Two days after Chewy (CHWY 1.54%) reported its third-quarter earnings, Sumit Singh and Mario Marte, the CEO and CFO, respectively, presented at two investment conferences in New York and San Francisco. The most interesting takeaway from these events was Marte's discussion of the online pet retailer's future gross margin drivers. Last quarter, gross margin expanded to 23.7% from 19.6% in the same quarter in the prior year, but the e-commerce company appears to have several levers to pull to continue increasing margins over time.
Here are five ways Chewy could see further margin improvement.
1. Mix shift
Chewy makes more profit on reorders from existing customers than it does from a new customer's first order. That's because some orders from first-time customers come with promotional pricing from one-time coupon codes or from the large discount customers get the first time they sign up for the autoship program. In addition, repeat orders from existing customers tend to have larger basket sizes as customers buy more per order from Chewy after a favorable first experience. Chewy's aggressive increase in product assortment has been a huge driver of that. For example, just two years ago, the company had 35,000 stock-keeping units (SKUs) on the site. Today, it has 55,000.
Chewy is rapidly growing its number of active customers -- the number grew 33% last quarter compared to the same quarter in the prior year. But as the company's customer base becomes larger, new customers in any given period make up a smaller percentage of the total than they used to. That means a larger percentage of the orders is coming from higher-margin reorders from existing customers. As that phenomenon continues, it should continue to drive Chewy's gross margin higher.
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2. Hard goods
Chewy's sales of hard goods, like dog beds, toys, leashes, and other non-consumable items, have both higher average sale prices and higher margins than food and other consumables. Not surprisingly, the company has been aggressively expanding its assortment of hard goods on the site. Higher selling prices and higher margins contribute larger dollar profits.
3. Private label
In addition, Chewy's expanding private label line has higher gross margins than the rest of the business, and it's growing quickly. Private label was only 5% of net sales last year, but it grew over 60% last quarter -- much faster than the 40% growth rate of the whole business. That's due to both an 80% increase in private label assortment -- most of which was higher-margin hard goods -- as well as effective merchandising.
Management has said private label should have 8% to 10% higher gross margins than the rest of the business over time, so that should be a meaningful margin driver to the extent it grows to reach management's long-term target of 15% to 30% of net sales.
4. Pharmacy
Similarly, the pharmacy business was the fastest-growing business within Chewy last quarter -- suggesting it grew faster than the over 60% growth rate of the private label line. Management has said pharmacy should have a 3% to 5% higher gross margin than the rest of the business over time. Management hasn't directly said how big this business could be, but it has called pet pharmacy a $15 billion addressable market. For context, the U.S. pet food and supplies business, which Chewy's core business participates in, is a roughly $50 billion addressable market today, so pharmacy seems to nicely expand its sandbox to $65 billion. It is difficult to say how much of the market Chewy could capture, but to the extent it continues to grow faster than the core business, its higher margins will help drive the overall company's margins higher.
5. Services
Finally, Chewy has the potential to launch a series of services to pet owners. This could be an online marketplace or platform of sorts for groomers, dog walkers, pet sitters, and even veterinarians. Admittedly, it's hard to have huge confidence in this because it appears to be only an idea at the moment, but the gross margin on something like this should be very high because it would essentially be part of the company's existing website that connects pet owners with service providers. Chewy would presumably either sell the pet owner leads to service providers, or it would take a cut of the transaction amounts it facilitates. Either way, this would be a very profitable business since there is no physical product cost involved.
