It’s been a tough couple of weeks for the major market averages (NYSEARCA:SPY), and Chewy (CHWY) has not been immune from the selling pressure. The online pet-food retailer came into September with a triple-digit year-to-date return, but since then, its share price has since seen a 30% haircut. The good news is that the company just came off a strong Q2 report with double-digit revenue growth, and the correction has not done any material damage to the technical picture yet. The bad news is that the reaction hasn’t been great, suggesting the news was fully priced in, and the bulls will need to step up soon to prevent any technical damage. As long as the bulls can defend the $46.50 level on a weekly close, the bulls will remain in control of the bigger picture.
A couple of weeks ago, I covered Chewy, noting that the stock was priced for perfection at 5.3x sales heading into its Q2 report. While the company reported a massive revenue beat of $60 million, we saw a marginal drop in auto-ship figures. Meanwhile, net sales per active customer came in nearly 3% below consensus at $356. However, this is likely due to the sharp increase in new customers with a lower average spend, which tends to mature over time if they stay with Chewy. Let’s take a closer look at the quarter below:
As we can see from the chart above, which measures total active customers and the percentage of revenue from auto-ship, it’s clear that COVID-19 has been quite a tailwind for Chewy. Chewy was averaging a net increase in active customers of 700,000 per quarter in Q1 2019 through Q4 2019 but saw this figure increase to 1.5 million in Q1 2020, and it accelerated to 16.6 million in Q2 2020. This is more than doubled the pace of the previous sequential net increase in active customers, and it’s helped the total active customer count grow by over 38% year-over-year (16.6 million vs. 12.0 million). This is incredible growth, and it explains why Chewy delivered record revenue of $1.7 billion in the quarter.
If we look at the percentage of revenue from auto-ship, it peaked 70.40% in Q4 2019 and has since slipped 210 basis points to 68.30%. However, when we factor in that most new customers will not immediately apply for auto-ship without first testing out the product & service, this is not an unreasonable drop in auto-ship as a percentage of revenue. Auto-ship as a percentage of revenue is quite important. This is because it’s recurring revenue, is the highest quality sales growth and carries the largest premium as there’s lots of visibility around how each quarter should trend. If the above assumption is correct, we should see auto-ship begin to trend back up following this quarter as new customers have now spent a full quarter with the company to decide if they want to migrate to auto-ship. Therefore, this will be a crucial metric to watch for Chewy investors.
Moving over to quarterly revenues, Chewy managed to grow revenue by an incredible 47% year-over-year, making it one of the top-250 growth stocks on the US market currently. This sales growth rate translated to a 100 basis point acceleration sequentially, and it’s worth noting that Chewy was lapping a tough year-over-year comp of 43%, making the growth even more impressive. If we look ahead to Q3 and Q4 2020, revenue growth rates are expected to drop materially based on estimates but are expected to hit new all-time highs. Q3 revenues are forecasted to grow 40% year-over-year, while Q4 revenues are expected to increase by just 28%. Obviously, revenue estimates are not set in stone. Still, it would be ideal to see some stronger growth rates here, or it won’t be easy to justify a revenue multiple above 5 (where we traded before the September 2nd peak).
If we look at Chewy’s earnings trend above, net losses per share continue to narrow, with FY2020 estimates forecasting a net loss of $0.63 and FY2021 narrowing to $0.46. This trend in earnings suggests that the company is likely on the path to profitability, but the key will be holding onto this new customer base and driving average net spend per active customer higher. Critics are quick to point out that Chewy is not profitable, but very few companies adopting a model similar to Amazon (AMZN) are profitable right away; it often takes a decade or longer. We heard the same critics when Amazon debuted in 1997, poo-pooing the company because it was not generating positive earnings. Jeff Bezos’ plan was securing market share, gaining brand recognition, and worrying about profits later, and it paid off handsomely for Amazon. Therefore, while we don’t have earnings on the table yet, I believe the more important metric to watch is sales growth, which continues to grow at a brisk pace.
So, how’s the valuation and technicals looking after the drop?
If we look at the chart above, we can see that the 4.80+ zone for the price to sales ratio is clearly a brick wall for Chewy as the stock slid 30% after reaching this level earlier this month. Meanwhile, the area with the most margin of safety for buying Chewy is below 2.60x sales, and we continue to trade quite a bit above this level currently. This does not suggest that Chewy has to trade down to 2.60x price to sales before bottoming, but this is where the real low-risk buys would come in for investors looking for a margin of safety. Therefore, if Chewy could head under 3.10x price to sales and closer to this zone, I believe this will finally flip valuation to bullish from neutral currently. Two things could accomplish this: a lower share price, or the stock consolidating to grow into its valuation over a couple of quarters.
The good news for Chewy investors is that the recent decline hasn’t done any material damage to the stock, as Chewy continues to trade above its 7-month moving average (white line). The rally last year saw the stock reclaim this key moving average, and the stock has found immediate support at this level since, and even during the COVID-19 Crash in mid-March. Therefore, while volume has picked up considerably in the recent sell-off and momentum has clearly shifted to the downside, the bulls still have a chance to keep the big picture bullish view intact if they can play defense if this sell-off continues.
If we look at a zoomed-in view of the technical picture, we can see the stock broke its uptrend line off of the March lows, a negative development, and is now hovering just 10% above its first support level at $46.50. Ideally, the bulls will want to play defense here, as this area lines up with the monthly support at $47.00, and the area where valuation would begin to move closer to bullish. However, the issue for Chewy is that we now have strong resistance at $69.00, and I would expect this level to be a brick wall on any rallies. This is because the stock would be back to trading at near 5.0x sales at this level, despite a lower sales growth rate, making it hard to justify this valuation. Therefore, while the bulls remain in control of the big picture, for now, I would be a seller above $69.00.
While the post-earnings reaction has not been kind to Chewy and momentum remains down, the bulls still have a shot at playing defense at the pivotal $46.50 support level if this weakness continues. Even though the company is not yet profitable and certainly saw some weakness in net spend per customer, I believe this was largely to be expected. This is due to the massive increase in new customers who are unlikely to be big spenders right off the bat, which dragged down the weighted average. Therefore, I see no reason to panic-sell Chewy here, but the key is for the bulls to prove they’re in control of the big picture by defending the $46.50-$47.00 level if it’s tested. For now, I remain neutral on the stock.
Disclosure: I am/we are long AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: Taylor Dart is not a Registered Investment Advisor or Financial Planner. This writing is for informational purposes only. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Taylor Dart expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.