Chewy: Just turned profitable, does it make it a buy?
Chewy just had their first profitable year. They have a 41 % market share in a market that is expected to grow by an 8 % compounded annual growth rate, while they are also looking into new higher margin segments to boost profitability in the future. Furthermore, I write this the stock is trading way below its past highs of $118 that 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.
This analysis will be a bit different from what you are used to read in my blog. Chewy did their IPO in April 2019, meaning I don't have access to the historical numbers dating back longer than that. So instead of using the principles I have learned from my Phil Town workshop, I use the principles I have learned from the GOAT academy. I should also mention that most of the numbers I use in this analysis is from Finbox, which I believe is a great tool to easily get the numbers you need from various companies.
Before I start with the analysis, I should mention that I do not currently own shares in Chewy, meaning that I have no skin in the game when it comes to the company. If you would like to see or copy my portfolio, you can read how to access it here. As always, I will keep this analysis unbiased.
Chewy is an American e-commerce company that sells pet food and treats, pet supplies and pet medications. Chewy partners with more than 3.000 brands in the pet industry and offer more than 100.000 products. Since 30th of January 2022, they also offer expanded services such as "Connect with a Vet" telehealth offering for veterinary care and the largest pet pharmacy in the United States. They have extensive infrastructure, which means that they can serve over 80 % of the U.S. population over night. Most of their sales (73 %) is from their auto-ship scheme, which is a sort of subscription where the customers get send some products every month automatically until the subscription is actively cancelled. Chewy has grown fast and has a 41 % market share of the market they operate in. Furthermore, Morgan Stanley expects that the pet industry will increase by an 8% CAGR until 2030. However, despite having a 41 % market share and operating the largest pet pharmacy in the United States, I don't see that Chewy having a strong moat. However, as 73 % of their sales are through subscription, it could indicate that they are slowly building a moat.
Their CEO is Sumit Singh. He joined Chewy in 2017 as COO and became the CEO in 2018. Before joining Chewy, Sumit Singh held senior leadership roles in 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 at the Board of Directors at Chewy, he also serves at 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 changed the global business landscape. In 2020, e was also on the list of Comparably's best CEO's. Under his leadership, Chewy has been named as the "2022 best place to work" by Built In, while Newsweek has named Chewy to the list of America's best customer service" in the last four consecutive years. As we will see later in the analysis, he has also delivered good results as he has tripled revenue in the last four years. All in all, I feel confident in Sumit Singh being the right person to move Chewy forward.
I don't think that Chewy has a moat yet, but they could build one moving forward. I really like the management. Later I will do a discounted cash flow model to calculate a price for Chewy but before I do so, let us just have a look at some key financial metrics.
Down below we see some key financial metrics Chewy over the last three years. Chewy's fiscal year ends by the end of January. Thus, the numbers from 2023 cover the period 01-02-2022 to 31-01-2023. It is worth noticing that revenue has grown every year, which is always positive. However, growth has eased as Chewy only managed a 13,6 % growth compared to 24,4 % in 2022 and 47,4 % in 2021. Gross profit margins have increased every year though, which is very nice to see. 2023 marked their year where Chewy reached a positive operating income, which is good, albeit the operating margin being very low. Net income was positive in 2023 for the first time ever, as was EPS, which is nice to see. EBITDA and EBIT were also positive for the first time in 2023 but margins still leave a lot to desire. Hence, top line growth is slowing down but bottom line is positive for the first time. I would like to see much higher margins in the future, but these numbers suggest that Chewy is on the right path.
Before we continue to the discounted cashflow model, I would like to investigate the risks and potential of Chewy. Number of active customers isn't growing as fast as previously. Chewy has been growing their customer base steadily over the years but from fiscal 2021 to fiscal 2022, Chewy only managed to grow their active customer base by 0,6 %. Furthermore, their active customer base decreased in the fourth quarter in 2022 as Chewy went from 20,5 million active customers in Q3 2022 to 20,4 million customers in Q4. While it wasn't a large decrease it is worrisome when a growth company is not growing their active customer base. Competition. Competition is a risk factor when a company does not have a strong moat. Furthermore, as Chewy mentions in their annual report that the pet products and services industry is highly competitive as they compete with a wide range of competitors. In the annual report they mention that that competition is particularly strong within the e-commerce channel as the industry continues to experience a secular shift from in-store to online shopping. They operate in a low margin sector. Retail and e-commerce are historically low margin businesses that require a large amount of scale to generate significant operating leverage. As we saw in the financials earlier, Chewy hasn't yet being able to show that they can generate a significant operating leverage as their operating income just turned positive. And even if they manage to scale their business to generate operating leverage, it still won't be a high margin business, just look at Amazon that makes their profits (when they are profitable) from AWS.
There are also potential for Chewy moving forward. Higher net sales per active customer. While the number of active customers is not growing as fast as desired, net sales per active customer is growing steadily. In fiscal 2022 net sales per active customer grew by 15 % year over year, reaching $495 in 2022, which is up by $65 year over year. Interestingly, Chewy mentioned that their three oldest cohorts of customers spent $1.000 a year, which indicates that the longer they have been customers the more they spend. And nearly 60 % of all Chewy's customers have joined in the last three years. In the last earnings call, management mentioned that they believe "a tremendous opportunity remains ahead for us to fully unlock the revenue potential of our existing customer base". New vertical integrations. New vertical integrations could boost profits and margins moving forward. Chewy Health is still in early stages and management mentioned in the earnings call that they see it fueling growth and increase margins. Management also talked about other vertical integrations in sponsored advertising and insurance. Chewy has already released their beta version of sponsored advertising and expects to have it live in the first half of 2023. Management mentioned that it is something that they will quickly ramp up, and as we know, online advertising has high margins. Insurance takes longer time to build, and management believe it can be up to three years until it can contribute meaningful but if they succeed, it will increase margins as well. International expansion. Management plans to launch their first international market over the next few quarters. When Chewy expand internationally it will grow their total addressable market. Management mentioned in their last earnings call that their international expansion will be an organic play and not an acquisition, and that they considered size of total addressable market, geographic proximity and consumer behavior similarities with the U.S. when deciding on international expansion, which should increase the odds for success.
I have now investigated the financials, risks, and potential of Chewy. I will now look at the price by doing a discounted cash flow model. To do so I will need some numbers that you can see below. The numbers are the 2023 numbers, which I could find at Finbox. However, the perpetuity growth rate and the discount rate are numbers I have come up with myself. The reason I chose 3 % as perpetuity growth rate is that it is usually a between the historical inflation rate of 2-3% and historical GDP growth of 4-5%. I decided to go with an option in the middle. The chosen discount rate of 12% is because it is usually between 9-12%. I decided to go with the highest one because of the current market conditions. Remember that all the numbers made in these calculations are in millions.
I also need to determine how much EBIT, Depreciation & Amortization and Net Working Capital will evolve over the next couple of years. I decided to use an EBIT growth of 20 % year over year. It might be too high for some and too low for others. The EBIT growth has been 54 % year over year the last 5 years but as we saw, growth is slowing. I calculated with a growth in Depreciation & Amortization of 15 % a year, which is a bit lower than EBIT growth. The average Depreciation & Amortization growth the last 5 years has been 46,5 %. Finally, I decided to that Net Working Capital will grow at 10 %. I haven't found a smart way to share all my spreadsheet here but once I did my calculations, I found that the intrinsic value of Chewy to be $37. And you would probably like a 50 % discount on that.
Having investigated Chewy, I find the lack of moat slightly concerning. However, I feel confident in the management, and they may be able to build a moat moving forward. I find it a little concerning that the number of active customers is not growing, despite the net sales per customer is growing. Their customers will at some point reach a point where they cannot spend more, which is why it is essential that they attract more active customers, which may happen through international expansion. I'm not impressed with the margins that Chewy delivers. However, if they manage to be successful in their new vertical integration, margins could expand significantly, but until I have seen that these new vertical integrations result in higher margins, I will not open a position in Chewy. Nonetheless, I find the sector very interesting and in my April newsletter, I will write about two companies in the sector that I find more interesting as they both have a moat and significantly higher margins. If you are interested in knowing what companies I talk about, you will just need to sign up for my newsletter in the bottom of this page, it is free.
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