Chewy (CHWY +2.04%) is a rapidly growing online pet retailer in the U.S. After launching in 2011, it is expected to total almost $5 billion in net sales in 2019, and it continues to expand at an impressive pace. While some suggest Amazon (AMZN +0.34%) is too powerful to take on in e-commerce, Chewy's success shows that it is possible to compete against the online retail leader. Chewy's strategy has been to focus intently on one specific category, pets, and do it better than everyone else. When it comes to pet supply prices, selection, and service, no one -- not even Amazon -- is doing it better right now. So is Chewy a millionaire-maker stock?
There is no standard definition for the term "millionaire-maker," but fellow Fool Brian Stoffel defined it as well as anyone when he said it was "a stock that can return 10 times its value in 20 years." That works out to a 12.2% average annualized return for 20 years, which is well above the roughly 10% return that the S&P 500 has averaged over the last 90 years. To achieve that sort of superior return, a public company needs at least three things:
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1. A great business with a competitive advantage
First, it needs a great business with a "moat," also known as a sustainable competitive advantage. Online retail can be a great growth business because the cost structure at scale is lower than that of physical retail. It's cheaper to run fulfillment centers and ship products than it is to operate hundreds, if not thousands, of fully staffed retail stores. So at scale, Chewy should be more profitable than physical peers.
Does Chewy have a moat? Yes. While there are few barriers to entry in e-commerce, there are significant barriers to scale, and therefore success. That's especially true in a world where Chewy and Amazon already exist. Why? Anyone can set up a website and store ready-to-ship dog food in their garage. But new entrants today would have to outbid Chewy, Amazon, and others for the best advertising keywords on Alphabet's industry-leading search engine Google to attract customers. It would be impossible for an upstart to do so without first having millions of customers and billions of revenue. And even if they could somehow attract customers, there's no opportunity to undercut Chewy on price -- the company's prices are already rock-bottom and it isn't even profitable yet. A new entrant undercutting Chewy would need deep pockets to compete.
Can Chewy compete with Amazon? It has so far. Chewy is matching Amazon on price and convenience while beating it on selection. And Chewy is really differentiating itself from Amazon with its world-class, personal level of category-specific customer service. The company sends hand-written welcome cards, sympathy cards, and surprises customers with hand-painted pet portraits. The customer service representatives know pets, own pets, and have pets walking around the office. That's how Chewy has taken Amazon's customer service playbook to a whole new level. In short, Chewy has a moat.
2. A large and growing addressable market increasingly moving online
Second, a millionaire-maker needs a huge market opportunity to grow into. The market for the U.S. pet food and supplies business is estimated to be about $48 billion, and it grows about 4% per year. But the portion of that market that's online is still estimated to be less than 20%. Chewy's share of the online market appears close to 50% and is increasing. According to Chewy's CEO, the pet food and supplies market grew by $1.8 billion in 2018 and Chewy was $1.4 billion of that growth. That means Chewy was 78% of the market's growth. Chewy's market share will only increase if that continues.
Over the next 20 years, if the pet food and supplies market grows 4% annually, 60% of it moves online, and Chewy represents 55% of the online piece, then Chewy could have about $35 billion of net sales in that year. That's over seven times the $4.82 billion to $4.84 billion that management forecast for 2019. In addition, there would be further upside if the pharmacy and services segments of the company gain traction. So Chewy clearly has a huge opportunity ahead of it.
3. Secular tailwinds
Third, a millionaire-maker needs to benefit from big picture trends that are likely to last for the long term. Chewy benefits from the "humanization of pets" trend where people are increasingly treating their pets like members of the family. You can see this in rapid growth of premium pet food brands like Blue Buffalo, which was acquired in 2018 by General Mills for a cool $8 billion. You can also see it in the fact that Americans spent an unbelievable $490 million on Halloween costumes for their pets last year. As the one-stop-shop for all things pet related, Chewy stands to ride this trend for the long term.
In summary, I think Chewy's shares could increase 10-fold over 20 years due to its great business, its huge opportunity, and the big picture trend it is riding. And as privately held, majority shareholder PetSmart -- which acquired Chewy a few years ago and took the subsidiary public in June 2019 -- continues to sell down its stake to repay debt, it is increasing the number of Chewy's publicly traded Class A shares available. As more shares become available to trade, Chewy becomes more investable for large institutional investors. That should only help Chewy's valuation over time.
