Business Strategy and Outlook
The pet care industry is quite attractive, with brand loyalty, sticky purchase habits, pet humanization, and minimal cyclicality representing just a handful of alluring structural features in a $119 billion U.S. market (per Packaged Facts). While a slew of players jockey for upstream (manufacturing) and downstream (retail) market share, Chewy’s service-intensive subscription-driven platform looks poised to capture a disproportionate share of online sales, with the firm building a strong brand around customer service and perceived quality.
Chewy was founded with the intention of outcompeting wide-moat Amazon for online pre-eminence in a category that was rife with inefficiencies and saw only low-single-digit online penetration at the time. By emphasizing the labour-intensive aspects of the business model that its largest competitor intentionally eschewed (building out an army of dedicated customer service representatives whose principal qualification was their love of pets), the firm amassed a loyal customer base, with robust auto ship penetration and strengthening monetization over time, generating net revenue retention of over 100% for each annual cohort. The firm’s 72% auto ship penetration, a subscription-based model that pet consumables lend themselves to particularly nicely, defrays fulfilment cost pressures relative to large peers, given that a high degree of order predictability renders inventory management markedly easier, reducing split shipments.
With a digital native platform, expansion into adjacent sales layers in pet healthcare (filling prescriptions, offering telehealth services, partnering with veterinarians through “Practice Hub,” and offering pet wellness and insurance plans in conjunction with TransUnion), Chewy has been well-positioned to benefit from explosive e-commerce growth in the category–en route to high-40% online market share in 2021, by analyst’s estimates. With the expansion of higher-margin private label product, pet healthcare, and increasingly valuable maturing cohorts, Chewy looks poised to continue its leadership well into the future, in a category with 30% online penetration and no apparent glass ceiling for e-commerce saturation.
Financial Strength
With no long-term debt and $605 million in cash and cash equivalents on the balance sheet at the end of the first quarter of 2022, it is assessed Chewy’s financial position to be strong. The firm also maintains access to a $500 million credit facility with a $300 million extender. Consistent with many high-growth e-commerce names, Chewy has elected to fund its growth entirely with internally generated funds and proceeds from equity issuances, freeing the company from the constraints of debt covenants and the restrictions on corporate actions that those often carry. While it is encouraged for the firm to optimize its capital structure with the addition of leverage longer term (lowering its WACC and expanding its frontier of net present value (NPV) positive projects), it is understandable, management’s reluctant approach given the company’s stage in its life cycle. The firm’s investment priorities strike us as reasonable–investing in expanded fulfilment centre (FC) capabilities, with $20 million in buildout costs adding an incremental $750 million to $1 billion in sales capacity (for automated centres), retrofitting existing traditional FCs, and continuing to invest in platform development and ease of use. Though Chewy’s free cash flow, or FCF, generation (with FCF clocking averaging less than 1% of sales through 2024) doesn’t afford a ton of flexibility, it offers the leeway to make fulfilment centre investments without necessitating a costly capital raise, and should see the firm through the leaner years of profitability during its high-growth phase. As margins (and free cash flow generation) expand over time, it is alleged shareholder returns to find their way onto management’s agenda, with CEO Sumit Singh and company likely to favour share repurchases, in analyst’s view, for the flexibility they offer (given the signalling properties of dividends). Analyst’s forecast anticipates share repurchases as soon as 2024, accelerating through 2031 as Chewy approaches mid-to-high-single-digit operating margins.
Bulls Say’s
- E-commerce penetration should continue to increase in the category, favouring digital native players like Chewy.
- Chewy’s subscription-based model (72% auto ship penetration) should help it retain the bulk of the customers it has added since the onset of COVID-19.
- With two thirds of Chewy’s customer base also boasting Amazon Prime memberships, it is probed that pressure from the e-commerce behemoth could prove less onerous than many expect.
Company Profile
Chewy is the largest e-commerce pet care retailer in the U.S., generating $8.9 billion in 2021 sales across pet food, treats, hard goods, and pharmacy categories. The firm was founded in 2011, acquired by PetSmart in 2017, and tapped public markets as a standalone company in 2019, after spending a couple of years developing under the aegis of the pet superstore chain. The firm generates sales from pet food, treats, over-the-counter medications, medical prescription fulfilment, and hard goods, like crates, leashes, and bowls.
(Source: MorningStar)
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