Pet Valu Holdings Ltd

TSX:PET

Earnings Call Transcript 2024-Q3

[Operator]

Good morning, everyone, and thank you for standing by. Welcome to Pet Valu's Third Quarter 2024 Earnings Conference Call. My name is Lydia, and I will be coordinating today's call. [Operator Instructions] I'd now like to turn the call over to James Allison, Investor Relations at Pet Valu. Please go ahead, Mr. Allison.

[James Allison, executive]

Good morning, and thank you for joining Pet Valu's call to discuss our third quarter 2024 results, which were released earlier this morning and can be found on our website at investors.petvalu.com. With me on the call is Richard Maltsbarger, Chief Executive Officer; Linda Drysdale, Chief Financial Officer; and Greg Ramier, President and Chief Operating 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 Q3 2024 MD&A, 2023 Annual Information Form and other filings available on SEDAR+. Today's remarks will also be accompanied by an earnings presentation. which can be viewed through our live webcast and is also available on our website. Now I'd like to turn the call over to Richard.

[Richard Maltsbarger, executive]

Thank you, James, and good morning, everyone. Linda and I are pleased to be joined today by our new President and Chief Operating Officer, Greg Ramier, who joined us in August. He brings over 30 years' experience in the Canadian retail industry, including over 20 years as a senior executive at Canada's largest food retailer. Greg adds valuable leadership experience in omnichannel retail, supply chain optimization and productivity, hybrid corporate franchise operations and data-driven merchandising, all of which strengthened his fit at Pet Valu to help drive strong retail and wholesale fundamentals.

Before we jump into our prepared remarks on the quarter, I'd like to give him an opportunity to share some comments. Greg?

[Greg Ramier, executive]

Thank you for the warm welcome, Richard. I'm thrilled to join Pet Valu and work alongside some incredibly talented individuals as we chart out the next chapter of our growth. Over the last 3 months, I've traveled the country, walking dozens of stores and speaking to hundreds of our ACEs, franchisees and devoted pet lovers. Through all these conversations, I can clearly see the key elements that have propelled Pet Valu into the market leader it is today. First and foremost, it's because of the strength of our people.

From our frontline franchisees and corporate store ACEs all the way through the distribution network and head office. We fostered a culture built around the safety and compassion for pets. This shows in the passion, commitment and pursuit of expertise I see in our people and in the trust that our devoted pet lovers have in our ACEs, our stores and in their communities through our local franchise owner operators.

Second, the flexibility and agility of our stores and supply chain is truly unmatched in Canada. Our franchise-first model has a proven track record of success across all types of markets, providing industry-leading reach, while the transformation of our supply chain is driving industry-leading service levels, as well as expanding wholesale and retail assortment.

And third, the breadth, legacy and innovation of our proprietary brand portfolio is a real differentiator, giving us the ability to deliver premium quality products at great value to devoted pet lovers. With the exceptional people, assets and capabilities, I see clear, achievable opportunities to drive same-store sales growth and efficiencies by leveraging the investments we've made over the last few years and I look forward to helping facilitate this through a focus on operational excellence and drawing more from these strengths. Back to you, Richard.

[Richard Maltsbarger, executive]

Thank you, Greg. As we anticipated, consumer spending remain constrained through the third quarter as macroeconomic headwinds persisted. Within this context, our third quarter performance tells a story of continued resilience and responsible execution. Despite flat system-wide sales and negative same-store sales growth in Q3, we grew revenue over 5%, driven by higher wholesale shipments, having added 50 franchise stores in the past 12 months, together with providing an increasing share of our franchisees' product needs.

We paired this with diligent cost control, resulting in 13% adjusted EBITDA growth perhaps our greatest financial accomplishment was our strengthening free cash flow profile. With over $60 million of free cash flow generated year-to-date, we have surpassed annual amounts in both 2022 and 2023. This inflection afforded us the opportunity to begin returning additional cash to shareholders a little earlier than expected with share buybacks commencing in September.

When we look at the underlying drivers of sales performance, our comps and needs-based items like food and services remained in positive territory, underscoring the trust devoted pet lovers place in Pet Valu to provide their needs for their pets. And we continue to see even faster growth in key products unique to specialty pet such as culinary, including frozen, gently cooked and freeze-dried and in super-premium kibble.

At the same time, we continue to see softness primarily in discretionary categories like hard lines and treats where devoted pet lovers have greater flexibility to defer or substitute. It is also where we are seeing the greatest near-term promotional intensity and where we are successfully growing our proprietary brand penetration priced at 5% to 20% below comparable national brands.

To note, despite softer demand today, we are maintaining our long-term objectives and progressing our most strategic initiatives, which I'll review in more detail. Let's start with our first focus to be Canada's local and everywhere pet specialty retailer. We opened 6 new stores in Q3, bringing us to 22 new stores year-to-date and 805 locations by quarter end.

Our real estate team has a full agenda for the fourth quarter, and we are on target to open roughly 40 stores this year. In addition to new stores, we renovated, expanded or relocated another 9 sites in the quarter, bringing us to 25 year-to-date and on pace to complete 40 projects this year.

Together with our franchisees, we are committed to reinvest in our existing corporate and franchise network to refresh older stores so that they deliver a modern and consistent shopping experience for devoted pet lovers. We resold 11 corporate stores in Q3, bringing us to 19 year-to-date, surpassing our busiest years in both 2021 and 2023.

This underscores the continued strong interest we see from new and existing franchisees. We appreciate the long-term value our franchise can deliver. As you've heard me often say, our franchisee community represents a critical ingredient to our success through the deep bonds they form with local communities and devoted pet lovers while simultaneously enhancing our returns on invested capital.

In our digital channel, we continue to be pleased with the replatforming of our website this past spring and have been refining the customer experience and leveraging the many benefits of our new architecture. One key enhancement unlocked by our new platform is the ability for all online shoppers to order from our national inventory instead of previously being limited to stock in each region's respective distribution center.

And with increased capacity in our new distribution centers, we are growing our extended online aisle every day, providing more options to devote pet levers across Canada. Having now reached a milestone of over 10,000 products available for our customers online. Moving to our second focus, delivering the best pet customer experience. Our merchants are continually curating compelling assortments of premium products to voted pet lovers want and need at values they desire.

Earlier this spring, we invested in targeted price investments, which have strengthened our direct price competitiveness to key pet specialty competitors. These investments primarily in food and key premium consumables have helped us to hold or grow share in their respective categories.

Now as the Canadian consumer continues to be challenged, we are investing in additional ways to further strengthen our value offerings, including investing further and lowering prices for our industry-leading Fresh 4 Life proprietary cat litter, tightening the gap between our stores and mass offerings, launching a limited time Performatrin Prime bonus bag, which offers 10% more high-quality kibble for the same price, increasing our offering of value packs, particularly in treats and wet food and continuing to differentiate through exclusive launches of innovative products or brands such as functional superfood sticks from Dog Treat Naturals and simple ingredient treats from Just2.

At the same time, we remain hard at work enhancing our complementary offering of proprietary branded products. In consumables, we continue to be pleased with the uptake of our recently launched Performatrin Culinary lineup, which is overindexing with customers new to the frozen raw and gently cooked category. We are also continuing to see strong growth in our key innovations such as Performatrin Ultra Limited Ingredient Kangaroo, Performatrin Prime, Urinary Care and our Performatrin Ultra Freeze Dried, which is in its third year since introduction and still growing triple digits.

In hardlines, we successfully launched our fall and Halloween apparel lineup and completed the refresh of our Bailey & Bella and essential beds portfolio in the quarter. This included launching over 20 new beds of all sizes, shapes and styles including a smaller collection of eco-friendly beds made with recycled material and several key items directly competitive to mass offerings at higher quality.

We also saw JUMP! become our #1 toy brand following the introduction of 300 new products over the last 12 months, which offer improved or similar functionality at a 5% to 20% lower price point to benchmark national brands. Underscoring our commitment to expertise, we continue the expansion of our digital look books with the release of our culinary guide in August, providing facts and recommendations for customers new to the category or our products.

We also upgraded our expert level culinary conversations, training module, providing key examples of how to share expertise in everyday ways. We are expanding the appeal and efficacy of our loyalty programs, which allow us to tap into our 3 million active loyal customers. First, we continue to add national brands to our free bag program. And second, we are continuing to refine and improve our personalized promotions expanding our customer segmentation beyond traditional groupings.

Leveraging AI software to offer more specific value to the most valuable and devoted pet levers. And finally, none of these activities would be as effective without our 360-degree always-on marketing strategy. In September, we reran our they grow up so fast brand spot, featuring not only on traditional mediums like TV but also on Amazon Prime and Disney+ as we lean into opportunities to broaden reach.

And this month, we are launching our holiday brand spot, featuring one of the hottest trends in pet, winter suspender boots with a challenge, don't laugh. Moving to our third focus to fortify strong retail and wholesale fundamentals, especially through our ongoing supply chain transformation. I'd like to provide 2 ways of looking at the success and progress of this transformation.

The first is the implementation path, which is progressing on time and on budget to our original plans started in 2022. And the second is how these investments are now and will continue to drive both value and competitiveness in the coming years. First, in terms of implementing our supply chain information, we are moving forward as planned.

For this quarter, the most notable development was the successful transition into an official opening of our new distribution center in Surrey BC. At 350,000 square feet, this facility represents Canada's second largest DC dedicated to pet specialty products surpassed only by our own DC in the GTA.

Our new Surrey DC delivers multiple enhancements to our distribution network in BC. including roughly tripling our capacity, enabling us to fully exit expensive 3PL storage in Vancouver last month and most importantly, the ability to onboard additional vendors for wholesale distribution that were previously constrained in our older buildings.

Additional features include modern DC building design with higher ceilings and efficient layouts, enhanced employee welfare spaces and sustainability elements such as LEED-gold certification and our first venture into more sustainable delivery with a pilot of 2 EV delivery trucks. At our GTA DC, the automation is fully activated, and we have successfully transitioned all legacy facilities moving from 5 warehouses to 1 in less than 15 months.

We were pleased to welcome equity analysts to the DC earlier this fall and look forward to hosting subsequent tours with shareholders and investors in the future. And finally, subsequent to the end of the quarter, we signed a lease for a newly built 300,000 square foot facility in Calgary for our third and last key distribution center transition.

We expect to take possession early next year and transition into the new space by Q3 2025. Now I'd like to turn to how the supply chain investments are now and will continue to drive value in the coming years. First, these investments unlock the capacity to continue to grow. With the successful GTA and Surrey DC launches and next year's planned Calgary launch, we will have doubled our supply chain capacity in less than 3 years and through additional space available to the GTA and Surrey facilities have established a base that can support all 1,200 or more stores we see in the future of the company, and has already allowed us to expand more than 1,000 additional items onto our website.

Second, adding the capacity to the GTA specifically unlocked a critical integration lever with our Chico acquisition and expansion in Quebec. At the time of the acquisition, Chico could only self-distribute less than 5% of the goods to its franchisees. We are already delivering more than 5x that amount today, only one year after we began using the GTA DC in October of 2023. We are well on our way to further expanding our wholesale catalog to Chico franchisees and are speedily tracking towards reaching 50% or more wholesale penetration by Q4 2025 with our Chico stores, a more than $50 million annual revenue unlock only made possible by this transformation.

Finally, and most importantly, we are just beginning to also unlock what will be years of increased productivity gains, already achieving year-over-year improvements in turns, customer service levels, in-stocks and product breadth. With only a few months of full operation of the automation in our GTA DC, we recently achieved a 100% improvement in pick productivity compared to 2022 levels at our legacy facilities in that market.

And this is without further labor, transportation and load efficiency software that we will be implementing during the coming years. All told, we expect at least 20 to 30 basis points of efficiency from our supply chain every year for the next 5 years, contributing to long-term opportunities to improve gross margin rates as we also expect to achieve fixed cost leverage as we continue to grow. And our fourth and final focus to enhance free cash flow and return on invested capital.

As I mentioned earlier, through the concerted efforts of our teams to safeguard profitability through the current cycle, we have recently seen our free cash flow inflect. We expect further upside as we near the end of our supply chain transformation and leverage the capital-light benefits of our highly franchised model, freeing up capital for alternative deployment.

I am excited as we embark on this next phase of our growth. Now I'll turn it over to Linda to walk through our Q3 financials in more detail. Linda?

[Linda Drysdale, executive]

Thank you, Richard, and good morning, everyone. Our responsible actions in Q3, together with the inherent advantages of our resilient business structure helped deliver another quarter of solid profitability and maintained our excellent financial positioning as we weather current transitory macroeconomic headwinds. Let me walk you through some of the headline metrics. Q3 system-wide sales were $358 million, similar to last year.

We opened 6 new stores in the quarter and 39 in the last 12 months, bringing us to 805 locations at the end of the third quarter. We continue to grow our franchise mix over time with our franchise store network representing over 73% of our total compared to less than 71% in Q3 last year. Same-store sales declined 2.5% with average basket growth of 2%, offset by a 4% decline in transactions.

As Richard mentioned, at a product level, softness remains primarily in discretionary categories like hardlines and treats, while needs-based products such as food and services continue to grow. Third quarter revenue increased 5% to $276 million, outpacing system-wide sales, mostly due to stronger wholesale shipments as we grew wholesale penetration with Chico franchisees, onboarded additional vendors into our Surrey DC. and increased our franchise store network.

Gross profit was $89 million, up 2% from last year. As a percentage of revenue, gross margin rate was 32.4% or 33.5%, excluding 110 basis points of cost related to our supply chain transformation. Excluding these costs from Q3 and the comparable period last year, gross margin decreased 160 basis points, primarily driven by higher fixed distribution and occupancy costs from new distribution centers, higher fall sales and merchandise sales and a weaker Canadian dollar, partially offset by the allocation of promotional funding.

Selling, general and administrative expenses in the third quarter were $49 million. Excluding costs not indicative of business performance, our SG&A expenses were approximately $44 million, down 6% compared to last year and 190 basis points favorable as a percentage of revenue. Our continued delivery of expense leverage in the current environment is a direct function of our relentless pursuit of discretionary cost savings, the reprioritization of noncritical projects and lower variable compensation accrual.

This in turn, safeguards our ability to advance our long-term strategic initiatives. Adjusted EBITDA was $65 million, up 7% from last year. As a percentage of revenue, our adjusted EBITDA margin expanded 160 basis points attributable to our diligent cost control. Net income increased 29% to $23 million. Excluding items not indicative of our underlying performance, adjusted net income was $30 million or $0.41 per diluted share, an increase of 6% and 5%, respectively.

Looking at our balance sheet, we had $35 million of cash on hand at the end of the quarter and total liquidity of $165 million when including our revolver, which remained undrawn through the quarter. Total debt, net of deferred financing costs was $283 million. Taking into account net lease obligations, our leverage ratio sits at 2x, providing ample financial flexibility.

Q3 inventories were $135 million, flat to last year despite growing revenues 5%. This leverage is largely attributable to benefits unlocked by our supply chain transformation with greater capacity and technology enhancing our productivity while our improved product visibility and traceability feeds prudent replenishment decisions.

Overall, the quality and quantity of stock across our business remains in good standing as we enter the holidays and begin our busiest season. Net capital expenditures were $14 million in the quarter and $38 million year-to-date and we continue to expect to invest roughly $50 million this year.

Third quarter free cash flow was $31 million, up significantly from $18 million last year. Year-to-date, we've generated over $61 million in free cash flow, surpassing annual amount for 2022 and 2023. With our free cash flow inflecting sooner than expected, we have begun to return excess capital to shareholders through our normal course issuer bid. Repurchasing almost 80,000 shares in Q3 for a total cash consideration of $2 million.

We've remained active through the first month of the fourth quarter, and we'll continue to be opportunistic repurchasing our shares at compelling valuation levels. Before turning to the outlook, I wanted to note that last week, we entered into an amended and restated credit agreement. Leveraging our strong financial position and operating track record, this agreement provides several favorable terms, including lower cost, greater financial flexibility and extends maturity out to 2029.

This achievement is a testament to the years of responsible financial and operational execution by our teams and marks a key milestone for Pet Valu as a public issuer. Moving to our full year outlook. 2024 has been a dynamic year for the Canadian pet industry. Economic projections and retail studies at the start of the year suggested consumer demand would strengthen through the back half. However, updated projections have now delayed that until the second half of 2025.

In response to this evolving environment, we've been adapting our discretionary spending and managing inventory to safeguard profitability. As Canada's leading pet specialty retailer, we appreciate the role our products play in the lives of millions of pets across Canada. And as devoted pet lovers needs for greater value group, so have the actions we have taken to provide it.

Through the price investments we made last spring, further expansion of our proprietary brand offering at discounts to national branded products, especially in the hardlines categories, and enhancement of our loyalty program. In the fourth quarter, we are taking additional steps to provide incremental value through targeted price investments and greater emphasis on key events and media buys to generate excitement in-store and online.

Factoring this in, together with our year-to-date performance, we've narrowed our 2024 guidance towards the lower end of prior ranges. We expect revenue of between $1.08 billion and $1.1 billion, supported by continued growth in our store network, increased wholesale penetration and roughly flat same-store sales growth.

On adjusted EBITDA, we now expect to reach between $243 million and $246 million. This implies softer adjusted EBITDA margins in Q4 compared to last year, driven by a few factors, including industry-wide promotional and advertising intensity and the necessary actions we will take to responsibly drive excitement and traffic. Clearance sell-through, as we utilize carryover stock to provide greater value to customers, and we would be lapping lower variable compensation expense last year, which we don't expect to repeat this year.

Factoring in our refined range for adjusted EBITDA and minimal changes to other items below the line, we expect adjusted net income per diluted share of between $1.50 and $1.53. As you begin to turn your attention to 2025, we want to leave you with some high-level thoughts as we pull together our plan. Consumers continue to invest in higher quality products for their pets and humanization trends continue to hold strong.

Our financial framework remains unchanged. We aspire to grow with the industry and then execute initiatives to earn market share, such as through our recent launch of performance and culinary. Improved same-store sales growth trends in Q4 to date compared to Q3 rates are potential early signs for a more constructive pace of industry growth in 2025.

Our pipeline of new store opportunities indicates we can continue a similar pace of growth in 2025 to that we've achieved over the past few years. We expect earnings growth will be stronger in the second half of 2025 as we annualize step-ups in fixed costs of our GTA and Vancouver DCs during the first half. And most importantly, we continue to expect to generate over $100 million in free cash flow, which we plan to deploy in accretive ways.

As always, we will share more details on our financial and operational outlook for 2025 when we report Q4 results in early March. With that, I'll turn it back to Richard for some closing thoughts. Richard?

[Richard Maltsbarger, executive]

Thank you, Linda. As noted, our teams work together across leaders, ACEs and franchisees to manage through a challenging consumer backdrop to deliver solid revenue and adjusted EBITDA growth in Q3. As the consumer continues to feel challenged, we are taking responsible targeted steps to sharpen our value offerings and generate the right type of excitement and interest in Pet Valu and our products during the fourth quarter.

As we look to 2025, the key strategic initiatives that we have delivered this year, including our supply chain transformation, the relaunch of our digital website platform, our continued new store openings and the launch of Performatrin Culinary have all contributed to strengthening our competitiveness for the days ahead.

As always, I could not be more proud of how our people come together regardless of the environment to serve our customers deliver expertise and compassion and continue to represent the best of what animal care experts should provide to customers in stores and online across Canada. With that, we are now happy to take your questions.

[Operator]

[Operator Instructions] Our first question today comes from Irene Nattel with RBC Capital Markets.

[Irene Nattel, analyst]

That was a great overview. I'm trying to understand what you're seeing out there in terms of demand that's causing you to essentially be more cautious on Q4 despite the better-than-expected outcome in Q3. How is Halloween? What do you think about Christmas? Is it demand? Is it promotion? Any help that you can give us would be very much appreciated.

[Richard Maltsbarger, executive]

Certainly. Irene, thanks for the question. But demand trends in Q3 continued much as they have through the first half of the year as we expected and indicated on our call in August. Consumers continue to prioritize need space purchases for their pets. We now have consumables and services accounting for more than 80% of our system-wide sales during Q3 because we're well positioned to continue to meet those specific needs.

We're also continuing to see healthy signs of continued humanization demand for culinary, premium kibble are both outpacing the company average in positive territory for the quarter. And with the recent launch of Performatrin Culinary, we're even better positioned. Also, as you heard on the call, right? Our Performatrin Ultra Freeze Dried is now in the third year and is still seeing triple-digit growth.

So those particular elements were really quite attuned to. Now at the same time, value-seeking behavior or more discretionary items such as toys, apparel and collars, continues, as you heard in our prepared remarks. These are the items where devoted pet lovers do have a bit of flexibility to defer our substitute. It's also where we're seeing the greatest amount of promotional intensity.

There was a bit of an incremental change in Q3 to the first half. Really a step-up in competition in mid-tier cat litter. And as always and as we've noted since the IPO, we closely monitor key competitors and we're committed to maintaining relative value, especially in key value perception driving items such as cat litter. So we took actions to adjust our opening price point litter back in the spring as part of those pricing investments and just recently, as of this week, we are now taking additional steps for several of our key Fresh 4 Life cat litter products to make sure that customers can be assured that they can come in and receive everyday value inside of our stores.

The other small incremental change in Q3 was a bit of softening beyond just the urban cores. We did have a few surrounding suburban markets, primarily tied also to very high housing value markets where we did see a slight decrease in Q3 compared to earlier in the year. Now having said all that and to the back half of your question on Q4, from a sales perspective, we have started to see some strengthening same-store sales trajectory across the first 5 weeks of Q4, but we are headed into a busy holiday season.

And while our focus is always on ensuring that we have that devoted pet lover at the core of our resilient success of making sure that we meet their core needs, we do make small adjustments to adapt to the environment. We've been making these adjustments since we first saw a pullback in discretionary spending last year, and we continue those adjustments throughout this year.

We will also make a few more adjustments as Linda shared in her prepared remarks as we go into Q4 to ensure that we've got the right level of not only promotions but also advertising to ensure that we can generate excitement and traffic and some adjustments on key value pricing, such as the litter and a few others to make sure we're also delivering everyday value to customers.

So altogether, trends pretty similar to what we've seen shaping up throughout the year. We are making some small adjustments specifically in Q4 to make sure that we are competitive in the market environment that we're proposed and seeing and at the same time, we're quite happy with the steps our teams took to manage cost in Q3, and we'll continue to do some of those steps to manage as we go into Q4.

[Irene Nattel, analyst]

That's really helpful. And a follow-up question, if I might. So taking all that into consideration, what are you seeing in terms of new store openings just in terms of sort of, I guess, the run rate on revenues of new store openings as you've gone through the year?

[Richard Maltsbarger, executive]

Certainly. We're pretty much right on track. So construction windows in Canada always push our new store openings typically to be a bit back-end loaded. We're very confident we're going to reach roughly 40 this year. Our real estate and store operations teams have been quite active already in Q4. So we'll actually be above 30 new stores year-to-date next week.

[Operator]

Our next question comes from Mark Petrie with CIBC.

[Mark Petrie, analyst]

Sorry, Linda, could you just go back to the comments about Q4? And I guess, specifically on SG&A, you guys have obviously been getting some excellent leverage. Just wondering about sort of the sustainability of that and then also how to think about 2025.

[Linda Drysdale, executive]

Yes. Thanks, Mark. First off, I'd like to say that we're really pleased with the continued efforts of our team to closely monitor the cost and reevaluate project spend in the context of this current environment. These actions are necessary in a meaningful contributor to how we're able to keep our SG&A expense down. In Q3 specifically, we also benefit from lower variable compensation accruals and looking into Q4, we expect SG&A dollars to normalize back up in line with the Q2 or first half run rate.

With respect to 2025, I'd say we're -- obviously, we're just currently building our budget, and we'll provide more commentary when we release our Q4 earnings early next year. However, I will say we do plan to keep a heightened focus on cost management as long as the demand environment remains constrained.

[Mark Petrie, analyst]

Yes. Understood. Okay. And then I also wanted to ask about the wholesale shipments. Obviously, that outpaced sales nicely. And I think you talked about 3 different drivers for that, Chico, Surrey and then more SKUs. Could you sort of talk about maybe the sustainability of the potential for wholesale shipments to outpace sales growth into 2025?

And then I don't know if you can sort of rank order those 3 drivers, and again, sort of the sustainability of each of those in the coming quarters?

[Richard Maltsbarger, executive]

Certainly. Mark, this is Richard. I'll take that question. look, in the context of the current environment, we've been quite pleased with the ability to actually continue to have revenue growth outpace system-wide sales. I'm actually going to answer the end of your question and then circle back to the beginning. So the end of your question on sustainability into 2025. You've seen a trend over several quarters of slight revenue outpaced the system-wide sales.

We do expect that will continue a bit going into next year. And now let me give you the drivers for why. The sustainability starts first and foremost and the largest impact to your question about rank order is absolutely the success we're seeing with Chico. So with our Chico franchisees, we continue to grow their wholesale catalog that's now available to them and their uptake has been tremendous.

We were able to make additional products available to them beyond our expectations in the quarter. And it's clear they're seeing the operational benefit of consolidating their orders with us and the time savings and simplicity it provides. So as noted on the call, our wholesale penetration rate at Chico is now more than 5x the less than 5%, it was when we first acquired them. And we're well on our way to the 50% or more of their business being purchased from Pet Valu on a run rate in Q4 2025.

So as I noted in my supply chain comments, this was a significant unlock that was just not possible without making the supply chain investments and it's helping to drive our revenue outside to system-wide growth in the near term. But we had an additional benefit to the supply chain in the quarter that was beyond our expectations and why this is a bit different than what we were expecting.

You heard on the call, we're growing our wholesale penetration with our franchisees also in our other banners. This benefit was really unlocked by the capacity in our Surrey DC that we opened up and the automation that we've opened up within our GTA DC. Both of these have allowed us to bring in either incremental new brands that we were unable to ship wholesale before or we've been able to greatly expand the availability of products from existing brands.

As I noted on the call, we've added more than 1,000 SKUs, and we now have over 10,000 SKUs available online. So this is unlocking both online and in-store sales to our franchisees who are tapping into some of these extended IO products to put onto their shelves. So those are by far the 2 largest drivers. And then every other quarter, we always have a few timing or other things that come up.

But generally, it is the success, the planned success and execution of our Chico wholesale business. And then the incremental benefit we picked up on a little earlier than we expected being able to add more SKUs into both the Surrey DC and the GTA automation as we really, quite frankly, stabilized those systems very quickly, early and midway into the quarter, just faster and more successful than we expected to.

[Mark Petrie, analyst]

Okay. And then just to clarify, the refranchising of the 11 sites, that doesn't materially affect sort of wholesale shipments in the period.

[Richard Maltsbarger, executive]

Not in the period. Over time, as I noted on the call, we do have resales as a normal part of our business. So over time, absolutely, we will continue to move more of our revenues to wholesale. I think Linda noted specifically in the prepared remarks, we were at 73% franchise now versus 71% last year, but not in the quarter itself, Mark.

[Operator]

Our next question comes from Michael Van Aelst with TD Securities.

[Michael Van Aelst, analyst]

Just wanted to touch on your comments about the outperformance of products that are unique to the pet specialty I'm wondering to what degree you can tell that, that's happening. Obviously, you can see that in your own stores, but is that because of the industry demand is growing faster still in those unique products and premium products. Or is it because consumers are going elsewhere for the more mainstream products?

[Richard Maltsbarger, executive]

Mike, this is Richard. So it is both our own analysis as well as through third-party analysis. We believe we're holding market share overall and likely continue to gain share in these core food categories specific to pet specialty. So it's both our outperformance within our business, but as well our third-party analysis.

So while we generally only publish on an annual basis, we do still try to track along the way throughout the year. And the indicators are that we're continuing to grow in those places. The key is, right, most of the promotional intensity and competition continues to be heightened primarily in hardlines and more discretionary goods. We think our strategy in this time to remain focused primarily on retaining habitual needs-based trips and providing exceptional service and expertise by continuing to invest in great ACEs in the aisles.

And as I noted on the call, continued development of expertise training to help to support those are really at the center of our strategy to make sure we retain lifetime value of the most devoted pet levers. We think we're being responsible by not overly promoting hard lines, absolutely continue to participate in the market, but making sure that we are positioning the products that will put us in the best case for long-term success going forward.

[Michael Van Aelst, analyst]

All right. That's helpful. And then the investments that you're making in Q4, particularly on the gross margin side, is that something that you expect to continue into next year? Or is this -- are we expecting Q4 margins to just be coming down relative to the first 3 quarters? Like because usually, Q4 is a little bit higher, but the mix seems to be shifting a little bit away from the higher-margin products in Q4 given the consumer. So I'm just wondering what the outlook is for gross margin beyond Q4?

[Richard Maltsbarger, executive]

Yes. So Mike, let me talk about what's going on in the marketplace, and then I'll turn it over to Linda to talk a little bit more specifically about gross margin in Q4 and into 2025. So look, these we consider the right small adjustments in a long-term race to ensure that we are at the center of devoted pet lovers. And I just want to reemphasize again, devoted pet lovers.

So we are orienting all the actions we take around those that are devoted to their pets and specifically making sure that the balance that we're striking in the marketplace provides great value overall, but specifically focuses on those customers with the highest lifetime value. Our value proposition hasn't changed with anything that we're doing in Q4 nor has the financial framework.

We really just continue to make the smaller, more necessary and incremental investments that align with maintaining the right value proposition overall for our target customers. The cat litter is a great example. Again, as we said constantly, we consistently look at the market.

We understand where our competitiveness is and we make sure that we retain relative value and make our investments very pointedly and very specifically in everyday value for the most value-sensitive items. Now I'll turn it over to Linda to talk about the margin implications.

[Linda Drysdale, executive]

Yes. So as mentioned in my prepared remarks, and as Richard said, we have updated our 2024 outlook to reflect primarily 3 things. The actions we'll take to drive the excitement and traffic in Q4 amid the increased industry-wide promotional and advertising intensity. Second, the everyday price decreases we're taking to increase our competitiveness, such as Richard mentioned, the Fresh 4 Life litter products. And third, the expected sell-through of the carryover stock as we utilize these products to provide additional value to customers during the holidays.

I do want to stress that our actions will continue to be responsible and balanced in line with our value proposition and supportive of reestablishing a stable trading environment. So I think that in terms of 2025, we're not providing incremental guidance on gross margin at this time. That said, we do continue to expect gross margins to remain below that 35% at least for the next few years because of the step-up in the fixed DC cost, which is more of an impact than these other matters.

[Operator]

The next question comes from Martin Landry with Stifel.

[Martin Landry, analyst]

My first question is on -- with now Calgary lease signed, can you update us on what you expect in terms of EPS headwind from your Vancouver DC and your Calgary DC in 2025?

[Linda Drysdale, executive]

Yes. For EPS on -- specifically related to -- I mean, I just talked about the impact of -- on gross margins. As we indicated in our 2024 outlook, we do expect a $20 million step-up in this year's depreciation and interest expense related to the new DCs in GTA and Vancouver. And as we've already communicated, we anticipate another step-up of roughly half that size in 2025 as we annualize the transition into our Vancouver BC and activation of the GPA automation and bring Calgary on board.

So we do intend to offset those pressures and return to some EPS growth next year. That being said, and I'll just remind you that we do have seen the free cash flow inflects recently and are confident in our ability to surpass the $100 million in 2025.

[Martin Landry, analyst]

Okay. So just to be clear, the $0.10 headwind next year includes Vancouver and Calgary?

[Linda Drysdale, executive]

Yes, roughly, roughly.

[Richard Maltsbarger, executive]

And annualization of the automation in GTA.

[Martin Landry, analyst]

Okay. Okay. And Richard, you've talked about an upgrade of your digital platform. I was wondering if you could tell us how much sales now are coming from your e-commerce? And do you have an internal target as to where you want to bring e-commerce as a percentage of total sales?

[Richard Maltsbarger, executive]

So Martin, thank you. And the bought answer to the second half is no. Now let me answer why we don't have an internal target for e-commerce. We are truly an omnichannel retailer. We are not choosing to force the customer to select any particular channel. We are maintaining and building an e-commerce capability that rivals the best of e-commerce capabilities in pet in North America. With the activation of our automation to the GTA and the expansion of our SKU base through the increased capacity, we are continuing to invest and expand that business to make ourselves even more relevant if a consumer chooses to buy e-commerce, whether that's through direct-to-customer click and collect or our Autoship subscription program.

But we don't set an internal target. The key is we always use -- and you've heard me make this joke, but I'll repeat it. We use our Head of Marketing, Tanbir's mom to make our decisions, right? And does it make sense to Tanbir's mom if we tell her if she buys something only online, she can get a discount, but if she buys it from our ACE in the stores, she can't. That doesn't make any sense to us. We don't think it makes sense to customers.

So we do everything possible to make sure that we are just as convenient as anybody else in North America when it comes to buying pet and with the largest store footprint in Canada, the most convenient in Canada when it comes to just cutting around the corner to get into your neighborhood store. So we're quite proud with what we've done with our digital platform, as I highlighted on the call.

Not only have we expanded our relevance, but we've also expanded our distribution capability now with any product on our website now available for national shipping, which we are able to do with the activation of both Surrey and the GTA. So it continues to grow. The growth, as we've noted in the past, continues to outpace our regular business. But simply part of that is because, remember, we didn't activate a transactional website till 2021.

But overall, pleased with what we're seeing, pleased especially now with the parity that we've been able to establish in the marketplace to any other leading pet specialty offering and look forward to continuing to be a truly omnichannel however the customer wants the retailer going forward.

[Martin Landry, analyst]

Okay. That's fair. I was -- is it -- is there any chance you can share with us your e-commerce sales as a percentage of total sales for the quarter?

[Richard Maltsbarger, executive]

We do not because we don't again set that as even an internal KPI.

[Operator]

The next question comes from Vishal Shreedhar with National Bank.

[Vishal Shreedhar, analyst]

I just want to get your perspective on traffic and what you think is causing the weakness in traffic, given that you're holding market share? Is it that people consolidating trips? Any color you can provide there? And also related to that, you said the sales were improving intra-quarter into Q4. Is that on the traffic line as well?

[Richard Maltsbarger, executive]

So let me take first the Q3 transactions. So to your overall question, we believe we're, in general, seeing that the value-seeking behavior and softness of discretionary items is resulting in fewer both casual trips and sort of larger stock up trips, most especially for customers not in our loyalty program. So similar to prior recessionary or challenged consumer environment, we often see these casual trips go away early in the cycle and begin to rebound alongside an improving economy.

It even happened most recently with COVID, where we immediately saw casual trips pull back and then later, a year later, start to see them come back in as the economy improves and things bounce back. As always, we pay the closest attention to our key monthly customers. And once again, we were able to increase our total monthly customer segment size but even among our monthly customers, we did see some additional pullback in hardlines and discretionary purchases, specifically, as I noted on the call, in the urban and some of the surrounding suburban markets that are hardest hit by mortgage servicing and rental costs.

So we're continuing to be hopeful that as economists are now reprojecting a later 2025 improvement, but we also continue to be balanced and focused on making sure that we maintain diligence in this type of environment. Going back to your question on Q4 trends to date, as noted on the call, the trajectory of our same-store sales and our growth has improved and what we've seen in the first 5 weeks of Q4, but I will also caution that just remember, we do have our largest sales days ahead of us with the holidays period starting here within the next week or 2.

[Vishal Shreedhar, analyst]

Okay. Changing topics, how should we think about the impact of FX on Pet Valu? There's considerations or thoughts that the Canadian dollar could weaken further? And how should we reflect upon that as we look forward to 2025? And is there anything management can do to abate that pressure?

[Linda Drysdale, executive]

Yes. Well, I think I say first, Vishal -- it's Linda speaking again. We continue to purchase the vast majority of our merchandise in Canadian dollars as our supplier base, particularly in consumables is domesticated. That said, we did see a modest increase in the proportion of Canadian dollar purchases. So we currently don't hedge because of the 20 to -- just over 20% of the products that we purchase are denominated in U.S. dollars.

And we've -- at this time, we've assessed that the relative benefit of running a hedging program doesn't aweigh the cost. So I don't have anything to announce on hedging at this time.

[Operator]

[Operator Instructions] Our next question comes from Adrienne Yih with Barclays.

[Adrienne Yih-Tennant, analyst]

Great. Richard, I know there's so much on macro. What I want to actually ask you something about kind of from the year-to-date perspective. Is there something that you saw that was a point in time over maybe the last quarter or so a change in behavior, frequency of shopping.

And I know we've seen some of the underlying trends, but is there something new right to the story as we go into maybe the back half of this year and then early next year? And then for Linda, I know we're not talking about next year's numbers, but there was a point earlier in the year where it was that return to kind of EPS acceleration. And I'm just wondering if you can talk about sort of going for market share, making investments into promotions, right, into price investments and how we should think about that in driving comp, the conversion side of comp versus average unit retail, maybe being under some pressure.

[Richard Maltsbarger, executive]

Certainly. Adrienne. So I'll circle back to first question again, just to make sure I have this down. As we look at the year-to-date trends, you were asking specifically around a point in time change in frequency of shopping, any other sort of online trends. So I'll talk to specifically what I said in my prepared remarks and a couple of other small statements.

First of all, the trends throughout this year have been relatively consistent. We haven't seen a whole lot different. Again, even in Q3, we continue to see it primarily isolated mainly in urban markets with what I noted incrementally different weakness in some of the surrounding suburban markets. Note that the rate of Canadian mortgages and the dollars subject to reset are going to double in 2025 from what they were in 2024.

So I think more consumers are looking ahead. So while rates are coming down, that still means a substantial reset unless they come down appreciably faster for many homeowners in the first half of the year. We did see the small incremental change in cat litter. So I did highlight that out. I also highlighted out the pricing actions that we've taken on our highest volume proprietary brand, Fresh 4 Life SKUs as [indiscernible] us responding to that with everyday value as opposed to just with promotions.

And then really, we have seen just a step-up in the media spend, but part of that is associated with the season that we're going into. And so part of the pressure on Q4 is a recognition that we are going to play in that media spend, make sure that we are appropriately capturing share of voice, generate excitement and traffic. As I noted on my prepared remarks and keep an eye out for this, I think you're about to see one of the funniest television commercials you've ever seen because there's just something about a dog and a pair of suspended boots looking ashamed that just makes you laugh.

So we're making sure we're going to wait to invest in that. And if you could, just for Linda, since I went so long, can you just repeat a bit your second question just to make sure that we got the gist of it.

[Adrienne Yih-Tennant, analyst]

Yes. The second question was earlier in the year, I believe there was a comment on -- specifically on EPS in year 2025 and 2026, an acceleration in EPS growth. So I'm just wondering if kind of if that has changed at all? Or we should kind of think about -- how we should kind of think about casting '25 and '26?

[Linda Drysdale, executive]

Yes. So I think I addressed a little bit about EPS growth earlier in the call about -- just in terms of the impact of the depreciation this year and then the incremental step-up that we have again next year or roughly half that size, so the $20 million this year and $10 million or roughly half of the $20 million for next year. So we do intend to offset those pressures with -- and return to some EPS growth next year. And -- so I think that's the answer to the question. I'm not sure if there's anything to add.

[Richard Maltsbarger, executive]

Yes. So just to reiterate what Linda said, we fully intend to offset the incremental fixed cost pressures from the supply chain next year and return to EPS growth. I think that aligns with the messaging that you heard all year long as we are really absorbing this onetime step-up to the capacity and the capability improvements that we have in our supply chain, and we'll get back to growing EPS as we annualize those investments.

But throughout all of that, I just want to reiterate, we have maintained free cash flow generation. So we've self-funded the largest supply chain transformation in company history and have already seen the inflection of cash flow allowing us to actually dip into the market and initiate buybacks actually earlier than we planned with some activity even into the end of Q3.

And throughout, Adrienne, just a bonus for you because I know you pay such close attention to it, super proud of the team for maintaining inventory leverage every quarter this year despite the largest supply chain transformation and transition of buildings and automation that we've ever had.

[Adrienne Yih-Tennant, analyst]

We did note that, and that is actually remarkable, to be honest, because a lot of times, you have to put in duplicate inventory and just to make sure. So we are -- we did notice that, kudos on that.

[Richard Maltsbarger, executive]

To get out of 5 buildings down to one in the GTA in less than 15 months that successfully activated the largest pet specialty automation in Canada. It's been a pretty busy year.

[Adrienne Yih-Tennant, analyst]

It's been excellent. We very much like to see that transition.

[Operator]

Thank you. We have no further questions. So I'll pass you back to Richard Maltsbarger for any closing comments.

[Richard Maltsbarger, executive]

Perfect. Thank you, Lydia, and thank you to everybody for investing your time with us today. Incredibly proud of the work the team has done to establish the resiliency and the success of a balanced approach to both growing sales and managing costs in a challenging and shifting environment. And we look forward to sharing more with you on our next call in March.

[Operator]

This concludes our call today. Thank you for joining. You may now disconnect your lines.