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Presentation

Operator: Good morning and welcome to the Petco’s Fourth Quarter 2022 Earnings Conference Call. All participants will be in 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 Cathy Yao, Vice President of Investor Relations. Cathy, you may begin.

Cathy Yao: 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.

Ron Coughlin: 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 Zs 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 earlier this month we paid down an additional $35 million of principal on our debt, as well as taking further actions to manage our floating rate exposure and we’re committed to pay down additional debt, while continue to invest to enable our long-term growth strategy. Brian will elaborate shortly. At our inaugural Investor Day last year, we laid out three core growth pillars: first, the rapid scaling of services; second, furthering the differentiation of our merchandise; and last, leveraging data and membership to build loyalty and share of wallet.

Let me share our progress and results across those pillars. Services delivered a strong 14% comp growth in the quarter, up 36% on a two-year basis. In veterinary services, we are now at scale with a veterinary presence in 90% of our pet care centers. Petco’s hospitals and clinics saw nearly 1.9 pets in 2022, positioning us as one of the leading providers of veterinary services in the United States. Record veterinarian hires, improvements in ease of online booking and innovation in medical technology significantly boosted transaction volume, bucking industry trends with double-digit sales growth for the full-year. We added over 1,100 veterinarians to our ecosystem in 2022, representing a 40% increase, compared to year ago. We also added 50 new full service vet hospitals this year, in line with expectations.

We now have a total of 247 hospitals across the country, a significant milestone having come from just 10 at the beginning of 2018 and cementing our position today in the top 10 from a hospital unit standpoint. Petco continues to provide a single trusted ecosystem for pet wellness that remains unique in the industry. Pet Care Centers of vet hospitals continue to see a mid-single-digit center store lift are growing faster and have higher profit dollars, compared to locations without hospitals. Vet customers are also demonstrating a 2.3 times higher lifetime value than non-vet customers. Last year, we ran over 58,000 vet co-clinics across 46 states, up strong-double-digits, providing convenient, affordable and critical preventative medicine. With great care at a great price, our vet clinic business is the right offering at the right time for many of today’s pet parents.

Clearly, Petco has built a unique and profitable services offering with veterinary services at its heart, but it’s more than that. Under the exceptional leadership of our Chief Veterinarian Dr. Miller and our team, we are redefining what a veterinary network looks like through powerful industry partnerships, innovative trading programs, and technological advances in medicine, including AI radiology, diagnostics, and multi-species ultrasound. The results — our vet business is an incredible growth driver and our model provides a compelling home for veterinary professionals, while improving and saving lives of even more pets. Turning to our differentiated merchandise, 2022 was another strong year. The addition of exclusive and formally independent only store brands such as Backcountry and Stella & Chewy’s, have been powerful in driving our premium mix and accessing new customers.

Meanwhile, our mix of popular own brand supplies and consumables including Reddy and WholeHearted, which both grew in revenue and penetration over the year, continue to meet the core humanization trend, while also catering to a variety of wallet sizes. Taken as a whole, our differentiated assortment is driving retention with our health focused customers offering products unavailable in mass or many online channels and reducing our competitive promotional exposure. Total merchandise sales were up both in the quarter and for the full-year. Highlights include double-digit growth in consumables, driven particularly by our own brand WholeHearted. Continued year-over-year growth in both revenue and customers and Fresh Frozen and double-digit growth in RX making progress in this $12 billion addressable market.

And while our more discretionary supplies in companion animal categories saw a decline year-over-year. Our fourth quarter saw an over 100 basis point improvement in the year-over-year growth rate versus Q3. In the high value Fresh Frozen category, we maintained our structure advantage versus online only players. With over 90% of e-com customers choosing same day delivery of BOPUS when available, we’re able to leverage our pet care centers as micro distribution centers, getting product to customers faster and in many instances with lower fulfillment costs. And today we announced an absolute breakthrough in the industry first an exclusive partnership with Freshpet, the number one brand in Fresh Frozen pet food. This makes Petco the first national omnichannel pet retailer to offer a customized fresh pet food subscription delivered direct to customers’ doors.

With the Fresh Frozen pet category expected to reach $6 billion within the next four years, and the direct-to-consumer pet segment growing faster than traditional pet e-commerce. These custom meals further enhance Petco’s ability to lead the way in the megatrends of personalization and humanization. The fact that the leader in Fresh Frozen chose to exclusively partner with Petco is a validation of the power and advantages of our unique omnichannel and micro distribution center capabilities. We’re delighted to be bringing this industry first offering to market. But it’s not just our merchandise it differentiates us, it’s also our omnichannel delivery capabilities. Our digital channels continue to gain momentum. App and website sales delivered double-digit growth both in the quarter and for the full-year, translating to 32% growth on a two-year stack and an incredible 138% on a three-year stack for the full-year.

And this year, we hit a milestone surpassing $1 billion in recurring customer revenue, driven by repeat delivery, vital care and insurance. Securing revenues that are both predictable and retentive. In our pet care centers, we achieved 11 consecutive quarters of brick and mortar comp growth. And as promised, every non-trainee partner at Petco is now paid a base wage of at least $15 an hour. PCC partner application retention rates continue to be strong and are up year-over-year as we provide an engaging and rewarding environment to work and flourish. Strengthening our business in the short and long-term. Internationally, our number one Mexico business continued to go from strength-to-strength delivering double-digit revenue growth year-over-year.

We added 12 new locations this year, furthering our penetration in this rapidly growing market and bringing us to a total of 120 locations. Our world pilot continued to scale profitably, making progress in capturing the $7 billion addressable market. As the organization increases and pet spend continues to grow in rural markets, this natural extension of our core offering provides pet products and services that are unique and highly desired by passionate pet parents. As a result, in aggregate, the pilot is performing above model and trending to be cash flow positive within the first year. In addition, our lowest pilot in Canadian Tire partnership continue to perform extremely well, both with significant runway for growth. Finally, turning to customer loyalty insurer wallet.

Our insights driven approach to data, marketing and customer experience enhancements added 1 million net new customers for the full-year. Including over 70,000 ads in the quarter, our total active customer base now stands at over 25 million. In January, we unified all memberships under the Vital Care program. Members of our Pals program were transitioned to Vital Care Corp. Members of our existing paid Vital Care program were transitioned to Vital Care Premier. Dramatically simplifying loyalty of Petco and enabling a clear trade up path is already paying dividends with increased upgrades from free to paid. In February, we had a major milestone, reaching $0.5 million paid active Vital Care Premier plans. In addition to providing tailored benefits, savings and advice pet parents, our Vital Care Program drives loyalty and brings them further into our ecosystem.

Premier members have a 3.6 times higher lifetime value than non-members. They visit more and we see a lift in spend across all categories translating into higher Petco margin dollars versus non-members with recently acquired members spending more than prior cohorts. Finally, before I close, let me turn to Petco Love. In the fourth quarter alone, together we saved over 97,000 pet lives and have now reunited over 17,000 pets to-date through Petco Love Lost. And in partnership with Merck, Petco Love delivered 172,000 free vaccines in the quarter, making great progress against our second million free vaccine commitment saving pets from preventable deadly diseases. All incredible examples of how we deliver against our mission of purpose-driven performance.

And we’re grateful to Blue Buffalo for their financial support to the Yummy Memorial Cancer Fund, a program geared to my heart, providing financial assistance to our Petco partners for pet cancer treatment. Personally, I’d also like to thank the teams at Petco Love and priceless pets rescue in Southern California for helping me find the newest member of the Coghlan family, our sweet new chocolate lab, Yogi, which having a father who is lifelong net span required some research to confirm Yogi Berra spent almost 10-years with the meds, a few days as a player and the remainder as a coach. Yogi is fitting into his new role as Chief Dog Officer well, pony his skills with Dog Trainer Zooey at our Delmar location and keeping up to-date are all as vaccinations with Dr. Rice at our Vetco Hospital in Encinitas.

To conclude, I’m energized about the strength of the pet category and our differentiated strategy. To be sure, there is still significant progress to be made, but we’re executing well in the current environment and our strategy for long-term growth is unique and working. The pet category remains vibrant and we continue to have one of the best teams in retail whose dedication is delivering day in and day out. With that, let me hand it over to Brian.

Brian LaRose: 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 of 39.8% was 220 basis points year-over-year and gross margin for the full-year of 40.2% was down 160 basis points. The decline for both the fourth quarter and the full-year was driven primarily by the mix impact of consumable strength and transitory supplies pressure combined with elevated supply chain and associated capitalized rate costs, which as for many, brought headwinds on a year-over-year basis. Our team has worked tirelessly to improve operating leverage by focusing on strategic cost initiatives and have picked up momentum throughout the year. As a result, I’m pleased to report that in the fourth quarter, SG&A as a percentage of revenue improved from 36.5% to 34.8% year-over-year, down 170 basis points.

For the full-year, SG&A as a percentage of revenue was 36.5%, down 70 basis points. On an absolute basis, fourth quarter SG&A expense was $550 million, down $3 million from prior year, inclusive of continued investment in our pet care center partners. Demonstrating our cost discipline in a balanced approach to managing the short-term, while making strategic long-term investments. For the full-year, SG&A was $2.2 billion, up 2% from 2021. Q4 adjusted EBITDA was $170 million, down 1% from prior year with an adjusted EBITDA margin rate of 10.8%, compared to 11.4% in the prior year. For the full-year, adjusted EBITDA of $582 million, was down 1.5% with an adjusted EBITDA margin rate of 9.6%, compared to 10.2% in the prior year. Q4 adjusted EPS was $0.23, a decrease of $0.05 from the prior year based on $266 million weighted average fully diluted shares and a normalized effective tax rate of 26%.

Full-year adjusted EPS was $0.75, a decrease of $0.16 from the prior year. I now want to take a moment to provide an update on changes to our go forward adjusted EBITDA, adjusted net income, and adjusted EPS definitions. To-date, we’ve been reporting these metrics consistent with the approach taken by other newly public companies. Following a period of evaluation and review over the last few months, feedback from investors and to remain in line with evolving best practices, we are updating the treatment of certain adjustments on a prospective basis. While our fourth quarter adjusted non-GAAP results reflect our prior definitions, future results will be based on these updated definitions. To be clear, none of these changes will have an impact on Petco’s cash flow or affect the company’s operations and strategic priorities.

We will no longer include store pre-opening, store closing and non-cash occupancy expenses in our add backs and will limit non-recurring costs to restructuring charges one-time material legal reserves and significant one-time transaction related charges. We believe these updated definitions will create more clarity and insight into Petco operating results. To assist investors in this transition, we’ve provided reconciliations between our prior and new non-GAAP definitions. Moving beyond the P&L, our liquidity position remains strong. We ended the quarter with $646 million inclusive of $202 million cash and cash equivalents and $444 million of availability on our revolving credit facility. We’ve continued to make meaningful improvements in our cash flow performance with a 96% increase in Q4 operating cash flow over the prior year and free cash flow of $71 million, up $76 million over the prior year.

The way the team managed the inventory was a key contributor to our strong free cash flow. And outcome of our investments into strategic supply chain enhancements, as well as operational discipline. In-stocks were up tangibly year-over-year and we continue to work actively with our vendors to position us well while we navigate this environment. Last quarter, we said we expected to be free cash flow positive for the year, while still investing in pillars of future growth, including veterinary hospitals and cooling infrastructure to accelerate our Fresh Frozen business. With exceptional cash flow performance in the fourth quarter, free cash flow for the full-year was $68 million. We continue to see opportunities to further improve our working capital moving forward.

Given our strong cash position, as Ron noted, last week we paid down $35 million principal on our debt, $31 million more than the required quarterly payment, an indication of our strengthening balance sheet and commitment to reduce overall debt levels. Additionally, to take further actions to manage our interest rate exposure, we implemented callers on a portion of our floating rate debt. Combined with the caps we implemented last quarter, we have significantly mitigated our interest rate exposure. Now shifting to 2023, as we plan for the year, we remain confident in the strength of our unique health and wellness ecosystem that continues to set Petco apart and, in our ability, to deliver against our strategic priorities, including vet digital and owned and exclusive brand differentiation.

We fully expect the pet category to remain resilient with growth overall, as seen in past economic downturns with notable strength and consumables and services. While discretionary categories remain pressured and while we anticipate the macro environment to remain fluid, we expect our supplies and companion animal businesses to work their way toward normalization. In the meantime, we are focused on programmatic cost initiatives to mitigate against mix pressure to manage our business in the short-term, while reinvesting in the business to improve long-term profitability and create additional shareholder value. We’re confident in our ability to continue to improve free cash flow in 2023, and to do so without sacrificing ongoing investment in our strategic long term growth initiatives.

Turning to guidance, I’d like to remind you that our outlook reflects our new updated non-GAAP definitions. Additionally fiscal 2023 will be a 53-week year for Petco, leading to an incremental week of operations relative to fiscal 2022. Our guidance reflects the extra week. In fiscal 2023, we expect revenue of $6.15 billion to $6.275 billion. Adjusted EBITDA of $520 million to $540 million to be roughly flat. Adjusted EPS of $0.40 to $0.48, including an incremental $0.12 to $0.15 and expected interest expense since fiscal 2023. Approximately $273 million of shares outstanding and an effective tax rate of 26% and $225 million to $250 million of capital expenditures. The expected reduction in capital spend in 2023 reflects the completion of one-time investments in high ROI initiatives such as freezer build outs for Fresh Frozen and the retirement of some technical debt in IT.

Importantly, we will continue to invest in our long-term growth drivers. Additionally, we are targeting principal debt payments of approximately $100 million as a commitment to further strengthening our balance sheet. Our guidance is based on the current economic outlook and represents a one-time forward-looking comment on our debt paydown in light of this unique environment. We expect to open 50 to 55 owned vet hospitals in 2023 and 10 to 15 rural locations, both of which are reflected in our guidance. When thinking about our guidance, there are a few things to keep in mind: in light of our expectations of the macro evolution and the transitory softness in the discretionary categories, we anticipate adjusted EBITDA to be down in the first-half with Q1 being a low watermark and flat to up in the second-half.

As we start to see normalization and discretionary trends, we expect improvement to the revenue and gross margin trajectory that we are currently anticipating for the year and correspondingly an enhanced EBITDA rate. We saw modest improvements in freight costs in the back half of 2022 and we expect to see further improvements to our freight costs in 2023 as the overhang on freight alleviates, which will be increasingly realized as we progress through the year. And finally, I’d like to reiterate our emphasis on investing for long-term growth and our continued execution against our working capital optimization provide us confidence to support our balance sheet, while also making high ROI capital investments. To conclude, we remain committed to delivering against our short, medium and long-term goals to provide the best and only full service health and wellness ecosystem for pets and to deliver sustainable profitable growth.

We remain focused on what’s in our control and on our structural investments and services, differentiated merchandise and data and memberships continue to be the drivers for growth in a resilient category, while making us well positioned for consumers in any economic environment. Thank you for your time. And with that, we’d be happy to take your questions.

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

Kate McShane: 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?

Ron Coughlin: 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 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.

Brian LaRose: Yes. In terms of assumptions for the guide Kate piggybacking on-site, we expect consumables to continue to grow, we expect services to continue. Part of our guide implied that if you look at 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.

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

Ron Coughlin: 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.

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

Oliver Wintermantel: Yes, good morning. And, first of all thank you for changing the adjusted EBITDA calculations. So my questions are the slowdown in the 4Q you 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.

Ron Coughlin: 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, 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 quarters of net adds.

Brian LaRose: 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. 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 won’t get into a specific we’re committed to deleveraging.

Operator: Our next question comes from Elizabeth Suzuki from Bank of America. Please go ahead.

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

Brian LaRose: 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 (ph) 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 inventory. If you look at our overall operating 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.

Elizabeth Suzuki: Great. Thank you.

Ron Coughlin: Thanks, Liz.

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

Corey Grady: 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.

Brian LaRose: 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.

Corey Grady: 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.

Brian LaRose: 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.

Corey Grady: Not to mention the debt paydown.

Brian LaRose: Not to mention the debt paydown.

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

Anna Andreeva: 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.

Brian LaRose: 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.

Ron Coughlin: 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.

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

Simeon Gutman: 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?

Brian LaRose: 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.

Simeon Gutman: 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?

Ron Coughlin: 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.

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

Steven Forbes: 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?

Brian LaRose: 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.

Ron Coughlin: 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.

Steven Forbes: 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?

Brian LaRose: 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.

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

Seth Basham: 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.

Ron Coughlin: 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.

Brian LaRose: 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.

Seth Basham: 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?

Brian LaRose: 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: Our next question comes from Michael Lasser from UBS. Please go ahead.

Michael Lasser: 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?

Brian LaRose: 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.

Michael Lasser: 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?

Brian LaRose: 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.

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

Chris Bottiglieri: 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?

Brian LaRose: 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.

Chris Bottiglieri: 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 consumer — is consumer like healthy? Like are you seeing people trade down from the 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?

Ron Coughlin: 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.

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

Ron Coughlin: Thank you, operator. To our analysts and our investors, as always, we’re (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.

Cathy Yao: 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.

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