Chewy: Great product fit to market, still too expensive (CHWY)

Cute little maltipoo puppy

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Chewable (NYSE:EVERYONE) is one of those companies that consumers love. Proof of this is the incredibly high rating their apps have, with 4.8 stars on the Google Play Store and 4.9 stars on the Google Play Store. Apple App Store. These are some of the highest ratings we’ve found for a widely used app. To us, this indicates a strong fit between the product and the market. Another sign that the customer has an excellent fit between product and market is the increasing percentage of customers opting for the “auto ship” feature, trusting the company to deliver without having to manually order each time. .

Chewy app rating

google play store

Finance

Chewy has been growing its revenue at an impressive rate, nearly doubling in the last two years. He was helped by the pandemic and the corresponding increase in pet adoption, but even before that, he was already increasing income at a very rapid rate.

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A common criticism of Chewy relates to its relatively low gross margins, which have tended to average ~25%, even if they have generally increased over the past three years. At least one thing we see is that the company is showing operating leverage, improving operating margins as sales increase. There are a lot of fast-growing tech companies that don’t show operating leverage, and that’s a red flag for us. If Chewy can make modest improvements to its gross margin and continue to provide operating leverage as revenue increases, then we believe the company is not that far from being sustainably profitable.

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Short-term gross margin pressures likely peaked in the fourth quarter of 2021. Fourth quarter 2021 gross margin decreased 170 basis points to 25.4 percent. The main drivers for this were cost inflation lagging in fourth quarter prices and higher inbound freight costs.

The company reports in its Q4 FY21 shareholder letter that in February 2022, the first month of their first quarter, they saw a sequential improvement in gross margin. Therefore, we believe that one of the main concerns of investors regarding lower margins seems to be resolved. The other main concern is slowing growth, which we will show later in the article.

Below is Chewy’s market cap, to keep in mind when we discuss valuation. The current market cap of ~$18bn is about 2x TTM revenue, which may sound cheap in many industries, but we think Chewy is more akin to a low-margin retailer and therefore should be trading higher. about 1x income.

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Below, we share key financial and operating statistics for Chewy, taken from the Q4 FY2021 shareholder letter. As can be seen, the company is operating very close to break-even profitability. Even the most optimistic adjusted EBITDA margin is not very high at all.

However, there are some positive operating statistics that we would like to highlight, such as the increase in sales per active customer. This went from $372 in 2021 to $430 in 2022. Another positive statistic is the increase in the percentage of customer sales by “autoship”, which went from 68.2% in 2021 to 70.2% in 2022.

Chewable Key Finances 2021

Fourth Quarter 2021 Shareholder Letter

Addressable target market

The company believes its target market today is ~$120 billion, which should give it a good growth track. This is probably one of the best arguments in favor of expecting growth rates to pick up again in the future. Here is what the company has to say about its TAM and growth in its most recent letter to shareholders:

In many ways, we are just beginning. We currently compete in a $120 billion Total Addressable Market (TAM) that is expected to grow rapidly over the next five years, and within that broader pet TAM, eCommerce sales are expected to grow even faster. We believe Chewy will continue to be a strong beneficiary of these secular tailwinds, as we continue to deliver a superior customer experience as the most trusted and convenient destination for pet parents and partners worldwide.

Valuation

Measured by EV/Revenue multiple, the stock is close to being the cheapest it’s ever been. However, as we mentioned earlier, we think Chewy is really a retailer, even if it uses a lot of technology and apps. And as a retailer, almost doubling revenue is still costly, unless the company can accelerate revenue growth to impressive levels again.

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As seen in the chart below, revenue growth has slowed significantly. At one point it was above 50%, but now it is below 20%. Along with margin deterioration, these are the two issues that we believe have caused investors to push the stock lower.

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The combination of declining margins and reduced growth made net cash provided by operating activities negative in the fourth quarter of fiscal 2021. Yet even in a bumper year like FY21, it was only $192 million. At the current market capitalization of ~$18 billion, the multiple of this level of operating cash flow is ~90x. We think this is extremely expensive, especially now that the hypergrowth phase seems to be over.

Chewable cash provided by operating activities

Fourth Quarter 2021 Shareholder Letter

conclusion

Chewy is an interesting company that seems to be delighting their customers and has achieved an excellent fit between product and market. Additionally, some operational statistics, such as average sales per customer and percentage of customers on autoship, show a trend in the right direction. We also like that the company has shown operating leverage, which makes us think that sustainable profitability is not too far in the future.

That said, we believe the company is still valued more as a technology company than a retailer, and we’re not willing to pay double sales for it unless revenue growth accelerates significantly again.

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