Participants

Lisa Stark; Senior Director of Communications; Petco Health and Wellness Company Inc

Joel Anderson; Chief Executive Officer; Petco Health and Wellness Company Inc

Brian Larose; Chief Financial Officer; Petco Health and Wellness Company Inc

Kaumil Gajrawala; Analyst; Jefferies

Steven Shemesh; Analyst; RBC Capital Markets

Matthew McCartney; Analyst; Wedbush Securities

Michael Lasser; Analyst; UBS

Julio Marquez; Analyst; Guggenheim Partners

David Lance; Analyst; Wells Fargo Securities

Lauren Ng; Analyst; Morgan Stanley

Kendall Toscano; Analyst; Bank of America

Presentation

Operator

Good afternoon and welcome to the Petco third quarter, 2024 earnings conference call. (Operator Instructions) Please note this event is being recorded.
I would now like to turn the conference over to Lisa Stark, Senior Director of Communications. Please go ahead.

Lisa Stark

Good afternoon and thank you for joining Petco's third quarter, 2024 earnings conference call. In addition to the earnings release, there is a presentation available to download on our website at ir.petco.com, summarizing our results. On the call with me today are Joel Anderson, Petco's Chief Executive Officer; and Brian Larose, Petco's Chief Financial Officer.
Before they begin, I'd like to remind everyone that on this call, we will make certain forward-looking statements which are subject to a number of risks and uncertainties that could cause actual results to differ materially from such statements. These risks and uncertainties include those set out in our earnings materials and SEC filings. In addition today's call, we will refer to certain non-GAAP financial measures, reconciliations of these measures can be found in our earnings release, presentation and SEC filings.
And finally, during the Q&A portion of today's call, we ask that you please keep to one question and one follow up. With that, let me turn it over to Joel.

Joel Anderson

Thank you, Lisa. Good afternoon, everyone and thank you for joining us today. Our third quarter results came in slightly ahead of our expectations. As we more effectively navigated a dynamic consumer environment and the actions we are taking to strengthen our retail fundamentals and drive cost out are beginning to take hold.
Revenue was $1.51 billion up 1% driven by consumables and services. Gross margin expanded 130 basis points to 38.1% driven by progress on product cost margin -- management and improvements in services margin. Adjusted EBITDA was $81.2 million.
While there is much more work to do, our improving results increase our conviction that we are on the right path as we position Petco to win. Throughout the quarter, I spent significant amount of time meeting with teammates across the organization from working alongside our associates in our pet care centers to visiting our distribution centers, to hosting small group listening sessions at our support centers.
I've witnessed firsthand, the passion our people have for pets and the dedication they bring to serving our customers. Importantly, it's exciting to see the entire organization rally behind our plans to drive operational and financial performance improvement. On our call, I outlined our commitment to resetting the trajectory of our business on the last call. Today, I will share specific areas of opportunities, discuss developing plans to drive improvement and holding ourselves accountable while we're on the path to returning to long term sustainable, profitable growth.
Our initiatives are currently focused on three critical areas, merchandizing, servicing our customers, driving efficiency across our business. Allow me to provide you with an update on each including specific examples.
First, improving merchandise remains the greatest near term opportunity for us to strengthen profitability. I'd like to take this moment to thank our merchandizing team along with our merchant vendor partners for their collaboration and support as we take the necessary steps to make Petco a better retailer, employer and partner. We're optimizing our assortment to be aligned more closely with customer demand and make it easier for them to shop with us. In support of this, we completed a detailed review of our assortment across both consumables and supplies and have identified several opportunities to enhance our offering.
Key focus areas for us include creating more space on shelves, for faster turning SKUs as well as reducing SKUs in certain categories to simplify the customer's decision making process. In addition, I've met one on one with several of our vendors in order to directly learn how we can improve our relationships. As consumers continue to be judicious in their spend, we have to meet them where and when they want with the value they're looking for.
We've implemented new processes to deliver timely product resets that allow us to offer more exciting products. We're also sharpening our approach to pricing to remain competitive in the market and drive financial outcomes for Petco. To date we put in place stronger pricing guardrails, implemented more robust reviews of our pricing gaps and established processes for promo and assessments.
An example of our merchandizing work in action is the recent launch of our welcome to the family program. Given the importance of first time pet ownership. We designed this program in partnership with our key vendors, as well as our expert vet, training and grooming teams provide dog and cat parents with guidance resources and savings on new pet essentials and services.
Second, to win today's retail environment, we must improve the way we service our customers across our pet care centers online and in our services platforms. For my time spent working in our pet care centers, I observed several opportunities to drive greater consistency across the entire footprint which will generate savings that can be reinvested into the customer experience and strengthen profitability.
Let me share several examples of where we are making meaningful improvements to better serve our customers. We've set new standards for our labor model to staff our stores and in a way that allows our partners to spend more time with the customers and less time on tasks in the back of the store. This extends to store leadership where we're reducing tasking, administrative responsibilities and overall complexity for our general managers, bring them up to spend more time leading their teams and driving store productivity.
Additionally, leveraging automation to standardize the online order fulfillment process in our pet care centers is one area in particular I see significant potential. Finally, in services, our bed offering remains a key growth driver and differentiator for Petco. Services revenue was up 9% with strength across both hospitals and Vetco mobile clinics.
As our hospital fleet continues to mature, our services team is focused on accelerating utilization to support structural margin improvement of our vet hospitals and ensure we can meet the growing demand for our customers in a timely manner. And we're leveraging our vet customer data to better understand their purchasing patterns, inform how we engage with them and ultimately drive greater wallet share. These initiatives are having a direct impact on our top and bottom line as we're creating more selling opportunities for partners while simultaneously driving greater efficiencies.
Turning to our third commitment, driving greater efficiencies across the business to bend the cost curve. Within merchandizing, we're taking action to improve our commercial execution. In Q3, we completed key vendor negotiations and we're pleased with the outcome as we continue to strengthen our vendor relationships and differentiated merchandizing offering. In our supply chain, we're renegotiating multi-year contracts with our shipping partners reducing split shipments and driving incremental improvements and distribution center labor to reduce cost per shipment and improve speed of shipping.
In that, we're closely measuring performance at the individual hospital level, providing us greater visibility into the needs of each hospital and the staffing required to maximize efficiency and productivity. We believe there is significant opportunity to improve the profitability of the existing fleet by ensuring hospitals remain staffed and are supported through marketing and merchandizing efforts. And we're taking action to professionalize our procurement team. As a start, we requested contract negotiations and conducted RFPs across a broad selection of medium to large scale indirect procurement partners.
We're pleased with the engagement and the outcomes we're seeing so far. Overall, our cost initiatives are well underway and tracking against our prior expectations, importantly, these aren't just one time savings. These initiatives are designed to fundamentally change the way we think and work to consistently identify areas of opportunity to unlock long term value. This redefinition of retail fundamentals is expected to have an enduring impact on our people and culture leading to greater accountability and transparency.
Further ensure our success around our three initiatives of merchandizing, servicing our customers and driving efficiency, we've added two key executives. Leadership is critical to shaping the direction of the business and I'm pleased with our recent hiring of two new leaders that will help us realize our full potential. We named Joe Venezia, Chief Revenue Officer, a newly created role in charge of developing the integrated strategies for improving the customer experience and driving revenue across the organization. Joe will oversee these critical areas attribute to Petco's growth including the pet care centers, services, real estate, and customer success capabilities.
Dan Calista also has joined us as our Chief Strategy and Transformation Officer. In this role, Dan will be responsible for building the internal capabilities, we need to get our fundamentals right, maintaining accountability through our ongoing transformation and positioning ourselves for growth.
These hires underscore our top priority for improving profitability through structural cost out while positioning Petco for growth. It's still early days, but our actions are beginning to take hold. We're setting ourselves up to play offense as we build momentum into fiscal 2025.
Before I close, let me leave you with this. Having been in the role for over 100 days, I can say with conviction and certainty that I'm more excited today than I have ever been on our potential here at Petco. The time I spent working alongside our associates showed me how their knowledge, expertise and simply raw passion for improving the lives of pets and their parents is unlike anything else in the industry. This enthusiasm that sets us apart, makes me confident in our trajectory.
With that over to Brian, to provide more details on our financial performance and guidance. Brian?

Brian Larose

Thanks Joel and good afternoon everyone. First, I want to extend my thanks to our Petco partners for their continued dedication to delivering for our customers. Our third quarter performance demonstrates improved operational and financial execution, enabling us to deliver results ahead of our expectations. For the quarter, net revenue was $1.51 billion, up 1% year-over-year with comparable sales up 2% year-over-year.
Breaking this down by category, consumables grew 3%. Supplies and companion animal remain soft at down 3% but improved roughly 200 basis points sequentially on a percentage basis. Services and other which is comprised of services, wholesale and recently disposed non-core businesses delivered 5% growth. Services specifically were up 9% driven by ongoing strength in our vet hospitals, mobile clinics and grooming.
Moving down the P&L, gross profit was $576 million, up 5% from prior year. Gross margin for the quarter was 38.1% up nearly 130 basis points from prior year driven by progress on product cost management and improvements in services gross margin. SG&A was $572 million increasing 2% year-over-year. As a percentage of sales SG&A rate was 37.8% up, nearly 40 basis points driven primarily by our planned step up in store labor in line with our expectations and reflecting our commitment to improving the in store customer experience.
We expect these increased SG&A costs to continue into the fourth quarter. Adjusted EBITDA was $81.2 million with an adjusted EBITDA margin rate of 5.4% up almost 60 basis points year-over-year. All in adjusted EPS was negative $0.02 compared to negative $0.05 per share in the prior year.
Turning to the balance sheet merchandise inventories were $690 million at the end of the third quarter as we effectively controlled our inventory, which along within stock rates are in excellent shape. Liquidity remains strong at $644 million inclusive of $117 million in cash and cash equivalents and $528 million of availability on a revolving credit facility.
CapEx was down $31 million year-over-year for the quarter. Year-to-date down approximately $85 million year-over-year in line with our guidance to reduce CapEx in 2024. Free cash flow was negative $10 million, a meaningful improvement year-over-year supported by lower inventory levels achieved as part of our ongoing approach through disciplined inventory management, and we remain firmly on track to deliver positive free cash flow for fiscal 2024.
Before moving on to guidance, let me address the recent announcement of potential tariffs on goods imported from China, Mexico and Canada. We have a few immaterial vendors where we source directly from Mexico and Canada, which we do not expect to impact us negatively.
Regarding China relative to broader retail, we have a lower level of exposure to imported products and we believe the proposals as currently outlined would not be meaningful to our overall business. Specific to Petco Mexico, we do not source or import any products from them, rather they source their products primarily from the US with select products exported directly to them from Asia or sourced directly from suppliers based in Mexico. Petco, Mexico remains the clear market leader in pet specialty in Mexico and an important strategic partner for us continuing to drive long term profitable growth.
I'll now turn to outlook. As a reminder, Petco's fiscal 2023 fourth quarter and full year included an additional week. For the fourth quarter of fiscal 2024, we expect revenue of approximately $1.55 billion. Adjusted EBITDA between $90 million to $95 million, which is inclusive of a minimum of $10 million in third party consulting fees associated with our transformation effort. And adjusted EPS between $0 and $0.02.
Additionally, for the full year, we expect net interest expense of approximately $140 million inclusive of the estimated impacts of our hedges against the forward rate curve. $273 million weighted average fully diluted shares and $130 million of capital expenditures.
Stepping back, we're encouraged by the structural improvement we're seeing throughout the business. The meaningful changes we've made in the first nine months of the year sets us up for a solid finish to 2024 as we build momentum heading into 2025.
Thank you for your time. And with that, we'll be happy to take your questions.

Question and Answer Session

Operator

(Operator Instructions)
Kaumil Gajrawala, Jefferies.

Kaumil Gajrawala

Hey, thank you. I guess the first question, you've made a lot of progress on the cost side. What would be a target, same store sales figure where, you could start levering off this newer cost base.

Joel Anderson

Yeah. Thank you for the question. I'll give you some of my thoughts and Brian, if you want to add anything. Look, I think our focus right now is, as you said, even in your question is about, taking costs out of our base permanently. It's a structural change that we want embedded in our DNA to drive accountability and transparency.
But as it relates to a longer term and the question you're asking, I think that's something that we should leave for March as we think about the longer term, a lot's going to change. Obviously, the number is much lower right now because we're so focused on the structural elements of costs that we think are permanent and not one time.

Brian Larose

Yeah, I would just add to that. If you look at SG&A, we've talked for two, three quarters in a row now about sort of step up in labor investments that we needed to make to improve the in store customer experience. We've done that. We've seen that actually manifest in an improved customers experience in the stores. Simultaneously, we have taken cost out of the SG&A structure through some G&A actions as well as making sure that we reduce the tasks in store, simplifying the experience for our GMs and partners in the store and again improving that customer experience.

Kaumil Gajrawala

Okay, great. And --

Joel Anderson

Thank you.

Kaumil Gajrawala

Thank you.

Operator

Steven Shemesh, RBC Capital Markets.

Steven Shemesh

Great, good evening. And thank you for taking my question. I wanted to ask on supplies and companion animals and the more discretionary segment. So still negative, but the underlying trend is improving there, wondering if you can elaborate on that if that's just that all sub segments generally just doing better or if there's any insight to glean from specific sub segments?

Joel Anderson

Yeah. Look, I think you're asking about discretionary. I think it's more important to think about Petco in the broader business, which -- as I look at it is really two pronged. We have a huge consumables business and that's really all about being in stock. And that's where a large focus is -- of ours has been, we just implemented a new inventory management system.
We're improving shelf utilization and then as it relates to discretionary, you're right, we've seen a 200 basis points sequential improvement. But discretionary is really all about innovation, newness being trend, right, and really driving impulse buying. We'll continue to get better at that, but we're really focused on both sides of the business and getting them right.

Steven Shemesh

Got it. Helpful. Thank you. And maybe just as a follow up, one of one of your competitors has been talking for a few quarters now on adoption, trending in the right direction, curious if that aligns with what you guys are seeing in the market, I know that the data for adoptions is pretty spotty. And if not, has it stabilized? What are you looking for to maybe get ahead of an inflection there?

Joel Anderson

Yeah, look, I think everybody is looking at it a little bit differently, the market it is rather flat is what we're seeing. But, as it relate to Petco in the short term. And by that, I mean, throughout 2025 we're really in a self-help situation and that we don't have to rely on the market getting better in order for our business to get better. And so look, if the market improves, like you're talking about, that's just icing on the cake and makes us even stronger. We're really focused on what's in it, in our control and we don't need the industry success to drive near term operational and profit improvement. The market growth upside as I said.

Brian Larose

Thanks.

Joel Anderson

Got it.

Operator

Seth Basham, Wedbush Securities.

Matthew McCartney

Hi, this is Matt McCartney on for Seth Basham. Just wondering if you could talk about the pricing impact in the quarter, whether it was positive or negative and how we should think about pricing going forward as you tweak your product mix.

Brian Larose

Yeah, thanks for the question. We don't typically talk about the impact of pricing. I will tell you that the overall environment -- I'll comment on the overall environment has been rational both from a pricing standpoint and a promotional environment.

Matthew McCartney

Great. Thanks. I was just wondering then if you could talk about the services margin and what drove the improvement there this quarter?

Brian Larose

Yeah, a couple things. First, I'll talk in overall gross margin if you look at our gross margin improvement year-over-year of 130 basis points, that was with mix going against us. So, although supplies and CA was down 3% versus 5% last quarter, it was still a negative mix year-over-year, the two biggest drivers of the gross margin improvement for the company were number one, our cost actions taking hold and seeing improvement throughout the cost ecosystem.
Number two was that services gross margin improvement that you talked about. And that's a function of a number of things. First and foremost, would be maturation of the vat hospitals and all the great work that the team is doing there going hospital by hospital. And as Joel indicated in his prepared remarks, we believe we have ample opportunity to improve the profitability of the existing best fleet.
Second would be the continuation of strength in our Vetco mobile business, so Vetco mobile is all a -- it's a volume and utilization business and we continue to actually increase the top line in that business. And with that drags along incremental margin improvement and then the grooming business also remains strong for us.

Matthew McCartney

Great. Thank you. I'll pass it along.

Brian Larose

Thanks Matt.

Operator

Michael Lasser, UBS.

Michael Lasser

Good evening. Thank you so much for taking my question. So Joe, it seems like your initial priority is to come in custom cost focused on retail fundamentals. So A, how much of an opportunity for savings is there? If you could size that, that would be great.
And B, how much are you of that? Are you going to have to reinvest in the business to drive sustainable same store sales growth? Because as we know, this is a very competitive market with some reinvigorated players who are all looking to address the addressable market here. Thank you.

Joel Anderson

Hey, thanks Michael and good to hear your voice. Look, I think at the phase we're at right now, Michael, none of what we're taking out at this point in time is stuff that we see, we need to reinvest. We think we still have significant more cost out opportunities. And as we get down to that second wave of stuff, certainly, that's when we'll start to look at things to reinvest, like, more marketing to drive top line growth. But at this point in time, our real focus right now is about, taking costs out of the business. That's not just one time in nature that has to be reinvested in the business, but it's a permanent cost out. And that's kind of how we're thinking about it, Michael.
All right, thanks Michael.

Operator

Steven Zaccone, Citi.

Hi, this is Ariana on for Steve. Thank you for taking our question. My first question is, how is the business trended thus far in 4Q? And are there any call outs for holiday performance relative to the implied 4Q outlook for revenue growth?

Joel Anderson

Look, I'm not going to get into kind of inner quarter trends and stuff. I mean, that's clearly reflected in our guide. We're pleased with the start of the quarter and you can see by the guide, the sequential improvement from Q3, is a nice improvement. And so that's kind of where we're tracking for now and I think we've got momentum going into the back half of the quarter here.

Thank you. And then my follow up is, how do you think about the ability to regain market share in 2025 and in the medium term, like aside from better growth in the category, what you see is the specific drivers to have customers re engage with Petco.

Joel Anderson

Well, look, I hopefully, what you took away from my remarks is that I'm more bullish than ever on my decision to join Petco. The passion I saw from our associates, the way everybody here has just embraced us in turning this business around and getting back to retail disciplines. Certainly then sets us up for growth in '25 and beyond. And as far as specific numbers and everything, we'll outlay that for you as we get into March and next year. But hopefully you sense in my tone in my prepared remarks, how excited I am and the progress we've made in an extremely short period of time.
Thanks Ariana.

Operator

Steve Forbes, Guggenheim.

Julio Marquez

Hey guys, this is Julio Marquez on for Steve Forbes. I wanted to touch on the vet hospitals an opportunity for efficiency enhancements. I think you mentioned, in a need for full time staffing, maybe some improvement on the merchandizing side. So any color you can provide there on staffing and merchandizing and maybe the anticipated to lift and finally any way to contextualize, maybe the end state margin for the vet clinics and I guess maybe the scaling to get there. Thank you.

Joel Anderson

Yeah, if I heard you right, your question was about the hospitals. Look, we've made a lot of progress this year, Steven who joined us earlier this year and leads our hospital operations team has just done a great job of delivering better profitability, helping us invest better in terms of staffing, utilization rates, etcetera, etcetera.
So, the progress we're making there is fantastic and it certainly resulted in sales continuing to grow. I mean, our hospitals and Vetco were up 17% this last quarter and really pleased the progress we're making with, hospitals and vets overall.
Is there a second part to that question, I missed on there.

Julio Marquez

Maybe on the merchandizing opportunities there. And just if -- how you guys are thinking about like the end state margin for the bad hospital business and maybe, the scaling to get there. Is it more like intermediate kind of thing or long term kind of thing?

Joel Anderson

Yeah. Look, I think on the merchandizing piece, it's us getting better at [RX]. It's us getting better at connecting our vets back into the stores and the grooming and the recommendations there, our product that's something we're just still in our infancy on and we can get better. As far as the ultimate goal on margins, there's just still so much improvement there that we're no nowhere close to the peak there of what the ultimate margin is. Our hospitals are rather still in their infancy and we'll continue to improve as our utilization rates go up.

Julio Marquez

Thank you.

Joel Anderson

You bet.

Operator

Zach Fadem, Wells Fargo.

David Lance

Hey guys, this is David Lance on for Zach. Thanks for taking our questions. So I guess how should we think about the potential glide path of gross margin improvement from here? And is there any color you can provide around Q4 outside of lapping the 130 basis points inventory write down.

Brian Larose

Thanks for your question. We're not going to get into guiding for the rest of the year on gross margin. I will tell you we're encouraged by what we saw in Q3. As I mentioned earlier, there were two fundamental drivers in the improvement year-over-year. Number one was the cost actions beginning to take hold. Number two was the improvement in the services business. And again, that's with mix going against us. So we are starting to see those actions take hold. Joe talked about those being not one time in nature but being fundamental to our D&A and how we operate and run the company. So beyond that though, we're not going to give anything forward.

David Lance

Got it. Okay. That's helpful. And then --

Joel Anderson

Sorry, go ahead.
No, go ahead, David.

David Lance

Okay. Can you talk about the 3% decline in services and companion animal in the context of the broader market?

Brian Larose

I would contextualize it this way. Just as we said earlier, we're in self-help mode here and when we think about the market, we're not passively waiting for the market to recover and supplies and companion animal. We're taking actions. Part of the cost actions are in those two categories. The assortment actions are in those two categories and we see a lot of room for improvement for us regardless of how the market performs overall.

David Lance

Got it. Thank you.

Operator

Simeon Gutman, Morgan Stanley.

Lauren Ng

Hi, this is Lauren Ng on for Simeon Gutman. We wanted to ask about the consumables improvement in Q3. Just curious to know if this was ticket driven. Are you seeing new pet owners or customers coming to Petco? Just any color on the improvement there? Thank you.

Joel Anderson

Yeah, look, consumer was something I talked about a couple of questions ago and that business, is all about being in stock. And I think it's a combination of our new inventory management system that's now fully in place in Q3, it's about the teams getting better at flowing inventory, better shelf utilization and then just being priced competitively. So all those actions we're taking are starting to show up in better sales and that's what you saw start to happen in Q3.

Brian Larose

I would just add one thing to that and that's fresh frozen continues to be really strong for us. That was up 20% year-over-year in the quarter. So that continues to be strong.

Lauren Ng

Great. Thank you.

Joel Anderson

Thanks Lauren.

Operator

Kendall Toscano, Bank of America.

Kendall Toscano

Hi, thanks for taking my question. I just wanted to go back to you, you talked before about opportunities in merchandizing and negotiating better terms from your suppliers and it may still be early but just curious if there's any update on what the response has been from vendors and how receptive they've been to your efforts there. Thanks.

Joel Anderson

Yeah, thanks for the question, Kendall. Look, I actually think I commented on specifically in my prepared remarks, the discussions with our vendors have been really well received. I personally have met with some of our merch vendor partners myself. And the key to all that is transparency and openness and talking to them about what they need as much as what we need. We've had just really successful discussions there as we build our joint business plans for 2025. And I'm really pleased with the progress our merchant teams have done.

Kendall Toscano

Got it. Thanks for the help there. Another question I had was just on an another one that may still be early to ask, but curious if there's any update on the vet hospitals and when you're thinking about potentially returning to rolling those out, since you're kind of positive for this year in the foreseeable future. Curious on the timeline of that.

Joel Anderson

Yeah, the vet hospitals are a key growth driver for us and they're also a key differentiator for us as all our vet hospitals are Petco owned. As far as what the specific growth for next year will be, we'll lay that out for you in detail as we get into March. But we do expect that to continue to be a growth driver for us.

Brian Larose

And I would just add Kendall the decision to open a handful this year was not because that's not strategic, not because we don't believe it's a short, medium and long term opportunity. There's may because we wanted to make sure we continue to strengthen our balance sheet, generate free cash flow and get the company back in the position of strength so that we can invest in those high ROI projects going forward.

Operator

This concludes our question and answer session. I would like to turn the conference back over to Lisa Stark for any closing remarks.

Lisa Stark

Thank you for your time and for your question. That concludes today's earnings call. Thank you.

Operator

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