By Geoffrey Seiler, The Motley Fool,Trades Of The Day, 2024-09-19
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his year has been a rollercoaster ride for Chewy (CHWY). The stock started the year on a downward trajectory after management said that pet industry spending for 2024 would be lower than historical levels.
The stock then got a lift in late May when it reported solid first-quarter sales results. Later in the summer, the stock shot higher when Keith Gill, aka Roaring Kitty on the Wallstreetbets message boards of Reddit, posted a photo of a cartoon dog on his X (formerly Twitter) account and then later revealed a large stake in the company. Gill helped spark the meme-stock run from a few years ago, but had been absent on social media the past three years before returning in May of this year.
The action in Chewy's stock has left it up over 35% on the year, but down about 18% from its late June 27 intraday high when Gill posted the photo of the cartoon dog.
Let's look at three reasons to buy this growth stock while it's still down.
Recurring revenue
Recurring revenue
As an e-commerce firm specializing in pet products, Chewy has been able to create a strong recurring business model that saw 78.4% of its sales last quarter coming from Autoship customers. These customers are also Chewy's most loyal and fastest-growing. While its overall second-quarter sales rose just 2.6%, Autoship sales climbed by 5.8%.
The company has about 20 million active customers, and sales per active customer has also been increasing, growing by 6.2% last quarter. Meanwhile, the company said that last year, approximately 85% of its sales came from non-discretionary items such as pet food and pet health products.
Pet owners continue to spend more on their pets, but a dip in pet household formation following a jump in pet adoptions during the pandemic's height has slowed revenue growth a bit this year. However, pet ownership has been on the rise in the past three decades, and Chewy expects 2025 to return more to normal trends.
Chewy's Autoship model provides a lot of predictability and visibility into future revenue, which is something investors value highly. Both subscription models and non-discretionary sales tend to get higher multiples, and Chewy offers both to investors.
Margin improvement
Margin improvement
Chewy's continued margin improvement will be one of the big drivers for its future, leading to earnings growth nicely outpacing sales growth. This should come from both gross margin improvement and operating expense leverage.
On the gross margin side, Chewy is benefiting from a few things. Taking a page out of Amazon‘s playbook, the company has started using sponsored ads on its site. With gross margins of about 70%, this business carries much higher margins than the overall Chewy business.
In addition, the company has been pushing into the pet pharmacy segment, selling pet medications and offering other health services. This is a much higher-margin business than retail sales, up to 1,000 basis points higher than its retail business. With only about 20% of its customers using Chewy's pharmacy services, this is a potential big revenue and margin driver.
The company has also pushed into private label brands, which at scale carry 700-basis-point higher gross margins than national brands. While private label was in the mid-single-digit sales last year, the company thinks it can reach 15% or more over the long term.
Oh the other hand, Chewy is keeping its operating expenses in check and driving cost and efficiency improvements. The company has a very high fixed cost infrastructure, so as sales rise, it is also seeing nice operating leverage.
The company's efforts in these areas could be seen in its Q2 results. Its Q2 gross margins rose 120 basis points to 29.5% in the quarter. Adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) margins, meanwhile, climbed from 3.2% to 5.1%.
The effect of these margin improvements could be seen in its adjusted EBITDA soaring from $88 million to $145 million. That's a 65% increase on only a 2.6% increase in sales.
Attractive valuation
Attractive valuation
From a valuation perspective, Chewy stock currently trades at a forward price-to-earnings (P/E) ratio of around 26 based on next year's analyst estimates. While that may not seem cheap given its projected 4% to 6% sales growth this year, there are a few things to remember.
The first is that Chewy is expanding margins and showing nice operating leverage, so its profitability metrics, such as earnings and EBITDA, are growing much faster than sales. Meanwhile, companies that tend to have recurring revenue streams or sell non-discretionary items both tend to merit higher valuations, given their resiliency and predictability.
On that front, the company's valuation is below that of Walmart and just above Tractor Supply, two retailers that primarily sell everyday necessities. But Chewy is also growing its earnings more quickly than these two retailers.
Given that, the stock looks like it's trading at an attractive valuation and has more upside ahead as sales and margins continue to improve.
— Geoffrey Seiler
Source: The Motley Fool
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