2023-08-16 15:42:08 ET
Summary
- Chewy stock presents an opportunity for long-term investors as it is on the verge of achieving significant operating leverage.
- It is also facing several tailwinds for revenue growth such as international expansion, e-commerce penetration, and new segments like insurance and telehealth.
- The stock is trading at a slight discount to fair value.
Investment Thesis
Chewy ( CHWY ) stock made a round trip since it became public: It went up more than 300% during the pandemic, came back, and is currently trading below its IPO price. However, this may represent an opportunity for long-term investors. Chewy is on the verge of achieving significant operating leverage, expanding to new markets, and trading at a fair valuation. Because of this and much more, we believe it may be a perfect stock to hold in a conservative/growth portfolio.
Company Overview
Chewy is a pure e-commerce business that provides food, treats, supplies, medications, and other pet-related products in the US and soon Canada. They serve more than 20.4 million customers who, in large part, subscribe to the Autoship program, a service that makes it easy to set up repeat deliveries like food from Chewy. In the latest quarter, Autoship sales represented ~75% of the total sales.
Most Chewy bears argue that selling pet supplies online is not rocket science and that the company has no moat. They argue that Amazon ( AMZN ) or any other retailer provides the same items Chewy does, and they don't differentiate from the competition enough.
And sure, Chewy has many of the same products as other retailers, competitive pricing, and fast delivery, but the factor that differentiates Chewy from them is that it puts its customers in the center of its model and engages with them on a personalized level. For example, I've read many times how Chewy sends flowers to a family who recently lost their pet or surprises them with a hand-painted pet portrait. This may not be tangible, but for sure influences customer choices.
Moreover, online retail pet product sales still represent a large opportunity. Packaged Facts estimated that 38% of all U.S. retail product sales were made online in 2022, with over $21 billion of pet food and treats sold online. They also estimate the e-commerce channel will rapidly increase to 48% of total retail channel pet product sales by 2026, while all other channels are projected to decline.
Lastly, Chewy also has an insurance and telehealth segment. They offer a "Connect With A Vet" as well as a pet pharmacy. Moreover, last year the company rolled out "CarePlus" pet insurance plan, and recently bolstered it through a new partnership with Lemonade's ( LMND ) pet insurance segment. This is a big and exciting chance for Chewy to make its business grow faster and expand its margins.
Q1 F2023 Financial Results
Chewy reported Q1 F2023 on May 31. Net sales came in at $2.78 billion, an increase of 14.7% YoY. This was driven by higher customer engagement and strong net sales per active customer (NSPAC), which grew 15% YoY, exceeding $500. Moreover, Autoship sales jumped ~19% YoY.
Gross margin reached 28.4%, expanding 90 basis points year-over-year. Gross margin has been trending higher since Chewy became public as operating leverage has started to kick in, and we should expect this trend to continue during the following quarters.
Adjusted EBITDA was $110 million, an increase of $50 million from last year, and net income totaled $22.2 million compared to $18.5 million in Q1 F2022. Adjusted EBITDA margin improved 150 basis points year over year to 4.0 percent as a result of gross margin expansion and SG&A leverage. The company holds $800 million in cash and equivalent and has no debt.
Lastly, the management guided for 13-14% YoY growth in net sales for Q2 and for 10-12% YoY growth for F2023. They also estimate an Adjusted EBITDA margin of ~3%, which would represent $338 million. The market seemed to like the report because the stock jumped 21% the day after they reported .
Valuation
Chewy generates a substantial amount of revenue but has razor-thin margins. This is the reason why it trades at 1.1x EV/Sales and more than 36x EV/EBITDA (using the company's guidance for F2023). The stock definitely doesn't appear extremely cheap, but we have to factor in the margin expansion and operating leverage it could achieve over time. The story may develop similarly to Amazon, a business where you have to invest heavily in building distribution centers and logistics and wait a lot of time to see the profits and free cash flow materialize.
Chewy's business is also recession-proof, which is very important since they can always count on money coming in no matter how the economy is doing. Profitability may drop during hard times, but we don't see a scenario where the company has to sell shares or issue bonds to fund its operations. Nonetheless, it's important to keep an eye on share-based compensation, which rose almost 100% YoY in Q1 F2023 to $48 million.
Overall, we don't think equity is expensive in the ~$30 level. To justify this, we decided to do a DCF model. We assumed long-term EBITDA will achieve high-single digits and capex to be 2% of sales (historical average). We also assumed a WACC of 8.5% and a TGR of 4%.
With these assumptions, we arrived at the conclusion that the fair value of Chewy is just over $32 per share, which implies a mere 8% increase from current prices. If intangible factors like brand, customer loyalty, and recession proof were taken into account, the equity may be worth more than we think.
Conclusion
To sum up, Chewy is rapidly becoming profitable and has several tailwinds for revenue growth. We recommend either staying long or initiating a small position.
For further details see:
Chewy: Waiting For Operating Leverage To Kick In