Why Chewy’s Stock is a Must-Buy
This year has been turbulent for Chewy (CHWY -1.84%). The stock initially declined after management projected that pet industry spending for 2024 would be lower than historical levels.
In late May, however, the stock received a boost following the release of promising first-quarter sales results. The uptrend continued in the summer when Keith Gill, known as Roaring Kitty on the Wallstreetbets message boards of Reddit, posted a cartoon dog on his X (formerly Twitter) account and later disclosed a significant stake in the company. Gill, who helped instigate the meme-stock surge a few years ago, had been absent from social media for the past three years before making his return in May.
These developments resulted in Chewy’s stock rising by over 35% year-to-date, although it remains about 18% below its peak on June 27, when Gill shared the cartoon dog photo.
Three compelling reasons to consider investing in this growth stock are outlined below.
Recurring Revenue
Chewy, an e-commerce firm specializing in pet products, has benefited from a robust recurring business model. In the last quarter, 78.4% of its sales were from Autoship customers, who are noted for their loyalty and rapid growth rate. While overall second-quarter sales increased by just 2.6%, Autoship sales climbed by 5.8%.
The company boasts approximately 20 million active customers, with sales per active customer rising by 6.2% last quarter. Furthermore, around 85% of last year’s sales were derived from non-discretionary items such as pet food and pet health products.
Despite a slight slowdown in revenue growth due to a dip in pet household formation following a pandemic-driven surge, Chewy anticipates a return to normal growth trends by 2025, as pet ownership has been increasing over the past thirty years.
Chewy’s Autoship model ensures predictability and visibility into future revenue, which is highly valued by investors. Both subscription models and non-discretionary sales are typically awarded higher multiples, and Chewy offers both attributes to its investors.
Margin Improvement
Margin improvement is set to be a significant driver for Chewy’s future, promising earnings growth that exceeds sales growth. This will stem from both gross margin enhancement and operating expense leverage.
Chewy is seeing benefits on the gross margin side by incorporating sponsored ads on its site, drawing inspiration from Amazon. These ads generate gross margins of about 70%, which is significantly higher than the overall business margins.
Additionally, the company is expanding into the pet pharmacy sector, providing pet medications and other health services. This sector offers margins up to 1,000 basis points higher than retail sales. With only about 20% of Chewy’s customers currently using its pharmacy services, there is substantial potential for revenue and margin growth.
The company is also advancing its private label brands, which at scale yield gross margins 700 basis points higher than national brands. Although the private label products accounted for mid-single-digit sales last year, Chewy aims for these products to reach 15% or more of sales over the long term.
In terms of operating expenses, Chewy is maintaining cost controls and improving efficiency. Its high fixed-cost infrastructure means that as sales grow, the company also realizes significant operating leverage.
These efforts were reflected in Chewy’s Q2 results, where gross margins rose by 120 basis points to 29.5%. Adjusted EBITDA margins increased from 3.2% to 5.1%, leading to a 65% rise in adjusted EBITDA from $88 million to $145 million, despite a sales increase of just 2.6%.
Attractive Valuation
From a valuation standpoint, Chewy’s stock trades at a forward price-to-earnings (P/E) ratio of approximately 26 based on next year’s analyst estimates. While this may not appear inexpensive given the projected 4% to 6% sales growth this year, there are important considerations.
First, Chewy is expanding margins and demonstrating strong operating leverage, leading to profitability metrics like earnings and EBITDA growing faster than sales. Companies with recurring revenue streams or those selling non-discretionary items usually command higher valuations due to their resilience and predictability.
Comparatively, Chewy’s valuation is below that of Walmart and just above Tractor Supply, both of which are retailers that primarily deal in everyday necessities. However, Chewy’s earnings growth outpaces these two retailers.
Thus, Chewy’s stock appears to trade at an attractive valuation, suggesting potential for further upside as sales and margins continue to improve.
Disclosure Policy
John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Geoffrey Seiler holds positions in Chewy. The Motley Fool has positions in and recommends Amazon, Chewy, and Walmart. The Motley Fool also recommends Tractor Supply.
