Chewy Threatening An All-Time Low, Don’t Write It Off Yet
2022.05.13 08:26
In February 2021, the high point for the market’s most speculative stocks, Chewy (NYSE:CHWY) stock traded at $118. That price incredibly valued the online pet retailer at a whopping $50 billion.
In retrospect, that valuation looks absolutely foolish. But it was questionable even at the time. PetSmart had acquired Chewy in 2017 in the biggest e-commerce acquisition ever — for just $3.35 billion. Chewy went public two years later at a valuation of less than $9 billion.
Obviously, Chewy had been a huge beneficiary of the novel coronavirus pandemic. E-commerce businesses of all kinds gained market share from closed and/or limited brick-and-mortar rivals. The pandemic even promised faster growth for the industry, owing to skyrocketing adoption rates in 2020.
Still, the rally went too far, as a simple metric shows. But that metric, well understood, also shows why Chewy stock, now, might have some value here.
Chewy Weekly Chart.
At its peak, CHWY stock was valued at nearly 6x its original revenue guidance for fiscal 2021 (ending January 2022). In the market of early 2021, and perhaps even this market, that figure doesn’t sound that high.
But the problem in focusing so intently on price-to-revenue for Chewy stock is that its gross profit margins are not terribly high. In FY21, gross margins were just 26.7%. Below that line, operating expenses are still material, and Chewy continues to see relatively high capital expenditures as it builds out its fulfillment system.
In other words, looking solely at gross profit, CHWY at 6x sales and 27% gross profit margins is equivalent to a software company at 18x sales with 81% gross profit margins. Both stocks trade at about 22x gross profit. Yet, even that comparison fails somewhat, as software companies almost without exception are capital-light. Much of the company’s post-tax profit should turn straight into free cash flow.
Focusing solely on price to revenue for a business like CHWY is a good way to get into trouble. Overall margins simply aren’t that high yet — and won’t ever be that high. Investors got burned by focusing on a “cheap” price-to-revenue multiple last year; now, they’re focusing intently on those margins.
The Margin Problem
Looking to price-to-revenue, CHWY stock now looks like a steal, trading at almost exactly 1x its sales guidance for this year. But, again, it’s margins that matter in this market — and Chewy’s margins aren’t great.
In FY21, Chewy posted an adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) margin of just 0.9%. Free cash flow for the year was $9 million. In FY22, the company is guiding for margins of 0% to 1% — and capital expenditures of 2.5% of net sales.
Given that guidance, Chewy itself expects to return to negative free cash flow this year. And that’s with the help of a projected $170 million in share-based compensation, a real expense which dilutes existing shareholders’ value (though it isn’t reflected in cash flow figures).
The core problem for Chewy stock, particularly in a nervous market, is that the company simply isn’t profitable. And while the company is relatively young — it was founded only in 2011 — it should generate more than $10 billion in sales this year. That kind of revenue should create the scale necessary to consistently turn a profit. It hasn’t yet.
The worry — and the reason why CHWY stock still has a reasonably high short interest — is that Chewy never will be consistently profitable. Zooplus, Chewy’s far older European counterpart, was taken private this year. But its EBITDA margins topped out in 2020 at just 3.5% amid the pandemic, and dropped to 1% — within its historical range — over the first three quarters of 2021.
It’s difficult to ship heavy pet food across a continent, particularly with very little pricing power. The high-volume e-commerce model in general isn’t easy. Amazon.com (NASDAQ:AMZN), the biggest player in the space, saw margins of less than 6% in its North America segment in 2021.
Were Chewy to generate 6% EBITDA margins this year, the stock would trade at about 16x EBITDA. But free cash flow figures would still be rather soft; after taxes and capital expenditures, CHWY still would trade at about 35x free cash flow. The valuation here to some extent incorporates margin improvement going forward.
The Case For CHWY Stock
All told, there are real concerns here. And CHWY stock isn’t a buy simply because it’s fallen 80%, or because it might hit an all-time low in coming sessions.
But there is real promise here as well. Like Amazon, Chewy has built out a best-in-class logistics. And, like Amazon, that structural edge will prove a competitive edge, allowing the company to offer the best prices and the best service. As Amazon’s own history shows, over time that kind of business can scale to at least reasonable profit margins.
Continued top-line growth — Chewy expects revenue to grow 15% to 17% this year — and EBITDA margins of even 5% suggest Chewy’s valuation is at least reasonable looking at the core delivery business. And, of course, the company has other initiatives that can help margins and profits.
Chewy Pharmacy continues to grow; according to the company’s Q4 conference call, revenue in that business has tripled over the last two years. Practice Hub allows veterinarians to sell on Chewy.com, creating a way to partner with pet owners’ most trusted resource, and ending some of the long-running friction between veterinarians (who make money selling prescriptions directly) and online sellers like Chewy.
Chewy is moving into health insurance as well. The $2.3-billion market cap for Trupanion (NASDAQ:TRUP) shows that effort can be material against Chewy’s roughly $10-billion valuation.
To be sure, Chewy was a big winner during the pandemic. But part of the reason the stock gained is that investors believed that customers acquired during that period would stick with the company. Guidance for 15%-plus growth this year shows that’s still the case.
Short-term challenges, like wage inflation and sky-high shipping costs, will moderate. The new initiatives will drive growth. There’s still a pretty clear path for Chewy to double sales to $20 billion over the next five years (about 13% annualized growth), and get free cash flow to $500 million or more.
That should be enough to drive gains from the current $10-billion valuation, with potential upside if the new efforts really hit, or e-commerce margins get closer to those of Amazon or Walmart (NYSE:WMT).
Admittedly, that kind of model doesn’t make CHWY stock compelling just yet. But it shows that assuming the company is doomed simply because current EBITDA is essentially zero is too bearish.
Right now, many investors are panicking; that will change, and the market will again take the long view. When it does, CHWY should at least find a bottom — and, potentially, see a nice rebound.
