Petco Health and Wellness Company, Inc. (NASDAQ:WOOF) Q3 2022 Earnings Conference Call November 30, 2022 8:30 AM ET
Company Participants
Benjamin Thiele-Long – Director, Executive and Business Communications
Ron Coughlin – Chief Executive Officer
Brian LaRose – Chief Financial Officer
Conference Call Participants
Liz Suzuki – Bank of America
Simeon Gutman – Morgan Stanley
Peter Benedict – Baird
Oliver Wintermantel – Evercore ISI
Michael Lasser – UBS
Chris Bottiglieri – BNP Paribas
Steven Zaccone – Citi
Seth Basham – Wedbush
Julio Marquez – Guggenheim
Corey Grady – Jefferies
Anna Andreeva – Needham
Operator
Good morning and welcome to the Petco’s Third Quarter 2022 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Benjamin Thiele-Long, Petco’s Director of Executive and Business Communications. Please go ahead.
Benjamin Thiele-Long
Good morning, everyone and thank you for joining Petco’s third quarter 2022 earnings conference call. In addition to the earnings release, there is a presentation and infographic available to download on our website at ir.petco.com, summarizing our third quarter 2022 results.
On the call with me today are Ron Coughlin, Petco’s Chief Executive Officer; and Brian LaRose, Petco’s Chief Financial Officer. In a few moments, I will invite Ron and Brian to provide their perspective on Petco’s financial and operating performance for the quarter and the outlook and priorities for the remainder of the year.
Before they begin, I would like to remind you that on this call, we will make forward-looking statements regarding our current plans, beliefs and expectations, which are not guarantees of future performance and are subject to a number of risks and uncertainties and other factors that could cause actual results and events to deliver materially from results and events contemplated by such forward-looking statements. These risks and uncertainties include those set out in our earnings materials and our filings with the Securities and Exchange Commission. These forward-looking statements are made only as of the date marked and except as required by law, we undertake no obligation to update or revise any of them, whether as a result of new information, future events or otherwise.
In addition, today’s presentation contains references to non-GAAP financial measures. Reconciliations of these non-GAAP financial measures to the most directly comparable GAAP financial measures are included in our earnings release and our presentation as well as in our filings with the Securities and Exchange Commission. And finally, during the question-and-answer portion of today’s call and to allow us time for questions from as many participants as possible and finish the call on time, we will be grateful if you could keep to one question and one follow-up.
With that, let me turn it over to Ron.
Ron Coughlin
Thank you, Benjamin. Good morning, everyone. Our third quarter results demonstrate the resilience of our category, the strength of our unique model and dedication of our incredible Petco team members.
In a challenging macroeconomic environment, we delivered our 16th consecutive quarter of comp sales growth, added customers for the 15th consecutive quarter accelerated our Vital Care member sign-up rate, made progress in scaling our growth drivers of vet and digital, continue to see product mix shift towards premium and launch landmark partnerships leading brands. All strategic initiatives that secure Petco’s ability to deliver sustained future growth while capturing category megatrends.
Financially, on EBITDA, we did what we said we would do. And we also made tangible progress on strategic cash flow enhancing initiatives. Our consistent delivery of growth despite macro disruptions exemplifies our nimbleness, our execution capabilities and the strength of our one of a kind ecosystem in a defense growth category. Capabilities that have generated revenue growth enabled us to navigate mix pressures and continue to deliver enhanced value to a growing customer base.
In the third quarter, comparable sales were up 4%, equating to 20% and 36% on a 2 and 3-year stack. Net revenue grew by 4%. The appeal of our unique model and power of our marketing engine enable us to add over 325,000 net new customers in the quarter, bringing our total active customer base above 25 million. Recurring customer revenue, driven by repeat delivery, insurance and Vital Care, grew by 56% year-over-year. High-value multi-category customers also grew in the quarter.
Contextualize, our sales and customer growth is driven by high value customers returning to shop for premium food and supplies who like our value-oriented customers are also leaning into our loyalty and membership programs. Additionally, the drivers of future category growth remained positive, including adoption levels, which continue to increase year-over-year and relinquishments trending below pre-pandemic levels. The category resiliency and uniqueness of our health and wellness ecosystem makes Petco a powerful partner for brands wanting access to these deeply engaged, high value customers.
In the quarter, we announced a new partnership with Nationwide Insurance, which I will touch on more later, followed by an innovative new collaboration with Marriott to facilitate traveling with pets. All while our rapidly growing advertising network continues to be a draw for well-loved brands like Nestle and Colgate-Palmolive’s Hill’s. Taken together, it’s clear that in addition to selling products and services, Petco is driving innovation and becoming a pet platform company. A key component of our platform capabilities is our industry leading membership offerings. This quarter, our flagship Vital Care saw an acceleration in weekly sign-ups of over 50% fueled by addition of companion animals and enhancements to in-store registration at point-of-sale.
Now with over 400,000 active Vital Care members, an increase of 42% quarter-over-quarter and over 200% year-over-year, we are even more confident that we have designed the right offering for pet parents sitting at the intersection of value and loyalty. Vital Care members continue to bring a 3.5x higher LTV over average customers, with over a third of members new to food and new to services with Petco, driving our share of wallet expansion.
Combined with Nutrition and Grooming Perks members, now over 1.7 million, our loyalty programs make it easier and more affordable for pet parents to care for all their pets’ needs in one place, especially during these inflationary times. They provide a tool for selling engagement in pet care centers, with Perks members increasing their visits by roughly 50% and spend by over 40%. These programs have been so successful that at the end of the quarter, we also launched Supplies Perks, which is showing early positive signs. Critically, a key contributor of expanding our customer membership base was marketing with targeted impactful messaging focused on healthier pet, healthier budget, proving powerful in driving upper funnel demand generation.
Turning to the core pillars of our business, services continued its double-digit growth, driven by accelerated sales momentum in Vet and Grooming across both businesses. The teams continue to make progress on building capacity and streamlining the booking process for customers. On Vet, earlier this year, we said we are focused on successfully integrating the Thrive business after which we have returned to our previous run-rate of new hospital openings. This quarter exemplified our execution against both. With the Thrive integration not only complete, but now delivering tangible operational synergies and new Vital Care members. We also accelerated hospital openings with 17 new hospitals. And from a veterinarian standpoint, we signed on more vets this quarter than any previous quarter.
Our vet hospital growth is bucking industry trends, contributing to in-store vet prescribed food sales that are at an all-time high. In addition to our 229 full-service hospitals, our Vetco clinics create a highly appealing offering for customers in these cost conscious times. A record number of in-store and mobile clinics delivered our highest ever quarterly sales while providing access to vaccinations in healthcare at the right place, time and cost for pets and their parents. 90% of our pet care centers now offer some form of veterinary care and we continue to add capacity to meet growing demand. These vet additions continue to be strong center store sales drivers. Between our full-service hospitals and mobile clinics, we added over 350 full-time and contract veterinarians, representing a record number of doctors in the Petco ecosystem for the quarter with referrals from our own veterinarians being the primary driver of new hires. The technological sophistication, competitive compensation package, and autonomous medicine approach of our full-service hospitals, offer an appealing home for veterinary professionals wanting to focus on the practice of medicine without the stress of managing a business, especially in these uncertain economic times.
Treatment advances included the addition of Solensia to our solution suite produced by Zoetis. It is the first and only antibody therapy in the market that treats feline osteoarthritis pain and mobility. We are already receiving testimonials of the life-changing impact this treatment has had for cats, who regain mobility and return to their mischievous and playful selves. We also partner with Petco Love as trailblazers in the AVMA and VAME journey for Teams program, a comprehensive national initiative that provides support and training for veterinary professionals to advance diversity, equity and inclusion in the industry.
In Grooming, full-service bookings remain strong. Platform optimizations have increased ease of booking and the introduction of same-day bookings supplement sales while negating the impact of last-minute cancellations. From new pets that need vaccinations to older pets that want to look at their best for the holidays and need ongoing care through end of life, services remain an unequivocal growth driver for us and a highly personalized differentiator from online and mass competitors.
And to further our mission of ensuring as many pets as possible, get the best care available, this quarter, we announced our ability to build on our existing double-digit growth insurance business with a new multiyear partnership with the number one player in pet insurance nationwide. With over 90 million pet families in the U.S. but only 2.5% of them estimated to be insured compared to 25% in parts of Europe, we are even better positioned to capture share in this high value 2.6 billion and growing addressable market. With the ability to cross-promote and market to each other’s customers, we are excited about bringing Nationwide’s growing number of pet families into our Petco Ecosphere, including our veterinary and grooming services, merchandise and memberships, with the combined whole health and wellness approach that can give them longer and healthier lives together.
Turning to merchandise. Consumables continue to surge, growing 12% year-over-year and 33% over a 2-year stack. Consumables customers also continue to deliver an elevated LTV over other customers. The key driver of growth in consumables remains our differentiated assortment. Sales in both RX and Fresh Frozen grew year-over-year. Specifically, RX, including prescriptions and food, grew almost 50% year-over-year, driven largely by repeat customers. Consumables strength continues to offset the transitory pressure on supplies, the combination of which weighs on gross margin. Importantly, supplies remain elevated since pre-pandemic levels, up over 20% on a 3-year stack. Our teams continue to do a fantastic job in managing inventory and we expect discretionary sales to normalize as the economic environment improves, the overlap dynamics pass and the sales impact of supplies perks sign-ups are realized.
Premium owned brands continue to be a unique draw aligning with the long-term macro trends we are seeing in the category. Our owned exclusive premium mix grew in the quarter. Sales in our own brands Reddy and WholeHearted both grew year-over-year. Two things are clear. The premiumization trend continues and Petco is firmly a retailer of choice for health-focused and premium brands. In September, we launched an exclusive partnership with Yummers, the pet lifestyle brand created by Queer Eye’s JVN and Antoni. And earlier today, we announced that we are adding the fantastic premium brand Stella & Chewy’s becoming the first and only national retailer to offer their raw and natural food products, both online and in brick-and-mortar locations. As well as bringing in Stella & Chewy’s customers who are high-value health and wellness focused pet parents. Experience shows us that when we bring in highly popular, narrowly distributed brands into our ecosystem, we see an incremental lift in sales.
Importantly, although the macro environment remains challenging, we continue to maintain great brand partnerships and are working closely with our vendors to control cost and maintain inventory. While our premium mix differentiates Petco from mass and grocery players, our agility also means we can drive affordability through Vital Care and our Perks programs and with demand continuing to outstrip supply in many parts of the category, the promotional environment remains rational, where we use promotions surgically, not only to remain competitive, but to drive specific outcomes such as BOPIS and loyalty program conversion.
Our digital channels continued to build on the profitable double-digit growth in the first half of this year, with Q3 total digital sales up 10% year-over-year, 42% over 2 years. Key drivers of growth included an increase in average basket, growth in repeat delivery, including RX, and continued innovation. We also saw strong gross margin improvement with particular efficiencies in cost per order. Specifically, the addition of multiple same-day delivery windows through our partners with DoorDash have extended the time in which orders can be placed and increased appeal. Innovations like these continue to deepen our competitive moat versus online-only players and reinforce our retail 3.0 strategy.
Our advertising network is a growing powerhouse for Petco, delivering double-digit growth quarter-over-quarter and triple-digit growth year-over-year. Household brands continue to be drawn to our digital channels as a platform for awareness, traffic and revenue generation with our high-value and health conscious customer base, both online and in-store. We expect continued strong growth for the balance of the year and into 2023.
Our pet care centers delivered their tenth consecutive quarter of positive comp sales and ninth consecutive double-digit comp growth quarter on a 2-year stack. Basket remained elevated driven by strength in consumables with both new and repeat customers drawn to fresh frozen offerings in store as well as own brand consumables and supplies. Across the business, we positively lapped Black Friday and Cyber Monday year-over-year. We are also excited about our fantastic holiday theme treats, toys and supplies, including our famous dill pickle and our fabulous Hanukkah range for dogs and cats.
Additionally, our number one in the market Mexico business continued its strong growth, now up almost triple-digits since 2019 and our Lowe’s pilot stores are exciting, both sides of the partnership. We have also now opened our third neighborhood farm in pet supply with locations in Texas and North Carolina and putting us on track for our target of 6% to 7% by the end of the fiscal year. Overall, early results are ahead of our expectations, underscoring Petco’s ability to serve unmet pet-specific needs in these markets to quickly scale profitably and to capture meaningful share of this significant and rapidly growing addressable market.
Whenever I spend time with our pet care center partners like I did 2 weeks ago in Oregon and Nevada, it brings home the unequivocal truth that we have the most knowledgeable and enthusiastic team in retail. Simply put, Petco is what it is because of our partners. The energy and insights that they bring remains pivotal in shaping Petco into the leading pet health and wellness company that it is. Their passion continues to be a key driver of growth while connecting deeply with our customers. I am so grateful for the work our partners do every single day.
Before I close, I’d like to focus on a personal note. As some of you may know, in October, the Coughlin family and Petco as a whole, lost our beloved Lab Yummy. Yummy was so much more than just a pet for almost 15 years he was a companion that made every aspect of my family’s life better. As Chief Dog Officer, he reminded us of the pivotal role pets play in our lives, the impact our health and wellness ecosystem has on pet lives and the thing that makes Petco so special or purpose of improving lives. Nowhere is our purpose more evident than the incredible work of the Petco Love team.
In the third quarter alone, together with Petco Love, we saved over 98,000 pet lives and have reunited over 13,000 pets to date through Petco Love Lost. And in October, Petco Love hit the 1 million free vaccines goal in partnership with Merck and recommitted to another 1 million vaccines to save pets from preventable deadly diseases in addition to all the other incredible lifesaving work that they do. As many of you will know, Yummy was treated successfully for cancer twice diagnosed and supported by our Petco veterinary teams. But for many pet parents, the cost of this treatment is beyond reach. That is why for years Petco Love has invested millions in helping pet parents obtain treatment by establishing funds nationwide to subsidize pet cancer care.
Now in his memory, I am delighted to share that Petco Love intends to establish a Yummy Memorial Pet Cancer Fund to support our own Petco partners who are unable to afford this costly treatment for their pets with cancer. This is just another way that Petco cares for the needs of our partners by caring for those they love and who bring so much joy to their lives. When I think of this and the other landmarks Petco has reached over the last 4 years, it brings home the value of our purpose-led transformation. It’s a transformation that has seen us make bold moves in pet health and wellness, elevate nutrition standards, push the possibilities of innovation and evolve our ecosystem to meet customer needs in changing environments. Bold moves we will continue to make.
To be clear, Petco is a growth business with distinct competitive advantages within a defensive growth category. As we set ourselves up to continue driving profitable growth into 2023, we will be both relentless in driving efficiencies and continue to scale our growth initiatives. We will be agile and align our offering to the needs of our high-value pet parents as they navigate changing economic conditions.
With that, let me hand it over to Brian.
Brian LaRose
Thanks, Ron. Petco and the pet category remain incredibly resilient. We continue to build a business to meet the needs of the growing number of pet parents throughout economic cycles with continued revenue growth, ongoing discipline and cost management and strategic investment and initiatives for long-term growth.
Looking at the quarter specifically, net revenue was $1.5 billion, an increase of 4% year-over-year, comparable sales driven by sustained strength in average basket trends grew 4% year-over-year and 20% on a 2-year stack. Total services grew 14% year-over-year, translating to 38% over a 2-year stack driven by strength in Vet and Grooming and buoyed by operational synergies and enhancements in our online and in-store booking systems.
In merchandise, strength in consumables, which were up 12% year-over-year and 33% over a 2-year stack offset the transitory impact of discretionary purchasing in supplies and companion animals. Consumables customers, including Fresh Frozen, continue to be among our highest value customers in terms of both spend and trips. Regarding mix, our focus on delivering the healthiest merchandise and services for pets remains both a cornerstone of our differentiated offering and continues to prove compelling with both new and repeat health-conscious pet parents. Due to the ongoing demand for these products and astute planning by the team we’ve remained largely insulated from the inventory challenges faced by the broader retail sector.
Moving down the P&L. Gross profit increased $3 million to $598 million. Gross margin was 39.8%, down 139 basis points year-over-year and 34 basis points quarter-over-quarter, driven primarily by the mix impact of consumable strength and transitory supplies pressure combined with elevated supply chain and associated capitalized freight costs from the first half that are cycling through the P&L.
As stated in Q1 this year, we’ve been building our executional muscle since the fall of 2021 in anticipation of economic headwinds. As we have done for the last year, we continue to proactively carry out programmatic cost initiatives that allow us to mitigate headwinds while also staying ahead of consumer reaction to the macroeconomic environment in the short and long-term. These initiatives range from strategic investments such as our recently opened distribution center that will serve as a hub for internationally sourced inventory and generate efficiencies over time to more tactical improvements, including limiting split shipments and weight overages and shipments from store enabled by alerts through partners’ handheld Zebra devices.
SG&A as a percent of revenue improved from 36.9% to 36.6% year-over-year, down 30 basis points. On an absolute basis, SG&A expense was $550 million, up $17 million or 3.1% from prior year, including continued investments in our pet care center partners as we continue to take both a short- and long-term view of managing costs, enabling us to improve retention and positioning us to invest strategically and sustained future growth.
Q3 adjusted EBITDA was $138 million, a decrease of 70 basis points from prior year, with an adjusted EBITDA margin rate of 9.2% compared to 9.6% in the prior year a decline of 40 basis points. Q3 adjusted EPS was $0.16, a decrease of $0.04 from the prior year based on 266 million weighted average fully diluted shares and a normalized effective tax rate of 26%. We continue to have strong liquidity, ending the quarter with $593 million, inclusive of $149 million cash and cash equivalents and $444 million of availability on our revolving credit facility.
Thinking about Q4 and 2023 more generally, operational excellence and agility sit at the bedrock of our approach. Specifically, when thinking about cash and liquidity, we’ve made meaningful improvements in our cash flow performance with a 55% increase in free cash flow over the prior year and year-to-date free cash flow at a near break-even level as we enter what is historically a strong cash flow quarter.
We’ve also made meaningful progress in our ability to get further leverage out of our balance sheet. As a result of cash flow trending positive and continued efforts to improve working capital, we expect to be free cash flow positive for the full year while still investing in pillars of future growth, including Vet, Fresh Frozen and Neighborhood Farm and Pet Supply.
Additionally, we’ve taken actions through financial instruments, including interest rate caps on portions of our variable rate debt to minimize impacts of future rate increases. As a result of these actions, we feel extremely confident in our ability to continue to incrementally generate free cash flow in 2023 and to do so without sacrificing ongoing investment in our strategic long-term growth initiatives.
Finally, turning to guidance. We are reaffirming guidance for the full year on revenue, adjusted EBITDA and capital expenditures with revenue of $5.975 billion to $6.05 billion, adjusted EBITDA between $580 million and $595 million and $250 million to $275 million of capital expenditures. For adjusted EPS, we now expect between $0.75 and $0.79, assuming $100 million of interest expense, which is $10 million higher than our prior guidance, 26% tax rate and a 267 million weighted average diluted share count.
When thinking about our guidance, there are a few things to keep in mind. Our consumables and services businesses continue to be largely non-discretionary with strong growth expected to continue. While we fully expect the typical seasonal uplift of the holidays from Q3 to Q4, given the current broader uncertainty in consumer dynamics and spending behaviors, it’s prudent to anticipate EBITDA may be in the lower end of the range. And our interest expense guidance is based upon the forward yield curve, which is reflected in our updated interest and adjusted EPS guidance.
To conclude, while the current environment creates some cyclical pressures, the more enduring aspect is Petco’s ability to meet changing consumer dynamics while leading the evolution into the structural megatrends in the Pet category. To ensure that we capitalize on these trends, we will remain relentless in our focus on cash generation, inclusive of cost management across supply chain, our Pet Care Centers and infrastructure, in addition to driving meaningful improvements in our working capital. These cost and balance sheet actions will enable us to maintain our capital priorities, which include: one, reinvesting in our business through significant high ROI opportunities to fuel future growth; and two, managing our overall debt position. This approach, combined with the sustained appeal of our product and services portfolio throughout the entirety of their pets’ lives makes us confident in our ability to not only grow today but to come out of the current economic cycle stronger and even better positioned to drive profitable growth long-term.
Thank you for your time. And with that, we’d be happy to take your questions.
Question-and-Answer Session
Operator
[Operator Instructions] Our first question comes from Liz Suzuki from Bank of America. Please go ahead.
Liz Suzuki
Great. Thank you. And Ron, my condolences to you and your family on the loss of Yummy. He was a great dog.
Ron Coughlin
Thank you.
Liz Suzuki
So just a question on the gross margin headwind and when you expect that to abate, I mean I would imagine that there’s – just with the cost of food for humans and for pets, food inflation is probably a pretty big driver of the increase in consumables as a percentage of sales. Do you expect that to continue to be the case as we go into 2023 on a year-over-year basis, just that some of that mix headwind would likely continue?
Brian LaRose
Let me first start with the gross margin question, Liz, and thanks for the question. As I mentioned on the call, the margin pressure in the business is primarily due to the transitory mix pressures. And in fact, mix alone accounted for more than the year-over-year decline in gross margin, which was partially mitigated by improvements in underlying aspects of the business. Digital, we’re driving distribution savings through limiting split shipments and also scaling ad work. We’ve also opened a distribution center that will serve as a hub for internationally sourced inventory and get us efficiencies over time. I’d also say for this quarter and as we discussed last quarter, previously capitalized freight costs impacted gross margin this quarter sequentially as they begin to cycle through the P&L. And then the consumables business is really strong, as you touched on. And while we’ve seen softness in those discretionary categories through prior economic downturns, those categories experienced softness, but rebounded as the economy improved with strong growth. And just case in point, our discretionary categories are up more than 20% from pre-pandemic levels. And we would expect those to return as the economic environment stabilizes and help gross margins.
Ron Coughlin
I would just build on that, that in addition to strength in consumables, which is only going to be buttressed by the Stella & Chewy announcement that we made today, which is a really strong brand. But the services, we’ve had consistent double-digit growth on services, and we see no reason why that strong growth doesn’t continue.
Liz Suzuki
Great. Alright. Thank you.
Ron Coughlin
Thank you, Liz.
Brian LaRose
Thanks, Liz.
Operator
Our next question comes from Simeon Gutman from Morgan Stanley. Please go ahead.
Simeon Gutman
Hey, good morning. Ron. Good morning, Brian. I want to follow-up on this gross margin question. The third quarter grows at 39.8%. It looks like the lowest in the public company history and I wanted to ask how much – you kind of said it, Brian, that most of it was mix shift. I wanted to ask about how much vet investments could weigh on that? And then in light of, I guess, both of these factors, I don’t know if you’ve looked at – the Street gross margin for next year, I think it’s 40.5%. I wanted to see what your thoughts about that are relative to what the trends in the business look like today?
Brian LaRose
Thanks for the question, Simeon. I’m not going to talk about 2023 guidance today. What I will tell you in relation to your first point is, yes, on mix, more than 100% of the decline in gross margin. So we’re down 139 basis points year-over-year. the mix impact was more than that. If you look historically in this business and go back to when the supply mix was at a more elevated and normalized level you had a very different gross margin profile. We fully expect those categories to return. And with those categories return that will be very beneficial to gross margin.
Simeon Gutman
Okay. And a follow up – I’m sorry, Ron.
Ron Coughlin
I mean if you go back to the Great Recession, you look at what happened to supplies, as Brian said earlier, it was very similar. But a year later, it was back to being a robust category and back to where it was in the mix. So I have – I’ve looked at the top – growth rates for each of those businesses, I’ve looked at the growth – gross margin back then, but I would anticipate it would look pretty similarly with what happened in the Great Recession when supplies took a kind of 1-year softness due to the recessionary discretionary impact.
Simeon Gutman
And a quick follow-up, the percentage of the business that you would define or classify as discretionary and is the underlying run-rate stable or is – are those products decelerating?
Brian LaRose
Let me get into the mix first. If you look at the presentation that we posted online, you can see that combined between the services and the consumables categories, that’s about 60% of our mix. And within that, those are largely non-discretionary. If you look at the growth rates this quarter, 12% consumables, double digits in services, those remain very strong. Within the remaining 40%, not all of it is discretionary and what we believe is that a lot of the purchases today are being delayed. And some of those purchases are going to come back. So not entirely, that 40% category is discretionary. A portion of it is and we fully expect that growth to return.
Ron Coughlin
And with regards to the stable, I would call it stable with hopeful signs with green shoots, meaning we launched a supplies perks program. We have – we’re very happy with the sign-ups on the Supplies perks program. It takes a little while on our perks program. We know that from food and grooming for those customers to come back and redeem, but we’re very happy with the sign-ups there. And then secondly, we’ve taken some actions on companion animals that are showing early signs. So it’s stable with green shoots.
Operator
Our next question comes from Peter Benedict from Baird. Please go ahead.
Peter Benedict
Hi, guys. Thanks for taking the question. One kind of model question, just on the interest expense, Brian, you said you put some caps in place here. $32 million, I think, is the implied fourth quarter interest expense. Is that a good base rate to assume as we run through next year? Do we lock that in, to $125 million, $130 million for next year? Is that how we should think about this?
Brian LaRose
Let me try and help, Peter. I would remind you that we based our interest expense guidance on the forward yield curve, which is expected to continue to increase through the first half of 2023. So I’d say you factor that into the current run rate that yield curve is expected to increase. On the cap, yes, we’re looking at all ways to sort of mitigate risk here. We put some financial instruments in place and caps to protect a variable part of our debt. And then we’re going to remain, as I said on the call, a relentless on cash flow. We made good improvements this quarter, 55% improvement in free cash flow year-over-year. We made meaningful – got meaningful progress in our ability to get leverage on the balance sheet, and we feel confident in our ability to continue to incrementally drive free cash flow in ‘23 to both reinvest in the business and manage overall debt.
Peter Benedict
Got it. That’s helpful. And then I guess just a question on inventory and nice to see it managed well, but certainly in an environment where a lot of people have weighed too much, but let me flip that in a minute. How do you know you’re not running too lean on inventory? I know we’ve been in some stores and things – you see the out-of-stocks in certain areas. Just talk to us about just break down that inventory a little better. Do you feel like you’re too lean in certain areas? What are you doing to make sure your service to the customer? Thanks.
Ron Coughlin
I would say we are in the strongest inventory position that we’ve been in a few years. We have a great leader. We brought in who has Best Buy experience under Amy College, and they’ve done a great job managed inventory. We have favorable in-stocks versus a year ago that are tangible right now that turn green probably 6 to 8 weeks ago. And so our inventory position should be a contributor to growth and is a contributor to growth already. And as Brian cited, we don’t feel like we’re over-inventoried in any places or any tangible places but we feel like we have the right inventory in the right places. You always have episodic vendor type issues but just getting ahead of kind of a current conversation, our exposure to China is very low. We actually moved a lot of our sourcing away from China on supplies several years ago, and that is serving us well, should China have any issues with a kind of relapse of COVID.
Operator
Our next question comes from Oliver Wintermantel from Evercore ISI. Please go ahead.
Oliver Wintermantel
Yes. Good morning. I had a question regarding the comp and ticket versus traffic. I think, Brian, you said mostly with basket. Is it fair to assume that transactions were negative and ticket was all the offset?
Brian LaRose
Yes. It was driven by basket, Oliver. We did see some trip consolidation on the transaction side, but I would say, look, the team has done a tremendous job in continuing to drive basket, not all price driven, by the way that was the question prior on price. Most of our pricing actions, if you recall, holistic pricing actions took place in the second half of last year, which we’re starting to lap. So back it drove it, we did see some term consolidation on transactions.
Oliver Wintermantel
Got it. And then a quick follow-up.
Ron Coughlin
I would also build on that. We are not your traditional purely merchandise retailer. Our services are tangible. So as we get this significant increase in visits for vets, visits for grooming, training, etcetera, that drives trips for us. So that is a tangible lever, which is why we’re so intent on continuing out our vet network. So that’s another trip driver for us. Sorry to interrupt.
Oliver Wintermantel
No, perfect, thank you for that. I just had a follow-up question on the gross margins. Can you just explain again the freight component of gross margins? Was that – how did that trend in the quarter versus the first half? And how do you expect that to play out in the fourth quarter?
Brian LaRose
Yes. So in the first half, we had more elevated freight and broader supply chain costs, and those get – I think as we touched on last quarter, capitalized on the balance sheet and start to cycle through the P&L. So we signaled, we expected the P&L impact from those to get worse quarter-on-quarter Q2 to Q3. Now taking a step back on what’s on the balance sheet in terms of base rates and overall supply chain costs, those are starting to improve a bit in the second half. We expect to see more tangible improvement into 2023.
Operator
Our next question comes from Michael Lasser from UBS. Please go ahead.
Michael Lasser
Good morning. Thanks a lot for taking my question. Did traffic get worse from the second to the third quarter? It looks like the consumables growth on a multiyear basis has decelerated a bit. So, why would that be the case or are pet parents paying – feeding their animals less or your growth in new customer additions did moderate from 6% in the second quarter to the only being up 0.8% year-over-year in the third quarter? So, is that having an influence on traffic as well?
Ron Coughlin
Thanks for the question, Michael. Traffic was relatively stable and the dynamic that Brian talked about in terms of some trip consolidation happening, which actually makes us more efficient. And as I have said, services traffic continued to grow. If you look at our tools for driving traffic, they are tangible. I talked about the vet piece. The nice thing about getting the growth we are seeing in Vital Care is that the trip frequency visits are up by 60% pre, post on the Vital Care customers. Similarly, on the perks program, visits are up 50% on those. So, while there is a natural in a recessionary or hyperinflationary environment, you have some purchasing cutbacks happen. Those programs are helping us to maintain stability in our traffic trends.
Brian LaRose
And I will just add on consumables, Michael. Look, we were up 33% on a 2-year stack. And just as a refiner consumables customers are the most valuable customers we have from an LTV standpoint. So, we are really happy with that.
Ron Coughlin
Yes. Another contributor to that action you mentioned it is – we are selling more mega pack type offers, which inherently then you reduce your number of frequency or number of trips behind those types of products.
Michael Lasser
Thank you very much. My follow-up question is on the benefit you are going to get from the reduction in freight costs. Can you quantify it? And is there a point at which if the discretionary sales remain weak like they have been in the last couple of quarters, will the freight benefit that you see at some point be enough to offset the gross margin drag that you have been experiencing from the shift away from discretionary?
Brian LaRose
Yes. I would say on the mix impact, Michael, that’s much larger than the freight dynamics. And I tried to hit that part. If you look year-over-year, again, 139 basis points gross margin, more than that and the impact from mix. So, the return part of the discretionary categories, which we fully expect to happen, will be the biggest driver in terms of gross margin. In terms of the freight, I am not going to quantify it specifically for you. I would tell you, we will see some benefit in Q4. We will see more of a benefit as we head into ‘23.
Operator
Our next question comes from Chris Bottiglieri from BNP Paribas. Please go ahead.
Chris Bottiglieri
Hi everybody. Thanks for taking the question. Can you speak to the implied Q4 gross margin guide? It looks like it’s probably flat to down slightly, depending on where you were in the EBITDA range. I guess in a normal pre-COVID year, like typically, how much higher is gross margin in Q4 than Q3? And then I guess what are you assuming in terms of mix and promotional environment for Q4? I think in the past, you were, I think being a little bit conservative and taking that maybe the promotional environment picks up a bit in Q4. I just want to see how you are thinking out that today.
Ron Coughlin
Hey Chris, it’s Ron. Let me take the promotional environment, and Brian can walk you through any view on gross margin. So, from a promotional environment standpoint, the market remains rational. And part of that is the fact that for a long time now, aggregate supply has lagged aggregate demand. It’s gotten better, but the market continues to be rational in terms of pricing. If you look at what happened over Black Friday weekend, the promotions were similar to pre-pandemic levels and actually, if you look at our promotional depth, our promotional depth was 300 points below a year ago. So, the promotional environment seems rational. We anticipated continuing through the holidays. Obviously, you have episodic type things. But over the period, we anticipate rationality from a promotional standpoint, and that’s what we have seen all along. I will pass it on to Brian.
Brian LaRose
Yes. And I would just say on the discretionary categories, Chris, that we are not passengers on the bus here. We saw a great success when we launched our perks program. We saw very successful, but that led into launching the good perks program, which is why we launched the supplies perks program. So, we are encouraged by the early sign-ups there. We are excited about our holiday lineup, but in reference to the guide, until we see a tangible improvement in the trajectory of those discretionary categories, we think the guidance that we gave which gross margins implied in there and the commentary around it is appropriate.
Chris Bottiglieri
Got it. That’s very helpful. Thank you.
Ron Coughlin
Thanks Chris.
Operator
The next question comes from Steven Zaccone from Citi. Please go ahead.
Steven Zaccone
Great. Good morning guys. Thanks for taking my question. Our condolences also for the loss of Yummy, sorry, Ron. Could you talk about the implied fourth quarter outlook in a bit more detail. It’s a wide range of same-store sales. I think you cited Black Friday and Cyber Monday comp positive. Maybe how has the business trended overall thus far in November? What are the swing factors to get you to the high end versus the low end of the range?
Ron Coughlin
Maybe we will tag team again. So, one of the remarkable things about this business is there is very low variability. If you look on week-to-week, we have not had the significant swings that you see in some of the other retailers or I look at the NPD data, and I will see weeks when it’s up 2% and then weeks when it’s down 11%. We don’t see that. We have been very consistent through Q3, consistent through the Black Friday period. We had a great Cyber Monday, and we are tracking in November relatively consistently. So, we have not seen big swings on our business, which is why that’s feeding into the guide that Brian is providing. As Brian said, we have initiatives we have put in place like the supplies perks program. I would add to that, we are seeing early traction on Klarna, particularly for our companion animal, if you are setting up a companion animal, you are getting a tag, you are getting an animal, you are getting a bunch of accessories as well. So, we are seeing early traction with that as well on our companion animal business. But our business has been relatively consistent and which is feeding into the guide, but I will let Brian add anything to that.
Brian LaRose
I would just add that to build on Ron’s point, we continue to see solid growth. We saw growth in Black Friday and Cyber Monday, but given the consumer dynamic, Steve, and the fact that it is still there, while we got – we are past Black Friday, we are past Cyber Monday, but we still have the vast majority of the holiday season remaining. We feel like the range that we gave in the guidance is appropriate.
Steven Zaccone
Okay. Great. Follow-up question just on farm and pet supply. Could you talk a little bit more detail about the early learnings from the concept? Maybe what’s the potential sales productivity of these boxes? How do we think about the four-wall profitability relative to your existing stores? And then relative to the six to seven openings by year-end, what’s an appropriate level of openings for 2023?
Ron Coughlin
Yes. Thanks for the question. We are fired up about the farm and neighborhood farm and pet supply. If you look at rural markets today, it’s roughly a $7 billion TAM. We have not had our fair share of that, and that TAM is growing rapidly. So, then there was a question, can we compete with our brand. We did the research, research is, absolutely, people are looking for a pet specialty player in these markets. Then we launched our first or second and now our third and the performance is ahead of our expectations proving that people are looking for that pet specialty player. I have cited before, what I heard in the aisle when I go to these locations is, well, I don’t have to drive an hour anymore to San Antonio to get my pet specialty products or I am so glad that I could get these products. So, it’s very, very encouraging. As I said, we are going to get to seven or eight by the end of the year. We are in the process of finalizing capital allocations for 2023. But we would anticipate building out at a more rapid rate for 2023 because it is so promising. The other thing I would say is it extends our merchandise portfolio into these products. So, we are seeing some really nice sales in new products for chickens, new products for other breeds as well that adds to our portfolio.
Brian LaRose
The last thing I would add to you the great thing about these pet care centers is they turned positive in year one, which is a little bit anomalistic from the way we manage sort of a traditional pet care centers. So, that gives us a lot of positive momentum and the early signs from the three stores we have opened a promise.
Operator
Our next question comes from Seth Basham from Wedbush. Please go ahead.
Seth Basham
Thanks a lot and good morning. Since you brought it up, Ron, just regarding the near-term Black Friday and Cyber Monday periods, where you grew sales, you also mentioned that promo [ph] debt declined 300 basis points over this period. So, does that mean that merchandise gross profit dollar growth meaningfully increased year-over-year during this period?
Ron Coughlin
That would be dependent on mix. So, quite frankly, we have been here prepping for earnings. So, we haven’t dug into some of the mix dynamics there, but that would be dependent on mix. So, we are pleased with the sales that we generated. We are pleased with the response to our promotional activity. We are also pleased, by the way, with week-over-week our holiday merchandise sales have increased. But I think it’s premature to get into the mix of what we sold over Black Friday and Cyber Monday.
Brian LaRose
Yes. And I think I would say the other thing I had mention on promotions is – if you look at some of the promotions that we did, some of those were come back promotions, right. So, think about the ones that we did, you talked about $30 up $100 on, that is on your next visit into the pet care centers. So, some of the promotions that we did are not impactful from a gross margin standpoint around Black Friday, and they bring that customer back into our pet care center in the holiday season.
Seth Basham
Got it. Fair enough. And secondly, could you expand on the insurance offerings and the Nationwide agreement that you signed? Is that the tip of the iceberg in terms of a more pronounced offering that you will have for our pet insurance?
Ron Coughlin
We said it very well. Yes, it’s – what we have said so far at the start of it. Let me start by saying this is a partnership with the number one player in insurance. So, we are talking scale right from the get-go, number one. Number two, nationwide came to us. In our prepared remarks, I talked about Petco becoming a platform company. Companies are coming to us to partner with us, whether that be Nationwide, whether that be Marriott, whether that be even Klarna to partner with us because we are increasingly giving them access and data against a very valuable customer base. We see insurance as a significant upside. If you look at it today, it’s about a $2.6 billion market, but penetration in the United States is relatively low vis-à-vis Europe, this is a big upside market. Europe has roughly 25% penetration. U.S. is a fraction of that. So, big upside. We will be developing – we are developing a customized offering with Nationwide. It’s very easy to imagine bundling of insurance and veterinary care bundling of insurance and things like Vital Care, which is great because it’s a win-win, right, because if the pets are healthier, Nationwide costs are going to be lower. So, a lot of exciting things that can come of this. The other thing is they have a significant customer base that we can now market to. So, they might sell insurance to their existing customer base, but we can get – provide them with veterinary services. We can provide them at grooming services. We can provide them with merchandise. So, very excited about this partnership.
Operator
Our next question comes from Steven Forbes from Guggenheim. Please go ahead.
Julio Marquez
Hey guys. This is Julio Marquez on for Steven Forbes this morning. Just very quickly, congratulations on the quarter and on behalf of the Guggenheim team, our condolences to Yummy and good to see you guys setting up a fund in memory.
Ron Coughlin
Thank you.
Julio Marquez
So, in terms of Vital Care members, you mentioned an increase in POS conversions, I think if I heard that correctly. What exactly has changed there? And if you could, any color on demographics and new members and membership overall, specifically across generations. And maybe color on how – how you guys think about advertising across different cohorts there? Thank you.
Ron Coughlin
Sure. So, the fact that we accelerated our sign-up rate 40% is really exciting for us. The fact that we are now at 400,000, I think at Analyst/Investor Day, I said we are going to get to 1 million. It’s not a matter of if it’s when that timetable got accelerated with the success of some of the things we rolled out. One was companion animal, and we find companion animal customers, really, really interested in leaning into Vital Care, which is great to move that business. But the second thing, as you cited, is sign up at point of sale. So, before we enable that, you would – a customer would have to go on their phone and go through the whole registration process on their phone. Obviously, in some instances, that’s contingent on WiFi, etcetera. Now, the Petco partner at the register at checkout can add on a Vital Care membership onto that purchase while they are having their credit card there for purchasing whatever they are in purchase. So, we saw a tangible increase in sign-ups. With that, we also needless to say, have more interactions from our Petco partners with customers because of that ability. So, it’s been a real win. And then back to Vital Care in terms of the Vital Care benefit to us, we get tangibly more traffic. 30% of these Vital Care customers are new to food with us, 30% are new to services with us. So, that means that we are getting more share of wallet of these customers. So, it’s been really, really effective. And I think there is a broader theme there which is Petco shifting more of its revenue base to recurring revenue, which makes us more predictable. So, our revenue from recurring customers was up over 50%, and we are going to continue to drive into those recurring revenue programs like Vital Care, like insurance, like PupBox, etcetera.
Brian LaRose
The last thing I would add is just the point of sale underscores what an asset our pet care center partners are, to give them that capability at point of sale and give them the ability to connect with the customer is such an advantage for us.
Julio Marquez
Great. Thank you. Appreciate the color.
Ron Coughlin
Thank you.
Operator
The next question comes from Corey Grady from Jefferies. Please go ahead.
Corey Grady
Hey. Thank you very much for taking my questions. I wanted to follow-up on your comment on in-stock rates turning favorable. Can you give us an update on where your petco care centers are in terms of in-stock rates and when you expect to be back to grades?
Brian LaRose
I won’t give a specific percentage there, but I would tell you we are in the best shape we have been in a while. We are up year-over-year. We are up quarter-over-quarter. We continue to see improvements across the portfolio, and we are really happy with our in-stock levels today.
Corey Grady
Okay. Great. And then for my follow-up, I just wanted to get more color on your priorities for cash or capital going forward. Can you talk about like the balance between thinking about like store upgrades that rollout and then the neighborhood farm and pet supply rollout?
Brian LaRose
Great question. First, I would tell you that we are focused on generating cash in multiple ways through driving the P&L and also through can we get leverage out of our balance sheet. We made good progress this quarter, up 55% free cash flow on a year-over-year basis and near breakeven in a year where we are investing in our long-term growth initiatives. So, you mentioned a couple of different things. I would tell you those growth areas are not binary investments for us. So, we will continue to invest in that. We are excited about to be and we think there is an incremental opportunity there for us. I would tell you that we have retired a bunch of the technical debt that we had on the IT side, which historically had sort of dogged us a little bit. We are investing primarily in innovation in IT, and we have gotten rid of some of that technical debt. So, it’s across all of those areas that you mentioned. I would tell you that if you think about CapEx in ‘23, well I am not going to give a specific number, I would not expect ‘23 CapEx to be above ‘22 levels in total, while we continue to invest in those areas.
Operator
Our next question comes from Anna Andreeva from Needham. Please go ahead.
Anna Andreeva
Great. Thank you and good morning guys. And Ron, our condolences on Yummy as well.
Ron Coughlin
Thanks Anna.
Anna Andreeva
Two questions. So, first, I guess to Ron, on net adds, pretty strong results. Nice to see that consistency sequentially. And I know Vital Care is a really big part of that. Just curious, can you talk about where you are seeing those customers come from? And secondly, I guess this is to Brian. Good to see the company make progress on inventories. Can you talk about where we should expect inventories to end the year? And at which point should inventories be more in line with sales in ‘23? And thank you so much.
Ron Coughlin
Thanks Anna. Yes, we were very pleased with the net adds. And I should say that we continue to add customers into Q4. So, the momentum, we continue to see momentum into Q4. In terms of where we are sourcing them, we have consistently been able to source customers from the independent channel as we have a broader offering as our service offering comes. We are sourcing customers who are new coming for veterinary services. That’s part of the power of that where they are coming because they want to consolidate their purchases with us. They were going to another veterinary provider before. We are sourcing customers from e-com customers who are looking for things like same-day delivery, things like BOPUS, that the online – pure online players can’t provide. So, those are the main two sources of it. It would be three independent veterinary customers and e-com customers looking for fulfillment options that aren’t available to – from other online players.
Brian LaRose
And then on inventory, Anna, let me just hit a couple of things. I was really pleased with the way the team has did play this quarter, how the balance sheet land and where it is while improving in-stocks quarter-on-quarter and year-over-year was really an exceptional job. I would tell you that historically, I am not going to give a number for Q4, but typically, what you would see in Q3 and Q4, it’s a bit of an inventory decline as you build up inventory going into the strong holiday season, sales are typically elevated in Q3 and Q4 and then inventory normalizes. When you think forward-looking on ‘23, I would tell you that throughout ‘22, our units in inventory have remained relatively in line with revenue growth. The increase in dollars is driven by inflation. So, as inflation normalizes on the balance sheet and units stay in line with sales, I think that’s when you start to see things come converge a little bit closer.
Operator
This concludes our question-and-answer session. I would like to turn the conference back over to Ron Coughlin for any closing remarks.
Ron Coughlin
Thank you, operator. To our analysts and our investors, thank you, as always, for your time and your support. Petco is a growth company, which continues to build momentum in an exceptional category with tangible competitive advantages. We remain committed to delivering against our long-term strategic priorities with purpose-driven performance. Thank you, and happy holidays from all of us at Petco.
Benjamin Thiele-Long
That concludes Petco’s third quarter 2022 earnings conference call. The team will be available after the call if you have follow-up questions. Thank you. Happy holidays.
Operator
The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.
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