Pet Valu Holdings Ltd

TSX:PET

Earnings Call Transcript 2023-Q2

[Operator]

Good morning, everyone, and thank you for standing by, and welcome to Pet Valu's Second Quarter 2023 Earnings Conference Call. My name is Daisy, and I'll be coordinating today's call. [Operator Instructions]I would now like to turn the call over to James Allison, Investor Relations at Pet Valu to begin. So please go ahead, Mr. Allison.

[James Allison, executive]

Good morning and thank you for joining Pet Valu's call to discuss our second quarter 2023 results, which were released this morning and can be found on our website at investors.petvalu.com. With me on the call is Richard Maltsbarger, President and Chief Executive Officer; and Linda Drysdale, Chief Financial Officer. Before we begin, I would like to remind you that management may make forward-looking statements, which include guidance and underlying assumptions. Forward-looking statements are based on expectations that involve risks and uncertainties, which could cause actual results to differ materially from those expressed today.For a broader description of risks related to our business, please see our Q2 2023 MD&A, 2022 Annual Information Form and other filings available on SEDAR. I would also like to note that today's remarks will be accompanied by our earnings presentation for Q2 2023, which leads you to our live webcast and is also available on our website.Now I would like to turn the call over to Richard.

[Richard Maltsbarger, executive]

Thank you, James, and good morning, everyone. I'll begin my comments today with highlights from our second quarter and first half before sharing our outlook for the balance of the year. We were pleased with our second quarter results. Together with Q1, the first half of 2023 performed well within our expectations with same-store sales growth of 8%, revenue up 15% and adjusted EBITDA increasing 4% despite significant FX headwinds. Our business continued to deliver a superior pace of growth relative to other retail categories, highlighting the unique characteristics underpinning the Canadian pet industry and our differentiated position as a market leader.During Q2, we continued to execute against our strategic priorities while delivering strong performance across all key metrics. Revenue increased 13% in the quarter, led by strong merchandise shipments and retail sales growth in both our brick-and-mortar and online sales channels. We delivered same-store sales growth of 6% on top of 21% last year and 28% the year prior, with both basket and traffic contributing to growth. We completed 23 real estate projects through a combination of new store openings and renovations. We drew greater traffic to our digital channels, while loyalty sales penetration hit another all-time high of 80%, and we grew profits with adjusted EBITDA up 4% to $54 million as our teams effectively navigated unfavorable FX rates.Let's review our success through the components of our growth formula. First, expanding our store network. We opened 7 stores in Q2, which brings us to 14 new stores year-to-date and well on our way to hitting our target of 40 to 50 new store openings in 2023. Our network now consists of 758 stores coast-to-coast, up from 717 last year, with all this growth coming in the form of new or refranchised locations, which is a key ingredient to our ongoing success. Our store network enables us to provide unmatched convenience to devoted pet lovers across Canada, and we continue to strengthen this differentiating advantage. We also continue to see strong interest from both prospective franchisees and existing owners looking to add stores.Second, driving same-store sales growth. Both basket and traffic supported our 6% same-store sales growth in Q2. And once again, performance was relatively consistent across geographies, market types and vintages, a direct result from our store refresh program, designed to maintain consistent shopping experiences across our network. Our real estate team completed 16 renovation expansion, our relocation projects in the quarter and 18 year-to-date. We continue to drive double-digit sales growth in consumables and services, which now collectively account for roughly 80% of our sales, underscoring our SKU towards recurring necessity-based products.In hardlines, we observed softness across more discretionary oriented product lines, which we believe is reflective of macroeconomic conditions pressuring consumer wallets. As a result, we did see same-store sales growth rates slow starting in late May. Despite this, we continue to see resilient trends in the broader Canadian pet industry. The strong consumables growth is clear evidence humanization and premiumization tailwinds continue as the industry sees broadly normalized adoption and surrender rates. Our merchandising strategies delivered on multiple fronts in the quarter.In national brands, we continue to see strong growth in some of our most premium pet food brands like ACANA and ORIJEN and Big Country Raw, and we were very pleased with the performance of some of our exclusive offerings like the Canada Pooch Barbie collection. We also continue to grow our proprietary brands as we invest to broaden our offering. In fact, we received recognition for one of our newer products with our performance in Ultra Freeze-Dried Raw Bites winning a Product Innovation Award at this year's Retail Council of Canada Grand Prix. Our marketing teams continue to release creative and well-timed content, staying true to our 360-degree always-on media strategy.We ran our first proprietary brand campaign in recent years, showcasing the breadth and quality of Performatrin family of products. This consisted of 15 and 30-second national TV spots, supported by online streaming and digital ads. We followed this up with our first-ever promotion, including the entire Performatrin family of products, starting in June and continuing into early July. This promotion successfully caught the attention of many pet owners looking for greater value. Most especially in our recently rebranded Performatrin Prime line, which provides a scientifically formulated solutions many customers need for their pets and our Performatrin Naturals line, which in its third year since introduction is rapidly growing as it provides a natural meat-first ingredient panel at prices very competitive to brand positioned at the higher end of the grocery segment.Traffic to our website continued to grow in Q2, driving robust growth in our e-commerce sales and customer loyalty trends also strengthened in the quarter with over 2.6 million active customers in our programs, this subset now accounts for 80% of our system-wide sales. In late June, we added Hill's Science Diet to our frequent buyers program, a big win for the program and our loyalty members. Our program now offers targeted value in almost all our top 20 food brands, providing further incentives to prospective and existing loyalty members. Our full suite of digital and loyalty capabilities, together with our leading physical store footprint enables devoted pet lovers across Canada to shop at Pet Valu, how, where and when it suits them. We believe this ecosystem delivers unmatched convenience and value and remains a key driver to supporting growth.And the final pillar of our growth strategy, enhancing our operating margins over the long-term. Q2 adjusted EBITDA margins were 21%, up from 19.5% in the first quarter. Margin rates were better than guided in May due to several factors. First, we experienced favorable freight rates as our transportation team captured improved rates for our key lanes. Second, as we began to see sales softening in our hardlines business late in the quarter, our teams took operational actions to adjust to these trends, including adapting store schedules, identifying project spend that could be reprioritized and more. Excluding non-recurring items, our SG&A as a percentage of sales hit the marks we set internally.For the most part, we have now lapped the purposeful investments in people and technology made through 2022 to support long-term growth and are in a stronger position to manage variable costs as we adjust to movements in consumer demand. I'd also like to provide a quick update on the progress we made integrating Chico into the Pet Valu family. Leveraging our Quebec-based leadership team, we are now beginning to achieve key synergy opportunities. Starting last fall, we began the rollout of our proprietary brand portfolio into Chico and are pleased to say that we have participation from 100% of Chico franchisees through all 4 rounds of introductions, encompassing almost 400 SKUs. We have also begun to align Chico's operational processes with Pet Valu.This past quarter, we opened the first franchise Chico store using our real estate model, where we are on the head lease and provide construction and set up support. We are also playing a more active role fostering strong franchisee relationships as we held our first franchise council meeting with Chico franchise representatives in April and implemented safe and ready assessment across the chain to improve consistency. Significant opportunities still lie ahead, including increasing wholesale capabilities to Chico as we ramp up our new GTA distribution center with some exciting milestones planned for this fall.As we look to the second half of the year, our business remains strong, fueled by the resiliency of the pet industry and the connections we have with our most loyal monthly recurring customers. The trends that have supported growth for decades remain intact. We continue to see humanization tailwinds, be it through outsized growth in our premium food tiers, the success of hardlines introductions like our Pica and Canada Pooch Barbie offerings or our updated line of over 100 jump, dog and cat toys. We anticipate continued growth in the number of pets over the long-term, commiserate with Canada's growing population, and we will continue to bring innovative products to market for these devoted pet lovers.Within this growing industry, Pet Valu's offering skews heavily towards recurring necessity-based shopping trips with consumables and in-store services accounting for roughly 80% of our sales today. History has shown that in periods of restricted spending, our devoted pet lover consumers often choose to prioritize the needs of their pet, providing resilient spending trends for the industry, especially when it comes to core assortments around pet food and recurring items like cat litter and supplements. We continue to have significant whitespace to expand across Canada with more than half of the opportunities situated in rural markets where our flexible franchise-first model has a differentiated advantage to pet specialty peers.While our industry is certainly resilient, it is not completely insulated from short-term changes in consumer demand. Again, while we continue to see double-digit growth in pet food and cat litter, we are seeing some softness across more discretionary hardlines categories, which started in late May and has continued through Q3 to date. These are categories that may be postponed or substituted such as bedding, crates and toys. Across our 47-year history, Pet Valu has seen many different demand cycles in the pet industry and has successfully adapted to meet the evolving needs of devoted pet lovers.In just the last 3 years, we've navigated sudden shifts to pandemic operating restrictions, quickly followed by a period of tremendous growth. We are again adapting as demand moves in the near-term towards consumables such as pet food and cat litter and services such as self-serve dog wash. During Q2, as we saw the shift in sales patterns, our teams quickly reprioritized investments from less critical initiatives to key customer-facing and franchise supporting actions needed in this environment. At the same time, we are also making operational changes to optimize the use of gross profit and SG&A dollars in the near-term. Where appropriate, we are adjusting staffing, commensurate with traffic trends by region, while still investing in the right wage, hour and training dollars needed to continue our below-market average turnover rates.We have and plan to continue activating targeted promotions while investing in key marketing and advertising dollars to support vendors who are prioritizing Pet Valu as a critical and important distribution channel. For example, today, it's the second of 5 Tuesday flash sales in the month of August geared to bring incremental basket building value to our devoted pet lovers. Many of these promotions include incentives for our franchisees to participate so we grow consumer traffic together while supporting our franchisees bottom lines as they continue to invest in new stores. Throughout all this change, we continue to invest in key initiatives that will support our long-term growth and create value for all our stakeholders.The most significant of these investments is our supply chain transformation as we build Canada's strongest pet specialty distribution network. We officially took possession of our new GTA facility in June, began receiving products into the facility in July and plan to deliver our first shipments to stores later this month. We are very pleased with the progress at the GTA facility, which remains on budget and on time for a completion and full transition in early 2024. At the same time, we have accelerated the work on our next DC in Vancouver, where we have recently signed a lease for a new facility that is nearly finished, allowing us to take possession earlier than anticipated, enabling a targeted launch in mid-2024. We will then turn our attention to Calgary and the completion of our significant supply chain transformation in 2025.Altogether, these upgraded distribution centers will double our capacity to help support our growth over the next decade, introduce automation to improve fill accuracy and lower costs and enable us to significantly increase our wholesale distribution capability to our growing Chico franchise base with a target of reaching over 50% of Chico wholesale purchases by the end of 2025. In our ongoing effort to continually improve our digital customer experience, we have decided to bring forward certain e-commerce investments we had initially planned for 2024 and 2025 and start those projects now. The work we completed during the last 4 years to modernize our platform has given us a strong base.Now bringing forward these planned enhancements will allow us to more rapidly implement several leading industry practices. Altogether, through the actions I've outlined along with others underway, we are reaffirming our outlook for 2023. We recognize we have work to do to achieve these targets with a particular focus on 3 elements. First, we need to have the right impact from our marketing and promotional investments to maintain our momentum in consumables and services. Second, we need to closely monitor and manage our gross profit and SG&A dollars to the best near-term use while maintaining investment in our highest priority, long-term value-creating programs.And third, we assume that the promotional environment in the pet industry will continue to normalize but maintain a sense of rationality despite the near-term softness in more discretionary categories. I am confident in our ability to support these outcomes, knowing that we have a deep pool of talented leaders across our organization with a united focus on enabling Pet Valu to once again adapt, while maintaining a commitment to long-term profitable growth. It is this responsible balance that drives the what, why and how we continue to manage this business.And with that, I'll pass it over to Linda.

[Linda Drysdale, executive]

Thank you, Richard, and good morning, everyone. Overall, we were pleased with our Q2 performance, which delivered stronger bottom line results than we had anticipated back in early May. Second quarter system-wide sales increased 10% to $344 million, driven by same-store sales growth of 6%. We were pleased to see continued basket and traffic growth, which increased 4.8% and 1.2%, respectively. We opened 7 new stores in the quarter and ended Q2 with 758 locations. Compared to last year, growth in our store network has been driven entirely from new and refranchised stores, consistent with our long-term growth plans to grow our franchise mix over time.Turning to our company performance. Second quarter revenue was $256 million, an increase of 13%. This outpaced our system-wide sales growth due to stronger wholesale shipments related to strong fill rates to our franchisees. Gross profit was $92 million, an increase of 8%. As a percentage of revenue, gross margin rate was 35.9%, slightly better than our internal expectations. Excluding 20 basis points of cost related to our supply chain transformation, gross margin rate was 36.1%, down 140 basis points from last year, primarily driven by a weaker Canadian dollar and higher wholesale merchandise sales related to increased franchise store mix and improved fill rates. This was partially offset by favorable product margins with lower inbound freight costs more than offsetting higher distribution costs.Selling, general and administrative expenses in the second quarter were $52 million. Excluding IT and business transformation costs, share-based compensation and other non-operating items, our SG&A expenses were just under $50 million, an increase of 16%, primarily attributable to purposeful investments in headcount, wages and additional labor hours in our corporate stores to support long-term growth. Adjusted EBITDA increased 4% to $54 million, modestly ahead of our expectations on the back of the favorable freight costs I just mentioned.As a percentage of revenue, adjusted EBITDA margin was 21%, an improvement from 19.5% in the first quarter. Net income was $24 million compared to $25 million in Q2 last year. Adjusted net income, which excludes items not indicative of our underlying performance was $26 million compared to $28 million last year, as growth in adjusted EBITDA was offset by higher interest expense due to rising rates and higher depreciation and amortization. Adjusted net income per diluted share was $0.36 compared to $0.39 last year.Now turning to the balance sheet. We ended the quarter with $9 million of cash on hand, while our $130 million revolver remains undrawn. Total debt net of deferred financing costs at the end of Q2 was $301 million. Taking into account lease obligations, our leverage ratio sits at 2.2x. The increase in leverage from Q1 was primarily due to the recognition of the lease obligations associated with our new GTA DC. Excluding this, our leverage would have been 1.8x. We ended the second quarter with an inventory balance of approximately $130 million, up 12% from Q2 last year.As expected, our inventory growth has begun to better align with revenue growth. We continue to make deliberate investments to supply our growing store base and maintain strong in-stock levels at our DC [indiscernible] stores. We also set another 5-year high on fill rates with our franchise customers, helping drive greater purchases to us, driving up our wholesale revenue.Net capital expenditures were $17 million in the second quarter and $28 million year-to-date, largely related to the construction of our new GTA DC and related warehouse systems and growth CapEx for new stores in [Reno]. Free cash flow in the quarter was $13 million, down from $20 million last year, a stronger cash flow from operations was more than offset by the higher CapEx I just described.Now turning to our outlook. We are reaffirming our guidance for fiscal 2023. As Richard mentioned, starting in late May, we observed a slowdown in sales growth across more of our discretionary hardline category, which has continued into Q3. In response, we have made and will continue to make targeted adjustments to our operations that responsibly adapt our business proportional to consumer demand signal, while maintaining investments in key initiatives here to drive long-term profitable growth. These actions include a reprioritization of investments to key customer-facing and franchise supporting activities geared to maintaining our momentum in this environment, resulting in an optimization of how we allocate our gross profit and, in particular, our SG&A dollars in the near-term.All said, based on strong performance in the first half of 2023, together with responsible actions being taken to navigate an evolving environment in the back half, we are reaffirming our financial outlook for the full year. This calls for revenue between $1.05 billion and $1.075 billion, adjusted EBITDA between $230 million and $237 million and adjusted net income per diluted share between $1.60 and $1.66. Key assumptions underpinning the achievement of these targets include continued momentum in our consumables segment supported by effective marketing and promotional investments, a normalizing but rational promotional environment and foreign exchange and interest rates in line with current market expectations.In terms of quarterly phasing, we anticipate adjusted EBITDA margins in Q3 will be similar to slightly below the 21% reached in Q2 before improving in the fourth quarter. We have updated our estimates for costs excluded from adjusted EBITDA and adjusted net income per diluted share. We expect business transformation costs of $17 million, which is inclusive of the GTA DC transition that is underway and now include costs for our new Vancouver DC starting in Q4. We estimate the portion of these costs expected to impact our reported gross margin rate will equate to 100 basis points for the full year, implying roughly 200 basis points impact in both Q3 and Q4.IT transformation costs are now expected to be $4 million as we recalibrated the timing of certain projects and share-based compensation is now expected to be $7 million. With over 4 decades operating through multiple demand cycles, we have a proven track record of growing our successful business. I am confident that our unique and differentiated offering, together with the commitment of our people positions us well to deliver on our expectations for 2023.And with that, I'll turn the call back to Richard.

[Richard Maltsbarger, executive]

Thank you, Linda. Before turning to questions, I would like to call out the hard work, team and franchisees across our business, who have been instrumental in both delivering strong performance in the first half and for quickly adapting to our evolving environment. Due to the ethos of our mission, our people continue to go above and beyond support pet and devoted pet lovers across Canada. For example, when wildfires first slipped across several provinces this past spring, our field and store operations team stepped up to provide aid to local shelters and rescues who are inundated with displaced people and pets even while we navigated temporary store closures in affected regions.In May, we once again sponsored the Lions Foundation of Canada through our Walk For Dog Guides program. And in June, we and our customers helped raise over $1.7 million for local rescues and shelters across Canada during our Pet Appreciation Month. The values of an organization are not tested when times are good, but when times changed and challenges are presented. Seeing our people rapidly adapt to changing conditions while continuing to lead and work in ways to promote and strengthen our core beliefs is powerful and for me, very moving. It is the teamwork and compassion in moments like these that remind me why I love this business so much.With that, we are now happy to take your questions.

[Operator]

[Operator Instructions] Our first question today comes from Martin Landry from Stifel.

[Martin Landry, analyst]

Richard, in your opening remarks, you mentioned making adjustments to react to the shift in consumer demand. I'm not sure if I heard correctly, but I think it included reducing staffing hours. So I'm just trying to understand, aside from the weakness that you quoted in hardlines, which is not surprising, are you seeing a traffic slowdown in June and July? Is traffic declining on a year-over-year basis in these months?

[Richard Maltsbarger, executive]

So Martin, thanks for the question. So to go back to the conversation that we had again on the quarter, let's comment first on second quarter results, specifically, where we had a 1.2% increase in same-store sales transactions, which is how we go about measuring traffic. We don't have conversion our counters because we don't have a big box environment. So the vast majority of the customers who walk through our door actually ultimately convert based upon third-party surveys. So the 1.2% increase would indicate that traffic was up, but not as far up as we were originally anticipating at the beginning of the year. So when we talk about adjusting our staffing levels, we're really talking about adjusting primarily to the number of people coming through the door.So again, our staffing levels are actually still up. We're still continuing to invest in more hours, wages and a few things to help us to drive lower than industry average turnover and great customer services. We're just adjusting along with. If you go back to Q3 and then Q4 and then we really touched upon it in our Q1 call, we have seen a number of customers buying up to larger bag sizes. As we indicated on the last call, we do believe that we'll set off a period here over the next few quarters in which our transaction growth will be suppressed as the regular number of return trips to come in and buy food will naturally go down as people go to larger bag sizes, and we have adjusted our staffing level for that trend.

[Martin Landry, analyst]

Okay. And so -- and then you're talking about a slowdown that started in late May, continued in June and July. So with that weakness that you're seeing now, what gives you the confidence that you're going to be able to meet your same-store sales guidance that's calling for a growth of 7% to 10% for the full year?

[Richard Maltsbarger, executive]

Well, Martin, I think you know us well enough. No, we're not going to take a slowdown at any time. It's just setting back. So in fact, today, if you pop on to your e-mail real quick, you'll see that we've got 25% of treats all day to day on the second of 5 Tuesday flash sales we're doing in August as well as we noted the Performatrin sale where we brought the entire family of Performatrin brands on the sale for the first time ever with all formats wet and dry and free rides. So we're going to take a continued set of very targeted, very specific, very tactical promotions in the back half that we know are more closely tied to our more elastic and our more specific traffic driving or basket building activities to help to continue to build on.As we noted on the call, with double-digit growth in consumables and services, we're continuing to see the core of our business that almost 80% of our volume really continue to be quite strong. It really now is how do we layer in the extra item into the basket, how do we layer in the extra incremental non-food trip. And so, we've got faith that the actions that we're going to take in the back half are going to begin to bolster some of the traffic that we may have seen slowing down as we've gone into the summer months. Look, it's been a beautiful summer in many places. Lots of people are traveling, and we're planning on leaning in as we go through the back half. Again, very rational, very aligned with our long-term normalization to the competitive intensity we saw in a pre-pandemic environment, but still more aligned with having us fight a little harder to get that next customer in the door.

[Operator]

Our next question is from Michael Van Aelst from TD Securities.

[Michael Van Aelst, analyst]

I wanted to continue along the sales and competition angle. And just to confirm, if you're -- I think if you are looking for 7% to 10%, you need to see a pickup in your same-store sales versus Q2 in the second half of the year. I think something closer to 6.5%, if you wanted, just hit the 7% for the full year. So is that coming from your expectations to improve traffic with your promotional activity or where is that coming from?

[Richard Maltsbarger, executive]

Michael, this is Richard. I'll take that. And you are correct. It is a slight pickup from what you saw in Q2, but again, we continue to see really strong growth in our core business, again, 2.6 million active customers, 80% of our customer sales are now on our loyalty program, and that's before we really get the big bump that we're expecting having added Hill's Science Diet now and almost rounding out our entire top 20 brands onto our loyalty program. So we're expecting those actions that we'll take will both increase traffic in the back half, but especial -- and specifically like with what we have going on today in the store and last Tuesday with wet and dry cans, it's really more tapping into the traffic for continuing to get into the store.How do we add something into that basket? As we noted on the call, it really is discretionary items, and we expect this to be a relatively near-term issue that we're going to continue to manage and take advantage of the loyalty that we have with 80-plus-percent of the people on our loyalty program and the core of our business being monthly customers, this is really more about tapping into the strengths we already have and continuing to earn share of wallet.

[Michael Van Aelst, analyst]

Okay. And then when you look at that slowdown in same-store sales from Q4 -- Q1 to Q2. Can you comment about how much you think that might have to do with an increase in competition during the quarter? Are other stores or channels taking -- starting to take some share? And how are you preparing for [ Chewers ] entrance in your fourth quarter?

[Richard Maltsbarger, executive]

Sure. Michael, let me take each of those in turn. So let's start first with the existing competition that we know about in the marketplace. All of our market share tracking would indicate that year-to-date, we are holding our own against the continued market growth and that our share that we've earned over the last few years, which has been over 400 basis points since the beginning of the pandemic continues to hold strong. As we've been noting consistently since the IPO 2 years ago, we fully expected at some point, the tremendous growth in the Canadian industry will come back towards its more normalized mid-single growth rates.And we feel that we're in the midst of returning to those levels. And so we don't foresee that it's necessarily much of a change in the competitive environment, Michael, as it is in a natural normalizing back to mid-single digits as we've been indicating for 2-plus years to occur at some point. And as we've noted with all of you many times, we plan our business to this mid-single-digit industry growth rate and then opportunistically lean in where we think there is a chance for market share growth.But look, it's just the whole industry is normalizing. In-stock levels are normalizing, both for us and for our competitors, promotional levels are normalizing back to the way they were and ultimately, market growth is normalizing. Yes, hardlines are causing that normalizing more than consumables but again, it's another demand cycle. The good news is that we've got a lot of people around here with a lot of history and a lot of great board members with history across the pet industry, and we're working on the levers that you pull as you begin to see the cycle normalize.To your second question, I don't know. That particular competitor still hasn't entered Canada. We'll be monitoring it closely when or if they should enter. And at that time, we'll see what adjustments we need to make. We are assuming the long-run rationality in the promotional environment of the Canadian industry will hold. We believe it's the right way for the industry to responsibly continue to have long-term profitable growth. But should the complexion of that change, as we've noted all along since the IPO, we will respond and we will protect and continue to work to grow market share.

[Operator]

Our next question is from Irene Nattel from RBC.

[Irene Nattel, analyst]

Sorry, I'm going to keep beating the same drum. So just on the consumer demand piece of that, can you talk about -- you mentioned sort of larger pack sizes. Can you talk about what you're seeing in terms of branded versus owned brands in terms of what you're seeing on services, where are we relative to pre-pandemic of what you're seeing there? And also as part of that, what are you seeing in your own e-commerce demand? Where are we now as a percentage of total?

[Richard Maltsbarger, executive]

Certainly, Irene. This is Richard. I'll take each one of those in turn. So let's start first with the branded versus proprietary brand products. We continue to see relatively similar penetration levels throughout this year. As we noted on the call, we do have 1 particular proprietary brand Performatrin Naturals, meat-first recipe, a very competitive price to the upper end grocery store segment brands that is doing quite well. So we do have some small indication that there could be a sub-segment of our population that's looking for value that way.But as soon as I say that, I also need to reiterate that our fastest-growing categories are premium, including our culinary with Frozen Raw. So Big Country Raw as well as our national brands of ACANA and ORIJEN are still amongst our fastest-growing categories. So we're not seeing significant trade down behavior. What we are seeing and we've noted it for several quarters and continue to see it, people trading up from, say, the 17 or 18 pound pack to the 30-pound pack as they try to continue to economize or cans trading up from a 5.5-ounce can to a 13.2 ounce can just to get that slightly better economy per pound to be able to continue to have the consistency of what they feed their pets.On the services side, we continue to see really strong growth. We are now up the volume levels of our self-serve dog washes that exceed what we saw in a pre-pandemic level. We're also seeing our grooming services for those stores who continue to have that, which is about 1/4 of our stores and predominantly in our franchise stores. We continue to see strong double-digit growth there as well. So again, people are still investing in taking care of their pets, especially the devoted pet lover, a segment we study really deeply who we understand will oftentimes make trade-off to try to keep the same lifestyle for their pet as much as possible.And then on e-commerce, quite pleased with the growth that we're seeing in our e-commerce. It is outpacing the growth of the overall average in our store. But again, we don't set a target nor measure specific e-commerce penetration internally because we are an omnichannel approach. We don't do online-only promotions. We will actually turn down vendor money for online-only promotions because we feel it's not the right customer-focused action to take in the marketplace where it makes no sense that a customer could get a deal on their phone standing in the store, but they couldn't get the deal standing at the register with our ACE. And so e-commerce, we're happy with it. We primarily use it to drive the convenience of when, where and how the devoted pet lover would like to shop.Having said that, we do realize that, that convenience and the ability to search our stores and have a great usability on the website is important. That's why we noted that we made a decision to pull forward some enhancements that we had originally planned for next year or even 2025 and to start to work on those later this year to ensure that we're continuing to bolster our capabilities.

[Irene Nattel, analyst]

That's really helpful. And just a follow-up to that question. What are you finding in terms of consumer uptake on the subscription piece of e-commerce? And are you finding any difference in pricing sensitivity of the online shopper versus the in-store shopper if that even exists or if they're all really just omnichannel.

[Richard Maltsbarger, executive]

So we really only focus on omnichannel. We -- I can't really answer the question on sensitivity because we don't price separately from online and in-store. We specifically want to make sure that we can continue to deliver the right value to customers. The vast majority of our online customers are both channel customers. We see them on our website as well as we see them in our stores. And in fact, the reason why we have a revenue share model with our franchisees for direct-to-customer is because we see then those same direct-to-customer customers showing up in the franchisee store. So we want to make sure we continue to support that.We are seeing good uptake on subscriptions. But no, we don't discount our subscriptions. We really tie into a brand factor. For every new subscription, we annualize again and renewed for this year. We donate an incremental $20 to our feeding program for the Lions Foundation of Canada Dog Guides. So you can actually do well why you also take advantage of our subscription capabilities. So overall, I know, Irene, we've had this conversation by reiterating to everybody we are an omnichannel player. We believe the best model to win in Canada is tapping into the strength of our 758 stores, while we continue to build great online capabilities if the customer wants to turn to that option.

[Operator]

Our next question is from Vishal Shreedhar from National Bank.

[Vishal Shreedhar, analyst]

So on the call, obviously, you referenced the slowing that you're seeing in the discretionary part of your business. And you're talking about some higher promotional activity, partially offset by labor savings, if I've got that all right, to assist with the business -- the financial model going forward. Your guidance suggests acceleration of same-store sales growth and acceleration of earnings growth. So you've already talked about the same-store sales growth and some of the promotional activity that you're seeing.But maybe just given all the movement that you have, the supply chain investment acceleration, the increased promotional activity, the labor changes, maybe if you can just underline why you feel comfortable about the EPS guidance and amidst this consumer change you're seeing? And also, if you can give us some sense of your initiatives are starting to work on the promo activity driving the traffic and the sales.

[Linda Drysdale, executive]

It's Linda speaking. I'll take this one. So I'll speak to the softer EBITDA margins we expect in Q3, and that will likely manifest in the form of softer gross margins. So I'll walk through the drivers there. So starting with the impact of higher supply chain transformation costs and those are really -- we'll start to recognize these duplicate operating costs for our new GTA distribution center. And I'll reiterate the comment that I made in the earlier remarks that we expect the impact on gross margin rate to be approximately 200 basis points in each quarter for Q3 and Q4 related to that.Additionally, the unfavorable FX rates persisted a few months longer than we had anticipated in the second quarter. So that will impact our Q3 margins given our 90-day inventory turns. And finally, we do anticipate increased promotional intensity in the back half of the year as the industry normalizes. That said, there are a few tailwinds that we are expecting for Q4. So they include lower distribution costs as we begin to exit the 3PLs that we've been using in the last little while to supplement our supply chain, the easing year-over-year FX headwinds that we expect based on economist productions and greater SG&A leverage as we grow further into our stabilizing expense base.

[Richard Maltsbarger, executive]

Yes. So just to add on to what Linda said there, Vishal. Yes, Q3 will also continue to be tight on the operating margins, primarily with the supply chain transformation, but also a little bit of the extended FX impact that we saw into Q2, which, of course, has a 90-day lag. But as you noted on the Q4 tailwind, again, we generally see a few 100 basis points higher revenue as a proportion of the year in Q4, which will give us a little bit of leverage, especially as we continue to really focus in on every SG&A dollar that we have going into both our corporate store as well as our corporate office SG&A. And then, of course, we will be cycling, we hope, assuming economist projections are correct, the FX pressures as our year-over-year compare gets a lot easier in Q3, especially into Q4, assuming that we don't continue to see any weakness in the Canadian dollar.

[Vishal Shreedhar, analyst]

Okay. And can you update us on intra-quarter trends and if your initiatives are bearing fruit or is it too early days?

[Richard Maltsbarger, executive]

So we're quite confident and quite set. Again, being a few weeks into the quarter, the actions that we've taken, note, we began them in Q2. So we could -- we didn't want to wait to react. So we started to go ahead and practice to take some of the actions in Q2. We will take incremental actions to manage SG&A in the back half as we continue to respond to trends but quite confident especially in our ability to adjust. The good news is -- good or bad, I've spent plenty of time working in other retail sectors that are far more attuned to more rapid demand cycle ups and downs than the pet industry is, but those muscles still exists and the ability to execute on pulling those levers is still there, even though I don't have to do it nearly as much as we used to have to do it in, say, another industry I used to be in. And so I'm really proud of the work that the team has done to pivot very quickly from tremendous growth back to the more normalized growth rate and what it takes for us to manage cost in that type of environment.

[Operator]

Our next question is from Mark Petrie from CIBC.

[Mark Petrie, analyst]

I know data is a challenge, but I'm just wondering if you can update us on what you're hearing with regards to trends in adoption rates and surrender rates? And if there's been any sort of acceleration or deceleration in either of those over this year so far?

[Richard Maltsbarger, executive]

Certainly, Mark. Our channel checks this past quarter would indicate that generally the puppy and kitten adoption market continues to be quite strong. If there is one thing that has slowed, it's been a bit of the older adult dog rescue adoptions. So the data is pretty consistent across Canada that as we've gone into the summer months, a bit less on that front, but essentially still right back to pre-pandemic norms, right? We're really just working our way back into where we were before the pandemic. I think that is contributing a bit to the discretionary, especially the bedding increase because again, those are a little more disproportionately allocated to new adoptions. But we know puppies are still being adopted. We've even got a couple of brand new puppies on the executive team where we finally talked Tanbir, our Chief Digital Marketing Officer, into adopting his first dog. So there's a little bit of peer pressure when you work in a pet company.

[Mark Petrie, analyst]

I can imagine. And I guess, the second one, just on -- with regards to the new store openings, consistent pace in Q2 from Q1. I know H2 is always heavier than H1, but typically do see a pickup in Q2. So any change in what you're seeing with regards to franchisee interest or maybe even more so the real estate market or anything that might be affecting the store rollout?

[Richard Maltsbarger, executive]

So in the near-term, no. We're still pretty confident on the 2023 pipeline, much of which we had signed already last year going into this year. If anything, there might be a bit of a slowdown in new development spend as some of the new developers across Canada with a heightened interest rate environment take a second look at projects that might not have already come out of the ground. So that could delay some of our longer-term pipeline sites that are related to new development. So we take a hard look at that as they think about next year's guidance.But for our as-is sites or the existing real estate sites or what we have in the '23 pipeline, really, we're pretty well on pace. We actually saw it as a positive. We pulled a few more openings into Q1 this year instead of all of the first half openings being primarily in Q2 to spread out the work a little bit for our teams. And we've been quite busy at opening up and building since then. Again, it's the natural cycle of Canadian retail. It's a little heavier in the second half, especially as construction projects really began to pick up pace again in the April and May time frame. So still on track for this year, still confident.And as we noted on the call, opened our first Chico store in our new model. So we'll have several more of those before the end of the year, which, again, is preferable to us as we go on to the head lease. We have the opportunity for percentage rent. But most importantly, we serve them as the landlord and have the opportunity to make sure that we maintain a consistency to the standards and the customer experiences that we expect to deliver.

[Operator]

Our next question is from Paul Kearney from Barclays.

[Paul Kearney, analyst]

Most have been asked already, but 2 quick ones. You mentioned bringing forward e-commerce projects. I'm wondering if you can say specifically which projects you are pulling forward into this year. And then second, just on the DC openings. Wondering if you can just -- I think you mentioned some duplicate costs. I'm wondering if you can just go over some of the timing of that, that we need to be aware of from a modeling perspective of when do some of the duplicate costs roll off and when you start to kind of leverage that investment on the additional capacity?

[Richard Maltsbarger, executive]

Certainly, Paul, it's Richard. I'll take the e-comm question first and then turn it over to Linda to talk a bit about the duplicate costs and the timing. So for competitive reasons, Paul, I'm going to have to defer and say I wouldn't like the list specifically what e-comm projects I'm bringing forward, but they're primarily in the area of customer usability and just continuous improvement. So we launched our entire network back in 2021 is when we first move to nationwide e-commerce platform, having completed Click & Collect in the latter part of 2021 and going AutoShip in the latter part of 2022. We're now turning more to just usability, speed improvements, making sure that we have the right platforms in place for the different elements of our site. And it's really just more as we look -- took a look at overall prioritization of spend, deciding to put a little more money there. And then I'll turn it to Linda for the DC.

[Linda Drysdale, executive]

Yes. So thanks for the question. So the duplicate costs are obviously related to rent and such, we have the GTA as well as in Vancouver. So I'll speak to GTA first. We expect to roll out the duplicate cost for GTA early in 2024, and Vancouver will be later. 2024 is our current expectation. And I'll just remind you, so we said 200 basis points in each quarter hitting gross margin for those duplicate costs. That's where that's this year, 2023.

[Richard Maltsbarger, executive]

And I just want to highlight, though, all of that has an assumption, though, that we are able to exit early on some of the existing leases since we do have significantly below market rents, we believe the landlords will want those back as soon as we can give those to them. But for some reason, if the market should slow for commercial real estate, no signs of which are happening right now in industry real estate. But if it should, again, our leases don't necessarily end on Vancouver until 2025. But again, we're quite below market on rents in a very tight DC environment. So we believe that they'll be interested in taking back the location as soon as we're ready.

[Operator]

Our next question is from Ty Collin from Eight Capital.

[Ty Collin, analyst]

Looked like another really solid quarter here for franchise wholesale revenues. I'm just wondering if you could speak to the level of inventory across the franchisee network at this point. Was there still some restocking going on in the Q2 that may have contributed to that? And then just how are you feeling about inventory levels at the corporate stores as well?

[Linda Drysdale, executive]

Yes, I'll take that. It's Linda speaking. The main driver behind the outsize growth in the wholesale shipments is the improved fill rates that we've been able to offer our franchisee owners. So that's allowed them to purchase more through us than seeking products from outside distributors. So we feel good about the inventory levels across all levels of our business from our DC to our corporate stores, to our franchisees. And so while we may see some timing of shipments versus sales, which can create a little bit of noise quarter-to-quarter, we expect -- and we expect shipments to align closely with sales growth over the long-term. But this might stay slightly elevated as we increase our wholesale capabilities to Chico in the next little while.

[Ty Collin, analyst]

And for my follow-up, just given where interest rates are today and I guess the outlook that they're probably going to remain elevated for a little bit and the impact that's kind of having on your net income and cash flow, are you looking at maybe directing a little more of your free cash to paying down the debt at an accelerated rate? Are you comfortable keeping leverage at where it's at today?

[Linda Drysdale, executive]

So we take a really prudent and purposeful approach to capital allocation, which is something we've employed over the last number of years. And because of this practice, we've built flexibility so we can weather different types of market environments, such as the shifts we're seeing today and the current interest rates. So we're really comfortable with where our leverage sits today in the context of interest rates environment and we don't have any announcements on debt repayment today.

[Operator]

Our next question is from Michael Glen from Raymond James.

[Michael Glen, analyst]

Just to start, have you seen any changes at all in supplier pricing in the period? Is it stable? Is it moving higher or is it moving lower? Just on the consumable side of the business.

[Richard Maltsbarger, executive]

Surely, Michael, this is Richard. I'll take that. And we are seeing the price increase request slow down a bit and the volumes of the sizes of the price increases becoming less than they were this time last year. Having said all that, they're still higher than pre-pandemic. We're still seeing more price increases come in from vendors, and we're still seeing them come in more often than we did. But I would also give credit to our merchandising team. And specifically, our team, the focus is on commodity pricing.We are also having greater success of pushing back on those price increases and leveraging our data and our understanding, both from our proprietary brand of our business. Again, 26% of our business is proprietary brands. So we see very specific cost plus environment and our commodity tracking to be able to push back against those. But I wouldn't say we've quite yet crested in seeing the level of pressure that suppliers are trying to pass through to us and their producer pricing.

[Michael Glen, analyst]

Okay. And then just on the Tuesday flash sales, is this a pet value initiative or are you working with the suppliers on these sales as well?

[Richard Maltsbarger, executive]

So I can't share that due to competitive reasons, Michael, when it comes down to specific promotions. So let me talk a little more generally. The vast majority of the offers we'd bring to market do have the assessment of our suppliers in them, including our loyalty, which is the largest programs that we operate, where we give the 13th bag free for a lot of our national branded components. I will tell you. We are giving preference to those brands that are making commitments to us as their primary distribution channel for [indiscernible]

[Operator]

Our last question today is a follow-up from Michael Van Aelst from TD Securities.

[Michael Van Aelst, analyst]

I just wanted to clarify your comments regarding your EBITDA margin expectations for the Q3 and Q4. You mentioned Q3 EBITDA margin to be slightly less than -- I think the same or slightly lower than Q2. But is that an adjusted margin you're talking about or is that -- in other words, does that include or exclude that 200 basis points of pressure from the supply chain?

[Linda Drysdale, executive]

That excludes, Michael.

[Richard Maltsbarger, executive]

Yes. It's absolutely in our adjusted EBITDA. So Michael, we're referring primarily to the 21% adjusted EBITDA that we had in Q2 when we make the statement that our Q3 adjusted EBITDA margin should be similar to slightly lower than that 21%. And that is adjusted inclusive of excess capacity approximately 200 or so basis points for our supply chain actions and transition during Q3. This is the first major quarter of our transition since we are live in the DC with real products and real people moving it around and prepping it for shipment in just a couple of weeks.

[Michael Van Aelst, analyst]

Right. But if you're excluding the 200 basis points, that's not affecting that margin. So what is affecting the EBITDA margin from Q2 to Q3 that normally you would see a step-up?

[Linda Drysdale, executive]

Yes. So a big one is the FX rates that I mentioned, Michael, as well as some -- what we expect into the promotional intensity. So those are 2 elements that we expect beyond the transformation that will hit margins.

[Michael Van Aelst, analyst]

And then for Q4, what was your --

[Linda Drysdale, executive]

Yes. I was to go there for you. So on the Q4, we expect -- so as we roll off some of the third 3PLs that we've been using, which have been driving the higher distribution costs. So we'll start to see that ease up in Q4. And then we expect the FX headwinds that we've been experiencing to also ease up at that point. And then from the -- I'll go further on the SG&A leverage that we hope to get or that we plan to get, and we're driving those actions as we've talked about and there's been a few questions related to those through deferring some of the backup projects and adjusting staff levels at our corporate stores. So we expect to see SG&A expenses in the second half be reduced and we'll align those closely to how our sales materialize over the coming months.

[Michael Van Aelst, analyst]

I'm just trying to reconcile your sales comments and your EBITDA margin comments to get to your EBITDA guidance for the year. It just seems like the EBITDA margins that you're commenting on don't support the EBITDA guidance. But I haven't gone through all the math, it seems a little late.

[Richard Maltsbarger, executive]

Yes. So Michael, just to reiterate the last point that Linda made, right, we are closely going to watch the SG&A. It's more than just corporate store hours. It is project corporate store staff. And we have also been paying a lot of money to use 3PL labor to move product around in these excess warehouses. So even if we haven't been able to roll off the rents yet until we finish our rent contracts with these 3PLs, we'll more immediately eliminate the labor cost of leveraging these 3PLs, which is a pretty significant impact to Q4.And with that, I'll go ahead and take over. And since we have no more questions and say thank you, everybody, for your time and attention, as always, to Pet Valu and for the depths and interest of your questions. So we are really excited about what we're continuing to do in the business with our double-digit revenue growth, and we're excited to talk to everybody again on our next earnings call in November. With that, the call is completed. Thank you.

[Operator]

Thank you, everyone, for joining today's call. You may now disconnect your lines and have a lovely day.