Chewy, Inc. (CHWY) Q2 2021 Earnings Report, Transcript and Summary

Good afternoon, and welcome to the Chewy Second Quarter 2021 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Bob LaFleur, Vice President of Investor Relations. Please go ahead.

Thank you for joining us on the call today to discuss our second quarter 2021 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 earlier today, have been posted to the Investor Relations section of our website investor.chewy.com. On our call today, we will be making forward-looking statements, including statements concerning Chewy's future prospects, financial results, business strategies, investments, industry trends, and our ability to successfully respond to business risks, including those related to the spread of COVID-19. 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 and in today's SEC filings. These non-GAAP measures are not intended as a substitute for GAAP results. Additionally, unless otherwise noted, results discussed today refer to second quarter 2021, and all comparisons are accordingly against the second quarter of 2020. 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.

Thanks, Bob, and thanks to all of you for joining us on the call. We have now crossed the halfway point of 2021, and our results once again demonstrate the strength of our business model and the incredible bond between pets and pet-parents. Our business remains healthy, customer engagement continues to grow, and we are confident in our ability to build upon the strong results we delivered last year, while navigating the uncertain market conditions due to the ever evolving COVID-19 pandemic. Let's start with our second quarter results. Q2 net sales rose 27% to $2.16 billion. To gain an even greater appreciation of our top line momentum, we believe it is also insightful to look at our net sales growth on a two-year stack basis. Through this view, Q2 2021 net sales grew at a two-year CAGR of 37%. We ended Q2 with 20.1 million customers, a year-over-year increase of 21% or 29% on a two-year CAGR. Gross customer adds are running higher than pre-pandemic levels, but below the record levels we saw last year during the peak of the pandemic-driven lockdowns. In fact, year-to-date, we have acquired approximately 20% more new customers than we did in the first half of 2019 prior to the pandemic. Our retention rates remained stable as well. In addition to the number of customers we add, customer spending is equally as important to our growth equation. Second quarter net sales per active customer or NSPAC increased 14% to $404. This is a meaningful acceleration over the growth we reported in the first quarter and the first time in the Company's history that NSPAC has surpassed $400. We have increased share of wallet from every cohort we've added to our platform over the past 10 years, and our long-term revenue retention levels from each cohort remain well above 100%. As a result, our base of recurring revenues grows over time as the revenue produced by each cohort stacks on top of one another, like the layers of a cake. Because revenue retention is above 100%, each new cohort's contribution to net sales is completely incremental to the base. This dynamic, combined with our ability to consistently improve margins, creates a powerful long-term growth and profitability flywheel. Returning to our second quarter results. Gross margin expanded 200 basis points to 27.5%. Driving 200 basis points of gross margin improvement in this difficult operating environment reflects our focused execution across multiple customer offerings and the strong and recurring purchase behaviors of our customers' overtime, combined with the benefits of our scale. The pricing and promotion environment remained stable throughout Q2, and we estimated that this benefited gross margins by approximately 50 basis points. As was the case across much of the economy, labor market challenges persisted throughout Q2. This impeded our ability to staff our FCs at desired levels and achieve optimal productivity. Aligned with the expectations we shared with you on previous earnings calls, we increased our investments in wages, benefits and hiring incentives across our fulfillment network in order to maintain customer experience and business continuity. As a result of these increased investments, Q2 SG&A leverage was minimal. Marketing is an area where the landscape evolved rapidly in Q2. The 80 basis point increase in advertising and marketing expenses as a percent of net sales in Q2 is the result of two main drivers. The first is the sharp recovery of input costs across advertising platforms. While this was expected to some degree, the magnitude of increase in Q2 was unprecedented. And second, seeing early signs of benefits from our continuous learning approach, we invested dollars into the opening of new marketing channels, which we believe will drive incremental long-term customer acquisition and build brand awareness. Usually, we see a couple of quarters lag between the initial investment in a new marketing channel and the realization of returns as those channels scale. The Q2 gross margin gains that were driven by our strong operating performance more than offset the environmental challenges from higher FC labor costs and elevated marketing expenses and Q2 adjusted EBITDA margin expanded 20 basis points to 1.1% and adjusted EBITDA increased 51% to $23.3 million. Mario will provide more color to this line item. Next, I'm excited to share some of the many innovations we've been working on at Chewy. These initiatives are improving operational efficiency, driving higher customer engagement and advancing sustainability. Collectively, we believe these efforts will unlock additional top line growth and support long-term profitability. Let me start by updating you on the latest developments across our fulfillment network. We recently announced that our 14th fulfillment center and fourth automated FC will open near Nashville, Tennessee, in the fall of 2022. Nashville now joins Kansas City and Reno in the pipeline of FCs that we will open over the next 12 to 14 months. Additional efficiency driving measures include technology, which custom makes boxes based on the size of the contents. This process is not only faster than manual pack-and-ship, but it also reduces the amount of corrugate and packaging materials used per order, which then reduces costs and is better for the environment. We are also refining our pick, pack and ship processes to reduce the time spent, configuring box content, which helps expedite how quickly packages leave our FCs. Collectively, once these three automated facilities and efficiency measures are fully ramped, we expect that increased fulfillment productivity will produce 40 to 60 basis points of incremental SG&A operating leverage and reduce our future exposure to labor market volatility. We are also deploying new software across our FC network to improve productivity, reduce per unit fulfillment costs, and positively impact sustainability. For example, in the second quarter, we launched proprietary machine learning-driven software, which streamlines order routing and allocation across our growing FC network to optimize shipment volume, customer promise and cost to fulfill. At our current scale, the fully realized benefits from this proprietary software are expected to be between 30 and 50 basis points of margin improvement. Once fully ramped across our FC network, we expect these initiatives to contribute a combined 70 to 110 basis points of incremental adjusted EBITDA margin. Moreover, these efforts have become increasingly relevant as labor markets remain challenged, transportation networks become capacity constrained, and inflationary pressures on freight costs begin to rise. Moving on to Chewy Health, we continue to think big and innovate rapidly to serve our growing base of customers and veterinarian partners. First, we are very excited to launch a marketplace for veterinarians directly on chewy.com to help them grow clinic revenues and improve experience for pet parents. This revolutionary free service enables veterinarians to choose items to list on chewy.com, set prices, create preapproved prescriptions, and earn revenue when customers place an order in clinic or purchase from them via Chewy. Moreover, the service allows millions of Chewy customers to purchase pet medications directly from their veterinarian while shopping on chewy.com with fast, free shipping directly from our nationwide network of fulfillment centers. What is even more exciting is that the back-end prescription management capability of this platform is powered by a Petscriptions product, which is currently in use at more than 8,000 clinics across the country. Collectively, we are branding this innovative new platform as Practice Hub, through which we are offering veterinarians a complete e-commerce solution for their customers. Practice Hub leverages the benefits of our quick and reliable delivery, unparalleled customer care and convenient Autoship subscription service. We look forward to sharing more details with you in our future earnings calls. Second, we are pleased to announce that our third Chewy Pharmacy will open later this year. This new facility located in Pittston, Pennsylvania, will provide fulfillment services for pet medications and special dietary food, providing Chewy Health customers in the Northeast and Mid-Atlantic with even faster delivery of pet prescriptions, and other health and wellness products. Last but not least, we continue to be pleased with the ramp of our Compounding Pharmacy service since its launch last fall. It is still early days, but the results thus far are confirming our investment thesis. Compounding net sales increased by almost 50% sequentially between Q1 and Q2 on increased order volume and larger basket sizes. And Autoship penetration increased over 250 basis points over the same period. More importantly, Compounding is attracting new customers to Chewy Health with 65% of new Compounding customers, either being new to Chewy entirely or existing Chewy customers, who are first-time health care consumers. Services like Compounding, which at the present moment, are available only to our end customers, show how Chewy is uniquely positioned to assist pet parents, who need customized solutions in an otherwise limited marketplace. Here at Chewy, we are pleased with and proud of our progress in the pet health care space. With every innovation that proves customer or vet experience, we progress one step closer to fulfilling our mission to make pet health care more affordable and accessible for every pet parent in the country, and we are doing so by keeping veterinarians at the center of the equation. Further, each new product or service that we launch to benefit our customers or vet partners, further positions us as the only player in the pet industry, who is building out a full pet health care ecosystem that effectively services both pet parents and veterinarians. In doing so, we are positioning ourselves to assume market leadership in the $35 billion TAM. Our pet health and wellness offerings from Chewy Health include OTC medicines, veterinary diet, pharmacy, Compounding medication, telehealth, Petscriptions, and now Practice Hub, a unique and innovative marketplace that provides the vet community a complete e-commerce solution that leverages all the strengths of chewy.com. More importantly, we are just getting started. In addition to what we have shared today, we are working on multiple new initiatives across Chewy Health, and we look forward to sharing these with you in the not-too-distant future. Let's exit these innovation updates with a brief check-in on our newest launch fresh prepared foods. Our expansion in the fresh and prepared food space continues as planned. The launch is still in early days, and we are refining the product and service offerings based on customer feedback, keeping food safety and customer experience top of mind. Here are a few data points to apprise you of the ramp. We can now successfully ship product in custom designed sustainable packaging to customers across 25 states, covering 56% of the U.S. population. Overall customer feedback is positive, and we continue to fine-tune our product and service offering based on this feedback. Fresh and prepared Autoship sales as a percent of net sales are already approaching 50%. With fresh and prepared foods, we intend to deliver a customer experience that will rival how pet parents shop today by offering them a broad selection, great prices and the unparalleled convenience and customer service that are Chewy's hallmark. I will conclude my remarks by reiterating my confidence in our second half outlook. Despite the uncertainty of the current operating environment, we continue to execute our business plan with rigor and enthusiasm. Our fundamental growth drivers, expanding our customer base, increasing share of wallet and building out our highly profitable verticals remain intact. We continue to drive year-over-year improvements in key metrics like net sales, gross margin, adjusted EBITDA margin, NSPAC and free cash flow. And finally, amidst all the ongoing uncertainty the Chewy team remains as relentless and customer-obsessed as ever, delivering new and exciting experiences to our pet parents and delivering top and bottom line growth for our shareholders. With that, I will now turn the call over to Mario.

Thank you, Sumit. I am happy to share our results as the execution of our long-term growth strategy continues to bear fruit. Beginning with our top line results, second quarter net sales were $2.16 billion, representing 26.8% growth. On a two-year stack basis, Q2 2021 sales were $1 billion higher than the second quarter of 2019. Out of stock levels remained elevated in the second quarter, but they improved modestly versus the first quarter, resulting in a smaller drag on net sales in Q2. This is a result of supply chain conditions improving in some areas as certain vendors reduced backlogs. However, other areas like wet dog food are still being affected by industry-wide production capacity limitations. Second quarter Autoship customer sales increased 30.3% to $1.51 billion or a 37.6% CAGR over the last two years. Second quarter Autoship customer sales as a percentage of net sales increased 200 basis points to 70.3%. This improvement in Autoship penetration rate reflects maturation of the 2020 customer cohort in AutoShip's growing value proposition. Active customers were 20.1 million at the end of Q2, an increase of 21.1% year-over-year. As a reminder, net customer adds are a function of new customers added in the period and the retention of customers acquired in prior periods. As Sumit mentioned, year-to-date gross customer adds are running 20% above the comparable pre-pandemic period in 2019 and retention rates are stable. To better demonstrate the dynamics of new customer adds and retention as they relate to net active customer adds, we have included a supplemental section on this topic in our shareholder letter this quarter. Second quarter net sales per active customer or NSPAC increased $48 or 13.5% to $404. This was a $16 sequential increase over Q1. On an absolute dollar basis, both the year-over-year and sequential NSPAC increases were the largest in the Company's history. We expect that NSPAC growth will remain strong for the balance of the year as the 2020 cohort continues to mature, and we expand our customer offerings. Moving down to income statement, second quarter gross margin increased 200 basis points to 27.5%. Delivering 200 basis points of gross margin expansion in the current environment is a strong testament to our ability to scale our operations, increased share of wallet and build a strong recurring revenue base by delivering best-in-class customer service to each and every pet parent. Second quarter operating expenses, which include SG&A and advertising and marketing, were $609.6 million or 28.3% of net sales compared to 27.4% in the second quarter 2020. The increase reflects the incremental investments we made in both SG&A to overcome the current demand and supply imbalance in labor markets, and in marketing. I will expand on both of these areas next. SG&A, which includes all fulfillment and customer service costs, credit card processing fees, corporate overhead and share-based compensation, totaled $437.7 million in the second quarter or 20.3% of net sales compared to 20.2% in the second quarter of 2020. SG&A, excluding share-based compensation, totaled $412.1 million in the second quarter of 2021 or 19.1% of net sales, an increase of 110 basis points. This increase reflects the incremental $30 million we invested in wages, hiring incentives, and recruiting in the second quarter. Not only was it budget that's been in line with the Q2 expectations we outlined on our last earnings call, but it is also approximately twice as much as we spent on these items in the first quarter. Without this $30 million of additional labor expenses, second quarter SG&A, excluding share-based compensation, would have scaled 30 basis points year-over-year to 17.7% of net sales. Said differently, the permanent leverage in SG&A that we have delivered and expect to deliver in the future is being offset by temporary macro factors that are driving incremental costs. This demonstrates our ability to fund needed FC capacity and still leverage operating expenses. We believe that the investments we are making in our team members, automation and technology will drive higher engagement, retention and productivity, enabling us to effectively scale SG&A over the long term. Second quarter advertising and marketing was $172 million or 8% of net sales, an 80 basis point increase versus second quarter 2020. While we expected an increase in this line item as ad rates have been on an upward trend since bottoming out in early 2020, and organic customer growth rates have returned to pre-pandemic levels, the rate of increase we saw in Q2 was unprecedented, even for the seasonally strong quarter. As we enter the third quarter, ad rates have moderated somewhat, but still remain above Q1 levels. It is worth noting that even with these two factors at play, when we take a two-year view, marketing spend in the second quarter scaled 160 basis points, while at the same time, we acquired more customers in the second quarter of this year than we did in second quarter 2019. What this reflects is the efficacy of our marketing spend, which primarily focuses on acquiring and then developing customers to produce higher levels of profitable sales that increase the longer they stay with us. As a result, marketing scales as we grow. This, combined with improvements in gross margin, drives our LTV DPAC ratios over time. Second quarter net loss was $16.7 million, improving $16.1 million versus the second quarter of 2020, and net margin improved 110 basis points to a negative 0.8%. Adjusted EBITDA was $23.3 million, improving $7.8 million versus the second quarter of 2020 and adjusted EBITDA margin improved 20 basis points to 1.1%. As we have previously shared, we expect to make gradual and incremental improvement in profitability on an annual basis while retaining the flexibility to make short-term investments in a given quarter for the long-term benefit of the Company and our shareholders. Moving on to free cash flow. Second quarter free cash flow was $60.3 million, reflecting $85.1 million in positive cash flow from operating activities and $24.8 million of capital expenditures. The positive operating cash in Q2 was primarily a function of favorable working capital, only partially offset by growth in our inventory levels as we work to protect our supply chain. Capital investments included additions to our fulfillment network, including cash outlays for our new FCs in Pennsylvania and Kansas City as well as ongoing IT projects. We finished the quarter with $725 million of cash and cash equivalents on the balance sheet and no debt. In addition, we recently upsized our ABL facility to $500 million. This facility remains undrawn, and combined with our cash on hand, provides us over $1.2 billion in available liquidity. That concludes my second quarter recap. So now let's discuss our third quarter and full year guidance. Environmental crosscurrents continue to make precision forecasting difficult. Macro conditions seem to be improving as vaccination levels increased, although the Delta variant is clouding that picture. At the same time, supply chain and labor market challenges remain, and no one really knows how long or to what extent these might prevail. Still, there's a lot to be bullish about as the trends toward increased pet ownership, higher per pet spending, and category shift towards online, all remain positive. Consumers may have started redirecting some of their discretionary spending back to areas like travel or dining out, but on the whole spending on the family pet isn't really discretionary. While there may be a few less indulgences on treats and toys as we return to the office and some consumers might cross shop more as they venture out and about, we don't believe that it's going to alter the long-term trajectory of the pet category's ongoing shift towards greater online penetration. In fact, Chewy's growing product and service offerings, compelling value proposition and unparalleled customer service have positioned us well to capitalize on the industry's expected growth and to keep gaining market share as sales continue to migrate online. Despite the elevated opacity of the current operating environment, we remain confident in our ability to deliver another year of strong top line growth and adjusted EBITDA margin expansion. With that, we are reiterating our full year top and bottom line outlook as follows. We expect third quarter net sales to be between $2.20 billion and $2.22 billion, representing 23% to 25% year-over-year growth. We expect our full year 2021 net sales to be between $8.9 billion and $9.0 billion, representing 25% to 26% year-over-year growth. And finally, we expect our full year 2021 adjusted EBITDA margin to expand between 80 and 120 basis points. As you update your models, please keep the following in mind. We still expect to add more new customers this year than we did in 2019, but not as many as we did during the pandemic last year. Normal attrition rates for a cohort as large as 2020 creates a meaningful headwind against net active customer adds this year. We expect this to be a one-year phenomenon and the delta between gross and net adds is anticipated to normalize next year. As I mentioned, we added a supplemental section on this topic to our shareholder letter this quarter. So please check that out for more details on the mechanics and math behind net active customer adds. Additionally, if the current labor shortages persist, they may lead to delays in orders leaving our FCs, similar to what we saw in the second quarter of last year, as demand surged and shipments lagged. This could affect reported net sales, because we do not book the revenue from an order until it ships. To be clear, this simply affects the timing of when sales are recognized, as reported revenue shifts from one quarter into the next. Any potential inter-quarter revenue facing is not incorporated into our current guidance, and improvements in the labor market could reduce or fully mitigate any risk. As we continue to execute against our strategic plan of increasing scale, growing share of wallet and expanding our product and service offerings, we remain focused on operational discipline and on driving meaningful margin expansion. Our 2021 guidance reflects net sales growth of 25% or better and adjusted EBITDA that is approximately 2x what we generated last year. We are delivering incremental profitability; at the same time, we are making meaningful investments in the infrastructure that will support our growth as evidenced by the fact that we will nearly double our fulfillment footprint in two years. In short, we are bullish about Chewy's future. And with that, I'll turn the call over to the operator.

We will now begin the question-and-answer session. [Operator Instructions] Our first question today comes from Steph Wissink with Jefferies.

Thank you. Good afternoon everyone. We have two questions. One is more of a technical question just on your comments on the wet food still being limited. If you could just talk a little bit about what you think that might have been as an impact to Q2 sales? And then maybe if you could talk a little bit about the NSPAC, it seems like it's coming in much stronger than we would have expected even at this point in your maturation. So talk a little bit about how you're thinking about NSPAC contribution? I think you mentioned balance across net adds and NSPAC. But how are you thinking about NSPAC over the back half of the year and then maybe as we think about 2022?

Hi, Steph, this is Sumit. I'll take the first one. Mario will take the second one. We estimate the impact to be lower than Q1 and in the range of $25 million to $30 million for wet food production.

Steph, this is Mario. I'll take the second part. So NSPAC, you're right. The strength in NSPAC is meaningful. In fact, if you look at the $404 that we reported in the second quarter, and you look back sequentially and year-over-year, that is the fastest growth we've seen in dollar terms for that metric. But let me sort of give you color around what's happening around NSPAC. So if we start with the cohort that joined us in the first half of 2020, since that's been a topic of conversation in the past. We now have at least one full year of data for the cohort. Those customers now have a NSPAC in the following four quarters since joining of over $400. That's higher than cohorts in 2019 and the first year following their acquisition. So what it tells us is that the hypothesis we had, that not only were those customers were going to spend more upfront, but their spend was going forward would be higher holds. Think about it in terms of the NSPAC curve that we've shared with you in the past, we believe that curve has shifted upwards for that cohort. So that's very positive, right? We also had a hypothesis that -- and we shared this with you last year that the 2020 cohort will develop LTV profiles that were as good, if not better than predecessor cohorts. And so far, that's also proving out to be the case. Now if we think about customer behavior more broadly, the average spend per new customer in the second quarter was higher than last year. So that the average spend per new customer in the quarter continues to rise year-over-year, and we've seen that trend in the last few quarters. Autoship sign-up rates remained strong and they're running higher than last year, and the average basket size remained above pre-pandemic levels. And the sales mix within our basket size is supporting the gross margin expansion. So, all those metrics and all those factors are helping in the various line items. Moreover, I think if you go back longer trend customer behavior, again, going back to what we shared with you in the past, remember that customer spend more the longer they stay with us -- they stay with us. And those trends have repeated themselves year after year after year since our launch. And to give you an example of that, every cohort that we acquired in 2015 and prior to 2015, has a NSPAC in the last 12 months of over $800. So again, all the trends, all the metrics that we're seeing are still pointing in the right direction.

Our next question comes from Mark Mahaney with Evercore ISI.

Okay, thanks. Let me ask a couple, please. First is, you talked about leaning more into some -- leaning into some new marketing channels, but I don't think you described what those were. Any color on those?

Hey, Mark, this is Sumit. No, we haven't provided color on those, Mark. Just on the basis of sensitivity and information that we're still kind of experimenting and don't want reveal publicly at this point.

Okay. Understood. Then let me switch. These elevated costs you're seeing in labor and marketing, there's no particular reason why you have visibility and to when those would change. Like as you think about it, to the extent to which they're temporary or permanent, I don't think there's a way to answer that, but do you have a strong point of view as to whether those elevated costs in both of those areas are things that are they permanent? Or is it after three or four quarters, those should abate, any opinion on that?

When you say both areas, you mean labor and which one is the second area?

And Mario, you talked about rising ad costs, price per ad.

Okay. Let me provide color on both. So on labor, no, we don't have perfect visibility. What we are is we're triangulating data across markets where we have fulfillment centers and the forecasted -- our forecast and the fill that we are getting as a result of that, both in terms of short-term and long-term fill rates. And we've triangulated data to understand the impact of where the pandemic or the Fed benefits have retained versus where they have expired. And the correlation to what labor inflow or increase they provided to us on an index basis. So what we have seen so far, Mark, is that the states where pandemic or the Fed benefits have expired, have provided us somewhere between a 25% to 35% improvement in labor fill rates. And -- but the data is not -- it's empirical data, and we're triangulating across a couple of different sources, but we are tracking it closely. We don't have full confidence on how the situation might evolve, but we are waiting for labor markets to kind of reveal themselves in terms of data points a bit stronger over the next couple of weeks, so that we can move into Q3 in the appropriate manner. For now, we're maintaining the level of investments that we've committed to make sure that there is business continuity and customer experience preservation in terms of managing our shipments. Coming to marketing, marketing is an area where the landscape evolved rapidly in Q2. And a part of this was expected in terms of add cost recovery and participation rates improving from all players, online and retail. The rate, of course, as Mario mentioned, was unprecedented, and I'll give you a little bit of color there here in the next one minute. And then -- and so what we really saw was overall shopper demand in the online in pet category in Q2 was flat to slightly down on a year-over-year basis. And before it started picking up again and towards the latter part of July and that uptick has actually continued into August. Amidst flat to declining industry-level pet traffic, Chewy's traffic in Q2 approximately increased or was up approximately 20 percentage point premium to the overall industry. And that indicates both a healthy inflow of customers and it also indicates that we're actually gaining share as the year plays out. Now the online segment softness in Q2, we also saw directly correlated with May and June, which were the months where queries for travel, restaurants, local retailers were at 12 months high, which makes sense because customers are venturing out pre-Delta evolution. So to counter this traffic decrease in online and at the same time to incent consumers to revert to their pre-pandemic store shopping behavior, both retailers and e-tailers spent marketing dollars vigorously on paid channels and participated across Q2 promotional events. As a result of this behavior, we saw pricing inputs increase across the board. So just as a reference, Google CPCs climbed 51% year-to-date in pet supplies category. And Facebook's average ad prices increased 47% year-over-year. And in pet, we actually estimate CPMs increased over 80% year-over-year in these months. These have been the highest year-over-year increases that we've observed in this space. Now I'll exit by saying this. As we've alluded to before, I mean, we don't really have -- we don't really spend to a predefined marketing budget. Instead, we let the returns and the LTV to CAC ratios guide our payback philosophies. All in all, we believe we spent incremental 50 basis points or $11 million higher than our internal forecast that could be attributed to these rising ad costs. Now as we step out of Q2 into Q3, ad costs have moderated, so they are running below Q2 highs and they're running above Q1 level at this point. So that's sort of the sentiment as we move into Q2.

And sorry, one last quick question. Thanks a ton for that page -- that's Slide 17 -- Page 17. I appreciate the simple math behind that. When in your press release in the shareholder letter, you talked about retention rates being consistent. That's the same thing as saying that the churn rates are relatively consistent, that you're using the same terminology there?

Yes. Yes, we're.

Our next question comes from Doug Anmuth with JP Morgan.

Thanks for taking the question. I have two. First, just on customer additions, would you still expect 2021 to return to pre-COVID or 2019 type of levels, which would suggest bigger sequential pickup in the back half? Or is the composition of how you get that revenue a little bit different with customers somewhat below that and then just the higher NSPAC that you're seeing? And then secondly, Sumit, if you can talk a little bit about Chewy Practice Hub for vets, curious on your view of how that opens up the addressable market for prescriptions? Any early feedback you can provide from vet partners and just what you've learned from the 8,000 clinics that you've been working with on the back end so far? Thanks.

Doug, I'll take the first part of the question, and then Sumit will address your second part. But when you think about the active customer adds this year -- and this is why we included a supplemental in the shareholder letter to show you the math behind it. I would expect the impact of the very large, I would say, record-size cohort in 2020, to still moderate or mask the number of adds we have this year. Said more plainly, I would expect our net active adds this year to continue to pace at a lower rate than we saw in 2019. Now that is a one-year phenomenon. So by next year, by 2022, we expect the -- this very large cohort and the attrition that happens naturally in absolute terms to work itself through the sort of the cycle, let's call it that. On the flip side, what you have is NSPAC that is growing very quickly. So that means that the customers that we're retaining and the customers we're acquiring are spending more and more on the platform. That's a very good sign. So not only have we acquired and are retaining a very large number of customers, in fact, adding more gross adds this year than we did in 2019, those customers are spending more and more with us over time. So those are very good dynamics that lead to expanding -- growing top line that lead to expanding gross margin, because repeat orders are more profitable than the first orders. And also lead to more efficiencies in the supply chain and therefore, expanding bottom line as well. So those are good inputs in terms of netback and active customer adds.

Okay. That's very clear.

Doug, I'll take the Practice Hub. So this one we're very excited about. The way -- if you recall in previous earnings calls, I've shared that our research indicates 1/3 of pet parents do not take their pet to the vet or don't do so at a recurring frequency. So compliance is constrained or compressed in the industry that actually holds back TAM. Secondly, as this allows us to work with veterinarians more closely as direct partners, right? And we've always been clear about the fact that we're building an ecosystem where the pet, the vet and the pet parent, are all very much in the center of the equation and Chewy becomes an enabler to improve experience and complete that journey. So Practice Hub essentially allows us to accomplish both, right? That's it offers veterinarian because veterinarians offers are directly listed at chewy.com, the vets get access to 20-plus million Chewy customers and they also get the benefit and not only access to our powerful Autoship program, but they get the benefit on earning revenue on all repeat Autoship orders. So it incentivizes improvement in compliance and working with a partner like us that actually understands customers and can build on those relationships from an education and awareness and driving repeat traffic point of view. And so it just -- with this type of a proposition, it just creates a lucrative flywheel for the veterinarians to be able to effectively participate and it opens up both the marketplace for not only the TAM for the veterinarians to participate, but also consumers in the way that we will improve compliance. And then your second part of the question was the exposure. So today, we're working across several independent clinics and also a very well-known nationally recognized vet group, who have so far been onboarded and they're helping us perfect the product, which is presently available on a curated and on an invite-only basis. But as the year plays out, we are rapidly looking forward to working across the 8,000 clinics or 8,000 veterinarian practitioners that we have a partnership with, who are already using Petscriptions. So excited about what's to come next.

And what's the timing for when you think this will be kind of fully open to all that?

Yes. So we will have more to share, Doug, in Q3, but we are actively working with our vet partners, and we believe we will be fully ramped over the next couple of quarters here.

Our next question comes from Brian Fitzgerald with Wells Fargo.

I wanted to follow up on Doug's question. And it's -- in the mechanics of the Practice Hub marketplace. It sounds like it could evolve into a lead gen platform for vets eventually. And Sumit, I think you mentioned a couple of days ago on the CNBC Evolve, you said, look, we're -- the tele-vet is acting as a triage and we're at a point right now where vets are being outpaced -- their capacity is being outpaced by demand. And so it almost acts like a triage situation. Is -- Is this a situation where you could eventually parlay this into a paid product for vets, that's helping them get leads, that's helping them manage and triage things and making them more kind of productive to getting the type of work that they need to do versus kind of sorting out stuff that really didn't demand a visit?

Brian, yes, in short, we have a big bold vision for what we can do with Practice hub as we continue to develop and improve the product. We're starting out with the concept of a curated marketplace and backed by the power of Petscriptions. But your intuition and the way that we're thinking big, there are many -- yes, there are many ways that we're thinking about expanding the product and the service in the future.

And then if I could ask a quick question. Do you have a rough figure for what percentage of the pharma business or the health care business is really akin to subscriptions like antiparasiticals that heartworm pills show up every so often, you have to keep giving them to the pet?

Our Autoship subscriber rate is equal or better in the pharma space. Is that sort of where -- what you were asking? Or did I misinterpret your question?

Yes. No, that's helpful. I just -- I wasn't sure what percentage of the TAM antiparasiticals make up of that $35 billion.

I see between heart and preventatives, it makes up 80% of the total $12 billion TAM that exists between OTC and pharma medication today. So, extreme pain medication and such makes up roughly 15% to 20% of pharma.

Our next question comes from Seth Basham with Wedbush Securities.

Good luck and good afternoon. My question is on your gross add commentary. You talked about being up 20% year-to-date versus 2019. What's your expectation for the full year 2021 versus 2019?

Yes, Seth, this is Mario. I'll take this one. So look, we -- no, we don't guide to active customer adds in the year. I think the best way to think about the pacing is that -- it will -- the effect of the cohort that we acquired last year, you'll see that continue to have an impact, a masking of the gross adds we're adding this year. So -- but from a breaking down gross adds and active adds in 2020 -- 2021 that is, we don't do that.

Okay. That's fair enough. And then secondly, as it relates to the customers acquired in this second quarter, what type of LTV do you expect to add as those customers versus the customers acquired in the last year, given the record high CAC that I think that you guys are incurring this quarter?

I'll start again and Sumit may add something to it. LTV to CAC, you have to think about it in both terms. So yes, the -- potentially, there were some input costs that were higher in the second quarter, and therefore, leading to a higher CAC potentially in the second quarter. But the margin is amongst the highest we've ever recorded at 27.5%. They're also spending more upfront. So they've joined the platform and immediately started spending more and the dollars are producing at a higher margin level. So there is an indication that the LTV to CAC should be in line with historical levels. So I would say that.

The customer of today in the way that they're exposed to expanding and broad choices and offerings from us, which we've incredibly expanded over the last three years, LTV expands by several hundred dollars on an annual basis. We haven't yet put a number to it, and it's hard because we're still graduating customers through different offerings that we've developed. And some of these offerings are early stages that we're actually maturing into. But when you look at it from a maturity point of view, there are several hundred dollars of LTV to be added up top, which actually provides us a nice cushion at the expanding contribution margin to be able to tolerate CAC and to be able to participate very effectively in the marketing environment, whether it be the marketing environment of today or the future as we continue to acquire more customers and add them to our platform.

Our next question comes from Lauren Schenk with Morgan Stanley.

This is Nathan Feather on for Lauren. Can you just talk through a little bit more some of the puts and takes on gross margin expansion in the quarter? And where do you think that could have ended up without the short-term impact in terms of discounting and other?

Sure. So Mario alluded to gross margin expansion, and we've provided the details in the script, not much more to provide there. Customers continue to robustly engage across the verticals that we've built out. We continue to see our work in improving discovery search and graduating customers into buying more cross-category as well as higher-margin verticals come to fruition, combined with the benefits of our scale is how we're driving the gross margin improvements. And we saw -- we estimated a 50 basis point uplift or a 50 basis point addition to gross margin as a result of the muted pricing environment or promotional environment that we're seeing currently.

And Nathan, I would add that back to the point that Sumit made in the opening remarks, but we are implementing this technology, what we call the ORS 2.0, our order routing system, that we estimate could lead to another 30 to 50 basis points of gross margin expansion. So there are puts and takes to gross margin expansion. We see the results in the second quarter. There is -- there are some initiatives that are in place that should expand that. And also, if you look at the mix of sales, consumable versus hard goods and other, there is opportunity to continue to move some of those sales to some of the more profitable mix in the future.

Okay. Great. Thank you. And then on top of that, on the marketing side, did you see any shift in channels within the quarter in terms of where you're marketing outside of the introduction of some of those new channels? And was there any potential impact from IDFA in the quarter? Thank you.

Our marketing mix is dynamic, and we spend relative to the returns that we're getting. So we don't have a predefined budget for a predefined channel or a fixed go-to-market strategy. So it's a bit of a hard question to answer because depending upon the dynamic nature and the volatility that we saw in Q2 reacted accordingly. And then what was the second part of your question?

Just did you see any impact from the Apple App Store or the Apple fee changes IDFA?

Yes. No. We've been actually working to sort of mitigate that from the beginning in the way that our architecture is built. So no, we didn't see a material impact on that so far.

Our next question comes from Peter Keith with Piper Sandler.

Thanks and good afternoon. Maybe a follow-up on the gross margin. It looks like you're seeing continued healthy mix shift. So with all of the new engagement with pet health, I think in the past, you've talked about health running about 500 to 800 basis points above your core business. When we think about like Practice Hub and Compounding rolling in and presumably growing very quickly, does that gross margin lift change in any way for better or for worse?

Sure. It's Sumit, I'll take it. So we've said at scale, we expect health care to be 300 to 800 basis points higher gross margin than the base business. And we're on track to deliver that. And you can see some of that starting to come through in the gross margin uplift that we've continued to deliver on a year-over-year basis. And then from here on out, as I've said in the past, we have many initiatives that we're working on to complete the road map that builds out towards our long-term guide of 25% to 28%. And so far, we've reserved the right to update that guidance, because there's so much more interesting stuff for us to work on and reinvest dollars in where we see the long-term return taking place. So in terms of building out our road map, we still have a full non-health care. We have health care to build out that we are starting to open up more and be more candid with here and starting to share with all of you. We still have non-healthcare services to build out, and we still have a lot of work to do in connecting the dots to be able to engage the customer holistically across these three or four verticals that connect the pet life cycle. And at the same time, we're thinking boldly about not just end consumers in the space, but also about the community that services pet, which is also embedded in our mission statement of being the destination for pet parents, but also partners. And a few of the examples that you've seen us bring to life so far are Compounding medications, which are today a B2C offering; and now with our telehealth, where we're working with veterinarians collectively and now with Practice Hub that we've actually opened up to veterinarians. So you should continue to expect us to innovate robustly and at pace and keep you apprised of gross margin expansion in the future.

Okay. Very helpful. Separately, I was wondering if you could address the growth for small animal. I know dog and cat gets a lot of attention, but we've been hearing rumblings out there that it's actually small animal adoption that remains white hot. I was wondering, if you're seeing that in your business? And maybe is it too small to matter or any quantification of sort of the ex-dog and cat business as a percent of sales would be helpful.

Yes. Your long-term trend is correct. Overall, in the United States, we believe somewhere between 30% and 40% of pets are small pets, and they are growing at slightly higher rate than large pets. It actually makes sense as a lot of Gen Y Zs and millennials adopt pets and at least pre-pandemic, city living and dwelling was a much more or continuing to become a popular option. And when you look at the density of space and the pet type that might be more suitable, it does give a little bit of a tailwind to the small pet data point. But it's not materially shifting or has shifted to the point where we need to update our planning assumptions or educate customers in a different way so far.

Our next question comes from Chris Bottiglieri with Exane BNP Paribas.

It was helpful to see the illustrative curves. I wanted to drill a little bit deeper. I think your overall consolidated attrition rate just naturally benefits from cohort maturation, as you have more overall customers. So it just naturally blends down at least historically anyway. If we look at your two attrition rates in '21 versus 2019, were the attrition rates better in '21 than '19? If you can comment there would be helpful.

Chris, this is Mario. I'll take it. The attrition rate, no matter how we look at it, and we do look at it from many different angles, has remained -- they've all remained at the historical levels. It doesn't matter if we're looking at the 2020 cohort, or we're looking at the 2018 or 2015. The curve of -- and the high levels of retention over time for those customer cohorts, almost regardless of the size of the cohort, remains steady. So I think that's the best way to answer that.

Got you. Okay. That's helpful. And then I wanted to check in on the Freshpet offering, with your own private label product and then with Freshpet selling their products now. Can you give us a sense for like what the early -- you gave us some growth rates, was nice to see, but can you give us a sense -- are you finding that your own customers are migrating up from kind of wet food and dry food into this? Or are you conquesting new customers from other channels with this initiative? And then just lastly, there's like a perception in the market that this might be lower contribution margin just given the elevated shipping costs again with us? Like what's been your experience been so far from a contribution margin perspective? Is it similar to other consumables at a similar price point? Or has it been diluted thus far?

Sure. So for the first part of the question, it's still a very new business, and we're ramping it up with limited assortment so far. And so the customer base isn't large enough to have an interesting conversation so far. It is ramping very quickly. And so far, we are seeing both, a lot of customers migrating. So, existing Chewy customers migrating -- either fully migrating or actually using these as a topper, which I will use again in my second -- in the second part of your question. We're also seeing a lot of net new customers being acquired directly into the vertical itself. So it's supporting the investment hypothesis of existing and new customer acquisition channels. And then to answer the second part of your question, yes, it has -- from a shipping point of view, okay, shipping supplies, when you utilize dry ice or cold chain, yes, you have a little bit of a higher burden on the shipping supplies cost. But at the same time, we are very good at building baskets with consumers and being able to drive repeat purchase using our Autoship program that allows us to plan better, forecast better and control all inputs that drive operational efficiency in a much, much more efficient manner. So, on the whole, at scale, we expect this business to be contribution profit positive and accretive to the base business.

Our next question comes from Justin Kleber with Baird.

Thanks everyone. Good afternoon. Just wanted to follow up on the active customer add questions. Can you give us a sense how those gross customer adds flowed across the quarters in 2020? Were they meaningfully different than the net adds that you reported? Just trying to understand if you've already cycled over the peak period of gross adds and how that might influence the pace of net adds as we look to the back half of this year?

Justin, it's Mario. The gross adds last year were even throughout the year, almost the same number of gross adds in Q1 versus Q4, Q3, Q2. So you won't find any discernible pattern there.

Okay. And then just lastly on -- as it relates to your outlook, what are you guys assuming from a promotional perspective in your guidance? Are you embedding a gradual return to a more normalized promo environment, particularly as we head into 4Q in the holidays?

So far, yes, this is actually directly correlated to the way supply chain and out-of-stock issues and overall freight conditions improve. And so, so far, we are continuing to assume a stable and relatively muted promotional environment as we move into the back half of the year.

Okay. And if I could just sneak one more in. Just wanted to ask about new pet parents and the maturation of their spending, particularly how it evolves in year two as you cycle some of those initial purchases associated with the new pet, picking things like a crate or a catcher? If you look at spending on an annualized basis, do those new pet parents do they grow in year two in terms of overall spend? Or do you see them take a bit of a step back?

No. On a -- whether on a customer basis -- per customer basis or on a cohort basis, revenue retention improves year-over-year. And unlike a traditional e-tailer or retailer where revenue dips from year one and year two, we see a steady, predictable increase from year one into year two. We provided the shapes back in the S-1 document in 2019. But when you look at it for eight years of cohorts, very predictable, the first year is at $150 to $200, the second year jumps to $350. And with Mario's recent comments today, we're actually seeing consumer spend higher earlier. So no, we don't see a compression. If you're buying full baskets for us, yes, generally, hard goods purchases are discretionary and the buying cycle is a little bit longer. So -- but on a consumables basis, we're able to forecast repeat purchase and frequency pretty accurately. And on a net basis, the spend actually increases from year one and year two.

And our final question today comes from Steven Forbes with Guggenheim.

Good evening. Sumit, I wanted to follow up on Chewy Health. You mentioned in the release that veterinarians can now earn revenue when a customer places an order. I was curious if you could provide any context around how this revenue share compares to other options that may have today and/or whether you think the improved value proposition has now neutralized the fulfillment preference, enabling the customer to truly drive the decision process as we think about the potential for market share gains into the future?

Our offering is very competitive, and we believe that it should allow the veterinarians to be -- the vets control part of that equation in the way that they price products with us. And we might charge a small fulfillment fee and that fulfillment fee is lower than what we currently see in the marketplace. So from that standpoint, we believe this should be accretive and the vet should be very happy with the equation that -- or the overall equation when they engage with Chewy and our customers in a holistic manner. And then I'm sorry, I did not follow the second part of your question. So would you please repeat that for me?

I think you answered. I was just curious whether you think the offering, right, that you're putting forth here really neutralizes the fulfillment preference among the vets enabling your customers, right, to really drive the decision process.

Practice Hub. Yes, sure, sure. Sorry. Yes, Practice Hub is -- we believe it's completely different than any other product or service in the marketplace currently. First, the service sits on chewy.com with 20 million active customers, who now have immediate access to buy from their vet. Secondly, Chewy owns the entire customer experience. We ship for free over $49. We don't charge them for life-saving items like insulin, which currently are being charged. You could expect to pay $30 plus on a single order with services that are available out there right now. We ship fast. It gets to you in one to two days, relative to the current delivery experience is somewhere between four and six days, the way that we've benchmarked it. And then Chewy customer care team is accessible to you, which is available 24/7 on top of us delivering tremendous value proposition on a P&L basis as well as customer base. So when you say neutralize, I actually believe that this is a really compelling superior product and an industry-defining, industry disruptive product that we're bringing to life here. We're very proud of it.

Super helpful. And then just a quick one for Mario, if I may. Just regarding the software enhancements that you discussed in the prepared remarks, any timeframe behind the recognition of the benefits that were mentioned? And are there any incremental scaling benefits that we should be considering?

For the software, S-1 is fully deployed and fully ramped. There's no specific time line that I can provide you on that. But it's something that we've begun to roll out through the network. And then your second part of the question was about additional scaling benefits. Continued sale, as mix of sales shifting from -- into the higher-margin verticals that we've talked about, the simple math of increasing our repeat order base because repeat orders tend to be more profitable than the first order and then scale alone, which should provide us additional benefits over time in the supply chain efficiencies. So, there's a few tailwinds there.

What we find very encouraging and it is the fact that we continue to improve customer engagement and develop our customers and achieve the -- combined with the benefits of our scale, we continue to deliver incremental gross margin, which is tremendous. Because the work that we're doing there is structural and customer-centric and P&L centric. At the same time, the -- when you flow this down, presently, there are macro environments that are hopefully temporary in nature that are holding back kind of the flow-through that goes from the gross margin all the way down to the EBITDA line. And even with the current constraints, we've delivered roughly $300 million on a stack basis over the last two years into the P&L. And on a year-over-year basis, we will deliver 2x the EBITDA this year relative to last year. So the scale and the efficiency and the work that we're doing with customers, we believe we're on the right path and the strategy is intact.

This concludes our question-and-answer session. I'd like to turn the call back over to Sumit Singh for any closing remarks.

Thank you very much. Stay safe. Have a great evening.

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