Over the last few weeks, the Fed’s whiplash stance on rates has put a fresh chill into the markets, especially in the growth sector where valuations have been held up by dovish Fed policy for years. This has led to giant corrections in high-quality stocks, and investors with strong stomachs have a chance to scoop them up in a temporary dip.
Chewy (NYSE:CHWY), in particular, is one stock I have a close eye on. Even though the company’s business is primarily on autoship deliveries for non-discretionary items (food, pet healthcare), this online pet supplies titan has not been immune to tightening macro conditions, and management is citing a slowdown in purchases of hard goods and other elective purchases. After reporting a slightly disappointing Q2 and slashing its guidance for the year, shares of Chewy fell by roughly 8%. Year-to-date, meanwhile, Chewy has lost 40% of its value; and over the trailing twelve months, losses have topped 60%.
Revenue guidance cut is offset by profitability wins
In spite of renewed bearish noise on this stock, I remain quite bullish on Chewy’s prospects. In particular, I appreciate the fact that Chewy took immediate actions to increase pricing on its products. Given that so much of Chewy’s business rests on staples like food, these increases have seemingly not provoked a tremendous loss of sales or customers, and helped Chewy to boost its gross margins – a major distinguisher for this stock in the current inflationary environment. Overall profitability margins are also higher, at a time that many other tech stocks are reporting major declines.
Yes, Chewy cut its guidance for the year. It’s now forecasting $9.9-$10.0 billion in revenue, representing 11-12% y/y growth – lower than a prior view of 15-17% y/y growth.
Two considerations we have to take into account here, however: first, this guidance cut is common across many companies in Q2. Secondly, Chewy actually raised its adjusted EBITDA margin targets to 1.75-2.00%, from a prior view of 0-1%. In my view, in the current risk-off market environment, Chewy’s achievements in profitability should weigh more than disruptions in growth – which are macro-driven and should be more temporary in nature.
The bullish thesis for Chewy, revisited
For investors who are newer to Chewy, here is a look at my long-term bull case for the company:
- Expanding wallet share. A Chewy customer, especially those on Autoship, tend to be very loyal. The company notes that a customer in Year 2 tends to spend $400 per year, $700 in Year 3, and $900 in Year 4. As pet needs and the willingness to spend for pets continues to rise, Chewy is there to capture that growing wallet share.
- Pet ownership is taking off. The trend of “pandemic pets” is still driving increased pet ownership in the U.S., and a lot of those new pet parents skew young and are highly disposed toward convenient online services like Chewy.
- Beloved consumer brand. Chewy has built up quite a lot of brand equity around being a very customer service-oriented company.
- Margin expansion driven by expanding product categories. Chewy’s push to grow its own brand (Tylee’s), plus focus more on selling higher-margin hardgoods, has proven very effective at producing margin expansion for Chewy. Gross margins have recently expanded to ~28%, vs. low-20s at the onset of the pandemic. In addition, Chewy’s success at passing on price increases to its customers has allowed it to preserve this gross margin progress even in the current inflationary environment.
- Nascent opportunities in pet telehealth and pet insurance. The craze in telehealth and doctor consultations via your mobile device is spilling over into the pet world, too. The company’s “Chewy Health” offering has built out a “Connect With A Vet” service, and it also has rolled out a pet pharmacy as well. In Q2, the company is rolling out its full “CarePlus” pet insurance plan. This is a broad, new opportunity for Chewy that can both accelerate its growth and grow its margins.
Let’s now cover Chewy’s latest Q2 results in greater detail. Similar to the guidance moves, Chewy’s slight disappointments in growth, in my view, are more than offset by the company’s wins on profitability.
Chewy’s revenue grew 13% y/y to $2.43 billion, slightly missing Wall Street’s expectations of $2.45 billion (+14% y/y). Revenue growth also slightly decelerated versus 14% y/y growth in Q1.
As mentioned previously, however, Chewy noted that non-discretionary spend held up. Products on auto-ship generated higher 17% y/y revenue growth, and the 73% contribution of autoship to overall revenue hit an all-time high.
On customer adds, Chewy notes that while additions are lower than during the pandemic highs, Chewy is still adding more customers than pre-pandemic. It also notes that current headwinds related to discretionary spend should be temporary in nature. Per CEO Sumit Singh’s prepared remarks on the Q2 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 Q2 net adds reflect gross customer additions that have come off their pandemic highs and the retention behavior of the large cohorts we acquired during the pandemic.
The number of gross customers that we added in Q2 2022 was mid-single-digit percentage points higher than their comparable pre-pandemic cohort from Q2 2019, even as softer demand across discretionary categories put some pressure on customer acquisition.
Once we fully cycle, the effects of elevated pandemic pet adoptions, and the macro environment recovers, we believe the customer acquisition headwinds related to discretionary demand levels will abate. Additionally, retention rates on the customers we acquired during the pandemic in 2020 and 2021 are still running low single-digit percentage points lower than their comparable pre-pandemic cohorts, which continues to affect total net adds due to the large size of these cohorts.
Having said this, we are encouraged to observe that the complexion of the new cohorts that we have acquired so far in 2022 is more consistent with the long-term retention profile of our pre-pandemic cohorts.
Notably, we believe that the dynamics that are impacting both gross adds and retention are temporary in nature. And it is important to remember that over the long term, our business model produces incredibly sticky customers, which result in retention curves that stabilize after the first two years of a customer’s relationship with Chewy.”
The big win this quarter was in gross margins. Chewy expanded gross margins by 60bps y/y to 28.1%, and also increased sequentially versus 27.5% in Q1. This was driven by successful pricing actions, which more than offset raw material inflation as well as higher logistics costs.
Overall adjusted EBITDA also grew by nearly 4x to $83.0 million, representing a huge 230bps boost to adjusted EBITDA margins to 3.4%:
On top of the gross margin gains, Chewy also benefited from greater marketing spend efficiency as well as a rollout of new automated fulfillment centers. The company’s three automated fulfillment centers contribute to 40-60bps of SG&A efficiencies annually, and it has plans to continue opening more in the future. Variable costs per unit for units fulfilled from these centers are 15% lower. By this time next year, Chewy intends to have one-third of its total outbound volume shipped from these automated fulfillment centers, up from 25% this quarter.
To me, Chewy is making smaller “under the hood” adjustments to its business model, including raising prices and improving operating and fulfillment efficiencies, which will benefit the business once cyclical macro headwinds subside. Take advantage of the dip here as a buying opportunity.