Description

Summary
Chewy(CHWY) is the largest online retailer of pet food and other pet products in the US trading at undeservedly high multiples. The stock has quadrupled in a year due to strong sales growth and widespread market and tech euphoria. The end of COVID pandemic should bring Chewy’s sales growth to a more normal range. As a consequence, Chewy’s share is going to lose roughly a half of its market value.

In light of recent events, shorting doesn’t have quite the same appeal as it used to, does it? Maybe, that's exactly the right time to short than. Anyhow, I had three candidates, all of them from the pet industry and the hardest part was to choose which one to write about: Freshpet, Zooplus or Chewy? Freshpet was written twice on VIC as a short, so it wouldn’t make much sense. It was Zooplus, a slower growing European online pet retailer trading at 0.8 sales or Chewy, significantly faster growing company but trading at much higher sales multiple of 6.4. Incidentally, they both comprise the same share in their respective markets, around 40%. Likewise, they will both experience a slower growth in the forthcoming years. Eventually, a traditional value investor inside me won that battle, so I chose a higher multiple company. But it was a tough call.

Thesis:

Chewy is a $43bn company with TTM revenue of $6.5bn and barely positive FCF. The business includes 3 segments: consumables ( dry and wet pet food, treats, litter, vitamins and cleaning supplies) account for 69% of sales , hardgoods ( pet toys, bedding, cages,...) 16% of sales, and the rest comes from pharmacy segment( prescription drugs and special diet) and shipping fees. As of Q3 Chewy serves 17.8  million active customers(+5.1mn yoy), it makes $363 in net sales per active customer and its gross margin is around 25%. The company provides access to 2000 brands and 60 thousand pet related products. Its subscription purchasing service, Autoship represents 69% of total sales. The company has been growing rapidly since its foundation in 2011 and its revenue growth so far has been the largest driver of stock performance. Chewy's gross margins have been on the rise since 2011 due to scaling, its increasing private label offering and entering into higher margin businesses like pet pharmacy. Chewy was founded by Ryan Cohen and Micheal Day and it was acquired  in 2017 for $3.35bn by Petsmart ( which was previously acquired by PE consortium led by BC Partners). After acquisition, it was ran as independent subsidiary of Petsmart and Cohen was CEO until early 2018. At the time, Chewy held 51% of the US online pet market. Cohen was succeeded by Sumit Singh, a former Amazon executive in charge of Amazon Fresh Worldwide. Under Singh, the company filed for an IPO and went public in June 2019 at $22 per share.

The year 2020 was particularly good to Chewy as was for many e-commerce companies. During lockdown, retail sales largely moved on-line, benefiting pure-play online retailers. Sales increased 46% yoy in the first three quarters of 2020. On the other hand, the stock price increased much more, by huge 264% in a year, clearly an overreaction since the company offered nothing new : neither a revolutionary product nor technology. Nothing that would give Chewy unique market position. There was just the results of COVID19. For a certain period of time, purchase in brick-and-mortar stores faced many obstacles and even now buyers find it still safer to order online . Another reason for so strong sales growth was an explosion of pet adoption during the lockdown due to the feeling of loneliness among people who had to stay in their homes. Pet adoption rates were so high in 2020 that shelters ran out of dogs. This led to increase in demand for pet supplies. In 2020 US pet expenditures increased by around 8%, approx. 300bps higher than its long-term CAGR. Probably two years of growth were compressed in just a few quarters of 2020. As Chewy's CEO said:“A growth curve that was supposed to play out over years has been played out over weeks.”  Last year, the number of customers increased to the level which under normal conditions would be reached only in the forthcoming years, so this will probably lead to  much lower customer acquisition numbers down the road. In the same period, Amazon growth, in the US and abroad, was as high as Chewy's, yet the stock price went through a much smaller appreciation, just 50%. Although there are long-term benefits of COVID pandemic to e-commerce, I believe they are significantly exaggerated by the market in the case of Chewy. In a quarter prior to the pandemic, Chewy was growing 35% yoy, considerably below the growth achieved in earlier years. Last year, as well as the first half of this year are aberrations and things will return to normal rather soon, with disappointing sales growth numbers for the market.

According to Packaged Facts, US pet supplies market( food and supplies) has grown to $58.8bn in 2020, $4.2bn increase over the previous year. By adding Vet care&products sales and other services like boarding, grooming, insurance, pet sitting and walking, the number jumps to $100bn. The online sales represents 27%, or close to $16bn. The online pet segment is dominated by two companies which combined hold 3/4 of the market. Chewy is the online market leader with 41% of the market ( just food and supplies), followed by Amazon holding 36%. They both had strong growth in the last two years, although Amazon growth was somewhat stronger. Having basically duopoly is nearly always a good thing for the profitability of related companies. Usually this kind of markets are not very competitive leading to high margins. Unless one of them is Amazon. Fighting Amazon is way too hard, and it guarantees low margins for the other retailer. Amazon has a big enough war chest to afford it . Over the previous 25 years it showed that it just doesn't care about its own profitability in the short term. It will bleed any competitor, particularly those in industries it finds strategic, rising and big enough to be important to them.Despite having a much wider selection, better customer service and user-friendly web site, Chewy wasn't able to increase its market share vs Amazon. Amazon is catching up fast, breathing down Chewy's neck. It has all the tools to close the gap.

Pet supplies customers are notoriously price sensitive, so they'll go where the lowest price is offered. As a result, Amazon will be the one that actually form the prices in the pet market and others will have to adapt, meaning Chewy's margins will never be able to detach. Launching Pharmacy in 2018 was Chewy's way to increase its margin and so far it was a success story, but I believe that the future is bleak. Selling pet healthcare products is not nearly as lucrative as it used to be. PetMed Express' gross margins are 29%, a considerable fall from 39% margins a decade ago. The decline will continue, as Amazon is moving into the pharmacy business.

Chewy's goal is to build strong customer support with the whole pet ecosystem as it is the only way to fight against general retailers like Amazon. To differentiate from Amazon they started providing several new services. Compounding is a new Chewy's pharmacy service that customizes medications to the specific needs of individual pets. Another service Chewy started to offer is ”Connect with a Vet”, a telehealth service, where licensed veterinarians answer questions and offers advices to pet owners. I believe this service would have many limitations even if Dr. Dollitle would be working for Chewy. Firstly, they are not allowed to give diagnosis or treatment recommendations online. They have to physically check the patient.  And secondly, giving medical advices for pets and charging for it (for Autoship subscribers it's free) has much less sense than to humans via the similar platform since animals can't speak. I believe this service is mostly just the hype to give an illusion they are building a huge moat around their business. It does add some value but it won't change much because it is not enough compelling proposition to customers. Besides Amazon, Chewy's competitors include omni-chanell retailers like Walmart, Petsmart, Petco, Target and Cosco. They were all forced to put more emphasize on their online platforms during the pandemic. Online competition is getting tougher.

The online will continue to take share from brick-and-mortar stores, albeit on a smaller scale than in 2020. That will ensure revenue growth of around 20%, but nowhere near percentages in previous years. Also, increased margins in 2020 shouldn't fool anyone. The online demand was so high that Chewy decreased promotional discounts while advertising and marketing expenses were 220 bps lower in 9 months of 2020 than in the same period of the previous year. That was a one time event. To keep the growth high, Chewy will have to invest money in customer acquisition.

Chewy is not a bad company and doesn't have a bad product. It will exist 10 years from now and it will have a higher revenue. Chewy's problem is that it isn't good enough. It operates in a tough business with a really tough competitor. To justify $43bn valuation it should have built a much stronger brand and platform. It failed to do so ( in its defense, it was not an easy task), and Amazon will now exploit their failings.

It seems that Chewy's insiders are even more pessimistic about the value of the company than I am as they are all selling their shares like crazy for quite some time ( 3 mn shares in the last 12 months). The company's CEO Sunit Singh in particular, who has been selling  all equity rewards he received so far. CFO is doing the same. They were selling shares at $30, $40, $50, so it looks like they never thought this was a good investment opportunity. Interestingly, long-term incentives awards for the management ( 2019 Omnibus Incentive Plan) are structured in such a way that the highest share price hurdle of $38.17 is now vastly exceeded. That speaks for itself.

Why does this opportunity exist?

The market is in a bubble. Euphoria with tech companies has gone to the roof. Some tech stocks like Tesla proved the nay-sayers wrong so the inevitable success of a fast-growing tech company became a prevailing theme in the market. A new generation of investors didn't go through dot.com bubble and they were strongly influenced by fairy tales of Amazon, Google, Facebook, Tesla,....Secondly, Chewy’s sales are growing fast, as well as its gross margin which makes investors believe that this will continue at the same pace in the future.

Risks

Besides the fact that the market can always get even more irrational does my thesis have any other risks? Have I underestimated the fundamentals of the company? Could I be wrong about Chewy's long-term prospects ? Could Chewy build such a moat that will allow it to become very profitable? Or might Chewy become a global online pet supplier? Or even enter some other non-pet markets? These are all  unlikely outcomes but currently priced in.

Valuation

In the year of its acquisition, Chewy's sales were $2.1bn and sales growth was 134% so Petsmart paid 1.6 x 2017 sales or less than 1 x 2018 sales. I believe Chewy shouldn't be valued at more than 2 times next year's sales or $40 per share tops.

Catalyst

Lower sales growth; stagnation or decrease in margins.