Chewy: Better-Than-Expected Long-Term Profit Margin Structure (NYSE:CHWY)

Overview

My recommendation is to go long Chewy (NYSE:CHWY). CHWY growth is driven by the secular trend of pet owners turning to online channels for pet products, which I expect to persist for a long time. While the question of a double-digit EBITDA margin is open, the company’s leadership is dedicated to growth, and private label mix and pet health have potential to contribute to margins. In addition, the pet health market (TAM $35 billion) presents a growth opportunity, and international expansion is a possibility in the future.

Business description

CHWY sells pet food and other supplies for pets online. In addition to a wide selection of pet food, treats, supplies, and healthcare products, the Company also sells clothing and medications for pets through its retail website and mobile application.

Pet owners turning to online channels for pet products

The pet industry is undergoing a shift as more consumers opt to buy their pets online rather than at a traditional retailer. Since there will be many advantages to buying online, I expect this to be a long-term secular trend. It’s not hard to figure out why this trend is picking up steam: it’s more convenient. The convenience of online shopping for pet supplies and products means that consumers can compare a large number of options without leaving the house. In addition, customers have the convenience of shopping at any time of the day or night thanks to the accessibility of online shops and marketplaces.

Comparing prices is a breeze when you shop for pet supplies and products online. Finding good deals on necessities for one’s pet can be a time-consuming ordeal. Shoppers, however, have it much easier now that so many stores and tools to compare prices exist online. Furthermore, the online market for pet supplies offers customers a much wider selection of products than do traditional brick and mortar stores. They can quickly and easily gain access to a worldwide market for pet supplies, which may include options that aren’t readily available locally.

Value proposition

CHWY’s primary value proposition is driven by its extensive catalog of premium products offered at reasonable prices, as well as its flexible and speedy delivery options, such as the hassle-free Autoship subscription service. On the flipside, I think the expanding customer base of CHWY presents an excellent opportunity for partners to expand their businesses and brands. CHWY also invests in technology and educational resources, which these partners can utilize, such as free instructional videos for their products. In addition, CHWY Autoship’s subscribers are more likely to buy from their partners again in the future. The speed and dependability with which their products can be shipped to customers is another way in which CHWY’s extensive distribution network helps its business partners.

EBITDA margin

The question of whether or not CHWY can achieve a double-digit EBITDA margin in the coming years remains open, but I believe it will depend on the company’s ability to scale and diversify its business. The company’s leadership deserves credit for its dedication to growth in order to improve customer service, broaden the range of products offered, and build out the company’s infrastructure. Although a shift in CHWY’s business focus to private label and pet health would likely increase margins in the short term, I believe that the inherent margin nature of the underlying products, cost of distribution, and competitive landscape will eventually put a ceiling on CHWY’s long-term margin structure.

I expect CHWY’s margin structure will face a number of headwinds in the near to intermediate term. In particular, as volume increases, Chewy will have to continue spending money to address labor shortages (which is already an issue throughout the country) by increasing wages and providing incentives to workers. Other than that, the expansion of fulfilment centers will increase OPEX as well because of the increased demand for customer service.

I believe that private label mix and pet health have the most potential to contribute to the long-term margin structure. Both of these have the potential to help the platform reach the long-term gross margin level of 25-28% (4Q22 earnings call) that management has discussed in the past. If CHWY is successful in implementing these two initiatives, I anticipate that the company’s long-term gross margins will rise above 30%.

Nonetheless, I believe that competition in the pet supplies and care end market is an important factor, especially with the advent of online giants like Amazon (AMZN) and the expansion of offline specialists into omnichannel and big box retailers. Although CHWY has risen to the top of its field in terms of online presence, I believe that it still needs to pay close attention to the competitive dynamic in terms of customer growth, customer spending, and the need to invest in marketing and distribution in order to differentiate itself. However, CHWY has done remarkably well in fending off rivals, especially with its Autoship product. It’s clear that Chewy’s customers are loyal, as the company has been able to grow its Autoship offering to account for 73% of sales in the most recent quarter.

Additional growth opportunities

I believe investors are particularly interested in CHWY’s potential expansion into the pet health and international markets. Both could be beneficial for CHWY’s business model, in my opinion, expanding its potential customer base and strengthening its long-term profit margins.

The TAM for pet health products and services is approximately $35 billion (3Q23 earnings call), which CHWY plans to enter. OTC drugs, pharmacies, pet hospital networks, and telemedicine are all part of these services. In my opinion, a higher margin structure and greater long-term customer value would result from well-executed efforts in this area.

The question of whether or not CHWY will expand internationally is one of many that will need to be addressed as the company develops further. It’s not likely to be a top priority in the near to medium term, but there’s potential for this to improve CHWY’s business model down the road. Concerns remain about how CHWY will operate in international markets, and whether or not the company will adopt the 1P distribution model, which places a premium on careful stock management and friendly, helpful staff. However, CHWY, like Amazon, may decide to take a 3P approach that requires fewer physical assets but still makes use of the company’s established name recognition and relationships with reliable vendors. The potential worth of expanding internationally is unknown at this time because it is viewed as a long-term opportunity with uncertain outcomes, similar to an out-of-the-money call option.

Demand remains strong with margin expansion on good path

The management team highlighted a few key points in the 3Q23 earnings report. The first positive sign is that the company has begun to recover from the negative effects of the pandemic period cohort churn on its overall customer spending, and has even begun to see net customer growth again. Second, a combination of favorable product mix and strong year-over-year comparisons has resulted in strong performance in terms of gross margins and free cash flow generation. Last but not least, it’s intriguing that beta versions of important long-term initiatives featuring sponsored ads have been released earlier than expected.

Despite the fact that I expect growth and margins to slow down in the fourth quarter of 2022, I still view CHWY as the leading player in the pet e-commerce sector, thanks in large part to its expanding private label and pet health businesses. Additionally, CHWY’s management has consistently outperformed estimates in terms of margins in recent quarters, suggesting the company’s long-term profit margin structure may be more robust than anticipated.

Forecast

I believe CHWY has 23% upside. My model, based on consensus estimates, indicates that it is worth $53.11 in FY24. As mentioned above, I believe CHWY will emerge as the leader in this field given its first-mover advantage and the scale it has built. While I have mentioned the headwinds that CHWY might face with regards to margin in the near-term, management has constantly executed well on margins – which I think could be a catalyst for valuation to move up (back to 2x).

Key risks

Failed ventures

The company has expanded into numerous pet-related categories in an effort to improve its value proposition and retain more customers. While I do think this will help win the loyalty of customers, a lack of cross-selling opportunities could hurt revenue growth and margins.

Competition

As was previously mentioned, even though CHWY has grown to be a sizable business (in terms of revenues), it is not immune to competition from firms like AMZN. My prediction is that this will always be a cloud over the stock because of the presence of rivals.

Conclusion

The growth of CHWY is driven by the trend of pet owners turning to online channels for pet products, which I expect to persist in the long term. CHWY’s value proposition is based on its extensive catalog of premium products, flexible and speedy delivery options, and partnerships with business and brand expansion. While the double-digit EBITDA margin remains in question, CHWY’s leadership is dedicated to growth and private label mix and pet health have potential to contribute to margins. However, competition in the pet industry and spending on addressing labor shortages and expanding fulfilment centers are headwinds for CHWY’s margin structure.