This article was written exclusively for Investing.com
On June 17, 2019, Chewy (NYSE:CHWY) went public. The initial public offering priced at $22 per share; Chewy stock ended its first day of trading at $33.70. Just under three years later, CHWY closed Wednesday at $28.99.
The 32% gain from the IPO price, and the 14% decline from the first-day close, both obscure highly volatile trading. Despite the initial optimism, Chewy stock actually sold off during its first few months on the market. Then the novel coronavirus pandemic arrived, promising two boosts for the company: both an accelerated shift to e-commerce sales and millions of pet adoptions.
There was a third boost for the stock: an equity market willing to pay almost any price for growth. In less than a year, CHWY quadrupled, with the stock touching $118 early last year. From that high, shares now have lost more than three-quarters of their value.
That big sell-off on its own doesn't make CHWY stock a buy. As I wrote last month, at the highs, the market clearly overvalued the stock, perhaps in part because its price-to-revenue multiple looked so reasonable relative to other growth names.
But as I explained then, at last month's lows the market seemed to be undervaluing the stock as well. There's still a strong growth story here. Profit margins remain a key question, but as long as Chewy continues to take market share those margins will improve.
Fiscal first quarter earnings, last week, suggest those market share gains will continue—which in turn suggests that share price gains should continue as well.
The Business Stays On Track
One of the ironies of the volatility in Chewy stock is that the underlying business performance actually has been rather consistent. For the most part, Chewy has delivered on the potential investors saw at the time of the IPO.
In fiscal 2019 (fiscal years end the Sunday closest to Jan. 31 of the following year), revenue rose 40.5%. Growth accelerated to 47.4% the following year, thanks in part due to the pandemic. Against that tough comparison, revenue increased 24% in FY21; Chewy is guiding for 15% to 17% growth this year, with sales clearing $10 billion.
Given overall industry growth is in the mid-single-digit range at most, Chewy clearly continues to expand its market share. That alone dispels some of the long-running bearish arguments that the likes of Walmart (NYSE:WMT) and Amazon.com (NASDAQ:AMZN) could disrupt Chewy's e-commerce edge. It also shows no sign that Petsmart—Chewy's former owner—or Petco (NASDAQ:WOOF) have an advantage with their hybrid in-store/online model. (Petco, for instance, expects revenue growth of just 7% this year.)
The core e-commerce business has been the main driver. But, as management promised, new initiatives continue to boost the business as well. Most notably, Chewy pharmacy sales have tripled. The company's “hub” for veterinary practices is gaining adoption. On the way are insurance (offered through a partnership with Trupanion (NASDAQ:TRUP) and a telehealth offering.
Nothing about this story changed in Q1. Rather, Chewy simply hit its targets—but the sell-off in CHWY stock wasn't even pricing that in. Even after a solid post-earnings rally, valuation still looks reasonable. Shares trade at about 1.2x this year's revenue; the IPO valuation countenanced a multiple just shy of 2x, and CHWY peaked last year at about 6x sales.
Profitability, admittedly, is more difficult, but Chewy continues to invest behind its business and build out its industry-leading logistics. Given that customers, once captured, rarely leave the platform, those investments make sense. As revenue continues to grow, and expenses start to flat-line, Chewy should have plenty of cash flow once management decides that's where the focus should be.
What Goes Wrong Here
At least, that's the theory. Bears—and about 23% of the float, though only ~5% of shares outstanding, is sold short—would argue that Chewy isn't profitable, and probably won't ever be that profitable. The company is guiding for Adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) of just 0-1% of revenue this year.
That's about $100 million at the high end—but Chewy is on track to have stock-based compensation expense (which is excluded from Adjusted EBITDA) of roughly the same amount. In other words, when accounting for the dilution from that stock issuance, Chewy's free cash flow is negative (with capital expenditures guided to about 2.5% of sales this year).
Long-term, the case here really comes down to where those profit margins fall. Something in the high-single-digit range as a long-term target means the company easily could clear $1 billion in EBITDA annually—and that in turn likely means the stock doubles.
It's not guaranteed the company can get to that level. It's about equal to where Walmart and Amazon operate, at least in North America. But the newer initiatives offer sharply higher profit margins, and Chewy should be able to leverage marketing expenses going forward. Some margin expansion is on the way, and likely enough for Chewy to at least generate consistent, growing, profits and free cash flow.
Near-term, a still-volatile market suggests some risk. If investors again sell off growth stocks, CHWY almost certainly pulls back.
But taking the long view, it's worth reiterating that during its three years on the public market Chewy has done what it's promised to do. Revenue has grown, the user base has expanded, and Chewy has moved into markets beyond its core e-commerce offering. Above $100, that wasn't enough to make the stock a buy. Below $30, where valuation is far more reasonable, it should be.
Disclaimer: As of this writing, Vince Martin has no positions in any securities mentioned.
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