Seeking Alpha

Chewy: Good Business But Not Cheap Enough

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About: Chewy, Inc. (CHWY), Includes: AMZN
by: Long Hill Road Capital
Summary

Chewy is the online leader in the U.S. pet food and supplies business.

It has a nice tailwind in the growing pet category and increasing e-commerce penetration rates.

But about half of pet spending still occurs at grocery or mass merchant stores, which is a tough habit to break. Amazon is aggressively trying to capture new auto-ship customers.

It is difficult to estimate how big Chewy can be over time, but given my hurdle rates, I would need a lower price to make an investment.

Chewy (NYSE:CHWY) is the leader in the U.S. online pet and supplies business. Having started in 2011, it has grown like a weed and should generate close to $4.8 billion of revenue this year. That is an unbelievable amount of success in a very short time, and is even more impressive considering Amazon's (NASDAQ:AMZN) presence in the category.

Chewy is a richly-valued recent IPO in terms of current profitability levels. So far this year, it has negative $113 million in operating income.

Source: Chewy 2Q 2019 10-Q

It has also burned through about $53 million of cash (cash flow from operations minus capex) even after adding back $51 million of stock-based compensation expense since it's non-cash. Given SBC is a real expense, I'd look at "economic" free cash flow as closer to negative $105 million year-to-date.

Source: Chewy 2Q 2019 10-Q

As a result, for investors to earn an adequate return, they are banking on significant growth and margin expansion continuing for a very long time. As always, whether the business can exceed the fairly lofty expectations that are priced into the stock will determine whether CHWY is a good investment or not from here.

Chewy's Key Drivers of Value

Often times it is difficult to estimate how much a business might grow over the long term, but Chewy is fairly straightforward to model because it has three main variables that are going to drive its long-term revenue growth.

The first driver is the U.S. market for pet food and supplies. This is a $73 billion market last year, which has been growing around 4% per year. It is well-known that people love their pets and are increasingly spending more on them.

The second driver is the e-commerce penetration rate of this market. Last year, the online component of the pet food and supplies market was about 15%. It looks like that will grow to something around 17% this year. More importantly, management expects this to increase to about 25% by 2022.

Source: Chewy S-1

How high this goes over the longer term is difficult to estimate, but one major headwind is that almost half of people today buy their pet food and supplies in the food, drug, and mass channel (grocery stores, drug stores, and mass merchants like Walmart). This makes sense because people can easily buy a bag of dog food at the grocery store while they are there anyway doing their grocery shopping. It does not require a separate dedicated trip to the pet store. This pie chart breaks down the pet care market by channel.

Source: Chewy S-1

While the online component should take share from pet superstores and independents over time, I think it will have a harder time breaking into that 47% share in the food, drug and mass channel. Why? Despite the ability to shop for groceries online and have them delivered being around for decades, that has not taken off like other areas of e-commerce. According to Bain, just 3% of U.S. grocery shopping occurs online today. In-person grocery shopping is a habitual activity that is very hard to break. Consumers tend to like to inspect the produce they are buying, and see the various cuts of meat in person. In the past when I have used it, I have found it very time consuming actually picking out the products that I want on the site. You also don't get to impulse buy as much, which is either a good thing or a bad thing depending on who you are. For those reasons, I believe grocery shopping is likely to remain an in-person activity for the vast majority of consumers and a tough nut to crack for online pet retailers.

The third driver is Chewy's market share of the e-commerce slice of the market. Today, Chewy appears to have just over 50% of the market. Amazon appears to be right up there with Chewy at perhaps 45% or thereabouts. Importantly, Chewy appears to be growing faster than Amazon. However, I don't think one should assume Amazon is going to roll over and let Chewy dominate this category. As I shop on Amazon for dog food, I see a huge 40% discount for my first auto-ship dog food order.

Source: Amazon.com

That is a bigger discount than the 30% discount that Chewy offers, and Chewy is widely considered to be paying a lot of new customers. So Amazon is being extremely aggressive.

Source: Chewy.com

Whatever one might think of Amazon's approach to the pet category, it seems clear that it cares deeply about acquiring new auto-ship customers. The auto-ship pet food business is a fantastic business with high lifetime value because customers will continue feeding their dogs or cats as long as they are alive, and are unlikely to switch foods. That provides great visibility into future demand. It also allows the retailers to use the slowest and cheapest shipping options available because they know in advance when the customer will need the product.

It is also possible that Amazon could have a cost advantage over Chewy given Amazon's increasing use of its own last-mile delivery infrastructure and personnel. That cost advantage could allow it to underprice Chewy and recapture market share over time. I'm not necessarily predicting that but it is a risk.

So to estimate how big Chewy can be over the long-term, one can simply estimate how fast the overall pet market grows, how much e-commerce penetrates that market, and Chewy's share of the online market.

This is not my forecast, but if the U.S. pet food and supplies market grows 4% per year, online gets to 25% penetration as expected, and Chewy keeps its 50% share of online, Chewy would have core business revenues of about $6.8 billion in 2022. That is up from the consensus estimate of about $4.9 billion this year, which works out to an 11.4% annualized growth rate between 2019 and 2022.

Given Chewy's recent growth rate of about 43% last quarter and the consensus estimate of $7.3 billion in 2022, this would likely be an unwelcome surprise for investors. Clearly, the market is expecting more. And it may be right. I would own CHWY at some price, but given my high hurdle rates, it would need to be a lower price than $26 per share.

Disclosure: I am/we are long AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.