Chewy: Buy The Dip

Summary

• Shares of Chewy have declined 50% year to date as investors digested the impacts of the inflationary environment on Chewy's bottom line.
• Gross margins have peeled back by roughly two points, driven largely by higher logistics and freight costs.
• The company has implemented operational initiatives that should offset these price increases within two years, though as usual Wall Street is primarily concerned about today's earnings.
• Trading at just ~1x forward revenue, Chewy is appropriately priced for its fundamental risks.
• Looking for a helping hand in the market? Members of Daily Tech Download get exclusive ideas and guidance to navigate any climate. Learn More »

Ирина Мещерякова/iStock via Getty Images

During the height of the pandemic, there was no sector hotter than e-commerce; and now, in 2022, seemingly no investor will touch an e-commerce stock with a ten-foot pole. Chewy (NYSE:CHWY), the beloved pet supplies e-commerce vendor that has virtually supplanted major pet retailers like Petco and Petsmart, has been one of the biggest victims of the recent pullback. In Chewy's case, both fundamental risks and poorer sentiment have weighed heavily on the stock, which is now down roughly 50% year to date.

With such a sharp drop from highs, it's a good time for investors to re-assess the damage and see if there's value to be salvaged. When we step back from the near-term pessimism and noise, I still find Chewy to be an incredibly promising company that has dominated the pet e-commerce space and found a rare niche in which Amazon.com (AMZN) has lagged. In other words, investors who are able to stomach some short-term pain have an opportunity to buy into a fantastic long-term hold while it's trading at fire-sale levels.

Data by YCharts

While logistics rate squeezes are having a near-term impact on Chewy, investors should focus on the long-term bull case.

I remain bullish on Chewy. While I acknowledge that Chewy is more impacted by the current inflationary environment because its mid-20s gross margin profile is thinner than that of most tech companies, I still find comfort in the fact that Chewy has built up tremendous brand equity, with a revenue base that is nearly three-quarters on autoship.

Secondly - it's not like Chewy is sitting back and letting cost inflation go unchecked without taking action. In the company's most recent Q4 shareholder letter, it wrote as follows:

For full-year 2022, we estimate the outbound freight impact on gross margins will be between 100 to 150-basis points, inclusive of higher fuel prices.

In anticipation of this pending increase in freight rates for 2022 - and in the spirit of continuous improvement that is engrained in our culture - our teams were already contemplating several logistics and supply chain initiatives to lower freight costs. Several of these were launched in the first quarter, while others will launch in the second quarter and beyond. We expect these initiatives will help mitigate part of the impact from the new contract this year and help mitigate most of the impact within two years.

Looking at full-year 2022, the current macro environment has many moving parts. Taking everything into consideration, we are estimating full-year 2022 gross margin to be broadly in line with full-year 2021."

The key points here: FY21 should be the trough for margins and FY22 should be in-line with it, and Chewy already has initiatives in motion that will dampen price spikes. Additionally, there are many who believe the current freight environment is more of a passing phenomenon, sparked by COVID-driven port logjams around the world that should be temporary in nature. Should this prove to be true, Chewy's logistics initiatives may help the company grow gross margins over time.

Here's a full rundown on what I believe to be the bullish drivers for Chewy:

• Expanding wallet share. A Chewy customer, especially those on Autoship, tend to be very loyal. The company notes that a customer in Year 2 tends to spend $400 per year, $700 in Year 3, and $900 in Year 4. As pet needs and the willingness to spend for pets continues to rise, Chewy is there to capture that growing wallet share.
• Pet ownership is taking off. The trend of "pandemic pets" is still driving increased pet ownership in the U.S., and a lot of those new pet parents skew young and are highly disposed toward convenient online services like Chewy.
• Beloved consumer brand. Chewy has built up quite a lot of brand equity around being a very customer service-oriented company.
• Margin expansion driven by expanding product categories. Chewy's push to grow its own brand (Tylee's), plus focus more on selling higher-margin hardgoods, has proven very effective at producing margin expansion for Chewy. Gross margins have recently expanded to ~26%, versus low-20s at the onset of the pandemic.
• Nascent opportunities in pet telehealth. The craze in telehealth and doctor consultations via your mobile device is spilling over into the pet world, too. The company's "Chewy Health" offering has built out a "Connect With A Vet" service, and it has also rolled out a pet pharmacy as well. This is a broad, new opportunity for Chewy that can both accelerate its growth and grow its margins.

Cheap valuation

Chewy's sharp fall from highs has also left the stock in quite a cheap position to be bought. At current share prices near $27, Chewy trades at a market cap of $12.22 billion. After we net off the $603.1 million of cash on Chewy's most recent balance sheet, the company's resulting enterprise value is $11.62 billion.

Meanwhile, for the current fiscal year, Chewy is guiding to $10.2-$10.4 billion in revenue, representing 15-17% y/y growth, on top of breakeven adjusted EBITDA margins.

Chewy FY22 outlook (Chewy Q4 shareholder letter)

Against the midpoint of this revenue outlook, Chewy trades at just 1.1x EV/FY22 revenue. That puts Chewy's multiple at quite a bit less than Amazon's - which, among a basket of e-commerce stocks, has the most similar business/revenue profile with first-party merchandise sales dominating the revenue base.

Data by YCharts

Right now, Chewy's profitability profile is muted because it's digesting a temporary freight price squeeze while waiting on operational efficiencies to kick in. Once Chewy can expand its 0-1% adjusted EBITDA margin, I see this company becoming a profit story in the very near future.

Q4 download

Let's also clarify: Chewy's gross margin struggles are certainly not company-specific; every single other consumer products company in the stock market is undergoing the same challenge, and these issues were already well-known heading into 2022 and expected on Wall Street.

Other than this, Chewy continued to post excellent results, especially when we consider how much the business has scaled (and continued to hold onto that scale) in the post-pandemic era.

Chewy Q4 revenue trends (Chewy Q4 shareholder letter)

Revenue in Q4, as shown in the chart above, grew 17% y/y to $2.39 billion, while also growing 73% over the fourth quarter of FY19 - showing how much consumer buying for pet supplies has shifted to online channels post-pandemic. Chewy has also boosted its average spend per customer to $430, an increase of $70 over the prior two-year period.

Chewy's percentage of revenue in Autoship also continued to rise, to a record-high of 70.7% of total revenue. Autoship is what makes the Chewy habit difficult to break, and what continues to give Chewy an edge over traditional pet retailers: it becomes incredibly convenient to order the same supplies, over and over again, on a set schedule without needing to be reminded. Autoship revenue in 2021 was virtually equal to Chewy's total revenue in 2020, reflecting the staggering growth in the business since the pandemic began. And yet, with Chewy estimating the global pet supplies market at $120 billion, Chewy's current ~$10 billion annual revenue scale/$7 billion annual autoship volume still barely scratches the surface of the total global market opportunity.

It's worth noting as well that out-of-stock levels remained elevated in the quarter due to Omicron-related disruptions in the fourth quarter. Absent this, Chewy estimates its growth rate would have come in closer to the high end of its original guidance range for Q4 (17-19% y/y growth).

Chewy gross margin trends (Chewy Q4 shareholder letter)

Gross margins, of course, were the main challenge in the quarter. As shown in the chart above, Chewy's gross margins fell 170bps y/y to 25.4%, down from 27.1% in the year-ago quarter. Now, for many tech companies a two-point margin slip might not be a big deal, but for Chewy whose margins are already sitting in the 20s, it's a fairly significant slice.

The good news, however, is that management does not believe these pricing pressures to be permanent. CEO Sumit Singh noted as follows during his prepared remarks on the Q4 earnings call:

Operationally, 2021 was a challenging year amidst an ever-evolving pandemic, which continued to impact supply chain and disrupt the natural flow of consumer behavior and business execution.

As we close the book on 2021 and move forward in 2022, we are already seeing improvements in labor availability, inbound shipping costs and pricing, while out-of-stock levels and outbound shipping costs remain elevated. Ultimately, we believe most of these challenges are not permanent in nature. And over time, companies like Chewy that are long-term focused and built on the fundamentals of strong customer engagement and innovation will continue to enjoy a durable and sustainable competitive advantage.

The bottom line is that we remain optimistic about our future and our ability to execute to earn customer trust, gain market share and create shareholder value."

Unfortunately, the gross margin slip this quarter did eat into adjusted EBITDA, which fell to a -$28 million loss (-1.2% margin), a 420bps margin slip versus 3.0% adjusted EBITDA margins in the fourth quarter of FY20.

Chewy adjusted EBITDA (Chewy Q4 shareholder letter)

Chewy still, however, generated positive adjusted EBITDA for FY21 and continues to expect to do so in FY22. Note as well that Chewy generated a healthy $191.7 million in operating cash flow in FY21; and on top of the ~$600 million of cash that Chewy has on its balance sheet unencumbered of debt, the company has plenty of liquidity to navigate through the current tight environment.

Key takeaways

There's a lot of undue pessimism against Chewy at the moment that has taken its stock far below its intrinsic worth. Be patient throughout 2022 as Chewy muscles its way past temporary supply-chain and freight challenges and capitalizes on its scale (roughly ~2x larger than pre-pandemic) to start driving meaningful profitability gains.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of CHWY either through stock ownership, options, or other derivatives. 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.

Comments

[blaumeise]

Chewy understood market reaction and will improve margins significantly in the first quarter.
They stopped a new warehouse, no air traffic with dog and cat litters and reduced extensive advertising. Over time margins will increase over 31%.
Actually they have more buying power as Petsmart, Petco, Cosco, Walmart and Amazon.
Amazon made a huge loss last quarter, has also to look for more profitability and will so stop aggressive pricing.
So I see a very positive outlook.

[Oramokoma]

Read the comments. Only people who have positive expectation are the bag holders who have hard time coming to terms with their losses and who have difficulty understanding money-losing businesses are not good investments UNLESS the Fed is doing that mega vega exponential QE-unlimited

[Oramokoma]

Freight cost spike is temporary? What is your evidence? If anything gas and labor prices have been shooting higher and higher. If 2021 was challenging for chewy, I wonder what they would call 2022

[r cohn]

CHWY is an online pet food company , not a a high tech growth stock. It does not deserve a high P/e
. It’s policy of buying sales via no -low margins may have impressed Wall St in the past , but does not now.
Nevertheless it represents a good trade in the 18 area. Be patient and do not pay up

[Oramokoma]

@r cohn why $18?

[blaumeise]

Every day there is a new dip. Now value is below 2022 revenue. Estimate only 90% of revenue.

[blaumeise]

Consumers have less to spend due to 8% inflation. Due to high oil and gas prices FedEx in Q4 and from Q1 onwards will cost 150 basics points more. CEO told to have savings which equalize this.
It will not get totally but help to get margins from 25,4% in Q4 to 26 in Q1 and perhaps 26.5 % in Q2 and that is break even and will be enough to stop cash burn.
Some time in the future this stupid war will end and gasoline prices will normalize then Chewy can earn 2-5% of revenue.
My revenue projections 2021 9 billion, 2022 10.8 billion , 2023 12.5 and 2024 14 billion of total 140 billion dollars.

[kpmedia]

@blaumeise "Consumers have less to spend due to 8% inflation. "

While I have less money, that hits my discretionary budget, and this is a pet staple. Dogs still have to eat, cats still have to poop, etc. So I'm not sure how your statement applies here.

[blaumeise]

@kpmedia consumers will have to save and so use every bargain they can get.
Amazon made some deep discounts which will eat into Chewy's revenue. So my conclusion is that Chewy will grow only 15 to 20% instead of 30-40%. Amazon, Walmart, Costco and Petsmart all will fight with bargains for customers.
Chewy's buying power next year in the US will increase from 6 .5 billion to about 7.5 billion that is already very competitive and gives them an edge over all competitors.

[kpmedia]

@blaumeise I agree with your conclusion, they will gain more and more advantage over competition on an annual basis. It's been happening, and will keep happening.

But "competition" sometimes strikes me as daft in these SA conversations. That happens far too often here. Comparing every to a FAANG stock, mostly.

If you ever watch Amazon loss-leader discounts, they tend to reverse hard, or end up as a discontinued product. But I've not seen anything at Amazon less than Chewy, and several items are more expensive. They don't carry many things Chewy does, and instead carry super cheap Chinese made crap in its place, much like Walmart. For example, they stock some very questionable cat inhalers that don't work as per the reviews, while Chewy only carries the reputable item suggested by vets.

Walmart is such a horrible places to shop. Finding items in stock there, either B&M or online, is often 50/50. At least online, no wasted gas, just wasted time.

Petsmart and Petco are competitors, but mostly just for the B&M. The online presence is just so stripped compared to Chewy, and usually more expensive by as much as 15%. But when you're not in a large city, and with either being close and convenient, it's still not really an option, therefore not a competitor for that consumer.

From what I've seen, the only way to save money on pet food and supplies, more than Chewy, is to feed them crap (fat soaked cereal, aka off-brand dry food) and give them cheap Chinese items that may be not work or be dangerous. And you can use eBay for that.

[HPBunker]

Telehealth for pets is laughable. Pets can't tell a vet over Zoom what their symptoms are, so if the vet can't physically examine them, the appointment is a complete waste of time (and money).

Telehealth generally is great for medical professionals, who don't have to bother going to work, but a terrible deal for consumers of health care.

CHWY's main problem remains that even as they massively increase revenue, they keep generating losses. It's hard to see how they ever become consistently profitable. Note that AMZN is only ever profitable because of AWS. Will CHWY be starting a cloud hosting service? If not, they're likely to remain a non-profit charity for pet owners, rather than a profitable business.

[SeattliteTrader]

@HPBunker shipping 240lbs of cat litter to our place every few months for free can't help their bottom line, either... Great for us, but terrible from a business perspective unless they're making that up somewhere else. Oh wait, what about the other heavy stuff like cans of food, etc. Nope! No margin on our purchases!

[r cohn]

@HPBunker
Your point is one that was never made in the past and is just coming to the investors
Very few online businesses operate with high margins ; most have low margins - with rising costs of labor and fuel their margins are negative.
Online businesses , including AMZN do not deserve high P/Es

[blaumeise]

Started today with a position of 250. Let's wait and see.

[Doba2]

Good points from the article.
These levels are starting to seem like a good entry but in this macro environment, I still can't bring myself to start a position in Chewy, although the valuation is getting my attention.
Still need to see a profit for at least 2 quarters in a row or the share price at $20 before I initiate a position.

[Analyze This]

White I just ordered some things for my dog a mere moment ago from CHWY, I'm not paying $12 billion for a company where break even consistent EBITDA after adjustments is possible in a few years. I personally think $2 billion is even over priced. While this stock is an easy pitch to pet owners, it's a tough sell to anyone who understands what makes a company worth something.... and this is profits. Dress it up all you want it's still a barely break even business with huge competition, thin margins butt has nice customer service.

At $10 the company is valued at $4 billion which is still expensive considering competition and cost will continue to increase and make profitability a far stretch.
Just because a stock is down a lot doesn't make it cheap.

[kpmedia]

@Analyze This What competition? The local B&M for those living in large cities? Or limited stock no-pharmacy Amazon?

[Analyze This]

@kpmedia You apparently have never Googled "Pet supplies".....and Amazon and WalMart is a major player on line. Furthermore, considering the prices are often the same.... Amazon is 5% cheaper if you use their free credit card.

[kpmedia]

@Analyze This What's Google? Duh....

Walmart mostly stocks cheap crap. If you want Fluffy to eat garbage and have a short life, well then I feel sorry for your pet. They also stock a lot of inferior (and questionable) meds and supplements. The online site has far too many overpriced "third party" sellers of goods, and too many Walmart goods are often out of stock, or only sold in store. Walmart is essentially a B&M. Prices at Walmart are not any better than Chewy, sometimes worse. Plus time, gas and the hassle of Walmart.

Target is a bit more upscale, some decent house-brand supplies (but not food). I've bought there, infrequently.

Amazon prices fluctuate daily, sometimes multiple times daily. Same for Amazon stock. Amazon is almost always the worst choice for pet supplies. So that 5% Prime Chase benefit is usually offset. (And the 5% isn't really all that special anyway. I get similar rewards from Discover, BofA, Citi, Synchrony, and Fidelity. Right now, I'm not even using my Prime CC, better returns elsewhere.)

The only "competitor" to Chewy really isn't a competitor right now. Traditional pet stores that finally got online, or finally got their crap together for the existing site. But they lag. However, most have higher prices. But at least these stores have a wide variety of food, pharmacy, supplies, unlike the big box stores.

CVET is pushing hard to get vets to partner with them, but I take a dim view of that company, and they're in lawsuits over those issues.

Again, the biggest catalyst is customer service.
- Walmart? HAHAHAHA! Hahahaha!
- Amazon? Pfft. Very mixed.
- Target? Not really. Mixed.
- Pet stores? Usually decent.
- Chewy? Impressive. Speechlessly so at times.

[ndardick]

Thanks for the opportunity to revisit CHWY after its price fell over 43% (from $47 to $29) during the past month. I am a loyal customer of CHWY but not a shareholder because I view its future profitability as elusive in a very competitive business when CHWY has an extremely high debt/equity ratio of 2,947:1 according to YahooFinance, even though you contend that CHWY is "unencumbered of debt". If you will excuse my sense of humor, I cannot get on the CHWY BANDWAGON because, as my Romanian gypsy ancestors taught me, YOU CANNOT SELL WHAT YOU DO NOT HAVE ON THE WAGON. Every time I call CHWY I am unable to buy many of the items on my list because they are not in stock, and CHWY refuses to allow me to "backorder" what they don't have in stock. Perhaps the well-known supply constraints are the primary cause of this imbalance, and these might indeed abate over time, but at the current time I am able to find the products CHWY cannot deliver at Petco, Target and CVS. Additionally, while I agree that CHWY has sufficient cash to survive for years at the current run rate of losses, I am skeptical of your contention that CHWY has been generating positive "adjusted" EBITDA when statistics on YahooFinance and SA do not agree with your contention. Adjusted for what, I would ask? I also note that the short interest as a percentage of the float is a whopping 32% (as of April 14). These short sellers see a far different situation and future prospects than you do. My own conclusion is that CHWY is more of a meme stock than a fundamentally solid investment choice at this particular time. What am I missing? Are the metrics that I see on SA and YahooFinance blatantly wrong?