Sturdy outcomes ought to imply that Chewy’s inventory won’t fall

This article was written exclusively for Investing.com.

On June 17, 2019, Chewy (NYSE 🙂 went public. The starting price of the public offering was $ 22 per share; Chewy shares ended the first day of trading at $ 33.70. Just under three years later, CHWY closed Wednesday at $ 28.99.

An increase of 32% from the IPO price and a decrease of 14% compared to the closing of the first day are both signs of high volatility. Despite initial optimism, Chewy’s shares actually sold out in the first few months on the market. Then came a new coronavirus pandemic, which promised two incentives for business: an accelerated transition to online sales and millions of pet adoptions.

Stocks also received a third boost: a stock market that is willing to pay almost any price for growth. In less than a year, CHWY has quadrupled, with shares reaching $ 118 early last year. Since that peak, stocks have lost more than three-quarters of their value.

This big sale does not in itself make the shares a CHWY purchase. As I wrote, at the peak the market was clearly overvalued by stocks, perhaps in part because its price-to-earnings ratio seemed so reasonable compared to other developing companies.

But as I explained then, at last month’s lowest level, the market also seemed to be undervaluing stocks. There is still a strong story of growth here. Profit margins remain a key issue, but as long as Chewy continues to take market share, those margins will improve.

Fiscal Q1 last week suggests that these market share gains will continue – which in turn suggests that stock price growth should also continue.

The job stays on track

One of the ironies of the volatility of Chewy shares is that trading performance was fairly consistent. Overall, Chewy realized the potential that investors saw at the time of the IPO.

In fiscal 2019 (fiscal years ending on the Sunday closest to January 31 next year), revenues increased by 40.5%. Growth accelerated to 47.4% the following year, thanks in part to the pandemic. Compared to this difficult comparison, revenue rose 24% in fiscal year 21; Chewy expects growth of 15-17% this year, with sales of more than $ 10 billion.

With overall industry growth ranging from medium to high single digits, Chewy is clearly continuing to expand its market share. That’s enough to dismiss some of the long-standing arguments that companies like Walmart 🙂 (NYSE 🙂 and Amazon.com (NASDAQ 🙂 could undermine Chewy’s e-commerce advantage. Nor does Petsmart – the former owner of Chewy – or Petco (NASDAQ 🙂 seem to have an advantage in terms of its hybrid model in-store and online. (Petco, for example, expects revenue growth of just 7% this year).

The main activity of e-commerce was the main driver. But, as promised by the management, new initiatives continue to drive activities. In particular, sales of Chewy Pharmacy tripled. The “hub” of the company for veterinary practices is gaining more and more adoption. Insurance (offered through a partnership with Trupanion (NASDAQ :)) and telehealth offerings are under development.

Nothing in this story changed in the first quarter. On the contrary, Chewy simply achieved its goals, but the sale of CHWY shares did not even take this into account. Even after strong post-earning growth, the estimate still seems reasonable. The shares are traded about 1.2 times more than this year’s revenue; The IPO estimate reached a multiple value of just under 2x, and CHWY peaked last year at around 6x sales.

It is true that profitability is harder, but Chewy continues to invest in its business and develop its state-of-the-art logistics. Since customers, once trapped, rarely leave the platform, these investments make sense. As revenue continues to grow and costs begin to stagnate, Chewy should have enough money available when management decides to focus on it.

What’s wrong

At least that’s the theory. The Bears – and about 23% of free trade, although only ~ 5% of outstanding shares are sold in the short term – would argue that Chewy is unprofitable and probably never will be. The company expects adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) of only 0-1% of revenue this year.

That’s about $ 100 million at a high level, but Chewy is on track to have stock-based compensation costs (which are excluded from adjusted EBITDA) of roughly the same amount. In other words, considering the dilution from the issue of shares, Chewy’s free cash flow is negative (with capital expenditures expected to be around 2.5% of sales this year).

In the long run, it really comes down to where those profit margins lie. The long-term goal in high single digits means the company could easily generate $ 1 billion in EBITDA a year – and that probably means the stock will double.

It is not guaranteed that the company can reach this level. It is roughly equal to Walmart and Amazon, at least in North America. But the new initiatives offer significantly higher profit margins, and Chewy should be able to take advantage of marketing costs in the future. Some margin expansion is underway, and it’s probably enough for Chewy to at least generate consistent and growing earnings and free cash flow.

In the short run, continued market volatility poses a certain risk. If investors resell growth stocks, it is almost certain that CHWY will withdraw.

But in the long run, it’s worth remembering that in his three years in the public market, Chewy has done what he promised. Revenue has grown, the customer base has expanded, and Chewy has entered markets beyond its core e-commerce offering. Above $ 100, that wasn’t enough to buy the stock. Below $ 30, where the estimate is much more reasonable, should be.

Disclaimer: At the time of writing, Vince Martin had no position in any of the securities mentioned.

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