Chewy: Riding the Wave of Pet Industry Growth

Chewy has recently turned profitable. They continue to gain market share in a market that is expected to grow at an 8% compounded annual growth rate. Additionally, they are exploring new higher-margin segments to enhance profitability in the future. Furthermore, I am writing this because the stock is currently trading well below its previous high of $118, which it reached in February 2021. It all sounds good, but does it make the stock a buy? It is something I will investigate in this analysis.

This is not a financial advice. I am not a financial advisor and I only do these posts in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.

Before I begin the analysis, I should mention that I do not currently own any shares in Chewy. This means that I have no personal stake in the company. If you would like to view or copy my portfolio, you can find instructions on how to access it here. As always, I will keep this analysis unbiased. If you want to purchase shares or fractional shares of Chewy, you can do so through eToro. eToro is a highly user-friendly platform that allows you to get started on investing with as little as $50.

The Business

Chewy is an American e-commerce company that sells pet food, treats, pet supplies, and pet medications. Chewy partners with over 3.500 brands in the pet industry, while also offering its own private label. Through its websites and mobile applications, Chewy offers its customers approximately 115.000 products and services. Since January 30, 2022, they have also been offering expanded services, such as "Connect with a Vet" telehealth for veterinary care and the largest pet pharmacy in the United States. They have an extensive infrastructure, which enables them to serve over 80% of the U.S. population overnight. Most of their sales (73%) come from their auto-ship scheme, which is a type of subscription where customers receive products automatically every month until they actively cancel the subscription. Chewy has experienced rapid growth and currently holds a 41% market share in its respective industry. Furthermore, Morgan Stanley expects the pet industry to experience an 8% compound annual growth rate (CAGR) until 2030. Despite holding a 41% market share and running the largest pet pharmacy in the United States, I do not perceive Chewy as having a strong moat. However, as approximately 75% of their sales come from subscriptions, it could indicate that they are gradually establishing a moat.

Management

The CEO is Sumit Singh. He joined Chewy in 2017 as the Chief Operating Officer (COO) and became the Chief Executive Officer (CEO) in 2018. Before joining Chewy, Sumit Singh held senior leadership roles at Amazon and Dell. He holds a master's degree in engineering from the University of Texas and an MBA from the University of Chicago. Besides being the CEO and serving on the Board of Directors at Chewy, he also serves on the Board of Directors at Booking Holdings. He was named to the Bloomberg 50 in 2020, which is a list of innovators, entrepreneurs, and leaders who have transformed the global business landscape. In 2020, he was also on the list of Comparably's best CEOs. Under his leadership, Chewy has been named the "2022 Best Place to Work" by Built In, while Newsweek has listed Chewy as one of "America's Best Customer Service" providers for the past four consecutive years. As we will see later in the analysis, he has also achieved good results by tripling revenue in the last four years. All in all, I feel confident that Sumit Singh is the right person to lead Chewy forward.

The Numbers

The first number we will investigate is the return on invested capital, also known as ROIC. We require a 10-year history with all figures exceeding 10% for each year. Chewy made its IPO in June 2019, so we don't have data prior to fiscal 2020. Chewy's fiscal year runs from February to the end of January the following year, which means that the numbers from fiscal 2020 do not cover a full year. Chewy's Return on Invested Capital (ROIC) has been inconsistent over the five years for which we have data, which is not surprising given that Chewy is still in its growth phase. Furthermore, all recent years have been affected by either a pandemic or a challenging macroeconomic environment. Therefore, I don't want to assign excessive significance to these numbers. However, it is slightly concerning that Chewy didn't manage to deliver a Return on Invested Capital (ROIC) above 10% in fiscal 2024, considering that the company is transitioning towards a more established position rather than relying solely on growth.

The following numbers represent the book value + dividend. In my previous format, this was referred to as the equity growth rate. It was the most important of the four growth rates I used in my analyses, which is why I will continue to use it in the future. As you are accustomed to seeing numbers in percentage form, I have decided to provide both the actual numbers and the year-over-year percentage growth. We only have data from the past five years as Chewy made its IPO in June 2019. It is noteworthy that Chewy has achieved positive equity over the past three years, and this equity continues to grow at a high rate annually. Hopefully, this is a trend that will continue moving forward.

Finally, we will analyze the free cash flow. Free cash flow, in short, refers to the cash that a company generates after covering its operating expenses and capital expenditures. I use levered free cash flow margin because I believe that margins provide a better understanding of the numbers. Free cash flow yield refers to the amount of free cash flow per share that a company is expected to generate in relation to its market value per share. It is encouraging that Chewy has maintained a positive free cash flow for the past four years, with only one year of negative free cash flow since its initial public offering (IPO). Another positive indicator is that Chewy has increased its free cash flow every year since its initial public offering (IPO). It seems like this trend will continue as management has mentioned their expectation to generate significant and increasing levels of free cash flow in 2024 and the years to come. Levered free cash flow has also increased in the past three years, which is another positive sign, even though it is still low. The free cash flow yield is currently at its highest level, which could suggest that Chewy is trading at an attractive valuation. However, we will reassess this later in the analysis.

Another important aspect to consider is the level of debt. It is crucial to determine whether a business has manageable debt that can be repaid within a three-year period. We calculate this by dividing the total long-term debt by earnings. However, it is not possible to calculate the financial ratios for Chewy because they have no debt, which is another positive indicator. Actually, Chewy hasn't had any debt since its IPO, which I believe is a great sign.

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Risks

Based on my findings so far, I believe that Chewy is an intriguing company. However, no investment is without risk, and Chewy also has its fair share of risks. One risk is competition. The pet products and services industry is highly competitive. Chewy competes with pet product retail stores, supermarkets, warehouse clubs, and other mass and general retail and online merchandisers, including e-tailers. Many of these competitors are larger than Chewy and have significantly greater capital resources. Many of Chewy's current competitors have longer operating histories, greater brand recognition, larger fulfillment infrastructures, superior technical capabilities, significantly more financial, marketing, and other resources, and larger customer bases than Chewy. These factors may enable Chewy's competitors to generate higher net sales and profits from their current customer base, acquire customers at lower costs, or adapt more swiftly than Chewy to new technologies and shifts in consumer preferences. Furthermore, macroeconomics may lead to customers opting for more affordable alternatives. For instance, management has mentioned that Walmart has excelled in the value segment amidst the current macroeconomic backdrop.

Dependent on third-party suppliers. Chewy purchases significant quantities of products from several suppliers with limited supply capabilities. There can be no assurance that Chewy's current suppliers will be able to accommodate its anticipated growth or continue to supply current quantities at preferential prices. The inability of Chewy's current suppliers to deliver products in a timely or cost-effective manner could hinder Chewy's growth and significantly impact Chewy's business, financial health, and operational outcomes. For instance, Chewy has previously experienced disruptions when existing suppliers were unable to provide products to Chewy in a timely or cost-effective manner. Furthermore, most of Chewy's premium pet food brands are not widely available in supermarkets. If any premium pet food manufacturers were to make their products widely available in supermarkets, it could result in supermarkets offering these premium pet food brands at lower prices. This, in turn, could adversely affect Chewy's sales and gross margin. 

Share dilution. When a company issues additional shares of stock, it reduces the value of existing investors' shares and their proportional ownership of the company. Chewy has increased its shares outstanding from 398,0 shares in fiscal 2020 to 431,776 shares in fiscal 2024, representing an increase of approximately 8,5% since its IPO. Furthermore, management anticipates that this trend will persist, with shares outstanding projected to reach around 440 million by the end of fiscal 2024, driven by share-based compensation. Chewy has not initiated a buyback program that would protect investors from dilution. Thus, investors' proportional ownership of Chewy will continue to decrease.

Reasons to invest

There are also numerous reasons to invest in Chewy. The Growth of Autoship. Autoship is Chewy's subscription program, and approximately 75% of Chewy's sales are through Autoship. In 2023, the growth in Autoship customer sales significantly outpaced overall top-line growth, reaching nearly 15%. Chewy's Autoship business is a highly predictable subscription-based revenue stream. One reason Autoship growth outpaces overall active growth is that Chewy continues to deepen its engagement with existing customers. This has led to compelling wallet share growth in fiscal 2024. Net sales per active customer grew to $555, a year-over-year increase of approximately 12%, building on the 15% increase from fiscal 2022 to fiscal 2023. Management believes there is a significant opportunity for further expansion of net sales per active customer, especially as Chewy continues to broaden its range of products and services on its pet platform.

Chewy operates in an appealing market. Chewy operates in the approximately $144 billion U.S. pet market, which is comprised of pet food and supplies totaling around $87 billion, pet health contributing approximately $47 billion, and pet services representing roughly $10 billion. Following Chewy's expansion into Canada in Q3 of 2023, the company now also participates in the approximately $10 billion Canadian pet market. The pet category is a recession-resilient industry that grows above GDP and is increasingly shifting online. Chewy has been and remains a key driver and beneficiary of this trend. Over a multi-decade period, the overall pet industry grew at an annual rate in the mid-single digits. This growth was based on low-single-digit unit growth as well as low-single-digit pricing growth, further supported by a secular trend towards premiumization. The premiumization trend should benefit Chewy as well. Looking ahead, the pet category is projected to grow at a similar rate over a multi-year period.

Chewy Vet Care clinics. Chewy has opened its first pet health practices under the brand name “Chewy Vet Care.” Chewy anticipates opening four to eight clinics in fiscal year 2025. Management believes that Chewy Vet Care is a natural extension of Chewy's ecosystem and that its clinics will be unlike anything in the market. Chewy Vet Care clinics allow Chewy to expand its total addressable market by approximately $25 billion. The company believes that Chewy Vet Care has the potential to increase both net sales per active customer and active customer growth over time. Furthermore, management believes that expanding into healthcare will be beneficial for Chewy from a corporate margin perspective. As those aspects become a larger part of Chewy's business over time, they should enhance profitability.

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Valuation

Now it is time to calculate the share price. I perform three different calculations that I learned at a Phil Town seminar. If you want to make the calculations yourself for this or other stocks, you can do so through the tools page on my website, where you have access to all three calculators.

The first is called the Margin of Safety price, which is calculated based on earnings per share (EPS), estimated future EPS growth, and estimated future price-to-earnings ratio (P/E). The minimum acceptable rate of return is 15%. I chose to use an EPS of 0,09, which is from the fiscal year 2024. I have selected a projected future EPS growth rate of 15%. Finbox expects EPS to grow by 23,7% in the next five years, but I only use 15% as the highest. Additionally, I have selected a projected future P/E ratio of 30, which is double the growth rate. This decision is based on Chewy's historically higher price-to-earnings (P/E) ratio. Finally, our minimum acceptable rate of return has already been established at 15%. After performing the calculations, we determined the sticker price (also known as fair value or intrinsic value) to be $2,70. We want to have a margin of safety of 50%, so we will divide it by 2. This means that we want to buy Chewy at a price of $1,35 (or lower, obviously) if we use the Margin of Safety price.

The second calculation is known as the Ten Cap price. The rate of return that a company owner (or stockholder) receives on the purchase price of the company essentially represents its return on investment. The minimum annual return should be at least 10%, which I calculate as follows: The operating cash flow last year was 486, and capital expenditures were 143. I attempted to analyze their annual report to calculate the percentage of capital expenditures allocated to maintenance. I couldn't find it, but as a rule of thumb, you can expect that 70% of the capital expenditures will be allocated to maintenance purposes. This means that we will use 100,1 in our calculations. The tax provision was 9. We have 431,776 outstanding shares. Hence, the calculation will be as follows: (486 – 100,1 + 9) / 431,776 x 10 = $9,15 in Ten Cap price.

The final calculation is called the Payback Time price. It is a calculation based on the free cash flow per share. Chewy's Free Cash Flow Per Share at $0,79 and a growth rate of 15%, if you want to recoup your investment in 8 years, the Payback Time price is $12,47.

Conclusion

I believe that Chewy is an intriguing company because they have consistently delivered higher free cash flow every year. I also believe that management is excellent, and that the CEO is the right person for Chewy moving forward. However, the lack of a moat is concerning, even though there are indications that Chewy is building one. Chewy is operating in a competitive industry without a moat to protect its market leadership. Many of its competitors have greater capital resources than Chewy, which could potentially pressure Chewy in the future. Chewy is dependent on third-party retailers, and in some cases, these retailers have not been able to keep up with Chewy's growth, which could pose a risk as Chewy scales up. Chewy focuses on premiumization, which is still a niche. If large supermarkets start offering these premium pet food brands at lower prices, Chewy's sales and gross margin could be adversely affected. Another concern is that Chewy is diluting its shares every year, and there is no indication that this trend will end soon. Chewy generating around 75% of its sales through its Autoship program is something I like. This provides highly predictable recurring revenue for Chewy. Furthermore, its net sales per active customer are also growing year over year. Chewy operates in an attractive sector with a total addressable market that offers ample room for growth. Additionally, the trend towards premiumization is expected to benefit Chewy. Chewy has also ventured into a new initiative with its first Chewy Vet Care, expanding its total addressable market. If Chewy succeeds, it will also enhance its profit margins. Nonetheless, I don't like that Chewy doesn't have a moat, and I certainly don't like the continued dilution. Therefore, I will not be investing in Chewy at this time.

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