Chewy, Inc. (CHWY) Q4 2022 Earnings Report, Transcript and Summary

Good afternoon. Thank you for attending today's Chewy Fourth Quarter Fiscal Year '22 Earnings Call. My name is Hannah, and I will be your moderator for today's call. All lines will be muted during the presentation portion of the call with an opportunity for question-and-answer session. [Operator Instructions] I would now like to pass the conference over to our host, Bob LaFleur with Chewy. Please go ahead.

Thank you for joining us on the call today to discuss our fourth quarter and full year results for fiscal 2022. Joining me today are Chewy's CEO, Sumit Singh; and CFO, Mario Marte. Our earnings release and letter to shareholders, which were filed with the SEC on Form 8-K earlier today, have been posted to the Investor Relations section of our website, investor.chewy.com. A link to the webcast of today's conference call is also available on our site. On our call today, we will be making forward-looking statements, including statements concerning Chewy's future prospects, growth, financial results, business strategies, industry trends and our ability to successfully respond to macroeconomic conditions and business risks. 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-K 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 our earnings release and letter to shareholders, which were filed with the SEC on Form 8-K earlier today and in our 10-K. These non-GAAP measures are not intended as a substitute for GAAP results. Finally, this call in its entirety is being webcast on our Investor Relations website. A replay of this call will also be available on our IR website shortly. I'd now like to turn the call over to Sumit.

Thanks, Bob, and thanks to all of you for joining us on the call. Our fourth quarter results capped an incredible year. Against the backdrop of a rapidly changing operating and economic environment, Chewy produced record high revenue, profitability and free cash flow. Chewy's dedication to serving pet parents and partners with a widening ecosystem of offerings led to another year of market share gains in the pet category, which once again demonstrated its historical resilience despite evolving macro conditions. Looking ahead, we continue to be excited about the growth opportunities for our business. The pet category has a U.S. total addressable market that is over $130 billion, which has grown consistently through the ups and downs of economic cycles. Importantly, we continue to see significant white space for expansion, and we remain committed towards innovating at a high pace across both new product and service offerings as well as technological and operational advancements. Most importantly, our strategy remains focused on relentlessly advancing our mission of being the most trusted and convenient destination for pet parents and partners everywhere. Now let's review our Q4 and full year 2022 performance followed by a discussion of our operating philosophy. After that, I will turn the call over to Mario to discuss our results in greater detail and share our 2023 guidance. Q4 net sales increased 13% to $2.71 billion, which brought our full year 2022 net sales to $10.1 billion, reflecting annual growth of approximately 14%. Non-discretionary categories, including consumables and health care remained the pillars of strength with the offset coming from discretionary categories such as hard goods. Our top line expansion reflects our success in managing the dynamic pricing environment as well as the recurring nature of our business model and our ability to expand share of wallet from our customers over time. Autoship customer sales increased 18% and generated 73% of our Q4 net sales, representing a 260 basis point increase over the prior year period. We further deepened our customer engagement with net sales per active customer, or NSPAC, growing 15% year-over-year to reach nearly $500 in Q4. With nearly 60% of our customers having joined our platform within the last three years, we believe there remains significant runway for our customers to spend progressively more with us, the longer they stay. Moving on to customers. We ended Q4 with 20.4 million active customers. We believe the modest sequential decline in active customers reflects the continued softness in discretionary spending experienced across the broader economy as well as the residual impact of attrition from our 2020 and 2021 cohorts. We anticipate returning to positive active customer growth this year and expect NSPAC will continue to strengthen. Turning to profitability metrics. Fourth quarter 2022 gross margin expanded 270 basis points to 28.1%. The significant improvement in year-over-year Q4 gross margin was driven by favorable pricing comps relative to Q4 of last year and to a lesser degree, by our ongoing supply chain and transformation. Full year 2022 gross margin improved by 130 basis points to 28% in line with the high end of our long-term guidance, continued pricing strength combined with the progress we have made in our supply chain initiatives enabled us to deliver these results. In 2023, we are excited about our ongoing work to grow high-margin verticals, many of which remain in early stages and are expected to provide gross margin tailwinds in the current year and beyond. At the same time, we expect these contributions to be balanced against our expectation of continued suppressed demand in the discretionary categories such as hard goods and the flexibility that we wish to retain to manage overall demand elasticity. To elaborate on demand elasticity, considering the magnitude of price increases that consumers have already experienced and may yet continue to experience, we will continue to take a surgical approach to optimize pricing. Additionally, with supply chains recovering, we are closely monitoring our catalog to ensure we remain competitive in light of current consumer mindset. At this point in the year, we expect the overall result of these drivers to produce a net neutral impact on gross margin in 2023. That said, over a longer time horizon, given the nascency of many of our initiatives, such as private brands, Chewy Health, including insurance, sponsored ads and more, we believe there is additional runway left for incremental gross margin expansion. Staying on profitability. Q4 adjusted EBITDA was $92 million, and adjusted EBITDA margin was 3.4%, an increase of $120 million and 460 basis points, respectively. The strong gross margin performance and SG&A leverage were the primary drivers of Q4 adjusted EBITDA growth. We saw these same key drivers manifest themselves in our full year 2022 results as adjusted EBITDA nearly quadrupled from 2021 levels to over $300 million, and adjusted EBITDA margin expanded 210 basis points to 3%. Moving away from fiscal 2022, let me now spend some time sharing our operating philosophy for 2023 and beyond as well as various growth and margin-enhancing initiatives that we plan to launch. Delivering long-term profitable growth remains our North Star. Over the past four years, we have increased revenues from $3.5 billion to over $10 billion while concurrently expanding gross margins from 20% to 28% and adjusted EBITDA margins from negative 6.5% to positive 3%. These results are both a testament to our team's focus on scaling our core businesses and our ability to ideate new ways to improve customer experience or to launch new services for customers and partners and following through with disciplined high bar execution. Our 2023 strategy is consistent with this operating philosophy, scale our existing cost base and simultaneously make purposeful investments to drive sustainable growth and profits over a multiyear period. Let me provide a few examples of each of these, starting first with how we have already driven cost leverage in our business and how we plan on further scaling our existing cost base. The supply chain transformation initiatives that we began in 2021 have helped us expand our gross margin while simultaneously improving customer experience. As a reminder, these efforts included areas such as import routing, inventory planning and placement and middle mile. Additionally, our decision to invest in fulfillment center automation in 2019 is now providing significant leverage in SG&A with meaningful upside left to go. In 2023, we plan to continue scaling these efforts and drive further SG&A leverage. For starters, given the success of our automation initiatives and the productivity benefits we are realizing in ramping our first three automated facilities, we have made the decision to close our two oldest FCs, both of which are non-automated assets. Each of the facilities are located near one of our new automated FCs, which allows us to combine operations and offer team members the ability to transfer locations. We believe that this action will enable incremental order volume to flow through our automated facilities, which we expect will allow us to realize approximately 50 basis points of additional SG&A leverage in 2023. Furthermore, we are on track to open our fourth automated facility in Nashville in the first half of this year. The punch line here is that in 2023, we expect to continue benefiting from the strategic investments we made just a few years ago in warehouse automation. Moving forward, we remain committed to demonstrating strong operating discipline in running the business and tightly managing expenses along the way. Now moving on to the investments and innovation part of our operating philosophy. In addition to leveraging our existing cost base, in 2023, we plan on making conscious investments in areas that we believe will create sustainable growth and profits over the long term and generate high ROI for our shareholders. Such areas include our higher-margin verticals, where we plan to accelerate growth. Additionally, having strengthened our fundamentals over the past few years, we believe that the time is right to bring the Chewy brand and our superior value proposition to pet parents outside of the U.S. We are actively building the capabilities and team to launch our first international market over the next few quarters. We expect this important development to unlock meaningful incremental TAM, and we are excited to introduce Chewy to a broader customer base with whom we believe our brand and mission will resonate strongly. We look forward to discussing more specific plans with you on our Q1 call. Our operating history demonstrates a strong track record of making such capital allocation decisions. Chewy Pharmacy is a powerful example of investment and execution behind a new vertical that began four years ago and is now contributing superior growth and profit at scale. Today, we operate the largest pet pharmacy in the U.S. As we have demonstrated in the past, we plan to remain highly disciplined about our level of commitment to and support of the investments that we seed and will continually evaluate them against our expectations. In closing, I'm proud of our team's relentless execution that has enabled us to deliver strong results over the course of another dynamic year. As we enter 2023, I remain incredibly optimistic about our road map ahead. With that, I will turn the call over to Mario. Mario?

Thank you, Sumit, and thank you all for joining us today. Fourth quarter net sales were $2.71 billion, a $319 million or 13.4% increase year-over-year. Our non-discretionary consumables and health care categories continued to demonstrate strength in the quarter as they had collectively represented 82% of total net sales and grew at a combined rate of 18.5% year-over-year. These favorable trends were modestly offset by a decline in sales in our hard goods category. For the full year, net sales reached $10.1 billion, increasing $1.2 billion or 13.6% year-over-year. Our Autoship business saw another year of strong growth as pet parents increasingly value the convenience and benefits of the program. Q4 Autoship customer sales increased 17.5% to $1.98 billion, exceeding the pace of our overall sales growth by 410 basis points. For the quarter, Autoship customer sales as a percent of total net sales reached 73.3%. For the full year, Autoship customer sales increased 18% to $7.4 billion, with ownership customer sales representing 73% of total net sales, a new record high on an annual basis. In Q4, Chewy continued to consolidate share of wallet from pet parents who shop with us as NSPAC reached a new record high of $495, up 15.1% or $65 year-over-year. As we have shared on previous calls, top line growth for Chewy is driven by our ability to attract and retain over time while capturing an increasing portion of their annual pet spend. In 2022, our active customer count remained relatively flat versus 2021, as we work through the short-term attrition of our record-sized cohorts acquired in the preceding two years. At the same time, customers continue to consolidate their shopping with us with our three oldest cohorts, each spending over $1,000 in 2022, and all but our two most recent cohorts spending over $500. Said differently, we believe a tremendous opportunity remains ahead of us to fully unlock the revenue potential of our existing customer base. Moving now to financials. Fourth quarter gross margin expanded 270 basis points to 28.1%. More than half of the improvement was the result of favorable comping relative to Q4 2021. The balance came from our continued supply chain transformation initiatives, leverage in freight and packaging due to increased basket sizes and other one-time true-ups. The items that were one-time in nature contributed approximately 40 basis points of benefit to our Q4 gross margin. Relative to our expectations, the lower-than-expected spend on promotions and fuel this holiday season, drove the outperformance in the quarter. Full year 2022 gross margin increased 130 basis points to 28%, a new full year record high. As Sumit noted in his comments, our ability to maintain pricing strength overcame persistent cost inflation, and our team's hard work across various supply chain and logistics initiatives continued through Q4. Collectively, they also helped achieve gross margin outperformance relative to our expectations at the beginning of the year. Moving to OpEx. SG&A, which includes all fulfillment and customer service costs, credit card processing fees, corporate overhead and share-based compensation, totaled $561 million in the fourth quarter or 20.7% of net sales, scaling 90 basis points compared to the fourth quarter of 2021. On a full year basis, 2022 SG&A deleveraged by 50 basis points to 21%, sorely due to higher share-based compensation. Excluding share-based compensation, SG&A totaled $510.8 million or 18.9% of net sales. This is an improvement of 210 basis points compared to the fourth quarter of 2021. On a full year basis, SG&A, excluding share-based compensation, leveraged 20 basis points to 19.4%. Now I'll take a moment to walk through the details of how we were able to scale SG&A, excluding share-based compensation in Q4. Variable fulfillment and customer service costs provided 170 basis points of year-over-year SG&A leverage in the fourth quarter. Our variable fulfillment costs declined as a result of productivity gains and continued volume shift into our automated facilities, which collectively drove a 13% year-over-year reduction in system-wide variable fulfillment cost per order. Additionally, our improving in-stock position, supply chain initiatives and technology deployments across our customer care organization have improved overall customer experience, resulting in fewer customer contacts. This led to a 15% year-over-year reduction in customer service cost per order. We drove additional leverage of 70 basis points through our automated fulfillment centers as they absorb more incremental fixed carrying costs alongside with our ongoing management of corporate expenses. Partially offsetting these gains are the investments in personnel and technology we began making in Q4 2021 to support the many initiatives we shared with you throughout the year as well as the higher D&A costs associated with the facilities we launched in the last year. Altogether, these areas contributed approximately 30 basis points of year-over-year deleveraging. These results are consistent with our stated operating philosophy, scale-based costs, fund new initiatives, grow revenue and profits from those new initiatives and redeploy some of the gains into additional areas that we believe will drive further growth and profitability over time. Moving on to marketing. Fourth quarter advertising and marketing was $183.4 million or 6.8% of net sales, a 40 basis point increase from Q4 2021. Sequentially, advertising and marketing expenses scaled by 20 basis points as a result of the marketing efficiencies we normally see in the fourth quarter. On a full year basis, advertising and marketing represented 6.4% of net sales scaling 60 basis points versus 2021. For both the quarter and year, our marketing spend was in line with our expectation of 6% to 7%. Wrapping up the income statement, fourth quarter net income was $6.1 million and net margin was 0.2%, a year-over-year improvement of 290 basis points. We marked our first full year of positive GAAP net income in 2022 with a reported $49.2 million in net income, a $123 million improvement versus 2021. Our net margin reached 0.5%, expanding by 130 basis points versus 2021. Fourth quarter adjusted EBITDA was $92 million, and adjusted EBITDA margin expanded 460 basis points to 3.4%, reflecting gross margin momentum and SG&A leverage. Full year adjusted EBITDA was positive for the third year in a row, reaching $305.9 million and adjusted EBITDA margin expanded 210 basis points year-over-year to 3%, both of which are new records for Chewy. Turning now to free cash flow. Fourth quarter free cash flow was $42.1 million, reflecting $100.6 million in net cash flow from operating activities and $58.4 million of capital expenditures. The majority of our capital expenditures in the fourth quarter were focused on future automated fulfillment center launches. For the full year, we generated $119.3 million of positive free cash flow. Full year 2022 is the first year in our history where our free cash flow generation was materially above breakeven. From the end of 2018 through 2021, we were essentially free cash flow neutral, which was in line with our growth strategy, before turning meaningfully positive in 2022. Over that period, we nearly tripled our net sales, launched six new fulfillment centers, opened three new pharmacy locations, added two new customer service centers, one dedicated pharmacy customer service center and scaled multiple other growth initiatives. We accomplished all of this without consuming any cash and while remaining debt free. We finished the year with $677.4 million of cash and cash equivalents and marketable securities on the balance sheet, $74 million higher than 2021. Further boosting our liquidity position in the fourth quarter, we expanded our ABL by $300 million to $800 million with an additional $250 million accordion that will give us incremental liquidity should we choose to exercise it. At year-end, between cash on hand, marketable securities and availability of our newly expanded ABL, total year-end liquidity stood at over $1.4 billion. That concludes my fourth quarter and full year 2022 recap. So now let's discuss our first quarter and full year 2023 outlook. Our guidance reflects a balanced view that incorporates the strength and visibility of our business model, while also providing some flexibility against an uncertain economic backdrop. With that, we expect first quarter net sales of between $2.72 billion and $2.74 billion, representing year-over-year growth of 12% to 13%. Full year 2023 net sales of between $11.1 billion and $11.3 billion, representing year-over-year growth of 10% to 12%, and full year 2023 adjusted EBITDA margin to be flat to 50 basis points below our full year 2022 adjusted EBITDA margin of 3%. Our 2023 adjusted EBITDA margin guidance reflects approximately 50 to 75 basis points of impact across SG&A and marketing as a result of the investments related to the international launch and other growth initiatives. Without the impact of these growth initiatives, our expected 2023 adjusted EBITDA margin would be around 3.5%. As you update your models for 2023, here are a few other things to keep in mind. Regarding net adds, we are maintaining a balanced view in light of the uncertain macro backdrop and the long-tail attrition for our large COVID cohorts. Therefore, we anticipate returning to net adds growth during the second half of this year. As such, we expect NSPAC to be the primary driver of revenue growth through the first half of the year before shifting to a blend of customer and NSPAC growth in the second half of the year. We anticipate our overall growth investments to be front-end loaded with adjusted EBITDA margins expected to reaccelerate in the back half of this year. We expect CapEx in full year 2023 to return to our historical target range of 1.5% to 2% of net sales and full year 2023 share-based compensation, including related taxes, to be approximately $250 million. Finally, after factoring in the investments we intend to make in 2023, we expect to generate meaningfully positive free cash flow at approximately twice the level that we generated in 2022. To conclude, our 2022 results demonstrate our unwavering focus on day-to-day execution and our ability to get big fast and fit fast. Meanwhile, we remain highly encouraged by the growth road map ahead of us, and an ongoing opportunity to maximize value for the millions of pet parents whom we serve, our team members and our shareholders alike. With that, I'll turn the call over to the operator.

Thank you. We will now begin the question-and-answer session. [Operator Instructions] The first question is from the line of Nat Schindler with Bank of America.

A couple of quick questions. So one, looking at your margin guidance of actually there is slight -- flat to slightly down EBITDA guide for this coming year. Despite the fact you have NSCAP growing, and it looks like given your revenue growth, it's going to be -- revenue growth is going to be driven as it has been recently by NSCAP more than customer growth. And considering that your marketing cost is mostly customer acquisition, how would that not result other than investments in international and other, how would that not result in meaningful improvement in EBITDA? --:

Nat, it's Mario. Great to hear from you. So on -- I'll take the second question first, and then Sumit will talk about the first one. You're asking about the order declining, it's not -- that's not the case. So what you're seeing in the 10-K -- you're referring to it in the 10-K, it's more about packages that we ship out. We've been pretty consistent about the way we explained it in the 10-K. The reason why we are able to ship out fewer packages is because we are continuing to get better at cartonization, meaning we can fit more of an order into a single package, and therefore, lower our freight costs, as you can imagine, our packaging costs as well and improve the customer experience. So we do that because we're expanding our network and because we're just getting better and better at inventory placement. So a lot of good work has been done behind the scenes. And Sumit will answer the first question.

Nat, this is Sumit. When you look at margin, I mean, 2022, I think it's important to frame up 2022 EBITDA in context of kind of how the year has played out. And EBITDA margin for 2022 was a result of strong gross margin performance and added to that SG&A leverage that we drove. So when you look at particularly gross margin, that was a result of pricing strength, combined with our work on supply chain transformation, offset by the headwinds that we faced on the freight and logistics side. So when you move that forward to 2023, we do not expect pricing leverage benefit as we did in 2022, including pricing float benefit, where pricing exceeded cost for a few months, if you recall. Further -- I mean we expect continued gross margin expansion driven by our efforts in higher-margin verticals. At the same time, given the uncertainties associated with the current macro backdrop, this guidance reflects a nuanced assessment of risks and opportunities and an appropriate level of cautiousness that we've baked in, which we are constantly monitoring performance around. And as always, we'll update guidance. Like for example, we're currently leaving room for the category to be slightly more promotional than last year. And should this not bear out, that could potentially create upside to our outlook. We're also not assuming any hard goods reacceleration happening in 2023 to any material degree. And to the extent that there's a macro reacceleration in hard goods, that should actually impact both sales and margin. And so there's assumptions like those that are built in, which are essentially having us guide to gross margin net neutrality. And then when you come down to the SG&A side, we're basically leveraging SG&A, but we're reinvesting the leverage back into driving growth. And as a result, our EBITDA guide kind of comes out at this point of the year in a way that we're guiding today.

Makes sense, but how much are you putting in is assumed in there in the international expansion in costs? So I assume that's almost no revenue.

Yes. We haven't -- we're not quantifying the two separately. But broadly speaking, 50 to 75 basis of investments in growth initiatives, including international, but it's safe to say that the largest contributor of the 50 to 75 is in the international.

And then when it comes to top line, active customers NSPAC, Nat, we are not assuming any material impact for those from the launch at this point.

Yes. Any impact -- we're not assuming any impact to core as well. Yes.

The next question is from Anna Andreeva with Needham. You may proceed.

Great. Two questions. In the past, I think you talked about international growth and margin expansion simultaneously. So could you talk about the specific buckets of investments in '23? And international typically takes a while to scale to domestic profitability. So does this change your longer-term goal for high single-digit EBITDA margin? That's my first question. And then secondly, you mentioned net adds improving in the back half. Are you seeing any improvements in the business quarter-to-date to give you any confidence for that back half improvement?

Anna, this is Mario. I'll take the first question, and Sumit will answer the second one. But when it comes to the investments in international, most of that you're going to see in SG&A and marketing. As we said, the 50 to 75 basis points, you'll hear us say that a few times. The largest portion of that is going to be international. No real material impact top line, gross margin, et cetera, in terms of investment for international launch.

The only thing to add, Anna, there is as we ramp up demand, we're going to view the market opportunistically. And if there is an opportunity to invest at the top -- to drive top line, there may be some gross margin impact there, but all of that is built into our guidance today. And then your second question -- go ahead.

Okay. That's helpful. On the net add improvements in the back half. Just curious, if you're seeing any improvements in the business quarter-to-date to give you confidence there?

Well, what we said on the early remarks was that we expect net adds to begin to improve in the second half of the year for that active customer base to grow in the second half of the year. We're stepping into it carefully into the first half. We still have the long tail attrition from the 2020, '21 cohorts to work through. And of course, there's still some somewhat subdued demand for -- in the discretionary categories, hard goods. So we expect there will be more in the second half of the year.

And, Anna, our gross adds rate continues at mid- to high single digit higher than pre-pandemic and our reactivations also continue to be strong. So to the extent that those could be considered signals, I think you could take that into account, and then Mario's answer kind of rounds out the perspective.

Yes. I would add to that, Sumit, the retention for those cohorts is basically in line with what we have said in the past. So that's also a good indicator for us that things are stable on that end.

The next question is from the line of Mark Mahaney with Evercore ISI. You may proceed.

Great. This is Jian Li for Mark Mahaney. First, I want to just ask on -- I guess, higher-level question on the international. If you can just talk through what is kind of the TAM opportunity you see for international market? And how are you going about -- like what's the game plan for expansion? Are you thinking about it mostly -- it sounds like it's going to be organic expansion. Are you considering inorganic? And if you can kind of talk through the key regions? That's my first.

Sure, Jian. This is Sumit. I'll take it. So international expansion has long been a part of our strategy, as we've noted on prior calls, it was a matter of when, not if Chewy would take our superior value proposition into new geographies. So we're excited to talk about it now. We took into account the size of TAM, the geographic proximity and consumer behavior similarities to the U.S., among other factors, as we thought about entry markets that possess attractive characteristics for our initial international expansion plans. And yes, at this point, this is an organic play, not an acquisition per se. In terms of operationalization, I would say, consistent with our track record of operationalizing investments, such as pharmacy could be one. We are thinking about our international plans and stages with certain milestones that will responsibly govern the pace of our expansion. And then as Mario already noted a few minutes earlier, the revenue active customer and NSPAC impact of launching international operations is fully reflected in our guidance and is not a material contributor to any of those items in the guidance or for core. We -- that's as much as we can share today. We're excited about sharing more details on our Q1 call.

Great. And one more on the gross margin. Beyond this year -- this is, I think, the third quarter that you hit the high end of your current long-term gross margin. So how should we think about kind of an updated long-term gross margin target beyond this year? And what are the key drivers to that? I think you mentioned the -- this year going to accelerate some higher-margin verticals. So if you can kind of expand on that?

Sure. This is Sumit again. So we're excited about the continued gross margin or the continued journey that we're on to expand our gross margins. In the core businesses, we have continued work to do on our private brand area. Private brands is mid- to high single digit, and we want to get it to between 15% and 30% of net sales. At that ratio, we expect several hundred basis points higher premium to our core business as that business achieves that penetration level. Number two, when you look at Chewy Health, Chewy Health is in its early stages relative to categories such as pharmacy. And we have a tremendous runway in this category as consumers more and more shift their preferences to online, and Chewy leads in delivering customer value proposition in that particular area. It is also a tremendous NSPAC expansion driver for us and is fueling both our growth and mix impact on our gross margin performance. On top of that, then there are verticals which are more nascent in their categories. Sponsored ads is the next one that we are quickly ramping up, happy to click into details if anybody is interested. But we're pleased with the progress there. We will expect to bring sponsor live at a more fuller scale this year ramping into 2024. Behind that is our categories like insurance, which are on slightly longer arcs because you have to build customer consideration and the consideration to conversion arc there is slightly longer, and therefore, those might be on a one- to three-year arc and can contribute meaningful gross margin expansion opportunities as well. And then last but not least, our continued work on either expanding our Autoship benefits, working towards loyalty programs or continued supply chain initiatives that we've talked about, provide us tailwind opportunities in the future. So we're excited. There's a lot of work in front of us. This will not be easy, but at the same time, we have a clear road map and the team's hard work so far has paid off, and we will continue to remain resilient and focused as we play through 2023 and beyond.

Great. And if I might just like one quick follow-up to that. Is there any -- I guess, can you quantify how much of sponsored ads is embedded in the full year guide?

Yes. At this point, it's still fairly small. It's still a small expectations for this year. We're just ramping -- we're excited about where it is and the trajectory it's on, but it's still not a meaningful driver yet.

The next question is from the line of Doug Anmuth with JPMorgan. You may proceed.

Just on the international expansion, is it safe to assume that at the core, you'll be looking to replicate the strong and differentiated approach in terms of customer service? So that's number one. And then second, just circling back to the customer growth in '23. Just trying to understand really what drives the confidence there given that you're not really building in either macro improvement or discretionary product really coming back much. It sounds like it's just some improvement or working through the big cohort over the last couple of years.

Sure. Doug, this is Sumit. So on international, your assumption is 100% right. We plan and expect to bring all components of our value proposition to the international market. And at the same time, we are going to be very actively listening to the voice of the customer and designing our launch working backwards from that. So that there is no dissidence in the way that we show up in the cultural nuances as Chewy's brand enters the international market. On the balance, we are excited and confident about our brands' resilience and extension outside of the United States per se. So that's the first one. In terms of customer adds, there are several programs that we are working internally inside the Company, which are -- they're not dependent on the macro, but despite the macro, we are excited about these particular programs. These are -- when you look at kind of the way that we're optimizing our site, improving our search results, maximizing conversion, particularly as it comes to new search traffic that lands on our website. And we're seeing some early, very early signs of goodness there. Number two, we've talked about this in the past where Chewy is not actively invested in CRM type capability, and we're building out our CRM capability in 2023 to a much more fuller extent than we had in 2022. Now the work will continue through 2023. But again, these are programs that allows us to recognize customers, segment them accordingly, target them and then track them through their life cycle to be able to either incentivize, motivate or offer propositions to be able to reactivate towards Chewy at a greater degree. So the combination of those two kind of gives us confidence that there is more than just the market that is happening inside Chewy. But of course, we have to bring these to life and play them through.

The next question is from Corey Grady with Jefferies. You may proceed.

I wanted to ask about the automated FC initiative. So apologies if I missed this, but what percent of volumes did you say are running through the automated fulfillment centers currently? And where do you think that can get by the end of the year? And then what's assumed in that 50 bps of SG&A leverage?

Yes, this is -- Corey, this is Mario. I'll answer that. So, we've said that we're about 30% of the volume going through automated facilities at this point, which is an increase from where we were certainly in the third quarter and almost double the volume that was going through our quarter at the same time last year, meaning Q4 '21. But we haven't given a target by the end of the year. But you can see that we're going from having three out of 13 to now having four facilities are automated out of 13 once we launch our Nashville in the next couple of months. So, we are -- we continue to move volume into the automated facilities for many reasons. One of them, obviously, is a lower cost to variable cost per order, which then flows through to SG&A and EBITDA. So we'll continue to push as much volume as we can into those facilities. Anything to add, Sumit?

No. Corey, did you have a follow-up? Or was that the main question?

Yes. If I can, I'll ask a quick follow-up. I would love for you to just say more about the sponsored ads beta? I mean I don't know if you can share speak to any initial learnings, customer feedback? Any update around timing of full launch? And any change in how you're thinking about the long-term opportunity?

Sure, sure. So we're pleased with the progress of the sponsored ad vertical. The beta that we launched in Q4 has continued building towards the full product, which we expect to have live in the first half of 2023 as per original expectations. Our team is hard at work right now on the supply side of the platform, where we expect to deliver a great customer and partner experience with improvements in ad serving, tracking and relevance. The reception from brands has been and continues to be positive, including the reception on our ROAs framework. So we're looking forward to the program launch in first half and then continuing to ramp throughout 2023 and into 2024.

Our next question is from Seth Basham with Wedbush. You may proceed.

My question is on gross adds. Good to hear your continued mid- to high single-digit growth there. As you look to 2023, you're expecting that type of growth to continue, and what does that mean for advertising growth?

Yes. Seth, this is Mario. So yes, so we are continuing to see strength in gross adds versus the pre-pandemic. In fact, you've heard us talk about all year that we've been in the -- somewhere in the 6% to 10% range, give or take, increase versus the same quarter 2019, and that continued into Q4. So that's a good indicator for us, the strength of the platform. For '23, let me not try to split out between gross adds and net and retention initiatives. But you've heard us certainly explain what we think is going to happen to our -- we project is going to happen to our active customer base and how we expect it to grow in the second half of the year. But it's going to be a combination of those two things, continue to reactivate and add brand-new customers and work hard to keep the ones that are on the platform.

Okay. Fair enough. And then as a follow-up, just thinking about the 2020, 2021 cohorts with the churn rates. Are those churn rates higher than you expected even just three months ago? And how is the 2022 cohort repeat purchase behavior trending?

Let me see if I can decouple that into the two separate questions. The -- when it comes to the '20 and '21 cohorts, the retention levels have continued to remain more or less what we expected, and we have been talking about for several quarters now. High, but it's still low single digits, lower than pre-COVID cohorts. And that has been pretty steady for several quarters at this point. The repeat purchase behavior of the 2022 cohorts. Well, you probably heard us say early in '22 that we were trending to acquire more customers into our non-discretionary categories, the repeatable categories, consumables, health care. And so that's -- the behavior has proven out throughout the year.

The next question is from Brian Fitzgerald with Wells Fargo. You may proceed.

We think this is the first time you provided a specific growth breakout for non-discretionary. Wondering if you could give us some color on how discretionary has been tracking? Have you seen any trend improvement? How are you thinking about cycling the discretionary weakness and potentially getting back to growth at some point in 2023?

Brian, this is Mario. Let me try to clarify the question here. You're saying we provide specific guidance. Are you talking about how -- when we talk about the discretionary part, how would you expect to break on the trends that we've seen recently, is that -- just to be specific about?

We think this is the first time you kind of broke out discretionary versus non-discretionary growth. So we're wondering on the discretionary side, how has that been tracking? And are trends improving on the discretionary side? How do you think about cycling through discretionary weakness and when it kind of gets back to stronger growth?

Brian, this is Sumit. So discretionary continues to be suppressed and pressured. When you look at hard goods, second half was better than first half. That was primarily due to easier comps. When you look at hard goods sequentially, Q4 ramped because of seasonality and was expected. So at this time, as it comes to discretionary categories, and we're baking in things like hard goods, creates and stuff like that, we're not expecting a material reacceleration in '23. And we stand prepared to invest if we see further deterioration or opportunities alike. Ultimately, specifically as it considers categories such as hard goods, we believe that this is cyclical and tied to the inputs of the macro environment. And as the macro and those inputs improve, we expect hard goods to revert to its historical growth mode. But as of right now, we're not providing specific guidance, of course, at the category level, and we're not expecting material reacceleration in '23. That's what's baked into the guidance right now.

Our last question is from the line of Lauren Schenk with Morgan Stanley. You may proceed.

Great. Just a couple on gross margin, if I can. First, what are you assuming around price increases this year from a manufacturing perspective? Was there one in this current first quarter? And then secondly, Sumit, you mentioned in your prepared remarks, a surgical approach to optimize pricing and in the shareholder letter, you talked about sort of increasing value proposition. Are you looking to lower pricing inflect categories? Any color there would be really helpful.

So starting with the second one, no, we are not looking to actively lower prices. We are certainly vigilant across the catalog, particularly as a result of improving supply chain positions to ensure that if there is heightened market competitiveness or market activity that we stand ready to respond to that. But no, we are not actively looking to price down. Number two, in terms of price increases that we expect or have come through, those are in the low to mid-single-digit range.

Any timing of when you would accept this?

Sure. So as anticipated, we have experienced cost increases in Q1, and this is already reflected in our pricing. The market is adjusting and has adjusted well, and we're seeing overall good math compliance, Lauren. So at this point, we believe that the frequency and taste of cost increases is largely behind us. But of course, as we receive more information from our suppliers, we'll pass that on, but we're not expecting more cost increases for the balance of the year at this point.

We have reached the end of our allotted time for questions, and I will now turn the call over to Sumit for closing.

Thank you all for joining. We appreciate it, and we'll see you next time.

That concludes today's Chewy's Fourth Quarter Fiscal year '22 Earnings Call. Thank you for your participation. You may now disconnect your lines.