Chewy: Even With Explosive Growth, The Price Is Unpalatable (NYSE:CHWY)

Editor’s note: Seeking Alpha is proud to welcome Jacob Cordes as a new contributor. It’s easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to SA Premium. Click here to find out more »

Cute playful Welsh Corgi dog playing

piola666/E+ via Getty Images

Chewy (NYSE:CHWY) has all the makings of a Retail Investor darling. It is embracing technology to disrupt a massive stagnant industry, it offers explosive growth at a reasonable price, and its shares recently witnessed a massive rundown due to the knee-jerk reaction from Walmart (WMT) and Target’s (TGT) recent reports. Unfortunately, valuation is never simple and what we are shown on the surface is very misleading. The underlying metrics show why I believe Chewy to be far from an appealing intrinsic value after running a neutral DCF model.

Chewy – The Story of the Valuation

When using a DCF model, drafting a story to go alongside your valuation is critical, especially when approaching young, high-growth firms. Originally, I had a pretty harsh aversion to digging into Chewy. Truth be told, I am one of those rare individuals that doesn’t like animals. But before you cast judgement and leave this article because I am one of the ten people on this planet that don’t like animals, let me tell MY side of the story!

It all started when I was 8 years old… After harassing my parents for months about getting my own puppy and after spending a couple hundred dollars on Tylenol, my mother gave in and purchased the cutest Pomeranian puppy you could imagine. It was my first animal and as any childhood pet owner could probably relate, I was extremely attached. So, you are probably wondering where things went wrong? During summers in my childhood I would spend time on vacation in the Midwest. This left my new beloved puppy into the hands of barbarians… well, not really barbarians in the most traditional sense, but just my Dad who is, let’s say, a little callous in the “old school” sort of Dad way… My Dad decided, under the influence of his Dad-ish “life is about toughness” arrogant philosophy that he would take my new puppy out camping at the nearby lake. This, despite the fact that the puppy did not have his rabies vaccine, check that, ANY vaccinations! You can probably deduce what happened next, me arriving from my vacation suddenly pet-less once again and, to this day, I still haven’t replaced that dog.

Coming back to Chewy, the recent drop in the share price was too great to ignore. Thus, much to my dismay, I simply had to dive in head first to a valuation analysis of the company. When using a DCF with high-growth firms, the levers of the DCF (that is the growth and margin expansion) become the quintessential element. Thus, this section will be broken down into three parts: the revenue growth story, the margin projections, and the loose ends.

Revenue Growth

Net sales numbers from Chewy’s 1Q report indicated a 13.7% Y/Y increase, and the company guides a similar increase for 2Q. Furthermore, Chewy has full-year forward guidance indicating a 15%-17% increase Y/Y, as indicated in its 1Q shareholder letter.

Chewy Forward Guidance FY22

Q1 Shareholder Letter

Such projections don’t seem too far off, but I like to have a clear understanding of macro industry effects that may influence my revenue growth story rather than just “taking the companies word for it”. Therefore, I dug up some important information regarding the Pet Supplies industry. An association called the “American Pet Products Association (APPA)” complies a rather comprehensive guide to Pet Industry Expenditures. In 2021, Pet Expenditures amounted to $123.6 billion, up from $103.6 billion, some of which can be attributed to organic industry growth. Of this amount, about $79.8 billion applies to Chewy; here is how the Pet Expenditure breakdown looked in 2021:

Total Pet Expenditures in 2021 Breakdown

Figure 1 (American Pet Products Association)

The top two lines from the APPA guide in Figure 1 are relevant to Chewy’s net sales. On the other hand, the bottom two lines should be excluded as the company does not have cashflows that involve them (“product sales” is ambiguous, so I let it be). Thus, we can safely assume that Chewy had 11.51% of the total market share of Pet Food, Treats, Supplies, Live Animals & OTC Medicine because net sales for Chewy totaled $8.89 billion, which is 11.14% of $79.8 billion, the TAM (total addressable market). Chewy doesn’t sell live animals either, which means this number is a not a perfect percentage of the TAM. But don’t worry, we will come back to this shortly. With this in mind, let us now look at future industry projections. Grand View Research recently released a “Pet Care Market Size, Share & Trends Analysis Report” detailing forecasts relevant to Chewy. In 2030, they expect the Global Pet Care market to be worth $232.14 billion, good for a CAGR of 5.1%. Most of this growth will be driven by technological advancements like GPS collars, Smart Feeders, and Smart Technologies.

Global Pet Care Market 2030

Figure 2 (Research and markets)

But unfortunately nothing is this easy. As I said above, the TAM numbers from APPA are imperfect because of the overlap from the “Live Animals” inclusion. To make matters worse, the data from Grand View doesn’t publicly disaggregate expenditures the way the APPA did; plus, the data from Grand View Research is global in scope vs. domestic from APPA. This means simply extrapolating the 11.14% number from before and using it here is not a perfect indication of Chewy’s actual market presence. To adjust for this, I am going to assume that Chewy will have something like an 8% market share of their specifics in 2030. This is in the middle of the 5.87% of the total global pet care market the company currently has (according to the data). Again, this is not a perfect number, but it seems to be the closest we can get when discussing TAM so we will use it. With these assumptions, we can draft our revenue growth story:

Chewy Revenue Growth over the next 10 years

Author’s DCF Calculator

Margin Projections

With revenue growth explained, we now must move onto the trickier part of this valuation and the more ambiguous one. Immediately you might be perplexed on how I arrived at a base year margin of 4.42%, much higher than the reported 0-1% by the firm. I learned valuation from Aswath Damodaran who approaches operating margins much in a unique way. We adjust firms’ operating margins by converting the operating leases from pure liabilities into hybrid debt/assets with the assumption that leases will contribute to future growth expansion. This way operating leases are treated as debt rather than a drag on operating income.

Chewy Operating Leases

Author’s DCF Calculator

But the more assiduous task here projecting margins for a firm that has never generated a profit (prior to our adjustments) and that does not have any direct industry comparable (not to be confused with direct competition which I will cover later) due to its nature as a disruptor. We know that Chewy has a measly 26.70% gross margin and spends about 28% of its income on SG&A expenses. But understanding how these margins will shift when they are a one of a kind is a difficult task. Rather than putting myself through the pain Olympics, I am going to estimate that Chewy moves toward a 6% operating margin. This is more in line with firms in similar gross profit dilemmas. Even though Chewy operates as an online retailer, it’s tough to fathom (without the introduction of new less margin-intensive cashflows) the margin exceeding anything greater than 6%. With that said, this valuation can easily be manipulated. If you are following along and want to play the permabull and project some magical ludicrous cashflow similar to the preposterous Tesla taxi service, then by all means, go for it.

ROIC

With the two primary levers now explained, I wanted to take a quick moment to talk about the ROIC of the firm. While Chewy has a very long track record of poor return on invested capital, its most recent quarter boasted a 9.88% ROIC. For the sake of my own sanity I projected that, going forward, the company’s sales to capital ratio would keep on the same pace as it did, because things can get extremely erroneous if you try and mess with this side of things. If you plan on investing in the firm, I implore you to take a deeper fundamental analysis into the functionings of its invested capital as simply taking one quarter as your guide is risky at best for understanding true ROIC performance.

Competition & Risks

But before finishing up the valuation, here’s a quick word on competitive risks and what each competitor specifically means for the final valuations.

Direct competition for Chewy comes by way of the big player pet stores we all know: Petco Health and Wellness Company (WOOF) and Petsmart, the big boxes such as Walmart and Target, and finally, the dark horse in all of this, Amazon (AMZN). It’s worth noting that Amazon has put a relentless focus on the industry as highlighted in a different article on Seeking Alpha by author LD Investments.

Despite direct competition from the biggest companies in the world, I believe in Chewy and its ability to entrench itself in the minds of its consumers. A recent Forbes article mentioned that the company retained 99.7% of its customers in the first quarter and, in its most shareholder letter, cited a 14.9% increase in Net Sales per Active user.

Chewy Net sales per active customer

Active Customers and Net Sales per Active Customers (Q1 Letter to Shareholders)

So while Petco and Petsmart have proved themselves as mainstays and will most likely accumulate a stable growth rate, I side with the customer relationships Chewy has slowly built up coupled with the high growth it provides. The same applies for Walmart and Target, both of which most likely won’t appeal to customers in a Pet-focused capacity the way Chewy can. Most Walmart and Target sales originate with customers already in their stores, unlike for Chewy which sees a bulk of its sales (72.2%) from Autoship, its recurring subscription-like service. Unless Walmart or Target specifically come out and offer unique brands, I am not worried at all by their presence given the customer retention numbers boasted by Chewy. That leaves the scariest competitor of all, Amazon. I believe that Chewy still holds a ton of value in both its prescription food and pharmacy offerings while Amazon does not match such offerings. Furthermore, Chewy has highlighted growing its Pet Healthcare segment as a “strategy” going forward. This strategy focus (along with the development of proprietary brands) should stave off Amazon. Shareholders of Petco should be the ones worried about Amazon, not Chewy.

Chewy Pethealth Strategy

10-K Annual Report

Intrinsic Value Of CHWY

I roped you into this post by stating I would be looking for a tangible intrinsic value, one that is logical and connected to my story. Here are 3 scenarios (including my base case). You can decide which is most tangible and fits your investing style!

Intrinsic Value for Chewy

Base Case (Author’s DCF Calculator)

The CHWY stock is extremely overpriced in my base case. We see the value at just about $12 a share. This is primarily driven by the ambiguous operating margin. I didn’t feel compelled to break down my discount rate and cost of capital projections because the firm has very low leverage, an easily projected beta, and only has one country equity risk premium to worry about, thus its cost of capital is standard.

In the end, I give my base case a confidence score of 3/5 with an overall “conservative” bias throughout. My mild confidence score is primarily driven by the fact that the operating margin assumptions I made were very loose and could easily come in much lower or higher. It is also worth mentioning that the revenue growth numbers derive from projections that could greatly differ from reality.

Now let us move onto an even bleaker picture to try and adjust for a worst case scenario.

Chewy Bear Case

Bear Case (Author’s DCF Calculator)

If we assume my original assumptions that strong revenue growth will continue are wrong, that Chewy would lose market share thanks to increasing competition, or that the underlying research would come in lower than expected during market conditions, we would see the total sales (revenue) dip down to $13.964 billion by the terminal year. In my bear case, I also assume that my rosy margin assumptions don’t come to fruition. Such assumptions result in the CHWY shares being valued at $6-7.

But what if we create a full-fledged bull case? What would it take for the firm to become investable?

Chewy Bull Case Valuation

Bull Case (Author’s DCF Model)

O boy, is this one rough?… But we did it! After several adjustments we end up at $56 per share. That matches with the CHWY stock price in late December 2021 but is still a considerable gap from the $120 realized on February 16, 2021. What did it take to get here? For starters, I had to pump up the growth rate to 25% for the next 3 years. Factoring in a medial decline into the terminal year, this would result in a year 10 revenue of $45 billion. In year 8 (which would be 2030, the same year projected in the pet care market report cited above) that would mean that Chewy has 19% of the TOTAL pet care market in 2030. We also assume that ROIC increases to 19% by the terminal year and that operating margins move to 10%. This results in a nominal FCF.

As you could probably observe from my tone, this seems like an extremely far-fetched fairy tale. It’s almost impossible for Chewy to amass 19% of the total market share no matter how amazing its rapport is with pet owners. Even if you think that the global market estimates are on the low side, we are talking about massive increases for the company to realize such a high revenue projection. That’s before even venturing into operating margin reliability. Ultimately, this route appears to only be fit for those interested in a pure gamble play.

Final Word

In the end, I side with the base case. Even with its resilient growth strategy, it is hard to imagine Chewy escaping tight margin pressure. I advise readers to steer clear of the CHWY stock until we are offered clearer guidance for profitability that is more tangible. Once that time comes, I will revisit the valuation and my general thesis.

I hope you enjoyed my first article and I hope that you got something out of this article that you didn’t previously consider!

Be the first to comment

Leave a Reply

Your email address will not be published.


*