

Thanks. I guess, I'll just ask two specific P&L questions. The - with the specific drag factors on gross margins, I know they were up nicely year-over-year, there was nice revenue growth sequentially, but the gross margin was the same. Is that where the build out of the new fulfillment center cost kind of came in and and limited the sequential gross margin expansion?

And then secondly, you talked about this rising competitiveness for online ad spend. Do you feel like what you - where you ended the quarter? Is that back to kind of par based on your historical experience? Do you think you're still - would you - to get back to par, would you expect advertising costs, advertising intensive to continue to rise. So just put that in context, where are you now versus where you think you normally would run the business? Thanks a lot.

Sumit Singh - Chief Executive Officer and Director

Okay. Hey, Mark. This is Sumit. I'll take them. See from a gross margin point of view, we saw a drag in two places, right. One was a natural drag. As we came into the holiday season, there is obviously a higher degree of promotability, particularly as the holiday season arrived earlier in October. On a year-over-year competitive basis, the promotions environment was relatively muted, but on an absolute basis, we obviously did see promotions kick in. So that's kind of one.

Number two, when you look at our supply chain, our supply chain is healthy from an in-stock level point of view, but the placement of inventory right is - could be suboptimal in places as we are still adjusting and balancing out value chains as we work closely with our suppliers to get products into the warehouses. So from that standpoint, there is still a little bit of an effect on us either shipping products over longer zones, which generally shows up in freight costs that generally is a drag to gross margin. So that's sort of the first part of the question.

But overall, must be said, I mean 180 basis points improvement year-over-year and the fact that our newer strategic pillars are driving positive incremental gross margin into the portfolio is something that we're tremendously proud of and satisfied with.

Moving on to marketing. Marketing, as expected, as we came out of Q2 when we talked to you in September, we said, “Hey, marketing costs are starting to rise, because inputs are starting to rise as the economy opens up as more advertisers come in and the demand-supply ratio offsets to be able to raise kind of bid costs in the market environment.” What we saw was essentially - exactly that happen. On the back of that, we also saw opportunities where we could efficiently spend money and acquire customers, which our team continued to do. Overall, due to the shifting in holiday we observed a pull forward trend in new customers that were acquired kind of pre-Cyber period starting from late October into mid-November. And that growth was built on strong shopper demand that reflected across the digital network.

On the television side, obviously, this is pre-bought inventory given everybody anticipated sort of the political campaigning advertisement spend. So there we pulled in our spend a little bit to the left and spent money efficiently. We - overall marketing costs, as you know and as you've seen in the P&L, continues to trend below from a year-over-year point of view. It's obviously higher than the hyper-efficient periods that we saw in the early onset of the pandemic. And yes, we do believe that marketing costs will continue to be pressured as we execute the rest of Q4, perhaps even into next year.

Mario Marte - Chief Financial Officer

And Mark, if I can add one more thing, because I think what you're referring to a couple of points on gross margin. One is, obviously, we've stated that. We did increase gross margin 180 basis points year-over-year. But if you're looking at quarter-over-quarter, you're right, there were 25% in both quarters. Now if you look at the mix of sales in the second quarter versus the third quarter, you see that in the third quarter, we had an increase in the percent of sales went to consumables, and we've talked about the relative margin performance of different components of revenue. So when you go from 69.4% or rather 68.2% of sales being consumables in the second quarter and that increased over 69%, it is those mix between the sales, the components of net revenue that would have an impact on gross margin.

Mark Mahaney - RBC - Analyst

Okay. Thank you for the clarification. Thank you, Mario. Thank you, Sumit.

Sumit Singh - Chief Executive Officer and Director

Thanks, Mark.

Operator

Our next question will come from Brian Fitzgerald with Wells Fargo. Please go ahead.

Brian Fitzgerald - Wells Fargo - Analyst

Thanks, guys, and then, Sumit, congrats also. Could you guys talk to the opportunity to monetize Connect with a Vet? Did referrals to local vets, is that really monetize today? What is the monetization mechanism there. It seems like there is a lot of new paying them parents and this is a good way to drive Autoship for the uninitiated? And then, similar topic on Connect with a Vet, can you talk about how you're growing awareness of this offering with your current Autoship customers? It's very early, but do you have any sense of how much awareness you have been able to drive already and maybe how you think about how that can help drive Autoship retention? And last point, the path to availability that service in all 50 states. Thanks.

Sumit Singh - Chief Executive Officer and Director

Hey, Brian. Thank you. Let's start with the availability. So as of this morning, the services available across 47 of the 50 states. So we have rapidly expanded it from the 35, four, five weeks ago to the 47 as of this morning. So as of this morning, it is available coast-to-coast across our base of Autoship customers, which we're happy and proud of.

Number 2, of course, us starting the opportunity with Autoship customers, and strategic in my mind as what we expect to do there is to observe. We believe this will help both fuel acquisition into the Autoship program or stronger acquisition and also help with the retention of Autoship members, which is obviously both of them are incremental to the portfolio in driving top line and bottom line to the portfolio. Over time, as you pointed out the opportunity, this is - these are early innings. And as we develop the product, we will obviously seek opportunities to embed it or offer it to our entire base of customers, and there we have several ideas in the way that we can monetize this product over time. But so far, we're focused on Autoship customers and learning how the service does there.

Did I miss a part of your question?

Mario Marte - Chief Financial Officer

I don't believe so.

Brian Fitzgerald - Wells Fargo - Analyst

No, I think you got it all. Thanks guys.

Sumit Singh - Chief Executive Officer and Director

Yeah. Thanks.

Operator

Our next question will come from Lauren Cassel [Phonetic] with Morgan Stanley. Please go ahead.

Lauren Cassel - Morgan Stanley - Analyst

Great. Thanks for taking the question. I guess following up a little bit on an earlier question, thinking about marketing spending into next year, obviously, I think we're hearing about CPC's [Phonetic] largely going to be higher in the next year. But from a, sort of, retention of new buyers perspective, is there anything that you think you need to invest in from that perspective, or is it really going to be sort of continued new customer growth? And to that effect, how should we think about new customer growth next year given the really strong growth that you've seen this year?

Sumit Singh - Chief Executive Officer and Director

Sure. Hi, Lauren. We'll stay away from speculating on numbers for next year. We'll talk to you more about 2021 on our Q4 call, but I will generally answer the question. First of all, no, we do not expect to spend incremental dollars on retention. In fact, as we have seen or as we have shared on this earnings call, customer retention year-to-date is up more than 600 basis points, including - that obviously includes the cohort of customers that we acquired this year, who continued to engage with us in a positive manner with higher AOVs driven by ASP and mix, not actually driven by higher UPL, therefore not indicating any kind of pandemic buying behavior there.

Number 2, we expect to continue to broaden or open up more marketing channels as we step out from 2020 into 2021. So you should expect us to broaden our range, our reach, our frequency. Overall, we are a strong direct response performance marketing engine, and you should expect us to be - to hold ourselves disciplined and accountable in the way that we spend money and acquire customers. Last but not least, I will remind the audience that - we've enhanced the value proposition of products and services that we bring to Chewy customers. And in that way, we've actually - not only are we seeing customers spend more early on, we believe the overall potential of net customer spend and LTV is greater. Therefore generating higher LTV to CAC ratios which has been our North Star as we think about marketing, and we will continue to do so as we move from this year into next.

Lauren Cassel - Morgan Stanley - Analyst

Great. Thank you.

Operator

Our next question will come from Seth Basham with Wedbush Securities. Please go ahead.

Seth Basham - Wedbush - Analyst

Thanks a lot and good afternoon. My question is around sales per active customer. We saw our metric increased by a slowed a little bit sequentially in terms of year-over-year growth. Is there anything to think about as it relates to that metric here?

Mario Marte - Chief Financial Officer

Yeah. Hi, Seth. This is Mario. So you're referring to NSPAC and so the mechanics of NSPAC, if you remember is that we take all of the revenue in the last four quarters and divide by the active customers at the end of the quarter. So we're starting to see the sequential increase is the positive revenue impact of the large customer cohorts that we acquired earlier this year. So now, we're seeing that number move up again. You would expect that - we would expect that NSPAC should continue to improve over the balance of the year and into next year, as the revenue from those cohorts continues to be realized for the full trailing four quarters of having acquired the cohort itself.

I think we have to do - for the last year, you still have to adjust with the extra week in the fourth quarter of 2018. If we do that then our NSPAC is up almost 3%, and you can see how many new active customers we added in the quarter, which obviously has a temporary drag on that number for moving up.

Seth Basham - Wedbush - Analyst

Understood. Thank you.

Operator

Our next question will come from Oliver Wintermantel with Evercore ISI. Please go ahead.

Oliver Wintermantel - Evercore - Analyst

Yeah. Hi, thanks. I just had a question regarding the cost headwinds that you mentioned in Q3, and I think in your prepared remarks, you said they should shift into Q4, and then maybe into next year as well. While overall, you said that they should be not permanent in nature, but you mentioned labor and logistics, as well as COVID. So maybe a little bit more information of of what you expect in Q4 and what part of these cost headwinds should fall off in next year?

Mario Marte - Chief Financial Officer

Yeah, certainly. Hey, Oli. It's Mario. I'll answer that one. So you've heard us say that unlike the first quarter, COVID did not have a material impact to our gross margin in the third quarter. But we did see an impact in SG&A. We had approximately $8 million of expenses that were either directly or indirectly related to COVID in the third quarter, which is about in line with what we shared with you for first quarter and second quarter. We said $11 million in the first quarter and - rather $11 million in the second quarter, $10 million in the first quarter. For the fourth quarter, we do expect somewhere between $15 million and $20 million of incremental SG&A, and again directly or indirectly related to COVID, and that's partially due to higher wages and benefits for our fulfillment center team members. But we do believe these are temporary in nature.

Sumit Singh - Chief Executive Officer and Director

Oli, I'll add a couple of things. As you know, we're also ramping up two fulfillment centers along the way that kind of go into that SG&A number. And then, we've just talked about marketing where input costs are increasing, and it's a bit of an open playing field and marketing. So there, we will continue to remain disciplined and also opportunistic, so that depending upon how the market behaves our team can respond accordingly to drive both yield as well as net customer adds to the portfolio.

Oliver Wintermantel - Evercore - Analyst

And just, if I may, the $15 million to $20 million incremental SG&A, does that compare to the $8 million COVID cost or was that a total number?

Mario Marte - Chief Financial Officer

It's a total number.

Oliver Wintermantel - Evercore - Analyst

Got it. Thanks very much.

Operator

Our next question will come from Erin Wright with Credit Suisse. Please go ahead.

Erin Wilson Wright - Credit Suisse - Analyst

Great. Thanks. On pharmacy, how much do you think you are taking share from other e-commerce players versus veterinary practices? And then, more broadly on the pharmacy business, do you anticipate this will be a largely organic approach over time when down the road? Do you see the opportunity to bolster your pharmacy business more rapidly through acquisitions or just potentially highly synergistic pharmacy filed by which could be an opportunity for you or will this be a more organic approach?

Mario Marte - Chief Financial Officer

Hi, Erin. I'll take the question. So first of all - the first question on share. We - let's start from the top. So we view healthcare as a $35 billion market, and of that $35 billion, approximately $7 billion in our research is Rx medication, which is growing at 10% CAGAR. And we believe if you do that match then we're roughly 7% of the overall total available market share. In that category, 70% or higher is still owned within the veterinarian channel. E-commerce in our opinion is approximately between $1 billion to $1.3 billion for total Rx medication, which gives us a segment share of somewhere between - somewhere around 40%, 45%. So that's the first part of that question.

With the market growing at 10% and the vet channel owning over 70%, I mean at these dynamics, the category in our opinion has multiple - has room for multiple simultaneous winners. And our job is to ensure that, Chewy is one of them. In terms of our strategy, in terms of the growth, we're clearly focused on organic growth at this point, and as that strategy evolves, we are first focused on making sure that we have value-added services and products, both for our customers and the veterinarian space, where we can keep the veterinarians in their center of equation as we go, make healthcare more affordable and accessible. That will be our primary focus over the next nine months to 12 months to 15 months, as we grow the category and the space overall.

Erin Wilson Wright - Credit Suisse - Analyst

Okay. That's helpful. And just a related question on the triage offerings. How do the economics work with the veterinary referral partners? Can you view [Phonetic] these clinics would in turn partner with you on the prescription management side? Will this be material near-term? And now these exclusive relationships with these practices, how does that essentially work?

Mario Marte - Chief Financial Officer

Sure. So far - thus far, there are no exclusive relationships. The referrals are - essentially, we are providing a service to the customer in identifying the type of veterinarian that might be suited to be able to appropriately diagnose the medical condition or the level of urgency with which the diagnosis might be required. In that way, Chewy partner veterinarians are redirecting customers to either neighborhood veterinarians, the customers' own veterinarian or to emergency clinics. When the - if you've gone through the experience, what you will find is that we provide a full diagnosis summary or a full summary of the conversation, and some specific notes for the veterinarian in clinic to take a look at that can actually serve in.

In this way, what we are essentially doing is driving what we call high-quality traffic into the veterinarian's office, where the opportunity for conversion or offering that service or treatment and receptiveness on for the customer is the greatest and the highest. So that's one way to think about it. The other way that we are thinking about it, which we're excited about is, when you think - look, we believe that services like these can help solve challenges like compliance and also grow TAM for the healthcare space, which is obviously a vested interest on a joint mission that the veterinarians have. How? Well, we believe that, and I've shared this data point earlier on this call. We believe that a third of pet parents in the U.S. either do not take their pets to wet or don't do so routinely.

And the barriers to doing so in our opinion is either the cost of wet care, the barriers are friction in the process itself, or just a lack of awareness around preventative healthcare in the minds of the pet parents. And so, by offering or by bringing three hour services, like Connect with a Vet, we can offer the service to that type of pet parent from the convenience of their home and essentially earn their trust to be able to educate them and therefore drive that traffic into the veterinarian clinics and in doing so both increased compliance as well as open up the entire TAM for that particular customer segment that's not touched or not fully on lease-on [Phonetic] opportunity from a veterinarian standpoint.

So those are two different ways of thinking about it.

Erin Wilson Wright - Credit Suisse - Analyst

Thanks. That makes lot of sense. Thanks.

Operator

[Operator Instructions] Our next question will come from Rick Patel with Needham & Company. Please go ahead.

Rick Patel - Needham - Analyst

Thank you and good afternoon. [Technical Issues] Earlier you touched on how newer cohorts are spending more earlier on compared to prior cohorts. I believe that historically, revenue per active customer has been in the 150 to 200 ballpark for year one. If this - if that - if this had, in fact, ticked higher, do you see upside to hence back [Phonetic] in the out years as well or does this mean that lifetime value is consistent with the ability to capture revenues earlier on has improved?

Mario Marte - Chief Financial Officer

Rick, I think - this is, Mario. I think I understood your question. So - but let me - I think the answer to that question is both. Not only are we capturing more revenue earlier, which impacts LTV to CAC, and therefore, we would expect that behavior to continue going forward, continuing to improve the LTV to CAC versus prior cohorts. But the - an uptick in the first year revenue per active customer could be a good indicator of future year NSPAC per active - NSPAC also being higher than prior customer boards.

But that doesn't just happen right. We've been doing that actively by expanding the catalog, expanding the categories. The fact that two years ago, we did not have a pharmacy that meant that a customer could spend potentially $700, $800 with us on their products and being consumables are hard goods, but they could buy their medicine. Well, they can do that today. Our hard goods catalog itself was much smaller two years ago. And as we continue to expand not only the product selection, but also the price point, that means that the customer now has an opportunity to buy their food and their dog bed, Catry, etc. from us.

We've expanded the product selection of non-dog, no-cat pets at home, so again, that customer may have to split their purchases with us in another channel and other can consolidate all their spend on our - on chewy.com. So therefore, the answer is the - not only can we capture more of the revenue earlier, but also the LTV to CAC to those - for those customers should improve not only with higher revenue, but also more profitable orders for each of the - for those customers.

Rick Patel - Needham - Analyst

Very helpful. Thank you.

Operator

Our next question will come from Peter Keith with Piper Sandler. Please go ahead.

Peter Keith - Piper Sandler & Co. - Analyst

Hi, thanks. Good afternoon. Maybe as a quick follow-up to Rick's question on the cohort spending. You have had this impressive 150% increase in cohorts spend from year one to year two historically, so maybe with a higher starting point year one, do you still see that type of increase for all these customers moving into next year or do you think maybe that growth moderate somewhat?

Mario Marte - Chief Financial Officer

Peter, this is, Mario. So the cohort has been increasing from your one, year two. Look, without speaking to 2021, because we will do that on the fourth quarter call. Nothing that we're seeing from the customers that we acquired this year would have us believe that they're going to behave any different than prior year customers. So I think that's a short answer, without me getting into 2021 any guidance expression.

Peter Keith - Piper Sandler & Co. - Analyst

Okay, that's fair enough. And if I can ask a - maybe a simplistic big picture follow up. So impressive numbers that you're giving out in the higher retention rate this year. I think there some views out there that maybe your churn rate would actually be higher, retention will be lower, because you've acquired a lot of customers when brick and mortar stores were closed. So simplistically, could you just maybe give us an overview of why you think the retention rates this year in particular are trending so much stronger?

Sumit Singh - Chief Executive Officer and Director

Hey, Peter. This is Sumit. I'll take that. Well, I think it goes back to the entire value proposition. I mean, we - first of all, we seek to deliver a high bar credible experience from the get-go, and we aim to repeat that with every interaction that a pet parent has with us. So much so that we build relationships not acquire mere transactions. And in some way the relationships that we acquire fuels long term loyalty and evangelism towards the brand, and that has a lot of value in category like pet, where customers refer to themselves as pet parents. It's an emotive category.

Underneath of that, when you layer on the core tenets of e-commerce on offering competitive pricing, broad assortment and reliable and convenient delivery services, and you complement that with an expanded portfolio of products and services. It allows us to inch closer every month, every quarter to our mission statement of being the most trusted convenient destination for pet parents everywhere. And we believe that it's reflected in the numbers that we're sharing today, including retention type statistics or spend per cohort statistics that we've shared or numbers that we've shared on the call today, both up more than 600 basis points on the retention basis, and cohorts on a year-over-year basis spending 10% higher in quarter, as I kind of shared earlier on the call. You should expect us to continue to operate in a high disciplined and high customer experience high-bar manner.

Peter Keith - Piper Sandler & Co. - Analyst

Okay. Very helpful. Thank you.

Operator

Our next question will come from Deepak Mathivanan with Barclays. Please go ahead.

Deepak Mathivanan - Barclays - Analyst

Hey guys. Thanks for taking the question. So the first one on Autoship, you had the first order discount on Autoship program at around 40% for a few months now. What are the benefits you're seeing from this change, and how do you think about the ROIs at these levels. Also as the Autoship penetration, currently, the same on more recent cohorts, maybe on a monthly basis, because of the pandemic there has been some fluctuation there. So just curious on how that adoption has been? Thank you.

Sumit Singh - Chief Executive Officer and Director

Sure. Hey, Deepak. I'll take the second one. Mario will take the first one. The Autoship penetration is same or better on customer cohorts that we are acquiring.

Mario Marte - Chief Financial Officer

Yeah. But, I think that your first part of your question was about the discount and then the - I think the simple answer is, you're right. The Autoship penetration is increasing or is higher at this higher level. But then the other side is what is the cost to us, right? And the cost is minimal until that you have the benefit of having more sign-up rate, the higher sign-up rate net of any cancellations and a lower cost which then leads to an improved LTV to CAC for these customers.

Sumit Singh - Chief Executive Officer and Director

And Deepak, these are transient seasonal promotions that we do. We're not seeking to [Technical Issues] value proposition in the program driven by deep discounting or any such sort. These are seasonal holiday driven promotions where we are particularly sensitive and data driven and understand what our gross customer adds would be in Autoship and also understanding the cancellation rate post event, therefore arriving at net adds that we - that form the basis off the payback calculation, given that we understand how long the customers are going to stay with us, what their spend patterns are going to be and how we can develop them from one category into purchasing multiple categories over time. That's how we think about it.

Deepak Mathivanan - Barclays - Analyst

Got it. No, that's very helpful. Thanks, guys.

Mario Marte - Chief Financial Officer

Sure.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Sumit Singh for any closing remarks. Please go ahead, sir.

Sumit Singh - Chief Executive Officer and Director

Thank you, everyone. Have a good night.

Operator

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CHEWY INC

Q3 2020

Earnings Transcript

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