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 filing. 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 filing.
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 Petc 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 Petco has been where the pets go, for consumables, for grooming, for veterinary care, for pharmacy, and more. Petco along a talented team as we embark on the next 60 years.
As I complete my first 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 Petco have leaned into.
As we enter the back half, we continue to execute on phase II 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 III 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 of Petco we've uncovered so many positive aspects about our heritage and identified the details of what our customers expect us to improve 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 opportunity to meet our companion animals while learning from our knowledgeable and friendly pet experts. Personally, one of my favorites, in 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 III, 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 III 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 work together to simplify and optimize our processes that drive inventory accuracy, four-wall in-stock, and ultimately improve on-shelf in-stock of our entire assortment. These efforts were a contributor to our improved Q2 adjusted 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 end-cap 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 pet parents shared that they are interested in buying pet-themed 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 are offset by the softness in e-comm as we retool that channel. Finally, as we look to Q3, it's important to remember we are lapping our toughest comparer 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 II 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. We can then increase our marketing efforts to invite new customers back to Petco.com.
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 comparable 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 two-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 one-time 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 a quarter 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 recognized the benefit of all this work as we trued up our reserves to the semi-annual 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.
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 III, a return to profitable sales growth.
For the third quarter specifically, it's important to keep in mind that over the last five 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. 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-$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.