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.
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:
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.
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.
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.
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.
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).
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 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.
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.
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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.