Seeking Alpha

Chewy: Improving Fundamentals And A Large Total Addressable Market Already Priced In

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About: Chewy, Inc. (CHWY), Includes: AMZN, PETS, ZLPSF, ZOPLY
by: Trembling With Greed
Trembling With Greed
Growth, Deep Value, contrarian, value
Summary

Chewy is a well-run company with numerous industry leading metrics.

Chewy operates in a market with a large and growing TAM.

The market has priced in all these benefits.

My recommendation is to sell Chewy.

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Overview

Chewy, Inc. (CHWY) is a well-managed company and has industry-leading metrics; however, based upon my Discounted Cash Flow (DCF) model and making assumptions regarding the various economic drivers of this business, I see that the market has already "priced in" these industry leading metrics and, more importantly, the market has priced in continued improvements in Revenue / Customer, Gross margin (%) and EBITDA margin. Based upon my DCF model, Chewy is valued at $25 per share

Chewy sells pet food, supplies and prescriptions predominantly in the United States and operates in an industry with a Total Addressable Market (TAM) in excess of $48B and growing. Moreover, by my estimates, Chewy captured ~10% of the market for pet food, supplies and medication.

Chewy is a well-managed company and, compared to other publicly traded pet food e-tailers such as Zooplus (OTC:ZLPSF) and PetMed Express (PETS), Chewy has industry leading:

  • YTD YoY Revenue growth at 43%
  • Revenue / customer at $361
  • Cash Conversion Cycle at (45) days
  • Days of Inventory at 7 days
  • Net customer additions of 2.1k on a YTD basis

In addition to these attributes above, over 70% of Chewy's revenue is driven by Autoship where customers opt-in to choose to receive shipments of pet supplies on a subscription basis. Clearly, Chewy is doing something right and the market has taken notice and, rightfully so, as the stock is up 33% from its IPO price of $22 / share.

Based upon my DCF model and making assumptions regarding the various economic drivers of this business, I see that the market has already "priced in" these industry leading metrics and, also, is expecting improvements. Based upon my DCF model, Chewy is valued at $25 per share.

The model built assumes that Chewy's management team maintains current course and speed with its operations and the following factors were not considered when developing the model and will positively impact the model:

  • Increased penetration and growth of private-label products since private-label products carry Gross margins (%) 800 to 1000 bps higher than Chewy's core business
  • New revenue opportunities from the website such as partnering with other third parties providing other services for pets
  • Launch of a new geography

Risks to the financial model, include:

  • Chewy is unable to increase its Revenue / Customer over the long term;
  • Customer Acquisition Costs rise faster than modeled causing Chewy management to either:
    • Increase Marketing spend (lower profitability) to drive incremental customers higher; or
    • Sign up fewer customers each year
  • Further entry of Amazon (AMZN) in the sale of pet food and supplies to its customers.

Industry Overview

The business of selling pet food and supplies online is a competitive marketplace. Not only does one compete against "category killers" such as PetCo and Petsmart (both of which were taken private by private equity several years ago), but also competition against traditional bricks and mortar stores and, last but not least, online offerings by those listed above and, also, Amazon. In light of this competitive marketplace, the market for selling pet food and supplies is growing above GDP. According to the American Pet Products Association, this is a $75B industry and over the past 5 years, the CAGR is 5%. More importantly, the sale of pet food, supplies and medicines represents 64% of this industry in the United States and has achieved a 5 Year CAGR of 6%.

Drilling into this further, the business of selling pet food, supplies and medicines is a fragmented market wherein the top 5 providers captured ~38% of the industry. This information was disclosed in a WSJ article titled "PetSmart vs. Petco: A Dogfight That Neither One Is Winning."

With the top 5 in this space generate 38% market share, the split between online and offline revenue is interesting since online sales represent 47% of the $17.8B and, furthermore, Chewy and Amazon have 45% and 39% market share of online sales, respectively.

Additionally, over the past two years, market share for Chewy and Amazon shifted little as well. This can be seen in the market share chart below that is as of 1Q'16.

Source: PetfoodIndustry.com

Analysis of Pets.com

Prior to analyzing the operations of Chewy, any analysis of any company selling pet food and supplies online should begin with an analysis of Pets.com. Within a year from its formation - i.e., commencement of operations - Pets.com went public with what I consider to be a cool sock puppet as their mascot and the tagline "Because pets can't talk." With the money raised by going public, Pets.com began an advertising campaign to attract customers to purchase their pet supplies online. Within a year of going public, Pets.com ceased operations in the fourth quarter of 2000 and was in liquidation. As a result, is the selling of pet food and supplies over the Internet a bad business model?

Profitability Metrics

From a profitability perspective, Pets.com was selling its goods below its costs. However, throughout its operations Gross Margin (%) improved each quarter and, by 3Q'00, Gross Margin (%) was at -3% or close to breakeven. EBITDA, however, was much worse as the company had to market to customers to get them to go to their website. Ultimately, Pets.com lost money not only for selling their products below costs, but also the advertising expense consumed their cash flow. When a company is consuming cash to build their brand awareness and achieve scale, the company must have investors willing to fund those losses. In the case of Pets.com, investors were unwilling to fund these losses and, as a result, Pets.com ceased operation.

Customer Metrics

Looking at the table above, Pets.com paid ~$137 / customer to acquire their 443k customers in 2000; however, Pets.com only generated ~$30 in revenue per month from that customer. With a revenue payback period in excess of 5 months, Pets.com needed to generate positive contribution margin. From the profitability metrics, it appears that Pets.com was on the path to generate positive contribution margin; however, investors were unwilling to continue to fund the operation.

Pets.com Conclusion

Is the sale of pet food and supplies a bad business model? Probably not since one can see from the summary-level financial statements that Gross Margin (%) was improving as the company grew its revenue and added customers. However, Pets.com ceased operations since Pets.com went public when it was sub-scale or, in other words, Pets.com would require more capital from investors to become a functioning business model and/or a sustainable business and the market was unwilling to provide additional funding to sustain their operations.

Analysis of Chewy

Below I am providing a table I compiled using company reports, SEC filings with some of my estimates to compare Chewy to other competitors who sell pet food & supplies online. Additionally, one can also compare these companies to Pets.com.

First, let's provide a brief summary of the competition:

  • Zooplus is a European operator selling pet food and supplies online.
  • PetMed Express is an online pharmacy for pets and also sells pet food and supplies.

Analysis of Revenue

Looking at the table above, my first takeaway is that Chewy is almost 3X larger than its closest peer (exchange rate assumed: 1€ = $1.12USD).

When evaluating the operations of Chewy the four charts below are some of the most important aspects of their business model.

Source: Company reports & tremblingwithgreed estimates

Revenue, Autoship revenue, Customers and Revenue / Customer continue to grow and Chewy's revenue grew 40% YoY based upon its 3Q'19 report. Autoship revenue is, also, important and in 3Q'19, Autoship revenue reached $865M or 70% of Chewy's total revenue. Typically, when a customer enrolls in Autoship, the customer will receive a discount of 5% to 10% off of the product; however during the Barclays Global Technology, Media and Telecommunications Conference, Chewy Management disclosed:

[T]here is a 5% to 10% discount that we provide to customers while they're on the Autoship program. But the key to understand how that works is. [Autoship] is almost 100% funded by our vendors. (emphasis added)

Autoship is an important aspect to Chewy's revenue model as this reflects subscription-based (or recurring) revenue to the company and while Chewy offers discounts to entice a customer to enroll in Autoship, the discount is funded by the vendor. Thus, there is virtually no margin dilution to Chewy and both Chewy and its vendors receive a recurring revenue stream.

However, it is important to clarify what constitutes Autoship revenue. Chewy defines autoship revenue as

For a given fiscal quarter, Autoship customer sales consist of sales and shipping revenues from all Autoship subscription program purchases and purchases outside of the Autoship subscription program by Autoship customers. (emphasis added)

Source: SEC filings

In other words, when Chewy reports its Autoship revenue, Chewy is reporting on the revenue associated with customers who enroll in Autoship; however, not all this revenue is driven by Autoship.

Chewy does not publicly discloses its Customer Acquisition Costs (CAC); however, this information can be inferred by looking at their Advertising and marketing costs and dividing it by their change in customers. Since 2Q'17, CAC continues to grow each quarter. However, this event is not only limited to Chewy, but also its peers Zooplus and PetMed Express. During Zooplus' Capital Markets Day presentation on March 20th (Presentations / Webcasts), Zooplus discussed that they have been vulnerable on new customer acquisition and that online-only traffic acquisition and google traffic acquisition as hit some limits. While Chewy's CAC has increased from 2Q'17 by 32%, Zooplus' CAC has increased 63%. Assuming that Chewy is (or will face) the same trends as Zooplus, Chewy's customer growth and advertising spend should be monitored on an ongoing basis.

Source: Zooplus financials & tremblingwithgreed estimates

Analysis of Gross Margin (%)

Gross profit and Gross margin (%) continue to rise for Chewy and just to emphasize the scale of Chewy, Chewy generated more Gross profit in 3Q'19 than 1-800-PetMeds generated in revenue during 2018!

Source: Company reports & tremblingwithgreed estimates

However, Chewy's Gross margin (%) is the lowest when compared to its peers, but the difference is that while Chewy's Gross margins are increasing over time, it appears that its peers' Gross margins are, at best, remaining flat. When looking at PetMed Express gross margins, they are ~500 bps higher than Chewy's margins and given that Chewy announced that they are opening up online pharmacies in 2018, further expansion into this new business should help Chewy expand their Gross margins on an on-going basis.

Source: Company reports & tremblingwithgreed estimates

The other reason for Chewy's lower gross margins is their consumables business. According to Zooplus' management, Consumables carry a lower gross margin (%) from other products and while these products still constitute over 70% of Chewy's revenue and are still growing, the percent contribution of consumables has declined ~300bps from 1Q'18 to 3Q'19. Last, but not least, other revenue constitutes Chewy's higher margin products such as their private brands (which carry margins 800bps to 1000bps higher than Chewy's core business) and Chewy's pharmacy business. As Chewy enters these new businesses and continues to sell more of its private brands, the Gross margin (%) gap between Chewy and its peers should close and Chewy's margins should rise.

Source: Company reports & tremblingwithgreed estimates

Cash Conversion Cycle

Last, but not least, let's discuss the Cash Conversion Cycle (CCC) of these companies. The CCC is a framework which shows how quickly a company can convert its revenue to cash. While interest rates on money in the bank are fairly close to zero, the lifeblood of any company is how much cash they can generate.

This, to me, is where things are interesting since all companies (with the exception of Pets.com) have similar Days Sales Outstanding and Days Payable Outstanding - what separates Chewy from its peers is that it holds very few Days of Inventory and, as a result, is not tying up its cash in inventory. While it is unclear why Chewy is able to hold fewer days of Inventory than its peers, perhaps this is driven by Autoship revenue since Chewy knows when they have to ship goods to a customer, they order the inventory in a Just In Time Fashion.

Source: Company reports & tremblingwithgreed estimates

Conclusion

Chewy is a well-managed company that operates in an industry with a large and growing TAM. I believe that based upon my DCF model and this operational analysis, the market is pricing in continued revenue growth and margin expansion for this company. In view of where the stock price sits today, all of these benefits are currently priced in its current market price $30.52 per share.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.