Summary
- Chewy is a leading ecommerce company which specializes in pet food, pet treats and pet medicine.
- The company offers a popular subscription model for its products, which generates consistent revenue.
- Chewy produced mixed financial results for the second quarter, as they missed revenue expectations but beat earnings forecasts.
- The stock is undervalued intrinsically and relative to historic multiples.
Chewy ( CHWY ) is a market-leading pet products website that has over 20 million active customers across the US. The company is poised to ride the secular growth trend in pet ownership as 77% of U.S households or 90.5 million families own a pet. This is up from 56% of US households in 1988 and 67% in 2019. The lockdown of 2020 further accelerated this trend with "pandemic pets" becoming popular as people sought a loving household companion. Despite this secular growth trend, Chewy's stock price peaked in February 2021 as the high inflation numbers caused Wall Street investors to shift from growth to value stocks. Since then, Chewy's share price has been decimated by over 72%. However, the company recently beat earnings estimates and they have a solid subscription-based product model. In this post I'm going to break down Chewy's business model, financials and valuation, let's dive in.
Barking Business Model
Chewy is a pure-play e-commerce company that specializes in the supply of pet food, treats, medications, insurance and more. The company offers over 100,000 products across 3,000 partner brands. Its pet categories include; dogs, cats, fish, birds, reptiles, and even horses.
Chewy offers a masterclass in branding and subscription sales. The company doesn't just offer bland, undifferentiated products like many pet stores. It offers a captivating product with enticing graphics and funny captions. Chewy has realized that people don't just buy for their pets, they also buy for themselves. For example, the company follows themes such as Halloween and Christmas with its product range. Its website advertising changes to show pets dressed up in festive outfits, while also enticing "Pet Parents" to dress up their own pets to create fun for the family and "instagrammable" memories. For example, these neckties for dogs look pretty funny and of course, will offer minimal discomfort to the animal, it kind of reminds of the guys on Wall Street.
Chewy has also started to sell "Goody Boxes" which offer a selection of treats and toys for Dogs and Cats. These retail at ~$28/box including discount and for a few cheap toys, the margins look significant (but we will dive into them more in the financials section). I believe Chewy got "the Goody Box" idea from competitor BARK which pioneered the "BarkBox".
The company also offers a subscription service called "Autoship" for its pet products, medicines, and Goody boxes which saves the customer time and generates consistent recurring revenue for the company.
Chewy has effectively reinvented pet retailing and are experts at Product marketing to its ideal customer. Chewy believes they are offering a "superior value proposition" with "high touch customer service" and a "personalized shopping experience". These factors help to boost brand loyalty and drive repeat purchases.
The Amazon Of Pet Treats
Similar to Amazon (but much smaller) the company is building out automated fulfillment centers across the US. In the second quarter, Chewy opened its third center in Reno, Nevada. Management is also learning from past experience and expects the Reno facility to take half as long to ramp up as compared to others. As its fulfillment network expands and shipping volume increases, its variable cost per package is declining thanks to economies of scale. For example, Chewy's variable cost per unit has declined by 15% with the use of its two automated fulfillment centers when compared to its legacy network. When the third fulfillment center comes online, management expects 40 to 60 basis points of annual run rate SG&A leverage. Chewy Freight Services [CFS] which is the company's own middle mile network also continues to grow.
Pet Insurance
Pet Insurance is a growing business line and its CarePlus service has expanded to offer coverage across 31 states, with a nationwide rollout expected by the end of 2022. This offers the company a major opportunity to enter the under-penetrated Pet insurance market, by offering a great alternative to incumbents. The North American pet insurance market is forecasted to be worth $3.8 billion by 2027.
Vet Platform
The company created a product called PracticeHub, which offers a unified e-commerce solution for veterinarians. This platform integrates directly with existing Vet software and allows Vets to easily approve and manage medications, diet, and prescriptions. These vets can then earn referral fees when customers make orders through Chewy.com.
Chewy now has over 1,000 Veterinary practices using the platform, up from just 300 in March 2022. This is extremely sharp growth and a testament to Chewy's business development team.
Give Back Program
Chewy also has a give-back program which has given back $100 million so far to over 9,000 nonprofit animal welfare organizations. This is a great program from a human perspective but also helps to connect the brand with customers' hearts further increasing its connections. The $2 billion Insurance tech company Lemonade ( LMND ) also offers a similar giveback program. I recently interviewed Lemonade's CFO on my stock investing YouTube Channel [Motivation 2 Invest] where he discussed the program in more detail for those interested. A more extreme example of this is TOMS shoes which give a pair of shoes to a poor kid every time you buy a pair.
Second Quarter Earnings
Chewy released mixed financial results for the second quarter of 2022. Net Sales were $2.43 billion which missed analyst expectations by $19.33 million and increased by 12.8% year over year. When Chewy went public it was sold to investors as "growth stock", but despite its fantastic products and strategy, its growth rate has been slowing. For example, between August 2020 and 2021 the company increased its sales by over 26%. But on the chart below you can see that between Q1 and Q2 results in 2022, sales have been pretty much flat which is not a great sign. This slow growth was driven by "growing economic uncertainty" among its Pet category consumers. But the good news is this was partially offset by consistent buying activity for nondiscretionary items like pet food and medicine, which makes up approximately 80% of revenue according to management.
Its Autoship subscription sales popped by 17.3% which was a positive sign and now makes up over 73.1% of total sales. This "SaaS style" recurring revenue model is a unique part of the Chewy platform.
Chewy's Gross Margin expanded by 60 basis points year over year to 28.1%. This was driven by an increase in pricing and improved supply chain capabilities through systemwide inventory placement via its fulfillment centers.
Chewy also generated solid Earnings Per Share [EPS] of $0.05, which beat analyst expectations by $0.16. Net Income popped by $39 million to $22.3 million which was a positive sign and its Adjusted EBITDA margin also increased by 230 basis points to 3.4%. These improvements in profitability were driven by a boost in gross margins, and improved market and logistics efficiency.
The second quarter free cash flow was just $1 million, which did decline from $60.3 million in the prior year. This was mainly driven by $48.2 million in cash used for capital investments such as fulfillment center construction and upgrades. Overall, I think investing in infrastructure is a positive sign, but the cash flow will feel the pinch in the short term.
Chewy has a solid balance sheet with $607 million in cash and short-term investments. In addition to total debt of $457 million which is well covered. Moving forward management is guiding for 10% to 11% sales growth Y/Y in Q3. In addition to 11% to 12% for the full year 2022. Its adjusted EBITDA margin is expected to be between 1.75% and 2%, which would be a slight decline from Q2 (3.4%) due to short-term headwinds.
Advanced Valuation
In order to value Chewy, I have plugged the latest financials into my advanced valuation model which uses the discounted cash flow method of valuation. I have forecasted 11% revenue growth for next year and 13% revenue growth for the next 2 to 5 years.
I have also forecasted the company's operating margin to increase to 9% over the next 8 years, as the company scales its logistics capabilities and sales continue to grow.
Given these factors I get a fair value of $38/share, the stock is currently trading at $33 per share and thus is ~14.2% undervalued. With more optimistic (but not unrealistic) estimates of 15% annual revenue growth for years 2 to 5. Chewy stock is ~22% undervalued at the time of writing.
As an extra datapoint Chewy is trading at a Price to Sales ratio = 1.45, which is 57% cheaper than its 5-year average.
Risks
Competition/not unique products
Dog food and dog treats are sold in almost every brick-and-mortar supermarket as-well as online through giants such as Amazon. In economics, we say these types of products have "elastic" demand in that there are many substitutes. However, Chewy does offer a unique brand, better customer service and a subscription model which are key differentiators. It also sells specialist dog and cat food brands which generate significant recurring revenue. Direct competitors include Petco ( WOOF ), PetSmart, and the innovative BARK ( BARK ) who I mentioned pioneered the BarkBox subscription model. Relative to competitors, Chewy trades at a slightly higher price-to-sales ratio. But the company is much more diverse and established than smaller competitor BARK. I would also say they seem slightly more innovative than Petco and are growing faster (10% revenue growth rate vs 3% Y/Y for Petco).
Recession/Supply Chain issues
Many analysts have forecasted a recession and thus I expect a sales slowdown in discretionary items such as the "Goody Boxes". The company is also vulnerable to supply chain inflation, which has been common over the past year. However, their active development of fulfillment centers should help to offset this.
Final Thoughts
Chewy is a leading pet food supplier and is poised to ride the growth trends in pet ownership and e-commerce. It is still growing despite headwinds and has many cross-selling opportunities across pet insurance, medicine, and much more. The stock is undervalued intrinsically and relative to its own history and thus looks like a great stock for the long term.
For further details see:
Chewy: Investors Are Barking Up The Right Tree