Chewy: Great Business Model, Worryingly Low Margins

Chewy’s (CHWY) goal is to be the most trusted and convenient online shop for pet owners across the globe.

The company considers itself the predominant online source for pet products, supplies, and prescriptions. Since Chewy’s IPO just over two years ago, the company has managed to grow its revenues sequentially every single quarter. With pet owners in constant need of a supply of food and pet care products, Chewy’s net revenues are incredibly stable and predictable. Specifically, approximately $1.56 billion out of Chewy’s $2.21 billion in revenues in its most recent Q3 results were characterized as Autoship Customer Sales.

This refers to the amount sourced from Chewy’s subscription service, which provides pet owners with timely and adjustable auto-reordering and deliveries, which results in increased cash flow visibility for Chewy.

For this reason, I think Chewy’s platform comprises a fantastic asset, which has been built on a priceless element – that of trust. I consider this to be a tremendous competitive advantage in what is clearly a very competitive industry. Customer retention is everything in the pet business, and Chewy has certainly succeeded in that regard.

Chewy ended Q3 with 20.4 million customers, a 14.7% year-over-year increase, while net sales per active customer also expanded by 15.4% to $419. I can see the latter growing for years to come, as pet owners are becoming increasingly more passionate in terms of providing their beloved companions with the best supplies.

The pet care market alone is expected to grow by a CAGR of 6% in the medium term, and with Chewy gaining a higher market share over retail sales, this figure is likely to be larger in Chewy’s reports.

Management’s Q4 guidance points towards revenue growth of 18% at the midpoint of their estimates. That implies a deceleration from Q3’s growth of 24.1%, but it’s still a solid figure, considering that the company’s sales were boosted by the pandemic.

That said, I am neutral on the stock due to the company’s razor-thin margins, which have yet to improve.

Valuation and Net Margins

The pet industry is brutally competitive, and margins typically hover at very thin levels, especially when it comes to resellers.

While the company has been scaling successfully, gross margins have yet to surpass 28%. In Q3, despite gross margin expanding by 90 bps year-over-year, they still stood at 26.4%. When we account for the company’s additional selling, administrative, and operating expenses, net margins are barely positive.

I forecast the company could probably see net margins in the range of 5% to 10% as its subscription base grows. However, I find it unlikely that Chewy will become vastly profitable, at least within the next decade, in any case.

To value the company based on its forward P/E is rather meaningless, due to the marginal positive EPS. However, even if we were to utilize analyst estimates, which predict rapid profitability growth in the medium-term, their estimates point towards fiscal year 2025 EPS of 0.78.

To put it differently, investors are currently paying 76 times for FY-2025’s potential net income, which doesn’t sound like a great deal, in my view.

Wall Street’s Take

Turning to Wall Street, Chewy has a Moderate Buy consensus rating, based on six Buys, five Holds, and one Sell assigned in the past three months. At $73.18, Chewy’s stock projections imply 22% upside potential.

Disclosure: At the time of publication, Nikolaos Sismanis did not have a position in any of the securities mentioned in this article.