Petco Health and Wellness Co Inc - Ordinary Shares - Class A Aktie

Good day, and welcome to Petco's First Quarter 2026 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Roxanne Meyer, Vice President, Investor Relations and Treasury. Please go ahead.

Good afternoon, and welcome to Petco's First Quarter Fiscal 2026 Earnings Conference Call. Joining me on the call today are Joel Anderson, Petco's Chief Executive Officer; and Sabrina Simmons, Petco's Chief Financial Officer. In addition to the earnings release, we've posted a slide presentation on our website at ir.petco.com. I'd like to remind everyone that on this call, we will make certain forward-looking statements, which are subject to a number of risks and uncertainties that could cause actual results to differ materially from such statements. These risks and uncertainties include those set out in our earnings materials and SEC filings. In addition, on today's call, we will refer to certain non-GAAP financial measures. Reconciliations of these measures can be found in our earnings release, presentation and SEC filings. With that, I'll turn the call over to Joel.

Thanks, Roxanne, and good afternoon, everyone. Thank you for joining us to discuss our first quarter results. Our strong Q1 results provide an encouraging early validation of our Phase III Reach for the Sky strategy. We returned the business to a positive comp for the quarter while expanding our profitability, performing better than our quarterly outlook for both top line and adjusted EBITDA. We were particularly pleased to see the improvement in our consumables business, while our differentiated services business once again delivered strong results and continues to be a growth engine for us. This solid start to the year gives us deep confidence that our growth initiatives are taking hold.

It speaks directly to our innovation pipeline, rigorous execution, smarter marketing and most importantly, the advantages of our wholly owned omnichannel ecosystem. In light of our solid first quarter, we are pleased to reaffirm our full year outlook and remain confident in our ability to drive consistent top line results. Sabrina will take you through our financial details shortly. But first, I want to spend some time updating you on the progress we've made across our strategic 4 pillars, which are positioning Petco for long-term profitable growth.

Let's begin with our first pillar, compelling product. While we are still in the early innings of evolving our product mix and the flow of our merchandise, we have begun to introduce real newness to our aisles and we are seeing evidence that it is resonating with pet parents. Specifically, you should now see several of our main drive aisle end caps converted to new product and identified with a yellow new logo. From a top line perspective, we saw outperformance in the cat category this quarter. We anticipated the recent spike in demand for cat products. And as a result, we invested to make Petco the destination for cat parents. It was a key contributor to the improved sequential trends we saw in consumables overall. You will see cat newness ramping up even further in Q2 with exciting additions in areas such as furniture, beds and bowls, but also in novelty items such as cat trees.

We also continue to lead in the fresh frozen space. During the quarter, we added significant incremental freezer capacity to support the momentum in this category. We hold a distinct advantage in this category driven by the breadth of our offerings, our key brand partnerships and a wide range of price points. We have positioned Petco as a premier destination for pet nutrition, which we believe will serve us well as the pet humanization trend continues to pick up speed. Our expertise in dedicated in-store teams offer a level and type of service that you simply cannot find at grocery stores, big box competitors or online.

As a reminder, those that buy fresh food from us make over 4 more trips per year and spend over 50% more annually than drive food-only customers. Further, we experienced strength in seasonal categories. Specifically, in flea and tick, we saw our strongest start of the season in 5 years. While this was partially aided by weather patterns, for Petco, it's an ecosystem story. We capture over-the-counter sales, vet sales and grooming through our flea and tick packages all supported by a cohesive marketing push. In addition, as we previously announced, we launched our new gardening with your pet earlier this quarter. This performed above expectations with live house plants performing well.

Looking ahead, we have an exciting pipeline for both Q2 and the back half of the year. In consumables, we are leaning into emerging customer trends like high protein diets as well as new treats for dogs and cats. We've also recently launched several new supplements categories, such as for hip and joint care, liver health and a holistic care line based on the growing trend of health and longevity in the pet space, which we see as an important extension of the humanization trend. In supplies, we are introducing newness across categories, including grooming, toys and collars and leads. Within the Grooming category, we relaunched our own brand Well and Good, which was completed last week. This represents the beginnings of our investment in private label starting to show up in our stores. It includes new formulas without harsh chemicals as well as fresh packaging for our shampoos, conditioners and bans, all supported by marketing. And finally, in June, we'll be rolling out sports inspired collection, celebrating the World Cup and USA soccer.

Moving on to our second pillar, services at scale. Simply put, services are an important growth engine of ours. They are a massive point of differentiation and a competitive advantage. Through our wholly owned services model, we own the entire pet journey. And it isn't just about our vet hospitals, which continue to see solid gains in sales productivity, it's also about our clinics, grooming and training. Grooming is a strong annuity business for us and continues to perform well. To build on that momentum, we expanded our care reminders directly into our app late in the first quarter, a highly effective and frankly, obvious way to drive what is already a sticky repeat business even more frequently and consistently. Another call out was the puppy dog package. We began to offer in the first quarter in which a significant number of the customers that came in were new.

We will continue to offer this throughout the year. In the second quarter, we are driving excitement with the rollout of our Well and Good grooming products I just referenced as well as a new Disney Stitch grooming package, which includes Senate shampoo and Spritz conditioner teeth-rushing, nailed buffing and a seasonal bandana. Together, these initiatives are intended to ensure that our salons remain a premier destination for pet parents and a highly defendable driver of reoccurring foot traffic. On the vet hospital side, the strong performance we are driving today helps fuel our future expansion plans, which are on track to resume in 2027. We continue to see improving productivity across our footprint and we are on track to optimize about 25 significantly underutilized hospitals this year.

Crucial to this effort is our veterinarian team, and we are pleased to share that Doctor Days which is a combination of hiring additional doctors and adding hours per doctor continues to improve. Because of our scale, depth of expertise, unique ecosystem and the flexibility we offer, we believe Petco is an employer of choice for veterinarians and vet techs looking to build long-term careers. As we discussed last quarter, cross-selling continues to be a major and largely untapped opportunity between our clinics and the rest of the store. A great example of this clinical presence driving our broader business is our vet diet category, which performed extremely well this quarter, tying beautifully back into our veterinary ecosystem. Looking ahead, we believe we have several strong catalysts and opportunities in Q2 designed to drive ongoing traffic to our clinics.

In mid-April, we launched the new Vetco clinic packages, which offers bundles of services such as routine shots, which we are excited to see gaining early traction. Additionally, to drive traffic and care during National Pet Month in May, we offered free microchips, with the number of pets getting Microchips up 71% versus last year. Looking beyond these near-term drivers, we are incredibly optimistic about the long-term growth opportunity within our wholly owned vet business and the immense value it brings to the Petco ecosystem.

Our third pillar is our trusted store experience. The work is underway to build our basket size through better cross-selling and customer engagement. For example, we are now empowering our groomers with customer data to facilitate sales across the entire store. They can see a customer's last food purchase history. This allows our partners to have informed personalized conversations that drive cross-category sales and, importantly, can help enhance customer satisfaction and loyalty over time. In terms of customer engagement, we feel in-store experiences are how we best appeal to our core customer, the passionate explorer. This quarter, we hosted popular events such as Pictures with the Easter Bunny. We continued that effort with weekly store events throughout May to celebrate National pet months, including Mother's Day photos and weekly brand casting events.

Finally, our fourth pillar, an integrated omnichannel model. We are pleased with the headway we've made and our ongoing work to improve retail fundamentals in our omnichannel model compared to last year. By removing friction from the online checkout process, we have been seeing improved digital traffic. We achieved sales growth in omnichannel even while lapping the nonproductive, unprofitable sales we were still generating through 1Q last year. Looking ahead, we see ongoing opportunities to increase site speed and optimize shipping windows for our customers. The key call out is BOPUS, which was up strongly year-over-year. This is our differentiation in action, building loyalty through e-commerce but physically bringing the customer into our stores to experience our services, community and the cross-selling opportunities our partners provide.

Speaking of loyalty, I'm thrilled to share that we are relaunching our loyalty programs later this quarter, officially branded as Petco Perks. During our pilot phase, our biggest learnings was simplifying, removing friction and making the program distinctly customer-friendly had a massive impact. Petco Perks uniquely leverages our entire ecosystem, spanning both merchandise and services. The program will be heavily focused on personalized offers based on factors like shopping frequency and customer lifetime value, a strategy that successfully drove higher sales and stickiness during our pilot.

In conclusion, the first quarter served as an initial proof point of our inflection to growth. While the broader macro environment remains dynamic, we remain hyper focused on controlling what we can control, and our results prove that our self-help strategy is successfully navigating this environment. We are executing on our Phase III Reach for the Sky strategy. While we are pleased with these initial results, we are still in the early innings of what is a long, exciting journey. We have immense opportunity to deliver product newness, capitalize on cross-channel shopping, grow our differentiated services business and provide the most personalized experience possible to the passionate explorer and their pets.

I want to take a moment to deeply thank our teams across the organization. your hard work, adaptability, compassion for pets are what make these results possible. Our focus remains firmly on driving sustainable, longer-term top line growth and on delivering shareholder value. As we look ahead, we are pleased with the momentum our initiatives are generating, positioning us to continue to deliver positive comps. I look forward to our second quarter call and sharing with you the continued progress we are making with our Reach for the Sky strategy. With that, I'll turn the call over to Sabrina to take you through the details.

Thank you, Joel. Good afternoon, everyone. As we discussed, our primary goal is to build a stronger retail and financial foundation, which supports our focus on regrowing our top line in Phase III and driving sustainable, profitable growth. As such, we are committed to delivering upon our economic model for the full year in 2026 and are pleased to report that we're off to a solid start. Turning to first quarter results. Net sales were up 0.2% to $1.5 billion. Importantly, the first quarter marked a return to positive comp sales with a 0.7% comp providing evidence that our initiatives across our 4 growth pillars are beginning to take hold. The spread between comp and net sales reflected the 16 net store closures in 2025 and 4 net closures in Q1. We ended the quarter with 1,378 stores in the U.S.

Moving on to margin results. First quarter gross profit dollars were $574.4 million, while our gross margin rate expanded 21 basis points to 38.4% as we executed with discipline. Moving on to expenses. For the quarter, SG&A was $549.8 million or 36.7% of net sales, leveraging 34 basis points. The $3.8 million improvement in expenses year-over-year was driven by declines in G&A despite investments in marketing to support our omni-related initiatives. For Q1, our expanded gross margin and expense leverage resulted in operating profit of $24.6 million or a 50.5% improvement versus prior year. Operating margin rate improved 55 basis points year-over-year. Adjusted EBITDA increased $7.9 million or 8.8% year-over-year to $97.3 million and our adjusted EBITDA [indiscernible] balance sheet and cash flow.

First quarter ending inventory was down 1.9% year-over-year on top of a 5.2% decline last year. It's worth noting that inventory dollars were down year-over-year even with sales growth of 0.2%, reflecting our ongoing discipline and execution. Our first quarter ending cash balance was $167 million, an increase of approximately $33 million versus the first quarter last year. For the quarter, free cash flow was an outflow of $69 million. While our first quarter cash flow is historically our lowest, we wanted to call out 2 contributing factors. First, capital expenditures increased $10 million versus last year but are in line with the full year guidance we've provided. Second, as planned, inventory investments increased to support our growth, but we are pleased overall that inventory levels remain well controlled.

Moving on, total liquidity for the first quarter was $654.4 million, up versus the prior year. For the quarter, total debt was $1.48 billion, down over $100 million compared to Q1 last year. As many of you have heard me state, after completing our opportunistic debt refinancing, we have extended our maturities out to 2031 and achieved a more optimal mix of fixed to floating rate debt which provides us with ample flexibility. Importantly, we remain laser focused on our goal of reducing our leverage ratio to 2x. And now turning to our outlook. While the external environment continues to evolve, our solid foundation enables us to remain agile, and we are well positioned to deliver on our financial commitments this year. Therefore, we are reaffirming our full year sales and adjusted EBITDA outlook.

Specifically, we continue to expect net sales of flat to up 1.5% compared to last year as our growth initiatives take hold and build over the course of the year. We continue to expect adjusted EBITDA to be between $415 million and $430 million. Looking out, we wanted to outline some updates to our underlying full year assumptions. First, we now expect fuel prices to remain at approximately current levels for the remainder of the year. Recall that our prior full year outlook assumes higher fuel prices through the first quarter only. Next, our outlook includes the benefit of a tariff refund received in May. The refund represents only a portion of the IEPA tariffs we paid through February 2026. Our full year guidance assumes no additional tariff refunds beyond what we've received to date.

Further, our outlook also assumes that the current tariff policies remain for the balance of the year. With regard to other line items, the following assumptions remain unchanged for the full year. Net interest expense, about $125 million; depreciation and amortization, about $200 million; capital expenditures, about $140 million with an ongoing focus on ROIC net store closures between 15 and 20 weighted toward the back half of the year. And finally, we still expect the full year spread between total sales and comp sales to be about 50 basis points that will vary by quarter.

Moving on to the second quarter. We are comfortable with current consensus estimates for net sales implying growth of about 0.3% versus the prior year. We expect adjusted EBITDA to be between $110 million and $112 million. As you think about your models, we wanted to flag some considerations to be helpful. First, recall last year's Q2 reflected peak adjusted EBITDA growth including peak gross margin expansion. And last year's second quarter commentary, I flagged an approximate $9 million benefit in SG&A from a semiannual actuarial true-up. This was related to employee optimization work.

This year, we do not expect to anniversary this benefit. Finally, on tariffs and higher fuel costs. A simple way to think about these factors is that the tariff refund roughly offset incremental tariffs and higher fuel cost expected in the second quarter, thereby neutralizing 1 another in the quarter.

In closing, I want to thank our teams for their dedication and discipline in executing on our transformation this quarter, including a return to positive comparable sales growth. We will now open up the call for your questions.

[Operator Instructions] The first question will come from Michael Lasser with UBS.

When you look across the different categories between consumables, hard goods, services as well as the different species of animals that you serve, where was there a change or an inflection in your market share versus what Peco had been experiencing last year? And how do you see those market share trends continuing to unfold?

Thanks, Michael. I think as you -- as I reflect back on the quarter, I think less about market share a little bit and I think more about the sequential improvements. And we saw improvements in all 3 of those categories, both consumables, supplies and companion animals and services. So I think those are all really good early indicators that the new strategy is taking hold and the customer is reacting positively to it. While we haven't yet started to gain on market share, which is part of lapping the last year, we are really seeing that the market share decline moderate significantly, and that's showing up in the sequential improvements in all 3 areas.

Understood. My follow-up question is on the outlook. You exceeded at least the consensus forecast for the first quarter. you positive like you had anticipated, you are simply reiterating the full year outlook. So is there something that you're seeing currently in the business or have seen as of late that is influencing your conservatism or your decision not to flow through the upside from the first quarter to the full year?

It's Sabrina. And that's a great question. To our own range, we are really pleased that in the first quarter, we beat a couple of million, $3 million at the high end. The environment has continued to evolve, and there's a lot of different new cycles going on. We're super pleased that in the face of that, we are reaffirming our full year guidance and in particular, 1 of the big changes from when we initially laid out that guidance is fuel, right? So we are actually absorbing that second half fuel within our reaffirmation of the full year. So again, we're very pleased that we're able to do that through our discipline.

The next question will come from Kate McShane with Goldman Sachs.

We wanted to ask just with regards any kind of changes within the quarter by the consumer, what you saw across income cohorts? And any kind of consumer behavior with trading down?

Yes. Kate, great question. And I think like every retailer, we're watching the consumer trends closely. I would remind you and everyone on the call for that matter that Petco serves customers across all income demographics. We have a really nice offering from both value all the way to premium brands. And as we look back on the quarter, I would say there was nothing material amongst income demographics that performed differently. It was pretty consistent across all. So in total, we didn't see really any different change in behavior.

And then a follow-up question is just with regards to the pricing environment. I think you have a retailer out there that's talking about getting a little bit more aggressive on pricing. Just how does that influence anything in terms of your strategy or what you're thinking and just kind of in conjunction with that, it sounds like you're going to get a fair amount of tariff refunds here. It will be neutralizing in Q2 as you laid out, but could we see maybe tariff refunds be used for any kind of pricing investment as we get into the back half of the year. .

Yes. I'll start on the pricing piece, Kate. And just say, similar to when we were faced with tariffs last year, we told you all we don't really react on our pricing to any 1 event. So we are always reviewing our pricing architecture. Our lens is always customer first. We're always, of course, reviewing the competition. We make adjustments as necessary, but we're not having plans to do anything in reaction to any event. And then with regard to the tariffs, we are not counting on any further refunds. I think you all know there's a date coming up here in a few days, where there can be some appealing of the whole refund process. So we thought it prudent not to count on any of that. So none of that is in our assumptions. Should it come, fantastic. We can update you on our next quarter call.

The next question will come from Kaumil Gajrawala with Jefferies.

I guess the first thing is your positive comps, your cost structure has changed quite a bit over the sort of recent years. What is the comp level that we should be looking for to allow it to sort of really lever yourself down the P&L?

Yes. Great question, Kaumil The beauty of our model is we don't really need super high comps to make the economic model work. We're talking low-single-digit comps to be able to nicely leverage our SG&A, maintain our healthy margins and drive that operating profit growth. So we're really pleased that we've managed the expense structure such that we can deliver with that low-single-digit profile.

Okay. Got it. And then on these oil prices, and I guess not moving guidance because of the price of oil, by the way, not moving guidance is the right idea. Obviously, it's just been 1 quarter, but -- but the idea of absorbing the cost of oil, is that because of increases from prices from your suppliers? Or is it just a concern about things that are going to come your way over the course of the rest of the quarters?

Yes, mostly I'm addressing the direct cost to our transportation to our supply chain. So it will impact us most directly from our inbound which lags by the way, through our P&L a bit because it first goes into inventory and shows up on the P&L as cost of goods sold when we sell it. But the immediate impact of fuel to our transportation is to our outbound, so our DC to our stores and also our parcel business. So that's the piece that is most direct that we're looking at.

The next question will come from Oliver Wintermantel with Evercore ISI.

Joel, what was the biggest contributor to pushing comps from negative to positive this quarter. Is it improved transactions? Is it mix? Or is it price AUR? If you could give us a little bit more detail on what actually drove the comps positive this quarter.

Yes. I'd rather talk about it first from the strategy side. And then Sabrina can go into the specifics on the mix side of it because what's really important to remind everybody is, and I called this out last quarter, this is largely a self-help year for Petco and what really -- let's just call Q1 a trifecta, right? We delivered positive comps. We improved profitability, while outperforming on the outlook. And so what really drove that is the execution against all 4 of the pillars. And so we saw strengths in all of those. And it's resonating with the customer. And given we're in the early innings of that, I kind of have line of sight to the future, and I'm pretty excited about what's still to come with the rest of our strategy. .

Yes. And from a comp lever perspective, I'd just point out that UPT was quite strong. basket actually improved and the trend in transactions improved, but I would call out that, that remains a really good opportunity for us.

Got it. And on the gross margin side, a similar question there. Could you maybe give us a little bit more detail what drove the gross margins? Was it mix, was it merch margin, something like that? And then as you mentioned, the second quarter is a little bit tougher compares, but I think the third quarter as well. So maybe a gross margin outlook for the year, how we see it. .

Of course, we don't guide forward to gross margin in particular. I did try to be helpful on the second quarter outlook, just to remind that the entire second quarter last year was a bit unusual for the reasons I outlined. With regard to the first quarter, I would say we continue to use every lever at our disposal. So it's back to Phase II never ends retail fundamentals, so negotiating with our vendors making sure we're getting good costing, watching our promotions, our clearance, our markdowns, all of those levels sort of across the board, culminate in delivering on our margin.

The next question will come from Steven Zaccone with Citi.

Joel, you talked about effort that's underway to build the basket size with cross-selling and customer engagement. Curious if you could talk a bit about timing there? Is this something that can build over the next couple of quarters? Is this a multiyear initiative just to get better cross-selling within the store?

Yes. I mean we are just getting started on that, Steven. So it clearly has got tailwinds in front of us. And the biggest reason I called it out, and I think I talked about it a couple of calls before, we used to run services in center of the store. It's separate organizations. And really, as we've dissected the business and look for areas of opportunity. The integration between our services and our center store teams a real opportunity for us, and cross-selling is 1 example. And prior and the example I used is our grooming associates didn't have access or couldn't see a customer's consumables purchases as an example. Why is that important? .

Well, a groomer would notice their hair and skin and might see that they should be recommending sensitive skin consumables that that's not what they're using today. And the fact that they couldn't see it, our groomers couldn't be helpful to the customer. So giving them access to that is just 1 great example of certainly a cross-selling opportunity for us, but a way to be really helpful for our customer and the health of their pet. So real opportunity going forward for us.

Okay. Great. The follow-up I had is just on the industry overall. I mean, we're only 1 quarter into the year, but there has been mixed commentary across the pet landscape. As you think about industry growth forecast for '26, how do you think things are playing out versus expectations? You talked about cat outperforming and Fresh & Frozen doing well. But how do you think the year is kind of shaping out relative to expectations from an industry perspective?

Yes. Look, clearly, we're not seeing adoption trends growing at this point with the exception of cat. But I think it's -- I reminded earlier on this call, this is a self-help year for Petco. So we aren't beholden to the industry growing to achieve our objectives for this year. We'll take the tailwinds if they come. But right now, we're really driving our pillars, our Reach for the Sky strategy to make a difference on that.

The next question will come from Steve Forbes with Guggenheim Securities.

I appreciate the comments around optimizing the services business, but curious if you can maybe just take a step back and how do you expand on what you're exactly doing in the 25 underutilized hospitals today, what you're seeing with the customer post sort of those changes? And if there's any way to sort of size up how you see or contextualize the opportunity ahead based on sort of the number of customers today, engaging in services relative to the total pool of customers engaging in the product.

Yes. A lot to unpack there, Steve. So I'll try and answer your question completely. And if I miss anything, come back at me. Look, I think earlier in our vet growth, we were in a phase where we were just trying to hit the number of openings. And the focus and opportunity I saw when I got here was really more on optimization and driving productivity before we start the growth up. Having said that, we're in a much different position today, nearly 300 hospitals. We have 1,400 clinics, meaning we're in all our other stores with vaccination clinics. And so I think it's an asset I didn't fully appreciate before I joined. And we're really now operating at scale, Steven. But having said that, we've got the opportunity to have more flexible schedules. So we've been really good at opening up the schedule.

So if a customer needs a bet appointment, we can't make them wait 2 weeks or they'll go somewhere else. The teams have done a really good job changing that, optimizing doctor days, being more flexible with that, opening up more days in the week. And so all of those are really driving the productivity. And with that, that will just serve us better as we start to open up new hospitals, which are still on track for 2027, but really excited about the phase we're in right now for hospitals. Did I capture everything you asked?

Yes. I mean obviously, you can explore for a while. But as we think about the return to that hospital growth in 2027, most of us have sort of the prior maturation expectations of the vet hospital. I'd be curious, just based on sort of the initiatives underway and sort of what you're seeing, if there has been a directional improvement and if we can think about a better ROI or a shorter payback period? Or just any sort of initial thoughts on the conviction behind returning to that hospital growth?

I'll chime in there a little bit and just add that the improvement we've seen in these later year cohorts is significant. So we've learned lessons the tough way when we expanded very quickly in the early 2020s and we've been honing the model ever since. So it's absolutely true that we are improving and shortening that maturity curve in the recent cohorts. I'll also add, though, I just keep emphasizing to everyone, we have a great opportunity with this existing fleet to keep improving the return on those assets, to keep optimizing the fleet. That continues to be a terrific opportunity in addition to future growth. It's not just that like we have these 25, which we are super focused on. and we're done. We keep improving the entire fleet. And so that's a really important opportunity.

Yes, I think that's a great call, Sabrina. And I think all those learnings on both optimizing existing how to improve the productivity of the 25 we're concentrating, all those learnings are going into shortening the ROI curve or improving the ROI curve, I should say, as we start to open new hospitals next year. .

The final question will come from Simeon Gutman with Morgan Stanley.

This is Kyle Pennon on for Simeon Gutman. So your outlook looks to contemplate a slightly stronger earnings profile in the second half of the year. Can you touch on how much of the progression is driven by initiatives you've already outlined contributing versus potentially some incremental margin opportunities that haven't yet been fully realized.

Sure. If you think about our Q1 actual at 97% and the midpoint of our Q2 at 111 and our midpoint for our full year adjusted EBITDA guide, they have sort of break out 49% to 51%, which honestly, from a historical perspective, is very much in line. So what we've guided to is not unusual. And I'm actually very happy to say that because I always like to pull forward as much as we can, the earnings into the first half, so you're not looking at a big hockey stick. So with this guide so far, we've already, in some ways, derisked because we're looking at -- even with all of our initiatives coming in, we're looking at a very balanced year in terms of first half, second half profitability.

Okay. Great. And you highlighted some stronger performance in the cat category and suggested the demand pickup was largely expected. Could you just unpack the underlying drivers there a bit, please?

Yes. When I mean expected, it's -- we saw this trend really improving last year. So the merchants jumped on this already last year. and really got after it in Q1 with newness. And so that really played well with the strong year-over-year sales growth. And as I said in my prepared remarks, we're actually leaning in further with other categories in cat as we haven't seen trend go the other way at all. So we're really excited about cat. And specifically, I just show it to you that we're just getting better at being trend-right as merchants, and they're doing a really good job identifying where we can differentiate, where we should drive newness and cat was a great example.

Thank you. And I think, operator, that concludes our call today. And appreciate everyone getting on. As you can tell from Sabrina and I, we are really excited about the early results of our Reach for the Sky strategy and returning back to positive comps while still improving our productivity. Look forward to seeing you all on our Q2 call. Thank you very much, and have a great night.

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

Good afternoon, and welcome to the Petco Fourth Quarter 2025 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded.

I would now like to turn the conference over to Roxanne Meyer, Investor Relations. Please go ahead.

Good afternoon, and welcome to Petco's fourth quarter and fiscal 2025 earnings conference call. Joining me on the call today are Joel Anderson, Petco's Chief Executive Officer; and Sabrina Simmons, Petco's Chief Financial Officer. In addition to the earnings release, we posted a slide presentation on our website at ir.petco.com.

I'd like to remind everyone that on this call, we will make certain forward-looking statements which are subject to a number of risks and uncertainties that could cause actual results to differ materially from such statements. These risks and uncertainties include those set out in our earnings materials and SEC filings. In addition, on today's call, we will refer to certain non-GAAP financial measures. Reconciliations of these measures can be found in our earnings release, presentation and SEC filings.

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

Thanks, Roxanne, and good afternoon, everyone. Thank you for joining us to discuss our fourth quarter and full year results, where I'm pleased to share that Q4 sales were in line with our outlook, and we performed better than our adjusted EBITDA quarterly goal. Looking back on 2025, we successfully delivered on our robust agenda to strengthen our economic model and improve retail fundamentals, which resulted in significantly higher cash flow and profitability year-over-year. Specifically, for the year, we achieved a 21% increase in adjusted EBITDA and a 77% increase in operating cash flow. Our healthier EBITDA and opportunistic debt pay down drove a meaningful reduction in our leverage ratio at year-end, allowing us to start the year with greater financial flexibility. This was no small feat, and I'm exceptionally proud of our team. We collaborated across the organization, we strengthened our culture, we communicated expectations, and we acted with urgency and decisiveness. It's important to note that the majority of our senior leadership team, which is exceptionally well tenured and talented has only been together for about one year.

We entered '26 with a running start, something we didn't have in '25. Some of the most recent additions to the team include Sabrina Simmons, CFO, who many of you already know. Michael Romanko, Chief Customer and Product Officer; and Joe Venezia, Chief Revenue Officer. The entire team's work has been transformative, and yet, we are just getting started. In addition to strengthening our financial foundation in 2025 and rebuilding the leadership team, we completed our Petco North Star strategy, including a comprehensive customer segmentation and needs analysis. This work is already shaping how we prioritize assortment, services and experiences. And it also informed our updated brand positioning Where The Pets Go to live their real life.

One key takeaway from the segmentation work is the identification of who our most important engage customers are. That segment, we call passionate explorers. These are pet parents, who are highly invested in their pets and seek innovation, expert support and a welcoming shopping experience across the full pet journey. 2026, we are informed by this strategy work and execution will center on four growth pillars, which I will review in detail later on this call. They are: Number one, compelling product, driven by increased newness, brand launches and own brand expansion. Number two; services at scale, leveraging our wholly owned vet grooming and training ecosystem. Number three; trusted store experience, focused on driving traffic, engagement and basket; and finally number four, an integrated omnichannel model, improving convenience, loyalty and repeat behavior.

With that, I'll now turn it over to Sabrina to provide details on our fourth quarter financial performance and our 2026 outlook. Following her remarks, I will discuss the specifics our growth strategy for 2026, and we'll then open it up to your questions.

Thank you, Joel. Good afternoon, everyone. As we've discussed, our primary goal all year was improving profitability and cash generation through our economic model, namely expanding gross margin rate, leveraging expense and expanding operating margins. We're glad to report that we achieved this goal each and every quarter. For the full year 2025, we expanded our gross margin rate 66 basis points to 38.7%, leveraged SG&A 124 basis points to 36.6%, improved our operating profit by $113 million and expanded our operating margin by 190 basis points. Increased adjusted EBITDA 21.3% to $408 million with a margin of 6.8%, and we delivered positive GAAP net income for the year. Additionally, free cash flow improved 276% versus the prior year to $187 million. These results enabled significant progress in achieving our goal of lowering our leverage ratio. Our net debt to EBITDA improved from 4.2x when we entered the year to 3x at the end of 2025.

And now turning to the fourth quarter results, which reflect another quarter in which we delivered on our commitments, while building a stronger foundation. In line with our outlook, net sales were down 2.4% to $1.52 billion with comp sales down 1.6%. As expected, the decline reflects our decision to move away from unprofitable sales, which was our strategy throughout 2025. As a reminder, the difference between total sales and comp is driven by the 25 net store closures in 2024 and the additional net 16 closures in 2025. The number of 2025 closures came in a bit favorable to our expectations, driven by a combination of improved store performance, and favorable rent negotiations that supported improved unit economics for those locations. We ended the quarter with 1,382 stores in the U.S. Fourth quarter gross profit dollars were $581 million, while our gross margin rate expanded 37 basis points to 38.3%, including the sequential increase in tariff impact, which we anticipated.

Moving to SG&A. For the quarter, SG&A was $549 million or 36.2% of net sales, leveraging 62 basis points. The $23 million decline in year-over-year expenses was partially driven by lapping last year's consulting costs. Marketing expenses increased $7 million in the quarter. For Q4, our expanded gross margin and expense leverage resulted in operating margin expansion of 98 basis points, and our operating profit increased $14 million or 83% in the quarter. Adjusted EBITDA increased 10.6% or $10 million to $106 million, and our adjusted EBITDA margin expanded 82 basis points to 7% of sales.

Moving to the balance sheet and cash flow. Q4 ending inventory was down 9.7% versus our 2.4% decline in Q4 sales. We continue to manage inventory with discipline, which is one of the drivers of our improved cash flow profile. For the year, free cash flow was $187 million, an increase of $137 million or 276% versus last year. Our ending cash balance was $257 million, an increase of $91 million versus last year, including having voluntarily paid down $95 million of debt. As many of you have heard me state, our approach to our debt refinancing was opportunistic, and we're pleased to have executed the refinancing with favorable terms. We replaced a fully variable debt structure with a more optimal mix of fixed and floating, and extended our maturities to 2031, providing us ample flexibility.

On our first call together last March, we stated our goal of reducing our leverage ratio to 2x or less. We are thrilled with a product we made in just one year. As we said, we started fiscal 2025 at over 4x. And in just a single year, we have reduced that to 3x, enabled by our focus on driving improved profitability and cash flow. With our retail and financial fundamentals strengthened, we are well positioned to turn more of our focus to read growing top line and driving sustainable, profitable growth over the long term.

And now turning to our outlook. We are starting the year from a position of strength, while continuing to navigate a bumpy macro backdrop. Of note, our guidance assumes that fuel prices normalize by the end of the quarter. For the first quarter, we expect net sales to be down 1% to flat versus the prior year, with comp sales roughly flat at the midpoint of the range as we begin to build into the growth initiatives Joel will outline in a minute. We expect adjusted EBITDA to be between $92 million and $94 million.

Now turning to the full year. We expect net sales to be flat to up to 1.5% growth versus last year as our growth initiatives take hold and build over the course of the year. Of note, similar to 2025, we expect net store closures between 15 and 20 in 2026. As is typical, store closures are weighted toward the back half of the year. We estimate the full year spread between total sales and comp sales to be about 50 basis points, though it will vary somewhat by quarter. This expectation implies positive comp sales for the year. We expect adjusted EBITDA to be between $415 million and $430 million, with an overall goal of delivering on our economic model for the full year. To provide additional color on other line items, for the full year, we expect net interest expense to be about $125 million. Capital expenditures of about $140 million with an ongoing focus on ROIC, which we improved in 2025 by 3 percentage points. Depreciation and amortization to be about $200 million, similar to last year. And finally, to be helpful with your models, we expect stock comp to increase by a low double-digit percent versus last year. As a reminder, stock comp will remain well below years prior to 2025.

In closing, I want to thank our teams for executing on our transformation with great discipline, resulting in our significant growth in profitability and cash flow. And now I'll turn the call back over to Joel.

Thank you, Sabrina. With our foundation firmly in place, I'm energized to walk you through the specifics of our 2026 strategy that will drive our expected growth. As you know, we outlined a 3-phased approach to our turnaround. We laid the foundation in Phase I and Phase II, and we are now entering Phase III, which is about driving sustainable top line growth.

Internally, this Phase III strategy is called Reach for the Sky, which is all about looking up and driving forward, leveraging our competitive advantages and capitalizing on the growth opportunities we see across our business. It is also about the opportunity I see for Petco to be reimagined and broadened beyond primarily being a commodity-driven business. This is about the blue sky opportunities Petco has to engage with pet families through the ups and downs and the real-life experiences of raising a pet. Our team has tenaciously driven cost savings, and now we will continue with that same rigor while driving sales and reaching forward.

Petco is the only national fully integrated and comprehensive pet care ecosystem. Our vision for the Reach for the Sky strategy is centered around leveraging our differentiated store base model to bolster our competitive positioning, increased relevance and improve store productivity. We plan to fuel our growth by offering product newness and differentiation as well as further strengthening our community of pets and their humans through our unique store experiences, integrated omnichannel model, and wholly owned services.

We are in the early innings of capitalizing on the significant opportunities that we see to gain share of wallet across all our businesses. The groundwork in 2025 has served us well. We expect these initiatives to grow sales and become more impactful as they materialize throughout 2026 and beyond.

Now I'll outline the detailed framework of our Reach for the Sky plan to drive sales within each of our four pillars. I'll begin with our compelling product offering, specifically within consumables. This is roughly half of our business today. And in the U.S. alone, it's a $54 billion market. I'll talk about four key catalysts within consumables to jump-start growth beginning this year. First, fresh food is one of our biggest opportunities. We've been a primary destination for fresh food for a long time and are continuing to build on that foundation by expanding the assortment. This category at Petco experienced healthy growth in 2025, and we expect the momentum to continue in 2026. This is an example of a category that exemplifies a significant advantage of our store ecosystem brings.

Beginning in Q1, we are adding additional freezers, amounting to over 1,000 incrementally over the course of the year, which will enable us to expand our range of offers meaningfully. Our focus on driving share of wallet in the fresh food category is intentional. Of note, those that buy fresh food from us make over four more trips per year and spend over 50% more annually than dry food-only dog customers.

Secondly, we will launch new national brands. This area starts with communication. I have personally met with the leaders of several of our key consumables partners. They are aligned with our goals and objectives and excited about the renewed energy and focus of growth at Petco. At the center of our strategy, we will be infusing a high degree of newness, including a significant number of new brands and flavors being added this year. The majority of these are launching in the first half. We expect these to generate excitement and customer interest, and we look forward to discussing these with you in future quarters.

Third, we are increasing the frequency of product drops. Historically, we set consumables merchandise annually with one big cat and dog food reset. As you can imagine, this didn't provide our customers with multiple reasons to see what's new at Petco. And often, we are the last to roll out a new innovation or flavor. We are changing this approach meaningfully by continuously layering in product newness throughout the year, both in consumables and supplies. This is designed to create excitement and freshness of product and will entice our customers to walk our aisles more frequently.

And fourth, we are ramping our own brands business. This is within consumables and supplies. Own brands account for about 20% of our sales today and have the potential to become more meaningful over time. As part of our own brand strategy, we will anchor our focus on our strongest seven private labels, which already account for a significant percentage of our own brand sales. Therefore, leveraging the strength of these brands and increasing their presence and relevance. This focus on own brands is intended to allow us to go faster and fill and voids our national partners don't have visibility to. In terms of key initiatives, in consumables, we planned off for new formulas and packaging in dog food. In supplies, we'll expand our own brands business across categories and offer newness and innovation more broadly, such as in beds, bowls, collars, leads and toys. And as we've mentioned prior, the margins of own brands are significantly above that of national brands.

In the supplies and the companion animal category specifically, we are introducing new assortments that we believe will further differentiate us from competitors. An example is newness and insects since it's jumping spiders in tarantulas, which we see as a newer pet trend in the United States. This customer basket is also likely to include ancillary supplies and consumables. Additionally, we launched Gardening with your Pet this month, a new category for us in nearly all of our stores. It includes gardening products and plants that provide customers with pet-friendly options.

Moving on to our services pillar. We also see abundant opportunities to continue growing our wholly owned services business, which is a key aspect of our differentiated model. Services include that hospitals, vaccination clinics, grooming and dog training. This business was a strong performer in 2025, and we are expecting continued growth in 2026. While we took a purposeful pause in constructing new bed hospitals last year, we've been laser-focused on improving productivity of our existing locations. In 2025, we optimize a significant number of our approximately 300 hospitals, and we'll work on increasing the productivity of the still roughly 25 underutilized locations this year. Know that even after we complete these, there is still a sizable runway for driving higher sales and productivity improvements from these 300, and we will be focused on maximizing their potential.

Bottom line here is that we are committed to the vet business as a key growth engine and are in the early innings of assessing the longer-term opening cadence and growth opportunity. That said, you should expect us to start growing our hospitals in 2027. We will keep you updated on our plans as they come together. I'd like to emphasize that our key competitive advantage in this space is that our vet hospitals are wholly owned and are part of the store. We uniquely have the opportunity to capitalize on retail traffic and to share customer information. As we've discussed prior, the opportunity is twofold: Grow the vet business as well as become a full service pet needs provider by cross-selling food, prescriptions and supplies.

I'm pleased to announce that we are adding technology and functionality beginning later this year and into 2027 to better enable this. The goal is to drive incremental trips and increased sales per customer. We are now operating on a scale that gives us the depth of expertise, breadth of coverage and overall respect of the industry to be a desired employer of choice for veterinarians and vet techs to grow their careers at Petco.

The third pillar of growth opportunity I want to discuss is our key competitive moat, a differentiated high-touch store ecosystem. Our stores represent a significant portion of our total sales, and so they remain a key focus for us. We have changed leadership, reorganize how we operate and unified our center of store operations with our services. We have also physically brought our stores and services leadership together 3 times in less than 12 months, so the communication can be cascaded with one voice and expectations are clearly aligned. Our goal is to leverage stores to build community, excitement and customer loyalty through frequent newness, higher levels of customer engagement, such as holding fun events for families and pets and through wholly owned services that promote repeat visits. The end goal is to drive both traffic and basket. Our marketing efforts will be centered around driving traffic to our stores by building awareness of our product newness and in-store experiences. We will also capitalize on a more engaged customer in stores by focusing on increasing basket size. Specifically, we launched a major training initiative in February for all district and regional managers to promote cross-selling opportunities. This initiative is being cascaded to all stores this quarter.

We estimate that successful cross-selling can drive 1 to 2 additional trips as well as a higher sales per customer over a 6-month period. An example of this is a focus on converting rooming customers, purchase merchandise by giving groomers access to a customer's purchase history across the store. To give a sense as to how impactful this initiative could be, about half of our dog customers currently don't buy dog food from us. So you can imagine the opportunity to capture a much greater share of their wallet. What backs our confidence in the long-term viability of the store model is that shopper demographics are also on our side. Industry data tells us that 34% of Gen Z customers shop exclusively in stores. Interestingly, this group's preference for an in-store experience is much higher than Gen X or millennials and is virtually in line with boomer preferences. We see this as a huge long-term opportunity. With the Petco model well positioned to capture Gen Z's desire for experiences and connections, our field leaders are excited about these opportunities, and we will have more to share with you as the year progresses.

The final pillar of our reach for the Sky's initiative is centered around integrated omnichannel. We call it integrated omnichannel because a significant portion of customer transactions leverage a combination of our digital capabilities and our stores. We made great progress in 2025, fixing our foundation, including minimizing unprofitable sales improving e-commerce fill rates, fixing page load time and adding new capabilities. While we will keep making improvements, it is time we start to grow our digital capabilities in 2026.

One of the biggest opportunities we have is to turn up the dial in marketing. We have overhauled our media buying mix, which is taking hold in Q1, and our new branding, Where The Pets Go will become more pronounced as our creative as reimagined to better support this fun loving energy our physical stores bring to life. Additionally, we will relaunch the loyalty program later this year. Our goal is to offer a more personalized and relevant loyalty experience that is seamlessly integrated within our app. Our results from this initial pilot, which concluded in December, were encouraging. The next wave of our pilot began last week and will run through the spring season. We look forward to sharing an update on our Q1 call.

A second key omni sales growth initiative we're excited about is ability for our repeat delivery customers to now pick up their orders in store, which encourages our fresh food customer to visit our stores more often. This is an example of us leveraging omnichannel model to maximize our growth opportunity. We believe this will aid in growing traffic, conversion as well as basket size.

In conclusion, I'm proud of the long-term strategy we implemented last year to rebuild the foundation of our economic model, recruit an amazing team and complete a comprehensive customer strategy to fully understand how we can win at Petco. We delivered significant financial improvements. And it is with this backdrop that I'm confident in the actions we are taking to drive sustainable sales growth and profitability. We expect to start to see benefits beginning in Q1 and growing throughout the year. Specifically, the outlook that Sabrina provided implies a flat comp in Q1 at the midpoint. This would mark an inflection from the negative comp in Q4. For the full year, our outlook assumes our comps will be positive with increases modestly above our total sales growth. Importantly, we believe our ability to gain market share is not entirely reliant on a cooperative macro environment or pet industry sales growth. Our reach for the Sky initiatives are, in many ways, self-help in nature and designed to further differentiate Petco's merchandise and services versus our peers. We are approaching 2026 the same way we did in 2025. We developed a strategy, we assign leaders. We track milestones, and we execute. The months go by I'm confident you will continue to appreciate how driven we are to deliver on our commitments. And I trust that 2025 is a great proof point for what's to come in 2026.

I want to thank our teams for their dedication and hard work. While it's hard to single out any one team, the milestones our field teams achieved were truly incredible. We asked a lot of them, and they responded positively to every challenge. Our stores are the heart and soul of Petco, and it's great to see them playing offense. Collectively, we are well positioned for our reach for the Sky's plan, and I'm excited about its potential. Petco truly is for the pets go to live their real life.

I'll now I'd like to open it up for your questions. Operator?

[Operator Instructions] Our first question is from Michael Lasser with UBS.

Joel, you provided a lot of great information on the strategy, the focus. How are you thinking about what is going to lead Petco's growth from here? Is it going to be consumables first, which will then translate to the other parts of the business? Is this going to be services-led, which will then translate to other parts of the business? And how have you thought about the need to mix further price investments, promotional investments and other discounts in order to generate same-store sales growth over time.

Yes. Thanks, Michael, and really great question. A lot to unpack there. I think it's less about which one is going to lead. And what I hope you took away from what I just took you all through is, whereas last year, we were telling you what we were going to do to deliver growth, on this call, I showed you how we're going to do it. And we gave, as you said, specific examples in all four pillars. We are working simultaneously, Michael, on all four of them. Having said that, product probably takes the longest because you have your existing product that you have to sell through and then the new product will begin to come in. I can tell you, we have about 25 new brands or flavors coming this year as well as resets throughout all of supplies and many of the other areas like companion animals. All of that will take time throughout the year, and it will happen actually starting this quarter. But I'm really pleased that in all four of those pillars, you're going to begin to see change starting right now in Q1. And as for your pricing comment, you know what, we started in on that back in 2024, and we really feel like we got our pricing right throughout 2025. It is something that's dynamic, and we are watching it closely, and we'll continue to adjust as necessary, but feel like we've got our pricing in good shape for now.

Yes. I'd just add to that, Michael, that we're definitely focused on delivering healthy margins for the year. It's an important focus. And we will stay competitive. We will stay adaptable. But we have still nice levers at our disposal to deliver on the healthy margins. We'll continue to look, as Joel just said, where needed. We'll participate in promos, for sure, to help drive traffic where appropriate. And then remember, we have this whole initiative of mix, where we're moving toward our own brands, and that should also support delivering on healthy margins.

The next question is from Oliver Wintermantel from Evercore ISI.

My first question is about the drivers of the increase of the gross margins. And then as a follow-up, so maybe the first one for Sabrina. Joel, for you on the growth initiatives, so inventories were down this year, which obviously helped free cash flow with all these four pillars of initiatives. Do you expect inventories to increase this year? And what's the impact of -- for that on your free cash flow outlook?

Yes. So I'll just go through that gross margin levers one more time. So we are very focused on delivering healthy margins, and we're going to continue to use and review our pricing. We're going to deliver on promos where appropriate, and they make sense and they help us drive traffic in, et cetera, and we're focused on mix. So those are the big levers that will help us deliver on our goal of keeping those gross margins really healthy. With regard to inventory, yes, we did a lot of cleanup in 2025 on inventory. Some of the silver lining, if you will, of the tariff and position in the spring last year was that it kind of forced us to get very disciplined about cutting off the unproductive tail of SKUs. We're past that now as we look forward to 2026 for growth. We definitely want to invest inventory behind that. The important thing to us is that we remain disciplined in managing that inventory, so even as we invest in inventory, we will look to keep the growth in inventory at or below sales growth and keep that relationship very tight.

The next question is from Kaumil Gajrawala with Jefferies.

I guess there's been some oscillation over the years between you being specialty and premium and being mainstream. You mentioned a lot of national brands, which sort of making imply perhaps more of a mainstream look. But curious, when you think about the brand of PepsiCo and -- or sorry, the brand of Petco and what is the assortment says about says about the retailer. How do you -- how are you thinking about what that assortment is going to say from a branding perspective?

Yes. Look, you're absolutely right. I think in prior years, we narrowed our aperture. And I think as I look forward, we got to be there for all customers. And as a new pet parent adopts a pet, they go through several stages of that life. And one of those stages might be, I just need to get my dog fed. And as that dog becomes part of the family, they might decide to upgrade what their dogs being fed for food, and they focus on health and nutrition. And so the focus we've done over the last couple of years is really to widen the aperture. And so one of the unique advantages of being a specialty retailer is that we are able to carry that specialty premiumization, unique product, but we are also there for the customers that affordability is their primary need. And so I think we really have widened, and I feel really good about where the assortment is today.

Okay. Got it. And you said something fascinating earlier on Gen Zs preference to shop in person looking similar to baby boomers. Do you have a sense of why that is, or what has changed that generation versus the generations prior?

Yes. I mean, obviously, that is a bigger statement than just as it relates to pets. But like any good retailer, you have to understand your core customer, and we did the research. And part of that research, we studied what the makeup was of the age of our customer, and then that coveted 18 to 34, that younger customer. We skew about 5 percentage points higher than some of the other pet retailers. And so that happens to work out nicely because what also is a characteristic of that demographic is they like shopping in stores. And so I think there's been more of a return to stores. That serves us well with who our demographic is. And as we did the customer segmentation work, we took advantage of that, and that's something we're really focused on going forward. But it worked out to be nicely -- nice fit with who our customer is.

The next question is from Steven Forbes with Guggenheim Securities.

Given the goal of services at scale, I was curious like you did with dog food, if you can frame what percentage of your customers today engage in services in some form or fashion. And then given the customer segmentation work you did around the Passionate Explorer, curious if you can maybe expand on what you're sort of focused on in 2026 to make sure that specific cohort is engaging.

Yes. Let me take that cohort first. What we really learned about the Passionate Explorer is that they value discovery. They look for expertise, which plays in nicely to our services side. They seek innovation. And so -- and there are also somebody that shops more frequently and spends more with us. So our new merchandise strategy is certainly going to resonate with them, frequency of newness, innovation, the store events, and it also acts as a halo for all the other segments. And service is a really important part of the Passionate Explorer. Obviously, we still have a lot of room to grow in services. As an example, the hospital side of it, the vet side of it, it's only in about 20% of our chain, roughly 300 stores. So lots of room to grow there. Grooming is in all our stores. And that's an area we talked about on a couple of -- three calls now, we've been improving the technology. We've been making it easier to make appointments. And so I see a lot of growth opportunities there as well. But one of the reasons -- I said it many times, services is our moat. It's a point of differentiation for us, and we're going to keep leaning in on services.

And what I'll add to that, Steve, is that what's really important to us is to leverage the whole ecosystem because what we know is the NSPAC for a customer who engages in more than one channel or in services is 5x higher than our other customers. So it's really just expanding our relationship with our customer, wherever they want to shop and making sure we're getting that loyalty, retention and higher spend.

The next question is from Simeon Gutman with Morgan Stanley.

Hi, this is Lauren Ng on for Simeon. First, you mentioned 50% of dog customers don't buy dog food from Petco. Curious what parts of your strategy outlined today will capture these customers if they're already loyal to certain brands and platforms, will you be able to leverage your private label for this?

Yes, great pickup from our prepared remarks. Probably the main reason I shared that with you is it's always easier to grow if you start with your current customers. And as part of our deep dive into who our customer is, where they shop with us, how they buy from us, that was a real big aha for us. And so as an example, prior to just recently, our groomers had no knowledge of whether a customer -- a dog customer bought food from us. And now we've enabled our groomers with technology to see every customer that comes in, when is the last time they bought dog food from us, what type of dog food are they buying. Is it helping their sensitive skin or some sort of skin problem they have. And so that's just one example of us being able to cross-sell. And we believe the first place we're going to see growth is as Sabrina just alluded to, NSPAC, really growing the net spend per average customer, and I think we have a real opportunity with our dog customers that aren't buying food from us today.

Great. And just quickly following up. You talked about entering Phase III today. Can you share how much of Phase III is currently implemented versus maybe how much room there is to grow?

Yes. I would say from what the customer sees very little has been implemented yet. From a strategy and team work internally. We have work streams on every one of those I outlined for you today, plus a few others. And so they're in various elements of being lit up for the customers, product may be being shipped right now. Some may not come until second or third quarter, but very little of it. And you can see from our guide that we expect comp store growth to gain as the year goes by.

[Operator Instructions] The next question is from Peter Benedict with Baird.

So I want -- well, two questions. One, I just didn't know -- Sabrina, if you could expand on kind of the fuel cost comment you made. I think you said something about fuel costs normalized. Just maybe just help us understand maybe the variability with all the the macro stuff going on with oil, et cetera. And then my second question is on your expanded fresh effort. You mentioned more freezers. I'm just trying to understand is that you're expanding the frozen fresh product. How about the refrigerated or chiller-based fresh. And I'm curious, is it new brands? Are you expanding with existing brands? Maybe just expand on that effort around fresh a little more, if you would.

Sure. I'll start with the fuel comment. So it's been a bumpy ride the last week or so. So we were just trying to be helpful with regard to our base assumptions in our forecast. But here's how fuel impacts us, and it's similar to every retailer out there. We have our inbound ocean. And that sort of lags, it comes in later into our P&L through cost of goods sold. And then we have our outbound from our DCs to our stores, a lot of it trucking, that can impact more rapidly. And then we have our parcel shipping that can also be impacted. So we've incorporated in our scenarios in the range we gave, absorbing some of the volatility we've seen in gas prices over the last week or so. But the base assumption is that things start to normalize after Q1.

Good. And then as it relates to fresh and frozen, we look at that as one, and it ebbs and flows. And some of it's dependent on when our vendor partners are bringing out new product. And I think the most important factor you should take away from that is, I'm not just telling you we're going to grow fresh. You're seeing that we are making capital investments. And in this case, the example was the additional freezer coolers, but we also expect fresh to grow as well. And there are several new lines coming out middle of this year. So that's a category that grew significantly in '25, and we see more growth coming in '26. And some customers use it as a topper. Some customers use it as a full meal. And so sometimes you need fresh, and sometimes you need frozen depending on how you're using it with your respective pet. But a big growth area for us. We're really excited about it.

Next question is from Zach Fadem with Wells Fargo.

This is David Lantz on for Zach. I guess first one for me. Within the '26 outlook for top line growth, what are you assuming for the broader category, and how did your performance stack up relative to peers in '24 from -- or excuse me, in Q4 from a share perspective?

Well, look, I -- we're not going to break it down by specific areas. I think the focus on our end is to grow overall top line growth. And some of that will come from consumables, obviously, because that's over 50% of our business. But we're really -- as you can tell from my comments, we've got initiatives in all aspects of the business, services, consumables, companion animal supplies, and obviously, with us intentionally reducing unprofitable sales last year, we gave up some market share. And with our growth this year, we'll start to gain that back.

Yes. And I would just add to that, this year is really more about another self-health year as we look to grow sales. We're not overly reliant. We're not counting on big tailwinds from the sector. I mean, we feel like we have all of these opportunities that Joel outlined and these initiatives are going to really support our outlook. And as for how we think about our share, even though, yes, we gave up a little top line in '25, we really grew a lot of bottom line. So we've cleaned up the business. We're coming from a strong foundation. There's an opportunity, as Joel said, to first grow share of wallet with our current customers. I think the next opportunity to pick off is sort of small independents and small chains who have about 4 percentage points of market share in the pet sector. So there's lots of opportunities for us to go after without being overly reliant on any tailwind.

Got it. That's really helpful. And then one more. Within Q1 and the midpoint of the guide being flat comps, is there anything we should keep in mind that's embedded within that for stimulus and/or store closures from winter storms here quarter-to-date?

Yes. You know what we've taken into account, there's so many pluses and minuses in this kind of noisy macro we're living through. So sure. I mean, on the plus side, you've got like the tax refunds coming in all -- can only be a positive. On the minus side now, as we just talked about, you have some fuel pressure. So we've kind of tried to bake those scenarios within our guidance, and we don't -- we haven't been overly reliant on any of those levers because, again, even with the taxes, one doesn't know how much will go to savings versus spending, et cetera. Now what we like about this environment, or what we like about our customers, I should say, is our customers skew to the higher end of the income spectrum. So that's good news for us because that end of the spectrum can obviously withstand macro changes without it being as large of a percentage to their overall well-being.

And then as far as weather goes, first quarter is always volatile, volatile last year, volatility in it this year. But the way I think about a big picture is by the time the quarter is done, the volatility kind of evens out with pluses and minuses, and that's kind of what -- how we thought about it in the guide for this year.

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

Great. I want to thank everyone for joining the call today, and we look forward to updating you on our progress.

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

Good afternoon, and welcome to the Petco Third Quarter 2025 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Tina Romani, Head of Investor Relations and Treasury. Please go ahead.

Good afternoon, and thank you for joining Petco's Third Quarter 2025 Earnings Conference Call. In addition to the earnings release, there is a presentation available to download on our website at ir.petco.com. On the call with me today are Joel Anderson, Petco's Chief Executive Officer; and Sabrina Simmons, Petco's Chief Financial Officer.

Before we begin, I'd like to remind everyone that on this call, we will make certain forward-looking statements, which are subject to a number of risks and uncertainties that could cause actual results to differ materially from such statements. These risks and uncertainties include those set out in our earnings materials and SEC filings. In addition, on today's call, we will refer to certain non-GAAP financial measures. Reconciliations of these measures can be found in our earnings release, presentation and SEC filings. With that, let me turn it over to Joel.

Thanks, Tina, and good afternoon, everyone. Thank you for joining us to discuss our third quarter results, where I'm pleased to share that we delivered another profitable quarter in line with our plan. We've continued to strengthen the foundation of our operating model, improved retail fundamentals and position Petco for sustainable, profitable growth over the long term.

We delivered sales in line with our outlook and meaningfully improved our profitability, increasing operating income over the last year by over $25 million, generating $99 million in adjusted EBITDA and more than $60 million in free cash flow. I want to thank our teams across the organization for their dedication, focus and execution on our transformation initiatives that are continuing to gain traction as reflected in our improvement in profitability and cash flow in Q3 and year-to-date.

You've heard me talk about the importance of culture, and you will continue to hear that as a key theme of our transformation. When I joined Petco, we had a strong culture centered around pets first. The passion of our 30,000 partners was one of the many things that attracted me to joining. Over the last 9 months as a collective leadership team, we've been building on that culture in 2 ways. First, through reinstilling retail fundamental discipline, which is driving increased financial rigor and accountability, this is a testament to how the organization has embraced new ways of working with strengthened operating principles and was a large contributor to our results.

Second, creating a culture that is playing to win. We are fostering a culture equally focused on operating discipline and a winning mindset. Last month, I had the opportunity to spend time with our support center and store leaders at our Leadership Summit. Together, we aligned on what our go-forward values will be for a reimagined Petco and what that means for our customers and our plans to execute on our [ One Petco Way ] vision. We are squarely in Phase 2 of our transformation which is centered on improving profitability and strengthening our foundation from which to grow. The success to date has fundamentally changed the way we think and work to continuously identify future areas of opportunity that will further unlock long-term value. At the same time, we are now strategically shifting resources towards Phase 3, a return to growth now that our bottom line has meaningfully been improved.

Last quarter, I outlined the 4 pillars that support Petco's return to growth. First, delivering compelling product and merchandise differentiation; second, delivering a trusted store experience; third, winning with integrated services at scale; and finally, serving our customer with a seamless omni experience.

Let me now provide you more specific color on each pillar. Starting with compelling product and merchandise differentiation. I view this in 2 categories. On the consumable side, we have improved shopability with higher in-stock availability, our customers rely on us to have everyday go-to product, better integrated assortment planning and merchandising teams have been created an improved in-store experience as well as online. On the discretionary side, we are focused on infusing a steady stream of newness in 2026 that complements our evergreen product assortment with more seasonal and trend-driven buys.

Previously, there has been a said-it-and-forget-it mentality, which is not a very aspirational shopping experience and one that we are changing. As we look forward, we see significant opportunity to change our collective merchandise mindset from solely a needs-based business to also a wants-based business by overhauling our product offering and surprising our customers with unexpected ideas for their pets. A great example with the success of our online pilot, our new My Human product line was expanded into over 200 stores. This is a small milestone but exemplifies our team's focus and ability to lean into trend forward impulse purchases.

Next, moving to a trusted store experience. Joe Venezia, our Chief Revenue Officer, who joined us just about a year ago, leads our operations and services team. Since joining, he has been focused on store simplification, standardizing processes across our fleet and taking costs out of our operations. He is now shifting his focus to additionally include revenue-driving KPIs like increasing transaction size, driving sales contests and increasing customer interactions. With our passionate partners, strong customer engagement and a full suite of services, we can create both a fun and convenient experience that pet parents are unable to get anywhere else. Our store partners are a unique differentiator for Petco. We benefit from having long time, passionate and knowledgeable partners that serve our pets and our pet parents. Our opportunity today is around making it easier to run our stores, freeing up our store associates to interact with customers and use what we call their superpowers of pet knowledge, improving these areas will make it easier for us to drive sales growth in 2026.

Moving now to services at scale. Our nationwide wholly owned and operated services business continues to be our fastest-growing category and is our competitive moat, given its in-person nature, high barriers of entry and difficulty to replicate, a holistic ecosystem between grooming, owned hospitals, clinics and center of store can only be found at Petco. What especially excites me here is the opportunity we have with our existing assets. I think about it in 3 ways: one, improving utilization through increased staffing and appointment availability; two, improving engagement to enhance digital capabilities; and three, improving integration of services and center of store. With regards to veterinarian staffing, I'm pleased to share that we are ahead of our doctor hiring goals that we set at the start of the year with record high doctor retention. During the quarter, we also promoted 2 of our long-time leaders to chief veterinarians, reinforcing our commitment to growing our veterinary business. Simultaneously, we are fostering a culture of team development, top talent recruitment and execution of our strategic veterinary initiatives. All of this is foundational and is critical to increasing the utilization of our hospitals.

Additionally, we are increasing access to care by strategically adding hours back on peak client demand and making appointments easier to book. We are standardizing processes across our fleet to secure in-store follow-up bookings. We are increasing efficiency for our refined grooming apprenticeship model, freeing up both appointment availability and increasing volume. And finally, we are enhancing online appointment scheduling to ensure we have better coverage and better flexibility for our customers. Clearly, Q3 has been a busy yet productive time for our services businesses.

Let me spend a moment on improving integration between services, and center of store as the opportunity here may not be well understood. Historically, Petco stores and services operations were run relatively siloed which was a missed opportunity. There is a tremendous value unlock when better integrating our stores and services experience. I'll give you a simple example. Previously, our veterinarians did not have access to customer purchase data. We are in the process of fixing that. And in 2026, our veterinarians will be able to see purchase history and make more informed diet recommendations based on overall pet health and specific needs.

Taking that a step further, the veterinarian will be able to direct the customer to the recommended product in store, or recommend a store associate to assist. This is a simple example but illustrates how increased integration of services in stores can create a better outcome for pets and improved experiences for our customers.

Now moving on to our fourth and final pillar, seamless omni integration. Layered on to everything I just discussed are enhanced digital capabilities, a more compelling membership offering, and a frictionless digital to store experience to customers wherever they choose to engage. I'm happy to report we are on plan with our improvements -- and in fact, we are starting to implement some of these changes in Q4 of this year. For example, we are transitioning the way we buy media, beginning with better targeting and bidding strategies which we expect to drive efficiencies in our marketing spend as we continue to strengthen Petco's reintroduction of our tagline, Where the Pets Go. I'm pleased with the progress of the membership program, and we will begin live testing and pilot the program this quarter in a small handful of districts. Our focus on these 4 pillars will fuel our growth, which we still expect to see in 2026.

In closing, as you can hear in my voice, this has been a productive quarter at Petco, and I'm pleased with the progress we continue to make on the commitments I outlined at the beginning of the year. As each quarter passes, we get better at celebrating amazing pet experiences, executing our strategies and delivering on our promises internally and externally. The initiatives planned for the fourth quarter will advance the Petco transformation, and I look forward to sharing updates with you in March.

Ahead of the Thanksgiving holiday, I want to personally express my gratitude for our partners who puts pets first every day and boldly reflect who we are and what we stand for. Our Petco Love foundation has demonstrated our long-standing commitment to saving lives, finding loving homes for over 7 million pets to improve the welfare of animals. With that, I'll hand the call over to Sabrina to take you through the specifics of our third quarter results and outlook for the remainder of the year. Sabrina?

Thank you, Joel. Good afternoon, everyone. In the third quarter, Petco once again delivered against our commitments while building a stronger foundation from which to grow. As we've discussed all year, strengthening the health of Petco's economic model has been our top priority. I'm pleased with our progress, as demonstrated in our expanding gross margin, expense leverage and operating margin expansion, not only in the quarter but year-to-date. In line with our outlook, which reflects our decision to move away from unprofitable sales. Net sales were down 3.1%, with comp sales down 2.2%. As a reminder, the difference between total sales and comp is driven by the 25 net store closures in 2024 and the additional 9 net store closures year-to-date.

We ended the quarter with 1,389 stores in the U.S. Gross margin expanded approximately 75 basis points to 38.9%. Similar to the first half, gross margin expansion was primarily driven by a more disciplined approach to average unit retail and average unit cost, including stronger guardrails and more disciplined processes to effectively manage our pricing and promotional strategies. It's important to note that in this quarter, tariffs began to more meaningfully impact our cost of goods sold.

Moving to SG&A. For the quarter, SG&A decreased $32 million below last year and leveraged 97 basis points. As we've discussed previously, our shift in mindset an increase in rigor around expense management is evident in our results. Savings were achieved across the board and especially in G&A areas. Notably, marketing spend was about flat year-over-year. Our expanded gross margin and expense leverage resulted in operating margin expansion of over 170 basis points. Adjusted EBITDA increased 21% or $17 million (sic) [ $17.3 million ] to $99 million (sic) [ $98.6 million ] and adjusted EBITDA margin expanded nearly 140 basis points to 6.7% of sales.

Moving to the balance sheet and cash flow. Q3 ending inventory was down 10.5% while achieving higher in-stocks for our customers. We continue to manage inventory with discipline, which is one of the drivers of our improving cash profile. Free cash flow for the quarter was $61 million, and year-to-date was $71 million. Both the quarter and year-to-date were significantly above the prior year. Notably, year-to-date cash flow from operations has nearly doubled versus the prior year to $161 million. We ended the quarter with a cash balance of $237 million and total liquidity of $733 million including the availability on our undrawn revolver.

And now turning to our outlook for the full year. We are once again raising our adjusted EBITDA outlook for 2025. We now expect adjusted EBITDA to be between $395 million and $397 million, an increase of roughly 18% year-over-year at the midpoint. For the full year, given we are entering the last quarter, we are narrowing our range for net sales and now expect net sales to be down between 2.5% and 2.8%.

For the fourth quarter, we expect net sales to be down low single digits versus the prior year as we continue to execute on the initiatives we've outlined. We expect adjusted EBITDA to be between $93 million and $95 million. It's important to note that the impact of tariffs is sequentially more meaningful in Q4. Additionally, the significant progress we've made year-to-date against strengthening our economic model and improving our earnings profile has provided us the option to begin selectively investing behind the business where it may make sense as part of our ongoing efforts to set the stage for Phase 3, a return to profitable sales growth.

With regard to other guidance items. For the full year, we expect depreciation to be about $200 million, net interest expense of approximately $125 million, about 20 net store closures and $125 million to $130 million of capital expenditures with a greater focus on ROIC.

In closing, as Joel discussed, we're in a period of significant change, and I want to extend my deepest appreciation to all of our teams for embracing that change to deliver better outcomes for all of our stakeholders.

With that, we welcome your questions.

[Operator Instructions] The first question will come from Simeon Gutman with Morgan Stanley.

Let me -- I was intrigued by something you talked about some of the wants. Can you talk about -- can you frame what mix of the business is wants versus needs today and it may be far out there but what's the vision? And my guess is the wants aren't truly wants. I think it's -- given your background, there's probably some unique merchandising that's partially wants but curious how you can frame that and maybe tease it out a little.

Thanks, Simeon. It's a great question. And yes, if you think about it in the traditional sense, consumables is traditionally a needs business. And it's the overwhelming majority of our business but even that business, Simeon, I think, has some elements to it that can be more of a want in principle. And what I mean by that, and I alluded to it in my prepared remarks, we've just had this said-it-and-forget-it mentality for our entire business. And if I just focus on consumables for a second, for example, in 2025, we our dog food business was largely all surrounded around 1 big episodic reset in the middle of the year.

And we're really going to change that in '25, and as our big vendor partners come out with innovation, newness, different types of product, new flavors, cat extensions, we're going to roll that out in line with their timing, not our timing. So that's going to make more of a perception of wants rather than just needs in the sense that somebody walks in and -- is a sense of discovery and we just haven't been good at that in the past, Simeon.

So I think the whole business has an opportunity to create more of a exploration throughout our store, not just our supplies business which is traditionally probably the way you were thinking there's an element to it in consumables as well. And certainly, when we get on the call in March, we'll go through that in more detail. I cut you off, Simeon.

No, I cut you off. My follow-up, it's related. You talked about integrating the store functions. You talked about wants versus need, and then there was a little bit of maybe forward investing, I think, Sabrina just mentioned. So if you -- and by the way, the business itself is getting close to lapping like whatever tough compares. It seems like it's naturally getting back to positive territory. So what kind of clicks or what's the priority among the things we heard where the top line starts to move or? Is it something we haven't heard yet?

No, I don't think it's something you heard. I think, look, we're going to approach 2026 from the top line, the same way we approached 2025 from the bottom line. In 2024, we came out with the strategies that would fix the bottom line, and then we executed them in 2026 -- in 2025. We're doing the same thing for top line growth.

I outlined 4 pillars. We backed it up with building blocks which I talked about many of them today. And then we're going to execute against those with the same rigor and discipline. And so it's not just to cross your fingers and hope. We've got plans around 4 pillars with a lot of building blocks for each 1 of them. And I'm really excited about all 4 of them. I alluded to some of them that we're already testing here in Q4 but all of them are making traction and some just take longer to implement than others but teams are all focused and we got a good plan.

Next question will come from Oliver Wintermantel with Evercore ISI.

Joel, what is the realistic time line for comp stabilization? And which categories or customer behaviors would represent the biggest swing factors there?

Yes. Look, I'm not going to get into 2026 today on this call and the timing of it. But certainly, what you should expect from me in March is to not only give you guidance for Q1 but we'll give you an outlook on the full year. But specifically, I can tell you all 4 of the pillars I went through today are getting traction. And -- so I would expect all 4 of them to contribute towards comp in 2026, and then we'll just outline the timing for you on the March call.

Got it. That makes sense. And then just on the free cash flow side, strong improvements there year-to-date and in the quarter. But how much of the Q3 working capital improvement is sustainable, and what financial or operational levels continue to support the cash generation for next year?

Yes. I mean, I think we view cash flow and all of its levers as continuous improvement. So we certainly are focused on continuing on this path of generating strong free cash. The principal lever of core solver is net earnings. So we're going to continue to focus on our bottom line and growing net earnings. We'll continue to focus on inventory discipline. We're not done. We've made huge strides this year. in terms of rationalizing our SKUs and reducing our inventory compared to our sales which is fantastic. But I wouldn't say we're best-in-class in turns yet. We still have a lot of opportunity, so we'll be looking at that lever as well as all of our other levers to continue delivering on strong cash generation.

Question will come from Michael Lasser with UBS.

Can you size the magnitude of the potential investments that you would make in what form those are going to come in, whether it's labor, marketing or promotions? And are those investments necessary as you look to 2026 in order to drive top line growth.

Well, maybe I'll just start, Michael, with the framework, and then Joel can chime in on how he feels -- he's looking at each one. What we've tried to do, and we're really pleased that we banked so much profit improvement through Q3. And this has afforded us, as I said, the option, and it's only an option to consider investing in areas that we think can drive improvements both in Q4, but also for our future.

So everything you mentioned is on our plate of options certainly, marketing, certainly looking at labor. And sure, we'll always continue to look at promos to see if we can do them effectively in a way that brings value to our customer but also in a way that's very responsible as we continue to manage our margin expansion. Joel, do you want to...

Yes. Yes, Sabrina, I think you nailed that pretty good. And when Michael, I look at the 4 pillars, we outlined. I don't think any of them as it relates to 2026 require any substantial step change from what we're doing today in terms of cash investment or a change in OpEx investment or something. It's really -- you take merchandise, like we're selling through our existing merchandise and we're buying into new. So that's really just a steady flow change and really don't see any episodic change in 2026 from an investment standpoint from the run rate we're already on today.

I guess the question and the critical point is can Petco experience the same magnitude of the improvement in the profitability while reversing what seems like some market share losses this year and be on that path next year?

Yes. If I'm hearing you, Michael, and I might want you to repeat the question, but we for sure, believe that investments are going to be necessary. Our whole focus and what I talked about all year long in terms of the economic model we're pursuing is delivering leverage on expenses. But as you know, if sales improve, you increase operating expenses and still deliver leverage. So we're very aware that we need to make some investments. That's why we're talking about in Q4, we may make some of those investments in advance of entering the new year because we've been able to bank so much profitability and leverage.

And we will measure our success in meeting our goals and expanding margin and delivering expense leverage on a full year basis. That's another thing we always said, we never said every single quarter in the same way. It's on a full year basis. So that's why we've given ourselves the option because we know that the next phase will require investment and we are prepared to stand behind that in a responsible way that still delivers on our full year goal to deliver the model.

Sabrina, could I just clarify? If we look at what the embedded EBITDA margin is in the fourth quarter versus what Petco has experienced over the last couple of quarters. It looks like the pace of improvement is going to moderate. Should we think about the magnitude of the potential investment, the option for investing would be the difference between what Petco has achieved over the last couple of quarters and what's implied in the fourth quarter? Is that how we should think about quantifying that potential investment?

I think that's a fair framework, Michael. I would add to that, as we look to Q4, as I stated, remember, when we think about gross margin, there's more tariff impact. So that's just 1 factor. It's not enormous as we said all year. It's -- we're pleased that we're in a retail sector that doesn't have mountains of tariffs but it is an impact. So that's 1 factor.

The second impact is that investment that we're talking about, and how much we will choose to do and how we'll manage through that in the fourth quarter. So yes, I think your statement, broadly speaking, is fair.

Next question will come from Kendall Toscano with Bank of America Global Research.

Hopefully, you can hear me okay. I was just wondering if you could talk more about the impact of tariffs during the quarter. I know you mentioned they became more meaningful in 3Q but maybe not as much as you're expecting for the fourth quarter. But just curious what you saw in terms of COGS impact, if any, and then in maybe some categories where there was tariff impact on price? What did you see in terms of consumer elasticity?

Yes. Thanks, Kendall. Just to go back to your statement. So the first time we saw a tariff impact flow through our P&L through cost of goods sold in any meaningful way is the third quarter because the second quarter has like, let's call it, de minimis, amounts of that. We had it on our balance sheet, we had an inventory buys but it wasn't flowing through COGS yet. The third quarter is the first quarter of that.

And my only point was, in the fourth quarter, it becomes a bit more meaningful. So it's just a reminder that sequentially the tariff headwind is a bit more meaningful. But again, in the broad spectrum of things, it's a very manageable number which we've managed all year and have been revising guidance upward in the face of it. So I think that hopefully helps frame it up. We also know that it's mostly in the private label supplies area, as we've said in the past. So hopefully, that helps frame it up, too.

Got it. That's helpful. And then my other question was just in terms of some self-inflicted headwinds in the Services segment as you've deprioritized that program ahead of the planned relaunch. Just curious, as you're now getting closer to relaunching that in 2026, and it sounds like maybe starting to pilot it in the fourth quarter, what kind of tailwind would you expect to see on same-store sales growth or, I guess, just services growth?

I think you mean our membership program?

Yes, that's what's I meant.

Yes, that's what combined with services in the way we report services and others. So probably, Joel, if you want to start with the membership program and...

Yes, because our paid membership rolls into there. But I think the more important thing to take away from that is -- and I alluded to it in my prepared remarks that we are on track with our new membership program. And in fact, here in the fourth quarter, we have begun live end-to-end testing in several markets. And so -- we really haven't seen any major glitches in fact, minor at best. And so that's a really good sign for us.

We'll then take that to a few more markets and to roll out the new marketing attached to it and are still on track then for a rollout sometime in 2026 with the rest of the fleet. But membership so far has really come together nicely, and it's a really important element to our growth that's going to begin in 2026.

Yes. And since you raised it, Kendall, on the services piece, I think you can see that, that continues to be not only a strategically important area for us but it's also an area of nice growth and continues to be.

Next question will come from Kate McShane with Goldman Sachs.

We wanted to ask a little bit more of a higher level question. Just your view on where you think the industry is now from a digestion standpoint where you think the industry can grow in 2026 if we do return to growth in '26 for the industry? And just what you may have been seeing out of the competitive set this most recent quarter as some of these higher tariff costs and prices have come through?

Yes. Thanks, Kate. Look, overall, the competitive set really hasn't changed much from the last quarter. I would say, the -- what's changed is the consumer has been probably a little bit more cautious. I mean, obviously, with tariffs and political tensions and interest rates still high that's really been bogging down their outlook on the economy a little bit.

But as far as the pet industry goes, it's been pretty stable, flattish in terms of growth I think the progress we've made on our digital side has really been promising and that will be very important to us as we turn to growth next year. But overall, we're positioned nicely. Our services business is -- Sabrina just talked about is already growing, and that is an area of growth in the pet industry, and then we'll layer in the focus we've made and the progress we've made on our digital improvements. But overall, it's pretty stable.

Question will come from Chris Bottiglieri with BNP Paribas.

The first 1 I had was just hoping to -- now the cash -- free cash flow profile has improved. How do you think about prioritizing the usage of cash? Is it continued debt paydown. Do you think about reaccelerate veterinary practices? Just curious how you think about that over the next few years.

Yes. Our first priority would always be to invest in our business to sustain growth going forward. So that's definitely the priority. That said, we go back to our statement that we have a lot of assets on our books already that really are ramping up now, vet hospitals predominantly the #1 on the list that are already on our books that we are ramping up for better returns.

So we don't have to make big capital investments in those, and we, in fact, you'll hear us talk about more in the Q4 call, Chris, we have a set of those that where we're going to focus on bringing utilization up in 2026 as well without any large capital investments. So I view this as really great news because it provides a nice path for return improvement while not having to invest a lot of capital in it.

So of course, though, we'll be looking at pockets and areas as we move forward and we finalize what kind of remodel prototype we want to land on how we'll start to bring those into our system. But there's no huge big capital spend necessary in the horizon, likely to increase some in '26, but no big, enormous dramatic change overall in profile because we have these assets in our books where we're increasing utilization.

Now beyond that, beyond that priority to first invest in our business, the second, of course, is we are always looking, as I stated, on the first call when I talk to you guys, we want to bring down our leverage on an absolute basis. We also want to bring down our ratio. We're doing a terrific job with the growth and profitability of bringing down the ratio. So it's quite remarkable. We started the year at over 4x debt to EBITDA. And if we hit the midpoint of our new guidance, we should be below 3.5x net debt to EBITDA. So quite a bit of progress. And indeed, we'll look to opportunities to even potentially do some opportunistic debt pay down.

Got you. That's really helpful. And then your gross margins were, I think, down 20 basis points on the product line. Is that primarily that tariff headwind you're referring to? Or is it also somehow -- or is like -- is the elasticity offsetting the ticket increase and there's also a headwind on top. Just curious by like tariff headwinds that you're referring to there where it's manifesting?

I have our merch margins expanded both in our products and services.

Sorry, I meant quarter-on-quarter, not year-on-year.

Oh, quarter-on-quarter, sure. Yes, I would say that is primarily a little bit of tariff headwind coming in. Year-on-year, though, we are up in both products and services.

Next question will come from Steve Forbes with Guggenheim Securities.

Joel, you spoke about services in stores coming together. And I guess my question is, can you help us frame up sort of how you guys see that opportunity internally, whether it be how spending per customer sort of evolves as they engage in services, if they're a store-only customer or vice versa? Like any way to sort of talk about how like the net sales per customer evolves as they broaden their engagement across the store?

Yes. Look, look, I think any great bricks-and-mortar retailer has to define their moat, has to define what differentiates them from anybody else. And services is definitely 1 of our moats, right? It's 1 of our key elements that is really hard for any other pet retailer to replicate in the way we built out grooming, hospitals, vet clinics, dog walking, dog training, all those elements.

And so that's obviously an area there for we've leaned in the most, and we've made incredible progress with our existing assets, utilization we've improved, engagement improved. And then what you're getting at is the integration with the center of store with product. And so -- what's key to all that, Steve, as I look to '26 is layering that in with a membership program that really helps us better understand the profile of each 1 of our customers, how many are you using services? How many use services and merchandise, how many are buying in-store and online. And you put all those elements together, it starts to create profiles of different customers.

And we really see -- honestly, the better we get at services, the halo effect that has on the overall business just gets stronger because it's something that's hard for anyone else to replicate. So service is probably the area that we made the most amount of progress, pleased with the results we're seeing there. And you'll continue to see us talk about that and -- but that gives you a little color on how I see it playing out turning into 2026.

And then maybe if I just do a quick follow-up on that. Is there any way to set the baseline here on just sort of what percentage of your customers today actually buy services or any sort of baseline KPI that we can sort of begin to track as we think about your progression in the business?

Yes. Look, I think at this point in time, I'm not going to get into the specifics on it at that level of detail. I mean, I think the baseline KPI to track as we look into the future, it will be transactions overall and then let us manage it at the different elements we have to serve up to the customer. But services will definitely be a key component to it, Steve, as we keep growing.

Last question will come from Zack Fadem with Wells Fargo.

Is there a way to quantify the impact of moving away from less profitable sales and deemphasizing the member program in Q3. As it seems like you expect your Q4 comp to step down a bit more. I'm curious to what extent you're expecting those items to also impact Q4?

Yes. I mean I'll just start by -- it's a pretty broad range, Zack, the implied Q4, so we can land anywhere in that range. Clearly, what we've stated all year very consistently is our primary focus this year was around expanding our margins, walking those unprofitable sales and building this very strong foundation upon which to start sales growth in 2026. But Joel, I'll let you take it from there, if you want to...

Yes. I think -- Sabrina, I think you nailed it. And I think I'd add to that, like you asked what's the impact? Well, the impact you're seeing quite clearly is we're growing pet EBITDA market share. And so while sales are down, EBITDA is up. So clearly, we -- I think we've done a really nice job of identifying which sales are really onetime transactions and our empty calorie as I call them, versus which customers we want to grow lifetime value and be with us for the long term.

And so you've seen that play out quarter after quarter for us as sales have been down consistently low single digits but bottom lines continue to improve. So as each quarter goes by, we get better at identifying those, largely, getting them out of our base. And you layer in a membership program, more strategic media buying aspect and all that will start to lead towards improvement in the top line with the bottom line as well.

Thanks, Joel. And then just to level set as we look ahead to 2026, I mean the expectation is to return to sales growth. I'm curious how generally you would frame broader category performance in dog and cat food, supplies, services, et cetera, and then how you would layer in the impact of both your initiatives? And then net store opening and closings to kind of get to that total sales growth?

Yes. Look, I think it's too early now to spell that out specifically for 2026. I mean, clearly, if you look at what we published, you can see the consumables and supplies are negative this year and we're getting growth in services. We expect a return to growth in consumables and supplies going forward. And what I've got to just outline for you or translate for you is what I laid out today in terms of 4 pillars, how does that translate into growth at what time and what period next year.

But a lot -- what you guys can't see is all the progress we're making here internally. And then we just got to put the pieces together for you so you can help you think about your model. But we haven't -- I think I answered on a few questions before. We're approaching '26 the same way we approached '25, outline the strategies and then execute. And the team is just getting better at that as every passing quarter goes by.

Yes. And Zack, just to emphasize what Joel is saying, for sure, I think your thinking is in line with ours, where you always look at what's your base sales build, then we layer on all the many initiatives, which Joel has been outlining and we'll continue to get more granular as we go into '26 but we have all of those building blocks on top of that base, and they layer on throughout the year. So what you can count on is it's a gradual ramp. And then the last thing I'll say as a little bit of a preview is we would expect fewer net closures in 2026 than we had in 2025. And again, the 2025 expectation is about 20 net store closures.

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

Perfect. Thanks so much, Joel and Sabrina, and thanks, everyone, for your time. That concludes our call, and we hope everyone has a wonderful holiday.

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

Thank you for attending one of our last fireside chat of the conference. It's our pleasure to introduce you to Petco. Today, we have with us Joel Anderson, Chief Executive Officer. And we also have with us Sabrina Simmons, Chief Financial Officer. Thank you both for joining us today. We're excited to have you. You do have a lot going on.

Yes, we do.

I almost wonder if I have to be up here, like you could just launch into all your phases and initiatives. But obviously, this has been a big year of transformation for Petco so far. And you have this multiphased approach and focused on 3 stages. And the first one is the strengthening of the retail fundamentals. So I wondered if we could maybe just level set in terms of what you've been able to accomplish? How do you think you're positioned? And how soon and closer we are to the next phase?

Yes. Look, as you just alluded to, this transformation is very well grounded in specific phases. And we're well past Phase 1, but I think it's important to articulate Phase 1 for a second because that really led to the foundation of putting us in Phase 2. And so much of Phase 1 was just a combination of, one, identifying where the opportunities were as well as rebuilding the leadership team. And so we completed the rebuilding of the leadership team with Sabrina joining and a couple of others at the beginning of the year, end of February. But like any great strategy, it only works if you're also really good at execution. And so that's Phase 2.

And so if I had to summarize Phase 2, it's really about executing and implementing. And so while we had a long runway last year of really identifying a lot of things, what I'm most excited about and most pleased about, and it's already showing up in our results, both Q1 and certainly in Q2, is a lot of improvement in EBITDA. And specifically, Phase 2 was really about improving the bottom line. And that's really where we've been focused, and that's where you've seen the movement. And it's also, though, been about improving the culture. I mean we've changed the culture from playing not to lose to playing to win. And that's the part that's been, as Sabrina said a number of times, it's become fun to save money and people are excited about it. And we celebrate that at Petco. And so we're reinventing the culture, and I'm really pleased with where we're at in Phase 2.

That's great. And then if we can maybe jump ahead to Phase 3, which I know is on the come. But maybe what you're most excited about, what you think will come to fruition first?

Well, what's important about Phase 3 is that it's equally as grounded in the strategy. And so while many of you are very interested in when we're going to get to Phase 3, we're also being very disciplined in our approach. And as I said, we're squarely in Phase 2, but we are starting to think about Phase 3 strategically. And our strategy on Phase 3 growth is centered around 4 pillars. And I'm happy to go into all 4 of those pillars, but I'd articulate them quickly.

One is about amazing store experience. Like our partners are incredible. They love pets and fostering the fun of a great store experience is number one. Number two is merchandise differentiation. And I think we have an incredible opportunity to differentiate our product in our stores. Number three is services at scale. And while strategically, we've made many acquisitions and growing hospitals very fast, we have a big opportunity as part of our growth to take all our services to scale. Services are tough. They're hard to do. But in many ways, that's our moat. That's something we're really good at, and it's hard to replicate. And then finally, it's winning with omni. And so those are the 4 pillars that we are now looking at that will lead our growth that will start to show up in '26.

But it's also important I mention to you that the approach we're taking is very much a test-and-learn approach. So there's not some big unveil coming, Kate. If you think about merchandise differentiation, as we change a department, we will test and learn, try it in 25 stores, make sure it works and then roll it out. So there's not this -- we're going to change the whole store and wait until next July. As each department gets corrected and fixed and we bring more opportunities to it, we'll start to roll those out, but it will be grounded in a lot of facts that prove this works before we make the inventory investment. And of course, you have to sell through what you currently have.

And maybe a good place to drill down with regards to the pillars and then the piece that I find most interesting is the services. It's a traffic driver. It's a reason to go to the store. Now omnichannel is part of it, too. But also from a competitive standpoint, I think it's a differentiator. So I wondered if you could maybe talk through just services, what -- maybe how you found services when you got there, where you think services can go? And how big of a deal do you think it is versus your competitors?

It's a great question. And quite honestly, Kate, when I was making the decision to make a change, services was one of the compelling reasons I got excited about Petco. On one hand, we've had grooming a long time. On the other hand, we made the right strategic decision to grow hospitals internally. So all our vet operations are Petco owned. And I think that gives us a really nice point of differentiation that our veterinarians are connected to our groomers who are connected to the center of store, and it's one big Petco ecosystem. And like you alluded to, services is something that not in my lifetime will you take online, right? You have to physically show up. And so to your point, it drives traffic.

Having said all that, we've seen since looking under the covers, a big opportunity to optimize our services. And so if I look at vet, again, that's staged out how we're going to optimize it. And the first one is optimizing the existing fleet. So we went from 0 to 300 in a very short period of time. And now we have a fleet there that without having to spend a lot of capital, that's in the rearview mirror, it's been spent. We can really grow our hospital operations. We're improving the digital operations so that you can make appointments easier online. We're improving the number of days our hospitals are open. And that takes just training and developing more veterinarians, but doesn't take a lot of capital. So you're absolutely right. Services is a big point of differentiation for us.

And even on the grooming side, despite having it for as long as we had, we found there was a lot of times you could go online and there wasn't a grooming appointment available. So we've optimized the software. We've standardized how many pets our groomers can see. We're getting better at utilizing our junior pet stylists to maybe do the washings so that our senior pet stylists can do the more difficult ones, which then, again, you can train a junior pet stylist much quicker and you open up more appointments. So we're really making that efficient. And then down the road, we'll start to look at opening more hospitals as an example.

That's great. Just speaking of competition, I know it's very fragmented, but you also have some very solid competitors in the space, both with mass and specialty. We talked about services as a differentiator. But just overall, how are you thinking about competition and what Petco's value proposition is amongst the competitive set?

Yes. It's a good question, right? And we do have a wide spectrum of competitors. And if anything, the pet space became too easy to grow during the COVID years, just you opened a door and sales happened. And so as you've gotten back to a more normalized growth rate, you got to be tighter and you got to be differentiated. And I think for many of the reasons I just articulated our growth strategy, all 4 of those pillars are points I believe we can be different than the competition.

And even when I talked about omni, it's important I didn't say e-commerce. And our stores will play a really key role. And as we start to grow e-commerce again, same-day deliveries, 2-hour deliveries, buy online, pick up in store, even the fact of the mobile phone playing a very important role in making grooming appointments, making that appointments, checking your loyalty points. And so we really think of it as a digital operation that really enables the stores as well as serves the pure-play customer that wants an online delivery.

And speed has been actually something that we have heard across the board at this conference in terms of that is what the customer is looking for, obviously, value. But I think speed and convenience is right up there now with value based on what everybody is telling us. So how do you feel you are today with regards to the convenience and speed versus your competitors? And can you get better?

Yes. The good news about that is, well, a, we agree. It is an element the customer is looking for. But b, we can get faster without it having to be a huge capital outlay for us. So in addition to using our distribution centers for repeat delivery because that's a planned purchase. We know what date we owe them that shipment. It's much easier and efficient to use the distribution center. But for a customer that needs speed and want speed, those 1,400-ish stores we have out there are already kind of forward deployed inventory, and we're getting much better at using market fulfillment centers.

And we're being very strategic about that as well. We are utilizing our lower volume stores as opposed to our higher volume stores. So not to disrupt the customer that's coming in foot traffic. And by the way, that also makes a lower volume store more efficient because you're sending more inventory in there to fulfill an online order. But I agree 100% that speed is a component that we are focused on and it will get better in '26.

Great. You mentioned 1,400 stores. I think you've closed some stores since you guys have been at the company. How do you think about your store count and your fleet? Is there any criteria that you're looking at to evaluate store performance today?

Yes. Several elements. And Sabrina, if you want to weigh in as Sabrina sits in our real estate committee meeting every week. But first and foremost, we look at the financial performance of the store, bottom line profitability, labor rates, things like that. The second thing we look at is the market. Is this a node we want to be in, but maybe it's just in the wrong location. So we look at that. And then we look at the overall trajectory and health of our store fleet. And so we're fortunate enough that we're in a situation that over half of our stores come up for lease renewal in the next few years.

So that, Kate, really gives us a lot of flexibility that we can outward project where we need to be. Having said all that, the health of our stores is in pretty good shape where we have really looked at that. The EBITDA continues to improve. And as we alluded to, we closed 25 last year. We expect to close about that this year, then it will start to moderate next year. And I think as you get into '27, actually start to see growth. I don't know, Sabrina.

Yes. The only thing I'd add to that, all of that's right on, is there's a really nice opportunity that we have in store productivity. So we have a nice sized fleet nationwide. I think it's an advantage these days to be an omni player. Most pure-play e-com want to establish some brick-and-mortar. We have that differentiator in the services. So as over the last few years, as our gross margin came down, so did the performance in our stores. So building back as we are focused on gross margin expansion, focused on the 4-wall profitability of our boxes, we're just looking at square footage improve. So we've even seen that in the first half. So we're just at the very beginning, again, without having to spend a whole lot of capital of just reaping the benefits of increased profitability within those 4 walls as we improve our merchandise, as we improve how we operate around our pricing architecture, promotions, all of that to improve our margins.

And this might be too soon to ask, but just given that you do have 50% of your store base up for renewal in the next few years, does that give you an opportunity to maybe reassess the size of the store or think about a different way to approach the store?

Yes. We've actually already looked at the size of the store. Our average store is about 13,000 square feet. That's the optimal model. And we feel really good about the size of our store. It -- as Sabrina said, we still have opportunity to improve sales per square foot, and there's a lot of initiatives that are all about that. But that feels good and that does represent an overwhelming majority of our stores.

Sabrina, I know you've worked very hard on the cost side of things. And one of the areas that I think you've been focused on is moving towards more impactful targeted promotions and any kind of opportunity as a result of that. How have you been able to balance the promotional activity and maybe what the customer has been used to versus this new more targeted strategy?

Yes. I mean, first of all, we always start with a customer lens. And we know to play in retail effectively these days, you have to be very value conscientious. You have to offer value, play on the holidays, do promotion. So what we've been doing is not trying to take away any of that promotional cadence, but more responsibly execute it. So what was happening before in our stores purposefully and probably some inadvertently before the management team came in was we were allowing customers to use a lot of stacking. So they could take a coupon on a markdown on an extra 20 and you deteriorate margin quite quickly that way.

And I don't actually think most customers even expected to be able to do all of that stacking. So we're still offering the promotion, but we're getting much more careful and disciplined about how we're operationalizing that so that we're preventing all of that stacking. And we're also just looking overall at depth because, again, we got a little eager about chasing sales, and there wasn't enough balance on the profitability side. And so now we have a really talented team who's working on inventory planning, merchandise planning, managing our margin appropriately so that each promo we do, we have an opportunity to look at depth of promo and perhaps get the same lift without having to go so deep.

And then another area that I know you've been focused on is just average unit cost or just your cost. Could you maybe update us on how the conversations have been with suppliers and what you've been able to accomplish there?

No, not take it.

Okay. So yes, we started that at the very end of 2024. What we have found broadly speaking about the company is, again, a lot of -- this is why we talk a lot about retail fundamentals because there's a lot of low-hanging fruit and basics that we have found we can just do a better job executing to that reaps a lot of return. And I would say merch and non-merch procurement were both areas of opportunity where we really weren't using the weight of our size at $6 billion in sales to be assertively negotiating with our vendors. We always want to create win-wins. But we really weren't negotiating as hard as we could to affect that win-win balance with them. So we've done that much more effectively beginning last winter, and we're in the midst of doing that again as we're preparing in the summer to have discussions around 2026.

So that has reaped a lot of benefit for us as well. And I'd say, again, on the non-merch side, we put in a whole team now. We didn't have really a professional procurement team that was focused just on looking at negotiating deals on the IT side, on the freight side, having good discipline around RFPing everything to make sure we were getting the best pricing always. So all of that now has been put in place and it's starting to reap the benefits you're seeing in our financial statements.

That's great. I wanted to make sure I asked a question on the merchandising. It's kind of -- it can go 2 ways or 2 kind of big questions. Before you guys arrived at the company, the company had been more premium focused and didn't have many value brands. But I think once things started to kind of normalize after COVID, there was a realization that more had to be offered. And so there were more value brands introduced. So when we just think about the nondiscretionary or just the consumables piece, is there a lot of work to do there? Are you happy with the good, better, best and how things are positioned?

Well, look, as Sabrina just alluded to on pricing and AUC and all that, we've got a lot of work to do there. But as it relates to strategically how I think about it, I came out of a business that was largely discretionary. And my prior business was largely consumable, Walmart, right? We're blessed at Petco that we've got both, and they operate very differently. I think of the consumables business as our traffic driver. It's a reason to come to Petco all the time. And so where we've been really focused on that, like if you're going to be successful in consumables, you've got to be in stock all the time. And certainly, it's very national brands, so you've got to be sharp -- price sharped, right? And so a lot of our efforts on consumables has been about improving our in-stocks, and we've made incredible progress there.

As I think about the discretionary side, having spent 10 years in it, the opportunity with that is basket, right? So consumables is going to bring them into Petco and the discretionary provides us the opportunity to drive basket. And so I think we have an opportunity to not treat that side of the business so much in a set it and forget it mentality, and it needs to be one that changes much more frequently, surprise and delighted. I'm coming in from my bag of dog food and like that is a really cute color, and it's got my dog's name on it. And so there's a personalization element to it. There's a trend right, newness element of it. And so we're really working on both sides of it. Combined together, it will help drive more consumers into the store and drive a bigger basket.

That's where I was going to go with my second question on the discretionary side because Michael, the former Chief Merchant at Five Below is your Chief Merchant now. And we know he has great ideas. And so I wondered when we could maybe start -- it sounds like you're going to do a lot of test and learn, but when we could start to see more of that infiltrate into the stores.

I'm big in understanding what somebody's superpower is and Michael's true superpower is sourcing and product development. And so as he's gotten on board, joined right around the same time as Sabrina, he has already had a trip overseas, understands our brands, our private label brands. And not too surprising, he and I are aligned on the ability to use discretionary to really drive surprise and delight and drive newness and drive trend.

I think there's a license element to it that obviously exists on the human side, and I think it exists on our side as well. As I alluded to at the very beginning, Kate, this isn't going to be a big unveil. We're working on many categories. We'll start testing them later in the year, won't show up in real sales until next year, but -- because we want to get it right. And it's the same way I used to do it at Five Below, like you got to test it, right? Like this -- we are not going to bet the [ farm ]. I can't go to Sabrina and say, I need $100 million in inventory to go do this without having the facts to back it up. But it's a real opportunity for us to really drive a new assortment throughout our whole supply side.

And on our last call, I alluded to one example and share that with you. We brought in human, right, T-shirts and coffee mugs and sweatshirts and because the pet parent loves to show off who their pet is and snarky things for pets and bring that to life. So that's just one example of many to come.

That's great. We are asking 5 questions of every company who meets with us on stage. A lot we've touched on already. But this is more -- less about Petco, more just about your expectation for the consumer and the health of the consumer. Just what do you think the consumer will look like or what the environment will look like in the second half versus what you've seen in the first half?

I obviously have to look at it a little bit through the lens of Petco. But I think of the broader lens, they've been surprisingly Uber resilient, right? And I think about in our lens, Sabrina alluded to getting rid of double stacking. And so you would think despite pulling back on some of that, you look at our second quarter results on sales versus first quarter on a 2-year stack, we actually had 100 basis point sequential improvement. And so that, to me, big picture allude to the consumers remain resilient as we've tightened. Look, we all know tariffs are coming. In the pet space, it's not near as meaningful as it is in some of the other categories, but there will be a halo impact on it. So I think we're cautiously optimistic.

Look, I've been in the fourth quarter world. I mean, Five Below was very much fourth quarter and my Toys "R" Us days, the consumer is not going to pull back in the fourth quarter. I think that's a given. They'll buy for holiday. I'm a little concerned about the amount of consumer debt rising. And so I think that will be interesting to watch as we get into '26. But I think the back half of the year looks like it will maintain the consistency we've seen.

Okay. Our second question is on pricing. And you just mentioned tariffs really isn't necessarily anything huge in the pet space necessarily. But to the extent that maybe you've had to raise prices here and there because of tariffs or whatever else, have you seen an elasticity response as a result?

Yes. And Sabrina, feel free to jump in here, too. Like for us, pricing is a little different because we started looking at our pricing last year long before we knew tariffs were coming. And so we've taken price up. And in some cases, we've taken price down. But it was more about us fixing our model than it was being driven by tariff. I think of promo stacking as a pricing mechanism that we had to pull against. And so we don't have a huge tariff headwind coming. But at the same time, we know we have to be competitive, and we watch it every day. Sabrina's team has done a great job putting more guardrails around that, and maybe you want to talk about.

No, I think that's right. We've been using all of our AUR levers, including pricing since the beginning of 2025, and we monitor it closely. So again, in our sector, we're not faced with the same headwinds as some other sectors. And yet there's a meaningful change in the tariff. So we're aware of that. But we'll be monitoring the competition mostly. We want to stay competitive, again, customer-first lens. We'll also be watching any unit changes. But most of our changes have been in play, both up and down for the first half already. So we feel like we're managing through it fine.

Okay. Our third question is on inventory. Can you discuss your expectation for inventory growth into the second half?

Yes. This is an area that, I've been quite pleased that how quickly the teams rallied and responded very responsibly. It's one of the silver linings of tariffs, honestly, because we really quickly started to look at SKU rationalization. It first started with, do we really need to import all this, on the private label side. But it forced us then to really get a head start on we have a lot of inventory that's not as productive as we want it to be, and we should really start rationalizing this.

And so the team did a fantastic job. We delivered at the end of the first half year inventory down 9.5% on sales down 2%. So it's a great spread negative. We always want to keep a relationship to that. We expect to keep a healthy relationship with inventory below sales in the second half. And I think that's one of your best protections in a potentially volatile macro is being really, really well managed on inventory. So it's a strength for us.

Our fourth question is on non-tariff-related margin drivers. So freight, wages and materials, how do you think that will look into '26, better, same or worse?

Yes. I mean here, too, this is where when I mentioned how we brought in a professional procurement team, and they went to work on looking at all of these different areas of non-merch. One of the areas that we focus on most because of the dollars are big, are freight and supply chain. So we went and did really major RFPs with a lot of our providers. We feel like we're in a really good position with medium-term contracts that keep our pricing very well controlled. It's one of the things that has helped us leverage so much as well in 2025, and that will continue into 2026. So all of the -- and that's just part of the margin profile. Of course, we're going to continue to use all of the other levers as well. But we feel very well positioned and confident in where we stand there.

Great. And then our fifth question is about the competitive landscape and consolidation. Do you think market share consolidation will speed up, slow down or be the same in 2026?

Yes. Look, I think I look at it over a longer lens. And if you go back to pre-COVID, there was a consistent consolidation that kind of disappeared during COVID time. And we've seen that return in '23 and '24. So I wouldn't say it's an acceleration. I think it's more of what we've seen recently and more consistent with what we saw before COVID. And I think that's what's beautiful about retail if you got the stomach for it, right? You've got to keep reinventing yourself. You've got to have a point of differentiate and you got to stay relevant.

And it's one of the things I'm excited about Petco and why I came because I think the brand is still relevant. And Sabrina and I have been working along with the rest of the team to just fix some retail fundamentals, but relevancy is key, and those brands that got complacent during COVID because sales were just happening are probably the ones that are struggling the most. But it's not so much that it's an acceleration as much as if you look back further, this is kind of how retail works.

Yes. Well, thank you so much for joining us today. So it's great. Appreciate the time.

Thank you.

Good afternoon, and welcome to the Petco Second Quarter 2025 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Ms. Tina Romani, Head of Investor Relations and Treasurer. Please go ahead, ma'am.

Good afternoon, everyone, and thank you for joining Petco's Second Quarter 2025 Earnings Conference Call. In addition to the earnings release, there is a presentation available to download on our website at ir.petco.com. On the call with me today are Joel Anderson, Petco's Chief Executive Officer; and Sabrina Simmons, Petco's Chief Financial Officer. Before we begin, I'd like to remind everyone that on this call, we will make certain forward-looking statements, which are subject to a number of risks and uncertainties that could cause actual results to differ materially from such statements.

These risks and uncertainties include those set out in our earnings materials and SEC filings. In addition, on today's call, we will refer to certain non-GAAP financial measures. Reconciliations of these measures can be found in our earnings release, presentation and SEC filings. With that, let me turn it over to Joel.

Good afternoon, everyone, and thank you for joining us today. I'm incredibly proud to share the progress we are making in strengthening the foundation of our operating model and improving our retail fundamentals while positioning Petco for sustainable, profitable growth. We are continuing our transformation journey and pleased we have the confidence to raise our earnings outlook.

In addition to the progress we are making on our transformation, this month marks the 60th birthday of Petco, celebrating our rich heritage. In our 6-decade history, Petco has been where the pets go for consumables, for grooming, for vet services, for pharmacy and more. I'm honored to be leading Petco along a talented team as we embark on the next 60 years. As I complete my first year on the ground at Petco, it is gratifying to watch Petco regain confidence and relevancy in the pet sector.

I will spend a few minutes later in my prepared remarks outlining what this means and where I'm seeing progress. Looking to our financial performance in Q2, sales were in line with our outlook, and we meaningfully improved our profitability, increasing operating income by over $40 million and generating more than $50 million in free cash flow. For the quarter, we delivered $114 million in adjusted EBITDA. This is a true testament to the hard work all the teams at Petco have leaned into.

As we enter the back half, we continue to execute on Phase 2 of our transformation and expect to make improvements to our bottom line and overall performance versus last year. It is with this confidence in our ability to deliver improvements that we are able to raise our guidance and at the same time, begin thoughtful reinvestment behind the business as we set the stage for Phase 3 of our journey, returning to profitable sales growth.

As part of this work, our leadership team has been engaged in a North Star project to reimagine every key element of Petco. We've uncovered so many positive aspects about our heritage and identified the details of what our customers expect us to improve and have honed in on Petco's differentiated positioning in the marketplace.

From a marketing perspective, it quickly became obvious we needed to bring back a more emotional element to how we go to market and connect with pet parents. Our research has told us that we have an amazing heritage that resonates with our customers still today. As part of our 60th celebration, we reintroduced our beloved "Where the Pets Go" tagline, returning to the heart and soul of our brand with a fresh approach designed to increase relevancy. The campaign started in July and fully launched in August.

Initial results indicate it is resonating with strong feedback and positive reactions from our customers. As part of the campaign relaunch, we reintroduced unique in-store events and experiences for all members of pet families. In July, we hosted several experiences like Free Pet Food Tasting, and Meet the Critters where families had the opportunities to meet our companion animals while learning from our knowledgeable and friendly pet experts. And personally, one of my favorites, an honor of Shark Week, we hosted a Feed the Sharks event, allowing families to get up close and personal with our freshwater fish. Petco truly is where the pets go in real life.

The key for us to successfully move to Phase 3, a return to growth is to bring this to life through compelling marketing, improved merchandising, engaging creative and stronger store execution, giving customers a reason to step away from their screens and shop with their pets. While certainly acknowledging we are still in the early days, I'm pleased to share that we have seen positive customer sentiment and engagement around these events on our social channels and sequential increases in our NPS score since the end of last year.

Survey respondents highlighted partner friendliness and helpfulness with an average satisfaction rating above 90%, which speaks to our ability to deliver experiences that pets and their people aren't getting anywhere else. In addition, several of our store managers reported people waiting outside our doors before we open for in-store events. This is simply evidence the marketing message is breaking through the clutter and our pet parents want to engage and have in-store experiences with our store partners.

Now as I look to Q3, I mentioned earlier that we are going to begin to test our way into Phase 3 and invest back into the business. An important step towards cementing our brand for the future is to invest internally. And next month, I'm looking forward to bringing leaders across the organization together for our leadership summit. This is an opportunity for our support center and store leaders to come together to not only celebrate our 60th anniversary, but to launch our updated values and most importantly, align on what a reimagined Petco means for our customers and our plans to execute on that vision.

Throughout my career, I found that company culture is the baseline for success. Since joining Petco, I've been incredibly proud of the culture that exists today centered around pets first. We are harvesting that cultural heritage with an equal focus on operating disciplines and a winning mindset. It has been rewarding to watch the collective commitment and energy grow as we instill a One Petco Way attitude across the entire organization and set the foundation for the next stage of our journey.

Alongside culture, driving operational improvements remains in focus, and that was a success story in Q2. During the quarter, we continue to take steps towards strengthening our retail fundamentals. For example, our operations, merchandising and supply chain teams worked together to simplify and optimize our processes that drive inventory accuracy, 4-wall in-stock and ultimately, improve on-shelf in-stock of our entire assortment. These efforts were a contributor to our improved Q2 EBITDA performance.

Additionally, we continue to see improvements in both inventory per store and sales per square foot. In addition to operations, merchandising excellence remains at the forefront of our work. You've heard me talk about allocating more space to our higher productivity SKUs, adding capacity on shelf and improving endcap displays, all of which just launched over the last few months and are contributing to improved store performance.

We're also focused on bringing in product newness. For example, we launched our very first product category aimed at humans online and in-stores selectively in response to a customer survey where 90% of our pet parents shared that they are interested in buying pet theme products. Priced under $20, products are designed to be giftable, affordable and impulse worthy, celebrating the bond between pets and the people who love them. This is just one example of the merchandise overhaul we are making to reinvent Petco's overall product offering.

Over time, you will begin to see newness throughout our entire assortment that will differentiate us from others and surprise our customers with unexpected ideas for their pets.

Moving on to marketing. Last quarter, I spoke to you about the relaunch of our loyalty program, which is a great example of the work that is ongoing to implement a more sophisticated approach to customer segmentation. The new program will feature personalized rewards with a retention focus designed to strengthen long-term relationships throughout the pet life cycle. More to come in 2026, but I'm pleased with the strategic customer insights our teams are utilizing to guide the development of the program and the enhanced customer experience it will ultimately deliver.

As we've talked, we do not expect progress to be linear, and it's also important to note that some of the early top line progress is masked by areas where we still have opportunity for improvement or the need to further sunset prior behaviors and implement new Petco-defined go-forward operating principles. For example, in-store services growth is stronger than the total reported figure as we temporarily deprioritize our paid loyalty program ahead of the relaunch in 2026.

Similarly, consumables performance in stores is stronger than the total reported figure as underlying improvements in stores is offset by the softness in e-comm as we retool that channel. And finally, as we look to Q3, it's important to remember we are lapping our toughest compare from a comparable sales perspective. Most importantly, we believe our stores, together with our comprehensive services offering, are Petco's differentiator in the market long term, and this is where our initial transformation efforts have been concentrated and our success has been seen.

That said, while we have intentionally concentrated our Phase 2 efforts on improving our physical store fleet, given they represent the vast majority of our sales, we have a tremendous opportunity to continue to enhance our omnichannel customer experience. We recently welcomed a new leader for our e-commerce channel, and he has already identified several opportunities. I look forward to spending more time personally with the digital team to eliminate barriers and drive improvements with the goal of delivering a seamless omni experience that our customers are excited about.

And we can then increase our marketing efforts to invite new customers back to petco.com. Before I wrap up my thoughts and turn to Sabrina to share our financial details, I want to specifically comment on Phase 3 growth. While our strategy thus far has been intentional to give up certain sales, these decisions are making us more profitable, which allows us to begin to invest back into the business. The speed at which everyone worked to get us to this point is gratifying and the work I'm seeing internally for the future is promising.

Growing sustainable sales the right way takes time. And it also takes a company that has discipline, a positive attitude, a winning can-do mindset and a commitment to merchandise differentiation. I would share examples of each with you today. We have begun to order new merchandise and are working now to sell through our existing inventory. I'm confident you'll be excited about what is coming. And please know that while our merchandise overhaul is happening, all the wheels are in motion with our marketing, operations, services and digital teams to move ahead with speed and rigor.

While this is in motion, we expect the bottom line improvements to continue and further provide the necessary strengths to return Petco to growth. In closing, I'm incredibly proud of the work the teams have accomplished in my first year at Petco, while acknowledging at the same time, more work is ahead. I'm looking forward to our national meeting next month and engaging directly with our store general managers, vet leadership teams and leaders throughout our support centers. We are bringing everyone together to make sure the message is consistent, the focus is sharp and the urgency is universal.

We must be known as a company that celebrates amazing pet experiences, creates great strategies and delivers on our promises, both internally as well as externally. We'll accept nothing less. The initiatives planned for the back half will continue to move our transformation forward, and I look forward to sharing updates as we progress. With that, I'll hand the call over to Sabrina to take you through the specifics of our strong second quarter results and share the details of what we plan to accomplish over the balance of 2025. Sabrina?

Thank you, Joel. Good afternoon, everyone. I'm pleased to share our continued progress on strengthening our economic model. As we've discussed with you previously and in line with our goals laid out at the start of the year, we are executing with intention to build a strong foundation from which to grow. This means expanding our gross margins and leveraging SG&A, resulting in improved profit, cash flow and overall returns. Our teams are moving with urgency as we execute against this phase of our transformation, and our second quarter results reflect our continued progress.

In line with our outlook, net sales were down 2.3% with comparable sales down 1.4%. As a reminder, the difference between comp sales and net sales is driven by the 25 net store closures in 2024 and the additional 10 net closures year-to-date, bringing our U.S. store count at the end of the second quarter to 1,388. It's worth noting on a 2-year basis, comparable sales improved 130 basis points from Q1 to Q2, driven by improvement in our store performance.

Our top line results primarily reflect the decisions we are making to move away from unprofitable sales, shifting instead to disciplined promotional strategy, better retail execution and enhanced customer experience. This work resulted in gross margin expansion of more than 120 basis points versus last year to 39.3%, with gross margin in both products and services expanding once again this quarter.

Similar to Q1, gross margin expansion was driven by a more disciplined approach to both average unit cost and average unit retail, including stronger guardrails and the deployment of more disciplined processes to effectively manage our pricing and promotional strategies. It's also worth noting that there was minimal tariff impact in the second quarter.

Moving to SG&A. For the quarter, SG&A decreased $36 million below last year and leveraged more than 150 basis points. As we've discussed previously, our management of expenses is not simply a onetime cost-cutting exercise, but rather a fundamental shift in mindset around how we operate, and that new rigor is evident in our results. A little over 1/4 of the $36 million improvement year-over-year came from employee benefits optimization work.

Over the last several months, we conducted a comprehensive review that resulted in meaningfully improved actuarial results. We recognize the benefit of all this work as we trued up our reserves to the semiannual actuarial report in the second quarter. More efficient store labor and operations expense, along with expense management across the board drove the remainder of the improvement. Though notably, marketing expenses were about flat on a year-over-year basis in the quarter.

While there's more work ahead, we're pleased with the progress we've made to adopt a more disciplined mindset. Our expanded gross margin and expense leverage resulted in a $41 million increase year-over-year in operating profit to $43 million. Adjusted EBITDA increased $30 million to $114 million and expanded nearly 220 basis points to 7.6% as a percent of sales.

Moving to the balance sheet and cash flow. Inventory continues to be well managed with ending inventory 9.5% below last year, all while achieving higher in-stocks for our customers. Free cash flow for the quarter was over $50 million and year-to-date was about $10 million. Both the quarter and year-to-date were well above the prior year. We ended the quarter with a cash balance of $190 million and total liquidity of $684 million, including the availability on our undrawn revolver.

And now turning to our outlook for the full year. We are raising our adjusted EBITDA outlook for 2025. We now expect adjusted EBITDA to be between $385 million and $395 million, an increase of roughly 16% at the midpoint. For the full year, we continue to expect overall net sales to be down low single digits to last year, which includes the impacts of store closures in 2024 and 2025.

It's important to note that the impacts of tariffs will become sequentially more meaningful as we move through the back half. Additionally, the significant progress we've made during the first half against strengthening our economic model and improving our earnings profile provides us the flexibility to selectively invest behind the business where it makes sense as part of our ongoing efforts to set the stage for Phase 3, a return to profitable sales growth.

For the third quarter specifically, it's important to keep in mind that over the last 5 years, adjusted EBITDA in the third quarter has been sequentially lower than the second quarter. In line with that historical seasonality, we expect adjusted EBITDA to be between $92 million and $94 million, up nearly 15% year-over-year at the midpoint. We expect net sales to be down low single digits versus the prior year. And as an important reminder, we are lapping the toughest sales compare of the year in the third quarter.

With regards to other guidance items, for the full year, we expect depreciation to be about $200 million, net interest expense of approximately $130 million, about 25 net store closures and approximately $125 million to $130 million of capital expenditures with a greater focus on ROIC. In closing, Joel spoke about the energy inside the organization. And I wanted to also take a moment to thank all of our teams for the incredible work accomplished to date, the output of which is clearly evident in our strengthening bottom line results. With that, we welcome your questions.

[Operator Instructions] And the first question will come from Michael Lasser with UBS.

So it sounds like you're moving closer to Phase 3. Joel, when is a reasonable expectation for us to hold the firm accountable for generating a positive comp? Is that by the fourth quarter of this year? Or is that more likely a 2026 outcome?

Thanks, Michael. As -- I think both of us mentioned, Tina went into detail -- sorry, Sabrina went into detail, third quarter is our hardest compare of the year. And so like I outlined earlier, we are smack in the middle of Phase 2, Michael. And while we are beginning to seed ideas and test and learn, as we like to call it for Phase 3, the results will begin to show up in 2026 as it relates to a positive comp, but we will start to work on ideas right now, Michael.

And my follow-up question is, it sounds like the gross margin gains came in part from eliminating some promotional and unproductive activities. Were those mostly online? And is that what drove the weakness in the online segment? And if you were to take away the online channel, would Petco have generated a positive comp in the stores business?

Yes. Michael, I don't want to get into specific segments. But as you can tell from my remarks, we've really been focused on the stores. It is where the majority of our sales are. And so therefore, it was intentional that that's where we start. We see it as the biggest opportunity long-term for us, and we wanted to get that underway. So not only are we pleased in the results the stores are making, but the traction we're getting in e-comm is working as well, but that's been more focused on the bottom line.

And just to add a little bit to that, Michael, I would say everything Joel said about the stores ditto, online last year did have much more promo and stacking that we needed to clean up. So we have -- if you think about -- if you want to think about it between stores and e-comm, there was more cleanup to be done on the e-comm side to be helpful.

The next question will come from Steven Zaccone with Citi.

I want to follow up on Michael's question on gross margin. So could you just dig a little bit more detail there, how that performed relative to your own expectation because it looks like a big beat. And then it sounds like there's some timing aspect with tariffs. So can you just elaborate on that a little bit more, how we should think about gross margin rate in the back half of the year?

Yes. So we have been super focused from our first call together, we've talked about the economic model and how one of the most important tenets of that is expanding our gross margin on a year-over-year basis for the full year to get our business healthy so that when we do regrow sales, it has a nice flow-through on healthy margins. So we've been working every lever AUR, AUC within those, every lever, promo, pricing, clearance, markdown to deliver on that gross margin expansion, and we're really pleased how it came through on both merchandise and services in the second quarter.

When you look forward, though, Steve, for sure, tariffs start to impact. So we had almost no tariff impact in Q2. There was some, but it's like, let's call it, rounding. As we go to Q3, it becomes meaningful, and then it becomes even much more meaningful in the fourth quarter.

I guess the follow-up then on that is just how do we think about mitigation efforts? And maybe as it relates to top line specifically, how did pricing perform in the second quarter? And what's your view on pricing as we get into the back half of the year?

Well, we've been doing pricing all year long. So maybe different than a lot of retailers who perhaps are reacting to the second half tariffs. We have been using this vehicle as we came together as a new leadership team from the get-go. So really, there's less of a change in the second half, but will we be using that lever? Of course, we will, but it will be with a consumer-first lens. We are very focused on delivering on a value proposition to our customer. So no change there, but yes, it will continue to be used.

The next question will come from Steve Forbes with Guggenheim.

This is Jake Nivasch on for Steve. So 2 questions for me here. One, I think you guys mentioned last time that you were working on some planogram resets, and I wanted to circle back to see if you could provide some updates on the work there. And then I have a follow-up.

Yes. I think we were specifically talking about our dog and cat reset back then. And so think about my prepared remarks where I talked about on-shelf availability, better in-stocks, making it easier for our store associates to fill the shelves, which therefore makes them more productive, which makes our stores more profitable. So it was very successful. We've completed those resets. You'll continue to see more of those as we move through this year and into next year in other categories. But it's just a great example of the diligence the teams are making to improve the profitability in the stores, improve on-shelf in-stock for our customers and make our stores more customer-friendly.

Yes. Just to tag on to that, as you heard me say, part of our SG&A savings was store labor and operations. And that is exactly what Joel is talking about that we got a lot of operational benefits that are flowing through in our expense savings.

You had a follow-up, Steve?

Yes. Perfect. Yes. Just a follow-up...

Jake...

And I know -- yes, but, you touched on this a little bit, but curious if you guys can share some more detail around the North Star initiative that you guys have been working on. And maybe it's too early, but I'm curious if you have any updates there.

Yes. I think we'll certainly give you a more detailed outlook on that as we get into the specifics of Phase 3 and growth. But I can tell you, as we think about Phase 3, there are really 4 main pillars to it. It's all about delivering amazing store experience. Our partners are pet first, and that's what sets us apart. It's delivering services at scale. Services aren't easy. And in many ways, I think of that as our moat, and that clearly showed up in our North Star work of how important our services were. The ecosystem of interacting between grooming, hospital and center of store is something Petco only can do.

Third pillar, merchandising differentiation. I've alluded to that. I gave you several examples in my prepared remarks, but you're going to see more newness out of us, more surprise and delight. We have to be relevant, no more of set it and forget it, seasonal categories, pricing, that all comes into the merchandise differentiation. And then finally, number four is over time, winning with omnichannel. So those are kind of some of the pillars that are coming out of our North Star work that's going to drive our growth down the road.

The next question will come from Kaumil Gajrawala with Jefferies.

I guess, a couple of things. The first is just where we sort of are in the process of the e-commerce sort of pullback and eventual retool. Is that sort of complete? And exactly the same question, I guess, on the inventory side, inventories came down nicely. And so are inventories where you sort of intend them to be now? Or is there still more work to do? But really, like are those 2 projects kind of mission complete and time to move on or still more to get done?

Yes, Kaumil, let me take e-comm and then Sabrina, if you want to chime in on inventories. Look, as I said earlier, it was our intentional focus to start on the stores first. In a unique way by us reducing sales in e-comm, our e-comm channel is actually more profitable today. But the work we've been doing is just getting started and is ongoing. We hired a new leader, he's already making a big impact. We're reducing friction.

And quite honestly, we're just improving basic retail one-on-one operating principles like speed, page load time, appointment scheduling enhancements, improving repeat delivery. Our loyalty program will come in '26. We think we've got plenty of media buying optimization to do and really improve our targeting and personalization. So those are just several examples, but I would say we're in the phase on e-comm of identifying and now we'll focus on implementing. And then, Sabrina, on inventory.

Yes. With regard to inventory, I mean, yes, we're so proud of the work the teams have done even in the face of tariffs to get the inventory dollars down so far. So we're big on continuous improvement. I believe there's always opportunity, but we don't want to push it too far. We pulled off, as I said, down 9.5% with improving in-stocks at the same time. So our goal is to always have a tight relationship between sales and inventory and inventory below sales to me is always a great thing as long as it's not hurting the customers, and that's what we'll be focused on continuing to deliver.

Got it. And if I could ask about your commentary on the increasing NPS scores. Sort of postmortem, what's behind that? Is it just the marketing? Is it what's happening in store? It just feels given the way you've laid out the phases that it's something that you'd expect when you're much further along Phase 3 than at this stage. So just curious if there's anything behind that.

Well, nothing specific. It's a whole host of a lot of improvements. Joe Venezia, who leads our stores organization of the new leadership team, has probably been here the longest. And he's made traction in many different areas. We've already had one leadership meeting with the leaders of the stores organization. We've got another one I talked about coming up next month with all our store general managers and above.

And those are just examples of us reinvesting back in our people and really putting effort into the store experience. And it's clearly beginning to resonate with our customers. It's showing up in the metrics I shared with you. And I really believe it's really important for Petco to have a great store experience. And so that's why we've really leaned in initially with our store partners.

The next question will come from Kendall Toscano with Bank of America.

First thing I wanted to ask was just on the comp, if you could comment on any of the transactions versus AUR trends that you saw during the quarter.

Sure. Overall, we're pleased with UPT and basket. Transactions is a place we are very focused on improving. So that's really the biggest opportunity for us. And you heard Joel talk about how we're starting these great efforts on events and making the store fun and doing much more marketing. So we're looking forward to improvement there, but that was the one that held us back in the quarter. Joel, do you want to...

No, I think that really covers it nicely. And as we get towards growth, the real focus will be on starting to invite customers back into Petco, and we shared with you some examples of that with the store experiences.

Okay. That's helpful. And then the other question was just -- so it sounds like there's been a lot of progress in key areas like inventory and in-stocks. And curious just where the biggest remaining execution gaps are that you're working to address before you'd be more confident to shift fully into Phase 3.

Well, I think as I alluded to in my prepared remarks that our back half begins to contemplate reinvesting back in the business. So I think it's less about the gaps, and it's more about how pleased we are with the progress we've made to date. And that progress gives us the confidence that we will continue to make progress. Sabrina talked about inventory. There's always opportunities there. But the teams made such progress that we're beginning to invest. So it's now the shift starts to be talking about those 4 pillars of growth that I alluded to on a couple of questions ago, that's where our focus is.

And just to elaborate on what Joel said, we just think there's such a nice runway here, even if you just think about margins alone. So we've been really focused, like we said, on AUC and AUR levers, including inventory management and pricing and promo and markdown and clearance. But what's kind of yet to come that we're in the early stages of is we think there's a lot of opportunity in sourcing, we think there's a lot of opportunity in expanding categories like pharmacy in regrowing over time, our supplies business. So we still have a lot of levers left in front of us, which makes us very excited.

The next question will come from Simeon Gutman with Morgan Stanley.

Can you talk about number of pet families? Can you talk about growing, declining? And then Joel, what are you learning about the families as far as the departments they're shopping, the services they're using for -- using you for? Anything that's surprising you from when you started?

Yes. Simeon, good question. I would say our industry data is showing that the pet space is relatively flat right now. And in fact, for us, as we've intentionally focused on the bottom line rather than the top line, we're really pleased with our performance as we're not giving up that much market share and at the same time, making significant improvement on the bottom line.

As far as the observations we've made from -- that I've seen, I've been surprised at how many onetime customers we have. And I think that's probably some areas where we were too bottom of the funnel focused on our e-commerce channel as opposed to being more focused on omni customers, lifetime value of customers. So those are some of the changes we'll make. And we also have a significant amount of customers that shop us for our services only, and we've got an opportunity really there to grow that share of wallet with our customer into some of our other categories, merchandise, improve our repeat delivery capabilities so they use us. So those are just a couple of examples, Simeon, of things we've observed through all our North Star work.

Okay. And then you mentioned like just toggling some inventory, bringing some new stuff in. Is there any -- and I'm sorry if this was asked, is there any inventory movement markdown risk associated with changing merchandise mix going forward?

Nothing significant, Simeon. I mean, obviously, when you change inventories, optimize inventory, you can tell, as Sabrina said, our inventory was nearly down double digits, and that didn't come with a huge inventory risk at all. So look, we got to be disciplined about it, Simeon, and go at it methodically, but I don't see any big inventory risk on the horizon.

And just to underscore that, the teams are really focused on improving the governance and processes around inventory and buys. And we absolutely need more newness for our customers, and we're excited to bring it in. But those buys will be tight and well controlled and seasonal and fast turning. So we intend to manage it with a lot of good process and governance.

And the last question for today will come from Justin Kleber with Baird.

So first off, Joel, you've been talking about cleaning up these empty calorie promos for a handful of quarters. I'm curious if you could help us size the drag to the comp from this activity. If we normalize for what you're doing, I mean, is the business comping up kind of excluding the cleanup of these promotions?

Well, I don't know that's a little probably too specific to get into. I think it's more important to look at it of where we're at with the progress. And both Sabrina and I commented that Q3 is the toughest compare. So what you can glean from that is we started in on this progress in Q4 of last year. We identified more in Q1 and so on. So as we continue to find opportunities where there were empty calorie sales, we are offsetting those with some of the growth initiatives that are starting to take place, but we still need to get through especially this Q3 and the beginning of the holiday season.

The only thing I would add to that is -- I was just going to add, Justin, what Joel already said in his remarks, which is -- what we see under the covers is improvement in our store performance, and that's really important to us because that's the vast majority of our sales. So just to reiterate, that was our first area of focus, and it's just great to see the improvement there. And e-comm is probably 6 months behind because new leader just started, and as Joel said, identification phase. So we will get there because we know all the levers we need to work, but we're very pleased with what's happened in our stores.

And then just a follow-up on the implied fourth quarter adjusted EBITDA guide. It looks like at the midpoint, if you'd be the midpoint of your third quarter guidance, you'd be down 2% year-over-year. So just trying to understand what is driving the decline? Is it more about the tariff headwinds building or more about your intentional investments back into the business as you set the stage for a return to growth?

Yes. I mean we gave ranges. So it kind of depends where you model it and end up. But what I will reiterate about the fourth quarter is definitely tariffs have the most meaningful negative impact in Q4. Secondly, we're excited because of our strong performance in the first half. We're excited that we get to keep some powder dry in the second half for areas of investment should we deem them worthy of investing. The only thing we have committed to, by the way, is the Leadership Summit that Joel talked about, but we want to keep that dry powder. And then finally, I think it's good to just protect against volatility because I don't think the macro is completely out of the woods. We live in times where there's big news cycles nearly every day. So we feel like we've taken a prudent approach to the back half.

This will conclude our question-and-answer session. I would like to turn the conference back over to Ms. Tina Romani for any closing remarks. Please go ahead.

Perfect. Thank you so much, Joel and Sabrina, and thank you, everyone, for your time and your questions. We're looking forward to seeing many of you next week. And with that, that concludes our call.

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

Good afternoon, and welcome to the Petco First Quarter 2025 Earnings Conference Call. [Operator Instructions] Please note that this event is being recorded.

I would now like to turn the conference over to Tina Romani, Head of Investor Relations and Treasury. Please go ahead.

Good afternoon, and thank you for joining Petco's First Quarter 2025 Earnings Conference Call. In addition to the earnings release, there is a presentation available to download on our website at ir.petco.com. On the call with me today are Joel Anderson, Petco's Chief Executive Officer; and Sabrina Simmons, Petco's Chief Financial Officer.

Before we begin, I'd like to remind everyone that on this call, we will make certain forward-looking statements, which are subject to a number of risks and uncertainties that could cause actual results to differ materially from such statements. These risks and uncertainties include those set out in our earnings materials and SEC filings.

In addition, on today's call, we will refer to certain non-GAAP financial measures. Reconciliations of these measures can be found in our earnings release, presentation and SEC filings.

With that, I'll turn it over to Joel.

Good afternoon, everyone, and thank you for joining us today. As I discussed with you at the start of the year, we have a unique to reinvent our iconic brand for the future, and position the business to regain share in the large, highly fragmented and resilient pet market. We are taking a multi-phased approach to this work through improving our operating model, giving our stores a voice and restoring retail fundamentals. Our first quarter performance reflects these ongoing efforts as we delivered top line results in line with expectations, but most importantly, over delivered on our profitability goals. This is a great testament to how our teams across the organization are coalescing around our overarching goal of delivering profitable sales growth, while operating with this. I'm proud of our team's passion, agility and execution and delivering on our commitments.

During the quarter, I had the opportunity to spend time with our district managers and our service leaders at our field leadership team meeting, where we bought our stores and service leaders together for the first time ever. I saw firsthand the enter that was created by connecting as One Petco team and was motivated by the work underway to simplify our operations, strengthen our retail and services foundation and get back to our roots. Our first quarter results bolster my confidence that we have the right strategy in place and a reenergized team that shares a collective commitment to unlocking Petco's full potential.

With Phase 1 complete, and a highly experienced leadership team in place, our full attention has quickly turned to Phase 2. This phase is all about implementing and executing the multiple work streams we identified in Phase 1 to improve our overall retail fundamentals and financial performance. Said another way, we are putting our work into action and seeing our customers respond and react in real time. The examples I will share with you today all represent foundational building blocks that will support us when we transition to Phase 3, focused on growth.

Before getting into the progress against Phase 2, I'd like to spend some time on sourcing and the progress we've made to preserve maximum flexibility in the face of tariff uncertainties. Our cross-functional teams across merchandising, assortment planning, supply chain, finance and operations have mobilized together to identify various contingency plans and mitigation strategies. We are leaning into our long-standing scale vendor relationship, and we truly appreciate their partnership as we mitigate ongoing fluid dynamics and uncertainty.

The current environment has served as a catalyst to accelerate work that was already underway as we strengthen our operating fundamentals. We are working towards building best-in-class product cost management, pricing capabilities and centralized operating principles to our product import process, just to name a few. I'm proud of the work the teams have accomplished to date, pleased to see them harnessing the energy that comes from seeing their work positively impact our results. Our ability to reiterate our full year outlook despite absorbing the impact of tariffs currently in place illustrates the meaningful progress we've made.

Now turning back to Phase 2 is all about implementing and executing. Merchandise excellence is at the forefront of this work. As I discussed last quarter, we are optimizing our product assortment to more closely align with consumer demand, we are allocating more shelf space to higher productivity brands and SKUs. Let me give you a couple of examples, the teams executed on since our last call that you can already see in our stores.

First, we completed our cat category product reset at the end of May. Second, we kicked off our dog category reset this week. Both are being executed earlier in the year than we had done previously. What are many elements that go into a planogram reset, key focus for this year is centered around adding capacity for top-selling SKUs through both lower productivity SKU rationalization and increased shelf space. Let me give you one simple but powerful example.

As we complete the dog food reset, you will see our shelves move about 6 inches higher. While this may not seem material, it allows us to remove a lot of airspace throughout our dog consumable department and increases shelf capacity by more than 10%. This example demonstrates how detailed the teams are in fixing every part of our business. Increased capacity drives both operational improvements and customer experience enhancements. Operationally, we are reducing lost sales from on-shelf stock outs and improving labor productivity by eliminating constant or continuous replacement between truck replenishments.

From the customer perspective, we are improving ability with higher in-stock availability. When you put all this together, it reinforces Petco as a reliable destination for all our customers that care needs. Another example, you will begin to see in stores this quarter, with the continued rollout throughout the year is a more strategic approach to end-cap displays. Historically, our end-cap displays were more transactional agreements with our vendors without a customer lens. Today, we are implementing a more strategic sales-focused approach that is mutually beneficial to Petco, our vendor partners and, most importantly, our customers. We will leverage end-cap displays to highlight newness, spotlight innovation, feature seasonal offerings, and promote value. I encourage all our vendors to bring forth ideas of newness and innovation that can create a physical spotlight for our customers' needs to better serve their pets.

Next, services, the fastest-growing area of the pet category. In my view, our services offering is what fortifies our competitive moat. We have an established leadership position and a differentiated model of owned grooming and vet locations at scale. During Phase 1, we identified several opportunities for improved productivity and have already implemented several of them. For example, our Grooming software has been upgraded to allow more flexibility for online appointments. With over 40% of our appointments made online, it is important our pet parents constantly see multiple open time slots. They don't consider an alternative rooming solution.

On the vet side, we've made several software enhancements to our vet scheduling system to ensure we have better coverage. I believe our industry-leading services offering once optimized, will be a key driver of in-store customer traffic, customer retention and loyalty over time. Our aim is to provide a comprehensive ecosystem that embodies our mission to improve the lives of pets and pet parents.

Services remains our fastest-growing business and continues to deliver positive growth. Additionally, we are pleased with the productivity improvements seen in both hospitals and grooming operations support gross margin expansion in the quarter.

With respect to operational efficiencies, as you've heard me talk for several quarters now, we are instilling an owner's mindset when it comes to cost discipline. Though we've made some great progress in areas like marketing, store expenses and supply chain, we have more opportunity ahead and are leaving no stone unturned across the organization. In light of a more uncertain macro environment, this work is paramount. I'm impressed with how our teams have come together, working cross-functionally and in a more coordinated fashion with everyone driving towards the same objective. Specifically, the operations team led by Joe Venezia, our Chief Revenue Officer, is working on 3 areas of improvement: store simplification, retail excellence around leveraging the One Petco way and customer engagement. All 3 of these work streams were kicked off at the field leadership meeting I discussed earlier. Since joining last year, Joe has quickly assessed the opportunities and is unifying both the services and operations team to make quick and lasting optional efficiencies.

As we enter the second quarter and move into the back half, we remain focused positioning the business for a return to offense. But it is important to remind you that improving our retail fundamentals and delivering better financial performance is our first priority. We will continue driving productivity while beginning to seed and test revenue growth initiatives across product innovation, marketing and store experience.

Finally, let me conclude our Phase 2 progress from a customer lens. The Petco brand marks the sixth anniversary this year. This is an amazing milestone not many reach. With our rich heritage, we have an obligation to serve our customers a robust assortment of solutions-based and trend-right product with a compelling value proposition, and we see significant opportunity to continue to improve on this front. Let me give you some specific examples of customer-facing areas, you should expect to see change.

Number one, our stores over time increased newness and more fun product with the convenient weekly consumable items they count on always being in stock. Number two, our marketing message will be evolving to a more solutions-oriented framework, showcasing our comprehensive offerings. And number three, a new membership program is being designed to create a more personalized long-term loyalty experience with an expected launch in 2026.

In addition, our North Star work, which we expect to complete in the back half of 2025 has helped us better understand the customer segments we can own. We are in the midst of conducting both qualitative and quantitative analysis that will inform both our strategy and our customer engagement going forward. Results of this work will be foundational to informing our Phase 3, a return to growth. These examples demonstrate that while we are moving fast to improve productivity, and deliver better financial performance, we are equally now focused on identifying areas to grow and how to better communicate with our customers. We will be unified in our message to include both online and in-store and utilize a test-and-learn approach to ensure these changes truly resonate with our customers. We look forward to sharing more as this evolves on future calls this year.

So in summary, 2025 is a year of transformation for Petco. I'm incredibly pleased with the work accomplished to date, which you can see in our Q1 results. This is especially gratifying as it's all been done while we navigate today's evolving trade environment. Our leader team and our Board are aligned to the same goal of returning Petco to an industry-leading destination for pets and pet parents. I want to thank our nearly 30,000 Petco partners are leaning into our transformation while simulaeously delivering customers' service and experience they look to Petco for. Acknowledging there is work ahead, I'm confident in the detailed multiphased approach currently in place. I'm pleased with the -- and optimistic in Petco's ability to reach its full potential over time.

With that, I'd like to turn the call over to Sabrina, who will review the financials in more detail.

Thank you, Joel, and good afternoon, everyone. We entered the year with the #1 financial priority being to restore the health of our economic model through 3 key pillars, gross margin expansion, SG&A leverage and ROIC improvement. I'm very pleased we delivered against all 3 of these pillars in the first quarter. For the first quarter, comparable sales were down 1.3% with net sales down 2.3%. The difference between the comp and sales decline was driven by 25 net store closures in 2024 and the additional 5 closures we had in Q1, bringing our ending store count to 1,393.

We expanded gross margin rate by over 30 basis points versus last year to 38.2% with expansion across both our products and services business. As an organization, we're focused on improving all levers within margin, including a more robust approach to average unit cost and average unit retail management. We established stronger guardrails, implemented more robust reviews of our pricing gaps and deployed more data-driven processes to better manage markdowns and promotions. All of this work exemplifies our focus on executing the retail fundamentals well with greater attention to detail and higher levels of accountability with the goal of expanding our margins. It's through the same focus on disciplined execution that we delivered more than 180 basis points of expense leverage during the quarter.

Excluding last year's onetime disposition costs, we leveraged approximately 160 basis points. As we've spoken about previously, this work is not a onetime cost-cutting exercise, but rather a shift in mindset, resulting in greater efficiency, agility and increase productivity. Given the turbulent environment, we are especially proud of how our teams have mobilized quickly to accelerate several efficiency initiatives such as optimization of marketing spend, and implementation of operational improvements in our store labor model. We're pleased with the progress to date, and our teams continue to identify further savings opportunities as we adopt this more disciplined mindset in our day-to-day operations.

Operating profit was $16.4 million, an increase of $33 million or approximately $29 million when excluding disposition costs last year. Adjusted EBITDA increased $13.8 million to $89.4 million and expanded 105 basis points to 6% of sales. We're pleased that in the first quarter, we delivered on the framework we laid out at the start of the year to expand our gross margin rate and to leverage SG&A driving improvement in profitability.

Moving to the balance sheet and cash flow. We ended the quarter with a cash balance of $139 million, an improvement of $48 million versus last year. Inventory continues to be managed well with ending inventory 5% below last year. Free cash flow was negative $44 million, primarily driven by incentive payout during the quarter.

Now turning to our outlook. Let me start with an update on our tariff exposure. As a reminder, our most direct tariff exposure sits within our owned brands. On our fourth quarter call, we shared that our own brand inventory purchases from China, Canada and Mexico, were about 5% of our total merchandise cost of goods sold. When updating for the revised and expanded list of countries currently impacted, our exposure is -- higher at about 7%. Our indirect exposure sits primarily within our national brands. For many of these suppliers, we have long-standing relationships at scale and we are partnering together to navigate fluid dynamics and deploy mitigation excess.

With that, for the full year, we are reiterating our full year outlook for 2025. As a reminder, our outlook at the beginning of the year excluded any potential impact of tariffs. Assuming tariffs remain at today's current level and no [ hire ], we believe we can still deliver on the outlook we provided at the start of the year. For the full year, we continue to expect overall net sales to be down low single digits to last year, which includes the impact of 20 to 30 net store closures in 2025. We continue to expect adjusted EBITDA to be between $375 million and $390 million.

With regard to other guidance for the full year, we expect depreciation to be approximately $200 million, net interest expense of approximately $130 million and approximately $125 million to $130 million of capital expenditures with a greater focus on ROIC. For the second quarter specifically, we back net sales to be down low single digits versus the prior year and adjusted EBITDA to be between $92 million and $94 million, up approximately 11% year-over-year at the midpoint.

In closing, I want to thank our teams across the organization for moving with urgency as we execute against the phases of our transformation while also mobilizing quickly and taking action to prioritize profitability in light of a fast-changing operating environment. We are pleased with the progress we've made is demonstrated in our first quarter results and guidance for the remainder of the year.

With that, we welcome your questions.

[Operator Instructions] And your first question today will come from Michael Lasser with UBS.

This is Sachin Verma on for Michael Lasser. I'd like to start with what are you seeing in pet adoption trends? And how do these trends impact your full year outlook?

Yes. Thanks for the call. We're seeing -- it's pretty stable, not much change from the last call we had. And as far as the full year goes, and I said this last quarter 2025 is really a self-help story for Petco. So we're not relying on tailwinds from the category like pet adoption increase in order for us to deliver on the financial improvements that we talked about on this call and the last call. So we feel really good about the progress we've made. And I think Q1 is a great indicator of how strong the year is playing out.

My follow-up question is, as you're focused on improving your profitability and not focusing on onetime cost out, how are you ensuring guardrails to take permanent cost out while keeping the customer experience intact? In other words, what kind of ways are you looking to take permanent cost out while still maintaining your top line and adjusted EBITDA?

Yes, it's a good question, and maybe I'll turn it over to Sabrina for some specifics. But I can tell you, Sabrina has been here about 90 days now. And the discipline she's brought to the entire organization on cost controls has been a great focus for all of us. And -- Sabrina, maybe you want to talk about a couple of the findings you found and how we're not focused on onetime?

Yes. And I'll start at the highest level. I talked about last quarter and again this quarter, that we're really working on a change in mindset. That's the most important thing. Also, as I've articulated, our goal is not just about cost cutting. Our goal is to leverage SG&A. So we're very much setting the stage, building the strong foundation right now. This -- but as we grow sales, we can manage SG&A well and still deliver leverage that will help operating margin expansion. So it's not all about cutting and cutting. It's about managing it well to get high returns and help drive our business growth going forward.

And your next question today will come from Simeon Gutman with Morgan Stanley.

Joel, the top line journey, I realize Phase 3 is still a ways away to return to growth. As far as the pieces that you're putting in place now, can you go to the baseball analogy? Are you in the innings? Or you still haven't even started in terms of the repositioning and product assortment, anything front-end customer facing?

Yes. Look, Simeon, great question. I think to answer the baseball analogy, it depends on how you're looking at it. From your guys' perspective on the outside, I would say we haven't even started, you haven't seen it. But I'll tell you, inside we're already beginning to identify several levers of growth. We got to get better at to our customer. We're an omnichannel retailer. And I think that's a real opportunity. Our marketing being more solutions-oriented. We're starting to look at a lot of product innovation, which brings newness and The North Star project work is underway. And so all those put together are really starting to bubble up a lot of ideas on the organization. And just like in Phase 1 on the cost cutting, started with really looking at all the opportunities and Phase 2 has been about implementing and executing. We're doing the same on the side, Simeon. Right now we're gathering the ideas, looking at all of them. And then we're going to put them through a lens of both test and learn, backed up with data and analytics to ensure they really produce profitable growth for us. So the work is starting. You just won't see it yet until we get to the back half and into '26.

I don't know if I can do a follow-up, but I wanted to ask, when Sabrina was mentioning, I think price gaps looking at some things. I don't know if that was in reference to markdowns or actual price gaps that you have versus competitors today. So I wanted to ask what you learned? And are there any things you learned through this. It sounds like deep dive on the merchandising and product side, where there's some opportunities either to drive top line or actually take out costs?

Yes. Maybe I'll start with that since those were my words and explain and clarify what I meant. So we -- as you know, in 2023, started to shift and broaden our assortment to make sure we had enough value for our customers. So that was really important work strategically. The execution was a bit choppy. We're working through that now. So we're looking at our full assortment, how we're offering value to our customer at sort of every level of target. And unlike, I would say, importantly, unlike maybe some other retailers we were already in progress on using all our levers, including pricing as a tool for our margin expansion goals long before tariffs in the current macro situation. So that's sort of how we think about it. We're always balancing what the customer needs with driving the health of our own business. And certainly, none of this is a one-fits-all approach. We're doing work very surgically down to the SKU level and using a lot of good data and analytics now.

Your next question today will come from Steven Zaccone with Citi.

I was going to focus on margins. So Sabrina, could you just talk about gross margin a bit, how that performed versus your own expectations? And then in light of some of the new news in the guide, should we still expect gross margin to expand for the full year?

Yes. So I will start with the quarter. We're pleased with where we came out. We actually -- I think I said in my remarks last quarter that we would start modestly initially on this journey of expanding our margins. So pleased where they came out. AUC was a powerful lever this quarter. But of course, we're using every lever in the margin mix as we move forward. And it's very much still our goal to deliver gross margin expansion for the year. We feel, given our starting point, given all our work with all our levers including not just the AUC side, but of course, promo markdown clearance, assortment mix, pricing, that is a very, very important for us.

Okay. And then maybe a sales question to follow-up because it sounds like you did a bit of a planogram reset here in the month of May. As you think about that as an impact to sales could this be a bit of a helper in the near term or the Phase 3 to kind of return to growth is probably going to take a little bit longer?

Yes. No, look, I think the cat and dog reset that I spoke to on my prepared remarks was really more to show you the -- a specific example of how we're making progress. And the fact that we pulled that up into the year earlier is -- certainly will show up as we get into the back half of the year. Remember, every time you do these resets, they're very disruptive. So you don't see an improvement immediately. But early signs of the cat reset look very promising, and we got to get through the dog reset next week. But we wouldn't have brought these forward if we didn't think they wouldn't be a contributor getting back to growth in the back half of the year. But you shouldn't see it in Q2 as much as you'll see it in future quarters.

[Operator Instructions] And your next question today will be from Kaumil Gajrawala with Jefferies.

Can we maybe just talk a little bit about sort of services versus supplies and different sort of divisions, if you're seeing anything in today's consumer environment that's maybe suggesting that maybe they're fine, which is what we hear from some or that things are weaker and maybe they're delaying pet purchases or maybe they're backing off of discretionary? I'm just curious if as you look at the mix of your revenue, if it tells you anything about where the consumer is.

Yes. I mean, look, services has continued to lead our business. And I think it's leading for a couple of reasons. But most importantly, it's leading because, as I said, this is a self-help story here. And we saw significant opportunities for us to increase productivity. I gave you a couple of examples on in my prepared remarks, and I'll reiterate the grooming one. We've made several upgrades to the software so that our pet parents are always seeing openings in calendar. Almost 50% of our customers schedule a grooming appointment online. And if they don't see openings or they have to wait a week or 2. they're going to consider somebody else besides Petco. So that change has been very, very positive for us. Grooming is something that probably is more needs-based than, say, supplies. And so we continue to see our more needs-based categories driving our business. And I think that's a testament to how resilient the overall pet category is. And 2 out of the 3 of our pet categories are consumable in nature or needs based in nature. So that will continue to drive the business for us.

And your next question today will come from Kendall Toscano with Bank of America.

Curious, another kind of follow-up on the category growth. Just in net services, it looks like the growth slowed a little bit, just plus 1% year-over-year. Now curious within services, if there's any callouts in terms of businesses that are still seeing stronger growth versus maybe any that were a little bit softer in the quarter.

Do you want me to start on Yes. I would say, within services, we have our Vital Care membership business. And as Joel talked about, we're super excited about relaunching that. We're doing a lot of work in the back half, and we'll have the bigger relaunch in '26. We might have some soft relaunch in the back half. But because we have been deemphasizing that, while we work to relaunch it, that is within services and others. And that's actually been a bit of a drag. Our core service business without that is actually quite healthy.

Yes. And continues to get stronger as we make the changes that I just gave an example from the previous question.

Got it. Okay. That's helpful. And then another question on category sales, which is for consumables with that inflecting negatively during the quarter. Curious if that was in line with expectations and what kind of contributed to the softness there?

Yes. No, that was certainly in line with expectations. And part of the reason we pulled forward the reset is we can see changes that will have for us on having a bigger impact later in the year. But as we continue to clean up promotions that I'd like to call empty calorie, that is kind of self-induced, but we're really pleased with the margin profile and how we're continuing to get that business back on track.

And your next question today will come from Steve Forbes with Guggenheim.

This is Jake on for Steve. A quick question on, I guess, thinking through your wallet share opportunities here. So help us frame -- maybe help us frame up, I guess, what are your most loyal customer cohorts looking for here? It sounds like you guys have a lot of -- done a lot of work on and some exciting opportunities up ahead here. But maybe help us frame maybe in order of magnitude, what your loyal cohorts are looking for here?

Yes. Look, I think you'll hear more about that from us as we complete our North Star work. We're right in the middle right now of really understanding the customer segments that we believe we can not only win but grow. And so the stage we're in with our North Star work is really doing some qualitative and quantitative analysis of that. And with that, that will really inform everything we do as we focus on growth in the back half of the year. But it's too early here to give you some specifics on the segmentation piece of it.

And your next question today will come from Oliver Wintermantel with Evercore.

I had a question on your leverage ratio. In your deck, you said that you want to achieve below 2x. Can you give us a little bit more details on the timing and what do you expect the free cash flow to look like this year?

Yes. So that is a very important goal that will take some time, and the first step forward is the focus on profitability that we've articulated. So as we increase profit that will fairly bring the ratio back into a better position where we want it. The advantage of driving to this profitability goal is also that it improves free cash flow, obviously. So we're very focused on both, but the profitability is the most important piece of achieving our goals, both on bringing down the leverage ratio and expanding our cash flow over time.

Got it. And then on the comp, can you maybe talk a little bit about what the drivers were? Was it mostly transactions? Or was there some of just to level set us there.

Yes. The strongest driver in the comp this quarter was UPTs and the drag the offset was mostly in transactions. So that's where we'll be really focused as we evolve the marketing message that Joel was talking about and driving back into the store once we have this new setup, add new assortment, then roll out more exciting marketing. That's the big lever that we want to see improve its transactions.

And your final question today will come from Peter Benedict with Baird.

Curious, just your view on inflation and pricing, what the view is over the balance of this year, what's kind of baked in, whether it be on the commodity front, the food front or I know it was kind of a tariff exposure, but just on those items, what's the outlook in terms of pricing?

Look, you heard our forecast and that forecast includes us embedding the tariff impact. And I think the tariff side, it's relatively stable, and it's something we're watching consistently, but we haven't seen any strong spikes in inflation year-to-date. But we're certainly watching that piece and seeing where tariffs play out.

Yes. And just to reiterate a little bit what I said, Our approach and strategy around pricing started long before any of the choppiness and the noise in the macro. So we are always going to balance what is best for our customer with what is best for our business. And any action we take at pricing, whether after or at times down, is going to be surgical and focused on getting that for both our customers and our business.

Okay. That's helpful. And then maybe just a follow-up on -- I think may have asked about price gaps. You mentioned that earlier. I was a lot clear. Have you rightly identified price gas places where maybe you were off size? Or have you addressed those? Just curious maybe expand a little more on the price cap comment that you had earlier.

Yes. No, look, we -- I think Sabrina said it in her comments, we're now looking at the SKU level and not just at the category level. And so we've identified opportunities where we took price down. We've identity opportunities where we think there was an opportunity to take some price up. But as Sabrina said, reiterate this has been part of our holistic look at improving the retail fundamentals of the business more than it just being a tariff exercise. But we feel really good about the progress we've made on price and making sure we're able to still deliver value for our customers. It was a really good quarter for us. We feel really good on the long-term strategy. The progress we made with the leadership team with phased approach is really working. And I think the Q1 results are a great example of that.

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

Fantastic. Thank you, Joel and Sabrina, and thank you, everyone, for your time and your questions. As always, feel free to reach out to the IR team for any follow-ups. And that concludes today's call.

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