Stock Analysis & Ideas

Chewy: Uncertainty Over Profitability Remains

Chewy (CHWY) has a clear mission: to be the world’s most trusted and convenient vendor for pet owners. The company believes it is the prominent online seller of pet products, supplies, and prescriptions due to its extensive catalog of high-quality products and services, which it markets at competitive prices.

Additionally, due to Chewy providing an exceptional level of care and unique touch to develop its brand, the company’s customers have historically been very loyal, resulting in recurring purchases.

Chewy has been very successful in growing its sales over the years. That said, the pet industry is brutally competitive. Combined with the company’s efforts to provide its products and services at competitive prices, Chewy’s profitability prospects have been rather underwhelming.

With investors likely losing faith in the company’s ability to deliver growing profits over the long run, Chewy shares have been on a persistent downward trend for more than a year now. In fact, since February of 2021, Chewy shares have lost more than two-thirds of their value.

In my view, there is a lot to like about Chewy, including top-tier customer loyalty. That said, there are multiple risks attached to its investment case. While the stock price’s continuous decline could cause investors to reconsider whether Chewy is worth allocating capital to, I would rather see evidence of growing margins first.

I am neutral on Chewy stock.

Recent Performance

Ever since Chewy’s IPO in the summer of 2019, the company has achieved consistent quarter-over-quarter revenue growth.

Pet owners are in regular need of a supply of food and pet care products. Thus, Chewy enjoys very stable and predictable cash flows. Specifically, about $1.68 billion out of Chewy’s $2.38 billion in revenues in its most recent Q4 results were denoted as Autoship Customer Sales. In fact, Autoship sales as a percentage of total grew from 68.4% in Fiscal 2020 to 70.2% last year, with cash flow visibility further improvement over time.

This directs to the amount coming in from Chewy’s subscription service, which supplies pet owners with timely and modifiable auto-reordering and deliveries. This provides Chewy with predictable, high-quality cash flows and enhanced customer lifetime value. In my view, this is what makes Chewy’s platform a tremendous asset, as the company has invested in an invaluable component – that of trust.

In what is one of the most competitive industries, it appears that this is a great catalyst for Chewy’s customer retention strength. It makes for a great advantage for Chewy, as customer retention is the key to success in the pet business, and the company has certainly executed firmly in that regard.

Chewy ended Fiscal Q4 with 20.6 million customers, a 7.6% year-over-year gain, while net sales per active customer also grew by 15.6% to $430/quarter.

In my view, average revenue per user should continue to develop for years to come, as pet “parents” are increasingly passionate about providing their dear companions with the finest supplies.

Profitability Headwinds

The pet care market alone is anticipated to expand by a CAGR of 7.4% through 2027, and with Chewy accumulating a wider market share over retail sales, ARPU should continue growing at a more rapid pace.

Management’s Q1 guidance points towards revenue growth of 13% at its midpoint. Management expects revenue growth of close to 16% for the year, implying an accelerating intra-year pace. Still, growth is going to decelerate dramatically from Fiscal 2021’s revenue growth of 24.4%.

Here’s where my issue with Chewy arises. The company suffers from razor-thin margins (investors’ main concern), and with growth potentially decelerating in the medium term, Chewy is unlikely to achieve meaningful economies of scale any time soon.

Fiscal Year 2021 gross margins landed at 26.7%, a 120 basis point improvement compared to the previous year. However, they are still quite underwhelming.

Adjusted EBITDA for the year (which excludes the effect of non-cash expenses and certain variable charges) came in at $78.6 million, 7.8% lower year-over-year, with adjusted EBITDA margins falling from 1.2% to 0.9% during this period.

In fact, management’s guidance for Fiscal 2022 targets an adjusted EBITDA margin of around 1%, implying virtually no improvements.

Wall Street’s Take

Turning to Wall Street, Chewy has a Moderate Buy consensus rating based on nine Buys, seven Holds, and one Sell assigned in the past three months. At $60.13, Chewy’s stock projections imply 33.1% upside potential.

Valuation & Conclusion

While Chewy stock’s prolonged sell-off may initially suggest that shares could be cheap, it is all relative to Chewy’s future margin expansion capabilities.

If adjusted EBITDA margins don’t meaningfully advance, it is entirely meaningless to speculate on a fair multiple for the stock.

With management expecting adjusted EBITDA margins at 1%, the stock is currently trading at an EV/forward EBITDA of 250x. Unless adjusted EBITDA margins develop towards anywhere between 5% and 10%, Chewy stock’s movement is likely to be entirely speculative.

I believe the company could be a decent acquisition target, as a bigger distributor (Nestle, even Amazon) could absorb expenses and achieve economies of scale much more efficiently. Still, this is entirely speculative as well.

Accordingly, while Chewy does feature some noteworthy qualities, substantial uncertainty surrounds its investment case.

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