Chewy Inc

NYSE:CHWY

Earnings Call Transcript 2021-Q1

[Operator]

Good day, and welcome to the Chewy First Quarter 2021 Earnings Conference Call. [Operator Instructions]. Please note, this event is being recorded. I would now like to turn the conference over to Robert LaFleur, Vice President, Investor Relations. Please go ahead.

[Robert LaFleur, VP, IR & Capital Markets]

Thank you for joining us on the call today to discuss our first quarter 2021 results. Joining me today on the call 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, financial results, business strategies, investments, industry trends and our ability to successfully respond to business risks, including those related to the spread of COVID-19, including any adverse impacts on our supply chain, workforce, fulfillment centers, other facilities, customer service operations and future plans. Such statements are considered forward-looking statements under the Private Securities Litigation Reform Act of 1995 and are subject to certain risks and uncertainties, which could cause actual results to differ materially from those contemplated by our forward-looking statements. Reported results should not be considered an indication of future performance.

Also, note that the forward-looking statements on this call are based on information available to us as of today's date. We disclaim any obligation to update any forward-looking statements, except as required by law. For further information, please refer to the risk factors and other information in Chewy's 10-Q and 8-K filed earlier today and in our other filings with the SEC.

Also during this call, we will discuss certain non-GAAP financial measures. Reconciliations of these non-GAAP items to the most directly comparable GAAP financial measures are provided on our Investor Relations website and in our earnings release and letter to shareholders, which were filed with the SEC on Form 8-K earlier today and in our 10-Q. These non-GAAP measures are not intended as a substitute for GAAP results.

Additionally, unless otherwise noted, results discussed today refer to first quarter 2021, and all comparisons are accordingly against the first quarter of 2020. Finally, this call in its entirety is being webcast on our Investor Relations website. A replay of this call will also be available on our IR website shortly.

I'd now like to turn the call over to Sumit.

[Sumit Singh, CEO & Director]

Thanks, Bob, and thanks to all of you for joining us on the call. 2021 is already turning out to be an exciting and busy year for us at Chewy. Our business momentum and strong customer engagement continue. And that gives us the confidence to raise our full year 2021 guidance for net sales and adjusted EBITDA margin expansion.

Along with our financial results, today, I will share with you some exciting new launches that highlight our ongoing pace of innovation and further strengthen our customer value proposition. I will also share with you some of the headwinds we are facing and update you on the actions we are taking to protect customer experience and business continuity. After that, I will turn the call over to Mario to discuss our first quarter results in greater detail and share our updated guidance.

Let's start with our Q1 results. Q1 net sales increased 32% to $2.14 billion. Continued growth in our active customer base and strength in purchasing behavior drove our top line results. While we are pleased with our net sales in the quarter, elevated out-of-stock levels were a persistent headwind throughout the quarter and reduced our Q1 net sales by an estimated $40 million. This is clearly a supply-driven situation, which we expect to abate in the second half of this year as additional production capacity comes online. Until then, we will keep actively managing our inventory and using our recommendation engines to help customers find attractive alternatives.

Efficiently adding new customers to our platform and then growing their share of wallet remains a key part of our growth strategy. Active customers increased by 4.7 million or 31.6% to end the first quarter at 19.8 million customers. New customer additions remained above pre-pandemic levels and, as anticipated, moderated against the peak pandemic levels of this past year. Further, retention rates remained steady as the 2020 cohort matures into their second year on our platform.

Taking a broader view, over the past 2 years, we have increased our active customer base by 8.4 million or 75%. The practical effect of this is that the weighted average tenure of our active customer base is just under 2 years. In other words, our average active customer is still squarely on the left side of their lifetime spending curve with us. For context, our customers historically spend over $400 with us in their second year compared to approximately $700 in their fifth year and almost $900 in their 9 year. As such, we believe that we still have significant future share of wallet gains left to realize from a substantial component of our customer base.

First quarter net sales per active customer, or NSPAC, increased $31 or 8.7% to reach $388, a meaningful acceleration over our 2020 growth rate. In reviewing the purchase behavior of the Q1 customer cohort, we saw the same kind of positive engagement levels and basket size trends that we saw throughout 2020, which helped drive a 13% year-over-year increase in Q1 average spend per new customer.

Top line momentum translated into improved margin performance. Q1 gross margin was 27.6%, reflecting a 420-basis-point increase, approximately half of which is the result of our efforts to improve customer engagement and drive structural growth in our hard goods, proprietary brands, specialty and health care verticals. The remainder came from normalizing freight costs against the COVID-related spike last year and the muted pricing and promotional environment.

As we executed Q1 with rigor, we faced labor shortages in our fulfillment centers, or FCs, similar to those being faced by many companies nationwide. To offset these headwinds, we did a few things concurrently. We invested in higher wages and short-term incentives, which to some degree helped overcome FC staffing constraints. We also implemented other operating cost disciplines. For example, we developed algorithms, which enabled real-time improvements in inventory receipts and order allocation, leading to increased density in pick and pack across our FC network.

We introduced part-time shifts to better optimize interval-level labor forecasting and provide more flexibility options to our team members. These activities helped keep operating expenses in check. And this operating discipline, when combined with our strong gross margin performance, drove meaningful improvements and flow-through as Q1 adjusted EBITDA came in at $77.4 million and adjusted EBITDA margin increased 340 basis points to 3.6%.

In addition to these strong financial results, I am also tremendously proud of the broader transformations underway at Chewy. In 2018, we were mostly a provider of food and treats. Today, just 3 years later, we are delivering a multidimensional customer experience that spans food, treats, personalized accessories, health care and most recently services. And our pace of innovation and quality of execution has never been stronger.

With that in mind, I'd now like to spend a few minutes sharing some of the many things that are going on inside Chewy today. We are excited about these, because they represent continued progress in our effort to improve experience for our pet parents and partners and drive higher engagement with them. Additionally, they position us well to capture the large and growing opportunity in front of us.

First, we continue to make meaningful strides in upgrading our technology stack and architecture. In Q1 2021, we relaunched the chewy.com homepage and other stops in the shopping funnel at single page application. This enhancement allows us to offer a more targeted and customized shopping experience to our customers, which we are already starting to take advantage of. Once fully implemented across our website, these features will unlock hyperlocal and enhanced personalized recommendations that will improve the shopping experience and, through their revenue-enhancing functionality, support our efforts to increase customer share of wallet.

We are also excited to announce our entry into the fresh and prepared pet food space with new selections from the segment's leading brand, Freshpet; and our premium proprietary brand, Tylee's. Our highly trained and best-in-class customer service team, coupled with our personalized search and discovery features, make Chewy the right platform to drive customer adoption in this category, given the increased level of education and awareness pet parents need when deciding among the many pet food options that are available today.

To date, we have already developed and patented new sustainable packaging that allows us to preserve product quality throughout the customer delivery process. We are currently in beta mode and will soon launch our initial distribution in 3 geographies, covering approximately 60% of Chewy's customer base. And we intend to grow both our fresh catalog and expand geographic distribution as we scale this business.

We are enthusiastic about the fresh and prepared foods categories and the opportunity to serve new customers and expand assortment choices for our existing ones. With this launch, Fresh joins Connect with a Vet and our compounding pharmacy on the growing list of recently launched offerings that expand our TAM.

Over the past few years, we have expanded our pet health and wellness offerings to include a wide spectrum of products and services, which now include OTC medicine, vet diet, pharmacy and most recently Petscriptions, Compounding and tele-health. Collectively, we now call this still expanding effort Chewy Health, which consumers and veterinarians are starting to recognize as a brand that delivers innovative solutions designed to improve the health of every pet and empower those who care for them.

We continue to gain traction with our recently launched innovations, Connect with a Vet, Compounding Pharmacy and Petscriptions, which is our proprietary prescription management system for veterinarians. Recently, we enabled the video chat functionality for our proprietary tele-health solution and expanded its reach. Connect with a Vet is now available via text or video chat 7 days a week until 11:00 p.m. East Coast time 365 days a year, which provides important coverage on nights, weekends and holidays when care is often difficult to find.

These upgrades have significantly improved customer experience and are driving higher customer adoption of this service. Net Promoter Scores for Connect with a Vet remained strong, and over 85% of customers who rated the service in Q1 gave us perfect 10 out of 10 scores.

Our Compounding Pharmacy business continues to expand. We now publish 1,800 compounding SKUs, servicing dogs, cats and, as of April, horses. We also achieved a major milestone recently by earning our PCAB accreditation, which is the gold standard for quality and safety compliance in the compounding industry. As planned, our entrance into Compounding is improving customer access to pet health and wellness services and growing our customer base. Approximately 2/3 of our compounding customers are new to Chewy Health, including over 20% that are new to Chewy overall. As anticipated, compounding is also emerging as a strong recurring revenue driver, with over 60% of outbound shipments already going through Autoship.

And on Petscriptions, I am pleased to share that close to 7,000 clinics and veterinarian partners are now utilizing this product to simplify and automate all prescription management tasks with an intuitive, easy-to-use digital solution. This helps to reduce friction, improve veterinarian efficiency, reduce in-clinic costs and enhance customer experience for both the veterinarian and the patient. We will share more about our ongoing work in this space in our Q2 call in September.

Chewy Health is the only brand that blends technology and consumer innovation in pioneering modern pet health solutions for everyone. Our mission within Chewy Health is to make pet health care more affordable and accessible by developing value-added services and products that keep pet parents and veterinarians at the center of the equation. We are just getting started, and we'll keep you updated on our progress.

The same spirit that animates our quest to make pet health care more affordable and accessible also drives our charitable efforts through a program we call Chewy Gives Back. Chewy Gives Back operates under a mission to make the world a better place for pets and the communities that serve them. To this end, last year, we made approximately $35 million of in-kind donations to shelter and rescues, providing them with the critical suppliers they needed to perform their important work on the front lines.

Additionally, I am excited to share with you that last week, we launched our nationwide Pet Adoption Services that enables millions of Chewy customers and not-yet Chewy customers to discover and adopt a pet directly through Chewy's website. As with everything we do, we believe that customers will find this new service to be an engaging and bar-raising experience. Over 6,000 shelters and rescues have already signed up and the list continues to grow rapidly. The launch is supported with full Wish List integration, which enables shelter and rescues to list their needed supplies on chewy.com for our customers to conveniently discover, donate and have them shipped directly to the shelter.

Our launch of the Pet Adoption Service and features such as Wish List, again, shows how our innovation with customers continues to extend to our partners and service community and is in complete harmony with our mission of being the most trusted and convenient destination for pet parents and partners everywhere.

Now before I wrap up, let's quickly visit growth across our fulfillment center networks. As our top line momentum continues, we are investing in our distribution network to stay ahead of the growth curve and enhance customer experience. At the end of Q1, we opened our 12th fulfillment center located in Lewisberry, Pennsylvania. This facility primarily specializes in carrying our bulky assortment items like cat trees and dog crates and/or items that ship in their original containers.

I'm also pleased to share the news that we are expanding the capacity of our Phoenix, Arizona fulfillment center this summer and also that we will open our third automated FC and 13th FC overall in Reno, Nevada next year. This new facility, along with the Phoenix expansion, will further reduce ship times, improve customer experience and help reduce costs.

I will end my comments by reiterating my optimistic outlook for the balance of 2021. We continue to execute against our growth road map by expanding our customer base, increasing share of wallet, growing our TAM-expanding verticals and launching new ones.

While supply chain and labor market conditions remain challenging, we are successfully managing through these headwinds and still driving significant year-over-year improvements in gross margin, adjusted EBITDA and free cash flow. I am incredibly proud of the determination and focus of our teams and their ability to accelerate our pace of innovation while consistently delivering strong top line and bottom line results for our shareholders.

With that, I will turn the call over to Mario.

[Mario Marte, CFO]

Thank you, Sumit. We continue to execute on our long-term strategy, and momentum remains healthy. First quarter net sales were $2.14 billion, representing 31.7% growth. First quarter Autoship customer sales increased 34.4% to $1.48 billion. And Autoship sales as a percentage of net sales increased 140 basis points to 69.3%, which approaches the high watermark we reached in the fourth quarter of 2019.

These results reflect the maturation of the 2020 customer cohort and the growing appeal of the Autoship program's benefits, which include complementary access to our first-in-the-industry tele-health offering, Connect with a Vet. Autoship is a powerful tool for reinforcing the customer value proposition and strengthening loyalty bonds with pet parents.

Net sales per active customer, or NSPAC, increased $31 or 8.7% to reach $388 in the first quarter. Compared to the fourth quarter of 2020, NSPAC increased $16 sequentially and marks the largest absolute single quarter NSPAC increase in the company's history. Improved describability and merchandising, growth in our newest verticals and more spending from the 2020 customer cohort are the primary drivers behind the acceleration in NSPAC growth.

Moving down the income statement. First quarter gross margin was 27.6%, an increase of 420 basis points. As Sumit mentioned, approximately half of the increase came from structural business improvements, and the remainder reflects normalized freight and logistics costs compared to the elevated investments we made during the peak of the pandemic last year to protect customer experience and the muted price competition and promotional activity that we saw in the first quarter this year.

First quarter operating expenses, which include SG&A and advertising and marketing, were $550.7 million or 25.8% of net sales, scaling 50 basis points. SG&A, which includes all fulfillment and customer service costs, credit card processing fees, corporate overhead and share-based compensation, totaled $406.2 million in the first quarter or 19% of net sales, scaling 70 basis points. SG&A, excluding share-based compensation, totaled $381.4 million in the first quarter of 2021 or 17.9% of net sales, an increase of 80 basis points. This reflects the additional investments we made in wages and benefits for our fulfillment and customer service teams that we outlined on our last earnings call as well as the impact of the higher recruiting and hiring incentives that have been necessary to address persistent labor shortages. Absent the incremental wage benefit and recruiting costs related to the current disruptions in the labor market, our SG&A expense, excluding share-based compensation, would have been flat year-over-year as a percentage of net sales.

Launching four new FCs in 12 months while keeping SG&A flat as a percentage of net sales, aside from incremental expenses related to current labor markets, demonstrates our ability to fund incremental investments in capacity by efficiently leveraging operating expenses across the network.

First quarter advertising and marketing was $144.4 million or 6.8% of net sales, a 30 basis point increase versus first quarter 2020. We expected this line to increase year-over-year on a percentage of net sales basis as input costs recovered from the artificial lows we saw early in the pandemic.

Adjusted EBITDA reached a new high this quarter, totaling $77.4 million, improving $73.9 million versus the first quarter of 2020 for a net sales to adjusted EBITDA flow-through of 10.5% excluding the estimated $20 million negative impact that COVID-19 had on freight costs in the first quarter of 2020. Adjusted EBITDA margin improved 340 basis points to 3.6%.

In Q1, we also delivered our second quarter of positive net income, reaching $38.7 million, improving $86.6 million versus the first quarter of 2020. Our net margin was 1.8%, a 480 basis point improvement. As we have shared in the past, we expect our expanding and profitable repeat business, coupled with the benefits of scale, to drive increasing profitability over the long term.

Moving on to free cash flow. First quarter free cash flow was $59.5 million, reflecting $98.4 million in positive cash flow from operating activities and $38.9 million of capital expenditures. The positive operating cash in Q1 was primarily a function of Q1 profitability and favorable working capital, which mostly reflects a temporary reduction in inventory levels due to the ongoing supply chain situation. Capital investments include ongoing additions to our fulfillment network, including cash outlays for our recently opened limited catalog facility in Pennsylvania and our second automated fulfillment center in Kansas City. We finished the quarter with $638 million of cash and cash equivalents on the balance sheet, which is our highest ever level of cash on hand.

That concludes my first quarter recap. So now let's discuss our second quarter and full year guidance. We are raising our full year top line and profitability outlook, but before I discuss the details, I'd like to spend a few moments on how we formulated this guidance.

As Sumit mentioned at the beginning of the call, 2021 continues to be a busy and exciting year for us. Our strategy remains intact, demand remains strong, and we remain bullish about our future and our ability to maintain pace of execution. At the same time, as we prepare and ramp our network to handle the current and future momentum in our business, we are not immune to the labor shortages currently being faced across the country.

Even with the $60 million of enhanced wages and benefits that we committed to last quarter, labor markets remain constrained, and it remains difficult to attract workers. In an attempt to fill job vacancies, companies across the U.S. continue to invest in higher wages and benefits. As these conditions persist, we may choose to commit an additional $30 million to recruiting and hiring incentives over the next 2 quarters. Although we expect these types of expenses to be temporary in nature, that ultimately depends on how labor markets respond to the end of extended unemployment benefits in September.

While these higher costs may put near-term pressure on our ability to scale SG&A, we are increasingly confident that these investments in our workforce and automation will increase engagement, retention and productivity over the long run. When we net these headwinds and tailwinds, we are more positive in our outlook than we were just 9 weeks ago when we issued our initial 2021 guidance.

So with that in mind, we expect second quarter net sales to be between $2.15 billion and $2.17 billion, representing 26% to 28% year-over-year growth. We are raising our full year 2021 net sales guidance to between $8.9 billion and $9.0 billion, representing 25% to 26% year-over-year growth. And finally, we are raising our full year 2021 guidance for year-over-year adjusted EBITDA margin expansion to between 80 and 120 basis points.

As you update your models for 2021, please keep the following in mind. First, elevated out-of-stock levels are a stronger headwind this year than they were in 2020, and we have not yet seen signs of this abating. While macro conditions are clearly improving on the pandemic front as vaccination levels increase, predicting how exactly consumers will behave post-pandemic is not yet fully clear. What is clear to us is that our compelling value proposition and the predictable and recurring nature of nearly 70% of our business provides us real and tangible advantages in today's marketplace.

Second, as you saw in the first quarter, our advertising and marketing spend remains disciplined as we adjust in real-time to rapid changes in the advertising landscape. As always, we remain vigilant and ready to make additional investments to achieve long-term benefits, even if they come at the expense of short-term results.

And third, as we have shared before, net customer assets here should look more like they did in 2019, prior to the epidemic, which reflect the normal retention patterns we expect to see from the 2020 cohort as it moves from its first to its second year. NSPAC is expected to accelerate in 2021 as we annualize the 2020 cohort and as the many initiatives that we have launched over the past 2 years continue to expand customer share of wallet.

2021 is off to a great start. We grew first quarter net sales by 32%, and our growing scale and operating discipline drove 420 basis points of gross margin expansion. We also delivered our highest quarterly adjusted EBITDA ever. By increasing our net sales and adjusted EBITDA guidance, we are reiterating our bullish view on Chewy's market position and how we see the balance of 2021 playing out.

And with that, I'll turn the call over to the operator. Operator?

[Operator]

[Operator Instructions]. Our first question will come from Mark Mahaney with Evercore.

[Mark Mahaney, Evercore ISI]

Two questions, please. The out-of-stock issue, it sounds like, Mario, that, that's continuing. Can you just talk about your level of confidence that, that will abate in the back half of this year? And what you can do to help that abate? I don't know if that's completely out of your hands or not.

And then I want to ask about the statement about new customer acquisitions remain above pre-pandemic levels. The net adds in this April quarter were actually below the net adds you had in the first quarter of '19. Does that mean that you've got elevated churn just related to all the new customers you brought on during the COVID year or am I misinterpreting it? I just want to -- I want to get back to this issue of whether your net customer adds can this year be like they were in 2019.

[Sumit Singh, CEO & Director]

This is Sumit. I will take the first question. Mario will take the second one. On out-of-stocks, we believe, as we've indicated in the Q4 earnings call, vet canned food capacity constraints or production capacity constraints was where this started and primarily remains there. Any other out-of-stocks that we're facing, we're actually able to fairly mitigate, given our extensive size of the catalog and given the substitutability within discretionary categories such as hard goods or supplies. The -- primarily the area that out-of-stock issues are being felt on industry-wide, this is not a Chewy thing, this is an industry-wide issue, is consumables. So health care is also not as deeply impacted with this.

And while we don't have perfect visibility, obviously, there's no perfect data coming in, what we have heard and why we have confidence from our strategic suppliers and vendors and partners is that incremental investment is going in and incremental capacity is being unlocked and should be available in the back half of this year. The rate of improvement is the one that is a little bit unclear right now, and which is why, we've consistently, starting from Q4, said that this is a headwind that we will continue to monitor. But yes, we do expect it to abate back half of this year.

[Mario Marte, CFO]

And I'll answer the second part of your question. And first, you're right, we added 600,000 net active customers in the first quarter, ended at 19.8 million active customers in Q1. And that was right in line with our expectations for the quarter and what we've mentioned over the last couple of earnings calls. So I'll break it down into retention and then gross customer adds. I know you know the dynamics of this for everybody else to paint the full picture.

First, we said before that retention rates for us, our retention rates are multiples higher than traditional e-commerce platform. And then any attrition that we see happens year 1 into year 2. And that customers that stay with us after 2 years remain with us for a very long time. So then let's talk about the Q1 '20 cohort, because that's really what's going to drive some of the year-over-year impact here.

First, retention rate for that cohort is higher than the average retention rate over the last couple of years. But even with a higher retention, that cohort was so large that the normal attrition we saw created a headwind to net customer adds this quarter. Then if we look at the customer -- new customer adds this past quarter and first quarter '21, that was not only higher than pre-pandemic, but it was also higher than what we expected for this year just 18 months ago. So dial it back 18 months, what we projected this far out into first quarter '21, our pace of new adds was higher than then and higher than pre-pandemic. So we're still acquiring customers at a very fast clip.

So you think of it another way, we don't believe that any of the demand we saw in 2020 was a pull-forward from future years, still adding a lot of gross new customers. And then finally, take it from a revenue perspective, we expect the 2020 cohort to generate more revenues this year than they did last year. And in fact, when we look at all the mature cohorts, so 2011 through 2018, let's say, they produced more revenue in 2020 than they did in their first full year on our platform. So we would expect the same thing for our 2020 cohort coming into 2021.

[Operator]

Our next question will come from Nat Schindler with Bank of America.

[Nathaniel Schindler, Bank of America Merrill Lynch]

I'm actually wondering about some more of your longer-term plans on your growth and international expansion and what conditions and what areas would you look to go to and how you would enter new markets, particularly Europe, where similar size to the U.S.

[Sumit Singh, CEO & Director]

This is Sumit. I will take that question. Our plans, first of all, are squarely centered on achieving our mission statement to be the most trusted, convenient destination for pet parents everywhere. And obviously, we've gone back and now added the word partners there, because we believe we are effectively servicing and should service communities in pet that have not been serviced in a high-quality manner, in our opinion, in the past.

So given that, we have focused on the United States, and we believe there is a ton of online growth that is being driven and will continue to be driven in the United States. And we fully plan to capitalize on that growth, given our investments across the multidimensional experience that we talked about in the earnings script, food, treats, personalized accessories, health care and services.

International, the last word of our mission statement is to be present everywhere. We believe pet parents are more the same than different. We also believe that our brand and our capability is extensible outside the United States. That being said, focus has been important to us. We've been focused on the U.S. And we've said international plans are roughly between 1 and 5 years, and that step at the point of IPO, we had said that, and that's still -- that statement remains true.

When we do explore international, we would explore it -- keep our options open and explore every possibility. And in terms of what specific country we would enter and how we would do it is a matter of working through how customers behave, how markets are, how do you do marketing, supply chain, infrastructure, availability, customer behavior, all of that. And we'll work backward from that to be able to figure out what markets we enter. But rest assured, we're going to be thoughtful, we're going to be diligent, and we're going to be disciplined about the investments and our approach internationally.

[Operator]

Our next question will come from Erin Wright with Crédit Suisse.

[Erin Wright, Crédit Suisse]

Can you speak to the traction you're seeing across the pharmacy business? Is it -- is the stickiness across that business playing out according to plan as we lap some of the COVID dynamics from last year, some of that going back to the vet clinic? And you mentioned you're working with 7,000 vet clinics now. What sort of share do you have in terms of the percent of scripts that you're -- that -- at those clinics that are getting filled through Chewy?

[Sumit Singh, CEO & Director]

Sure. We believe a couple of things to be true. First of all, our data indicates that retention into our pharmacy and other health care verticals remains strong. Autoship subscription rates into these verticals remain stronger than the core business, which is a net positive. And our work with veterinarians and connecting customers into veterinarians continues to earn us trust and credibility in this space. A recently conducted independent research, driven by Mark, suggested that 86% of the veterinarian community would be open and favorable to working with Chewy. These are encouraging data points to us.

And the Petscriptions, as I mentioned, is present in 7,000 clinics. I'll refrain from the number of scripts that you asked, but what I will mention is 7,000 is roughly equivalent to 30% of the veterinarian clinic penetration in the U.S. at this point, which is something that we're tremendously proud of.

[Mario Marte, CFO]

And, Erin, let me add one more thing. So to point you back to our 10-Q, because you'll see that the other segment of our revenue, which includes all proprietary brands, pharmacy, other and specialty, notice the speed of growth for that part of the revenue. It's growing twice as fast as the overall business. So that should give you an indication of how we think about these newest verticals.

[Erin Wright, Crédit Suisse]

Okay. Great. And one just quick follow-up just on the incremental spending associated with higher union incentives, the $30 million. So that's not -- or is that embedded in your guidance at this point? Or is that an incremental expense?

[Sumit Singh, CEO & Director]

It is fully embedded in our guidance.

[Operator]

Our next question will come from Brian Fitzgerald with Wells Fargo.

[Brian Fitzgerald, Wells Fargo Securities]

We want to ask about the entry into the fresh market. Could you maybe provide us with some context around the opportunity, the current size of Freshpet food market? And maybe what happens with consumable spend as you move from traditional to fresh, what the margin uplift is there?

And then maybe really quickly on the adoption service. It sounds like you stood that up pretty rapidly. You've already done a really nice job there, integrating with shelters. We know it's early on, but what's the opportunity to build awareness there? And then are you investing behind that? And any early learnings with kind of the attach rates and what those cohorts look like and maybe how the adoption cohorts maybe differ from traditional cohorts?

[Sumit Singh, CEO & Director]

Okay. Nice to hear from you. There's a lot in there, so let's try to unpack them to at least two distinct areas, fresh and packaged foods and then shelter adoptions. Fresh and packaged foods, we believe -- we've always understood and believe that humanization and premiumization of pet is very real and our customers -- as customers become more aware, given our ability to educate them and given their natural ability to engage with their pets, categories such as fresh and prepared foods is an attractive opportunity for us to get into and service customers in a high-quality manner.

Another motivation for us is the fact that this is a category that requires education, and there are barriers to adoption if the customer isn't engaged or educated. And we believe that with the high customer care model that we bring to the pet industry as well as our focus on personalized care and experience building, we believe we can effectively educate customers and therefore drive customer adoption in the category.

In terms of the size, there's not perfect data available. The market right now is likely between $600 million to $1 billion in size. Growth rates also are hard to predict, because again, it's not an easy category to drive adoption into. And we believe that we can do an effective job in connecting customers with high-quality products to be able to drive that adoption. And you'll see us focus on that.

Of course, any business -- new business that we launch requires investment. The investment -- on the CapEx side, all of the investments is already baked in into our guidance as well as the 1.5% to 2% CapEx spend that we modeled in our P&L. And then we would expect the business to be -- to scale as we drive scale into the business. And right now, the impact of margins or any dilution is really immaterial and negligible. So that's on fresh and packaged foods.

On Pet Adoption Services, again, yes, very proud to work across the shelter community to bring this to life. It is our way of giving back to the community and connecting pet parents, who are likely Chewy customers and those who are not yet Chewy customers, to bring Chewy top-of-mind consideration where their journey begins. Over 55% to 60% of the pets in the U.S. are adopted via shelters and rescues. And this is our way of connecting the 2 communities to be able to serve a greater purpose and to build brand awareness and consideration towards Chewy, which then drives, again, future loyalty and engenders repeat visits to our platform. So we'll continue to enhance our work in this space and come back and share more as the program grows.

[Operator]

Our next question will come from Steph Wissink with Jefferies.

[Stephanie Wissink, Jefferies]

Mario, these might be best suited for you, but, Sumit, please jump in. I want to talk a little bit about gross margin advancement, because it is running several hundred basis points ahead of where we would have expected the model at this stage. So I'm curious if you can talk a little bit about what opportunities still exist to further enhance the margin, whether that's through mix or leverage.

And then, Mario, a question for you on cash. I mean the cash flow in the quarter was outstanding. I know that some of that was a benefit of working capital. But how should we think about cash flow for the year? And how should we also think about your cash priorities, therefore, as the cash continues to build on the balance sheet?

[Sumit Singh, CEO & Director]

All great questions. I will take the first one on gross margins. Mario will take the second one on cash. Gross margins, I would like to point you back to the road map that I have often shared on these calls, 3 buckets of gross margin improvement: acquiring customers and growing share of wallet, bucket one; growing -- investing in improved discoverability, merchandising and growing our sub-penetrated newer verticals, proprietary health care, et cetera, bucket 2; and then connecting the destination with services.

Yes, we believe we are making incremental and encouraging progress in our gross margin. We are now net of the pricing muted environments. We believe we are sitting at right about 26%, which is slightly above the low end of the long-range guide. And we believe there's a ton of headroom in front of us to be able to go achieve the long-term guide of 28% margin and perhaps even surpass that as we continue to build behind gross margin.

We still have -- less than 1/3 of Chewy customers today are exposed to proprietary brands. Less than 1/5 of our customers today are exposed to health care. And so there's a lot of opportunity and headroom as we develop that customer base to become full funnel shoppers with us and increase their basket sizes. At the same time, you've seen us expand our addressable market by launching newer categories such as fresh and packaged foods that we're describing today. And at the same time, we're starting to uptake our focus on services with Compounding and tele-health, which have great potential for us in the future.

So net-net, I want to give you the confidence that there's a lot of innovation that is going on inside the company. We're very disciplined. And we're focused on rapidly improving customer engagement so that we can achieve the high end of our gross margin targets as we've laid out. And then when we're ready to discuss any updates in the future, we will talk about that on future calls.

[Mario Marte, CFO]

This is Mario. So I'll answer the second part of the question in terms of cash. So you have seen us over the year be able to grow very rapidly without consuming any cash. And this year, if you look at the guidance we provided for net sales and for adjusted EBITDA margin, you would see, at the high end, we would produce over $200 million of adjusted EBITDA. So I'll let you draw a conclusion on what that means for free cash flow, since we don't explicitly guide to that. But obviously, those are two good components to how we -- what we expect for cash generation this year.

I would say two other things about cash. One is, you're right, we benefited to a degree from working capital, the fact that we drew down some of the inventory in the first quarter. Certainly, that's not -- that would otherwise not have been our intention, given that, that was more of a result of high out-of-stock and disruptions in the supply chain. So you would expect us to build the inventory back up throughout the year to make sure that we can serve our customers.

Then you look at the cash that we have available to us. And you're right, we ended the quarter with the highest cash level we've had in our history. We also ended the quarter with a facility of $300 million that's untapped. So roughly $1 billion of dry powder. That gives us both strength in the balance sheet and also flexibility going forward for things like incremental investments in technology, automation, potentially M&A and growing new verticals and expanding our TAM. So it's good to have the flexibility, and I think we're in the right place in terms of cash.

[Operator]

Our next question will come from Doug Anmuth with JPMorgan.

[Douglas Anmuth, JPMorgan Chase & Co.]

First, just on profitability. I know you raised the margin expansion, obviously, for the full year outlook. Just thinking about the $60 million potentially in the back half, is that essentially the reason for not seeing more flow-through on a full year basis? Or is there something else or additional that we should be thinking about just on the EBITDA for '21?

And then secondly, just on private label, I think you said about 1/3 of customers are exposed there. Just curious if you can help frame that in terms of where you are as perhaps a percentage of net sales and, I think, in relation to perhaps your ambitions that you've maybe mentioned in the past toward a 15% to 30% over time?

[Sumit Singh, CEO & Director]

Sure. This is Sumit. I'll take the second one. Mario will take the first one. So starting with private brands. What I mean by that is, of the nearly 20 million customers that we now have on Chewy, 1/3 of them have acquired or bought private label from us or our proprietary brands from us. So 2/3 of them haven't yet shopped proprietary brands. And our efforts in improvement in search and discoverability and newer launches or assortment will continue to provide us that exposure.

We're actually -- we're pleased with the progress that we are making. As you might recall from a previously shared fact, we've improved -- we've doubled the overall number of assortment on the platform, roughly 35,000 new SKUs added over the last 2.5 years. And about 1/4 of them have gone squarely towards building out proprietary and, more so, hard goods. And in hard goods, we gained 500 basis points share on a year-over-year basis, reaching 18% penetration, therefore bringing us closer to that goal of 15% to 30% that we're talking about.

We believe, in hard goods, we should be able to reach 40%, 45% penetration of net sales in proprietary and the balance coming from consumables. That makes up the 15% -- between 15% and 30% ranges that we've talked about. Gross margin for proprietary is favorable to the core business, which is reflected in the overall gross margin improvement that we're reflecting in our P&L or in the results. And you should continue to expect us to build assortment and expose more customers to buy more proprietary.

[Mario Marte, CFO]

And I'll take the first part of the question. So let me first start off with Q1 to sort of level set us. But in the first quarter, we added $0.5 billion year-over-year. We increased gross margin, and we had discipline in the expense line. And so we reported, as you saw, a record adjusted EBITDA of $77 million. And if you think about what that means versus full year 2020, our EBITDA in the first quarter was higher than all of last year, if you adjust out the onetime tax benefit in fourth quarter 2020.

Now for the full year, we -- you saw us guide to an adjusted EBITDA margin increase of 80 to 100 basis points, which if you combine that with the sales projection that we provided would mean tripling the EBITDA in the full year. And if you take that and you adjust the -- for the wages and benefits that we've called out explicitly in our fourth quarter and in our first quarter call, you get to about a 9% to 11% flow-through for the full year, very much in line with what we saw in the first quarter. So think about it in those terms, Doug, and I think you'll get to about the same conclusion.

[Operator]

Our next question will come from Seth Basham with Wedbush Securities.

[Seth Basham, Wedbush Securities]

My question is around advertising. How do we think about advertising as a percentage of sales this year? And I think you were commenting previously around 7% to 8%. You did better than that in the first quarter. Do you expect to move to that range and have the opportunity to grow your gross adds even more aggressively?

[Sumit Singh, CEO & Director]

Yes. This is Sumit. We believe advertising and marketing will likely be in line with levels that we saw in 2020, right about the 7% range, plus and minus. And the plus and minus, driven by efficiencies, if we pick up like we did 20 basis points in Q1. So we came in at 6.8%. And the plus is driven by if we see more opportunity in the marketplace to pick up new customers or if input costs become further degraded. In terms of overall Q1 levels, we're actually quite pleased, it's in line with our expectations. We've been continuing to scale marketing from 11% levels in 2018 to 7.2% coming out of 2020, albeit given some advantage due to the pandemic organic demand.

And on a net basis, on a year-over-year basis, we still incrementally spend $35 million higher on the $500 million of net sales that we added. So overall, I believe we're spending appropriate levels on an absolute basis to be able to efficiently acquire customers, and we remain open to opportunities to ensure that we're not leaving customers on the table.

[Seth Basham, Wedbush Securities]

Relative to 2019, are you expecting customer acquisition costs in 2021 to be higher?

[Sumit Singh, CEO & Director]

It's a very good question. If you recall the Q4 discussion that we had, it is hard to yet predict where marketing might end up this year. We've had a lot of platform changes that have come through across several advertisers. We've also -- it is yet unclear to really predict how customers might behave as the country opens up. So we're still in a bit of an evolving situation, but our guidance takes that into account. And therefore, I'm guiding -- or I'm providing my perspective that we should be flattish to 2020 levels on net spend.

[Operator]

Our next question will come from Peter Keith with Piper Sandler.

[Peter Keith, Piper Sandler & Co.]

I was hoping you could just discuss a little bit more around the new homepage launch around some of the customization and localization features that you have. Maybe just provide some specific examples on how you think that can improve the customer experience.

[Sumit Singh, CEO & Director]

Sure, Peter. So meta points, it improves our ability to target. It improves our ability to personalize the experience by showing you content that is relevant and dynamic and inspiring that speaks directly to the needs of a pet parent and their emotive state or their journey in their life cycle with their specific pet. And so from that standpoint, we already offer a personalized high-touch model. And this actually provides that on a virtual digital basis, which allows -- that targeting allows us efficiency of conversion and a development and -- efficiency in customer development, which allows us to then obviously grow basket sizes and share of wallet with customers.

So that's how we're approaching it. If you go to the homepage today, we have the ability to obviously target knowing if you have a dog, what type of dog now and what other dog parents might be buying, where specifically we're tying it back into knowing what could we recommend to you, et cetera, et cetera. So think of it as a data-driven and behavior-driven experience rather than an unauthenticated experience that we might have offered in the past.

[Peter Keith, Piper Sandler & Co.]

Okay. That's very interesting. The follow-up and unrelated question I had was just around the net customer adds. I know this was asked earlier in the call. But referencing back to the 2019 levels, and you did come in below that for Q1. I would think that the net customer adds moderate as the year progresses just from maybe gross add slowing or 2020 cohort churn picking up in just sheer magnitude. Is my thinking incorrect, or is 560,000 kind of a good level to think about on a run rate basis?

[Mario Marte, CFO]

Yes, Peter, I'll answer that. So look, it's -- I think the dynamics of net active adds is exactly what I had mentioned before. We do have the headwind of a very, very large customer cohort we acquired last year. So even at the retention levels that we're seeing, which are still high, we still would have a net headwind.

The key to net active adds is you have to think about it over a period of time, over a longer period of time than just year-over-year, so you can see the trend of additions. The very large cohort last year is going to have a headwind impact in this year. But the other side of that is how many more new customers we add, gross adds that is, how many of them we reactivate this year. There's -- it's -- I think to take just the one piece, which is customer retention, is going to lead us to the wrong conclusion.

[Operator]

Our next question will come from Lauren Schenk with Morgan Stanley.

[Lauren Schenk, Morgan Stanley]

I just wanted to ask about what you're seeing from sort of a COVID cohort spending perspective. If here, in sort of year one, they were already spending sort of over that $400 that you typically see in a second-year customer, and if that is the case, what kind of gives you the confidence that the COVID cohort will continue to expand spend at the same rate as previous cohorts?

[Sumit Singh, CEO & Director]

Lauren, as we -- this is Sumit. I'll take it. As we've mentioned in the script, we continue to see positive and engaged behavior from the cohort. Their frequency of purchase. Their subscribe rates into Autoship, their basket size, attach rates, all indicate positive momentum. And we believe that the uptick is driven by, as I've mentioned, improved discoverability, merchandising, growth in our new verticals and our work in connecting these all together.

So we're still not planning on deploying marketing spend to retain customers, which is an important indication if we believe that we're going to lose them. We don't believe so. Nor are we spending time on other initiatives that might drive customer development in an unnatural manner right now. If I'm not answering your question or if you have follow-ups, please ask.

[Lauren Schenk, Morgan Stanley]

Yes. I guess, if you look at sort of the COVID cohort of customers, is their spending because of just sort of the phenomenon that was COVID? Is that already above where a year -- a normal year 2 cohort would be spending? Or is there -- do you still think that the year-over-year growth opportunity in their spending is similar to previous cohorts?

[Mario Marte, CFO]

Yes. I think if I'm understanding your question right, Lauren, I would expect it to be -- to follow the same pattern as historical cohorts, where first year is X, second year is greater than X. So we're seeing that already. And in fact, even if you just look at the first quarter cohort that we acquired this year, their spend is 13% above last year's first quarter cohort. And last year, remember, there was a bit of pantry loading, and I would call it some panic buying really. In last year's first quarter cohort, spending was higher than the previous year. So we're seeing those curves and the overall lift in sales even in the first quarter of a new customer cohort. So positive indicators on that end. Hopefully, we're answering your question.

[Sumit Singh, CEO & Director]

Lauren, the -- we believe the LTV potential of our customer is stronger, given the newer launches, the expansion and assortment and all the work that we're doing to develop our customer base. And at the same time, we believe that we're capturing their share of wallet faster or sooner than we were with older mature cohorts.

[Operator]

Our next question will come from Nick Bacchus with Raymond James.

[Nicholas Bacchus, Raymond James & Associates]

So you talked a lot about new customer acquisition continued to be strong, but at a moderating pace, some of the headwinds from year 1 retention, but NSPAC continues to accelerate. How do you think about these drivers longer term? So kind of in the 5-year-plus plan, how much of your top line growth is going to come from each of those drivers? How do you think about that?

[Mario Marte, CFO]

Yes. Let me try to answer the question, and then Sumit can add anything if I miss anything. But first, I want to not break it down into active customers or NSPAC, because that won't give you the -- even if we get it wrong, that's not going to give you the right answer, right, the right sort of for your models. Think about it more in the sense of the average customer today has a tenure with us that's less than 2 years. And we've shown over time that the longer the customers stay with us, the more they spend.

So not only do we expect our customers as a base to mature over time and spend more and more -- and in fact, we've seen some customer cohort spending $800, $900 today, the older cohorts that is. We also would expect us to continue to attract more customers to the platform over time. So you find the 2 tailwinds working at once: overall, the base growing and maturing over time, spending more; us capturing more share of wallet and attracting more customers to the platform.

Add to that the fact that we continue to innovate and launch new verticals. 2 years ago, we had just launched, at this point actually 3 years, we had just launched Pharmacy. 4 years ago, we had just launched proprietary brands. In the last couple of years, you've seen us grow our catalog, especially in the hard goods and specialty categories. So we continued to add more and more products and more categories for our customers to shift more of the share of wallet to us and shift it faster.

So you have a combination of tailwinds, and I would say, sort of normal maturation of customers over time and shifting their spend with things that we're actively doing, which is attracting customers to the site and also adding more categories and more to our catalog. So hopefully, that gives you an idea of how we think about it.

[Nicholas Bacchus, Raymond James & Associates]

That's very helpful. And then just quickly on gross margin. You talked about, obviously, a very strong quarter. Half the improvement was driven by efforts to increase customer engagement, proprietary brands, et cetera, and the remainder from the normalization of some of the kind of more onetime or -- onetime effects from last year, promotional environment, et cetera. So from a comparative perspective, as you move through the year, how do the compares line up where that half that's coming...

[Sumit Singh, CEO & Director]

Yes. Nick, hopefully, we didn't lose you. Are you still there? Nick, you cut out for the last bit, but I think you were getting at, how does the gross margin sort of develop over time if we look at first quarter? Did I paraphrase it right?

[Nicholas Bacchus, Raymond James & Associates]

Yes. Yes. And as you look to the balance of the year and kind of the comparisons from prior year.

[Sumit Singh, CEO & Director]

Yes. If you remember, one of the things we called out, you're right, is that about half of the year-over-year improvement came from muted competitive environment, which is fairly new. We started seeing that in the fourth quarter of 2020 and part of it is the fact that we did not have the same higher freight costs that we did in the first quarter last year. If you recall, the first quarter '20, we experienced a significant backlog, a surge in demand, an imbalance in inventory. And therefore, we had higher freight costs. So that did not repeat, because our inventory is more balanced today, more aligned with our customer demand.

So that benefit, I would not expect it to continue. It was a onetime, right? It was a onetime event in 2020 that did not recur, and we don't expect that to be a driver going forward. Then it comes to promotional environment and pricing, and that will depend. We've said that we expect the out-of-stock situation, the capacity to come back online more or less in the second half of the year. Timing is TBD. But we don't -- just as that out-of-stock continues to -- would move into a more normalized state, we potentially could see promotions and pricing to also move into a more normalized state. So think about it that way. That might be temporary.

[Operator]

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

[Sumit Singh, CEO & Director]

Thanks. The Chewy team remains busy and excited about 2021 to execute with rigor and take care of our customers. Have a great evening. It was great having you. Thank you.

[Operator]

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