In my opinion, one of the best decisions investors can make during deep, sharp corrections is to take a deep breath and buy old Wall Street darlings at a deep discount. It’s advice I would particularly apply to Chewy (CHWY), the online provider of pet supplies that has taken a dramatic hit over the past few months due to both root causes and sentiment.
It doesn’t take too long to recall that Chewy was one of the hottest stocks during the pandemic. Rising alongside its e-commerce peers, Chewy’s stock tripled in 2020, only to decline around 35% in 2021. So far, 2022 has seen YTD losses an additional 15%. Shares of Chewy are now trading at levels not seen since June 2020. Now is the perfect time, in my view, for investors to take a second look at this stock while the rest of the market races for the hills.
Chewy’s bullish thesis remains unchanged despite short-term misfires
In a nutshell, here’s how I would describe Chewy’s problems: bad, but not irreparable. The company continues to grow decently, with revenue growth north of >20% y/y. Supply chain issues and inventory shortages, to a large extent, are behind the flattened growth and slower pace of year-over-year gross margin expansion, as in the past.
The good news here: expectations have been reset for Chewy, and much lower than they have been in the past. There’s a chance that sentiment on Chewy will also reset when the company releases its fourth quarter results, and especially its outlook for 2022, at some point in early March. In the meantime, investors should revisit Chewy’s longer-term bullish thesis. In my opinion, here are the main attractions of this stock:
- Expanding portfolio sharing. A Chewy customer, especially those on Autoship, tend to be very loyal. The company notes that a Year 2 customer tends to spend $400 per year, $700 in Year 3, and $900 in Year 4. While pet needs and willingness to spend on pets continue to rise, Chewy is here to capture that growing share of the wallet. .
- Pet ownership is taking off. The trend of “pandemic pets” continues to lead to an increase in the number of pet owners in the United States, and many of these new pet parents are young and very willing to use services online practices like Chewy.
- Beloved consumer brand. Chewy has amassed a lot of brand equity by being a very customer service-oriented company.
- Margin growth driven by expanded product categories. Chewy’s drive to develop its own brand (Tylee’s), and focus more on selling higher-margin durable goods, has proven very effective in increasing Chewy’s margin. Gross margins have recently increased to ~26%, from low 20s at the start of the pandemic.
- Emerging Opportunities in Companion Animal Telehealth. The craze for telehealth and medical consultations via your mobile device is also spreading in the world of pets. The company’s “Chewy Health” offering introduced a “Connect with a Vet” service, and it also rolled out a pet pharmacy. This is a vast new opportunity for Chewy to both accelerate growth and increase margins.
Take advantage of the recent decline as a buying opportunity.
Now let’s take a closer look at Chewy’s latest third-quarter results, which were a major driver of the stock price decline. Overall, while Chewy’s third quarter left a lot to be desired, I think the post-earnings reaction (driven both by the earnings themselves and the destruction of growth stocks in general) was an overreaction major to a quarter that was still marred by supply-chain woes that will hopefully unfold this year.
The third quarter revenue summary is shown below:
In the third quarter, Chewy’s revenue rose 24% year-over-year to $2.21 billion, in line with consensus expectations on Wall Street. It’s the second straight quarter that Chewy hasn’t beaten Wall Street’s mark by a considerable mile; in fact, in the second quarter, Chewy had missed growth expectations by one point. On top of that, Chewy saw revenue growth decelerate three points from 27% year-over-year growth in the second quarter.
There are, however, silver linings beneath this apparent growth slowdown. The first is that Autoship continues to generate much of Chewy’s business. All told, these Autoship customers are far more likely to stay on the Chewy platform and essentially generate recurring revenue, even if not exactly contracted, for Chewy. Autoship revenue grew 27% year-over-year in the quarter to $1.56 billion, a record 71% of Chewy’s total revenue.
On a related note, Chewy also notes that it has seen higher average engagement from its customers. He estimates that now the typical Chewy Autoship customer will deliver 12% more lifetime value than a pre-pandemic customer.
Finally, Chewy notes that website traffic has been very high and conversion rates have also improved. Due to increased marketing effectiveness and conversion success, Chewy notes that its cost per acquisition has decreased by 12%.
Then, in terms of profitability, Chewy’s gross margins were a little disappointing in the third quarter. Although Chewy’s gross margin of 26.4% in Q3 was up 90 bps year-over-year, it was down 110 bps from 27.5% in Q2:
The company attributes the slowdown to supply chain issues. According to remarks prepared by CEO Sumit Singh on the third quarter earnings call:
Running the third quarter, we observed 2 factors affecting gross margin that had been largely absent in the first half of the year, high inbound freight costs and product cost inflation. Together, these 2 factors, net of a favorable mix change and price adjustment, mitigated the gross margin expansion in the quarter by approximately 100 basis points. High inbound freight costs reflect macroeconomic trends that impact imports and the flow of shipments across the country.
And we believe these costs will remain elevated in the near term until global supply chain disruptions begin to subside. On product costs, we saw inflation rising on an expanded assortment of inventory items throughout the quarter. In consumable-focused categories, many national brand suppliers have increased MAP to reflect higher product costs, and we are adjusting our prices accordingly. »
Also note that labor shortages also impacted Chewy’s SG&A line, as it struggled to fill openings in its fulfillment centers. Overall operating costs as a percentage of revenue increased by 60 basis points, with labor-related increases in the SG&A line partially offset by economies of scale in sales and marketing. Hopefully, as labor shortages ease in 2022, the company will be able to turn around its margin performance.
Adjusted EBITDA in the third quarter increased again, albeit at a snail’s pace. The company’s adjusted EBITDA of $6.0 million in the third quarter represented a margin of 0.3%, stable compared to the prior year.
Valuation and key takeaways
The good news in all of this: given the number of investors who have abandoned Chewy for these risks, the stock is now trading at a very attractive valuation. at the current stock price near $48, Chewy has a market capitalization of $20.29 billion. After clearing the $726.9 million in cash on Chewy’s most recent balance sheet (another reason to stick with Chewy for a long time: the company keeps a sizable stack of cash unencumbered by debt, giving it a large financial flexibility), the result of the company the enterprise value is $19.57 billion.
For the current fiscal year, Wall Street analysts expect Chewy to generate $10.60 billion in revenue, a year-over-year growth of 19% (data from Yahoo Finance). Against this earnings estimate, Chewy is trading at just 1.8x turnover EV/FY22 – as the stock traded steadily at a forward earnings multiple >3x at its late 2020/early 2021 highs.
To me, this is a boon for a company that continues to cater to a massive and growing market of pet owners, has shown remarkable resilience against Amazon (AMZN), and continues to achieve progressive margin gains. Stay here long and use the drop as a buying opportunity.