Chewy Stock: Don’t be afraid to dive (NYSE: CHWY)
Over the past few weeks, the Fed’s blunt stance on rates has chilled markets, particularly in the growth sector where valuations have been held down by the Fed’s dovish policy for years. This led to giant corrections in high-quality stocks, and investors with strong bellies have a chance to recoup them in a temporary decline.
Soft (NYSE: CHWY), in particular, is something I’m watching closely. Even though the company’s business is primarily focused on self-delivery of non-discretionary items (food, pet health care), this online pet supplies titan hasn’t been there. sheltered from tighter macro conditions, and management is citing a slowdown in purchases of durable goods and other discretionary products. purchases. After announcing a slightly disappointing Q2 and slashing its full-year guidance, Chewy shares fell about 8%. Since the beginning of the year, Chewy has lost 40% of its value; and in the past twelve months, losses have exceeded 60%.
The reduction in revenue forecasts is offset by profitability gains
Despite a new bearish noise on this title, I remain fairly bullish on Chewy’s outlook. In particular, I appreciate the fact that Chewy took immediate action to raise the prices of its products. Since so much of Chewy’s business is based on staples like food, these increases apparently didn’t cause a huge loss of sales or customers, and helped Chewy boost its gross margins – a major distinguishing feature for this stock in the current inflationary environment. Overall profit margins are also higher, at a time when many other tech stocks are posting significant declines.
Yes, Chewy has cut its guidance for the year. It now forecasts revenue of $9.9-10.0 billion, representing 11-12% year-on-year growth, down from an earlier forecast of 15-17% growth in year-on-year.
However, two considerations should be taken into account here: first, this drop in forecasts is common for many companies in the second quarter. Second, Chewy actually raised its adjusted EBITDA margin targets at 1.75-2.00%, versus a prior view of 0-1%. In my view, in the current risky market environment, Chewy’s profitability achievements should outweigh the growth disruptions – which are macroeconomic and should be more temporary in nature.
Chewy’s Bullish Thesis Revisited
For investors new to Chewy, here is an overview of my long-term bullish case for the company:
- 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 ~28%, from low 20s at the start of the pandemic. In addition, Chewy’s success in passing on price increases to its customers has enabled it to maintain this gross margin improvement even in the current inflationary environment.
- Emerging opportunities in pet telehealth and pet insurance. 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. In the second quarter, the company is rolling out its comprehensive “CarePlus” pet insurance plan. This is a vast new opportunity for Chewy to both accelerate growth and increase margins.
Now let’s take a closer look at Chewy’s latest Q2 results. Similar to the guidance moves, Chewy’s slight growth disappointments, in my view, are more than offset by the company’s gains in profitability.
Chewy’s revenue rose 13% year on year to $2.43 billion, slightly beating Wall Street expectations of $2.45 billion (+14% year on year). Revenue growth also slowed slightly from 14% year-over-year growth in the first quarter.
As mentioned earlier, however, Chewy noted that non-discretionary spending has held up. Autoship products delivered 17% higher revenue growth year-on-year, and Autoship’s 73% contribution to overall revenue hit an all-time high.
Regarding customer additions, Chewy notes that while additions are lower than in the pandemic, Chewy continues to add more customers than before the pandemic. He also notes that the current headwinds related to discretionary spending are expected to be temporary in nature. According to CEO Sumit Singh’s prepared remarks on the second quarter earnings call:
Moving next to our customers. We ended the quarter with 20.5 million active customers, in line with the expectations we shared on our last call. Our net additions in the second quarter reflect gross customer additions that exceeded their pandemic highs and the retention behavior of the large cohorts we acquired during the pandemic.
The number of raw clients we added in Q2 2022 was an average number higher than their comparable Q2 2019 pre-pandemic cohort, although weaker demand in discretionary categories put some pressure on customer acquisition.
Once we complete the cycle, the effects of high pandemic pet adoptions and the macro environment recover, we believe the customer acquisition headwinds related to discretionary demand levels will subside . Additionally, the retention rates of customers we acquired during the pandemic in 2020 and 2021 are still lower single digits than their comparable pre-pandemic cohorts, which continues to impact total net additions due to the large size of these cohorts.
That said, we are encouraged to see that the skin tone of the new cohorts we have acquired so far in 2022 is more in line with the long-term retention profile of our pre-pandemic cohorts.
Notably, we believe that the dynamics impacting both raw adds and retention are temporary in nature. And it’s important to remember that over the long term, our business model produces incredibly sticky customers, which results in retention curves that level off after the first two years of a customer’s relationship with Chewy.”
The big win this quarter was in gross margins. Chewy increased gross margins 60 basis points year-over-year to 28.1%, and also increased sequentially from 27.5% in the first quarter. This development is explained by successful pricing actions, which more than offset the inflation of raw materials as well as the increase in logistics costs.
Overall Adjusted EBITDA also increased nearly 4x to $83.0 million, representing a whopping 230 bps increase in Adjusted EBITDA margins to 3.4%:
In addition to gross margin gains, Chewy also benefited from greater efficiency in marketing spend as well as the rollout of new automated fulfillment centers. The company’s three automated fulfillment centers contribute 40 to 60 basis points of SG&A efficiency annually, and it plans to continue to open more in the future. Variable costs per unit for units made from these centers are 15% lower. By this time next year, Chewy aims to have one-third of its total outbound volume shipped from these automated fulfillment centers, up from 25% this quarter.
Key points to remember
To me, Chewy is making small “under the hood” tweaks to its business model, including raising prices and improving operating and execution efficiencies, which will benefit the company once the macro-cyclical headwinds will have subsided. Take advantage of the decline here as a buying opportunity.