In June, PetSmart spun pet e-tailer Chewy (NYSE:CHWY) off in an initial public offering (IPO). The coming-out party is now over, and with the fast-money crowd having moved on to the next trade, it's an opportunity for business-focused investors to examine the first and foremost question: Does Chewy have an "economic moat" (i.e., a sustainable competitive advantage)? The vast majority of companies don't, so the "moat test" is a powerful filter.
Why is this question so vital? In September 1999 -- a(nother) period during which start-up companies were being floated at stratospheric valuations -- billionaire investor Warren Buffett told an informal gathering of friends, "The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage."
That central concept is the basis for my five-minute analysis of any company to determine whether it's worth a closer look. (I laid out the rationale and steps of the methodology in more detail here.) Let's apply that analysis to Chewy's offering prospectus, a legal document describing the stock offering and the paperwork that all companies must file with the Securities and Exchange Commission before going public.
Does Chewy's offering prospectus mention "competitive advantage"?
Yes, "competitive advantage" appears a total of seven times, and here is the most informative passage pertaining to Chewy's business (bold in the quote is my emphasis):
We also have been able to compete successfully by differentiating ourselves from our competitors by providing a large selection of high-quality pet food, treats and supplies, competitive pricing, convenience and exceptional customer service. If changes in consumer preferences decrease the competitive advantage attributable to these factors ... our business, financial condition, and results of operations could be materially and adversely affected. In particular, a key component of our business strategy is to rely on our reputation for exceptional customer service.
Chewy claims here to have a competitive advantage, but, at first glance, there is little to support the claim in that paragraph. We can surmise that there are other companies that provide (or are capable of providing) a large selection of high-quality pet products at competitive prices, topped off with convenience.
In fact, let's just acknowledge the gorilla in the room, Amazon.com, which is a standard-setter with regard to all of these factors.
Still, Chewy has very wisely chosen to zero in on customer service as a differentiator. Of all the competitive factors it mentioned above, exceptional customer service is arguably the most difficult to replicate. Why is that? Because providing exceptional customer service requires a customer-focused company culture, and creating such a culture is a challenging and lengthy process (all the more so if one must transform an existing company culture rather than build it from the ground up).
As a result, many, if not most, companies develop haphazard corporate cultures that lack purpose and consistency. All corporate executives pay lip service to their customers, but many companies fail to put the customer at the center of their actions and decision making. Superlative customer service and a corporate culture that demands and enables it are without doubt competitive advantages. If we can find evidence that Chewy possesses these attributes, it has the potential to become a good or great long-term investment.
Beyond the five-minute moat test
At Chewy, it's clear that the customer isn't an afterthought but is instead at the heart of the company's preoccupations. In the offering prospectus, under a heading titled "What sets us apart," the company states (bold in the quote is my emphasis):
We are a passionate group of people who love pets of all breeds, types, shapes, and sizes. We believe that pet parents are attracted to our trusted and convenient offering of high-quality products via our versatile e-commerce platform, and that they continue to shop with us because we offer personalized, high-touch customer service to every customer, every day, and in every interaction.
This is no idle boast, and the evidence for the claim isn't hard to find in the prospectus. For example, the company sends every new customer a handwritten welcome card and sends flowers to customers who have lost a pet. Every week, thousands of customers receive hand-painted portraits of their pets (the portraits can't be ordered -- recipients are selected at random). These gestures are part of what Chewy calls "the WOW experience," according to which "every customer contact [is] an opportunity to delight and surprise."
It's difficult to imagine Amazon -- let alone Walmart -- going to such lengths to support a single category (albeit an attractive one such as the pet industry)!
The evidence of outstanding customer care isn't purely qualitative, either, with customer satisfaction driving enviable economic characteristics. Indeed, Chewy has observed that "[o]ur economic model has demonstrated exceptional retention rates and in fiscal year 2018 our business achieved 120% of sales from our existing customer base from the prior fiscal year."
Chewy: A rare breed
A preliminary investigation suggests that pet e-tailer Chewy does indeed have a competitive advantage in the shape of superlative customer service and a business culture that enables it.
Does this mean you should rush to buy Chewy shares?
Not so fast. Even a great company can turn out to be a disappointing investment if it is purchased at the wrong price. Nevertheless, business quality trumps valuation over the long haul, and Chewy appears to score well on the former, which deserves a spot on a long-term investor's watch list (along with further research).