Chewy Is A Company I Want To Love, But The Valuation Is Expensive

Summary

• I never realized how large the pet market was and now that I know, I want exposure to it.
• Chewy Inc. has created a 360-degree company that has massive amounts of potential as they have become a one-stop shop for pet owners.
• Chewy will remain on my watchlist until the margins improve and the valuation becomes less expensive.
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I did some research on the pet industry in the U.S., and the amount of money spent is immense. Most pet owners consider their animals part of the family, and the global pet market is worth roughly $261 billion. Over 500 pet food manufacturers produce 3.3 billion pounds of food for U.S. dogs and cats annually. Roughly 67% of households nationwide have pets, and the average lifetime cost of having a pet will average between $23,400 and $27,200. Pets are big business, and I want exposure to the sector. One of the most well-known pet companies is Chewy Inc. (NYSE:CHWY). CHWY isn't just an online retailer; they have been launching proprietary brands since 2016 and have expanded into pet healthcare via telehealth, medications, insurance, and an e-commerce solution for veterinarians. I want to love this company and have placed CHWY on my watchlist. I am not investing today because the current valuation far exceeds what I consider an acceptable premium based on their financials.

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The pet industry statistics I found fascinating and how Chewy has become a titan among pet companies

I would speculate that everyone assumes that the amount of money spent on pets is large, but I am not sure how many people actually understand how large this industry is. I had yet to learn that the global pet market is worth roughly $261 billion and that in 2023 U.S. pet owners are projected to spend around $110 billion on their pets. What's even crazier is that $490 million is projected to be spent on Halloween costumes alone. To be honest, I didn't even know this was a thing, as I would have never thought to buy a Halloween costume for an animal. When I read this, it made me realize just how much pet owners are willing to spend on their pets. In the U.S., 83% of dogs and 17% of cats have insurance. The U.S. pet market is projected to grow to $325.74 billion by 2028, the U.S. pet supplement market is projected to grow to $1.05 billion by 2027, and the U.S. pet accessory market is projected to grow by $9.20 billion between 2021 and 2025.

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When I started researching CHWY, its revenue growth stood out, and I wanted to understand how they went from $900.6 million of revenue in 2016 to growing its business 986% over the next 7 years to $9.8 billion. During what I consider the Covid years of 2020 and 2021, CHWY increased its revenue by 102.28% or $3.61 billion, which is really interesting. Its revenue growth continued as they are on track to generate over $10 billion for this fiscal year.

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After going through CHWY's website and reading through its annual report, I have to say that I am impressed at the 360-degree company it built. Chewy.com isn't just an old-fashioned e-commerce site as they have created many different verticals to enhance their growth aspects. In Q3 of 2022, CHWY had 20.5 million active customers and generated $477 in net sales per customer. In Q3 of 2022, CHWY generated $2.53 billion of net sales, which was a 14.5% YoY growth rate.

CHWY has marked its territory in the pet industry by being customer-centric and creating a one-stop shop for pet owners. In addition to being a marketplace of brands, CHWY has developed its own proprietary brands, including its first hard goods proprietary brand, Frisco, followed by the launch of two consumables proprietary brands, American Journey and Tylee's. CHWY has expanded into pet healthcare, and in addition to offering prescriptions through the Chewy Pharmacy, CHWY also offers telehealth, compounding medications, a practice hub, and pet insurance. In October 2020, CHWY launched Connect with a Vet, a telehealth service allowing pet owners and veterinarians to leverage CHWY's proprietary tele-triage platform. CHWY introduced an offering that allows pet owners to order customized, pharmaceutical-grade prescription medications. In 2021, CHWY rolled out its practice hub, which is a complete e-commerce solution for veterinarians that can be integrated with their existing management software. The hub includes a proprietary app that veterinarians can utilize to create and manage pre-approved prescriptions. In 2022, CHWY introduced pet health wellness plans and pet health insurance to its customers.

While I love the business and the growth, the valuation is just too rich for me

Today, CHWY has a market cap of $19.44 billion, which is nowhere near its peak in 2021 when shares reached around $120. Even after shares have fallen more than -50% from their highs, the company looks very expensive to me. This is a company that still hasn't generated an annualized profit as its net income in the TTM is -$20.5 million so maybe the 2022 fiscal year will mark its first profitable year once Q4 is reported.

Chewy.com

The big problems for me are that this is a low-margin business and it's an expensive business to operate. In the TTM, CHWY generated $9.78 billion in revenue, but its cost of revenue was $7.1 billion. This created a gross profit margin of 27.37%, which isn't horrible, but it's not great either. I would probably think about this company differently if its gross profit of $2.68 billion went a lot further. In the TTM, it has currently taken the entire gross profit to run CHWY's operations as the total expenses came in at $2.7 billion, which leaves CHWY at an operational loss of -$23.1 million. This is a $10 billion revenue company that is almost breaking even.

CHWY is also not a business that generates large amounts of cash from operations. In the TTM, CHWY generated $183.1 million in cash from operations which is a 1.87% cash yield. CHWY is spending more in CapEx ($229.4 million) in the TTM than it produces in cash from operations, leading to negative FCF. To show that I am not cherry-picking data, when the data is looked at on a quarterly basis, CHWY did have its first quarter of generating over $100 million in cash from operations in Q3, and their Q3 FCF was $69.80 million. If they are able to replicate this sequentially in 2023, they will generate $279.20 million of FCF.

CHWY has a clean balance sheet with $0 in long-term debt and $0 in debt under its current liabilities. Just because I consider this clean doesn't mean I think it's a strong balance sheet. CHWY's total equity is only $164 million, as its liabilities and assets are almost the same. The book value per share is $0.39, which could be the most shocking aspect.

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Today, you're paying $45.91 per share or a valuation of $19.44 billion for CHWY when there is only $164 million in equity, they are unprofitable on a TTM basis, and the book value is $0.39. If I was to speculate that CHWY was to generate $300 million in FCF in 2023, it would be a forward FCF multiple of 64.8x, which is very high, in my opinion, and the $300 million of FCF is a generous speculation. To put some context in this, TSLA generated $8.91 billion of FCF in 2022, and its market cap is $561.76 billion, which places its current FCF multiple at 63.03x. Regardless if I agree with TSLA's valuation, TSLA is generating billions in FCF and net income, and has proven it can sustain future growth rates. There is no reason that CHWY should be given the same FCF multiple as TSLA, and their current multiple can't even be calculated as they generate negative FCF.

After looking at the financials, CHWY would need to increase its margins and continue its revenue growth. While I wouldn't be worried about its revenue growth, I am concerned about its ability to create larger margins. For instance, Blue Buffalo Life Protection Formula Healthy Weight Adult Chicken & Brown Rice Recipe Dry Dog Food, 30lb bag, sells for $60.98 with free 1-3 day shipping if you purchase on CHWY. The same product is $60.98 on Amazon, and if you're a prime member, the price drops to $57.93 when you click on the product, which matches CHWY's auto-ship program of $57.93. CHWY has built a great business, but from a cost of goods standpoint, I am not sure how much room there really is, considering most of the major companies, such as Blue Buffalo have storefronts on Amazon.

Conclusion

CHWY is on my watchlist, but it's too expensive for me at this point. I wouldn't be surprised if shares take another leg down in 2023 unless they make significant progress in their profitability and margins. The pet industry is interesting, and CHWY has definitely created a flywheel effect that is capturing almost $10 billion in revenue. The story that I need to see play out prior to investing is if the growth story deteriorates going forward and how hard it will be to drive profitability. I think CHWY is overvalued today, but that doesn't mean shares will fall or that its financials won't improve in 2023. I will be on the sidelines looking at margins and the financials until a better entry point arrives.

Disclosure: I/we have a beneficial long position in the shares of AMZN 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.