Chewy Inc

NYSE:CHWY

Earnings Call Transcript 2022-Q1

[Operator]

Good afternoon. Thank you for attending today's Chewy's Q1 FY '22 Earnings Call. My name is Hannah, and I will be your moderator for today's call. All lines will be muted during the presentation portion of the call with an opportunity for questions and answers at the end. [Operator Instructions]

I would now like to pass the conference over to our host, Robert LaFleur, Vice President of Investor Relations. Please go ahead.

[Robert LaFleur, VP, IR]

Thank you for joining us on the call today to discuss our first quarter 2022 results. Joining me today are Chewy's CEO, Sumit Singh; and CFO, Mario Marte.

Our earnings release and letter to shareholders, which were filed with the SEC earlier today, have been posted to the Investor Relations section of our website, investor.chewy.com.

On our call today, we will be making forward-looking statements, including statements concerning Chewy's future prospects, financial results, business strategies, investments, industry trends, and our ability to successfully respond to business risks, including those related to the spread of COVID-19.

Such statements are considered forward-looking statements under the Private Securities Litigation Reform Act of 1995 and are subject to certain risks and uncertainties, which could cause actual results to differ materially from those contemplated by our forward-looking statements.

Reported results should not be considered an indication of future performance. Also note that the forward-looking statements on this call are based on information available to us as of today's date. We disclaim any obligation to update any forward-looking statements, except as required by law. For further information, please refer to the risk factors and other information in Chewy's 10-Q and 8-K filed earlier today and in our other filings with the SEC.

Also during this call, we will discuss certain non-GAAP financial measures. Reconciliations of these non-GAAP items to the most directly comparable GAAP financial measures are provided on our Investor Relations website and in today's SEC filings. These non-GAAP measures are not intended as a substitute for GAAP results. Additionally, unless otherwise noted, results discussed today refer to the first quarter and all comparisons are accordingly against the first quarter of 2021.

Finally, this call in its entirety is being webcast on our Investor Relations website. A replay of this call will be also available on our IR website shortly.

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

[Sumit Singh, CEO]

Thanks, Bob, and hello, everyone. On our Q4 earnings call in March, I characterized the environment at that time as a tug of war between the fundamentally strong consumer demand that underpins our business and the challenging operating environment. When evaluated through that lens, Q1 2022 was not much different, which is why I'm even more proud of our results.

Across the organization, from our frontline teams and fulfillment and customer care to our corporate team members, Chewtopians came together and delivered top-up service to our customers and strong top line and bottom line results for our shareholders. Our Q1 results are a testament to the resiliency of the pet category and clearly demonstrate our ability to capture consumer share of wallet and execute against our stated objectives.

So with that, let's review our Q1 performance. 2022 is off to a good start as we delivered solid top line growth and sequential improvements in both gross margin and overall profitability. Q1 net sales increased 14% to $2.43 billion. Consumables and healthcare were the strongest categories this quarter, reflecting their non-discretionary nature and higher Autoship penetration rates.

Notably, first quarter Autoship customer sales increased to 72.2% of net sales, which is a new record high for the Company. We saw strong spending behavior from both new and existing customers, as Q1 net sales per active customer or NSPAC increased 15% and reached an all-time high of $446. As a reminder, NSPAC is a powerful indicator and input to our long-term revenue growth.

Since the pandemic began, we have grown NSPAC by $86 or 24%. The power of NSPAC metric is more fully appreciated, when you also consider the fact that approximately 2/3 of our active customers have been acquired within just the last three years. So they're still relatively early in the process of consolidating their spend with us.

Overlaying this tenure data with a consistent lifetime spending curves our customers demonstrate over time, spending less than $200 their first year, over $400 by their second year, approximately $700 by their fifth year, with our oldest cohorts spending nearly $1,000 per year, you can truly appreciate how much future revenue growth is already embedded in our active customer base, revenue potential, which we can and will unlock over time.

Moving on to customers. Our active customer base grew 4.2% year-over-year and Q1 at 20.6 million. Mario will share specific details in his remarks, but let me spend a few moments talking about the customer engagement and cohort spending patterns that are key to understanding our business model. Each year, we acquire a new cohort of customers.

While a certain percentage of those customers will attrite over time, we are focused on engaging with the high-value customers within each cohort, who will provide us with long-term record of revenue streams. These customers have predictable purchase patterns that are anchored by strong Autoship participation.

They tend to stay with us over long periods of time and increase their spend with us year after year, which is clearly demonstrated in the cohort spend data I mentioned a moment ago. As a result of these predictable patterns, each cohort generates progressively more revenue for us every year, which more than replaces any revenue loss to subsequent cohort attrition.

This pattern has repeated itself over time, resulting in net revenue retention in excess of 100% for each one of our cohorts going back to the original 2011 cohort. This is a key differentiator between our model and a fixed-rate subscription model. In our model, the ability to grow share of customer wallet over time is as important as adding customers is, if not more so, to the revenue flywheel that drives long-term growth.

Now shifting from top line and customer engagement to profitability, Q1 gross margin and adjusted EBITDA each showed positive sequential momentum from Q4. Q1 gross margin was 27.5%, down 10 basis points year-over-year and up 210 basis points sequentially compared to Q4 2021. We are pleased with the sequential rebound in gross margins, especially against the backdrop of a tough macro environment and our new outbound freight contract.

Our gross margin recovery this quarter reflects improved product margins, driven by pricing strength throughout Q1 and our disciplined execution around price management and promotions. Importantly, we have been able to execute these measures while preserving our competitive position in the market and maintaining the strong value proposition that customers expect from Chewy.

Our Q1 gross margin performance also reflects the ongoing benefits of supply chain and logistics initiatives that we have undertaken to improve customer experience and to mitigate the higher freight costs associated with our new rate card and escalating fuel prices, which we said could be 100 to 150 basis points headwind this year.

In Q1, long zone shipments to customers improved 15% and on-time delivery improved sequentially by approximately 800 basis points, resulting in lower costs and a better customer experience. Even with our strong Q1 gross margin performance, we still expect the macro and supply chain environment to remain volatile and inflationary pressures to persist throughout the balance of the year. As always, we are prepared to react as these conditions change or as new challenges emerge.

Moving on to marketing. Q1 advertising and marketing expenses scaled 80 basis points year-over-year to 6% of net sales; as I've articulated previously, we spend up to the level of optimal returns, closely monitoring marginal CPA and LTV levels, and our approach in Q1 was no different.

Q1 adjusted EBITDA was $60.5 million, and adjusted EBITDA margin was 2.5%, a year-over-year decline of 110 basis points. On a sequential basis, adjusted EBITDA margin improved 370 basis points from negative 1.2% in Q4, reflecting the strength of our gross margins, our focused execution as well as improved SG&A efficiency, which Mario will detail in his remarks.

Moving out of our financials. I'd now like to update you on some of our latest innovations. Innovating to improve our customers' experience or value proposition is the cornerstone of our customer strategy. First up is CarePlus, our wellness and insurance offering, which is set to launch publicly this quarter. Recall that we've partnered with a high-quality partner in Trupanion to develop these bespoke wellness and insurance plans. CarePlus represents an important step in our mission to make pet healthcare more accessible and affordable.

Our wellness plans cover preventative care, such as annual exams, vaccines, routine lab tests, and parasiticides, while our insurance plans offer protection against accidents, unexpected illnesses and surgeries. Pet parents looking for comprehensive protection can purchase the plans together.

As we built these difficult plans, we were intentional about bringing together Chewy's unique assets that enable us to offer a differentiated value proposition to pet parents seeking wellness and insurance coverage. A few examples of this include access to Chewy's award-winning 24/7 customer care team for those seeking education on insurance.

Our ability to offer telehealth service connect with a vet as a program benefit to insurance customers, as well as 100% cash back after deductibles for medication purchase from Chewy Pharmacy. We also strive to make the vet experience and interaction with our offering seamless with direct payments at participating practices. Overall, CarePlus represents an opportunity to drive even greater brand loyalty, customer engagement and incremental consideration for healthcare purchases with Chewy.

Today, we believe the U.S. pet insurance TAM is approximately $2.5 billion and covers less than 3% of the pet population. We see a compelling opportunity to serve our customers, expand this TAM, and gain meaningful market share in a highly profitable and underpenetrated part of the pet health ecosystem. We are looking forward to the launch and sharing our progress with you as we ramp up this exciting new offering.

Moving to innovation within our logistics and supply chain, both the logistics initiatives that I mentioned on our last earnings call launched during Q1 and are off to a good start. Chewy Freight Services, or CFS, is our line haul initiative where we are now operating a portion of our own middle mile network. We launched CFS in Phoenix market in Q1 and have since expanded it to cover seven fulfillment centers or FCs. We will continue scaling this throughout 2022 and 2023.

Our second initiative, Import Routing, was also successfully launched in Q1. This initiative enables us to route international inventory more optimally and in larger batches, thereby improving our inventory allocation in our fulfillment centers and lowering our overall cost to serve. This initiative will be fully scaled in 2022.

And finally, let me wrap up this innovation section with an update on how our automated fulfillment centers are performing. The data points which I'm about to share showcase the magnitude of potential contribution that these FCs can have to our SG&A leverage and continue to give us the confidence that our strategy of investing in automated fulfillment centers is the right one.

In Q1, we were able to significantly ramp our AVP to Pennsylvania automated FC. As a result, AVP 2 shipped over 10% of the entire network's volume at a variable fulfillment cost, which was 19% cheaper on average than our first-generation FCs. During its peak weeks in Q1, this AVP 2 site demonstrated overall throughput that was approximately 60% higher than the average throughput of our legacy FC network.

We are encouraged by these results and believe that as we scale our network of automated FCs, this operational strategy will enable us to reduce our capital spend in the FC network footprint, thereby unlocking greater SG&A leverage and expanding free cash flow.

Before turning over to Mario, let me close by saying that, even with the uncertainty that we see in today's macro environment, nothing has shaken our confidence in the secular current, which continues to flow strongly towards higher pet ownership, more per pet spending and greater online penetration, nor shaken our confidence in our long-term strategy and mindset.

At the same time, we are cognizant of many operating challenges we continue to face, such as inflation, ongoing supply chain disruptions, and related stresses these are placing on consumers. In response, our teams remain highly diligent and disciplined about our investments and P&L management as we run the business and build appropriately scaled infrastructure that will support long-term growth and sustained profitability.

Chewy's value proposition remains as compelling as ever, and our approach remains unchanged. Innovate robustly, attract customers with high lifetime values, drive engagement, nurture loyalty and capture a greater share of wallet. As we follow our strategic road map towards that future, we remain as optimistic as ever.

With that, I'll turn the call over to Mario.

[Mario Marte, CFO]

Thank you, Sumit. First quarter net sales increased 13.7% to $2.43 billion, a significant achievement in a quarter, where e-commerce sales have been flat to down across multiple industries. Net sales growth was driven by resilient consumer demand and pricing strength in our consumables and healthcare categories, while non-discretionary categories such as hard goods remain pressured, which we believe is a result of strong year-over-year comps and the current inflationary environment.

First quarter Autoship customer sales increased 18.5% to $1.75 billion, outpacing total net sales growth in the quarter by 480 basis points. First quarter Autoship customer sales as a percentage of total net sales increased 290 basis points to 72.2%. First quarter net sales per active customer or NSPAC, reached a new all-time high, increasing $58 or 14.9% to $446. As Sumit mentioned, since the pandemic began in Q1 2020, we have increased our NSPAC by $86 or 24%, demonstrating our ability to sustain robust growth in customer share of wallet across all of our customer cohorts.

We ended Q1 with 20.6 million active customers, an increase of 4.2% year-over-year. On a sequential basis, active customers were basically flat compared to Q4 2021. As we expected, one year customer retention rates for the first quarter 2021 cohort were stable compared to the fourth quarter of 2020 cohort, and remain low single-digit percentage points lower than pre-pandemic levels.

We believe these lower retention rates are the result of the reopening of the economy as well as the impact of inflation is having on discretionary spending in categories such as hard goods. All of that said, we should know that the 2020 customer cohort had net revenue retention in excess of 100% in 2021, again demonstrating that the growth in individual customer spend more than offsets any customer attrition we may see for any given cohort.

Moving to the financials. First quarter gross margin was 27.5%, a 10 basis point decrease year-over-year and a 210 basis point improvement sequentially compared to Q4 2021. In Q1, we closed the gap between pricing and product costs through surgical pricing actions and better observe market compliance management. In the first quarter, we were also able to mitigate some of the impact of our new outbound shipping contract through improved inventory placement and supply chain logistics initiatives.

Now let's go through our OpEx details. SG&A, which includes all fulfillment and customer service costs, credit card processing fees, corporate overhead and share-based compensation, totaled $504.3 million in the first quarter or 20.8% of net sales compared to 19% in the first quarter of 2021. Excluding share-based compensation, SG&A totaled $477.1 million or 19.6% of net sales, an increase of 170 basis points versus the first quarter of 2021. On a sequential basis, SG&A, excluding share-based compensation, improved 140 basis points.

Let me provide some color on both. Three factors contributed to the year-over-year deleverage of SG&A, excluding share-based compensation. The first is the full quarter impact of higher wages and benefits that we began to implement halfway through the first quarter last year. We estimate the year-over-year wage and benefit cost increase to be approximately $20 million or 80 basis points.

Second, in 2021, we launched our expanded three fulfillment centers and two pharmacy locations, which, along with higher depreciation, contributed to 80 basis points of deleverage year-over-year. The remainder of the increase in SG&A reflects the upfront investments we are making in personnel and technology to support our growth and profitability initiatives in areas such as Fresher prepared meals, healthcare, loyalty program and supply chain.

The 140 basis point sequential improvement in SG&A, excluding share-based compensation, was primarily the result of tight operational execution, including the actions we took to optimally staff and run our fulfillment and customer service teams, strict operational discipline across all corporate G&A, and, to a lesser degree, the release of a small legal reserve.

First quarter advertising and marketing expense was $144.7 million or 6% of net sales, an 80 basis point improvement over first quarter 2021. On a sequential basis, advertising and marketing expenses improved by 40 basis points. Our marketing spend in the quarter reflects advertising demand, our discipline in the investments we make to efficiently acquire new customers, and our customer development and reactivation initiatives.

Wrapping up the income statement, first quarter net income was $18.5 million, a decline of $20.2 million year-over-year. Net margin was 0.8%, a decline of 100 basis points versus the first quarter of 2021. Adjusted EBITDA was $60.5 million, a $16.8 million decline from first quarter of 2021. Adjusted EBITDA margin was 2.5%, a year-over-year decline of 110 basis points.

Notably, on a sequential basis, our adjusted EBITDA improved by $89 million and adjusted EBITDA margin increased by 370 basis points, returning to positive as a result of the recovery in gross margin and scaling of operating expenses noted earlier.

Moving on to free cash flow. First quarter free cash flow was $6.4 million, reflecting $82.4 million in cash flow from operating activities and $76 million of capital expenditures. Capital expenditures were primarily comprised of investments and upgrades to our existing fulfillment network, future fulfillment center launches, and ongoing investments in technology. We finished the quarter with $605 million of cash and cash equivalents on the balance sheet. And between cash and availability on our ABL, our liquidity stands at $1.1 billion.

That concludes my first quarter recap. So now let's discuss our second quarter and full year 2022 guidance. While our core fundamentals remain strong, ongoing volatility in the macro environment continues to make accurate forecasting difficult. As always, our current guidance reflects the balance of the opportunities and risks we see today.

We expect second quarter net sales to be between $2.43 billion and $2.46 billion representing 13% to 14% year-over-year growth. We are reiterating our outlook for full year 2022 net sales to be between $10.2 billion and $10.4 billion representing year-over-year growth of 15% to 17%. We are also reiterating our outlook for full year 2022 adjusted EBITDA margin to be between breakeven and 1%.

As you update your models, here are a couple of housekeeping items to keep in mind. While we may see some quarter-to-quarter variability, we still expect our full year 2022 gross margin to be broadly in line with full year 2021 gross margin of 26.7%. Full year CapEx is expected to equal approximately 2.5% of net sales this year, and we expect that across 2022 and 2023, CapEx will balance out in our normal range of 1.5% to 2% in aggregate.

The pet category is durable and has proven itself to be resilient through the full range of economic cycles. Chewy continues to execute in the face of unprecedented macro volatility to deliver strong top line growth and improving sequential profitability.

As we navigate the current economic landscape, we remain diligent and disciplined in the investments we are making to support the growth and margin expansion road map contained in our long-term strategic plan. We are pleased with the progress we've made to date and remain optimistic as we look towards the future.

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

[Operator]

[Operator Instructions] The first question is from the line of Mark Mahaney with Evercore. Please proceed.

[Mark Mahaney, Evercore]

If I could ask two questions, please. That advertising and marketing, I think, 6.0% of sales, I think that's a record low. Just talk about the sustainability of that. Is that -- are you at a point now, because of a buildup in the subscription model that, that's kind of the new normal going forward or is there anything that was onetime-ish that may have helped that stay down so low?

And then secondly, talk about, please, the net adds. So I think this was the first quarter in which your net adds declined sequentially. How should we think about that? And I know in the past, you've talked about some of the issues that you had in terms of the big cohorts, came out -- coming out of COVID and having normalized attrition against that, but was still leading to high churn numbers. When do we normalize that? What's the -- how should we expect to see net adds growth through the balance of the year?

[Sumit Singh, CEO]

Mark, nice to hear from you. I'll take the first one. Mario will take the second question. On marketing, so if you recall, Mark, on the March -- at the March call, I'd said that 2022 is going to be a super interesting year, as we sort of figure out the ebb and flow of consumer mind share and spending patterns as the economy reopens and some of these other macro factors continue to trend through. And Q1 was no different. We executed with rigor and the discipline.

And I can tell you, we're not guiding to a specific level of spend in this area. You've seen the line scale over time, and I expect will remain within our current range of spend, with some quarters being higher, but others being lower. We intend to remain disciplined. And at the same time, we don't intend to leave any opportunity on the table when it comes to making investments that will -- might or will drive acquisitions and engagement over time. I hope that helps.

[Mario Marte, CFO]

Mark, it's Mario. Great to hear from you. Look, I'll give you a bit of color on this one. So first, as we mentioned in the prepared remarks, we ended the first quarter with 20.6 million active customers, and that is an increase of 800,000 customers, over 4% year-over-year. On a sequential basis, our customers were basically flat. We retained 99.7% of active customers into Q1, and our revenue continued to grow. You can see that as well in both the top line and the NSPAC that we provided.

But let me break down the dynamics of the active customers again. You start with the retention rates. In the Q1 2021 cohort, which would have now anniversaried one year, there retention was in line with our expectations, and what we said on the last call. Single-digit lower than historical levels, but nothing changed. No material change from that, and it was full stop. That's a retention level for that cohort.

In terms of new customer acquisitions, those came in more or less in line with our expectations. And recall that we said that net active adds would be muted in the first half of the year. And we said that because the data was telling us two things. One was that Google searches on things like pet adoptions and categories like hard goods were down double-digit percentages in the first quarter, and we can see that in the data.

That's basically in line with discretionary categories, which is down year-over-year. And for us and the industry, by the way, it's not just Chewy. And by connection, customer acquisitions were also softer in that category. I should add that the customers that we did acquire in the first quarter, they show a favorable initial purchase behavior, and we look at that as well. They bought into stickier categories that correlate to longer -- to higher, long-term retention and lifetime values.

So that's the way to think about it. Now you said -- I'll add one more thing, which is how you should think about it for the rest of the year. We did say -- first of all, we don't guide to active customers, of course, and we don't -- also don't guide to NSPAC. But we, as I said, in the Q4 call, we said we expected first half net active adds to be muted, and we still believe that's going to be the case in the second quarter.

We do expect a year-over-year increase in active customers. So from that standpoint, we still continue to increase. But even on a flat active customers, our NSPAC would increase based on the guidance we provided on net sales. So hopefully, that gives you the full picture of how we think about net adds and NSPAC and everything else.

[Operator]

Our next question comes from the line of Doug Anmuth with JPMorgan. Please proceed.

[Doug Anmuth, JPMorgan]

Just given the 1Q upside on EBITDA, just hoping you could talk about some of the other considerations in maintaining the 0% to 1% outlook for the full year. And then second, can you talk about some of the ways that you're proactively engaging in those high-value customers, who have greater LTV within the COVID cohort?

[Mario Marte, CFO]

So Doug, this is Mario. I'll take the first question and Sumit will answer the second part. But -- so I'll start by saying that we're certainly pleased with the results of the first quarter. I think you can see that in just one quarter, from Q4 into Q1, we made material progress on adjusted EBITDA.

We returned EBITDA to positive, and we had a $90 million improvement quarter-over-quarter, and that's just a ton of work by every team member in the Company. So, we are off to a good start, but it's just one quarter. So, we still have 75% of the year to go. And so the way we're thinking about the year, we are still holding to our -- we're reiterating the guidance rather for the full year of being somewhere between breakeven and 1% on EBITDA.

[Sumit Singh, CEO]

And Doug, your second question was, you may need to repeat that for me because I caught how are we driving engagement with high LTV customers. Was that the question?

[Doug Anmuth, JPMorgan]

It was just how you're proactively engaging those higher LTV customers within the COVID cohort?

[Sumit Singh, CEO]

Sure, sure. So, we -- I'll come at it from both standpoints. And I think this is important to understand how we grow NSPAC as well. In terms of us spending money externally to acquire customers, as we said, our philosophy is to spend or monitor marginal CPAs and spend to the highest level of LTVs. And our sophistication continues to improve as we invest in martech and science and our capabilities to target these customers and to propense them towards the right category and then incent them to grow spend from there is the way that we approach engaging with these customers.

So now once a customer is acquired, at this point, the site targeting and segmentation sort of takes over and our capabilities there are materially and rigorously improving on a year-over-year basis. So internally, when you look at our data, these are some of the data points that I've shared with you in the past, which is the number of customers, who are propensed towards healthcare in the way that, that ratio has grown from 5% of customers in 2019 to just under 20% of our customers at this point being propensed to a category like that.

And so that's us kind of developing and engaging an existing customer to be able to get them to purchase cross-category and enhance their participation per category across the Company. We're combining services. We're flowing this back into our customer care engine and developing technology that allows our customer care agents to be able to recognize how to approach a customer, what conversations should we be having, where do the triggers lie for us to be able to incent the customer the right way to be able to complete their purchase consideration, et cetera. So those are just many ways.

And then underneath one last thing I would say, which I mentioned last -- in the last March call is, we're developing capability or enhancing our capability for CRM or customer relationship management, given that we have such a large customer file, and a huge network of complementary offerings, which we want to make sure that customers are discovering. And if not, then we are helping them discover, but also the fact that we're developing net new categories or complementary offerings in the future. So CRM is going to come in really handy and it will be fully live kind of within a 12-month period year.

[Operator]

The next question is from the line of Nat Schindler with Bank of America. Please proceed.

[Nat Schindler, Bank of America]

Yes, I just want to -- and I know this is probably an annoying question, but I want to follow up on the question that Mark asked earlier on net sub adds, and I know you don't guide to this, but because of the challenges of looking at -- you're looking at a trailing 12-month subscriber. So it gets very hard to know, did you actually service more customers in Q1 than you did in Q4? We don't have that answer. We have an answer of whether -- and it could be that those people fell off at the end of Q1 of last year. So can you help us -- guide us around when the timing of those subs have moved or users?

[Sumit Singh, CEO]

Yes, absolutely. So we did -- of course, we did service more customers in Q1, Nat. In fact, when you look at the rate of customer acquisition, just to sort of double click on this a little bit more, it is not materially off of the pre-pandemic kind of levels, right? And so it's a really interesting dynamic, the ebb and flow of gross adds and net adds that we're seeing right now.

And let me kind of qualify this, because I think it might actually answer some follow-up questions here. See, we -- what you saw in Q1 was when you come at it from a marketing end point of view, input costs or CPCs rose as search demand in the pet category softened. This Mario also kind of mentioned this about kind of the Google search as being down for certain type of searches.

And so as search demand in the pet category softened, what it also saw was, we saw resulting in shortages of the ad pool to bid on. So if you just -- if you sit back and just think about this observation, you'll find it to be consistent and logical to what I've articulated in our previous April -- March-April earning call also. So essentially, this is a result of two broad factors that is happening right now.

First, is factors like inflation are weighing in on consumers' minds, and as a result, they're rationing spend away from discretionary -- from non-discretionary categories -- discretionary to non-discretionary categories. And as a result, a higher degree of incentivization needs to be applied to get them to declare their intent to purchase. And the result of that actually is you have a smaller pool of customers that were shopping in Q1 and more dollars that are required to be spent per customer. And this is an industry statistic. This is not just kind of the Chewy specific.

Second is the fact that, as the economy is reopening, but it's not exactly clear if all that traffic is normalizing into retail stores. To us, it reads as if some of that traffic is actually going back into retail, but the other portion is redirecting purchases towards categories such as travel and dining. This again is an indicator of customers holding back intent. And so -- and then retail marketing engines having to work harder to acquire and engage those customers.

So we're -- amidst this dynamic, we are adding customers at a really healthy clip on non-discretionary categories such as consumables and healthcare. And any shortage that we're seeing is primarily coming from discretionary categories. And so on top of that, our engagement with existing customers and their customer spend patterns remain really strong. So we're servicing a larger batch of customers, no doubt.

[Nat Schindler, Bank of America]

Okay. And just -- and to further clarify on this effect on the discretionary spend being limited and getting harder as the consumers are facing more inflation across other categories. If you look back historically, this category isn't seemingly impacted by recessions. Do you see that dynamic changing? Or is it just parts of this category are affected?

[Sumit Singh, CEO]

So non-discretionary category, which is where the resiliency that we're seeing, which I believe is consistent with the rest of the staple as well, is being seen in non-discretionary categories. Discretionary categories such as hard goods, even treats to some degree, are counted as discretionary. These subcategories are essentially seeing pressure and suffering from the current macro environment.

The general resiliency that is pushing through is in consumables, core food and primarily in healthcare. Even in healthcare, flea and tick, by the way, was soft in Q1 at the industry level, and we grew overall kind of pet med including OTC flea and tick at a very healthy clip, which indicates that we took share from the market in Q1.

[Operator]

The next question is from the line of Brian Fitzgerald with Wells Fargo. Please proceed.

[Brian Fitzgerald, Wells Fargo]

I had a couple of questions on CarePlus offering, wondering if you talk to some of the ways you can increase penetration among the customer base. Where do you think awareness of pet insurance and wellness plans stands among the current customer base today? Could you talk through some of the potential drivers of penetration gains, whether that's the strength of the trust in Chewy product differentiation wellness plans or your ability to highlight potential pharma savings? Anything you can share there?

And then second question is about -- I missed the current macro kind of trade wins. What are you seeing in terms of substitution to private label? We've been reading and hearing about, people are weaning off of premier brands and going on to cheaper private label brands? Any color there?

[Sumit Singh, CEO]

Sure. Brian. So on insurance, I don't believe I will satisfy your curiosity on the call today, since we are just preparing for our launch. And -- but let me just say a few things, right? We're excited to officially launch CarePlus over the next kind of few weeks, and we see this as an important step.

We believe -- first of all, we're bringing bespoke offerings to the marketplace. So these are plans that are curated for our customers. And they were created with obviously a high-quality partner such as Trupanion hand-in-hand working backwards from what our consumers might actually be propensed towards.

So the first kind of notion of earning trust with customers is to design products that will appeal to the segmentation or the demographic of customers that are propensed for these type of products. Number two, then it's about our ability to raise awareness. And we believe we have several opportunities to do this.

One, obviously, we have a large active file where we have a direct one-to-one connection. Number two, we have a a highly customized, curated concierge customer care team. And we've actually trained a specific pod of our customer care team to be able to really, really have high engaged conversations and drive education and awareness, finding the right triggers when customers actually call in.

Number three is our veterinary partners and the ability that insurance can be embedded in our complementary offering practice hub, just like compounding was last quarter. It allows us to fully close the loop from the service provider standpoint, which is the third very important leg of this particular stool. So I think we're thinking of all levers as we kind of build into the brand, which our marketing teams are working very hard with, to make sure that the brand is built both at the upper funnel level, but also down -- kind of down to the full funnel level.

So, we believe we have a fairly well-thought-out construct of how we will generate awareness, awareness that builds consideration. Consideration, which on the back of trust should drive customer conversion, is essentially the strategy that we will follow. Today, we believe awareness is -- familiarity of insurance is roughly 80%, 85% levels, but propensity of insurance is likely in the low teens.

And actual conversion from that low teens is probably a few single-digit points, which is reflected in the penetration that you see today. So we clearly have an uphill challenge in front of us. But as I've articulated previously, we are bullish on our ability to unlock this vertical and to commercialize the space with the help of our partners, and in servicing our customers that way.

And then your second question was about macro trades on private label substitution. So just generally speaking, we're not seeing any material or noticeable trade-down effect in the business. And we're also not seeing any discernible shift towards private brands away from national brands. There are two reasons for this or there are possibly two reasons for this on our side. One is our private brands are built with the highest quality in mind.

As you recall, we're not out there competing for one SKU national brand. We bring SKUs that are highly valuable and highly desirable in a certain space, whether it be a certain price point or a certain subcategory, and we essentially anchor on quality, and we believe our private labels can drive attractive pricing and -- or attractive conversion on the back -- and they can hold their way on price. So we're not really offering "cheap private brands."

And then two, I believe we have work to do in terms of really building consideration behind our private brands. And so particularly in consumables, folks migrate to private brands when the brand is essentially well known, and we have work to do there.

[Operator]

Our next question is from the line of Steph Wissink with Jefferies. Please proceed.

[Steph Wissink, Jefferies]

I had a question for you on like-for-like pricing. If you could just give us a sense on the consumable side of the business, how much pricing has been passed through to the consumer and how much may still need to be passed through based on the vendor conversations you're having?

[Sumit Singh, CEO]

Sure, Steph. So, we -- if you look at Q1, pricing and volume both contributed to the growth that we saw in Q1. And to give you an idea, I think it's really helpful to take in this data point. In Q1, about half of our SKUs had a price that was flat or down versus Q1 2021. So broadly speaking, right, across our catalog, average prices increased in line with expectation, which was in the low to mid-single digits as we had articulated in our March earnings call. And the cost that has come through, nearly all of it has been converted into pricing.

Now what remains to be seen is, if there are future rounds of costs that are going to flow through, which we are getting some indication from our supply partners that might be the case. And we stand ready to act in a manner that is responsible fiscally and at the same time, takes into consideration that we don't erode competitive position, and we're going to be watching demand really carefully when that happens.

[Steph Wissink, Jefferies]

That's really helpful. Can I ask one other follow-up question on the impact of out of stocks? I don't recall you talking much about it in your prepared remarks, which actually might be a good thing. I just want to make sure we close the loop on out of stock.

[Sumit Singh, CEO]

Sure. I mean out of stocks, we didn't see any material impact of out of stocks that was beyond our expectations that we'd already projected. And number two, we're seeing some positive signs of recovery as we indicated towards the latter half of the year, the sustainability of that remains to be -- remains yet to be seen. And then three, we did deliberate work around positioning our inventory, as I talked about or as we've mentioned in the prepared remarks today, that has helped drive greater or better availability within the right zones that has essentially improved customer experience and also helped lower some cost for us in Q1.

[Operator]

The next question comes from the line of Dylan Carden with William Blair. Please proceed.

[Dylan Carden, William Blair]

Yes, just on sort of a broader level, do you guys have a sense of what the online pet space grew in the quarter, even sort of broad strokes and whether or not you're kind of starting to see some of that overcorrection maybe to the retail channel start to revert back maybe to the industry trend? And then I just wanted to quickly confirm the Trupanion launch, that's not necessarily any meaningful capacity in guidance at this point. Is that -- do I have that right?

[Sumit Singh, CEO]

Starting with the second one, that is right Dylan. The first part of your question, so there is no refresh of specific pet e-com growth data. What we have is a couple of different triangulations in the way that we're understanding the overall retail landscape as well as the pet landscape, and I'll share those data points with you. When you look at overall retail, retail grew 11% year-over-year in Q1. E-com sales, overall retail, not pet, grew 6.5%. So clearly, you're seeing some impact of economy reopening and traffic going back into retail in this particular case.

When you put Chewy e-com on top of these data points, clearly, we grew 14%. Of course, this is not an apples-and-apples data point. But it is an indication of the fact that we continue to up the trend in general. When you look at Nielsen data, what we can see is that we grew consumables -- categories such as consumables, roughly 300 to 350 basis points higher than the pet industry. We also -- you also see similar data in our pet medication, flea and tick type spaces, where we materially outpaced the industry in Q1.

All of this indicates -- and then finally, when you combine this data point to what Mario was mentioning, which is search intent or traffic as a proxy for online share, all of this indicates that, yes, there is ebb and flow going back into retail. And on top of that, e-comm continues to grow, not sure what level and Chewy continues to grow and take share.

[Dylan Carden, William Blair]

Understood. And just -- you had mentioned it so real quick. The intent on things like adoption, do you think that, that's some early signs of an exhaustion, just given kind of the two years that we've had as far as sort of what do you expect from pet ownership from here?

[Sumit Singh, CEO]

Yes. When you look at pet adoption data, so far, in Q1, roughly 480,000 pets have been adopted and 478,000, I mean, this data is obviously not exact, but what we see is that a one-to-one on adoption and relinquishment, that's what we saw in Q1. Now when you double-click underneath of that, obviously, what would be interesting is to correlate income data to be able to see if the relinquishments is actually coming from low income and the adoption is actually continuing to push through to our income category, which is our -- our data point corresponds with the -- so whatever adoption pet profiles we are seeing, corresponds to the fact that it's right now propensed towards kind of medium or higher income.

[Operator]

Our next question is from the line of Lauren Schenk with Morgan Stanley. Please proceed.

[Lauren Schenk, Morgan Stanley]

Wondering if you could parse out the magnitude of the contribution and sequential 1Q gross margin improvement between the improved pricing, the commercial discipline and then the logistics initiatives? And then any commentary with what you're seeing on pricing and promotions in May?

And then a second question, just back to your commentary around sort of pet adoption and hard goods search is weaker in 1Q. I guess what gives you confidence that those trends will improve as we enter the second half of the year?

[Sumit Singh, CEO]

Lauren, this is Sumit. I'll take the first one. Mario will take out the second one. So in terms of passing out the magnitude of sequential improvement, again, I won't fully satisfy your curiosity, but I'll give you a directional indication that pricing and discipline on promotions played a bigger part or a material part, and the logistics initiatives played a lesser part given that we're still early in the innings here.

So I would kind of just leave it at that. And then I think you also asked May. We're expecting a rational environment, Lauren, for the balance of the year on promo and pricing. And I think, so far, nothing gives us the indication that, that is changing.

[Mario Marte, CFO]

Lauren, so the second part of your question was about what gives us confidence for the growth in the second half of the year, yes?

[Lauren Schenk, Morgan Stanley]

Yes, and specifically around maybe that hard goods and pet adoption improving?

[Mario Marte, CFO]

Yes. Yes. So a good question. I think there are a couple of factors that drive our expectations of pickup in growth in the second half. First, if you look at comps, they get a little easier in the second half, mainly, as we said, in hard goods. If you look at 2021, that part of the business grew faster in the first half than the second half. I mean first quarter 2021 was roughly 42% growth year-over-year in hard goods and then moderated into the second half. So comps get easier.

The second part is, as we articulated on the Q4 call, so the last time we spoke, is that we're expecting in-stock levels to be relatively better in the second half of the year versus this first half of the year. So the question earlier about where is in stock and how we expect those levels to play out, they're playing out roughly in line with what we expected and what we said we expected last time we spoke.

So it's a combination of those two factors that drive why we expect growth to be higher in the second half versus the first half. Now, I think in our opinion, we're all obviously and naturally going to have to watch where inflation trends continue to develop, and that's product, fuel, other inputs that are competing for share of wallet from the customer. But specifically, how much inflation is left in the system and how that -- how much more of the inflation can consumers absorb without impacting demand. We're obviously watching that part of the -- looking ahead.

[Operator]

The next question is from the line of Deepak Mathivanan with Wolfe Research. Please proceed.

[Deepak Mathivanan, Wolfe Research]

So I'll ask the question earlier on gross margin a little bit differently, more specifically on the logistics initiatives. What percentage of the volumes or sales currently is kind of served under this import routing and the injection into the cheaper delivery models at this time? And where do you sort of see that go towards the end of the year?

And then another piece on the pricing side. Sumit, you noted that your conversations with vendors is indicating potentially additional cost inflationary trends on certain products. Can you elaborate on that? What type of SKUs are those? How do you think about kind of the MAP compliance on that going forward?

[Sumit Singh, CEO]

Yes. So I'll take the second one first, Deepak. We don't have perfect visibility, but this is going to be broadly across the catalog given that it's the core inputs that are fundamentally absorbing the cost and that essentially passes through. So it's primarily -- we've heard this less from hard goods vendors, obviously, we've heard it more from consumables vendors. So perhaps that gives you an indication of kind of the core inputs flowing through into the inflation here.

In terms of MAP keeping pace, see, I think it's -- your question also grounds or baselines from what we saw in Q4, and I think it's helpful perhaps to spend a minute understanding the different dynamics between the seasonal changes in quarters. So what we saw in Q4 from a price and product cost, like price normalization tends to be delayed during the holidays, and that's especially true for e-commerce channel given the transparency. And so when you look at kind of pressures on MAP, it actually exacerbates or escalates during the holiday season, which we don't expect to get into as we play to Q2 or Q3.

And then second, our Q1 results demonstrate kind of two things. One, our ability to take action and to do so reasonably quickly. The second as well as the fact that our pricing technology can work surgically and be impactful in effecting change when we decide to take action. So we're looking at pricing through a surgical lens, and we're going to be really thoughtful and deliberate about not making perhaps blanket pricing changes and considering how pricing actions will impact customer trust in the short and the long term, and how those actions could shape customer demand. But we'll be fiscally responsible without eroding customer trust is the way that we're going to play this out.

And then your first part of your question on gross margins. There's a lot going on amongst -- within logistics right now. So it's hard to actually specifically pin down or put too much weight on the two initiatives. So let me give you an example. Like we -- in Q1, right, we improved our utilization of spot rates, right, where we essentially pay beyond contracted rates by roughly 15% to 20% levels on a year-over-year basis. And that contributed roughly 15 basis points of impact to gross margins.

And so it's -- what is that? That's the impact of better planning, developing tools and tech that provides us the transparency and the reactionary measures to be able to play through changing -- change in inputs on an appropriate basis. Some of these other ones that I've talked about, like Chewy Freight Services, for example, I mean on an entitlement basis, we could see 30%, 40%, 50% of our volume flowing through this, right? But this is a longer-term initiative that scales over perhaps 8 to 10 quarters.

The import service that we launched will actually scale over the next four quarters. So you can say, hey, you guys have played through 25% of the entitlement right now, and that's likely flowing in several basis points of improvement into the gross margin that you saw in Q1. So hopefully, that gives you a bit of an appreciation for the ebb and flow in how the team is looking at to overturning each lever.

I'll also mention the order routing technologies that we've actually been developing to make sure that our inventory is placed in the right zone, closest to the customer, so that we don't incur long zone shipping costs, which you saw improved by 15%, long zone improved by 15%, as mentioned in the prepared remarks. All of this essentially plays through and lowers our freight entitlement that flows through to gross margin. Hope that context helps.

[Operator]

Our next question is from the line of Justin Kleber with Baird. Please proceed.

[Justin Kleber, Baird]

I wanted to just ask about the profitability of Autoship, recognizing you probably don't look at the business -- or that business in a silo. But it's annualizing at $7 billion today. So just curious what's the EBITDA margin profile look like on those sales given marketing and ad spend related to retention? It's fairly low with your model. Any perspective you guys can share on that, I think, would be helpful.

[Sumit Singh, CEO]

Justin, without staying away from specific numbers, I'll build your intuition on, obviously, why Autoship is helpful to us. One, the AOV, average order values, for Autoship orders are higher kind of mid- to high-single digits over non-Autoship orders. So it just -- it starts there. And then you multiply on top of that, the fact that we're able to get customers to consolidate their baskets or build baskets around an Autoship order, because our Autoship customers are not dormant customers. It's not like they're not engaging. They're very much actively engaging to put peripherals or build attach, and we help them build that attach.

So that, again, gives you a perspective of how we kind of build AOV around an Autoship order and how that order might actually provide leverage through the fixed infrastructure that we've built, because those are fixed costs that the Autoship holder is leveraging. Underneath of that, clearly, the base that runs through Autoship allows us to lower the entire cost structure for the Company, because you need fewer number of people. You can plan using algorithms versus tons of humans trying to plan a business that is repeat and predictable. You -- better labor planning leads to better staffing levels, better staffing level needs to better optimal productivity levels.

We can build effective middle mile routes, right? One of the reasons we're taking on the freight initiatives, right? We have predictability in last mile delivery. We provide a baseload to our carrier network that allows us to leverage to draw favorable or the most favorable rates in the industry. So, it's -- without giving you specific kind of impact, it just broadly permeates through our network and allows us to run a really efficient business and a really disciplined operation. So hopefully, that context helps.

[Justin Kleber, Baird]

No, that's helpful. Just a follow-up. Sorry, go ahead, Mario.

[Mario Marte, CFO]

Justin, this is Mario. What I wanted to add was that I think the point that you brought up is exactly right. I mean that business -- that part of our business now it is over $7 billion run rate. And as Sumit mentioned, that is a consistent flow of products that helps every single order that flows through our warehouses. So, there's real power in the Autoship program.

[Justin Kleber, Baird]

Yes, great. Just a follow-up then on unrelated, but was there any headwind on gross margin from mix, just given the 8% decline in hard goods during 1Q? And is it fair to assume that you think that the first quarter marks the low point for hard goods, just in terms of year-over-year change, given the comparisons, as you mentioned, start to ease here in 2Q and over the balance of the year?

[Sumit Singh, CEO]

Yes. The second part of your question is an interesting one. We're not speculating and we're not kind of -- we're not yet kind of providing guidance on how we feel about this. It goes back to Mario's point about just waiting and watching how macro trends change, and how the consumers' mindset continues to remain pressured and when those constraints actually alleviate to the back half of the year or to the rest of the year. So, we'll share more in our Q2 results on that.

[Mario Marte, CFO]

Yes, I would say to your point about the mix, I mean, if it was all going into the consumables part of the business, there will be more of a mix pressure. But if you notice how fast our other revenue grew in the quarter, you can see that the shift is mostly happening to the other part of the revenue stream. So I would say that's not necessarily the case. And I would not project Q1 gross margin through the rest of the year. Think about the full year guidance or at least color that we provided in terms of gross margin. That's how you should think about sort of the ebbs and flows on gross margin quarter-to-quarter throughout this year.

[Operator]

That concludes the Q&A session. I will now hand the call over to Sumit for closing remarks.

[Sumit Singh, CEO]

Thank you everyone. Stay safe, and we'll see you next quarter.

[Operator]

That concludes today's call. Thank you for your participation. You may now disconnect your lines.